Accounting_Essentials.ppt
- 1. Accounting Essentials • Managing by the Numbers • Jay Jacquet 1
- 2. Learning objectives for Accounting Essentials • The objectives for Accounting Essentials are listed below • They have been developed to guide the user to the core issues covered in this class • Learn how various business transactions are reflected in the financial statements • Identify the five cost categories and their components • Explore the three types of costs and their effect on profitability • Understand the concept and calculation of break-even analysis • Learn about operating leverage and its impact on profitability • Discover the various influences on determining the appropriate price for a product or service • Understand the problem-solving process of identifying costs relevant to decision-making 2
- 3. Business runs by the numbers • This class helps to explain the relationships among numbers and how they affect decision-making • The one question managers and customers are always asking is: • What is this going to cost me? • It is important to understand terms related to costing products and services • Then it is important to understand how costs relate and build on each other • Finally, it is important to understand the impact costs have on your decisions 3
- 4. Accounting Essentials is about understanding the impact of financial data on day-to-day operations • Managers today cannot leave financial decision-making to the accounting or financial departments only 4
- 5. All involved must understand: • The cost of their product or service • The price strategies • The impact that short and long-term decisions have on the bottom line 5
- 6. Effective Communication • Understanding more about financial decision making should enable you to communicate effectively throughout your organization • This class will introduce you to how financial data is • Collected • Allocated • Used within your organization 6
- 7. Introduction • Decision-making is key to every aspect of a business • Whether you are in your own business or working for someone else • You will make a variety of decisions every day • The ability to respond effectively to decision-making conditions requires quantitative information • A better understanding of how to use these numbers in the basic functions of business will lessen the risk associated with a decision 7
- 8. Management consists of five basic functions: •Control • Lead • Organize • Plan • Staff 8
- 9. Accounting Essentials is about decision- making in relation to the control function • Two basic objectives of this function are to create • Efficient • Effective • Processes within the organization 9
- 10. Report card • To determine whether the company is efficient and effective the organization needs a report card • This report card is based on • Numbers • Numbers • More numbers 10
- 11. Historical data • Most of the financial information for the external and internal users in your company is historical data • But decision-making is about looking into tomorrow 11
- 12. Decisions into tomorrow require formats other than classic financial statements • Reorganizing this information will provide many answers to questions you may have raised with your associates • The objective is to get you • Asking more questions • Understanding the “whys” and “ways” that numbers affect process 12
- 13. Part 1: Getting the “Right” Numbers • Qualitative vs Quantitative decision-making • Standards • Effective and efficient decisions • Constraints 13
- 14. Part 2: Review of the Financial Statements • The balance sheet and income statement • Statement of cash flow • What the financial statements do not tell you 14
- 15. Part 3: Making Money • Maximizing profit or minimizing cost • Thinking in units • Defining cost 15
- 16. Part 4: Identifying Costs and Their Behaviors • Fixed • Variable and mixed costs • Relevant range • Cost per unit • Cost categories on the income statement • Discerning variable costs • Discerning mixed costs 16
- 17. Part 5: Controlling Costs • Contribution margin on the income statement • Activity-based costing • Non-value-added activity 17
- 18. Part 6: Am I Breaking Even? • The cost-volume-profit graph • The contribution margin approach to break-even • Calculating “What If” profit • Margin of safety 18
- 19. Part 7: Operating Leverage • Defining operating leverage • Operating leverage and the bottom line 19
- 20. Part 8: Influences on Pricing • Pricing in line with the competition • Trade-offs between price and demand • Elasticity of demand illustrated • Market and cost influences on pricing • Qualitative factors in relation to price 20
- 21. Part 9: Making The Numbers Work for You • Responsible decision-making • Quality management 21
- 22. Part 1: Getting the “Right” Numbers 22
- 23. Qualitative vs Quantitative decision-making 23
- 24. Let’s say you are thinking about purchasing a new car • There are two kinds of decisions you will need to make • One requires quantitative data—such as information about • Price • Car payments • Miles per gallon • The manufacturer’s maintenance history • The other kind of decision requires qualitative information • Color • Interior material • Seat comfort • And so on 24
- 25. The difference between the two is defined as follows: • Quantitative decision-making should be capable of measurement • Qualitative decision-making is simply information that is not quantifiable 25
- 26. Accounting Essentials emphasizes the use of quantitative data • The quality • Efficiency • Effectiveness of decision-making • Require the use of numbers to measure progress 26
- 27. Management must make the best decision using all the tools available • Many of the numbers may be soft (within a range) and involve other non-quantifiable alternatives • The more solid the numbers calculated • The less risk involved in that decision 27
- 28. Standards • A key question in every organization is “how do we measure progress?” • The response to this question is in the data provided such as: • Profit or loss • “the bottom line” related to net income or loss • Growth • Increase in market share • The return on investment (ROI) • Percent of return on investment • The “right” cost for the product or service • Cost to deliver goods and services to the customer • Increase in sales • Continued growth by selling more product 28
- 29. These items require numbers to help answer the question of progress • Data alone will not answer all the questions • Today • With databases and computer-integrated systems • There is an increased ability to capture a great deal of information • All of this financial information must be put into usable formats 29
- 30. Maintaining consistency • The importance of maintaining consistency of information in financial statements for managerial decision-making cannot be overstated • Many businesses have gotten into serious financial trouble from management’s failure to • Respond to internal or external quantitative information • Simply to ask the “right” questions 30
- 31. Establish control • Remember one of the major functions of management is to establish control • A large part of the control process requires being efficient and effective • Especially with today’s global competition 31
- 32. To be efficient and effective • An organization must establish standards • A standard is a measure of adequacy 32
- 33. Management can set very high standards or low ones • Standards become the benchmarks for you to measure success or failure • Standards can be obtained through your own and others’ experience and the analysis of technical processes 33
- 34. Other control methods are available in every business • The numbers drive all of these methods • Budgets • Financial reports • Observations • Control charts and graphs • Ratios (comparisons and relationships among numbers) 34
- 35. Effective and Efficient Decisions • A major role of management is to create processes that are both • Efficient • Efficient—the ability to produce a product with a minimum of effort or expense • Effective • Effective—the ability to produce a desired or definite result 35
- 36. Using numbers • It would be difficult to prove a process is efficient or effective without using numbers • These numbers need to be • Accurate • Timely • Consistent • Failure to follow these guidelines will create unusable information 36 Accurate 2 + 2 = 4 Timely Consistant Proceedures are the same from period to period
- 37. Caveats (beware!) • This class has been written using generally applied cost principles and terminology • Others within your business may • Collect • Analyze • Distribute the financial information 37
- 38. Numbers should be explained • Some of the processes and allocation of costs may not be the same in your company • But no matter what system of data collection is used • The numbers and the methods for getting those numbers should be explained to those who need them 38
- 39. How we got the numbers • The first step in making sure that we have the right numbers is for everyone to understand how we got the numbers 39
