author:collinsqianreviewer:bobarmacost

bccostaccountingmarch1998copyright?1998bain&company,inc.1cu7030298imb

importanceofcostallocationclientexampledefinitionsdirectvs.indirect,fixedvs.variablebreakevenvolumeexercisescostallocationbreakevenvolumekeytakeawaysagenda2cu7122397eca

importanceofcostallocationclientexampledefinitionsdirectvs.indirect,fixedvs.variablebreakevenvolumeexercisescostallocationbreakevenvolumekeytakeawaysagenda3cu7122397eca

whichproductsareprofitable?whatisthebreakevenvolumebyproduct?whichproductsrequirecostreductionefforts?howshouldwepriceourproducts?whichcustomersegmentsaremostprofitable?itiscriticaltohaveaccurateandcompletecostdatatomakesoundstrategicandtacticalmanagementdecisions.whyallocatecosts?4cu7122397eca

historically,only20%ofmanufacturingcostswere“shared”acrossproductlines.today,typically50%ofcostsare“shared”acrossproducts.sharedcostsmightincluderent,freight,andadministrativecosts.forsimplicity,accountingtrackscostsbyfunction(e.g.,materials,salaries,benefits)ratherthanbytheactivitydevotedtoproductlines(e.g.,maintenanceofproducta,freightforproductb)forcoststhatarenoteasilyassignedtoindividualproductlines,companiesnormallyselectthemostconvenientwaytoassignthem,notnecessarilythebestwayforexample,companiestendtoallocaterentcostsbasedonsomethingthatiseasytomeasure,suchasdirectlabordollarsforeachproductline.abetterallocationmethod,however,mightbetheactualspaceresourcedemandsofeachproductlinemostcompanieslackaccuratecostdatabyproduct.whycostsareoftennotallocatedcorrectly5cu7122397eca

importanceofcostallocationclientexampledefinitionsdirectvs.indirect,fixedvs.variablebreakevenvolumeexercisescostallocationbreakevenvolumekeytakeawaysagenda6cu7122397eca

middleamericamanufacturing,abainclient,believedthatallthreeofitsproductlineswereprofitable.returnonsales:10.0%2.4%1.6%sales:$250mm$100mm$75mmmiddleamericamanufacturing-estimatedprofitability7cu7122397eca

afterathoroughevaluation,thebainteamfoundthat$8.0mmincostshadbeenallocatedincorrectlyamongthethreeproducts.middleamericamanufacturing-costallocation8cu7122397eca

thebainteamalsodeterminedthatanadditional$18.8mmincostsshouldbeallocatedtothethreeproducts.middleamericamanufacturing-additionalcosts9cu7122397eca

bain’sanalysisindicatedthatbothbicyclesandwalkingmowerswereunprofitable.middleamericathenbegantoinvestigatewhethertoexitorfixthesetwobusinesses.returnonsales:7.2%(3.0%)(6.9%)sales:$250mm$100mm$75mmmiddleamericamanufacturing-actualprofitability10cu7122397eca

importanceofcostallocationclientexampledefinitionsdirectvs.indirect,fixedvs.variablebreakevenvolumeexercisescostallocationbreakevenvolumekeytakeawaysagenda11cu7122397eca

definitions:coststhatdonotvarydirectlywithchangesinoutputcoststhatvarydirectlywithchangesinoutputcostsincurreddirectlyintheproductionordeliveryofafirm’sproductorservice.thesecostscaneasilybeidentifiedwith,orassignedto,aparticularproductcostsgenerallyincurredbythefirmoutsideoftheproductionprocess.thesecostscannoteasilybeidentifiedwith,orassignedto,aparticularproductallcostscanbebrokendownalongtwodimensions.fixedvariabledirectindirectvs.vs.examples:equipmentdepreciationrentadvertisingrawmaterialsproductionlabordeliverycostsdirectlabordedicatedequipmentrawmaterialssg&aofficesuppliesplantmanagerruleofthumb:ifaparticularcostchangeswhenproductionincreasesordecreases,thecostisvariable.ifaparticularcost“goesaway”whenaproductisdroppedfromtheproductline,thecostisdirect.typesofcosts12cu7122397eca

allcostsarevariableoveraverylongtimehorizon(i.e.,forverylargeincreasesinvolume)coststorunandmaintainacomputersystemthattracksproductordersareclearlyfixedforasmallchangeinvolume,suchasthatassociatedwithaslightlybusymonth.however,theyarevariableforalargechangeinvolume,suchasthatassociatedwithanewplant.mostcostsaresemi-variable(i.e.,theytendtobeaddedinlumpsasvolumeincreases)supervisorylabortendstobeconsideredfixedbecauseitisunlikelythatadditionalsupervisorswouldhavetobeaddedtohandleasmallincrease,say10%,involume.buttheworkforcecanonlyincreasesomuchbeforeanadditionalsupervisorisneeded.intheory,productionlaborisvariable.however,inmanyclientsituations,restraintsplacedbyunionsanddifficultyinhiringandfiringpeopleinresponsetoshort-termvolumefluctuationsmakeit,inpractice,semi-variable.definingtheappropriatetimehorizonfortheanalysisisimportant.ameaningfulanalysiswillisolatethefixedcostandvariablecomponentsofaparticularcostfixedvs.variable13cu7122397eca

