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Cost Accounting
Author: Collins Qian Reviewer: Bob Armacost

March 1998
Copyright 1998 Bain & Company, Inc.

Cost Accounting Agenda

Importance of cost allocation Client example Definitions
– direct

vs. indirect, fixed vs. variable volume

– breakeven

Exercises
– cost

allocation volume

– breakeven

Key takeaways

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BOS Cost Accounting 2

Copyright 1998 Bain & Company, Inc.

Cost Accounting Agenda

Importance of cost allocation Client example Definitions
– direct

vs. indirect, fixed vs. variable volume

– breakeven

Exercises
– cost

allocation volume

– breakeven

Key takeaways

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BOS Cost Accounting 3

Copyright 1998 Bain & Company, Inc.

Cost Accounting Why Allocate Costs?
It is critical to have accurate and complete cost data to make sound strategic and tactical management decisions.

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?

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BOS Cost Accounting 4

Copyright 1998 Bain & Company, Inc.

Cost Accounting Why Costs Are Often Not Allocated Correctly
Most companies lack accurate cost data by product.

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. than by the activity devoted to product lines (e.g., maintenance of product A, freight for product B)

For simplicity, accounting tracks costs by function (e.g., materials, salaries, benefits) rather

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

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BOS Cost Accounting 5

Copyright 1998 Bain & Company, Inc.

Cost Accounting Agenda

Importance of cost allocation Client example Definitions
– direct

vs. indirect, fixed vs. variable volume

– breakeven

Exercises
– cost

allocation volume

– breakeven

Key takeaways

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BOS Cost Accounting 6

Copyright 1998 Bain & Company, Inc.

Cost Accounting Middle America Manufacturing - Estimated Profitability
Middle America Manufacturing, a Bain client, believed that all three of its product lines were profitable.
$30 Pretax Operating Profit (Millions of Dollars) $25 $20 $15 $10 $5 $2.4MM $0 Riding mowers Bicycles $1.2MM Walking mowers $25.0MM

Sales: Return on sales:

$250MM 10.0%

$100MM 2.4%

$75MM 1.6%
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BOS Cost Accounting 7

Copyright 1998 Bain & Company, Inc.

Cost Accounting Middle America Manufacturing - Cost Allocation
After a thorough evaluation, the Bain team found that $8.0MM in costs had been allocated incorrectly among the three products.

$10

$8 Cost (Millions of Dollars)

$8.0MM
Walking mowers

$8.0MM Walking mowers

Bicycles $6 Bicycles $4 Riding mowers $2 Riding mowers $0 Original allocation Revised allocation

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BOS Cost Accounting 8

Copyright 1998 Bain & Company, Inc.

Cost Accounting Middle America Manufacturing - Additional Costs
The Bain team also determined that an additional $18.8MM in costs should be allocated to the three products.

$20

$18.8MM General administative expenses

$18.8MM

Cost (Millions of Dollars)

$15 Systems costs $10

Walking mowers

Bicycles

$5

Riding mowers Inventory carrying costs

$0

Additional unallocated costs

Additional costs reallocated

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BOS Cost Accounting 9

Copyright 1998 Bain & Company, Inc.

Cost Accounting Middle America Manufacturing - Actual Profitability
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.
Product Line Profitability (Millions of Dollars) $20 $15 $10 $5 $0 ($5) ($10) ($3.0MM) ($5.2MM) Riding mowers Bicycles Walking mowers $18.0MM

Sales: Return on sales:

$250MM 7.2%

$100MM (3.0%)

$75MM (6.9%)
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BOS Cost Accounting 10

Copyright 1998 Bain & Company, Inc.

Cost Accounting Agenda

Importance of cost allocation Client example Definitions
– direct

vs. indirect, fixed vs. variable volume

– breakeven

Exercises
– cost

allocation volume

– breakeven

Key takeaways

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BOS Cost Accounting 11

Copyright 1998 Bain & Company, Inc.

Cost Accounting Types of Costs
All costs can be broken down along two dimensions.
Fixed Definitions: Variable Direct Indirect

vs.

vs.

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

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.
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BOS Cost Accounting 12

Copyright 1998 Bain & Company, Inc.

Cost Accounting Fixed vs. Variable
Defining the appropriate time horizon for the analysis is important.
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. 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.

– In

A meaningful analysis will isolate the fixed cost and variable components of a particular cost
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BOS Cost Accounting 13

Copyright 1998 Bain & Company, Inc.