- 40. Keep an open mind while learning the processes used in this class • These methods may be different from company to company • The basic tools used here are a starting point • It is equally important when using quantitative information that you understand how the number is calculated and how it relates to other numbers • Ask questions 40
- 41. Internal decision-making • Management has a responsibility to use the financial information for internal decision-making • This responsibility requires an understanding of financial and management reports generated within your company 41
- 42. Constraints • Every organization has constraints • Management’s responsibility is to provide resources (where possible) to ease these constraints 42
- 43. Limitations • The organization must continuously deal with the following limitations: • Money • Capacity • People 43 Money Capacity People
- 44. These constraints are major concerns for any business • Other constraints may appear in production systems • Bottlenecks • Backorders • Downsizing production personnel • This stretching and shrinking of the production environment and other constraints are a continual challenge for managers 44 Result People Capacity Money
- 45. The purpose of “good” data is to • Aid the manager in providing solutions to these constraints furthering • Cost reduction • Containment 45
- 46. Before major changes in costs are implemented • The following question must be answered: • What impact does this change or reduction in cost have on the process? 46
- 47. Very few costs work in isolation from each other • There are process links between customer and product • Reduction of costs without considering process can create a deadly mix resulting in loss of customers 47
- 48. Avoid customer dissatisfaction • Personnel must • Understand the reasons for cost containment • Aid in making sure improved process results from these changes • Cutting costs alone may lead to loss of quality and customer dissatisfaction 48
- 49. Part 2: Review of the Financial Statements 49
- 50. The Balance Sheet and Income Statement • It is important to have a basic understanding of the financial statements and reports used in your company • This section is not meant to cover everything you need to know about these statements but to serve as a review of the fundamentals 50
- 51. Transaction impact • All transactions in an accounting system will have an impact on • Two or more accounts 51
- 52. Five categories • These accounts can be classified into one of five categories used throughout the system • The five categories are: • Assets • Liabilities • Equity • Revenue • Expenses 52
- 53. Examples of accounts in each of the five categories are shown in the following table: Assets Liabilities Owner’s Equity Revenue Expenses Cash Accounts Inventory Equipment Buildings Land Accounts payable Notes Payable Capital Contributions Withdrawals OR Common Stock Additional Paid in Capital OR Capital AND Retained earnings Sales Interest Earned Wages Rent Depreciation Advertising 53
- 54. These five categories are combined to create two important financial statements: • The income statement • Income statement accounts include revenue and expenses • This is usually done month to month July August Revenue $1,000 $1,500 Total Expenses 850 1,750 Net Income or (loss) $150 -$250 The Income Statement 54
- 55. These five categories are combined to create two important financial statements: • Balance sheet • Balance sheet accounts include assets and liabilities and equity • The purpose of the balance sheet is to provide the financial “position” of the company on a specific date The Balance Sheet Assets = Liabilities + Owner’s Equity 100,000 = 49,000 + 51,000 55
- 56. Let’s illustrate how various transactions can affect the two financial statements • These are the transactions: • Invested $10,000 in the business • Made sales of $400 on account • Paid the rent, $300 • Purchased a building for $25,000 and land for $3,000 with $5,000 cash and the remainder on credit • Made sales and received cash of $600 • Purchased $5,000 of equipment on credit • Paid wages of $500 • Received a utility bill for $150 56
- 57. Now let’s see which categories each of these transactions falls in to • The five categories for accounts are: Assets Liabilities Owner’s Equity Revenue Expense 57
- 58. 1 Invested $10,000 in the business • Because the $10,000 is your own money • This transaction increases cash and capital Assets Liabilities Owner’s Equity Revenue Expense Cash +10,000 Capital +10,000 58
- 59. Made sales of $400 on account • This is revenue • The company earned it even though it was not paid and because it was not paid it is placed in accounts receivable (A/R) Assets Liabilities Owner’s Equity Revenue Expense A/R +400 Sales +400 59
- 60. 3 Paid the rent of $300 • This is an expense paid in cash Assets Liabilities Owner’s Equity Revenue Expense Cash -300 Rent expense -300 60
- 61. 4 Purchased a building for $25,000 and land for $3,000 with $5,000 cash and the remainder on credit • This is a complicated transaction but notice that the difference in the assets (25,000 + 3,000 -5,000) falls into the liability category as a note payable Assets Liabilities Owner’s Equity Revenue Expense Buildings +25,000 Land +3000 Cash -5000 Notes payable +23,000 61
- 62. 5 Made sales and received cash of $600 • In this transaction the company was paid for a job completed Assets Liabilities Owner’s Equity Revenue Expense Cash +600 Sales +600 62
- 63. 6 Purchased $5,000 of equipment on credit • The company borrowed money to purchase equipment Assets Liabilities Owner’s Equity Revenue Expense Equipment +5000 Notes payable +5000 63
- 64. 7 Paid wages of $500 • Paid company employees’ wages Assets Liabilities Owner’s Equity Revenue Expense Cash -500 Wage expense -500 64
- 65. 8 Received a utility bill for $150 • Received the bill but it is not yet paid Assets Liabilities Owner’s Equity Revenue Expense Accounts payable +150 Utility expense -150 65
- 66. Assets = Liabilities + Cash $4,800 Accounts payable $150 Capital $10,000 A/R $400 Notes payable $28,000 Equipment $5,000 Building $25,000 Land $3,000 Totals $38,200 = 28,150 + $10,000 Income 50 $10,050 Balance Sheet Owner's equity A summary of the transactions follows: See next slide 66
- 67. Not balanced • Note: the balance sheet—$38,200 = 28,150 + 10,000—does not balance • The balance sheet will not balance until net income or loss is included in owner’s equity • Once the $50 of income (see the following income statement) is added to owner’s equity • The assets of the company—$38,200—will equal the liabilities—$28,150 plus owner’s equity of $10,050 67
- 68. Income statement transactions • Revenue: • This statement is a collection of company revenues and expenses for a period of time • usually one month Income Statement Transactions Revenue: Sales (transaction 2) $400 Sales (transaction 5) 600 Total sales $1,000 Expense: Rent expense (transaction 3) 300 Wage expense (transaction 7) 500 Urilities expense (transaction 8) 150 Total expense (transaction 80 950 Net Income (sales - expense) $50 68
- 69. Income statement Income Statement Revenue from sales and services $1,000 Less Expenses: Wage Expense $500 Rent Expense 300 Utilities Expense 150 950 Net Income $50 69
- 70. Statement of cash flow • Two accounting systems: • The accrual system • Revenue is recorded at the time the service is performed or the product is sold • Expenses are recorded at the time they are incurred regardless of when the money actually changes hands • The cash system • Income and expenses are recorded when money changes hands • Someone pays you for a service and you record that as revenue • You pay for office supplies and you record that as an expense 70
- 71. Statement of cash flow • Because revenue and expenses are not the same as cash • External reporting requires that a statement of cash flow accompany the income statement 71
- 72. This statement reflects all transactions in cash • The purpose of this statement is to explain the difference in the cash account from one year to the next on the balance sheet 72
- 73. A large non-cash expense to be reflected in the cash flow statement is • Depreciation • Which is a method of expensing large assets • Buildings • Equipment • Autos 73
- 74. Accounting standards • Accounting standards require that a major asset be expensed over its useful life rather than all at once at the time of purchase • The depreciation per year is not cash • It is an expense on your income statement but does not require any cash payment • It must be added back to net income on the cash flow statement Example: Truck Cost $25,000 Depreciation per year 5years (useful life) = $5,000 74
- 75. The Cash Flow statement generally consists of: Cash from operations Begin with: Net income (the "bottom line") Add: Depreciation of assets Adjust for: Sales not received in cash (A/R) Expenses not paid in cash (A/P) Inventory purchases 75
- 76. Deductions or additions • Note that the adjustments for A/R • A/P and inventory may be deductions or additions depending on the change in the account balance from the prior year 76
