Cost analysis – a helpful tool or stumbling block?

Cost reduction is one of the most frequently considered issues in virtually all businesses, especially manufacturing. Regrettably, consideration is seldom given to profit optimization or maximization. Maximizing profit requires a sound understanding of price constraints and cost behavior. The opportunities available are closely influenced by the markets served and the unique factors associated with the business. Addressing some pricing and costing issues can help you identify the cost analysis pitfalls that prevent your company from reaching its maximum profitability.

Profit Optimization

Business opportunities are pursued to improve the bottom line (profit). Incremental business opportunities are beneficial when the revenue they generate exceeds all variable costs and therefore contribute to covering the overhead costs or directly to the profits. One of the difficulties is that these terms have various interpretations by those who use them.

Those involved in generating business (the sales team) often see them differently from those who tally costs and expenses and track the company’s performance (the accounting team). For the business manager, sales manager, or owner, their use is centered on optimizing the business’s performance. Depending on the circumstances, this may be a matter of minimizing losses or maximizing profits.

These different perspectives increase the difficulty in recognizing business opportunities that could result in a net improvement in business unit profits.

In pursuing optimization, a company’s decision to develop a new revenue opportunity may not be a matter of determining whether the gross margin exceeds a set minimum. If the goal is optimization, the question may be as simple as this: Is it going to improve the profit performance of the business? Keep in mind that when the business owner reviews the business’s performance with bankers or investors, they focus on how many dollars have been generated with their investment. In many cases, accountants consider the percentage of improvement. Bank deposits are made in dollars, not percentages.

This evaluation can be relatively simple and straightforward. However, depending on the actual business cost behavior and the approach used in assigning the costs to a piece of business, the decision-making process may become somewhat complicated.

To avoid making the decisions that fail to improve the profitability, it is helpful to consider some of the cost behavior issues and their effect on the opportunity evaluation process. This is not in any way intended to be a lesson in accounting, but rather an effort to stimulate additional methods of evaluating business opportunities, which will then lead to the desired optimization of profit results.

The goal is to take on any business opportunity that generates a positive margin. A simple formula for margin is sales revenue minus cost, usually expressed as a percentage of the sales revenue:

Margin = (Revenue – Cost of Goods Sold [COGS])/Revenue

The challenging part is determining the COGS. In many organizations, the cost is fully burdened, which is the variable cost plus some allocated portion of the fixed costs (overhead).

A variable cost is any cost that correlates to the order quantity as a function of labor hours, machine hours, and pounds or units of product produced. These costs include the materials, labor, packaging, consumables, utilities, and material yield losses. It is important to recognize that select costs can behave as fixed or variable, depending on the time period covered by the opportunity being considered.

A fixed cost remains unchanged whether the quantity changes or whether the business is taken at all. These are baseline utilities, management salaries, quality control/assurance services, support staff salaries and wages, real estate taxes, and so on.

Fixed or Variable?

The question usually is as simple as this: Should the opportunity be pursued or rejected?

Using simple overhead allocation methods based on labor or machine hours can result in rejecting business that has the potential for adding to the bottom line.

Looking at one business opportunity two ways reveals two outcomes, depending on how the accounting is done. In the first scenario, the labor hours and machine time are fully burdened, or treated as fixed costs. Simply stated, this includes costs such as worker benefits and machinery wear. The goal is to achieve a gross margin of 20 percent or more.

Accounting Scenario 1