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Accounting 102: Lecture # 12 – July 21, 2004
1.
Cost Hierarchies
2.
Traditional Treatment of SG&A Costs
3.
Distortions with Traditional SG&A Treatments
4.
Example
5.
Cost-Volume-Profit Analysis
6.
Example
1a.
Production Cost Hierarchy (Manufacturing Company Example)
1.
Unit-level activities are those that are performed each time a unit is produced.
Examples: Machine hours. Direct product costs such as materials and labor are usually unit level
activities.
2.
Batch-level activities are those that are performed each time a batch of products is produced.
Examples: Setups and inspections.
3.
Product-sustaining activities are those that are performed to support a product or product line.
Examples: Product advertising and engineering changes.
4.
Facility-sustaining activities are those that sustain a factory's manufacturing process.
Examples: Plant management, general maintenance, security, and plant depreciation.
For any level in the hierarchy, the activities for levels lower in the hierarchy are variable and the activities
at higher levels are fixed.
Once the decision to produce a batch has been made, the batch level costs are fixed, but the unit
level costs depend on the number of units in a batch.
For a decision concerning the number of products in a plant, the costs associated with unit, batch
and product-sustaining activities would be variable while facility-sustaining costs would be fixed.
For a decision on whether to keep a plant open, the costs associated with all four levels of activities
would be variable.
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1b.
Customer Cost Hierarchy:
1.
Order-level costs are costs of activities that are performed each time a customer order is
received.
Examples: Order entry, shipping, billing, freight, etc.
2.
Customer-level costs are costs of non-order-related-activities that are attributable to
individual customers.
Examples: Making sales calls, evaluating credit, sending samples, managing collections,
etc.
3.
Channel-level costs are costs of activities related to particular distribution channels (i.e.,
retail sale channel vs. web site channel).
Examples: Managing and maintaining channel, advertising and promoting the channel.
4.
Market-level costs are costs of activities related to particular markets or customer bases
(i.e., retail banking market vs. private banking market).
Examples: Brand advertising, trade shows, etc.
Note that customer characteristics also affect the product cost hierarchy:
Product-sustaining activities are determined by what target markets want in product.
Customer diversity can cause changes in batch-level and unit-level activities:
Examples:
JIT customers require more batches and more delivery; higher quality
requirements may mean more careful set-ups and more inspection.
Examples:
Customer wants customized product; higher quality requirements may
mean more machine hours.
Once they realized that variation in customers leads to variation in costs, businesses have
changed the products and service they offer and the prices they charge. Examples:
Alienating unprofitable customers (WSJ, 1/9/99).
Minimums, volume discounts, charges for order changes.
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2.
Traditional Treatment of SG&A Costs
Selling, General and Administrative (SG&A) costs are the expenses for items such as selling,
advertising, promotion, distribution, research and development and allocated corporate costs.
These costs represent a significant fraction of sales. Consider Dell Computer:
Sales
Manufacturing Costs
1997
$7,759
6,093
% of Sales
100%
79%
Gross Margin
SG&A Costs
Operating Income
1,666
952
714
21%
12%
9%
Recall that under GAAP, SG&A expenses are non-inventoriable period costs.
Firms often simply mark-up product costs to obtain a price (which implicitly assumes that
SG&A costs are a constant proportion of product costs). For example, many companies (e.g.,
consulting firms, job shops, and contractors) use some form of cost-plus pricing:
Price /unit = Mark-up %  (product cost/unit)
To compute product profitability, SG&A is typically allocated using one of two ability-to-bear
methods:
1.
Allocate SG&A costs to product lines or customers using the percent-of-sales method.
For example, if the company's SG&A costs are 10% of sales, each product line will be
charged 10% of its sales for SG&A expenses.
2.
Allocate SG&A costs to product lines or customers using the cost-of-sales method. For
example, if the product's manufacturing costs are 10% of the total manufacturing cost,
that product line will be charged with 10% of the SG&A expenses.
3.
Distortions with Traditional SG&A Treatments
If the consumption of SG&A resources is not correlated with sales or cost-of-sales, traditional
allocation methods will distort the costs of products and serving customers.
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Most cost systems are product-focused, not customer focused. Using reported product costs can
lead to bad decisions if cost differences in selling the same product to different customers are not
considered. Example: Delivery to convenience store vs. supermarket.
The goal of customer profitability analysis is to uncover the cause-and-effect relationships that
give rise to SG&A.
4.
Example (1998 Exam 2 modified)
Example: Spring Distribution purchases bottled water for $0.50 per bottle and delivers the water
to its customers. Spring is re-evaluating the price it charges to PITA and NPITA, its only two
customers. Currently it charges both customers $0.60 per bottle.
Following is forecasted monthly data:
Customer
Bottles purchased
Sales visits
Deliveries
Miles traveled per delivery
PITA
100,000
3
20
40
NPITA
100,000
0
1
100
Why might Spring be charging both customers $0.60 per bottle?
