The Fast Forward MBA in Finance_12 pptx

(see Figure 17.1 again). The total of sales returns is very important control information. On the other hand, in external income statements only the amount of net sales revenue (gross sales revenue less sales returns and all other sales revenue negatives) is reported. Lost sales due to temporary stock-outs (zero inventory situ- ations) are important for managers to know about. Such non- sales are not recorded in the accounting system. No sales transaction takes place, so there is nothing to record in the sales revenue account. However, missed sales opportunities should be captured and kept track of in some manner, and the amount of these lost sales should be reported to managers even though no sales actually took place. Managers need a measure of how much additional contribution margin could have been earned on these lost sales. Customers may be willing to back-order products, or sales may be made for future delivery when customers do not need immediate delivery; these are called sales backlogs. Informa- tion about sales backlogs should be reported to managers, but not as sales revenue, of course. If a customer refuses to back- order or will not wait for future delivery, the sale may be lost. As a practical matter, it is difficult to keep track of lost sales. The manager may have to rely on other sources of informa- tion, such as complaints from customers and the company’s sales force. Key Sales Ratios Many retailers keep an eye on measures such as sales revenue per employee and sales revenue per square foot of retail space. Most retailers have general rules ($300 to $400 sales per square foot of retail space, $250,000 sales per employee, etc.). These amounts vary widely from industry to industry. Trade associations collect data from their members and pub- lish industry averages. Retailers can compare their perform- ances against local and regional competition and against national averages. Hotels and motels carefully watch their occupancy rates, which is an example of a useful ratio to measure actual sales against capacity. When sales ratios are lagging, the business probably has too much capacity—too many employees, too much space, too END TOPICS 260 many machines, and so on. The obvious solution is to reduce the fixed operating costs of the business. However, reducing these fixed expenses is not easy, as you probably know. Employees may have to be fired (or temporarily laid off ), major assets may have to be sold, contracts may have to be broken, and so on. Downsizing decisions are extremely diffi- cult to make. For one thing, they are an admission of the inability of the business to generate enough sales volume to justify its fixed expenses. Nonetheless, part of the manager’s job is to make these painful decisions. The tendency is to put off the decision, to delay the tough choices that have to be made. In an article in the Wall Street Journal, the former CEO of Westinghouse observed that one of the biggest failings of U.S. chief executives is one of procrasti- nating—executives are reluctant to face up to making these decisions at the earliest possible time. In Closing I would like to show you examples of management control reports. But control reports are highly confidential; companies are not willing to release them outside the business. In some situations, control reports contain proprietary information that a business is not willing to give out without payment (e.g., cus- tomer lists). Management control reports are like income tax returns in this regard—neither is open for public inspection. However, you may be able to get your hands on one type of management control report—those that are required in a franchise contract between the franchisee and the parent company that owns the franchise name. These contracts usu- ally require that certain accounting reports be prepared and sent to the home office of the company that operates the chain. These reports are full of management control informa- tion that is very interesting. Perhaps you could secure a blank form of such an accounting control report. Last, I should point out that management control reports vary a great deal from business to business. Compare in your mind, if you would, the following types of businesses—a gam- bling casino, a grocery store, an auto manufacturer, an elec- tric utility, a bank, a hotel, and an airline. Each type of business is unique in the types of control information its 261 MANAGEMENT CONTROL managers need. The preceding comments offer general obser- vations and suggestions for management control reports with- out going into the many details for particular industries. SALES MIX ANALYSIS AND ALLOCATION OF FIXED COSTS Typically, two or more products share a common base of fixed operating expenses. For instance, consider the sales of a department store in one building. There are many building occupancy expenses, including rent (or depreciation), utilities, property