Author: Collins Qian Reviewer: Bob Armacost bc Cost Accounting March 1998 Copyright© 1998 Bain &...

Author: Collins Qian

Reviewer: Bob Armacost

bc

Cost Accounting

March 1998Copyright© 1998 Bain & Company, Inc.

2Cost Accounting

bcBOS

Copyright© 1998 Bain & Company, Inc.

Cost Accounting

•Importance of cost allocation

•Client example

•Definitions

–direct vs. indirect, fixed vs. variable

–breakeven volume

•Exercises

–cost allocation

–breakeven volume

•Key takeaways

Agenda

3Cost Accounting

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Cost Accounting


•Client example

•Definitions


–breakeven volume

•Exercises

–cost allocation

–breakeven volume

•Key takeaways

Agenda

4Cost Accounting

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Cost Accounting

•Which products are profitable?

•What is the breakeven volume by product?

•Which products require cost reduction efforts?

•How should we price our products?

•Which customer segments are most profitable?

It is critical to have accurate and complete cost data to make sound strategic and tactical management decisions.

Why Allocate Costs?

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Cost Accounting

•Historically, only 20% of manufacturing costs were “shared” across product lines. Today, typically 50% of costs are “shared” across products. Shared costs might include rent, freight, and administrative costs.

•For simplicity, accounting tracks costs by function (e.g., materials, salaries, benefits) rather than by the activity devoted to product lines (e.g., maintenance of product A, freight for product B)

•For costs that are not easily assigned to individual product lines, companies normally select the most convenient way to assign them, not necessarily the best way

– for example, companies tend to allocate rent costs based on something that is easy to measure, such as direct labor dollars for each product line. A better allocation method, however, might be the actual space resource demands of each product line

Most companies lack accurate cost data by product.

Why Costs Are Often Not Allocated Correctly

6Cost Accounting

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Cost Accounting


•Client example

•Definitions


–breakeven volume

•Exercises

–cost allocation

–breakeven volume

•Key takeaways

Agenda

7Cost Accounting

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Cost Accounting

Riding mowers Bicycles Walking mowers

$25.0MM

$2.4MM$1.2MM

$0

$5

$10

$15

$20

$25

$30

Pre

tax

Ope

ratin

g P

rofit

(M

illio

ns

of D

olla

rs)

Middle America Manufacturing, a Bain client, believed that all three of its product lines were profitable.

Return on sales: 10.0% 2.4% 1.6%Sales: $250MM $100MM $75MM

Middle America Manufacturing - Estimated Profitability

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Cost Accounting

Walking mowers

Bicycles

Riding mowers

Walking mowers

Bicycles

Riding mowers

Original allocation Revised allocation

$8.0MM $8.0MM

$0

$2

$4

$6

$8

$10

Cos

t (M

illio

ns o

f Dol

lars

)

After a thorough evaluation, the Bain team found that $8.0MM in costs had been allocated incorrectly among the three products.

Middle America Manufacturing - Cost Allocation

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Cost Accounting

Generaladministative expenses

Systems costs

Inventory carrying costs

Walking mowers

Bicycles

Riding mowers

Additional unallocated costs Additional costs reallocated

$18.8MM $18.8MM

$0

$5

$10

$15

$20

Cos

t (M

illio

ns o

f Dol

lars

)

The Bain team also determined that an additional $18.8MM in costs should be allocated to the three products.

Middle America Manufacturing - Additional Costs

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Cost Accounting

Riding mowers Bicycles Walking mowers

$18.0MM

($3.0MM)

($5.2MM)

($10)

($5)

$0

$5

$10

$15

$20

Pro

duc

t Lin

e P

rofit

abi

lity

(Mill

ion

s of

Dol

lars

)

Bain’s analysis indicated that both bicycles and walking mowers were unprofitable. Middle America then began to investigate whether to exit or fix these two businesses.

Return on sales: 7.2% (3.0%) (6.9%)Sales: $250MM $100MM $75MM

Middle America Manufacturing - Actual Profitability

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Cost Accounting


•Client example

•Definitions


–breakeven volume

•Exercises

–cost allocation

–breakeven volume

•Key takeaways

Agenda

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Cost Accounting

Definitions: • Costs that do not vary directly with changes in output

• Costs that vary directly with changes in output

• Costs incurred directly in the production or delivery of a firm’s product or service. These costs can easily be identified with, or assigned to, a particular product

• Costs generally incurred by the firm outside of the production process. These costs cannot easily be identified with, or assigned to, a particular product

All costs can be broken down along two dimensions.

