1. Author: Collins Qian Reviewer: Bob Armacost bc Cost Accounting March 1998 Copyright© 1998 Bain & Company, Inc.

2. bc BOS Copyright© 1998 Bain & Company, Inc. Cost Accounting 2 Importance of cost allocation Client example Definitions – direct vs. indirect, fixed vs. variable – breakeven volume Exercises – cost allocation – breakeven volume Key takeaways Agenda

3. bc BOS Copyright© 1998 Bain & Company, Inc. Cost Accounting 3 Importance of cost allocation Client example Definitions – direct vs. indirect, fixed vs. variable – breakeven volume Exercises – cost allocation – breakeven volume Key takeaways Agenda

4. bc BOS Copyright© 1998 Bain & Company, Inc. Cost Accounting 4 Which products are profitable? What is the breakeven volume by product? Which products require cost reduction efforts? How should we price our products? Which customer segments are most profitable? It is critical to have accurate and complete cost data to make sound strategic and tactical management decisions. Why Allocate Costs?

5. bc BOS Copyright© 1998 Bain & Company, Inc. Cost Accounting 5 Historically, only 20% of manufacturing costs were “shared” across product lines. Today, typically 50% of costs are “shared” across products. Shared costs might include rent, freight, and administrative costs. For simplicity, accounting tracks costs by function (e.g., materials, salaries, benefits) rather than by the activity devoted to product lines (e.g., maintenance of product A, freight for product B) For costs that are not easily assigned to individual product lines, companies normally select the most convenient way to assign them, not necessarily the best way – for example, companies tend to allocate rent costs based on something that is easy to measure, such as direct labor dollars for each product line. A better allocation method, however, might be the actual space resource demands of each product line Most companies lack accurate cost data by product. Why Costs Are Often Not Allocated Correctly

6. bc BOS Copyright© 1998 Bain & Company, Inc. Cost Accounting 6 Importance of cost allocation Client example Definitions – direct vs. indirect, fixed vs. variable – breakeven volume Exercises – cost allocation – breakeven volume Key takeaways Agenda

7. bc BOS Copyright© 1998 Bain & Company, Inc. Cost Accounting 7 Middle America Manufacturing, a Bain client, believed that all three of its product lines were profitable. Return on sales:10.0%2.4%1.6% Sales:$250MM$100MM$75MM Middle America Manufacturing - Estimated Profitability

8. bc BOS Copyright© 1998 Bain & Company, Inc. Cost Accounting 8 After a thorough evaluation, the Bain team found that $8.0MM in costs had been allocated incorrectly among the three products. Middle America Manufacturing - Cost Allocation

9. bc BOS Copyright© 1998 Bain & Company, Inc. Cost Accounting 9 The Bain team also determined that an additional $18.8MM in costs should be allocated to the three products. Middle America Manufacturing - Additional Costs

10. bc BOS Copyright© 1998 Bain & Company, Inc. Cost Accounting 10Cost Accounting Bain’s analysis indicated that both bicycles and walking mowers were unprofitable. Middle America then began to investigate whether to exit or fix these two businesses. Return on sales:7.2%(3.0%)(6.9%) Sales:$250MM$100MM$75MM Middle America Manufacturing - Actual Profitability

11. bc BOS Copyright© 1998 Bain & Company, Inc. Cost Accounting 11Cost Accounting Importance of cost allocation Client example Definitions – direct vs. indirect, fixed vs. variable – breakeven volume Exercises – cost allocation – breakeven volume Key takeaways Agenda

12. bc BOS Copyright© 1998 Bain & Company, Inc. Cost Accounting 12Cost Accounting Definitions: Costs that do not vary directly with changes in output Costs that vary directly with changes in output Costs incurred directly in the production or delivery of a firm’s product or service. These costs can easily be identified with, or assigned to, a particular product Costs generally incurred by the firm outside of the production process. These costs cannot easily be identified with, or assigned to, a particular product All costs can be broken down along two dimensions. FixedVariableDirectIndirect vs. Examples: Equipment depreciation Rent Advertising Raw materials Production labor Delivery costs Direct labor Dedicated equipment Raw materials SG&A Office supplies Plant manager Rule of thumb: If a particular cost changes when production increases or decreases, the cost is variable. If a particular cost “goes away” when a product is dropped from the product line, the cost is direct. Types of Costs

