By Dave Burt, CPA - Dear E.N.Ananthanarayanan
Cost accountants’ utilize various tools in an attempt to draw management’s attention towards opportunities and problems, to solve problems and report historical data in a usable format. For example, the Cost-Volume-Profit (CVP) formula:
(Unit Sales Price X Units Sold) – (Unit Variable Costs X Units Sold) – Fixed Costs = Operating Income
This formula can be used to calculate how much earnings a certain product will contribute (contribution margin) towards paying for factory overhead and toward generating any operating profits. Its contribution margin is figured by subtracting variable costs (costs directly identified with the production of the item) from sales. For example, $16.99 Sales Price minus $ 5.39 Variable Costs = $11.60 contribution margin per unit (CMU). CMU can be used to project operating profit if you have a sales projection and estimated or budgeted fixed costs. For example, If, CMU = $11.60, units sold = 5000 and fixed costs (FC) = $30,750:
5,000 units sold X $11.60 CMU = $58,000 CM - $30,750 FC = $27,250 Operating Income (margin)
If you want to determine how many units the company must sell to break even, you would set the above formula’s operating Income to zero and solve for Units Sold. And how do you find the number of units that must be sold to reach a budgeted sales target? Add that target amount to your Fixed Costs and solve for Units Sold.
When sales managers consider adding a new product to the line up, they consider many things. For example, they must decide on target market, packaging design, unit size, case size, display type, and distribution method. But before they get too far into to the process, they need to have some idea how many units they can expect to sell, for how much and how much it will cost. Sometimes sales has a product they sell by the truck load and makes tons of money on, and others they price just to cover their out of pocket (variable) costs because it fills out the product line.
Where does a cost accountant come into the picture? What kinds of tasks do they perform? Let’s consider a cost accountant working for a food manufacturer. The cost accountant might start by being an important member of the product development team. She would be present on the discussions and decisions on packaging type and size, ingredients, case size, production line, distribution channels, etc. She may bring with her historical sales and gross margin numbers on similar products the company has sold. She may help bench mark a competitor’s product by analyzing the ingredients statement on the back of the sample package.
Once a decision has been made on package size, design, case size, ingredients (bill of materials), and production and packaging lines to be used, the cost accountant’s first job may be to create a new bill of materials (BOM) for the product. A BOM is detailed list (in quantities and costs) of direct materials used for one unit (e.g., case of 8 oz pretzels) of the product. Often, the job is eased by the fact that the company has other established products that are similar. So, sometimes it is as easy as cut and paste and modify. Other times, say, if the company wants to produce a product that’s similar to a competitor’s the job is much harder.
The cost accountant’s next task might be to determine direct labor. The type of product and pack size will normally determine which production and packaging lines will be utilized which determins cases per hour and manning (direct labor.) This production and packaging route will give the cost accountant her variable direct labor costs per unit and an allocation base (e.g., direct labor hours that can be used to allocate overhead. For example, based on an annual budget, for every direct labor dollar spent, three dollars are spent on factory overhead. So, factory overhead is 300% of labor.
Next the cost accountant constructs a gross margin analysis of the new product in columnar format in Excel.
Unit sales price = $16.99
BOM (Direct Material costs) = $3.34
Direct labor = $2.05
Total variable unit cost ($3.34 + $2.05) = $5.39
Contribution margin per unit= ($16.99 sales unit price - $5.39 variable cost/unit) = $11.60
Then, allocate factory overhead on labor costs, 300% X $2.05 direct labor = $6.15
Total production costs ($5.39 variable costs + $6.15 allocated factory overhead) =$11.54
Gross margin ($16.99 sales price – $11.54 total production costs) = $5.45
Gross margin percent ($5.45 / $16.99) = 32%
The cost accountant would bring this analysis to the next product development meeting for review and discussion by the group. If the gross margin percent was out of place compared to other similar products or not close to a target gross margin, then rework maybe necessary. When an acceptable percent is acquired, then other costs are added on such as special promotional costs of the product roll out, cost of coupons that might be issued, transportation, etc.
Both the CVA formula and gross margin analysis are useful problem solving tools for a cost accountant.
David E. Burt