Author: Collins Qian
Reviewer: Bob Armacost
bc
Cost Accounting
March 1998
Copyright© 1998 Bain & Company, Inc.
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BOS
Copyright© 1998 Bain & Company, Inc.
Cost Accounting
•Importance of cost allocation
•Client example
•Definitions
–direct vs. indirect, fixed vs. variable
–breakeven volume
•Exercises
–cost allocation
–breakeven volume
•Key takeaways
Agenda
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BOS
Copyright© 1998 Bain & Company, Inc.
Cost Accounting
•Importance of cost allocation
•Client example
•Definitions
–direct vs. indirect, fixed vs. variable
–breakeven volume
•Exercises
–cost allocation
–breakeven volume
•Key takeaways
Agenda
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BOS
Copyright© 1998 Bain & Company, Inc.
Cost Accounting
•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?
It is critical to have accurate and complete cost data to
make sound strategic and tactical management decisions.
Why Allocate Costs?
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BOS
Copyright© 1998 Bain & Company, Inc.
Cost Accounting
•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.
•For simplicity, accounting tracks costs by function (., materials, salaries, benefits) rather
than by the activity devoted to product lines (., maintenance of product A, freight for
product B)
•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
Most companies lack accurate cost data by product.
Why Costs Are Often Not Allocated Correctly
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BOS
Copyright© 1998 Bain & Company, Inc.
Cost Accounting
•Importance of cost allocation
•Client example
•Definitions
–direct vs. indirect, fixed vs. variable
–breakeven volume
•Exercises
–cost allocation
–breakeven volume
•Key takeaways
Agenda
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BOS
Copyright© 1998 Bain & Company, Inc.
Cost Accounting
Middle America Manufacturing, a Bain client, believed
that all three of its product lines were profitable.
Return on sales: % % %
Sales: $250MM $100MM $75MM
Middle America Manufacturing - Estimated Profitability
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BOS
Copyright© 1998 Bain & Company, Inc.
Cost Accounting
After a thorough evaluation, the Bain team found that $ in costs
had been allocated incorrectly among the three products.
Middle America Manufacturing - Cost Allocation
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BOS
Copyright© 1998 Bain & Company, Inc.
Cost Accounting
The Bain team also determined that an additional $
in costs should be allocated to the three products.
Middle America Manufacturing - Additional Costs
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BOS
Copyright© 1998 Bain & Company, Inc.
Cost Accounting
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.
Return on sales: % (%) (%)
Sales: $250MM $100MM $75MM
Middle America Manufacturing - Actual Profitability
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BOS
Copyright© 1998 Bain & Company, Inc.
Cost Accounting
•Importance of cost allocation
•Client example
•Definitions
–direct vs. indirect, fixed vs. variable
–breakeven volume
•Exercises
–cost allocation
–breakeven volume
•Key takeaways
Agenda
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BOS
Copyright© 1998 Bain & Company, Inc.
Cost Accounting
Definitions: • 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
All costs can be broken down along two dimensions.
Fixed Variable Direct Indirectvs. vs.
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.
Types of Costs
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BOS
Copyright© 1998 Bain & Company, Inc.
Cost Accounting
• All costs are variable over a very long time horizon (., 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 (., 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.
– In 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.
Defining the appropriate time horizon for the analysis is important.
A meaningful analysis will isolate the fixed cost and
variable components of a particular cost
Fixed vs. Variable
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BOS
Copyright© 1998 Bain & Company, Inc.
Cost Accounting
The following is an illustration of cost behavior for fixed, semi-
variable, and variable costs:
C
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Volume (Units)
Variable costs
Semi-variable costs
Fixed costs
Fixed vs. Variable - Illustration
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BOS
Copyright© 1998 Bain & Company, Inc.
Cost Accounting
It is useful to know the following terms when doing cost analysis:
Simplified
income
statement:
- 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”
Revenue
Income Statement Terms
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BOS
Copyright© 1998 Bain & Company, Inc.