- 77. For instance • If A/R is higher than the prior year • You have received less of your sales in cash and that is a deduction • In contrast • If A/P is higher than the prior year you have used less of your cash for expenses and that is an addition 77
- 78. Cash from investments vs financing Cash from Investments Add: Cash from sales of long-term assets (Property, plant, equipment, securities) Deduct: Cash used to purchase long-term assets Cash from financing Add: Cash from sales of company stock Proceeds from long-term debt Deduct: Cash used to repurchase company stock Cash used to repay long-term debt 78
- 79. Differences can exist between cash flow and income • A simple example shows the difference that can exist between cash flow and income as reported under the accrual system 79
- 80. The Income Statement for comparison Revenue: Grass cutting $37,000 Expenses: Wage Expense $14,800 Gasoline 1,480 Maintenance 296 Suppliers 925 Truck Depreciation 1,200 Equipment depreciation 1,200 Telephone Expense 262 Advertising Expense 3,145 Administrative Services 1,020 Utilities expense 370 Rent Expense 2,400 Miscellaneous expense 1,850 Total Expense $28,948 Net Income or (Net Loss) $8,052 J.D. Lawn Service Income Statement For Months July, August, September 80
- 81. The following is a simple example of a partial cash flow statement • JD Lawn Service had no cash transactions from investment or financing activities • Notice the cash from operations is not the same as the net income figure on the income statement • This difference can be substantial when companies do not collect revenue quickly and have large amounts of depreciation from equipment Cash from operations: Net income $8,052 Add: Depreciation 2,400 Increase in A/P* 300 Deduct: Increase in A/R** 3,500 Total Cash from Operations $7,252 Difference $800 Net Income from the Income Statement $8,052 * A $300 bill for advertising was received at the end of the month. The Balance Sheet shows the account payable of $300. The advertising expense on the income statement shows $3,145 was purchased, but because only $2,845 was actually paid in cash, this $300 account payable must be added to net income on the cash flow statement. The cash has not yet been paid out. ** Grass cutting revenue is reduced by $3,500 because the Balance Sheet shows an Account Receivable indicating this cash revenue has not yet been received. J.D. Lawn Service Cash Flow Statement For July 1-August 31 Cash from operations: Net income A D Total Cash from Operations Net Income from the Income Statement * A $300 bill for advertising was received at the end of the month. The Balance Sheet shows the account payable of $300. The advertising expense on the income statement shows $3,145 was purchased, but because only $2,845 was actually paid in cash, this $300 account payable must be added to net income on the cash flow statement. The cash has not yet been paid out. ** Grass cutting revenue is reduced by $3,500 because the Balance Sheet shows an Account Receivable indicating this cash revenue has not yet been received. J.D. Lawn Service Cash Flow Statement For July 1-August 31 81
- 82. What the financial statements do not tell you 82
- 83. Mission statement • The goals of an organization are often expressed in its mission statement • The mission statement is a direct result of goals and objectives prepared each year 83
- 84. To achieve these goals • The organization needs • Financial resources • People • Daily processes 84
- 85. The ability of management to • Plan • Control • Direct operational activities • Affected by the financial statements 85
- 86. Management must • Work with the providers of financial information • Request the proper data to judge the company’s progress 86
- 87. Management should be able to answer: • How well is the organization doing financially? • Is the company financially viable for the present and the future? • Is the company being effective and efficient? • How does the customer view the organization? • How well is the organization creating new markets? 87
- 88. Cost effectiveness • The management team must be concerned with the • Cost effectiveness of its business processes • Production procedures 88
- 89. Customer needs and satisfaction • Management must continually monitor the needs and satisfaction levels of its customers 89
- 90. Golf score • The numbers on the financial statements are like a golf score • At the end of 18 holes you may have shot a score of 92 • But this number does not explain how many drives you flubbed or how many iron shots it took or the number of putts • The score does not answer the basic question of how to correct your various high scores and fix your game • It takes practice and patience and the ability to work through the problems • The numbers will help you • Looking at each of the various financial statements and their relationship with one another will help you fix your company 90
- 91. Where to look for company problems July August Sept Total Revenue: Grass cutting 12,000 10,000 15,000 37,000 Expenses: Wage Expense 4,800 4,000 6,000 14,800 Gasolinre 480 400 600 1,480 Maintenance 96 80 120 296 Suppliers 300 250 375 925 Truck Depreciation 400 400 400 1,200 Equipment depreciation 400 400 400 1,200 telphone Expense 86 84 92 262 Advertising Expense 1,020 850 1,275 3,145 Adminstrative Services 340 340 340 1,020 Utilities expense 120 100 150 370 Rent Expence 800 800 800 2,400 Miscellaneous expense 600 500 750 1,850 Total Expense 9,442 8,204 11,302 28,948 Net Income or (Net Loss) 2,558 1,796 3,698 8,052 J.D. Lawn Service Income Statement For Months July, August, September 91
- 92. Part 3: Making money 92
- 93. Maximizing profit or minimizing cost • Before knowing if your company is making money •You need to know how to make money 93
- 94. There are three ways to produce a more profitable business: • Increase sales: sell more units • Increasing total sales and producing more income • Decrease costs: reduce the costs of products or services • Providing more profit for the company • Increase sales and decrease costs • Sell more units and reduce the costs of products or services resulting in a more profitable position for the company 94
- 95. Simple example of increasing sales or decreasing costs • Let’s look at a simple example of increasing sales or decreasing costs • Company a and b have the same sales and expense figures • Management wants to increase net profit from $50,000 to $100,000 • To do so Company A decides to increase marketing (resulting in increased sales) while Company B decides to reduce costs Company A Company B Sales $1,000,000 $1,000,000 Expenses 950,000 950,000 Profit $50,000 $50,000 Company A Company B Sales $2,000,000 (was 1,000,000) $1,000,000 Expenses 1,900,000 900,000 (was 950,000) Profit $100,000 $100,000 95
- 96. *this problem assumes that expenses will increase proportionally with sales • Although this is not always the case • Company A had to exert considerable effort • Doubling sales to achieve the desired results • Company B merely reduced expenses by 526%(rounded) to achieve the same result Company A Company B Sales $2,000,000 (was 1,000,000) $1,000,000 Expenses 1,900,000 900,000 (was 950,000) Profit $100,000 $100,000 96
- 97. Simple model • This simple model compels you to think about the objective of either increasing sales or decreasing costs • Doubling the sales volume requires a great deal of activity • Reducing expenses requires some “belt tightening” and looking for efficiency within the organization • The reduction of 526%in costs produces the same profit result Company A Company B Sales 2,000,000 (was 1,000,000) 1,000,000 Expenses 1,900,000 900,000 (was 950,000) Profit 100,000 100,000 97
- 98. The above example illustrates the importance of looking at costs along with thinking about increasing sales Company A Company B Sales $1,000,000 $1,000,000 Expenses 950,000 950,000 Profit $50,000 $50,000 Company A Company B Sales $2,000,000 (was 1,000,000) $1,000,000 Expenses 1,900,000 900,000 (was 950,000) Profit $100,000 $100,000 98
- 99. Not all costs increase proportional to sales • When business is good and sales are strong • There is less pressure to cut costs • When business downturns occur • Cost containment and reduction become requirements to maintain a competitive edge 99
- 100. Thinking in units • As we begin to think about costs • It makes sense to reduce the numbers to a size that can be grasped 100
- 101. Easier to imagine • It is easier to imagine drinking • eight 8-oz glasses of water a day • than a 64-oz jug of water • The same is true when considering financial information 101
- 102. Using large numbers that are difficult • Governments are well-known for using large numbers that are difficult to understand • Let’s say the village of Fairfield wants to pass a tax for $2 million to collect refuse weekly • This number does not have much significance to individuals because it is large and difficult to grasp • But if the $2 million is divided by the number of households in the village and the number of weeks of pickup service • The cost comes out to $15 per household per week $2,000,000 2.565residents = $780per year $780 52weeks = $15per week for refuse collection 102