taxes, fire and hazard insurance, and so on. All products sold in the store benefit from the fixed expenses. Or consider a sales territory managed by a sales manager whose salary and other office costs cover all the products sold in the territory. Should such fixed expenses be allocated among the different products? Allocation may appear to be logical. The more basic question is whether or not allocation really helps management decision making and control. Allocation is a controversial issue, espe- cially where product lines (or other product groupings) are organized as separate profit centers for which different man- agers have profit responsibility (and whose compensation may depend, in part at least, on the profit performance of the orga- nizational unit). If a company sold only one product, there would be no cost allocation problems between products—although there may be common costs extending over two or more separate sales regions (territories). The main concern in the following discus- sion is the allocation of fixed expenses among products. Sales Mix Analysis Suppose you’re the general manager of a business’s major division, which is one of the several autonomous profit cen- ters in the organization. (I treat this as a profit module in the following discussion.) Your division sells one basic product line consisting of four products sold under the company’s brand names plus one product sold as a generic product (no brand name is associated with the product) to a supermarket chain. Figure 17.2 presents your management profit report for the most recent year. END TOPICS 262 MANAGEMENT CONTROL 263 Products Product Line Totals Generic Economy Standard Deluxe Premier Units Dollars Sales price $28.25 $42.50 $60.00 $75.00 $95.00 $5,261,000 Product cost ($20.05) ($26.65) ($32.00) ($36.00) ($40.60) ($2,886,500) Variable expenses ($1.13) ($6.80) ($11.80) ($16.50) ($21.15) ($922,390) Unit margin $7.07 $9.05 $16.20 $22.50 $33.25 $1,452,110 % of sales price 25% 21% 27% 30% 35% 28% Sales volume 28,000 18,000 35,000 10,000 9,000 100,000 % of total sales volume 28% 18% 35% 10% 9% 100% Contribution margin $197,960 $162,900 $567,000 $225,000 $299,250 $1,452,110 % of contribution margin 14% 11% 39% 15% 21% 100% Fixed expenses ? ? ? ? ? ($766,000) Profit ? ? ? ? ? $686,110 FIGURE 17.2 Management profit report. The question is whether or not to allocate the total fixed expenses among the five products to determine profit attributable to each product line. All five products are earning a contribution margin—though these unit profit margins vary in dollar amount and by percent of sales price across the five products. The premier product has the highest percent of profit margin (35 percent), as well as the highest dollar amount of unit margin ($33.25). You might notice that the generic model has a higher percent of contribution margin and generates more total contribution margin than the economy model. Production costs are cut to the bone on the generic product, and no advertising or sales promotion of any type is done on the product—the variable expenses are mainly delivery costs. Product cost is highest for the premier product because the best raw materials are used and additional labor time is required to produce top-of-the-line quality. Also, variable advertising and sales promotion costs are very heavy for this product; variable expenses are 22 percent of sales price for this product ($21.15 variable expenses ÷ $95.00 sales price = 22%). The economy model accounts for 18 percent of sales vol- ume but only 11 percent of total contribution margin. The premier model accounts for only 9 percent of sales volume but yields 21 percent of total contribution margin. Which brings up the very important issue of determining the best, or opti- mal, sales mix. The comparative information presented in Fig- ure 17.2 is very useful for making marketing decisions. Shifts in sales mix and trade-offs among the products are important to understand. The marketing strategy of many businesses is to encourage their customers to trade up, or move up to the higher-priced items in their product line. As a rule, higher-priced products have higher unit margins. This general rule applies mainly to mature products, which are those products in the middle-age or old phases of their life cycles. Newer products in the infant and adolescent stages of their life cycles often have a competitive advantage. During the early phases of their life cycle, new products may enjoy high profit margins until competition catches up and forces sales price and/or sales volume down. In fact, the CEO of Kodak made this very point a few years ago in an article in the New York Times. Compare the following two products: standard versus deluxe. You make a $6.30 higher unit contribution profit margin on the deluxe product ($22.50 deluxe − $16.20 END TOPICS 264 TEAMFLY Team-Fly ® standard = $6.30). Giving up one unit of standard in trade- off for one unit of deluxe would