Cost Accounting Fixed vs. Variable - Illustration
The following is an illustration of cost behavior for fixed, semivariable, and variable costs:

Variable costs Cost (Dollars)

Semi-variable costs

Fixed costs

Volume (Units)

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BOS Cost Accounting 14

Copyright 1998 Bain & Company, Inc.

Cost Accounting Income Statement Terms
It is useful to know the following terms when doing cost analysis:

Simplified income statement:

Revenue - 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"

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BOS Cost Accounting 15

Copyright 1998 Bain & Company, Inc.

Cost Accounting Breakeven Volume
Breakeven volume is the volume at which the company covers its fixed costs. At breakeven volume, the operating profit is zero.
$ Contribution margin (i.e., revenue less variable costs)

Contribution Margin

Operating Profit Fixed costs Operating Loss Breakeven volume

Volume Breakeven volume = Fixed costs Unit contribution = Fixed costs Price per unit - Variable cost per unit
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BOS Cost Accounting 16

Copyright 1998 Bain & Company, Inc.

Cost Accounting Backup for Breakeven Formula

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 contribution = Fixed costs Price per unit - Variable cost per unit

Breakeven volume =

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BOS Cost Accounting 17

Copyright 1998 Bain & Company, Inc.

Cost Accounting Agenda

Importance of cost allocation Client example Definitions
– direct

vs. indirect, fixed vs. variable volume

– breakeven

Exercises
– cost

allocation volume

– breakeven

Key takeaways

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BOS Cost Accounting 18

Copyright 1998 Bain & Company, Inc.

Cost Accounting Cost Allocation Exercise - Background
Maple Leaf Company wants to allocate costs to the three products it makes and sells.

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)

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BOS Cost Accounting 19

Copyright 1998 Bain & Company, Inc.

Cost Accounting Cost Allocation Exercise - Question
How would you characterize the following costs over a time horizon in which the company plans to increase sales volume by 10%?
Fixed Direct Variable

Indirect

Costs:

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
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BOS Cost Accounting 20

Copyright 1998 Bain & Company, Inc.

Cost Accounting Cost Allocation Exercise - Answer
Most costs are fixed indirect or variable direct.
Fixed Variable

Advertising
Direct

Raw materials Production floor labor Freight to customer Interest expense to finance
inventory Sales commissions

Indirect

Equipment depreciation CEO's salary Supervisory labor Rent Office supplies Goodwill amortization Sales people's salaries Sales travel and expenses

Electricity to run
machines

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BOS Cost Accounting 21

Copyright 1998 Bain & Company, Inc.

Cost Accounting Cost Allocation Exercise - Detailed Answer (1 of 3)
Cost Components Advertising Fixed vs. Variable Fixed, because advertising is usually not tied directly to volume Fixed, because excess capacity exists for a 10% increase in volume Fixed, assuming his/her salary does not change with 10% sales increase Fixed, because it is unlikely that additional supervisors will be needed to handle a 10% increase in volume Fixed, assuming current facility has excess capacity Direct vs. Indirect Direct, because, in this case, most of it is product specific

Equipment depreciation

Indirect, because all products are made on the same machines Indirect, because CEO oversees the whole company

CEO's salary

Supervisory labor

Indirect, because supervisors oversee production of all three products Indirect, because all three products are produced at the same site

Rent

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BOS Cost Accounting 22

Copyright 1998 Bain & Company, Inc.

Cost Accounting Cost Allocation Exercise - Detailed Answer (2 of 3)
Cost Components Office supplies Fixed vs. Variable Fixed, because it is unlikely that additional office supplies will be needed to handle 10% increase in volume Fixed, because goodwill is not directly related to volume Direct vs. Indirect Indirect, because the office supplies are used to support all three products Indirect, assuming the goodwill is incurred to support the whole company Indirect, because each salesman sells all three products Indirect, because sales-force handles all three products

Goodwill amortization

Salespeople's salaries

Fixed, assuming that current sales force can handle 10% additional volume Fixed, assuming that 10% volume increase will not require significant increase in sales activities Variable, because a 10% increase in volume would require 10% more raw materials

Sales travel and expenses

Raw material

Direct, because raw materials are directly traceable to individual products
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BOS Cost Accounting 23

Copyright 1998 Bain & Company, Inc.