Fixed Variable Direct Indirectvs. vs.

Examples: • Equipment depreciation

• Rent

• Advertising

• Raw materials

• Production labor

• Delivery costs

• Direct labor

• Dedicated equipment

• Raw materials

• SG&A

• Office supplies

• Plant manager

Rule of thumb:

If a particular cost changes when production increases or decreases,

the cost is variable.

If a particular cost “goes away” when a product is dropped from

the product line, the cost is direct.

Types of Costs

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Cost Accounting

• All costs are variable over a very long time horizon (i.e., for very large increases in volume)

– Costs to run and maintain a computer system that tracks product orders are clearly fixed for a small change in volume, such as that associated with a slightly busy month. However, they are variable for a large change in volume, such as that associated with a new plant.

• Most costs are semi-variable (i.e., they tend to be added in lumps as volume increases)

– Supervisory labor tends to be considered fixed because it is unlikely that additional supervisors would have to be added to handle a small increase, say 10%, in volume. But the workforce can only increase so much before an additional supervisor is needed.

– In theory, production labor is variable. However, in many client situations, restraints placed by unions and difficulty in hiring and firing people in response to short-term volume fluctuations make it, in practice, semi-variable.

Defining the appropriate time horizon for the analysis is important.

A meaningful analysis will isolate the fixed cost and variable components of a particular cost

Fixed vs. Variable

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Cost Accounting

The following is an illustration of cost behavior for fixed, semi-variable, and variable costs:

Cos

t (D

olla

rs)

Volume (Units)

Variable costs

Semi-variable costs

Fixed costs

Fixed vs. Variable - Illustration

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Cost Accounting

It is useful to know the following terms when doing cost analysis:

Simplified income statement:

- Variable Cost

Gross Margin

- Fixed Cost

Operating Margin

Revenue = Price per Unit x Volume

Gross margin is also called “Gross Profit,” or “Contribution Margin”

Operating Margin is also called “Operating Profit”

Revenue

Income Statement Terms

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Cost Accounting

Breakeven volume is the volume at which the company covers its fixed costs. At breakeven volume, the operating profit is zero.

Volume

Contribution margin (i.e., revenue less variable costs)

Fixed costs

Breakeven volume

$

Operating Loss

Fixed costsUnit contribution Price per unit - Variable cost per unit

Breakeven volume =Fixed costs

=

Operating Profit

Con

trib

utio

n M

argi

n

Breakeven Volume

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Cost Accounting

Operating Profit = Revenue - Costs

= Revenue - Variable Costs - Fixed costs

= (Price per unit x Volume) - (Variable cost per unit x Volume) - Fixed costs

= Volume x (Price per unit - Variable cost per unit) - Fixed costs

= Volume x Unit contribution - Fixed costs

The breakeven volume is the volume for which operating profit = 0

0 = Breakeven volume x Unit contribution - Fixed costs

Fixed costsUnit contribution Price per unit - Variable cost per unit

Breakeven volume =Fixed costs

=

Backup for Breakeven Formula

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Cost Accounting


•Client example

•Definitions


–breakeven volume

•Exercises

–cost allocation

–breakeven volume

•Key takeaways

Agenda

19Cost Accounting

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Cost Accounting

•All products are made using the same equipment and machinery

•Plant supervisors oversee production of all three products

•Equipment capacity exists to increase production by 50%

•Sales people sell all three products

•Sales people are paid a base salary, plus a commission which is a percentage of the selling price

•Most advertising is product specific

•The company uses a trucking company to deliver products to customers (costs are based on the length of trip and weight)

Maple Leaf Company wants to allocate costs to the three products it makes and sells.

Cost Allocation Exercise - Background

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Cost Accounting

How would you characterize the following costs over a time horizon in which the company plans to increase sales volume by 10%?

