Performance Management 2: Product Cost and Cost Management

We are dealing with a company Manufacturing a product with a total cost of production, much higher than the market average, and profit margin, lower than other products in the same company. How should we start our investigation about the costs of production?

How can we enhance the cost structure, in a more meaningful way? Will the investors in our company, like to see a product which has a negative margin? Is it a good sign for investors?

In this article, I am trying to go into more details about different cost allocation schemes, and I will try to find the ideal reporting style.

Who can use this article?

  • CFOs of the companies
  • Auditors
  • Value Investors
  1. Introduction:

before starting the main concept, let's have a review of some general concepts:

1.1. Cost classifications:

To know more about the basics of categorization, you can check this article about Cost Classification. Fixed and Variable costs and Direct and indirect costs are the four main categories of costs that I will be working on within this problem. so before starting our investigations, we need to know how these costs are formed in our business.

Cost Classification (Courtesy: Xplained.com)

To make any kind of classification, we have to focus on selecting the most appropriate cost objects. for your information, a cost object can be a single product, or a product line, or a segment of the clients.

Direct costs: the cost of any resources used directly in the production of a product. these costs are linked directly to the products, like ingredients, labor working, …

Indirect Costs: Anything which is not related directly to the production, is considered an indirect cost. like Accounting, Admin, insurance, marketing, warehousing, patent, property tax, and so on.

Depending on the organization, the ratio of direct to indirect costs is different. In situations, where these indirect costs are enormous, then we should highly be careful about the structure of the costs. In the process of attaching the indirect costs to the cost of the product, there are different formulas, which are called, allocation schemes.

  1. Accounting Based Overhead Calculation:

at the end of the period of accounting, when I know that how much of the indirect costs I have, we can calculate the real overhead costs.

2. Predetermined Allocation rate:

This happens in line with our yearly budgeting plan, so the costs can be considered based on a base overhead allocation value. for example, we can consider it as a percentage or multiplier of direct labor cost.

But is this the optimal solution? to know more, check the Wilkerson example.

Example:

We have two projects below, and the total overhead cost in the company is 20,000 USD. Calculate the ideal allocation of the over cost on each of the following project.

Project A:

Direct Labour Hour: 800 Hour,

Machine Works Hours: 700 Hours

Project B:

Direct Labour Hour: 800 Hour,

Machine Works Hours: 300 Hours

So if we do the allocation based on the working hours, we will have

Allocation base1: 1600 Hour of Labours Works

Allocation Base 2: 1000 Hours of Machine Hours

So the indirect case in each project will be:

Overhead A: 17000

Overhead B: 12000

Based on the working hours of the machine that will be:

Over Head A: 14000

Over Head B: 15000

So which of the two methods mentioned is better? and how should we decide the best allocation method?

If we just look at three different types of settings,

  1. Service Sector: in the sectors like banking or insurance, the direct cost is not a major part of our costs. More than 50% of the total costs, for overhead costs
  2. Merchandise Sector: in this sector, the most cost is on the Inventories and overhead is lower.
  3. Manufacturing: it is something in between.

for each of these cases, we should know two important issues:

  1. Reorganizing:

Analyze the cost, making them in different categories, and then try to find a way to optimize the costs.

in a company, the pension costs can be on the overhead costs or they can be added to the direct costs of the labor. In that way, we will decrease the overhead costs, and this way, we will have a lower bias.

2. Grouping:

Instead of one big basket of overhead, we can make groups of overhead into different subcategories. like, Pack and ship, warehousing, Admin overhead, and,…. this way optimization of the costs based on the nature of groups will be easier.

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Iman Najafi

Iman Najafi

An Enthusiast Equity Analyst and Independent Financial Researcher with a passion for Fundamental Analysis. I use Medium for the daily records.