thefollowingisanillustrationofcostbehaviorforfixed,semi-variable,andvariablecosts:cost(dollars)volume(units)variablecostssemi-variablecostsfixedcostsfixedvs.variable-illustration14cu7122397eca

itisusefultoknowthefollowingtermswhendoingcostanalysis:simplifiedincomestatement:-variablecost

grossmargin-fixedcost

operatingmarginrevenue=priceperunitxvolumegrossmarginisalsocalled“grossprofit,”or“contributionmargin”operatingmarginisalsocalled“operatingprofit”

revenueincomestatementterms15cu7122397eca

breakevenvolumeisthevolumeatwhichthecompanycoversitsfixedcosts.atbreakevenvolume,theoperatingprofitiszero.volumecontributionmargin(i.e.,revenuelessvariablecosts)fixedcostsbreakevenvolume$operating

lossfixedcostsunitcontributionpriceperunit-variablecostperunitbreakevenvolume=fixedcosts=operating

profitcontributionmarginbreakevenvolume16cu7122397eca

operatingprofit=revenue-costs = revenue-variablecosts-fixedcosts = (priceperunitxvolume)-(variablecostperunitxvolume)-fixedcosts = volumex(priceperunit-variablecostperunit)-fixedcosts = volumexunitcontribution-fixedcoststhebreakevenvolumeisthevolumeforwhichoperatingprofit=0 0 = breakevenvolumexunitcontribution-fixedcostsfixedcostsunitcontributionpriceperunit-variablecostperunitbreakevenvolume=fixedcosts=backupforbreakevenformula17cu7122397eca

importanceofcostallocationclientexampledefinitionsdirectvs.indirect,fixedvs.variablebreakevenvolumeexercisescostallocationbreakevenvolumekeytakeawaysagenda18cu7122397eca

allproductsaremadeusingthesameequipmentandmachineryplantsupervisorsoverseeproductionofallthreeproductsequipmentcapacityexiststoincreaseproductionby50%salespeoplesellallthreeproductssalespeoplearepaidabasesalary,plusacommissionwhichisapercentageofthesellingpricemostadvertisingisproductspecificthecompanyusesatruckingcompanytodeliverproductstocustomers(costsarebasedonthelengthoftripandweight)mapleleafcompanywantstoallocatecoststothethreeproductsitmakesandsells.costallocationexercise-background19cu7122397eca

howwouldyoucharacterizethefollowingcostsoveratimehorizoninwhichthecompanyplanstoincreasesalesvolumeby10%?fixedvariabledirectindirectceo’ssalaryrawmaterialssupervisorylaborproductionfloorlaborrentequipmentdepreciationofficesuppliesfreighttocustomerelectricitytorunmachinesinterestexpensetofinanceinventoryadvertisinggoodwillamortizationsalescommissionssalespeoples’salariessalestravelandexpensescosts:costallocationexercise-question20cu7122397ecacostallocationexercise-answer

mostcostsarefixedindirectorvariabledirect.fixedvariabledirectindirectadvertisingrawmaterialsproductionfloorlaborfreighttocustomerinterestexpensetofinanceinventorysalescommissionsequipmentdepreciationceo’ssalarysupervisorylaborrentofficesuppliesgoodwillamortizationsalespeople'ssalariessalestravelandexpenseselectricitytorunmachines21cu7122397eca

costcomponentsfixedvs.variabledirectvs.indirectadvertisingfixed,becauseadvertisingisusuallynottieddirectlytovolumedirect,because,inthiscase,mostofitisproductspecificequipmentdepreciationfixed,becauseexcesscapacityexistsfora10%increaseinvolumeindirect,becauseallproductsaremadeonthesamemachinesceo’ssalaryfixed,assuminghis/hersalarydoesnotchangewith10%salesincreaseindirect,becauseceooverseesthewholecompanysupervisorylaborfixed,becauseitisunlikelythatadditionalsupervisorswillbeneededtohandlea10%increaseinvolumeindirect,becausesupervisorsoverseeproductionofallthreeproductsindirect,becauseallthreeproductsareproducedatthesamesiterentfixed,assumingcurrentfacilityhasexcesscapacitycostallocationexercise-detailedanswer(1of3)22cu7122397eca

costcomponentsfixedvs.variabledirectvs.indirectofficesuppliesfixed,becauseitisunlikelythatadditionalofficesupplieswillbeneededtohandle10%increaseinvolumeindirect,becausetheofficesuppliesareusedtosupportallthreeproductsgoodwillamortizationfixed,becausegoodwillisnotdirectlyrelatedtovolumeindirect,assumingthegoodwillisincurredtosupportthewholecompanysalespeople'ssalariesfixed,assumingthatcurrentsalesforcecanhandle10%additionalvolumeindirect,becauseeachsalesmansellsallthreeproductssalestravelandexpensesfixed,assumingthat10%volumeincreasewillnotrequiresignificantincreaseinsalesactivitiesindirect,becausesales-forcehandlesallthreeproductsrawmaterialvariable,becausea10%increaseinvolumewouldrequire10%morerawmaterialsdirect,becauserawmaterialsaredirectlytraceabletoindividualproductscostallocationexercise-detailedanswer(2of3)23cu7122397eca

