How Distorted Costs Undermines Profits

The profitability of an option available to your business can easily be distorted.

This occurs when a business fails to properly account for the cost-benefit ratio. Failure to do this results in a falsely confident decision that actually causes the business to under perform relative to what would otherwise have been possible.

Marginal analysis focuses on identifying what the incremental benefit compared to the incremental cost would be for decisions. This requires isolating what benefits and costs actually matter to the analysis. These are considered relevant to the decision at hand. Relevant benefits and costs are those that differ between the options available to pursue and occur in the future. The benefits and costs that have already occurred and will not continue into the future are excluded from the analysis. Sunk costs are a prime example. These represent the costs for events that have already occurred and cannot be recovered.

Costs are the more difficult area to properly classify between relevant and irrelevant.

The same cost can be relevant or irrelevant depending on the decision facing the business.

An example of this is a machine operator's salary. If our decision is determining what the optimal product mix is, this salary is irrelevant if the cost would remain the same regardless as to whether we produce 100% of Product A, 100% of Product B, or some combination in between. But that same cost would be relevant if we would require additional labor from this position to product additional units, whether product A or B or some combination.

So how do we ensure we are capturing the true financial implications associated with the various decisions facing the business to maximize profits?

The Two Pillars Capturing The True Costs of Decisions in Manufacturing

Capturing all relevant costs relies on two areas.

1. Determining what the cost driver
2. Identifying the cost object

Identifying Your Key Cost Drivers

Cost drivers capture how costs change when a level of activity changes.

An example is direct labor hours and wages. Direct labor hours are the cost driver. As they increase, so do total wages. Wages would be classified as a variable cost because it increases or decreases with changes in the direct labor hours cost driver. When direct labor hours is the cost driver, the facility's rent would be considered a fixed cost as it would not change even if direct labor hours drop to zero. The way costs behave in relation to the given cost driver determines whether they are classified as variable or fixed costs.

Some costs have both variable and fixed components. These are considered "mixed" costs. They include semi-variable costs and semi-fixed costs.

Semi-variable costs have a fixed costs element that remains unchanged regardless of the level of activity. It also has a variable cost element that changes as the cost driver's activity level increases or decreases. A common example here is sales reps. They have a base salary (fixed) and commissions (variable). The base salary is paid out regardless of sales performance as long as the rep is with the organization. As their sales performance increases, so would the amount of commissions earned by the rep.

Semi-fixed costs (aka step costs or step variable costs) are fixed costs with a far narrower relevant range than normal fixed costs possess. A shop supervisor salary is a good example here. Let's say the daily production capacity for 1 shift is 100 units. The costs incurred for the supervisor during this shift is the same whether zero or 100 units is produced for that shift. If we were to add a second daily shift, we would need to add another supervisor. The facility itself has a far greater relevant range than the supervisor has.

Let's see how these different cost behaviors affects decision making.

Scenario:

• We're operating at capacity for 1 daily shift (1,000 monthly production volume)
• We have an opportunity to gain a new contract that will increase our monthly production volume by 300
• We need to determine what our true incremental cost would for this new contract to determine the selling price appropriate to win the bid while being profitable

Here's a breakdown of our costs:

• $50.00 variable costs per unit
• Semi-Variable Costs associated with sales commissions are 5% of revenue
• Fixed Costs are $30,000
• The salary for a supervisor for a single month's worth of 1 daily shift is $6,000

In this analysis, we have two different cost drivers. One cost driver is the number of daily production shifts, which is required for our semi-fixed costs. The other is production volume, required for our variable and semi-variable costs. The cost driver for variable costs, as well as the sales commissions is volume. As volume increases or decreases, so do these costs.

The cost driver for the supervisor's salary (a semi-fixed cost), is the number of daily shifts. If we go from 1 to 2 daily shifts, we double our supervisor's salary costs as we'll need an additional supervisor. The salary costs for this position are not influenced by volume. Let's see how this shakes out if we were to add another daily shift:

Here we can see our relevant costs include $15,000 variable costs ($50 per unit multiplied by 300 units) and $6,000 semi-fixed costs (supervisor salary for the additional daily shift. This means we have a total of $21,000 of costs that must be covered by the additional volume. We need to determine what the minimum selling price should be to justify the incremental costs from the order.

To breakeven, we would need a selling price of $73.68 per unit [$21,000 total incremental costs ÷ 300 units = $70 selling price. $70 selling price ÷ (1 minus 5% semi-variable commissions rate) = $73.68]. If we wanted the same profit margin as we currently operate at (say 10%), we would need a selling price of $82.35 [$21,000 total incremental costs ÷ 300 units = $70 selling price. $70 selling price ÷ (1 minus 5% semi-variable commissions rate minus 10% profit margin target) = $82.35]. See below for the full view:

Since the supervisor salary is fixed within the range of zero to 1,000 units for this incremental daily shift, the price we would be willing to accept to breakeven or hit a 10% profit margin target would decrease as volume increases above the current incremental 300 units. If we were to increase the units to 600, our selling price required to breakeven would drop to $63.16 and our selling price to hit 10% profit margin would drop to $70.59 as seen below:

Neither the breakeven nor the 10% profit margin target selling prices will be what we bid for the new contract. These must be compared to market rates, which ideally are higher. But our breakeven and profit margin target selling prices provides us the much needed context required to bid appropriate prices. But the difference in breakeven and profit margin target selling prices between the 300 and 600 volume levels for this additional daily shift highlight the importance of a concept I call Profit Bands.

