Cost Analysis
• Control costs
– Improve cost structure – problems show up
• Cost structure – relative proportion of each type of cost –
fixed, variable, mixed
– Improve effectiveness of firm
– Which costs eroding profit margin
– What first? – earnings decrease
– Analyze situation, target problem areas
1
– Cost behavior –
• Fixed – remain constant – i.e. equipment
• Variable – dollar amount varies in direct
proportion to changes in activity level – i.e.
Battery in car
• Mixed – contains both variable and fixed
elements – license fee of $25,000/year and
$3/dinner party
• Stepped costs – variable but increases in big
chunks – i.e. Wages of maintenance workers
2
• Make sure that costing done correctly, reduce
costs
• Standard costing – assigning overhead costs based
upon one predetermined rate based on volume
• Activity based costing - designed to provide managers
with cost information for strategic and other decisions that
potentially affect capacity and therefore affect fixed as well as
variable costs.
– Most organizations maintain two costing systems –
internal – most useful information.
– Uses drivers at various levels
3
4
5
Annual Overhead Costs
(both Manufacturing and Nonmanufacturing)
Production Department:
Indirect factory wages ......................
Factory equipment depreciation ........
Factory utilities.................................
Factory building lease .......................
$500,000
300,000
120,000
80,000 $1,000,000
Shipping costs* ....................................
40,000
General Administrative Department:
Administrative wages and salaries .....
Office equipment depreciation...........
Administrative building lease.............
400,000
50,000
60,000
510,000
Marketing Department:
Marketing wages and salaries ...........
Selling expenses...............................
250,000
50,000
300,000
Total overhead cost ..............................
6
$1,850,000
Standard
Stanchions
Sales
$13,600
Cost:
Direct materials .............................. $ 2,110
Direct labor .................................... 1,850
Manufacturing overhead.................. 10,000 13,960
Product margin*................................
$ (360)
Product Profitability Analysis
Custom
Compass
Housing
$650
$ 13
50
200
Standard
Stanchions
263
$387
Custom Compass
Housing
Sales
$13,600
$ 650
Costs:
Direct materials ....................................$2,110
$ 13
Direct labor .......................................... 1,850
50
Shipping costs ...................................... 180
25
Customer orders................................... 630
315
Product design .....................................
0
1,285
Order size ............................................ 3,800 8,570
76
1,764
7
Product margin.....................................
$ 5,030
$(1,114)
Activity Based Costing
• Two stage allocation process
– Assign costs to pools, then assign to products using
cost drivers
• I.e. Sell 50,000 CD units, 200,000 tape units =
250,000 units total
– Both require two direct labor hours to complete =
500,000 direct labor-hours
– Total manufacturing overhead = $10,000,000
8
Traditional Costing Method
Direct Costs:
Direct Materials
Direct labor @ $10/hr
Manufacturing overhead
Total Unit cost
$
$
$
$
CD
90.00
20.00
40.00
150.00
$
$
$
$
Tape
50.00
20.00
40.00
110.00
Total manufacturing overhead
$
10,000,000
Traditional method
if apply with direct labor hours
10,000,000/500,000=
$ 20.00 per unit per direct labor hour
2 hours per unit * $20 = $40/unit OH
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ABC Costing
Activity Center and Costs
Labor related (labor hours)
Machine related (machine hours)
Machine setups (# of setups)
Production orders (# orders)
Material receipts (# of receipts)
Parts admin ( part types)
Product testing (# of tests)
General overhead (machine hours)
Total
Expected activity
Total
Costs
$800,000
$2,100,000
$1,600,000
$450,000
$1,000,000
$350,000
$1,700,000
$2,000,000
$10,000,000
10
500,000
1,000,000
4,000
1,200
5,000
700
20,000
1,000,000
CD
100,000
300,000
3,000
400
1,800
400
16,000
300,000
Cost Driver
Tape
400,000
700,000
1,000
800
3,200
300
4,000
700,000
Estimated
Total Expected
Overhead
Overhead Costs Activity Rate
Labor related
Machine related
Machine setups
Production orders
Material receipts
Parts administration
Product testing
General Factory
$800,000
500,000
$2,100,000 1,000,000
$1,600,000
4,000
$450,000
1,200
$1,000,000
5,000
$350,000
700
$1,700,000
20,000
$2,000,000 1,000,000
CD Units
Labor related
Machine related
Machine setups
Production orders
Material receipts
Parts administration
Product testing
General Factory
Rate * activity
Total
Units produced
$1.60
$2.10
$400.00
$375.00
$200.00
$500.00
$85.00
$2.00
Tape Units
$160,000
$630,000
$1,200,000
$150,000
$360,000
$200,000
$1,360,000
$600,000
$640,000
$1,470,000
$400,000
$300,000
$640,000
$150,000
$340,000
$1,400,000
$4,660,000
$5,340,000
50,000
200,000
11
Overhead per unit
$93.20
$26.70
• Full capacity – constrained resource?
