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Financial accounting is what we have talked about in the course thus far. Financial accounting reports the past. The past is helpful to know for context, but often doesn’t give you a complete understanding of what’s going on or what will go on. Management accounting is a related discipline that analyzes and explains what is going on and attributes cause and effect relationships to the results. The discipline of finance, looks forward and helps make better decisions. We will cover that off in a later lesson.
Financial accounting is also externally oriented. It serves the needs of owners, investors, and lenders. Management accounting is reporting for the insiders, in other words, the managers of the business. It’s designed to help managers run the business better. As an executive or a director, you may not be provided with reports that provide this level of detail, but there are times you may want to drill into important issues. That is the sole purpose of this lesson, to give you a framework for drilling into numbers. This happens more frequently than you might expect. You may be reading the financial statements and not fully understand why sales have declined or margins have compressed. The explanations provided by management may not adequately explain the variances you are seeing. In such instances, it is entirely your prerogative to request of management financial information that provides you with answers along the lines we will discuss in this lesson.
I’m fond of an old Ronald Reagan quote “If you can’t make them see the light, make them feel the heat.” Asking the right questions of managers can certainly put the heat on them to figure out and explain what is going on. You certainly want to know when an issue is developing in time that it can be dealt with before it’s too late.
To begin with, I have never seen a business that is composed of a single line of business. Think about that for a moment. A business with one product or service or one with one location or one homogenous segment of customers. Rather, I’ll boldly state that all businesses have multiple streams or channels. The streams of business can be segmented by geography, product line, market, customer segment, etc. I like to think of each of these streams of business as a tile. The problem with external financial statements is that they represent a composite of all the tiles. Management accounting helps you understand and identify the underlying characteristics of each tile. This is important because often issues arise in one or more tiles and those issues get masked because these are mixed in with all the other tiles. Management knows this, so they set up their management reporting systems to that they can identify when one tile is under or over performing and they can do something about it.
Tiles are often attributed to the organizational structure. An investment center needs to attract capital and to attract capital it requires either shareholder or lenders to fund the business. The level below an investment center is a profit center. This could be a subsidiary or a division. The manager of a profit center is responsible for running their business as effectively and efficiently as they can, however, they do not control the capital invested into their business. They would be accountable for delivery operating profit by maximizing sales and minimizing costs. There likely isn’t a balance sheet associated with a profit center, though often they are tasked with managing their own working capital and controlling their capital spending. Below a profit center, you have managers with an even narrower task. The sales executive is tasked with running a revenue center to maximize sales and gross margin. A cost center is tasked with supporting the rest of the business as cost effectively as they can. Most functional departments of a business are cost centers such as health and safety, quality, R&D, finance, IT, HR etc. The reason management accounting is organized this way is that these centres are managed by people. People drive results, not processes or systems. People are accountable, not processes or systems. So when something goes wrong, you can pinpoint where it’s gone wrong, diagnose what went wrong, make someone accountable and see to fixing it.
We talked about variances when we discussed horizontal analysis in our review of the income statement. Variances arise when an actual result varies from our expectation. Our expectation is set using either a prior period result or budget or both. So, let’s say the business has a sales problem. It’s one thing to identify that sales didn’t meet expectation, but quite another to understand why. Here is the list of ‘rocks’ you will need to turn over to get to the bottom of this sales issue. Pricing variance arises when our selling prices vary from plan for whatever reason. Sometimes it’s competitive forces, sometimes it’s commodity driven, and sometimes it relates to supply and demand imbalances. Volume is the other most common causes of variance. You sell more or less than you expected. But why did you sell more or less? Here you can probe further. Mix variance arises when we sell a different proportion of higher or lower margin products than we had planned. Quantity variance arises when we sell more or less total product than plan. Quantity variance can arise because we gained or lost market share relative to our competition. It can also arise when the market itself grew faster or slower than expected. Often quantity variances are very judgemental to pinpoint, but there should be some good data points from industry data or peer bench marking that give an indication as to whether the company is winning or losing vis-à-vis its competition.
Next, let’s drill into that pesky cost of sales number. For manufacturing entities, the explanation for variances can get complex. For your purposes, you are seeking a plausible explanation for variance, not calculating the variance yourself. Pricing variances come from the amount paid for raw materials, direct labour or variable overhead costs like electricity or other utilities. Production cost variances relate to quantity usage variances. Quantity variance can arise from changing the amount of inputs or yield issues on the back end which might arises from defect or scrap.