increase total contribution margin without any change in your total fixed expenses. Marketing strategies should be based on contribution margin information such as that presented in Figure 17.2. The position of the economy model is interesting because its contribution margin is by far the lowest of the company- brand products and not much more than the generic model. The economy model may be in the nature of a loss leader or, more accurately, a minimum-profit leader—a product on which you don’t make much margin but one that is necessary to get the attention of customers and that serves as a spring- board or stepping-stone for customers to trade up to higher- priced products. But the opposite may happen. In tough times, many cus- tomers may trade down from higher-priced models and buy products that yield lower profit margins. Large num- bers of customers may trade down to the standard or the economy models. Dealing with this downscaling is a challeng- ing marketing problem. Perhaps the sales prices on the lower- end products could be raised to increase their unit margins; perhaps not. Should you be making and selling the generic product? On the one hand, this product brings in 28 percent of your total sales volume and 14 percent of total contribution margin. On the other hand, these units may be taking sales away from your other four products—though this is hard to know for cer- tain. This question has to be answered by market research. If the generic product were not available in supermarkets, would these customers buy one of your other models? If all these customers would buy the economy model, you would be better off; you’d be giving up sales on which you make a unit contribution profit margin of $7.07 for replacement sales on which you would earn $9.05, or almost $2.00 more per unit. If customers shifted to the standard or higher models you would be ahead that much more, though it would seem that customers who tend to buy generic products are not likely to trade up. Many different marketing questions can be raised. Indeed, the job of the manager is to consider the whole range of mar- keting strategies, including the positioning of each product, setting sales prices, the most effective means of advertising, and so on. Deciding on sales strategy requires information on DANGER! 265 MANAGEMENT CONTROL contribution profit margins and sales mix such as that pre- sented in Figure 17.2. The exhibit is a good tool of analysis for making marketing decisions regarding the optimal sales mix. Fixed Expenses: To Allocate or Not? When selling two or more products, inevitably there are fixed operating expenses that cannot be directly matched or cou- pled with the sales of each product or each separate stream of sales revenue. The unavoidable question is whether or not to allocate the total fixed operating expenses among the prod- ucts. Refer to Figure 17.2, please; notice that fixed expenses are not allocated. Should these fixed expenses be distributed among the five different products in some manner? Fixed expenses generally fall into two broad cate- gories: (1) sales and marketing expenses and (2) general and administrative expenses. Most fixed operat- ing expenses are indirect; the expenses cannot be directly associated with particular products. The example here assumes there are no direct fixed expenses for any of the products. On the other hand, there could be some direct fixed expenses. For example, an advertising campaign may feature only one product. Suppose you bought a one-time insertion in the Wall Street Journal for the premier product. The cost of this one-time ad should be deducted from the contribution margin of the premier product as a direct fixed expense. Typically, however, most fixed expenses are indirect; they cannot be directly matched to any one product. Indirect fixed expenses can be allocated to products, although the purposes and methods of allocation are open to much debate and differences of opinion. For instance, the allocation can be done on the basis of sales volume, which means each unit sold would be assigned an equal amount of the total fixed expense. Or fixed costs can be allocated on the basis of sales revenue, which means that each dollar of sales revenue would be assigned an equal amount of total fixed expense. Alternatively, fixed costs can be allocated according to a more complex formula. Figure 17.3 shows two alternative profit reports for the example—one in which total fixed expenses are allocated on END TOPICS 266 267 Method A: Fixed Expenses Allocated on Basis of Sales Volume Generic Economy Standard Deluxe Premier Sales revenue $791,000 $765,000 $2,100,000 $750,000 $855,000 Cost-of-goods-sold expense ($561,400) ($479,700) ($1,120,000) ($360,000) ($365,400) Gross margin $229,600 $285,300 $ 980,000 $390,000 $489,600 Variable expenses ($ 31,640) ($122,400) ($ 413,000) ($165,000) ($190,350) Contribution margin $197,960 $162,900 $ 567,000 $225,000 $299,250 Fixed