Direct Costing: Strategic Management Accounting

Overview
Education Costing: Inventory Valuation or Decision Making Direct Costing Vision: How does this benefit me? Strategy of Price

Education
Definition of Fixed Costs Definition of Variable Costs Definition of Direct Costs Definition of Contribution Pricing Issue: All costs have a certain degree of fixed nature in them.

Education
What is a Direct Cost ? Is Direct Costing used to value inventory? Is Direct Costing really Variable Costing? Who can use Direct Costing? Is Direct Costing really Activity Based Costing?

Education
All prices are a function of cost Costing mechanics and philosophy are essential for determining price. Full Absorption Costing Cost Elements: - Materials - Labor - Manufacturing Overhead - Selling, General & Administrative Full Absorption Costing is mandatory for most US Federal Contracts. Full Absorption Inventory Valuation is mandated by the 16th Amendment to the Constitution, adopted in 1913, making Income Taxes permanent.

Education
Full Absorption Pricing works well in Stable capacity and pricing markets Government Contracts Cost Plus Contracting Full Absorption Pricing formula: - Material Cost + Mfg Overhead + SG&A + Desired Profit Forecasted Volume to be sold

The weakness of Full Absorption pricing is the Sales Forecast.

Education
Material Costs & Labor Costs can generally be tuned to capacity

Material Cost Labor Cost Mfg Overhead SG&A Total Cost Profit Margin Price Forecasted Units

$ $ 5,000.00 $ 2,000.00 $ 4,000.00 $ 1,000.00 $ 12,000.00

$ $ $ $ $ $ $

10,000

$/Unit 0.50 0.20 0.40 0.10 1.20 1.30 2.50 10,000

$/Unit $ 0.50 $ 0.20 $ 0.80 $ 0.20 $ 1.70 $ 0.80 $ 2.50 5,000

Education
Complicating the problem with Sales MIX

Product A $/Unit Material Cost $ 0.50 Labor Cost $ 0.20 Mfg Overhead $ 0.40 SG&A $ 0.10 Total Cost $ 1.20 Profit Margin $ 1.30 Price $ 2.50 Forecasted Units 10,000

Product B $/Unit $ 1.25 $ 0.40 $ 0.55 $ 0.60 $ 2.80 $ 2.20 $ 5.00 5,000

Education
Cost Pools
Cost Pools Variable Fixed 85% 15% Mixed 100% 0% 100% 0% 100% 0% 100% 0% 100% 0% 0% 100% 10% 90% Mixed 0% 100% 0% 100% 0% 100% 0% 100% Factory Energy Production Labor Fringe Benefits on P Labor Shop Supplies Lubricants/Oils Production Machine Maint. Machinery Depreciation Supervisor Salaries & Fringe Sales Salaries & Fringe Company Cars Property Taxes Legal Expense

Education

Direct Costing Solves the Forecasting Problem in Pricing

Direct Costing focuses on Variable and Incremental Costs With Direct Costing you will be able to calculate:
Floor Price Out of Pocket Price Break Even Price Target Profit Price Most profitable sales mix Profitable Sales Strategies

Direct Costing works well for Service Companies and Mfg Companies

Education
Direct Costing Solves the Forecasting Problem in Pricing

Sales (Prior Year) Material Cost Direct Wages & Fringe Other Direct Costs Total Direct Costs Contribution Margin Fixed Costs (Mfg & SGA) Total Cost Break Even Price Target Price Floor Price (OOP) Forecast Units

$ $ 25,000.00 $ 5,000.00 $ 2,000.00 $ 2,000.00 $ 9,000.00 $ 16,000.00 $ 3,000.00 $ 12,000.00

$/Unit $ 2.50 $ 0.50 $ 0.20 $ 0.20 $ 0.90 $ 1.60

% SP 100% 20% 8% 8% 36% 64%

$ $ $

1.20 3.00 0.90 10,000

48% 70% 0%

Education
Direct Costing Model

Marketing
Corp Parent

Operations
Corp Parent Sector Mgt Entity Bus. Unit Factory Cost Pool Mfg Cell

Data Standards

Sector Mgt Entity Bus Unit Market Segment Prod Line

Cost Driver
P&L

Part/Article Number

Education
Driving Pools to the Article Number

Cost Pools
Mfg Cell Labor Fringe Benefits Mfg Salaries Building Insurance Quality Labor Dept Shop Supplies
Repair & Maintenance by Dept