Cost Accounting Cost Allocation Exercise - Detailed Answer (3 of 3)
Cost Components Production floor labor Fixed vs. Variable Variable, because more production labor will be needed to handle the increase in volume Variable, because the freight cost clearly increases with the volume increase Variable, because more inventory means more inventory financing and hence more interest expense Variable, because sales commissions are paid based on a percentage of sales Variable, because it clearly varies with volume Direct 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

Freight to customers

Direct, because weight and distance can be directly traced to individual products Direct, because inventory is product specific

Interest expense to finance inventory

Sales commissions

Direct, because commissions are based on individual product sales Indirect, because all products are made on the same machines

Electricity to run machines

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BOS Cost Accounting 24

Copyright 1998 Bain & Company, Inc.

Cost Accounting Cost Allocation Exercise - Caveats
There are few caveats:

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.

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BOS Cost Accounting 25

Copyright 1998 Bain & Company, Inc.

Cost Accounting Breakeven Exercise - Background
A dean of a business school is considering starting an executive program. She estimates the revenues and costs as follows:
Revenue: Tuition per student Costs: 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 $3,000 $13,500

$30,000 per classroom $15,000 $20,000

$20,000 per faculty member $12,000 $3,200 $500
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BOS Cost Accounting 26

Question: How many students does the program need to break even?

Copyright 1998 Bain & Company, Inc.

Cost Accounting Breakeven Exercise - Answer (1 of 3)
First, you must categorize costs and calculate fixed costs.
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 Step 2: Calculate fixed costs Fixed costs: $3,000 $15,000 $20,000 $12,000 $50,000 Advertising Program administration Program director's salary Guest lectures
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BOS Cost Accounting 27

Fixed

Semi-Variable

Variable

Copyright 1998 Bain & Company, Inc.

Cost Accounting Breakeven Exercise - Answer (2 of 3)
Then you must calculate semi-variable costs and the unit contribution.
Step 3: Calculate semi-variable costs Classroom 10 students 15 students 20 students $30,000 $30,000 $60,000 Faculty $40,000 $60,000 $80,000

Step 4: Calculate unit contribution Unit contribution = Price per unit - Variable cost per unit = $13,500 - 3,200 500 $9,800 tuition room and board text and supplies

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BOS Cost Accounting 28

Copyright 1998 Bain & Company, Inc.

Cost Accounting Breakeven Exercise - Answer (3 of 3)
Now you are ready calculate the breakeven volume.
Step 5: Calculate breakeven volume Fixed costs Breakeven volume = Unit contribution For 10 students: $120,000 $9,800 = 12.2 students with 10 students the program does not break even

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 For 15 students: $140,000 $9,800 = 14.3 students
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*The most effective way to calculate the breakeven volume is to write a simple formula in Excel
BOS Cost Accounting 29

Copyright 1998 Bain & Company, Inc.

Cost Accounting Agenda

Importance of cost allocation Client example Definitions
– direct

vs. indirect, fixed vs. variable volume

– breakeven

Exercises
– cost

allocation volume

– breakeven

Key takeaways

bc
BOS Cost Accounting 30

Copyright 1998 Bain & Company, Inc.

Cost Accounting Key Takeaways
Cost Allocation Overview 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
Types of Costs 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

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 Fixed costs Unit contribution Fixed costs Price per unit - Variable cost per unit

Breakeven volume =

=

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BOS Cost Accounting 31

Copyright 1998 Bain & Company, Inc.

Cost Accounting Takeaway Slides
Types of Costs
Fixed vs. Variable Direct vs. Indirect

Fixed vs. Semi-Variable vs. Variable Costs

Definitions:



Cost (Dollars)

Costs that do not vary directly with changes in output



Costs that vary directly with changes in output



Examples:



Equipment depreciation Rent Advertising



Raw materials Production labor Delivery costs



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 Direct labor Dedicated equipment Raw materials





Costs generally incurred by the firm outside of the production process. These costs cannot easily be identified with, or assigned to, a particular product SG&A Office supplies Plant manager

Variable costs Semivariable costs Fixed costs Volume (Units) Cost Categorization Matrix Fixed Direct Variable

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.

Breakeven Volume
$ Contribution margin (i.e., revenue less variable costs) Fixed costs Operating loss Breakeven volume

Operating profit

Volume Breakeven volume = Fixed costs Unit contribution = Fixed costs Price per unit - Variable cost per unit

Indirect

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BOS Cost Accounting 32

Copyright 1998 Bain & Company, Inc.

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