- 103. This figure takes on a meaning citizens can grasp • They can look at how much refuse the average person in the village discards and the cost per 30-gallon container or some other standard • This results in data people can use $2,000,000 2.565residents = $780per year $780 52weeks = $15per week for refuse collection 103
- 104. Some idea of the cost • Village management and customers now have some idea of the cost per household and can make decisions using these costs • The village may ask: • Do we stay with city collection or outsource to a private carrier? • Is this cost too high or low? 104
- 105. Same concept • The same concept can be applied to a retail company with sales of $10 million • This is only a large number • It does not explain whether the company’s prices are • Too high • Perhaps not high enough • The number begins to take on meaning • When the company sees that it is selling 40,000 units at $250 per unit 105
- 106. It is important to look at sales and costs per unit • Collection of information other than a dollar figure will provide additional perspective to decision making • The number alone can be deceiving 106
- 107. The following inventory data is a good example of deception Year Inventory A retail company: 2019 $1,200,000 2020 2,400,000 107
- 108. Looking at the inventory number • You might assume the company has more inventory on hand • But additional information on units and cost reveals: • Inventory costs have skyrocketed! And there are fewer units Year Inventory A retail company: 2019 $1,200,000 2020 2,400,000 Units Cost per Unit Value Inventory 2019 60,000 $20 $1,200,000 Inventory 2020 50,000 $48 $2,400,000 108
- 109. Hasty assumptions • Do not make hasty assumptions about an increase or decrease of revenue and costs • The number of units and cost per unit will help greatly in decision making Year Inventory A retail company: 2019 1,200,000 2020 2,400,000 Units Cost per Unit Value Inventory 2019 60,000 $20 $1,200,000 Inventory 2020 50,000 $48 $2,400,000 109
- 110. Defining cost • Exactly what do we mean by the word cost? • In financial accounting the term cost refers to the use of • Cash • Other resources • The machine cost $300 • The utility bill cost $150 110
- 111. The cost terms below are used in different ways • These costs are associated with different purposes • Before identifying costs and their behaviors and other classifications • It is important to understand the terminology associated with these costs • Costs can be classified into the following categories 111
- 112. Classifications • Let’s look at each classification and define terms that make up each one 112
- 113. Operational function • Manufacturing costs: • Direct material • All materials that become a part of the product • Direct labor • Labor that directly makes the product • Factory overhead • Indirect material • Labor • Other costs in manufacturing 113
- 114. Non-manufacturing costs: • Cost of goods sold • Finished inventory ready to sell • Administrative expenses • All expenses in administration • Marketing expenses • All expenses to sell product 114
- 115. Traceable costs • Direct costs: • Direct material • Trace materials directly to the product • Direct labor • Trace labor directly to the product 115
- 116. Indirect costs: • Factory overhead • These costs are not directly related to the product • Common costs • These costs are related to the process but not specific product 116
- 117. Timing costs • Product costs: • Inventory costs • Inventory on hand • Raw material • Work in Process inventory • Finished goods inventory 117
- 118. Period costs: • Marketing expenses • Charged against revenue for the same period of time • Administrative expenses • Charged against revenue per month 118
- 119. Cost behavior • Variable costs • Costs that change with volume of activity • Fixed costs • Costs which do not change with volume of activity • Mixed costs • A cost with both fixed and variable elements 119
- 120. Decision-making types of costs • Standard costs • Predetermined costs budgeted • Sunk costs • Costs that have already been incurred • These are past costs • Opportunity cost • Loss of income from rejecting one alternative for another • Relevant costs • Costs that differ between alternatives 120
- 121. Cost behavior—volume of activity • From a control and planning management operational view • The most important of these classifications is cost behavior which changes with volume of activity 121
- 122. Part 4: Identifying costs and their behaviors 122
- 123. Fixed, variable, and mixed costs 123
- 124. Business expenses • All business expenses can be classified into one of three areas: • Variable expenses • Fixed expenses • Mixed (both variable and fixed) 124
- 125. These costs have a relationship to volume • The more volume • The more costs incurred • Although this is generally not true for fixed costs • This section defines these costs and looks at their relationship to volume 125
- 126. Total fixed costs • Fixed costs are expenses that do not change with volume • They remain the same no matter what the volume 126
- 127. Examples of fixed costs include: • Rent expense • Depreciation expense • Car lease • Equipment rental 127
- 128. Total refers to units times dollars • For fixed costs • The expense totals each month are not affected by the volume of the product or service produced • As the number of units increases • There is no change in the fixed cost 128
- 129. Total variable costs • Variable costs are expenses that change with volume 129
- 130. Examples of variable costs include: • Wage expense (hourly or piece- rate employees) • Material used in production of a product • Gasoline and other supplies to service the equipment 130
- 131. Total refers to units times dollars • For variable costs • The expense totals will change with volume • As the units produced increases • The total variable cost to produce the units continues to increase 131
- 132. Total mixed cost • Mixed costs have elements of fixed and variable expenses • So they will change with volume 132
- 133. Examples of mixed costs include: • Telephone expense • Basic monthly charge plus a cost per long-distance call • Water • Basic monthly charge plus a cost per gallon • Electricity • Basic usage charge plus additional costs for demand 133
- 134. Total refers to units times dollars • For mixed costs • The expense totals are affected by the volume of the product or service you produce • Notice the fixed cost of $20 does not change with the increase in units • The variable cost does increase with volume • Raising the total cost as units increase 134
- 135. Mixed costs • If a company has several mixed costs • It is important to separate the fixed and variable costs from each other • Particularly if the cost is significant 135
- 136. Relevant range • The relationship between • Variable cost • Fixed cost • Volume • Will remain consistent within the relevant range 136
- 137. Consistent relationship • This is the range within which costs will react with volume in a consistent relationship • Beyond the upper and lower limits of this range • Costs will not react in the same manner 137
- 138. For example • Rent expense is a fixed cost for a company producing 10,000 units • Beyond 10,000 units • The company will need additional space for production • This will require an additional cost 138
- 139. In the illustration that follows • The relevant range is 0 to 10,000 units • The cost is fixed at $800 for those required units • If the company produces more than 10,000 units • Additional fixed costs will be required to produce more volume 139
- 140. Cost per unit • Cost per unit is not the same as total cost for the number of units a company produces • Variable and fixed costs per unit will react much differently in relation to volume than total costs 140
- 141. Variable cost per unit • Variable cost per unit remains constant no matter how many units are produced • This is a justification for manufacturing plants to use a piece rate for direct labor employees 141
- 142. In this illustration • The variable cost per unit is $5 • Two units cost $10 to produce • Total variable costs rise with the production of units • but the cost per unit remains at $5 142
- 143. Fixed cost per unit • Fixed costs per unit will decrease as the production of units increase • This is logical considering that total fixed costs do not change with the number of units produced • Projecting fixed cost per unit • Is difficult without knowing the exact number of units to be produced 143
- 144. Wrong Assumption • You might assume in looking at this illustration that cost per unit could continue down as long as you continued to produce more units 144
