Author CollinsQian Reviewer BobArmacost bc CostAccounting March1998 Copyright 1998Bain Company Inc 2 CU7122397ECA ImportanceofcostallocationClientexampleDefinitionsdirectvs indirect fixedvs variablebreakevenvolumeExercisescostallocationbreakevenvolumeKeytakeaways Agenda 3 CU7122397ECA ImportanceofcostallocationClientexampleDefinitionsdirectvs indirect fixedvs variablebreakevenvolumeExercisescostallocationbreakevenvolumeKeytakeaways Agenda 4 CU7122397ECA Whichproductsareprofitable Whatisthebreakevenvolumebyproduct Whichproductsrequirecostreductionefforts Howshouldwepriceourproducts Whichcustomersegmentsaremostprofitable Itiscriticaltohaveaccurateandcompletecostdatatomakesoundstrategicandtacticalmanagementdecisions WhyAllocateCosts 5 CU7122397ECA 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 mightbetheactualspaceresourcedemandsofeachproductline Mostcompanieslackaccuratecostdatabyproduct WhyCostsAreOftenNotAllocatedCorrectly 6 CU7122397ECA ImportanceofcostallocationClientexampleDefinitionsdirectvs indirect fixedvs variablebreakevenvolumeExercisescostallocationbreakevenvolumeKeytakeaways Agenda 7 CU7122397ECA MiddleAmericaManufacturing aBainclient believedthatallthreeofitsproductlineswereprofitable Returnonsales 10 0 2 4 1 6 Sales 250MM 100MM 75MM MiddleAmericaManufacturing EstimatedProfitability 8 CU7122397ECA Afterathoroughevaluation theBainteamfoundthat 8 0MMincostshadbeenallocatedincorrectlyamongthethreeproducts MiddleAmericaManufacturing CostAllocation 9 CU7122397ECA TheBainteamalsodeterminedthatanadditional 18 8MMincostsshouldbeallocatedtothethreeproducts MiddleAmericaManufacturing AdditionalCosts 10 CU7122397ECA Bain sanalysisindicatedthatbothbicyclesandwalkingmowerswereunprofitable MiddleAmericathenbegantoinvestigatewhethertoexitorfixthesetwobusinesses Returnonsales 7 2 3 0 6 9 Sales 250MM 100MM 75MM MiddleAmericaManufacturing ActualProfitability 11 CU7122397ECA ImportanceofcostallocationClientexampleDefinitionsdirectvs indirect fixedvs variablebreakevenvolumeExercisescostallocationbreakevenvolumeKeytakeaways Agenda 12 CU7122397ECA Definitions Coststhatdonotvarydirectlywithchangesinoutput Coststhatvarydirectlywithchangesinoutput Costsincurreddirectlyintheproductionordeliveryofafirm sproductorservice Thesecostscaneasilybeidentifiedwith orassignedto aparticularproduct Costsgenerallyincurredbythefirmoutsideoftheproductionprocess Thesecostscannoteasilybeidentifiedwith orassignedto aparticularproduct Allcostscanbebrokendownalongtwodimensions Fixed Variable Direct Indirect vs vs Examples EquipmentdepreciationRentAdvertising RawmaterialsProductionlaborDeliverycosts DirectlaborDedicatedequipmentRawmaterials SG AOfficesuppliesPlantmanager Ruleofthumb Ifaparticularcostchangeswhenproductionincreasesordecreases thecostisvariable Ifaparticularcost goesaway whenaproductisdroppedfromtheproductline thecostisdirect TypesofCosts 13 CU7122397ECA 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 Ameaningfulanalysiswillisolatethefixedcostandvariablecomponentsofaparticularcost Fixedvs Variable 14 CU7122397ECA Thefollowingisanillustrationofcostbehaviorforfixed semi variable andvariablecosts Cost Dollars Volume Units Variablecosts Semi variablecosts Fixedcosts Fixedvs Variable Illustration 15 CU7122397ECA Itisusefultoknowthefollowingtermswhendoingcostanalysis Simplifiedincomestatement VariableCost GrossMargin FixedCost OperatingMargin Revenue PriceperUnitxVolume Grossmarginisalsocalled GrossProfit or ContributionMargin OperatingMarginisalsocalled OperatingProfit Revenue IncomeStatementTerms 16 CU7122397ECA Breakevenvolumeisthevolumeatwhichthecompanycoversitsfixedcosts