expenses ($214,480) ($137,880) ($ 268,100) ($ 76,600) ($ 68,940) Profit (loss) ($ 16,520) $ 25,020 $ 298,900 $148,400 $230,310 Method B: Fixed Expenses Allocated on Basis of Sales Revenue Generic Economy Standard Deluxe Premier Sales revenue $791,000 $765,000 $2,100,000 $750,000 $855,000 Cost-of-goods-sold expense ($561,400) ($479,700) ($1,120,000) ($360,000) ($365,400) Gross margin $229,600 $285,300 $ 980,000 $390,000 $489,600 Variable expenses ($ 31,640) ($122,400) ($ 413,000) ($165,000) ($190,350) Contribution margin $197,960 $162,900 $ 567,000 $225,000 $299,250 Fixed expenses ($115,169) ($111,384) ($ 305,759) ($109,200) ($124,488) Profit (loss) $ 82,791 $ 51,516 $ 261,241 $115,800 $174,762 FIGURE 17.3 Two common methods for allocating fixed expenses. MANAGEMENT CONTROL basis of sales volume (method A), and the second on the basis of sales revenue of each product (method B). Total profit for the product line is the same for both, but the operating profit reported for each product differs between the two allocation methods. Both sales volume and sales revenue for allocating fixed costs have obvious shortcomings; furthermore, both methods are rather arbitrary. Either method rests on a dubious prem- ise. Method A assumes that each and every unit has the same fixed cost. Method B assumes that each and every sales rev- enue dollar has the same fixed cost. Recent attention has been focused on the theory of cost drivers to allocate fixed expenses, which goes under the rubric of activity based cost- ing (ABC). This approach should really be called activity based cost allocation, because it’s a method to allocate indi- rect costs to products. Activity Based Costing (ABC) The ABC method challenges the premise that fixed expenses are truly and completely indirect. Total fixed expenses are subdivided into separate cost pools; a separate cost pool is determined for each basic activity or support service. Instead of lumping all fixed costs into one conglomerate pool of gen- eral support, each basic type of support activity is identified with its own separate cost pool. Each product is then analyzed to determine and measure the usage the product makes of each activity for which separate fixed-expense pools are established. In this example, for instance, all products except the generic model are advertised, and all advertising is done through the advertising department of the corporation. The advertising department is defined as one separate fixed-cost pool, and its activity is measured according to some common denominator of activity, such as number of ad pages run in the print media (newspapers and magazines). Each product is allocated a share of the total advertising department’s cost pool based on the number of ad pages run for that product. The number of ad pages is called a cost driver. This activity drives, or determines, the amount of the fixed-cost subpool to be allocated to each product. Alternatively, different types of advertising (print versus END TOPICS 268 electronic media, for example) could be identified and each product line charged with its share of the advertising depart- ment’s cost based on two separate cost drivers—one for the number of print media pages and a second for the number of minutes on television or radio. Some fixed expenses are quite indirect and far removed from particular products. Examples include the accounting department, the legal department, the annual CPA audit fee, the cost of security guards, general liability insurance, and many more. The cost driver concept would get stretched to its limit for these fixed expenses. Also, the number of separate activities having their own expense pools can get out of hand. Three to five, perhaps even seven to ten separate cost drivers for fixed-cost allocation may be understandable and feasible, but there is a limit. Returning to the title of this section, the fundamental management question is whether any allocation scheme is worth the effort. What’s the purpose? Does allocation help decision making? The basic management purpose should not be to find the true or actual profit for each product or other sales revenue source. The fundamental question is whether management is making optimal use of the resources and poten- tial provided by the division’s fixed operating expenses. The bottom line is finding which sales mix maximizes total contribution margin. Allocation of indirect fixed expenses in and of itself doesn’t help to do this. Indirect fixed expenses may have to be allocated for legal or contract purposes. If so, the method(s) for such allocation should be spelled out in advance rather than waiting until after the fact to select the allocation rationale. Sometimes a business may allocate fixed expenses to mini- mize the apparent profit on a product. I was hired to be an expert witness for the plaintiff in a patent infringement law- suit against a well-known corporation. The defendant had already lost in the first stage, having been found guilty of patent infringement. For three years the defendant corpora- tion had manufactured and sold a product on which the plain- tiff owned the patent without compensating the plaintiff. The second stage was to assess the amount of damages to be awarded to the plaintiff. 