- 145. Reaching maximum capacity • But there is a point where you reach maximum capacity and cannot reduce fixed cost per unit any further • To produce beyond maximum capacity • More equipment or a bigger building would be needed • At that point, the total fixed cost line would shift upward with the additional costs 145
- 146. Cost categories on the income statement • Isolate and separate the costs • Each cost item on the income statement reacts differently to volume • It is important to isolate and separate the costs into • Fixed • Variable • Mixed 146
- 147. Increases or decreases in volume • But how do we know which costs are which? • Fixed costs are costs that do not move with increases or decreases in volume 147
- 148. Three-step process The following three-step process will lead you to determine which are variable and which are mixed: • Step 1: • For each line item • Determine the basis • The element on which the item is based • If wages are paid by the hour • The basis is the number of hours • Step 2: • Divide two different activity levels by the basis • Step 3: • If the quotient is the same for different activity levels • The cost is variable • If the quotient is different • Then the item is a mixed cost 148
- 149. Example: Let’s use the JD Lawn Service example to see how this works Wage Expense Variable Gasoline Variable Maintenance Variable Suppliers Variable Truck Depreciation Fixed Equipment depreciation Fixed Telephone Expense Mixed Advertising Expense Variable Administrative Services Fixed Utilities expense Variable Rent Expense Fixed Miscellaneous expense Variable July August Sept Revenue: Grass cutting $12,000 $10,000 $15,000 Expenses: Wage Expense 4,800 4,000 6,000 Variable Gasoline 480 400 600 Variable Maintenance 96 80 120 Variable Suppliers 300 250 375 Variable Truck Depreciation 400 400 400 Fixed Equipment depreciation 400 400 400 Fixed Telephone Expense 86 84 92 Mixed Advertising Expense 1,020 850 1,275 Variable Administrative Services 340 340 340 Fixed Utilities expense 120 100 150 Variable Rent Expense 800 800 800 Fixed Miscellaneous expense 600 500 750 Variable Total Expense $9,442 $8,204 $11,302 J.D. Lawn Service Income Statement For Months July, August, September 149
- 150. Increases or decreases in volume • Fixed costs are those that do not move with increases or decreases in volume 150
- 151. For the Lawn Service • You can see that truck and equipment depreciation are two costs that fit into this category • As the income statement shows • Each of these expenses is $400 a month no matter what the volume July August Sept Truck Depreciation 400 400 400 Fixed Equipment depreciation 400 400 400 Fixed 151
- 152. Variable and mixed costs • Now let’s look at variable and mixed costs for the Lawn Service 152
- 153. Discerning variable costs • The JD Lawn Service income statement identifies the first two line items as variable costs • Wages • Gasoline July August Sept Wage Expense 4,800 4,000 6,000 Variable Gasoline 480 400 600 Variable 153
- 154. Let’s apply the three-step formula to see if this is correct 154
- 155. Step 1: determine the basis for each line item • Wage expense for JD Lawn Service is based on the number of hours • With the average lawn taking two hours to cut July: 120 lawns X 2 hours = 240 hours August: 100 lawns X 2 hours = 200 hours September: 150 lawns X 2 hours = 300 hours 155
- 156. Step 2: divide two (or more) different levels of activity by the basis • In this case • The activity level being checked is the monthly wage expense • The wage expense for a given month is divided by the number of hours for that month • As follows: 156
- 157. Step 3a: if the number is the same for both (or more) levels of activity • The number ($20) is the same for each level of activity • The cost is variable • Wage expense is pure variable cost • Wage expense increases and decreases depending on volume 157
- 158. Step 3b: if the number is the same for both (or more) levels of activity • The same procedure will be used for each line item on the income statement • Dividing these numbers into the monthly gasoline figures results in a calculation of • $4 per lawn—the same number for each level of activity • Gasoline is a variable cost • Apply the same formula on other variable line items July August Sept Gasoline $480 $400 $600 Variable 158
- 159. Discerning mixed costs • Mixed costs call for the same formula as variable costs • The difference comes out in step 3 • If the quotient is different, then the item is a mixed cost or is not purely variable July August Sept Telephone Expense $86 $84 $92 Mixed 159
- 160. In the income statement for JD Lawn Service • Telephone expense is marked as a mixed cost • With the following entries: July August Sept Telephone Expense $86 $84 $92 Mixed 160
- 161. Let’s apply the three-step formula to see if this is correct • Step 1: determine the basis for each line item • Telephone expense is based on the number of lawns: July August September 120 100 150 161
- 162. Let’s apply the three-step formula to see if this is correct • Step 2: divide two (or more) different levels of activity by the basis $86 $84 $92 120 100 150 162
- 163. Let’s apply the three-step formula to see if this is correct • Step 3: if the number is the same for both (or more) levels of activity • The cost is variable • Different quotients indicate the presence of fixed and mixed costs $86 $84 $92 120 100 150 July August September = 72% = 84% = 61% 163
- 164. Further discovery • Further discovery of the telephone expense shows that $64 per month is a fixed charge and the reminder is variable • Telephone expense must be separated into fixed and variable costs $86 $84 $92 120 100 150 July August September = 72% = 84% = 61% 164
- 165. Intent of this quick exercise • The intent of this quick exercise has been to look at the data to determine whether each line item was fixed or variable • This analysis has not been very scientific • For example • Wage expense in this exercise is variable because all of the workers are paid by the hour • This can be more complicated with different costs and with the additional information you would need to request in a real-life example 165
- 166. Part 5: Controlling costs 166
- 167. Contribution margin on the income statement • A fundamental need in controlling costs is to understand what costs you can control • Variable costs can be controlled and fixed costs cannot • It is helpful to define all expenses as either variable or fixed 167
- 168. Simple traditional income statement • A simple traditional income statement may indicate on its list of expenses whether the cost is fixed or not • But the costs are not separated out on the statement itself Sales Less = Expenses Net Income or (Loss) 168
- 169. Traditional income statement • A traditional income statement for a retail company with merchandise would include the additional element of cost of goods sold • This format does not separate fixed and variable expenses Sales Less = Cost of Goods Sold Gross Profit (or Margin) Less = Expenses Net Income or (Loss) 169
- 170. Contribution margin • The contribution margin approach • Separates all expenses into variable and fixed costs • This approach allows the manager to examine variable and fixed costs separately and determine their respective weights on net profits Sales Less = Variable Expenses Contribution Margin Less = Expenses Net Income or (Loss) 170
- 171. Examine variable and fixed costs separately • This approach allows the manager to examine variable and fixed costs separately and determine their respective weights on net profits • What follows is the JD Lawn Service income statement in the traditional format for July through September • The single list of expenses in this income statement does not provide an easy understanding of costs that can be controlled • Some are fixed and others are variable • Some may be both 171
- 172. Better approach • The better approach is to separate the costs 172
- 173. In the income statement that follows • Expenses are separated into variable and fixed costs • Costs that can be controlled (variable costs) are together above the contribution margin total • And noncontrollable costs (fixed costs) are below the contribution margin total 173
- 174. From this restatement of income • The ratio of variable to fixed costs is easily calculated • This gives an idea of the costs that can and cannot be controlled • 80% of expenses can be controlled • If sales shift downward by $1 • Then 80 cents (rounded) of the cost can be controlled and reduced to balance out a downturn in sales • The other 20% of the company’s total costs • Or 20 cents on every dollar (rounded) is, for the most part, fixed Variable costs are 79.68% of all expenses = $23,066 Variable costs $28,948 Total Expense Fixed costs are 20.32% of all expenses = $5,882 Variable costs $28,948 Total Expense 174
- 175. Activity-based costing • Accountants have used activity-based costing more and more in recent years • Managers should familiarize themselves with this term and its meaning • Identifies all major operating activities • Activity-based costing identifies all major operating activities manufacturing and non-manufacturing • Allocates the costs for those activities to products and services that use the resources supplied by those activities Example: Purchasing Department Costs $40,000 Activity 100,000 purchase orders 100,000 = $.40 per purchase order 175