Fixed Variable

Direct

Indirect

•CEO’s salary

•Raw materials

•Supervisory labor

•Production floor labor

•Rent

•Equipment depreciation

•Office supplies

•Freight to customer

•Electricity to run machines

• Interest expense to finance inventory

•Advertising

•Goodwill amortization

•Sales commissions

•Sales peoples’ salaries

•Sales travel and expenses

Costs:

Cost Allocation Exercise - Question

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Cost Accounting

Cost Allocation Exercise - Answer

Most costs are fixed indirect or variable direct.

Fixed Variable

Direct

Indirect

•Advertising •Raw materials

•Production floor labor

•Freight to customer

• Interest expense to finance inventory

•Sales commissions

•Equipment depreciation•CEO’s salary•Supervisory labor•Rent•Office supplies•Goodwill amortization•Sales people's salaries•Sales travel and expenses

•Electricity to run machines

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Cost Accounting

Cost Components Fixed vs. Variable Direct vs. Indirect

Advertising Fixed, because advertising is usually not tied directly to volume

Direct, because, in this case, most of it is product specific

Equipment depreciation Fixed, because excess capacity exists for a 10% increase in volume

Indirect, because all products are made on the same machines

CEO’s salary Fixed, assuming his/her salary does not change with 10% sales increase

Indirect, because CEO oversees the whole company

Supervisory labor Fixed, because it is unlikely that additional supervisors will be needed to handle a 10% increase in volume

Indirect, because supervisors oversee production of all three products

Indirect, because all three products are produced at the same site

Rent Fixed, assuming current facility has excess capacity

Cost Allocation Exercise - Detailed Answer (1 of 3)

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Cost Accounting

Cost Components Fixed vs. Variable Direct vs. Indirect

Office supplies Fixed, because it is unlikely that additional office supplies will be needed to handle 10% increase in volume

Indirect, because the office supplies are used to support all three products

Goodwill amortization Fixed, because goodwill is not directly related to volume

Indirect, assuming the goodwill is incurred to support the whole company

Salespeople's salaries Fixed, assuming that current sales force can handle 10% additional volume

Indirect, because each salesman sells all three products

Sales travel and expenses Fixed, assuming that 10% volume increase will not require significant increase in sales activities

Indirect, because sales-force handles all three products

Raw material Variable, because a 10% increase in volume would require 10% more raw materials

Direct, because raw materials are directly traceable to individual products


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Cost Accounting

Cost Components Fixed vs. Variable Direct vs. IndirectDirect, because even though the products are made on the same machine, the hours spent working on each of the products are directly traceable

Production floor labor Variable, because more production labor will be needed to handle the increase in volume

Freight to customers Variable, because the freight cost clearly increases with the volume increase

Direct, because weight and distance can be directly traced to individual products

Interest expense to finance inventory

Variable, because more inventory means more inventory financing and hence more interest expense

Direct, because inventory is product specific

Sales commissions Variable, because sales commissions are paid based on a percentage of sales

Direct, because commissions are based on individual product sales

Electricity to run machines Variable, because it clearly varies with volume

Indirect, because all products are made on the same machines


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Cost Accounting

•Labor– In many client situations, restraints placed by unions and difficulty in hiring and

firing people in response to short term volume fluctuations make a portion of labor costs behave as fixed costs

•Electricity to run machines– In theory this is direct, but in practice it is considered indirect because it is

difficult to trace electricity cost to products– Also, the 80/20 rule applies here. Electricity is usually a small cost item, and,

for simplicity, could be allocated using machine hours spent on production

•Advertising– Usually, advertising is not tied to volume. For example, advertising to support a

corporate brand is not tied to the volume of the products under that brand. If advertising is not tied to volume, it is fixed and indirect.

There are few caveats:

Cost Allocation Exercise - Caveats

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Cost Accounting

A dean of a business school is considering starting an executive program. She estimates the revenues and costs as follows:

Question: How many students does the program need to break even?