13. bc BOS Copyright© 1998 Bain & Company, Inc. Cost Accounting 13Cost Accounting All costs are variable over a very long time horizon (i.e., for very large increases in volume) – Costs to run and maintain a computer system that tracks product orders are clearly fixed for a small change in volume, such as that associated with a slightly busy month. However, they are variable for a large change in volume, such as that associated with a new plant. Most costs are semi-variable (i.e., they tend to be added in lumps as volume increases) – Supervisory labor tends to be considered fixed because it is unlikely that additional supervisors would have to be added to handle a small increase, say 10%, in volume. But the workforce can only increase so much before an additional supervisor is needed. – In theory, production labor is variable. However, in many client situations, restraints placed by unions and difficulty in hiring and firing people in response to short-term volume fluctuations make it, in practice, semi-variable. Defining the appropriate time horizon for the analysis is important. A meaningful analysis will isolate the fixed cost and variable components of a particular cost Fixed vs. Variable

14. bc BOS Copyright© 1998 Bain & Company, Inc. Cost Accounting 14Cost Accounting The following is an illustration of cost behavior for fixed, semi- variable, and variable costs: Cost (Dollars) Volume (Units) Variable costs Semi-variable costs Fixed costs Fixed vs. Variable - Illustration

15. bc BOS Copyright© 1998 Bain & Company, Inc. Cost Accounting 15Cost Accounting It is useful to know the following terms when doing cost analysis: Simplified income statement: - Variable Cost Gross Margin - Fixed Cost Operating Margin Revenue = Price per Unit x Volume Gross margin is also called “Gross Profit,” or “Contribution Margin” Operating Margin is also called “Operating Profit” Revenue Income Statement Terms

16. bc BOS Copyright© 1998 Bain & Company, Inc. Cost Accounting 16Cost Accounting Breakeven volume is the volume at which the company covers its fixed costs. At breakeven volume, the operating profit is zero. Volume Contribution margin (i.e., revenue less variable costs) Fixed costs Breakeven volume $ Operating Loss Fixed costs Unit contributionPrice per unit - Variable cost per unit Breakeven volume = Fixed costs = Operating Profit Contribution Margin Breakeven Volume

17. bc BOS Copyright© 1998 Bain & Company, Inc. Cost Accounting 17Cost Accounting Operating Profit = Revenue - Costs =Revenue - Variable Costs - Fixed costs =(Price per unit x Volume) - (Variable cost per unit x Volume) - Fixed costs =Volume x (Price per unit - Variable cost per unit) - Fixed costs =Volume x Unit contribution - Fixed costs The breakeven volume is the volume for which operating profit = 0 0 =Breakeven volume x Unit contribution - Fixed costs Fixed costs Unit contributionPrice per unit - Variable cost per unit Breakeven volume = Fixed costs = Backup for Breakeven Formula

18. bc BOS Copyright© 1998 Bain & Company, Inc. Cost Accounting 18Cost Accounting Importance of cost allocation Client example Definitions – direct vs. indirect, fixed vs. variable – breakeven volume Exercises – cost allocation – breakeven volume Key takeaways Agenda

19. bc BOS Copyright© 1998 Bain & Company, Inc. Cost Accounting 19Cost Accounting All products are made using the same equipment and machinery Plant supervisors oversee production of all three products Equipment capacity exists to increase production by 50% Sales people sell all three products Sales people are paid a base salary, plus a commission which is a percentage of the selling price Most advertising is product specific The company uses a trucking company to deliver products to customers (costs are based on the length of trip and weight) Maple Leaf Company wants to allocate costs to the three products it makes and sells. Cost Allocation Exercise - Background

20. bc BOS Copyright© 1998 Bain & Company, Inc. Cost Accounting 20Cost Accounting How would you characterize the following costs over a time horizon in which the company plans to increase sales volume by 10%? FixedVariable Direct Indirect CEO’s salary Raw materials Supervisory labor Production floor labor Rent Equipment depreciation Office supplies Freight to customer Electricity to run machines Interest expense to finance inventory Advertising Goodwill amortization Sales commissions Sales peoples’ salaries Sales travel and expenses Costs: Cost Allocation Exercise - Question