Fixed overhead variances is the hardest to interpret because bear in mind the two step recognition of production costs to the financial statements we discussed in our earlier lesson. First, production overhead costs get capitalized to finished goods inventory based on actual amounts spent. This bucket of fixed costs is capitalized to inventory based on what is called a “cost driver.” A cost driver tries to identify one or more most likely causes of cost. For example a machine intensive process, might use machine hours to allocate these fixed costs to a unit of inventory assuming different types of inventory use different amounts of machine time. Direct labour or units produced are other common cost drivers used to allocate fixed overhead. Until a finished good is sold, it is shown as inventory on the balance sheet as a current asset.
In the second stage, the finished goods inventory cost get recognized as cost of sales once the product is sold. That is when the production cost actually hits the income statement. So, sometimes figuring out that you have a production facility that is inefficient and spending too much isn’t self-evident immediately. Further complicating matters are situations when your production plant is not producing at full capacity for whatever reason. When this happens, that fixed-allocation of overhead is not being fully allocated to finished goods. You need to ask management what has been done with the “under-applied” fixed plant overhead. It should be expensed and not capitalized in inventory, otherwise, you are just delaying the bad news until the product is ultimately sold.
Finally, we have variances of general and administrative overhead spending. These are pretty straight forward to analyze. You set a budget and then measure spending against the budget throughout the period. If someone is spending too much, then it typically stands out like a sore thumb and it’s easy to identify and deal with. The explanations require the accountants to analyze what is includes in the general ledger account versus what we expected to be spent and flags any differences.
The accountants use a methodology call standard costs to measure cost variance. A standard is based on what the expected cost is to produce one unit. The Bill of Materials or “BOM” specifies the recipe for each product –this includes the expect quantity of each raw material and the production requirements. This sets the expectation and is used for preparing the budget. Variances are then analyzed throughout the year to identify where management is more or less productive versus this expectation. Bear in mind that management may make trade offs as the year goes along and that spending more is not always a bad thing.
Consider a few examples:
-Perhaps you have a negative spending variance on direct labour and the explanation is a decision to use more experienced workers rather than temporary contract labor. This decision may be offset by better yield variances that arise from high quality and few defects.
-Perhaps you have a negative raw material price variance. The explanation might be management decided to use a more expensive source for raw materials on the expectation that there would be lower scrap.
The point of all this discussion is that variance analysis is a management tool for drilling into issues and identifying root cause. As an owner, executive and director, you will unlikely explore every variance in the same way management might. However, the goal of this lesson is to give you a guide for drilling down when you have to, which typically arises when an actual result has missed expectations by a material amount. In our next lesson, we will go deeper into understanding cost management and the decisions that come out of this type of analysis.
In addition to variance analysis, management accounting will also delve into costing and pricing analysis. Costing analysis looks at the true cost of producing each SKU. This can get muddled for a variety of reasons the primary one being the cost allocation factor that we discussed in the last lesson. Remember the comments around cost drivers and allocating fixed plant overhead costs? When you allocate the pot of fixed overheads on the basis of one cost driver (labour hours or units, etc.), the risk is that fixed, indirect costs aren’t accurately allocated to each individual SKU. When costs aren’t accurately attributed to product lines, the risk for cross-subsidization exists across the portfolio of products.I’ll give you a simple, real-life example from my own experience. At one point in my career I became CFO of an ice cream company. We manufactured hundred of different flavors of ice cream.
In addition to plain vanilla, we also had very complex to produce flavors that had so called inclusions of peanut butter cups, fudge, chocolate chips, mints etc. Vanilla is the simplest product to produce and the production line moved the fastest. However, for the more complex flavors with the inclusions, the production line ran much slower so that the inclusions would be balanced throughout the texture of a container of ice cream. When it came to allocating overhead though, we treated every litre of ice cream as the same. So vanilla was getting allocated the same amount of overhead as a premium brand. When this happened, cross-subsidization occurred between different SKUs. Vanilla ice cream was carrying more cost than the premium brands which were carrying less.
A few things to watch for that often give rise to the “cross subsidization issue”
-Low volume SKUs often get under allocated their fair share of costs because these SKU’s incur a disproportionate amount of set up, ordering, handling costs.
-More complex SKUs often get under allocated their fair share of costs as they often require additional machine or labour to produce or can’t be produced at the same rate as simpler SKUs.
When you have these situations, the management accountants will attempt to identify a more reflective cost driver or perhaps more than one cost drivers to determine the true cost of each SKU. This helps the business better price different product lines to be more reflective of their true cost of production. Costing analysis has a lot of judgement involved, so I’m rather fond of the adage that “It’s better to be approximately correct than precisely wrong!” This adage has broad application in building your own financial intelligence.