A Profit Band shows how profits change over a given relevant range.

At the high end of the relevant range, fixed costs and semi-fixed costs are spread over the most amount of units. This decreases our costs per unit and maximizes profits. Operating at the lower end of this relevant range will have lower profits or even losses as there are fewer units to spread those costs over. This has substantial implications when it comes to pricing strategies to maximize profits.

Going back to our example.

The additional shift creates a new relevant range with its own Profit Band. When the company's goal is growth, it is not uncommon for profits to suffer as additional production capacity is established. This is because the incremental sales volume usually forces the business to operate at the low end of this new relevant range. The faster the company can increase volume to push towards the upper end of the Profit Band, the sooner losses will be minimized and profits can grow above what was previously possible.

How Failure to Allocate Indirect Costs Distorts Anticipated Profits

With cost drivers accounted for, we can move on to identifying cost objects to determine which costs are direct and which are indirect.

Anything that can have costs measured against can be a cost object. Cost tracing and cost allocating helps ensure we capture all costs associated with a cost object.

Cost tracing focuses on the direct costs for the cost object. Direct costs are those that are the result of the cost object existing. Without the cost object, these costs would disappear. Direct costs are easier to see and measure than indirect costs. Examples for a product as the cost object include raw materials, labor from production personnel, machinery used in the production process, etc.

Indirect costs are more difficult to measure and require cost allocating. Without allocating these costs, the economics for the given cost object would give us a distorted view. This inevitably will lead us to making costly mistakes such as pricing too high or too low. Both scenarios result in lower profits as incremental costs would fail to be covered by incremental revenues. An example of indirect costs for a product as the cost object includes indirect labor such as maintenance workers, repair technicians, and janitorial staff. These are not directly involved in converting raw materials into finished products. But the production process would suffer without these personnel. We would want to allocate these costs based on a cost driver such as machine hours, direct labor hours, or some other cost driver to ensure we are capturing all costs associated with producing that type of product.

Here's an example to show how important capturing the complete costs is for profitable decision making.

We're looking to determine whether a new product line is profitable to pursue over our current production mix.

Product A is all we currently produce and delivers $25,000. We can choose reduce our volume for Product A by 30% and manufacture 450 units of product B instead using the following data:

• Selling price: $150
• Direct material costs: $60
• Direct labor costs: $20
• Unit contribution: $70
• Sales Volume: 450 units
• Contribution Margin: $31,500

Based on the above, our profits would increase from $25,000 to $34,000. See the detail below:

This analysis shows the new product is a profitable option to pursue, but we've failed to properly account for indirect costs required for Product B.

Manufacturing two products requires increases to machine set up time. This means our costs would increase. To accommodate multiple products, we have to add $15,000 of costs to account for the additional set up time. The cost driver is the machine set up time. Product A consumes 55% of the additional costs for machine set up time while Product B requires 45%, despite the 70-30 product mix. Product B requires more set up time due to its complexity. By allocating these incremental costs across the new product mix, we see a different picture:

If we fail to capture the indirect costs required for the addition of Product B, we would likely go ahead with the decision. But the inclusion of all indirect costs for this new set up shows profits would actually decrease by $6,000 ($19,000 with the proposed mix versus $25,000 with 100% Product A mix).

Practical Matters: When to Trace and When to Allocate

In a perfect world, we would have access to all data required to properly classify costs as direct or indirect.

But reality is less than perfect. There are a variety of factors that can make this impractical, impossible, or simply not matter to the given analysis.

If costs are too low to matter, we may choose to classify costs as indirect. This is known as a materiality threshold. When costs are below this threshold, they are too small to influence the analysis in one way or another. The additional time and effort to trace these small costs to a cost object outweighs any benefit of doing so. Instead, we would allocate these costs.

Technology constraints play a significant role in our ability to trace direct costs to a cost object. An example is utilities costs for products. Our technology may not be able to record the exact utilities cost used in the production of a given product on a specific piece of machinery. Instead, we may allocate these costs using the number of machine hours to capture all production related costs for the product.

The structure of the business can either make it easier or more difficult to classify costs as direct. If the business produces two products, each in a separate production facilities, it is easy to classify all production costs to that product produced. But if they are produced in the same facility, this becomes more difficult to do and requires allocating costs to the given cost object - each product type.

Making the most informed decisions requires capturing all relevant costs.

Failing to do so will result in poor decisions that reduce long term profits and can even cause the business to go under.

Our next article will explore several use cases that use marginal analysis to guide profitable decision making.

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