- 176. Activity-based costs are often targeted as an area for potential cost reduction • The larger the company • The more complex and obscure activity-based costs can be 176
- 177. The fundamentals of activity-based costing are: • Non-manufacturing and manufacturing costs may be assigned to a product or service • In traditional accounting only manufacturing costs would be assigned to the product • The sales department cost would be assigned to the product • Usually this is a period cost • Some manufacturing cost may not be assigned to the product • An example of this might be plant security personnel • These personnel costs are unaffected by the products being produced • Allocation of costs can be different • Companies could use departmental overhead rates rather than companywide rates • Traditional costing • In traditional costing idle capacity (plant operations that were not used because of volume) would often be charged to the product • In activity costing only the amount of cost used from the plant would be allocated to the product 177
- 178. A “currency” • Activity-based information is important to provide a “currency” for personnel that are not involved in the • Production • Sale • Service of a product 178
- 179. Example: a salesperson hired at JD Lawn Service to make calls to prospective clients • In many companies we can establish the activity or outcome and then determine the cost of that outcome • This gives management a quantitative number to determine whether a position really does increase net profits • These costs may not be easily discerned from financial statements Salesperson cost $500 per week 4 new customers = $125 per customer 179
- 180. Non-value-added activity • It is important to understand that every activity in a company has an associated cost and that these activities may not add value to the product or service • An example of an activity cost in the JD Lawn company is the movement of equipment to different lawn sites • This activity, while necessary, does not contribute revenue to the service • It would be important to look at a map of planned job sites to reduce travel time • Other non-value-added activities would include: • Product inspection • Free delivery • Storage 180
- 181. It is important to control costs • We should be able to identify costs and activities to better understand costs related to the production processes 181
- 182. Activities need to be value-added where possible • Other non-value-added activities need to be reduced and contained 182
- 183. PART 6: Am I breaking even? 183
- 184. The Cost-Volume-Profit graph • “Am I breaking even?” • Is one of the fundamental questions in business 184
- 185. Volume of business • Every business needs to know the volume of business necessary to cover expenses 185
- 186. Activity in a business • If below break-even • Will use up cash 186
- 187. Cash replaced • Cash must then re[placed be either through • Further investment • Incurring debt 187
- 188. The relationship • The following graph illustrates the relationship among costs and revenue and break- even • Total the variable costs and fixed costs • Where the sales line intersects with the total cost line • Break-even will be calculated in units and dollars • This number represents the amount of money needed from revenue to cover total costs 188
- 189. The chart represents a simple approach to the solution Break-even in dollars = Variable costs + Fixed Costs 189
- 190. Needs how many per hour to break-even • Finding this number will ensure better decisions • A doctor might calculate how many patients she needs per hour to break-even • A retail store manager might wonder how many items are necessary to sell per day to break even 190
- 191. Break-even point • Let’s illustrate how we find the break-even point using the JD Lawn Services • It might seem easy to apply this formula to JD Lawn Services because the company’s income statement already separates expenses into variable and fixed costs • If those two numbers were added together • That should be break-even $28,948 = $23,066 + $5,882 191
- 192. The problem • The problem with this approach is that JD Lawn Services produced a profit of $8,052 • This means the variable costs of $23,066 are too high because they have contributed excess costs to reach a volume with $5,882 profit • The $28,948 figure is not break-even • It includes a profit of $8,052 192
- 193. Let’s try a different method • The contribution margin approach to break-even • Before calculating the break-even • A few more pieces of information are needed • JD has 15 commercial customers and charges them $100 per hour for Lawn Service • The average lawn takes two hours of time • Since JDIs using hourly rates • Break-even in hours and dollars • We are looking for the break-even in hours and dollars 193
- 194. What is break-even in hours? (1 of 2) • Using the contribution margin method: • Remember, over three months, JD had 370 hours of lawn-mowing activity • Breakeven is 157 hours Fixed cost CMper unit = Break-even in hours 194
- 195. What is break-even in hours? (2 of 2) • Using the contribution margin method: • Remember, over three months, JD had 370 hours of lawn-mowing activity • Breakeven is 157 hours • JD Lawn had cut 185 lawns during this three-month period • JD Lawn has a very good ratio of variable costs to fixed costs • A dry season of lawn cutting would still allow for a considerable drop in sales before the break-even point would be reached Fixed cost CMper unit = Break-even in hours 157hours 2hours = 79lawns (rounded) in 3months to break even 195
- 196. Calculating break-even in dollars • There are two methods for calculating the break-even in dollars • The first calculates break-even by unit and multiplies the resulting unit by the unit rate • The second method uses fixed cost divided by the contribution margin as a percentage of total revenue 196
- 197. Method 1 Revenue: Hourly rate Grass cutting $37,000 $100.00 per hour = 370 hours Less: Total Variable Expenses 23,066 -62.34 per hour ($23,066/370) Contribution Margin $13,934 = $37.66 per hour Less: Total Fixed Expenses $5,882 Net Income or (Net Loss) $8,052 Fixed cost CMper unit $5,882 = $37.66 157 hours x $100.00 per hour = $15,700 After calculating the break-even in hours, just multiply it by the hourly rate. J.D. Lawn Service Income Statement For Months July, August, September = Break-even in hours 157 hours (rounded) 197
- 198. Method 2 Revenue: Grass cutting $37,000 Always 100% Less: Total Variable Expenses 23,066 23,066/37,000 = 62% Contribution Margin $13,934 13,934/37,000 = 38% Less: Total Fixed Expenses $5,882 Net Income or (Net Loss) $8,052 Fixed Costs $5,882 Contribution Margin % 0.38 = $15,478 (difference due to rounding) J.D. Lawn Service Income Statement For Months July, August, September 198
- 199. Both methods • Using both methods can provide verification of accuracy in your calculations Revenue: Hourly rate Grass cutting $37,000 $100.00 per hour = 370 hours Less: Total Variable Expenses 23,066 -62.34 per hour ($23,066/370) Contribution Margin $13,934 = $37.66 per hour Less: Total Fixed Expenses $5,882 Net Income or (Net Loss) $8,052 Fixed cost CMper unit $5,882 = $37.66 = Break-even in hours 157 hours (rounded) 157 hours x $100.00 per hour = $15,700 After calculating the break-even in hours, just multiply it by the hourly rate. Revenue: Grass cutting $37,000 Always 100% Less: Total Variable Expenses 23,066 23,066/37,000 = 62% Contribution Margin $13,934 13,934/37,000 = 38% Less: Total Fixed Expenses $5,882 Net Income or (Net Loss) $8,052 Fixed Costs $5,882 Contribution Margin % 0.38 = $15,478 (difference due to rounding) 199
- 200. Calculating “what if” profit • Once you understand how to calculate break-even • Then it is easy to calculate any volume necessary to reach a “target” profit 200
- 201. To illustrate this point • Let’s say JD Lawn Service would like to generate a profit of $20,000 • Using the contribution margin formula • Just add the desired profit to fixed cost: Fixed cost CMper unit Revenue: Hourly Rate: Grass cutting $37,000 $100.00 per hour = New volume needed J.D. Lawn Service Income Statement For Months July, August, September Fixed cost CMper unit Revenue: Hourly Rate: Grass cutting $37,000 $100.00 per hour Less: Total Variable Expenses 23,066 -62.34 per hour Contribution Margin $13,934 =$37.66 per hour Less: Total Fixed Expenses $5,882 Net Income or (Net Loss) $8,052 Fixed Costs + Profit Contribution Margin per unit $37.66 $5,882 + $20,000 688 hours (rounded) or 344 lawns = New volume needed J.D. Lawn Service Income Statement For Months July, August, September 201
- 202. Margin of safety • The margin of safety is a measure of the difference between the actual level of sales and the break-even sales • It is the amount expressed in • Dollars • Percentage • Units • When it is expressed as a percentage • The larger the ratio • The less risk to the company of not reaching the break-even 202
