Cost Decision Making for Managers
In March, Cathedral takes a look at the product mix of small businesses. For a small business
owner, knowing the cost characteristics of the company’s products and services is essential to
understanding the profitability of these products. This knowledge also allows the owner to
determine what levels of product/service activity create profits. This paper explains the various
types of costs and how this information can be used in business planning. The tools for this kind
of analysis can be found in cost accounting. The following is a brief introduction to cost
accounting and its use in business planning.
Origins of Cost Accounting
Cost accounting was a product of the industrial revolution. Businesses developed cost
accounting to help managers determine the cost and profitability of the products. Initially labor
cost was viewed as the largest fraction of cost for products produced in the 1890s. Using timekeeping systems, the amount of hours that went into producing a product established the
understanding of variable costs (labor, direct materials.) As time progressed, companies
realized that fixed costs, such as administration and machinery, also impacted the costs that
belonged to each unit produced. Today, companies need to have the same knowledge to
operate their businesses. The good news is that these tools are now part of good business
acumen.
Types of Costs
There are three different types of costs that are associated with a product or service: variable,
fixed and step-variable costs. Each category of cost uniquely influences the production of the
product or service. Therefore, this analysis must address each category separately.
Variable Costs
Variable costs are those that change fairly uniformly with the level of production. Typically raw
materials and direct labor are variable costs. For example, Smith Fire Services produces fire
hydrants. They have orders of 1,000 hydrants per month. Raw materials are iron, forging and
paint. Raw material costs Smith $10,000 for a 1,000 unit order. The labor to produce and
assemble costs $40,000 for 1,000 units. Therefore, it costs Smith $50 per hydrant to produce.
If Smith wanted to breakeven considering only variable costs, Smith would sell each hydrant for
$50. There are, however, other costs besides variable costs that small business owners must
consider.
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Fixed Costs
Fixed costs are those that remain unchanged regardless of whether the activity level increases
or decreases. Rent, depreciation, insurance, maintenance, indirect labor costs, and
administration are examples of fixed costs. For example, Smith Fire Services has building rent
of $2,000 a month, insurance of $1,000 a month and $2,000 of indirect wages for a total of
$5,000 a month in fixed costs. Those costs will remain constant whether or not Smith
manufactures 1 or 10,000 fire hydrants.
Step Variable Costs
Step variable costs have elements of both fixed and variable costs. Step variable costs are
costs that stay fixed over a range of activity and change after this range is exceeded. For
example, Smith Fire Services can produce 500 fire hydrants with 5 employees. Each additional
employee can produce 200 hydrants. If Smith’s activity increases to 1,000 hydrants, Smith
would need to hire 3 employees to fill this, thus increasing payroll costs in steps. The challenge
for Smith is the cost increase caused by the order that requires the next step. This increase in
business may actually not be profitable.
10
8
6
4
2
Number of Employees
Step Variable Cost Graph
0
1
201
401
601
801
Fire Hydrants Produced
Capacity Pricing: The Problem of Fixed Costs
As mentioned, every business has fixed costs such as rent, insurance, maintenance, taxes, and
administrative costs that must be covered. Combining this with the variable cost of each
product, we can rightly deduce that the overall cost for each unit changes with the activity level.
Thus, the more activity increases, the lower the overall costs for a unit of product decrease.
For example, Smith Fire Services produces fire hydrants. They have variable costs of $50 per
hydrant and monthly fixed costs of $5,000. If Smith produces 1,000 fire hydrants a month, the
average unit cost per hydrant would be $55 per hydrant ($50 + ($5,000/1,000)). If Smith has
been operating at 60% capacity in producing the 1,000 hydrants then increasing the production
by 30% to 90% of capacity, the company produces 1,300 hydrants per month. These hydrants
would have a unit cost of $53.84 ($50 + ($5,000/1,300)) which is a reduction of $1.16 per unit.
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Putting it all Together: The Break-even Analysis
Let’s assume that Smith Fire Services management wants to determine the price they need to
charge per fire hydrant. In trying to determine a new price point, it is important to establish a
break-even point for the business. The break-even point is the number of units at a given price
that produces sufficient revenue to cover all of the costs to operate the business. Below is the
current model for Smith with a price point of $100 per fire hydrant sold. Using the facts noted
above, Smith has $50 of variable costs per unit. Therefore, each unit contributes $50 to offset
the fixed costs. The fixed costs are $5,000 a month, causing the break-even point to be 100 fire
hydrants. It is at that point where fixed costs have been covered. Every fire hydrant above that
point allows the business to produce a profit. Please note that step variable costs and variable
pricing increase the complexity of the analysis, but it is essentially the same exercise.
$14,000
$12,000
Dollars
$10,000
$8,000
Contributed Profit
$6,000
$4,000
Loss
Fixed Costs
$2,000
$1
51
101
151
201
Fire Hydrants Sold
Recommended Actions:
1. Prepare a breakdown of costs between variable and fixed and step variable.
2. Using a standard product or service, prepare the cost to deliver based on the variable
costs.
3. Using the standard product’s price and variable costs, determine the break-even level of
activity.
4. Consider the capacity of the business and the percentage of activity needed in the
break-even analysis.
5. Reflect on the level of activity needed, the profitability of each product and model the
break-even benefit of different levels of product/service and prices.
Phil Clements is CEO of Cathedral Consulting Group, LLC and a Managing Director in the
New York Office. Drew Dillard is a former Associate in the Midwest office.
For more information, please visit Cathedral Consulting Group LLC online at
www.cathedralconsulting.com or contact us at info@cathedralconsulting.com.
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