An important part of costing analysis is to determine which costs are variable, i.e. which vary with volume and which are fixed, i.e. those costs that don’t vary with volume. Management can make important decisions around the cost structure they want to employ and this becomes another point of leverage that can be used by managers to magnify returns (and losses) in the same way as we discussed debt can be used.For example, perhaps you don’t want to incur the cost of building your own manufacturing facility because that involves incurring a lot of upfront, fixed costs. If you have a lot of volume and can fully utilize that facility, you may achieve very higher margins, but it’s a lot of risk. However, another way to deal with your production plan might be to outsource production and only procure inventory as you receive inventory. You will likely pay a lot more for each unit of inventory, but you won’t have the same risk associated with carrying all those fixed costs of owning your own production facility. This is the essence of operating leverage.
Let me show you this with a few numbers to cement the idea. So for instance, you are trying to vet a management proposal on whether to manufacture or outsource production. To outsource production of a SKU incurs a variable cost per unit. This approach minimizes the risk of investing in production capabilities that typically require higher degrees of fixed costs. This lowers the company’s risk when sales fall because the company is able to scale back procurement of inventory to match sales. A cost structure with mostly variable costs is said to have a “low degree of operating leverage.” This is the equivalent “pillow” approach because it’s less risky in the event that sales fail to materialize.
Alternatively, the company may choose to manufacture the inventory itself by 130 investing substantial capital in building a plant and hiring a production team. These are fixed costs that are the same regardless of production volume. When you have fixed costs and increasing volumes, your production cost per unit goes down and your gross profit margin goes up. This is good when sales and production volumes are increasing. This is what we call a “high degree of operating leverage.” The downside of higher operating leverage is that if the opposite happens, sales and production are falling those fixed costs still must be paid to maintain the production capacity, regardless of whether that capacity is being utilized. As a result, gross profit margin falls faster than it otherwise would if you had a low degree of operating leverage. Thus, higher operating leverage is always our equivalent “sword.” Pillows and swords –there is that idea again.
So, if you really want to understand the levers of operating profit for the business, you will need to gain an understanding for the mix of variable and fixed costs of the business. In reality, in your role, you won’t likely have a precise understanding of every cost item incurred in the business. But we encourage you to take the time to understand how cost are incurred in the business and whether those costs vary with activity or are fixed. This insight will help you evaluate and predict costs under different levels of sales activity. Using this variable/fixed view of the accounts, you get a different picture of your income statement. Sales are sales, but using a management accounting perspective of costs, you will see cost of sales broken down between variable costs and fixed costs. Any costs that vary according to volume are considered variable. The fixed costs excluded from the schedule presented here includes your fixed plant overhead, your fixed operating costs and your fixed general, selling and administrative costs.
When you subtract your variable costs from your sales costs you are left with something called “contribution margin” instead of gross profit margin that we talked about earlier. Gross profit typically includes fixed manufacturing costs, whereas contribution margin does not. Contribution margin would also include other variable costs that might not be included in gross profit for example selling commissions and delivery costs that vary with volume. Those would show as selling, general and administrative costs in our traditional view of the income statement.
Contribution margin is an interesting number and useful for understanding break even points and target profits. When contribution margin is expressed as a percentage or cents per dollar, it shows you how much of each incremental dollar of sales should fall to the operating profit line with each incremental dollar of sales. So for instance, if the contribution margin percentage is 40% and you receive a new order for $100,000, then the quick math is that $40,000 should show up in operating income. Yes, it’s that easy to figure out the bottom line impact of a new order when you understand contribution margin.
To finish connecting the financial reporting world to the management reporting world…Fixed costs get deducted next and because these are the costs that are relatively insensitive to changes in volume, there is no incremental costs expected with the new order for $100,000.Operating income results are the same using either financial accounting or management accounting. However, management accounting makes margin analysis more predictive than financial accounting where you were just guessing on how many cents of each incremental dollar might flow through to the bottom line.
If you are able to understand the mix of fixed and variable costs with a line of business, you can quickly calculate break even and target profit sales required. Break even is the level of sales or the number of sales units to quite literally achieve zero operating income. This is an interesting number to calculate particularly for new start up lines of business as it gives you an indication as to how many sales are required before you start making money. If that level of sales or that level of units sold seems highly realistic, that tends to encourage you to approve management’s proposal to pursue the new initiative. But who among us wants to just break even, often we have a target profit in mind, particularly when we are making a capital expenditure to build that production capacity in the first place. So to calculate the target sales, we add target profit to our fixed costs and divide by the contribution margin percentage to determine how many sales are required.
Let’s look at a few numerical examples. To calculate break even, tabulate the fixed costs and divide by the $CM to calculation break even units or the CM% to calculation break even sales. If the $CM/unit is $0.50, then we need to sale 400,000 units to break even. With fixed costs of $200,000 and CM% of 40%, said another way, we need to $500,000 of sales to break even. And if we need to make an annual target profit of $60,000, then our calculated break even sales changes to 520,000 units or $650,000 in sales. You are now well positioned to assess management’s business plan, set a target for management, and make a decision on whether to proceed or not.
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