Costs:

Revenue:

Advertising

Classroom rental

(Each classroom can accommodate 15 students)

Program administration

Program director’s salary

Faculty salaries

(The program will be staffed with 1 faculty member for every 5 students)

Guest lecturer

Room and board per student

Text and supplies per student

Tuition per student

$3,000

$13,500

$500

$30,000 per classroom

$15,000

$20,000

$20,000 per faculty member

$12,000

$3,200

Breakeven Exercise - Background

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Cost Accounting

Step 1: Categorize costs

Advertising

Classroom rental

Program administration

Program director’s salary

Faculty salaries

Guest lectures

Room and board per student

Text and supplies per student

Fixed Variable

Step 2: Calculate fixed costs

Fixed costs: $3,000 Advertising

$15,000 Program administration

$20,000 Program director’s salary

$12,000 Guest lectures

$50,000

Semi-Variable

First, you must categorize costs and calculate fixed costs.Breakeven Exercise - Answer (1 of 3)

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Cost Accounting

Step 4: Calculate unit contribution

Unit contribution = Price per unit - Variable cost per unit

= $13,500 tuition

- 3,200 room and board

- 500 text and supplies

$9,800

Step 3: Calculate semi-variable costs

Classroom Faculty

10 students $30,000 $40,000

15 students $30,000 $60,000

20 students $60,000 $80,000

Then you must calculate semi-variable costs and the unit contribution.

Breakeven Exercise - Answer (2 of 3)

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Cost Accounting

*The most effective way to calculate the breakeven volume is to write a simple formula in Excel

Step 5: Calculate breakeven volume

Breakeven volume =

For 10 students:

= 12.2 students with 10 students the program does not

If you keep increasing the number of students by one and redoing the calculation*, you will find that the business school needs to have 15 students to break even on the executive program

Fixed costsUnit contribution

$140,000

$9,800

Now you are ready calculate the breakeven volume.

For 15 students:

$120,000

$9,800

= 14.3 students

break even

Breakeven Exercise - Answer (3 of 3)

30Cost Accounting

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Cost Accounting


•Client example

•Definitions


–breakeven volume

•Exercises

–cost allocation

–breakeven volume

•Key takeaways

Agenda

31Cost Accounting

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Cost Accounting

• A company must know the total cost associated with the production and delivery of its good and services in order to make the right strategic and tactical decisions

• Most companies lack accurate cost data by product

• All costs can be broken down along two dimensions: fixed versus variable and direct versus indirect

• Defining the appropriate time horizon for costs is important because fixed costs are “fixed” only for a certain time frame

• Breakeven volume is the minimum amount of product that a company must sell in order to cover its fixed costs. At breakeven volume, the company’s operating profit is zero

Breakeven volume = Fixed costsUnit contribution

=Fixed costs

Price per unit - Variable cost per unit

Breakeven Volume

Cost Allocation Overview

Types of Costs

Key Takeaways

32Cost Accounting

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Cost Accounting

Definitions: • Costs that do not vary directly with changes in output

• Costs that vary directly with changes in output

• Costs incurred directly in the production or delivery of a firm’s product or service. These costs can easily be identified with, or assigned to, a particular product

• Costs generally incurred by the firm outside of the production process. These costs cannot easily be identified with, or assigned to, a particular product

Fixed Variable Direct Indirectvs. vs.

Examples: • Equipment depreciation

• Rent

• Advertising

• Raw materials

• Production labor

• Delivery costs

• Direct labor

• Dedicated equipment

• Raw materials

• SG&A

• Office supplies

• Plant manager

Rule of thumb:

Types of Costs

Cos

t (D

olla

rs)

Volume (Units)

Variable costs

Semi-variable costs

Fixed costs

Fixed vs. Semi-Variable vs. Variable Costs

Volume

Contribution margin (i.e., revenue less variable costs)

Fixed costs

Breakeven volume

$

Operating profit

Breakeven volume = Fixed costs Fixed costsUnit contribution Price per unit - Variable cost per unit

Breakeven Volume

Fixed Variable

Direct

Indirect

Cost Categorization Matrix

Co n

t rib

u tio

n M

a rg i

n

Operating loss

=

If a particular cost changes when production increases or decreases, the cost is variable.

If a particular cost “goes away” when a product is dropped from the product line, the cost is direct.

Takeaway Slides

Author: Collins Qian Reviewer: Bob Armacost bc Cost Accounting March 1998 Copyright© 1998 Bain &...

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Transcript of Author: Collins Qian Reviewer: Bob Armacost bc Cost Accounting March 1998 Copyright© 1998 Bain &...