Cost Drivers
Quantity Produced Kilos Produced Kilowatt Hours Machine Hours Labor Hours Square Feet Takt Time Linear Meters

Education
Driving Pools to the Article(Item) Number (Example for a Steel Co) Cell Labor Energy
KW Hours Takt Time Kilos

Item Nbr Item Nbr

Annealing

Bldg Insur

Sq Feet

Assy Cell

Takt Time

Item Nbr

Traditional Standard Costing @ Item # Level

Used for Inventory Valuation
Materials & OSS Labor Mfg Overhead G&A
Material is approximated/driven by the Bill-of-material Standard Hours are an accurate reflection of labor content Overheads are traced to Item Numbers by the Labor Content G&A can be traced to Item numbers by the Labor Content Inventory Valuation objectives are compatible with pricing objectives.

Bill of Material
Std Hrs x Std Rate

% of Labor % of Labor

Direct Costing @ Mfg Cell & Product Line Level Used for Pricing, Order Selection, Make vs Buy, Market Analysis
Material is approximated/driven by the Bill-of-material to the Article Number Labor is pooled at the Mfg Cell Level Labor Driven Direct Costs Direct Overheads are traced to the Pool closest to the Article Number. Fixed Costs are traced to the Pool closest to the Article Number Direct Costs are built up to the Product Line Level and used in Estimating

Materials & OSS

Bill of Material

Actual Lbr in Cell

Overheads to Pools

Driven Fixed, Semi-Var

Cost Driver Data Collection

Education
Selling Price/Unit Material Direct Labor Direct Overheads Contribution Margin Fixed Overheads Total Cost Direct 100.00 50.00 10.00 10.00 30.00 0.00 70.00 Full 100.00 50.00 10.00 10.00 30.00 25.00 95.00

Education
Mix Analysis DC CM 350 $ 75 80 $ 100 80 $ 200 80 $ 160 590 $ 535

Market OEM Distributor Direct Retail Total

$ $ $ $ $

Sales 500 200 250 210 1,160

$ $ $ $ $

CM% 15% 50% 80% 76% 46%

%CM % Sales 14% 43% 19% 17% 37% 22% 30% 18% 100% 100%

In the example mix analysis above, the OEM market generates 43% of sales but only 14% of the contribution margin. Surprisingly, Retail generates 46% of the contribution margin but only 18% of the sales. The mix analysis gives a strategic direction to the sales effort, given that market saturation has not occurred.

Education
Engineer to Order, Make to Order
Sequence 10 20 30 40 50 60 70 Process Design Rough Cut Mill Shape Paint Electronics Test, Pack, Ship Total Hrs/Unit 1.00 2.00 0.50 1.50 0.50 2.00 1.00 8.50 $ $ $ $ $ $ $ $ DC$/Hr 10.00 15.00 35.00 20.00 80.00 10.00 15.00 19.12 $ $ $ $ $ $ $ $ DC$ 10.00 30.00 17.50 30.00 40.00 20.00 15.00 162.50

Make to Order Markets are defined by the process Design + Rough + Mill + Shape + Paint + Elec + TPS = HOURS Design + Mill + Paint + Elec +TPS = HOURS

Education
What we gain from Direct Costing

Upside
Target Price BE Price Floor Price Out-of-Pocket Point Consistent Business Analysis Tool Mix Decisions become easier Facts not Fiction Better Knowledge of our Strengths & Weaknesses Reconciliation of Cost

Downside
We must continue to maintain Std Cost for Inventory Valuation Drivers are expensive to collect Requires better training & education in pricing Requires IT systems to work.

Education
What is a Variable Cost? 1:1 Relationship with Volume Is a Variable Cost a Direct Cost? Only if its knowable with a reasonable degree of certainty. What is a Fixed Cost? No relationship to Volume.

Education
What is Contribution?

