Cost analysis – a helpful tool or stumbling block?
A guide to profit maximization
Business owners, accountants, and sales people don’t always agree on the definitions of business terms such as fixed cost and variable cost, and therefore they see business opportunities in different ways. Evaluating every new business opportunity in a way that includes the full burden rate (using fixed costs) seems like a good idea, but this isn’t always the best way to go. If the company is already paying all of its fixed costs, why not use variable costs to analyze a new piece of business?
Cost reduction is one of the most frequently considered issues in virtually all businesses, especially manufacturing. Regrettably, consideration is seldom given to profit optimization or maximization. Maximizing profit requires a sound understanding of price constraints and cost behavior. The opportunities available are closely influenced by the markets served and the unique factors associated with the business. Addressing some pricing and costing issues can help you identify the cost analysis pitfalls that prevent your company from reaching its maximum profitability.
Business opportunities are pursued to improve the bottom line (profit). Incremental business opportunities are beneficial when the revenue they generate exceeds all variable costs and therefore contribute to covering the overhead costs or directly to the profits. One of the difficulties is that these terms have various interpretations by those who use them.
Those involved in generating business (the sales team) often see them differently from those who tally costs and expenses and track the company’s performance (the accounting team). For the business manager, sales manager, or owner, their use is centered on optimizing the business’s performance. Depending on the circumstances, this may be a matter of minimizing losses or maximizing profits.
These different perspectives increase the difficulty in recognizing business opportunities that could result in a net improvement in business unit profits.
In pursuing optimization, a company’s decision to develop a new revenue opportunity may not be a matter of determining whether the gross margin exceeds a set minimum. If the goal is optimization, the question may be as simple as this: Is it going to improve the profit performance of the business? Keep in mind that when the business owner reviews the business’s performance with bankers or investors, they focus on how many dollars have been generated with their investment. In many cases, accountants consider the percentage of improvement. Bank deposits are made in dollars, not percentages.
This evaluation can be relatively simple and straightforward. However, depending on the actual business cost behavior and the approach used in assigning the costs to a piece of business, the decision-making process may become somewhat complicated.
To avoid making the decisions that fail to improve the profitability, it is helpful to consider some of the cost behavior issues and their effect on the opportunity evaluation process. This is not in any way intended to be a lesson in accounting, but rather an effort to stimulate additional methods of evaluating business opportunities, which will then lead to the desired optimization of profit results.
The goal is to take on any business opportunity that generates a positive margin. A simple formula for margin is sales revenue minus cost, usually expressed as a percentage of the sales revenue:
Margin = (Revenue – Cost of Goods Sold [COGS])/Revenue
The challenging part is determining the COGS. In many organizations, the cost is fully burdened, which is the variable cost plus some allocated portion of the fixed costs (overhead).
A variable cost is any cost that correlates to the order quantity as a function of labor hours, machine hours, and pounds or units of product produced. These costs include the materials, labor, packaging, consumables, utilities, and material yield losses. It is important to recognize that select costs can behave as fixed or variable, depending on the time period covered by the opportunity being considered.
A fixed cost remains unchanged whether the quantity changes or whether the business is taken at all. These are baseline utilities, management salaries, quality control/assurance services, support staff salaries and wages, real estate taxes, and so on.
Fixed or Variable?
The question usually is as simple as this: Should the opportunity be pursued or rejected?
Using simple overhead allocation methods based on labor or machine hours can result in rejecting business that has the potential for adding to the bottom line.
Looking at one business opportunity two ways reveals two outcomes, depending on how the accounting is done. In the first scenario, the labor hours and machine time are fully burdened, or treated as fixed costs. Simply stated, this includes costs such as worker benefits and machinery wear. The goal is to achieve a gross margin of 20 percent or more.
Accounting Scenario 1
|Raw material||$50,000||Standard budgeted rate of $5/lb.|
|Process 1||$12,000||240 labor hours at fully burdened rate of $50/hour|
|Process 2||$8,000||80 machine hours at fully burdened rate of $100/hour|
|Process 3||$21,000||21,000 pieces at fully burdened rate of $1/pc.|
|Profit||$4,000||4% gross margin|
The key formula is Gross Margin = (Revenue - COGS )/Revenue.
Result: Business rejected. Gross margin less than the minimum acceptable amount.
Accounting Scenario 2
Another view treats the labor hours and machine time as variable costs. Because the workers’ benefits are already paid for with other work the company already does, this project doesn’t need to contribute to worker benefits; it merely needs to pay the hourly wage. Likewise, the wear and tear on the machine is accounted for elsewhere. Because this is an additional piece of business, the machine cost can be figured at a much lower rate, the variable rate.
|Raw material||$50,000||Standard budgeted rate of $5/lb.|
|Process 1||$3,600||240 labor hours at $15/hour|
|Process 2||$400||80 machine hours at variable rate of $5/hour|
|Process 3||$21,000||21,000 pieces at rate of $0.10/pc.|
|Profit||$38,900||38,900 variable margin|
In this case, the key formula is Variable Margin = (Revenue–Variable Costs)/Revenue.
Result: Business accepted. Gross profit provides $38,900 contribution to overhead or directly to the profit line.
It is critical that your operation can perform at the levels used for your opportunity evaluation: material yields, production rates, quality levels, and delivery times.
A few additional thoughts:
- Keep in mind that estimating the raw material price is one thing, but negotiating with a supplier is something else altogether, and might yield a better price.
- When overhead costs are covered, the entire variable contribution goes to the bottom line. If not, the variable contribution will reduce losses associated with overhead costs.
- Prices are set in the marketplace, not by the production costs. There is often a very poor correlation between the two. Do not miss a good opportunity to quote at the highest price likely to be accepted.
- Avoid negatively affecting current business pricing levels. (Don’t cannibalize current business.)
- Purchasing agents or buyers frequently share your pricing with potential competitors. Your pricing decisions can positively or negatively affect the market pricing levels for the subject business and other current or future business.
- It is beneficial to estimate the cost structure of your likely or known competitors.
- Know your strengths and weaknesses and, to the extent possible, your competitors’ strengths and weaknesses.
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