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Cost Analysis. Control costs Improve cost structure – problems show up Cost structure – relative proportion of each type of cost – fixed, variable, mixed Improve effectiveness of firm Which costs eroding profit margin What first? – earnings decrease Analyze situation, target problem areas.

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Cost Analysis

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Cost Analysis

  • Control costs

    • Improve cost structure – problems show up

      • Cost structure – relative proportion of each type of cost – fixed, variable, mixed

    • Improve effectiveness of firm

    • Which costs eroding profit margin

    • What first? – earnings decrease

    • Analyze situation, target problem areas


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  • Cost behavior –

    • Fixed – remain constant – i.e. equipment

    • Variable – dollar amount varies in direct proportion to changes in activity level – i.e. Battery in car

    • Mixed – contains both variable and fixed elements – license fee of $25,000/year and $3/dinner party

    • Stepped costs – variable but increases in big chunks – i.e. Wages of maintenance workers


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  • Make sure that costing done correctly, reduce costs

  • Standard costing – assigning overhead costs based upon one predetermined rate based on volume

  • Activity based costing - designed to provide managers with cost information for strategic and other decisions that potentially affect capacity and therefore affect fixed as well as variable costs.

    • Most organizations maintain two costing systems – internal – most useful information.

    • Uses drivers at various levels


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Activity Based Costing

  • Two stage allocation process

    • Assign costs to pools, then assign to products using cost drivers

  • I.e. Sell 50,000 CD units, 200,000 tape units = 250,000 units total

    • Both require two direct labor hours to complete = 500,000 direct labor-hours

    • Total manufacturing overhead = $10,000,000


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Traditional Costing Method


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ABC Costing


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  • Full capacity – constrained resource?

    • Constraint – limited resource that could restrict company’s ability to satisfy demand – how used

    • Theory of constraints

    • Should not necessarily promote products with highest CM but rather promote the product with the highest contribution margin per unit of constrained resource


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  • Value chain analysis – major business functions that add value to product and/or service

    • Eliminate or minimize non-value activities

    • Value-added activities – efficient as possible

  • Design in quality – reduce rework or scrap

  • Costs of quality

    • Prevention costs – plan the process to ensure that defects do not occur

    • Appraisal costs – measure the level of quality to insure customer requirements

    • Internal failure costs – rectify defective output before reaches customer

    • External failure costs – costs associated with delivering defective output to customer


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  • Effectiveness ratios

    • Inventory turnover = COGS/average inventory – how frequently sells inventory

    • JIT inventory system

      • Lower costs by long-term contracts

      • Closer relationship w/suppliers – guarantee deliver

      • Reduce scrap by increasing quality

      • Obsolete inventory on hand?

    • A/R turnover – Credit sales/average accounts receivable – ability to collect cash from credit customers

      • What is working?

    • Reduce operating cycle – need less working capital – invest in more productive activities


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  • Gross margin covers all costs - customers

    • 80/20 rule – 80% of headaches come from 20% of customers – how to find them?

    • Customer profitability – no problems

    • Find all costs – product fulfillment cycle

    • Some customers require extra work

      • Extra sales calls, customer service, smaller transportation lots, smaller orders – all add to costs

    • Expend effort on customers that are most profitable

    • Drop services that don’t increase goodwill or profitable


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  • Operating leverage – increase profitability

    • Multiplying force – how sensitive is net operating income to percentage change in sales, if high a small percentage increase in sales can produce a much larger percentage increase in net operating income

    • Mix of fixed versus variable costs

    • Capital intensive vs. labor intensive

    • Leverage multiplier - CM/NI


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  • Download

    • Capital budgeting spreadsheet

    • Theory of constraints

    • Capital budgeting problems

  • Read Introduction to ABC Costing

  • Read internal control process

  • Read Survey Masters LLC

  • Assign #3 – ABC Costing/unit problem (due 2/2)‏

  • Assign #4 – profitability ratios (due 2/2)‏

    • Gross margin % - 07-05

    • Profit margin – 07-05

    • Return on Assets – 07-05

    • Return on Equity - 07-05


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