– Constraint – limited resource that could restrict
company’s ability to satisfy demand – how used
– Theory of constraints
– Should not necessarily promote products with highest
CM but rather promote the product with the highest
contribution margin per unit of constrained resource
Theory of Constraints Example
Sales Price
Var. Cost
Margin
Time
Contribution
A
$10.00
$5.00
$5.00
B
$5.00
$3.00
$2.00
2 hrs
.5 hrs
$2.50
$4.00
12
C
$15.00
$12.00
$3.00
1.5 hrs
$2.00
– Value chain analysis – major business functions
that add value to product and/or service
• Eliminate or minimize non-value activities
• Value-added activities – efficient as possible
– Design in quality – reduce rework or scrap
– Costs of quality
• Prevention costs – plan the process to ensure that
defects do not occur
• Appraisal costs – measure the level of quality to insure
customer requirements
• Internal failure costs – rectify defective output before
reaches customer
• External failure costs – costs associated with delivering
defective output to customer
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• Effectiveness ratios
– Inventory turnover = COGS/average inventory –
how frequently sells inventory
– JIT inventory system
•
•
•
•
Lower costs by long-term contracts
Closer relationship w/suppliers – guarantee deliver
Reduce scrap by increasing quality
Obsolete inventory on hand?
– A/R turnover – Credit sales/average accounts
receivable – ability to collect cash from credit
customers
• What is working?
– Reduce operating cycle – need less working capital
– invest in more productive
activities
14
• Gross margin covers all costs - customers
– 80/20 rule – 80% of headaches come from 20% of
customers – how to find them?
– Customer profitability – no problems
– Find all costs – product fulfillment cycle
– Some customers require extra work
• Extra sales calls, customer service, smaller transportation
lots, smaller orders – all add to costs
– Expend effort on customers that are most profitable
– Drop services that don’t increase goodwill or
profitable
15
• Operating leverage – increase profitability
– Multiplying force – how sensitive is net operating
income to percentage change in sales, if high a
small percentage increase in sales can produce a
much larger percentage increase in net operating
income
– Mix of fixed versus variable costs
– Capital intensive vs. labor intensive
– Leverage multiplier - CM/NI
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OPERATING LEVERAGE
Operating leverage measures how a given percentage change in sales
affects net operating income.
Contribution margin
Degree of
=
operating leverage Net operating income
Sales ....................................
Less variable expenses ..........
Contribution margin...............
Less fixed expenses ...............
Net operating income ............
Degree of operating leverage .
Company X
$500,000 100%
350,000 70
150,000 30%
90,000
$ 60,000
2.5
Company Y
$500,000 100%
100,000 20
400,000 80%
340,000
$ 60,000
6.7
If the degree of operating leverage is 2.5, then a 10% increase in sales
should result in a 25% (= 2.5 × 10%) increase in net operating income.
EXAMPLE: Assume that both company X and company Y experience a 10%
increase in sales:
Company X
Sales ........................................ $550,000 100%
Less variable expenses ..............
385,000 70
Contribution margin...................
165,000 30%
Less fixed expenses ...................
90,000
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Net operating income ................ $ 75,000
Increase in net operating income
25%
Company Y
$550,000 100%
110,000 20
440,000 80%
340,000
$100,000
67%
• Download
– Capital budgeting spreadsheet
– Theory of constraints
– Capital budgeting problems
• Read Introduction to ABC Costing
• Read internal control process
• Read Survey Masters LLC
• Assign #3 – ABC Costing/unit problem (due 2/2)
• Assign #4 – profitability ratios (due 2/2)
– Gross margin % - 07-05
– Profit margin – 07-05
– Return on Assets – 07-05
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– Return on Equity - 07-05