- 203. Lawn Service income statement • All of these numbers reflect the drop in volume to break-even Revenue: Hourly Rate: Grass cutting $37,000 $100.00 per hour Less: Total Variable Expenses 23,066 -62.34 per hour Contribution Margin $13,934 =$37.66 per hour Less: Total Fixed Expenses $5,882 Net Income or (Net Loss) $8,052 Actual Sales - Break-even Sales Actual Sales $5,882 + $20,000 $37.66 J.D. Lawn Service Income Statement For Months July, August, September =Margin of Safety =57.57% 203
- 204. PART 7: Operating leverage 204
- 205. Defining operating leverage • The term operating leverage refers to the percentage of fixed costs a company has on the income statement • The greater the amount of fixed costs • The greater the operating leverage • The degree of operating leverage indicates how sensitive the company is to sales increases and decreases 205
- 206. For JD Lawn Service • The fixed costs are not high in relation to the variable costs • The computation for the degree of operating leverage is: Revenue Grass cutting $37,000 Less: Total Variable Expenses 23,066 79.68% Variable cost Contribution Margin $13,934 Less: Total Fixed Expenses $5,882 20.32% Fixed costs Net Income or (Net Loss) $8,052 13,934 $ 8,052 $ Degree of Operating Leverage = Degree of Operating Leverage = 1.73 J.D. Lawn Service Income Statement For Months July, August, September Degree of Operating Leverage = Cotribution Margin Net Income Revenue Grass cutting $37,000 Less: Total Variable Expenses 23,066 79.68% Variable costs Contribution Margin $13,934 Less: Total Fixed Expenses $5,882 20.32% Fixed costs Net Income or (Net Loss) $8,052 13,934 $ 8,052 $ Degree of Operating Leverage = Degree of Operating Leverage = 1.73 J.D. Lawn Service Income Statement For Months July, August, September Degree of Operating Leverage = Cotribution Margin Net Income 206
- 207. 25% Sales Increase • If JD Lawn sales increased by 25%, the net income of the company would increase: • The same thing would happen if JD were to see a decrease of 25% in sales: The company’s income would decline by 433% Net income increase = Operating Leverage X Percent of sales increase 43.30% = 1.73 X 25% 207
- 208. Operating leverage and the bottom line • What is important about operating leverage is that the impact on the “bottom line” decreases as a company moves further away from the break-even point 208
- 209. JD Lawn Service income statement • If JD Lawn makes $50,000 in revenue such that profit becomes $12,948 • the company has moved further away from break-even Operating leverage has been reduced • Although this is important, it is even more important to look at the ratio of fixed and variable costs • The next illustration will show what can happen when a company has a very high degree of operating leverage due to high fixed costs Proposed Revenue Grass cutting $37,000 $50,000.00 Less: Total Variable Expenses 23,066 $31,170.00 Contribution Margin $13,934 $18,830.00 Less: Total Fixed Expenses $5,882 $5,882 Net Income or (Net Loss) $8,052 $12,948 Operating Leverage $13,934 $18,830.00 $8,052 $12,948.00 1.73 1.45 J.D. Lawn Service Income Statement For Months July, August, September 209
- 210. Variables and fixed cost switched • A decrease of 10% in sales would result in a 173 percent drop in net income where variable costs are high • A decrease of 10% in sales would result in a 386% change in net income if JD had high fixed costs • This concept is important because it illustrates the problems that can occur with large fixed costs • Of course with an increase in sales, the “bottom line” would improve dramatically • The lesson here is that companies with a high ratio of fixed to variable costs must be very careful of decreases in volume High variable costs and low fixed costs Low variable costs and high fixed costs Revenue Grass cutting $37,000 $37,000 Less: Total Variable Expenses $23,066 $5,882 Contribution Margin $13,934 $31,118 Less: Total Fixed Expenses $5,882 $23,066 Net Income or (Net Loss) $8,052 $8,052 Operating Leverage $13,934 $31,118.00 $8,052 $8,052.00 1.73 3.86 J.D. Lawn Service Income Statement For Months July, August, September 210
- 211. PART 8: Influences on pricing 211
- 212. Pricing in line with the competition • Most companies must keep an eye on the competition • If a rival firm reduces prices • You may need to do the same or lose market share • Yet it is important to remember that you cannot be at the mercy of your “dumbest” competitor 212
- 213. Lower profit margins • Continuing to lower selling price will result in lower profit margins • This is not a long-term strategy that most companies can continue 213
- 214. Weathering a price war requires cash reserves • Some companies will be driven out of business • Examples of this can be found throughout business history • The video rental business suffered through a period of increased competition and the lowering of prices to 99 cents for overnight rentals • At that price point many stores found themselves at break-even or below • After the shakeout and loss of numerous small businesses • Both the price and profits returned to industry norms 214
- 215. It is important to understand your costs and strategy • A customer focus will aid you in determining what defensive and offensive moves are required to combat competitive pricing moves 215
- 216. Trade-offs between price and demand • Should you set prices high to make more money on each unit sold • Or should you set prices low and make up the difference in volume? • Such are the trade-offs between higher prices and increased volume • Demand has to be very strong to increase selling price and not lose volume 216
- 217. Two strategies • There are two strategies to pricing in relation to demand: • Skimming the market • Penetrating the market 217
- 218. Skimming the market • Skimming the market is used by companies • That enter a market with a new product • That enjoy little competition for very high-quality products or services 218
- 219. More skimming • Such companies set prices high to cover costs and ensure profits after recouping research and development costs • Skimming the market produces a lower demand for units • If profit margins are high and the number of customers is sufficient • This can be a permanent pricing strategy • Many luxury products pursue this strategy 219
- 220. Penetrating the market • The pricing strategy of penetrating the market • Uses a lower price to increase volume and • Gain an advantage by taking as much market as possible quickly • Many internet companies in 2000 and 2001 that filed for bankruptcy had used just such a strategy to gain market share • The problem with this strategy is that profit margins are thin or nonexistent Penetration Pricing 220
- 221. Sudden changes in the market can result • In fewer sales • A drop below break-even based on volume • A sudden loss of cash flow Penetration Pricing 221
- 222. If companies have a high degree of operating leverage • This can produce sudden death for the organization Penetration Pricing 222
- 223. Setting the price for a product or service is an extremely important management decision • Set the price too low and a company may not meet profit expectations Penetration Pricing 223
- 224. A case in point was a new fitness facility that • Once completed • Failed to set its price to reflect current conditions • Underpricing memberships resulted in turning away customers because of demand and limited capacity • The business struggled to break even the first year of operation • It was forced to increase fees the second year • Causing many members to resign Penetration Pricing 224
- 225. While offering very low pricing initially works to attract customers to a new business • It is difficult to raise a price significantly in a short period without customer reaction • Had the initial discount been lower, the required increase might have been less objectionable Penetration Pricing 225
- 226. Elasticity of demand illustrated • Demand that is elastic will increase or decrease with price • The amount of increase or decrease is often difficult to determine • Quantitative models will aid in this decision but assumptions may not always come true 226
- 227. The following chart shows how changes in price affect volume • Demand that is elastic changes with volume • Demand that is inelastic changes little • Statistical models help to determine these changes in quantity and price • Further study will provide more information • The horizontal line in this example illustrates the point at which a company can maximize profit based on elastic demand Quantity X Unit Sales Price = Total Revenue per month - Total Cost per Month = Profit or Loss 20 $75 $1,500 $2,500 -$1,000 40 $70 $2,800 $3,000 -$200 60 $65 $3,900 $3,500 $400 65 $60 $3,900 $3,600 $300 70 $55 $3,850 $3,800 $50 75 $50 $3,750 $3,950 -$200 227