MARK-UP 20%:
$.50×120%= $.60
Suppose that Spring adopts an ABC system that allocates all of the costs related to its business as
follows:
Activity
Budgeted Allocation Rate
PITA
NPITA
Sales visits
$800 per sales visit
$2,400
0
Deliveries
$2 per delivery mile traveled
$1,600
$200
Product handling
$0.02 per bottle
Warehousing, Marketing, and all
$0.01 per bottle
$3,000 $3,000
other indirect costs
TOTAL
$7,000 $3,200
per unit
$.07
$.032
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Assuming that Spring wants to earn a 10% profit on sales to each customer, what per bottle price
should it charge each customer?
PITA: $.50 + $.07 = $.57; $.57 / (1-10%) = $.631>$.60
NPITA: $.50 + $.032 = $.532; $.532 / (1-10%) = $.591 < $.60
5.
Cost-Volume-Profit Analysis
a.
Cost-Volume-Profit (CVP) Model
Total Profit (Π) = Total Revenue (TR) - Total Cost (TC)
Assume:
1. Q represents both units produced and units sold (ignore inventory considerations).
2. a linear cost function of the form TC = F + V Q, where F denotes the fixed costs and V the
variable costs per unit.
3. a linear revenue function of the form TR = P Q, where P is the unit sales price.
Under these assumptions, profits may be written:
Π = P Q - (F + V Q)
b.
Equation Method of CVP Analysis
The level of output at which revenue and costs are the same is the "Breakeven Point".
Set the target profit to zero and solving this equation for Q = “number of units” gives the
breakeven point (QB/E):
0 = P QB/E - (F + V QB/E)
QB/E = F / (P - V)
QB/E =
Note: (P - V) = CM / unit
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
"Contribution Margin Method" of CVP Analysis
Fixed Costs
Breakeven output = Contribution Margin per unit
Thus,
Example: Sales Price = $10; Variable Cost per unit = $6; Fixed Costs = $200;
What is the firm's break-even point (in units)?
$200 / ($10/unit-$6/unit) = 50 units
d.
Target Profit Level
If the firm wants to reach some target profit level
T,
it must produce an amount QT that solves
Π T = P QT - (F + V QT)
QT =
Example: In the above example, suppose the firm has a target profit of $ 40. How much output
should it produce ?
(200+40)/4 = 70 units
e.
Margin of Safety:
A concept related to the Breakeven point, which measures the excess of actual or projected sales
over the Breakeven sales.
In the previous example, suppose actual sales were 70 units (as opposed to breakeven sales of 50
units). Then, the firm's Margin of Safety is 20 units.
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f.
Breakeven in Dollars:
For some firms (e.g., service firms), output cannot be measured in units. So breakeven has to be
expressed in terms of a sales revenue (in dollars) at which the firm's revenue equals its costs. For
this, we need a new concept:
Contribution Margin Ratio = Cont. Margin per dollar of revenue =
Revenues  Var Costs
Revenues
Fixed Costs
Breakeven Sales Dollars = Contribution Margin Ratio
Example: A firm has fixed costs of $ 200 and variable costs equal to 75% of revenues. What is
its breakeven point in dollars?
CMR = 25%
$200 / 25% = $800
Note: If a firm's output can be measured in units, then we have
Breakeven Sales ($)
 F 
= (Breakeven output) x (Sales Price) = 
 (P)
PV


Fixed Costs
F
 =
= 
(exactly as above).
 [P  V]/P  Contributi on Margin Ratio
CMR = 4/10 = 40%
$200 / 40% = $200 / 4 ×10 = $500
g.
Effect of Income Taxes
In the first example, suppose the firm has a tax rate of 40% and wishes to earn a profit level of
$48 after taxes. How much output should it produce?
$48 / (1-40%) = $80 (target profit)
280/4 = 70
How does the breakeven output change with the introduction of income taxes ?
IT DOES NOT!
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6.
CVP Example
Impulse Purchase Co. produces an item which it sells for $2.00 per unit. In 1996, Impulse made
a profit of $100,000, and its break-even sales volume was $1,200,000 and its fixed costs were
$300,000. Impulse expects that fixed costs, variable costs, and unit prices will be the same in
1997 as they were in 1996.
a.
What is Impulse's breakeven in terms of number of units?
$1,200,000 / $2/unit = 600,000units
b.
(We can solve for variable cost here)
0=600,000 (2-V) – 300,000
V=$1.5
How many units were made by Impulse in 1996?
$100,000 = Q (2-1,5) - $300,000
Q = 800,000 units
c.
Assume that Impulse hires a new manager who is paid a salary of $50,000 and a bonus
equal to 20% of dollar contribution margin. What would be the breakeven sales level if the
manager were hired?
CMR = .5/2 = 25%
NEW CMR: .8×25%=20%
(300,000+50,000) / 20% =$1,750,000
d.
Now suppose that Impulse hires a new manager who is paid a salary of $50,000 and a
bonus equal to 10% of pre-bonus profits. How many units does Impulse have to sell to have
profits of $100,000 (after the manager's bonus)?
LIKE A TAX
$100,000 / (1-10%) = $111,000
($111,000 + $50,000 + $300,000) / $.50/unit = 922,000 units