269 MANAGEMENT CONTROL [...]... like the blueprint for a building; control should be carried out in the context of the decision blueprint Budgeting is one very good means of integrating management decision making and management control, akin to constructing a building according to its blueprint Decisions are made explicit in a budget, which is the concrete plan of action for achieving the profit and financial objectives of the business... for the coming period and a budgeted financial condition report (balance sheet) at the end of the period As explained in previous chapters, the financial condition of the business is driven mainly by the profit-making operations of the business Capital expenditures for replacements and expansions of long-term operating assets of the business must be included in the cash flow budget and the budgeted... in turn are integrated with cash flow and financial condition (balance sheet) budgets The larger the organization, the more likely you’ll find a formal and comprehensive financial budgeting process in place And the more bureaucratic the organization, the more likely that it uses a budgeting system The budget is one primary means of communication and authorization down the line in the organization The. .. expense By minimizing current taxable income, the business could delay payment of income taxes The Internal Revenue Code takes a special interest in the problem of manufacturing overhead cost classification The Internal Revenue Service noticed that many manufacturers were misclassifying some of their costs The income tax law spells out in some detail which costs must be classified as manufacturing overhead... TOPICS The plaintiff was suing for recovery of the profit made by the defendant corporation on sales of the product The defendant allocated every indirect fixed cost it could think of to the product—including part of the CEO’s annual salary—to minimize the profit that was allegedly earned from sales of the product The jury threw out this heavy-handed allocation and awarded $16 million to the plaintiff... fixed operating expenses instead of in fixed manufacturing overhead costs Otherwise, everything else remains the same as shown before in the company example Figure 18.2 shows the effects of this misclassification error Pay particular attention to the operating profit line, which is taxable income before the interest expense deduction In Figure 18.2 fixed operating expenses are inflated by $480,000 (from... determined by dividing the total manufacturing costs for the period by total production output for the period: *During the production process, which can take several weeks or months, manufacturing costs are first accumulated in an inventory account called work -in- process When production is completed, the cost of the completed units is transferred to the finished goods inventory account † A manufacturing... BUDGETING OVERVIEW It goes without saying that managers should plan ahead and formulate strategy and tactics for the coming year—and longer The future does not take care of itself Any manager will tell you of the importance of forecasting major changes, adapting the core strategy of the business to the new environment, developing and implementing initiatives, and in general keeping ahead of the curve... and therefore capitalized Capitalize means to put the cost into an inventories asset account by including the cost in the calculation of unit 280 M A N U FA C T U R I N G A C C O U N T I N G product cost Remember that the cost of products held in inventory remains an asset and is not charged to expense until the products are sold The following costs should definitely be classified as manufacturing... for the 11,000 units sold during the year and $685,000 is allocated to the 1,000-unit inventory increase.* Thus $685,000 of the manufacturing costs for the year will not be expensed until next year or sometime further into the future when the inventory is sold.† Manufacturing overhead refers to all other production costs Some of these costs vary with total output, such as electricity that powers machinery . of the importance of forecasting major changes, adapting the core strategy of the business to the new environ- ment, developing and implementing initiatives, and in general keeping ahead of the. witness for the plaintiff in a patent infringement law- suit against a well-known corporation. The defendant had already lost in the first stage, having been found guilty of patent infringement marketing questions can be raised. Indeed, the job of the manager is to consider the whole range of mar- keting strategies, including the positioning of each product, setting sales prices, the