21. bc BOS Copyright© 1998 Bain & Company, Inc. Cost Accounting 21Cost Accounting Cost Allocation Exercise - Answer Most costs are fixed indirect or variable direct. FixedVariable Direct Indirect Advertising Raw materials Production floor labor Freight to customer Interest expense to finance inventory Sales commissions Equipment depreciation CEO’s salary Supervisory labor Rent Office supplies Goodwill amortization Sales people's salaries Sales travel and expenses Electricity to run machines

22. bc BOS Copyright© 1998 Bain & Company, Inc. Cost Accounting 22Cost Accounting Cost ComponentsFixed vs. VariableDirect vs. Indirect AdvertisingFixed, because advertising is usually not tied directly to volume Direct, because, in this case, most of it is product specific Equipment depreciationFixed, because excess capacity exists for a 10% increase in volume Indirect, because all products are made on the same machines CEO’s salaryFixed, assuming his/her salary does not change with 10% sales increase Indirect, because CEO oversees the whole company Supervisory labor Fixed, because it is unlikely that additional supervisors will be needed to handle a 10% increase in volume Indirect, because supervisors oversee production of all three products Indirect, because all three products are produced at the same site RentFixed, assuming current facility has excess capacity Cost Allocation Exercise - Detailed Answer (1 of 3)

23. bc BOS Copyright© 1998 Bain & Company, Inc. Cost Accounting 23Cost Accounting Cost ComponentsFixed vs. VariableDirect vs. Indirect Office suppliesFixed, because it is unlikely that additional office supplies will be needed to handle 10% increase in volume Indirect, because the office supplies are used to support all three products Goodwill amortizationFixed, because goodwill is not directly related to volume Indirect, assuming the goodwill is incurred to support the whole company Salespeople's salaries Fixed, assuming that current sales force can handle 10% additional volume Indirect, because each salesman sells all three products Sales travel and expensesFixed, assuming that 10% volume increase will not require significant increase in sales activities Indirect, because sales-force handles all three products Raw materialVariable, because a 10% increase in volume would require 10% more raw materials Direct, because raw materials are directly traceable to individual products Cost Allocation Exercise - Detailed Answer (2 of 3)

24. bc BOS Copyright© 1998 Bain & Company, Inc. Cost Accounting 24Cost Accounting Cost ComponentsFixed vs. VariableDirect vs. Indirect Direct, because even though the products are made on the same machine, the hours spent working on each of the products are directly traceable Production floor laborVariable, because more production labor will be needed to handle the increase in volume Freight to customersVariable, because the freight cost clearly increases with the volume increase Direct, because weight and distance can be directly traced to individual products Interest expense to finance inventory Variable, because more inventory means more inventory financing and hence more interest expense Direct, because inventory is product specific Sales commissionsVariable, because sales commissions are paid based on a percentage of sales Direct, because commissions are based on individual product sales Electricity to run machinesVariable, because it clearly varies with volume Indirect, because all products are made on the same machines Cost Allocation Exercise - Detailed Answer (3 of 3)

25. bc BOS Copyright© 1998 Bain & Company, Inc. Cost Accounting 25Cost Accounting Labor – In many client situations, restraints placed by unions and difficulty in hiring and firing people in response to short term volume fluctuations make a portion of labor costs behave as fixed costs Electricity to run machines – In theory this is direct, but in practice it is considered indirect because it is difficult to trace electricity cost to products – Also, the 80/20 rule applies here. Electricity is usually a small cost item, and, for simplicity, could be allocated using machine hours spent on production Advertising – Usually, advertising is not tied to volume. For example, advertising to support a corporate brand is not tied to the volume of the products under that brand. If advertising is not tied to volume, it is fixed and indirect. There are few caveats: Cost Allocation Exercise - Caveats

26. bc BOS Copyright© 1998 Bain & Company, Inc. Cost Accounting 26Cost Accounting A dean of a business school is considering starting an executive program. She estimates the revenues and costs as follows: Question: How many students does the program need to break even? Costs: Revenue: Advertising Classroom rental (Each classroom can accommodate 15 students) Program administration Program director’s salary Faculty salaries (The program will be staffed with 1 faculty member for every 5 students) Guest lecturer Room and board per student Text and supplies per student Tuition per student $3,000 $13,500 $500 $30,000 per classroom $15,000 $20,000 $20,000 per faculty member $12,000 $3,200 Breakeven Exercise - Background