- 228. Research needs to be done before changing price • Markets and consumers do not always react as predicted • Many decisions determining the outcome of price reductions or increases cannot be applied with certainty • The results will come about from historical and statistical models 228
- 229. Market and cost influences on pricing • In most industries there are market and cost influences on pricing 229
- 230. It is good to understand how much influence each has on your pricing strategy • The market is not always willing to pay the price necessary to cover your costs and desired profit • It is necessary to contain the costs and/or revise profit expectations to produce at the price the market is willing to pay 230
- 231. In agriculture • For example • The price of products is determined by the marketplace • To make a profit a farmer must produce below the market price • There are often periods when costs cannot be contained • And losses result from a decrease in market prices • This leads farmers to become more efficient and effective in their production techniques 231
- 232. Constraints • Constraints from customers and competitors force businesses to apply the same production principles used in agriculture • To survive a company will look to • Efficiency • Effectiveness • when price alone cannot increase profits or market share 232
- 233. Qualitative factors in relation to price • Some companies provide a product with market differential—a niche—where qualitative factors • Prestige • Image • Belonging • add to the ability to focus more on customer needs and less on price 233
- 234. Branding • This is where branding plays an important part in conveying a message consistent with your image 234
- 235. Brand identity • If you are able to establish a • Strong • Positive • Brand identity • Many customers will pay more for that brand • Even if the actual product is practically identical to “brand x” 235
- 236. Price is always an important consideration • Some companies enjoy little competition and provide high-end products • Some direct marketing companies control growth by increasing price to reduce demand • We would all like to be in that position • For most of us this is not the case 236
- 237. Part 9: Making the numbers work for you 237
- 238. Responsible decision-making • To make responsible decisions • A great amount of data must be collected during the problem-solving phase • The relevant information must be separated from the irrelevant 238
- 239. Two irrelevant costs are • Sunk costs • Costs incurred yesterday • Common costs • Costs that are the same for all alternatives under consideration 239
- 240. The impact on profit is one of the most important issues for a company • The effect on income involves cost and revenue decisions 240
- 241. Relevant revenue and cost can be defined as • Numbers that change as a result of a decision 241
- 242. The following process can help make identifying relevant costs more effective • An illustration of the process can also be found on the next slide • Identify all costs • Eliminate costs that cannot be changed • Examples of these costs include lease payments for • Machinery • Depreciation expense for assets previously purchased • Interest payments on existing debt • Etc • Eliminate costs that do not change between the alternatives under consideration • This will vary depending on the decision to be made • For example • If the decision is between parts suppliers and labor will be the same using either part • Labor can be eliminated as a relevant cost 242
- 243. The costs that remain are required for the decision • Some of these costs still may not be relevant 243
- 244. Further cost analysis will be required after all the data has been collected • The irrelevant data discarded • And costs looked at once more to make sure this data is necessary 244
- 245. The more important and costly the decision • The more time and analysis should be directed toward the differing outcomes 245
- 246. Quality management • There are costs associated with quality • Low-quality products lead to higher warranty costs and unhappy customers • This in turn leads to a poor reputation for the company 246
- 247. Quality costs can be classified into four groups • Prevention costs • Activities that reduce defects during the production process • Appraisal costs • Activities that identify defective products (inspection) • Internal failure • Identifying bad parts during process or inspection • External failure • Customer identifies the defect or the company recalls the product 247
- 248. QUALITY cost information • Quality cost information will help a company determine • The size of quality issues • The costs to resolve those issues • A better focus on the issues 248
- 249. Quality is an important component to costing • You can produce the best product or service in the world but you • Cannot let the benefit outweigh the price the customer can pay for the product or service 249
- 250. Companies must look at the customers they serve • And then deliver a quality product or service these customers can afford 250
- 251. Companies must look at the customers they serve • And then deliver a quality product or service these customers can afford 251
- 252. Review of the numbers • We have covered many areas of cost-related functions in this class • Let’s review the basics: 252
- 253. Accurate and consistent information • Recording financial information must be done consistently • Comparing records over time requires data to be historically correct and recorded in the same accounts and categories • Failure to do so creates the inability to compare and contrast financial information 253
- 254. Financial statement analysis • Managers need to have a greater understanding of the financial statements a company uses for external and internal reporting • The numbers should be studied and relationships among statements established 254
- 255. Cost categories • Reviewing definitions and explanations of the five cost categories will serve you well when discussing and analyzing internal financial reporting in your organization • Remember that all costs • And allocation of those costs to products and services • Are required to review pricing 255
- 256. Cost behavior • It is important in every organization to learn • The impact of volume on individual costs • How those costs behave related to various levels of production • This ability to identify costs and control them will aid in maximizing profits and in providing more efficiency and effectiveness in the production processes 256
- 257. Break-even analysis • This concept is critical for many small businesses and provides large companies with many divisions and product lines the ability to examine fixed and variable costs critically • For many companies • The ability to know how much product or service must be sold on a • Yearly • Monthly • Weekly • Daily • Hourly basis • is critical for survival • It also strengthens marketing efforts and cost controls 257
- 258. Operating leverage • Understanding the importance of fixed and variable costs to the “bottom line” is essential for all operations personnel • The degree of leverage a company has will influence decisions when selling prices and volume begin to fluctuate • Understanding how these costs affect your company will be the difference in making high profits or high losses • Responsiveness to sales fluctuation cannot be understated when a company has a high degree of operating leverage 258
- 259. Price • Price and its relationship to the customer and competition are very important • Competing on price alone is a strategy followed by many companies in every segment of business • It is important to determine if this will be long- or short-term advantage for your company • You must understand customer demand and customer perception of the products and services you sell 259
- 260. Decision-making ( 1 of 4) • The constraint of financial resources will influence all decisions made in an organization • The importance of relevant data to get to the “right decisions” cannot be ignored • The numbers can prove whatever you want them to prove in many decisions • We must resist the temptation to use only the financial information that makes our point 260
- 261. Decision-making ( 2 of 4) • The long-term health of any business is predicated on sound decision- making • We have seen the results of decisions that create short-term gains at the expense of long-term survival • We must exercise caution when using numbers 261
- 262. Decision-making ( 3 of 4) • Management’s responsibility should be to the long-range survivability of the company • Other objectives should include the ability to control resources and provide products and services to customers • There should also be a sense of responsibility to the financial well- being of the workers who have made your company grow 262
- 263. Decision-making ( 4 of 4) • The wealth created through prudent financial management can provide for the well-being of all that contribute to the company • This is a large task • Accounting essentials will help get you there 263
- 264. 264