Cost Accounting
Breakeven volume is the volume at which the company covers its fixed
costs. At breakeven volume, the operating profit is zero.
Volume
Contribution margin
(., revenue less
variable costs)
Fixed costs
Breakeven volume
$
Operating
Loss
Fixed costs
Unit contribution Price per unit - Variable cost per unit
Breakeven volume =
Fixed costs
=
Operating
Profit
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M
ar
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Breakeven Volume
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BOS
Copyright© 1998 Bain & Company, Inc.
Cost Accounting
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 Price per unit - Variable cost per unitBreakeven volume =
Fixed costs
=
Backup for Breakeven Formula
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BOS
Copyright© 1998 Bain & Company, Inc.
Cost Accounting
•Importance of cost allocation
•Client example
•Definitions
–direct vs. indirect, fixed vs. variable
–breakeven volume
•Exercises
–cost allocation
–breakeven volume
•Key takeaways
Agenda
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BOS
Copyright© 1998 Bain & Company, Inc.
Cost Accounting
•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)
Maple Leaf Company wants to allocate costs to the
three products it makes and sells.
Cost Allocation Exercise - Background
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BOS
Copyright© 1998 Bain & Company, Inc.
Cost Accounting
How would you characterize the following costs over a time horizon
in which the company plans to increase sales volume by 10%?
Fixed Variable
Direct
Indirect
•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
Costs:
Cost Allocation Exercise - Question
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BOS
Copyright© 1998 Bain & Company, Inc.
Cost Accounting
Cost Allocation Exercise - Answer
Most costs are fixed indirect or variable direct.
Fixed Variable
Direct
Indirect
•Advertising •Raw materials
•Production floor labor
•Freight to customer
• Interest expense to finance
inventory
•Sales commissions
•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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Copyright© 1998 Bain & Company, Inc.
Cost Accounting
Cost Components Fixed vs. Variable Direct vs. Indirect
Advertising Fixed, because advertising is
usually not tied directly to
volume
Direct, because, in this case,
most of it is product specific
Equipment depreciation Fixed, because excess
capacity exists for a 10%
increase in volume
Indirect, because all products
are made on the same
machines
CEO’s salary Fixed, assuming his/her salary
does not change with 10% sales
increase
Indirect, because CEO oversees
the whole company
Supervisory labor Fixed, because it is unlikely that
additional supervisors will be
needed to handle a 10%
increase in volume
Indirect, because supervisors
oversee production of all three
products
Indirect, because all three
products are produced at the
same site
Rent Fixed, assuming current facility
has excess capacity
Cost Allocation Exercise - Detailed Answer (1 of 3)
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BOS
Copyright© 1998 Bain & Company, Inc.
Cost Accounting
Cost Components Fixed vs. Variable Direct vs. Indirect
Office supplies Fixed, because it is unlikely
that additional office supplies
will be needed to handle 10%
increase in volume
Indirect, because the office
supplies are used to support all
three products
Goodwill amortization Fixed, because goodwill is
not directly related to volume
Indirect, assuming the
goodwill is incurred to
support the whole company
Salespeople's salaries Fixed, assuming that current
sales force can handle 10%
additional volume
Indirect, because each
salesman sells all three
products
Sales travel and expenses Fixed, assuming that 10%
volume increase will not
require significant increase in
sales activities
Indirect, because sales-force
handles all three products
Raw material Variable, because a 10%
increase in volume would
require 10% more raw materials
Direct, because raw materials
are directly traceable to
individual products
Cost Allocation Exercise - Detailed Answer (2 of 3)
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BOS
Copyright© 1998 Bain & Company, Inc.