27. bc BOS Copyright© 1998 Bain & Company, Inc. Cost Accounting 27Cost Accounting Step 1: Categorize costs Advertising Classroom rental Program administration Program director’s salary Faculty salaries Guest lectures Room and board per student Text and supplies per student FixedVariable Step 2: Calculate fixed costs Fixed costs:$3,000Advertising $15,000Program administration $20,000Program director’s salary $12,000Guest lectures $50,000 Semi-Variable First, you must categorize costs and calculate fixed costs. Breakeven Exercise - Answer (1 of 3)

28. bc BOS Copyright© 1998 Bain & Company, Inc. Cost Accounting 28Cost Accounting Step 4: Calculate unit contribution Unit contribution = Price per unit - Variable cost per unit = $13,500tuition - 3,200room and board - 500text and supplies $9,800 Step 3: Calculate semi-variable costs ClassroomFaculty 10 students$30,000$40,000 15 students$30,000$60,000 20 students$60,000$80,000 Then you must calculate semi-variable costs and the unit contribution. Breakeven Exercise - Answer (2 of 3)

29. bc BOS Copyright© 1998 Bain & Company, Inc. Cost Accounting 29Cost Accounting *The most effective way to calculate the breakeven volume is to write a simple formula in Excel Step 5: Calculate breakeven volume Breakeven volume = For 10 students: = 12.2 students with 10 students the program does not If you keep increasing the number of students by one and redoing the calculation*, you will find that the business school needs to have 15 students to break even on the executive program Fixed costs Unit contribution $140,000 $9,800 Now you are ready calculate the breakeven volume. For 15 students: $120,000 $9,800 = 14.3 students break even Breakeven Exercise - Answer (3 of 3)

30. bc BOS Copyright© 1998 Bain & Company, Inc. Cost Accounting 30Cost Accounting Importance of cost allocation Client example Definitions – direct vs. indirect, fixed vs. variable – breakeven volume Exercises – cost allocation – breakeven volume Key takeaways Agenda

31. bc BOS Copyright© 1998 Bain & Company, Inc. Cost Accounting 31Cost Accounting A company must know the total cost associated with the production and delivery of its good and services in order to make the right strategic and tactical decisions Most companies lack accurate cost data by product All costs can be broken down along two dimensions: fixed versus variable and direct versus indirect Defining the appropriate time horizon for costs is important because fixed costs are “fixed” only for a certain time frame Breakeven volume is the minimum amount of product that a company must sell in order to cover its fixed costs. At breakeven volume, the company’s operating profit is zero Breakeven volume = Fixed costs Unit contribution = Fixed costs Price per unit - Variable cost per unit Breakeven Volume Cost Allocation Overview Types of Costs Key Takeaways

32. bc BOS Copyright© 1998 Bain & Company, Inc. Cost Accounting 32Cost Accounting Definitions: Costs that do not vary directly with changes in output Costs that vary directly with changes in output Costs incurred directly in the production or delivery of a firm’s product or service. These costs can easily be identified with, or assigned to, a particular product Costs generally incurred by the firm outside of the production process. These costs cannot easily be identified with, or assigned to, a particular product FixedVariableDirectIndirect vs. Examples: Equipment depreciation Rent Advertising Raw materials Production labor Delivery costs Direct labor Dedicated equipment Raw materials SG&A Office supplies Plant manager Rule of thumb: Types of Costs Cost (Dollars) Volume (Units) Variable costs Semi- variable costs Fixed costs Fixed vs. Semi-Variable vs. Variable Costs Volume Contribution margin (i.e., revenue less variable costs) Fixed costs Breakeven volume $ Operating profit Breakeven volume = Fixed costs Fixed costs Unit contributionPrice per unit - Variable cost per unit Breakeven Volume FixedVariable Direct Indirect Cost Categorization Matrix Contribution Margin Operating loss = If a particular cost changes when production increases or decreases, the cost is variable. If a particular cost “goes away” when a product is dropped from the product line, the cost is direct. Takeaway Slides