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Author:CollinsQianReviewer:BobArmacostbcCostAccountingMarch1998Copyright©1998Bain&Company,Inc.bcBOSCopyright©1998Bain&Company,Inc.CostAccounting2CostAccounting•Importanceofcostallocation•Clientexample•Definitions–directvs.indirect,fixedvs.variable–breakevenvolume•Exercises–costallocation–breakevenvolume•KeytakeawaysAgendabcBOSCopyright©1998Bain&Company,Inc.CostAccounting3CostAccounting•Importanceofcostallocation•Clientexample•Definitions–directvs.indirect,fixedvs.variable–breakevenvolume•Exercises–costallocation–breakevenvolume•KeytakeawaysAgendabcBOSCopyright©1998Bain&Company,Inc.CostAccounting4CostAccounting•Whichproductsareprofitable?•Whatisthebreakevenvolumebyproduct?•Whichproductsrequirecostreductionefforts?•Howshouldwepriceourproducts?•Whichcustomersegmentsaremostprofitable?Itiscriticaltohaveaccurateandcompletecostdatatomakesoundstrategicandtacticalmanagementdecisions.WhyAllocateCosts?bcBOSCopyright©1998Bain&Company,Inc.CostAccounting5CostAccounting•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,notnecessarilythebestway–forexample,companiestendtoallocaterentcostsbasedonsomethingthatiseasytomeasure,suchasdirectlabordollarsforeachproductline.Abetterallocationmethod,however,mightbetheactualspaceresourcedemandsofeachproductlineMostcompanieslackaccuratecostdatabyproduct.WhyCostsAreOftenNotAllocatedCorrectlybcBOSCopyright©1998Bain&Company,Inc.CostAccounting6CostAccounting•Importanceofcostallocation•Clientexample•Definitions–directvs.indirect,fixedvs.variable–breakevenvolume•Exercises–costallocation–breakevenvolume•KeytakeawaysAgendabcBOSCopyright©1998Bain&Company,Inc.CostAccounting7CostAccountingRidingmowersBicyclesWalkingmowers$25.0MM$2.4MM$1.2MM$0$5$10$15$20$25$30PretaxOperatingProfit(MillionsofDollars)MiddleAmericaManufacturing,aBainclient,believedthatallthreeofitsproductlineswereprofitable.Returnonsales:10.0%2.4%1.6%Sales:$250MM$100MM$75MMMiddleAmericaManufacturing-EstimatedProfitabilitybcBOSCopyright©1998Bain&Company,Inc.CostAccounting8CostAccountingWalkingmowersBicyclesRidingmowersWalkingmowersBicyclesRidingmowersOriginalallocationRevisedallocation$8.0MM$8.0MM$0$2$4$6$8$10Cost(MillionsofDollars)Afterathoroughevaluation,theBainteamfoundthat$8.0MMincostshadbeenallocatedincorrectlyamongthethreeproducts.MiddleAmericaManufacturing-CostAllocationbcBOSCopyright©1998Bain&Company,Inc.CostAccounting9CostAccountingGeneraladministativeexpensesSystemscostsInventorycarryingcostsWalkingmowersBicyclesRidingmowersAdditionalunallocatedcostsAdditionalcostsreallocated$18.8MM$18.8MM$0$5$10$15$20Cost(MillionsofDollars)TheBainteamalsodeterminedthatanadditional$18.8MMincostsshouldbeallocatedtothethreeproducts.MiddleAmericaManufacturing-AdditionalCostsbcBOSCopyright©1998Bain&Company,Inc.CostAccounting10CostAccountingRidingmowersBicyclesWalkingmowers$18.0MM($3.0MM)($5.2MM)($10)($5)$0$5$10$15$20ProductLineProfitability(MillionsofDollars)Bain’sanalysisindicatedthatbothbicyclesandwalkingmowerswereunprofitable.MiddleAmericathenbegantoinvestigatewhethertoexitorfixthesetwobusinesses.Returnonsales:7.2%(3.0%)(6.9%)Sales:$250MM$100MM$75MMMiddleAmericaManufacturing-ActualProfitabilitybcBOSCopyright©1998Bain&Company,Inc.CostAccounting11CostAccounting•Importanceofcostallocation•Clientexample•Definitions–directvs.indirect,fixedvs.variable–breakevenvolume•Exercises–costallocation–breakevenvolume•KeytakeawaysAgendabcBOSCopyright©1998Bain&Company,Inc.CostAccounting12CostAccountingDefinitions:•Coststhatdonotvarydirectlywithchangesinoutput•Coststhatvarydirectlywithchangesinoutput•Costsincurreddirectlyintheproductionordeliveryofafirm’sproductorservice.Thesecostscaneasilybeidentifiedwith,orassignedto,aparticularproduct•Costsgenerallyincurredbythefirmoutsideoftheproductionprocess.Thesecostscannoteasilybeidentifiedwith,orassignedto,aparticularproductAllcostscanbebrokendownalongtwodimensions.FixedVariableDirectIndirectvs.vs.Examples:•Equipmentdepreciation•Rent•Advertising•Rawmaterials•Productionlabor•Deliverycosts•Directlabor•Dedicatedequipment•Rawmaterials•SG&A•Officesupplies•PlantmanagerRuleofthumb:Ifaparticularcostchangeswhenproductionincreasesordecreases,thecostisvariable.Ifaparticularcost“goesaway”whenaproductisdroppedfromtheproductline,thecostisdirect.TypesofCostsbcBOSCopyright©1998Bain&Company,Inc.CostAccounting13CostAccounting•Allcostsarevariableoveraverylongtimehorizon(i.e.,forverylargeincreasesinvolume)–Coststorunandmaintainacomputersystemthattracksproductordersareclearlyfixedforasmallchangeinvolume,suchasthatassociatedwithaslightlybusymonth.However,theyarevariableforalargechangeinvolume,suchasthatassociatedwithanewplant.•Mostco