Target Price BE Price

Profit

Contribution

Fixed Costs Unknowable Variable Costs Direct Costs

Floor Price (OOP)

Vision
Cost of Manufacturing Cost of Distribution Cost of Service

Vision
Cost to Manufacture
Cost to Collect Drivers Horse Power, Mach Hrs HP Connect BTU, Hrs BTU Consumed Coolant Lubricants, Cycle TimeFactor Shots, Cycles Die Life Man Hours, Process Man Hours Linear Feet Linear Feet Pool Energy Energy Lubricants Tooling Dir, Ind Labor Material Cost, Energy,

Direct Factory

Vision
Cost to Serve
High Cost Order custom products Small order quantities Unpredictable order arrivals Customized delivery Change delivery requirements Manual processing Large amounts of pre-sales support Large amounts of post-sales support Require company to hold inventory Pay slowly (high accounts receivable) Low Cost Order standard products High order quantities Predictable order arrivals Standard delivery No changes in delivery requirements Electronic processing (EDI) (zero Little to no pre-sales support No post-sales support Replenish as produced Pay on time

Direct SG&A

Vision
Cost to Distribute
High Cost Unique Packaging Special Pallets Heavy Items Bulky Items Requires HVAC Environmentally Hazordous Low Cost Simple Packaging Standard Pallets Light Weight Items Non-Bulky Items Does not require HVAC Environmentally Friendly

Direct Distribution Costs

Strategy of Price
Direct Costing is only one source of Price Strategy information. Other Strategy Information Points: 1. Customer Value Chain Analsyis 2. Market Floor Price 3. Market Ceiling Price 4. Government Intervention 5. Competitor Position

Strategy of Price
Hi
Price Point vs. Economic Value or Alternate Products

Strategic Pricing Freedom

Specialty Products

Where will price move given demand, cost, & capacity

Commodity Products

Low
Low

Competitive Intensity

Hi

Key Strategies & Blind Spots

Value Positioning vs. Competition Too little emphasis on exploiting product/service attribute advantages vs. competition Failure to identify product-specific or customer-specific costs (Cost to Serve) Low price on System, High price on replacement parts & service (or vice versa)

Understanding of Costs Balance System Profits vs. Component/Svc Profits Product Positioning & Cannibalization due to price Risks of a destructive competitor response to a new price initiative Penetration Pricing vs. Skim Pricing

Focus on Profit %s vs. Profit $Specialty vs. Commodity Product Underestimation of competitor capabilities and desires

Lack of understanding of current point on the demand curve

Strategy

What does the customer value?

Competitive Advantage Us Them Good Excellent Good Poor Excellent Good Good Good Good Excellent Good Poor Excellent Good Excellent Poor Poor Good Excellent Poor Good Good Good Poor Good Excellent Excellent Poor Poor Good Poor Good Good Poor Excellent Excellent Excellent Poor

Customer Values Product Downtime Reduction Material Savings Labor Sav ings Low Failure Potential Inventory Immediate Parts Av ailability Time saved in sourcing Sales Service Ready access to source Ability to ID parts for task Regular Bin Maintenance Minimized Paperwork Relationship w/Sales Staff Ability to solve order errors Ability to solve product problems Customer Service Regular Deliv eries On Time Deliveries No Credit Delays Billing Convenience Packaging fits inventory system Emergency Delv Capability y

Strategy
Customer Transparency

Price Elasticity

Customer Price Sensitivity

Low
Same or Higher Price Lower prices may not buy more business Higher Price Lower prices may not buy more business

High
Lower Price Lower prices will get business without competition seeing it Status Quo Lower price may move the market down Higher price may result in lost business

Low

High

Strategy

Price change timing

Cost vs Competition

Low Strong
Meet Price Decrease quickly (3 weeks)

High
Meet Price decrease quickly to protect share (1 Week)

Market Share

Meet price increase quickly (1 week) Meet Price decrease grudgingly (2 months) Follow price increase quickly (1 week)

Weak

Increase price grudgingly (3 months)

Direct Costing Implementation

Educate Leadership Create Sector Deployment Teams Identify IT System Deficiencies Establish Centralized Reporting System Develop Sales Mgt Scorecard