Slicing and dicing the income statement, costs

Originally Posted 6/25/2010 

We have seen all the points issues regarding the top section of the P&L statement. We have learned that each and every line should be analyzed according to responsibility criteria. We have also seen how measures should mimic the sales events.
Now it's time to go below the net sales value and see what to do with costs.

There are several different approaches on how to structure costs for the P&L and, once again, they depend on the company business model. The BI guy is given a list of measures in a specific sequence, but what's the rationale behind that? Usually the cost structure follows two guidelines: identify some levers the management can pull and spot external events which are not under management control but influence the margins.

We'll be discussing costs for many posts, because a large part of the managerial accounting doctrine is about cost control. Rather than doing a long theoretical introduction, we'll see some commonly used costing models.

The easiest costing schema is listing direct costs first and indirect costs down the row. Direct costs are those which can be directly traced to a product. The cost of raw materials used to manufacture an item, the cost of the people who manufactured it is a direct cost. These are usually very easy to calculate. If they're not given, a simple division will get the result. The cost engine of many ERPs does the job easily. Indirect costs are all those costs that can't be traced directly to the single product. For example, the plant director's salary can't be traced directly to a product. To associate them to a product, a process called "Allocation" must be applied; we'll talk about that in later post. Actually a cost can be defined as direct if it can be traced to a "cost object", that might be a product, a unit of service or even an employee. The same plant director's salary becomes a direct cost if we refer to the employee.
So, why are we talking direct costs to product? Because the product usually defines the lowest detail level in the orders or invoices which aggregate into the P&L. As said before, the ultimate purpose of a P&L is to evaluate a customer's or a product's or whatever's profitability. Attach a cost to the product and you'll attach a cost to every invoice row. It will easily roll-up into aggregated costs.
Note that the role of the product may be taken by whatever takes its role at the lowest sale level. It may be a working hour for a specific professional figure, a 30 seconds clip on the local radio and so on. You should always have somewhere in the company systems a table that says "sold n items of the x thing", and x is the object to refer the costs to.

What are the most widely used direct costs? As usual, it depends on the business model, but let's try to do a list with the usual manufacturing company in mind (we'll have different examples in the future). Commissions: they're often calculated as a percentage of the sale, so it's easy to associate it with the product. There are more complex environments but, ultimately, they're linked to "what" is sold, that is, the product. Cost of goods sold: these are the costs related to manufacture (or buy) what is (re)sold. They are usually split into: Materials: raw or semi-finished purchased to manufacture the product. Given the product components, these can be precisely defined. Usually they're calculated by the ERP cost engine. Machines: the cost of running the machines for a single product item. These are harder to calculate but they're usually pretty linear with the production. A limited cost accounting process may be necessary to define them but often few divisions are enough. Manpower:these are the salaries of the people who are directly involved in manufacturing the product. Given the time spent to produce a single item, those costs are easily calculated from salaries. Freight: it's a direct cost because it refers to a specific transport, but it may be difficult to calculate because of the freighter pricing. Usually, some simplifications offer a good approximation. These costs are often used because they're the easiest to be calculated, and they're already somewhere in an accessible format. These are also the old school costs because they relate to levers easy to pull.
Is the workforce cost too high? Let's pay less those dawdlers or make them work faster!
Are components costs too high? Let's grab suppliers' ties and pull!
Are machines too expensive? Let's keep working with the old steamers!
I could go on but I imagine that the concept is clear.

See you next time!