Cost Accounting
Cost Components Fixed vs. Variable 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
Production floor labor Variable, because more
production labor will be needed
to handle the increase in volume
Freight to customers Variable, because the freight
cost clearly increases with the
volume increase
Direct, because weight and
distance can be directly traced
to individual products
Interest expense to finance
inventory
Variable, because more
inventory means more
inventory financing and hence
more interest expense
Direct, because inventory is
product specific
Sales commissions Variable, because sales
commissions are paid based
on a percentage of sales
Direct, because commissions
are based on individual
product sales
Electricity to run machines Variable, because it clearly
varies with volume
Indirect, because all products
are made on the same
machines
Cost Allocation Exercise - Detailed Answer (3 of 3)
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BOS
Copyright© 1998 Bain & Company, Inc.
Cost Accounting
•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.
There are few caveats:
Cost Allocation Exercise - Caveats
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BOS
Copyright© 1998 Bain & Company, Inc.
Cost Accounting
A dean of a business school is considering starting an executive
program. She estimates the revenues and costs as follows:
Question: How many students does the program need to break even?
Costs:
Revenue:
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
Tuition per student
$3,000
$13,500
$500
$30,000 per classroom
$15,000
$20,000
$20,000 per faculty member
$12,000
$3,200
Breakeven Exercise - Background
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BOS
Copyright© 1998 Bain & Company, Inc.
Cost Accounting
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
Fixed Variable
Step 2: Calculate fixed costs
Fixed costs: $3,000 Advertising
$15,000 Program administration
$20,000 Program director’s salary
$12,000 Guest lectures
$50,000
Semi-Variable
First, you must categorize costs and calculate fixed costs.
Breakeven Exercise - Answer (1 of 3)
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BOS
Copyright© 1998 Bain & Company, Inc.
Cost Accounting
Step 4: Calculate unit contribution
Unit contribution = Price per unit - Variable cost per unit
= $13,500tuition
- 3,200room and board
- 500text and supplies
$9,800
Step 3: Calculate semi-variable costs
ClassroomFaculty
10 students $30,000$40,000
15 students $30,000$60,000
20 students $60,000$80,000
Then you must calculate semi-variable costs and the unit contribution.
Breakeven Exercise - Answer (2 of 3)
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BOS
Copyright© 1998 Bain & Company, Inc.
Cost Accounting
*The most effective way to calculate the breakeven volume is to write a simple formula in Excel
Step 5: Calculate breakeven volume
Breakeven volume =
For 10 students:
= students with 10 students the program does not
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
Fixed costs
Unit contribution
$140,000
$9,800
Now you are ready calculate the breakeven volume.
For 15 students:
$120,000
$9,800
= students
break even
Breakeven Exercise - Answer (3 of 3)
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BOS
Copyright© 1998 Bain & Company, Inc.
Cost Accounting
•Importance of cost allocation
•Client example
•Definitions
–direct vs. indirect, fixed vs. variable
–breakeven volume
•Exercises
–cost allocation
–breakeven volume
•Key takeaways
Agenda
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BOS
Copyright© 1998 Bain & Company, Inc.
Cost Accounting
• 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
• 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 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
Breakeven volume = Fixed costs
Unit contribution
= Fixed costs
Price per unit - Variable cost per unit
Breakeven Volume
Cost Allocation Overview
Types of Costs
Key Takeaways
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BOS
Copyright© 1998 Bain & Company, Inc.
Cost Accounting
Definitions: • 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
Fixed Variable Direct Indirectvs. vs.
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:
Types of Costs
C
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D
ol
la
rs
)
Volume (Units)
Variable
costs
Semi-
variable
costs
Fixed costs
Fixed vs. Semi-Variable vs. Variable Costs
Volume
Contribution
margin (.,
revenue less
variable costs)
Fixed costs
Breakeven volume
$
Operating
profit
Breakeven volume = Fixed costs Fixed costs
Unit contribution Price per unit - Variable cost per unit
Breakeven Volume
Fixed Variable
Direct
Indirect
Cost Categorization Matrix
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Operating
loss
=
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.
Takeaway Slides
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