costcomponentsfixedvs.variabledirectvs.indirectdirect,becauseeventhoughtheproductsaremadeonthesamemachine,thehoursspentworkingoneachoftheproductsaredirectlytraceableproductionfloorlaborvariable,becausemoreproductionlaborwillbeneededtohandletheincreaseinvolumefreighttocustomersvariable,becausethefreightcostclearlyincreaseswiththevolumeincreasedirect,becauseweightanddistancecanbedirectlytracedtoindividualproductsinterestexpensetofinanceinventoryvariable,becausemoreinventorymeansmoreinventoryfinancingandhencemoreinterestexpensedirect,becauseinventoryisproductspecificsalescommissionsvariable,becausesalescommissionsarepaidbasedonapercentageofsalesdirect,becausecommissionsarebasedonindividualproductsaleselectricitytorunmachinesvariable,becauseitclearlyvarieswithvolumeindirect,becauseallproductsaremadeonthesamemachinescostallocationexercise-detailedanswer(3of3)24cu7122397eca

laborinmanyclientsituations,restraintsplacedbyunionsanddifficultyinhiringandfiringpeopleinresponsetoshorttermvolumefluctuationsmakeaportionoflaborcostsbehaveasfixedcostselectricitytorunmachinesintheorythisisdirect,butinpracticeitisconsideredindirectbecauseitisdifficulttotraceelectricitycosttoproductsalso,the80/20ruleapplieshere.electricityisusuallyasmallcostitem,and,forsimplicity,couldbeallocatedusingmachinehoursspentonproductionadvertisingusually,advertisingisnottiedtovolume.forexample,advertisingtosupportacorporatebrandisnottiedtothevolumeoftheproductsunderthatbrand.ifadvertisingisnottiedtovolume,itisfixedandindirect.therearefewcaveats:costallocationexercise-caveats25cu7122397eca

adeanofabusinessschoolisconsideringstartinganexecutiveprogram.sheestimatestherevenuesandcostsasfollows:question:howmanystudentsdoestheprogramneedtobreakeven?costs:revenue:advertising

classroomrental(eachclassroomcanaccommodate15students)

programadministration

programdirector’ssalary

facultysalaries(theprogramwillbestaffedwith1facultymemberforevery5students)

guestlecturer

roomandboardperstudent

textandsuppliesperstudenttuitionperstudent$3,000$13,500$500$30,000perclassroom$15,000$20,000$20,000perfacultymember$12,000$3,200breakevenexercise-background26cu7122397eca

step1:categorizecosts

advertising classroomrental programadministration programdirector’ssalary facultysalaries guestlectures roomandboardperstudent textandsuppliesperstudent fixedvariablestep2:calculatefixedcostsfixedcosts:

$3,000 advertising $15,000 programadministration $20,000 programdirector’ssalary

$12,000 guestlectures $50,000semi-variablefirst,youmustcategorizecostsandcalculatefixedcosts.breakevenexercise-answer(1of3)27cu7122397eca

step4:calculateunitcontribution unitcontribution =priceperunit-variablecostperunit =$13,500 tuition -3,200 roomandboard -500 textandsupplies $9,800step3:calculatesemi-variablecosts

classroom

faculty 10students $30,000 $40,000 15students $30,000 $60,000 20students $60,000 $80,000thenyoumustcalculatesemi-variablecostsandtheunitcontribution.breakevenexercise-answer(2of3)28cu7122397eca*themosteffectivewaytocalculatethebreakevenvolumeistowriteasimpleformulainexcelstep5:calculatebreakevenvolume breakevenvolume =

for10students:

=12.2studentswith10studentstheprogramdoesnot ifyoukeepincreasingthenumberofstudentsbyoneandredoingthecalculation*,youwillfindthatthebusinessschoolneedstohave15studentstobreakevenontheexecutiveprogramfixedcostsunitcontribution$140,000$9,800nowyouarereadycalculatethebreakevenvolume.for15students:$120,000$9,800=14.3studentsbreakevenbreakevenexercise-answer(3of3)29cu7122397eca

importanceofcostallocationclientexampledefinitionsdirectvs.indirect,fixedvs.variablebreakevenvolumeexercisescostallocationbreakevenvolumekeytakeawaysagenda30cu7122397eca

acompanymustknowthetotalcostassociatedwiththeproductionanddeliveryofitsgoodandservicesinordertomaketherightstrategicandtacticaldecisionsmostcompanieslackaccuratecostdatabyproduct

allcostscanbebrokendownalongtwodimensions:fixedversusvariableanddirectversusindirectdefiningtheappropriatetimehorizonforcostsisimportantbecausefixedcostsare“fixed”onlyforacertaintimeframe

breakevenvolumeistheminimum