1 Cost Analysis Control costs –Improve cost structure – problems show up Cost structure – relative proportion of each type of cost – fixed, variable, mixed –Improve effectiveness of firm –Which costs eroding profit margin –What first? – earnings decrease –Analyze situation, target problem areas

2 –Cost behavior – Fixed – remain constant – i.e. equipment Variable – dollar amount varies in direct proportion to changes in activity level – i.e. Battery in car Mixed – contains both variable and fixed elements – license fee of $25,000/year and $3/dinner party Stepped costs – variable but increases in big chunks – i.e. Wages of maintenance workers

3 Make sure that costing done correctly, reduce costs Standard costing – assigning overhead costs based upon one predetermined rate based on volume Activity based costing - designed to provide managers with cost information for strategic and other decisions that potentially affect capacity and therefore affect fixed as well as variable costs. –Most organizations maintain two costing systems – internal – most useful information. –Uses drivers at various levels

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8 Activity Based Costing Two stage allocation process –Assign costs to pools, then assign to products using cost drivers I.e. Sell 50,000 CD units, 200,000 tape units = 250,000 units total –Both require two direct labor hours to complete = 500,000 direct labor-hours –Total manufacturing overhead = $10,000,000

9 Traditional Costing Method

10 ABC Costing

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12 Full capacity – constrained resource? –Constraint – limited resource that could restrict company’s ability to satisfy demand – how used –Theory of constraints –Should not necessarily promote products with highest CM but rather promote the product with the highest contribution margin per unit of constrained resource

13 –Value chain analysis – major business functions that add value to product and/or service Eliminate or minimize non-value activities Value-added activities – efficient as possible –Design in quality – reduce rework or scrap –Costs of quality Prevention costs – plan the process to ensure that defects do not occur Appraisal costs – measure the level of quality to insure customer requirements Internal failure costs – rectify defective output before reaches customer External failure costs – costs associated with delivering defective output to customer

14 Effectiveness ratios –Inventory turnover = COGS/average inventory – how frequently sells inventory –JIT inventory system Lower costs by long-term contracts Closer relationship w/suppliers – guarantee deliver Reduce scrap by increasing quality Obsolete inventory on hand? –A/R turnover – Credit sales/average accounts receivable – ability to collect cash from credit customers What is working? –Reduce operating cycle – need less working capital – invest in more productive activities

15 Gross margin covers all costs - customers –80/20 rule – 80% of headaches come from 20% of customers – how to find them? –Customer profitability – no problems –Find all costs – product fulfillment cycle –Some customers require extra work Extra sales calls, customer service, smaller transportation lots, smaller orders – all add to costs –Expend effort on customers that are most profitable –Drop services that don’t increase goodwill or profitable

16 Operating leverage – increase profitability –Multiplying force – how sensitive is net operating income to percentage change in sales, if high a small percentage increase in sales can produce a much larger percentage increase in net operating income –Mix of fixed versus variable costs –Capital intensive vs. labor intensive –Leverage multiplier - CM/NI

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18 Download –Capital budgeting spreadsheet –Theory of constraints –Capital budgeting problems Read Introduction to ABC Costing Read internal control process Read Survey Masters LLC Assign #3 – ABC Costing/unit problem (due 2/2)‏ Assign #4 – profitability ratios (due 2/2)‏ –Gross margin % –Profit margin – –Return on Assets – –Return on Equity