ACCTG 533, Section 1: Lecture: Profitability Analysis 1. [Slide Content]: Profitability Analysis 1. [Jeanne H. Yamamura]: Profitability Analysis 1.

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1 ACCTG 533, Section 1: Lecture: Profitability Analysis 1 Profitability Analysis 1 Profitability Analysis 1. Profitability analysis, also known as differential analysis and relevant cost analysis, builds further on the CVP concepts and applies them to decision-making situations. Only Relevant Revenues and Costs Matter Costs and revenues that differ between alternatives Never relevant sunk costs, costs that do not differ When making decisions, only the costs and revenues that differ between your alternatives are relevant to the decision. These relevant costs and revenues are also known as differential costs and revenues, avoidable costs, and incremental costs and revenues. Some costs will never be relevant to a decision. These include sunk costs and future costs that do not differ between alternatives. Sunk costs are costs already incurred and, because of that, cannot be avoided making them not relevant Sunk Costs Tendency to include in decision making Not relevant Beware of depreciation in a profitability analysis! [Picture Shown] Sunk costs are a difficult and emotional issue. We become attached to things we have already paid for and we really like to include them in our decision making. In a business setting, the book value of old equipment is a sunk cost, I mean you ve already bought it, but one that is 1

2 frequently included in a decision. Say you have an old machine with a book value of $14,000. A new machine can be purchased that will be 50% more efficient. The book value of the old machine should NOT be included in the analysis as it is a sunk cost and, therefore, cannot change the decision. You would see this showing up as depreciation expense on an old machine. Always beware of depreciation in an analysis if taken on an existing asset because what you re really doing is you re incorporating a sunk cost into your analysis. The only factor related to the old machine that would be relevant is its disposal value or what you can sell the old machine for. Despite this, the tendency is to include the book value in order to get your money s worth out of your original purchase price. Absorption vs. Variable Product Costing [Chart Shown] Check for operational purposes!! For operational purposes (not financial reporting or tax purposes but solely internal purposes), organizations can choose between absorption (also known as full) costing and variable (which is also known as direct or contribution) costing. Absorption costing assigns all costs to a product meaning direct materials, direct labor and both fixed and variable overhead. Under variable costing, only the variable costs are assigned to a product and the fixed costs are treated as period costs. Arguments for Variable Costing 1. Inventory increases affect profit so no incentive to overproduce 2. No requirement to allocated fixed overhead What is the difference between choosing one or the other? Under absorption costing, product costs remain in inventory until they are sold. A manager is motivated to produce the full estimated volume, regardless of sales need. This is due to the fact that overproduction will remain in inventory and will not affect the income statement. Under variable costing, if overproduction occurs, profits will decrease because all fixed costs are expensed. Another argument for variable costing is the fact that the fixed overhead included in product cost must be allocated remember overhead by definition is a cost that s not easily or directly traced 2

3 to a product. It is generally considered unwise to make decisions based on numbers that include allocated costs. Two Things to Remember 1. Variable costing makes determining profitability easier 2. In the long run, all costs must be covered While there are many more arguments for and against the two approaches, just remember these two things: Variable costing makes determining profitability easier. As a result, you can take action more quickly when action is needed; and, number two, in the long run, all costs incurred by an organization must be covered. So you couldn t plan to price your product using only variable costs forever. Managers, in general, should simply be aware of the implications of using absorption versus variable costing. Larry Harry Moe Total Consulting fees 150, , , ,000 Cost of services (variable) (100,000) (50,000) (125,000) (275,000) Administrative salaries, rent, other (allocated fixed costs) (42,857) (57,143) (100,000) (200,000) Operating profit 7,143 92, , ,000 Now, on to some examples.. Mandrake Consulting performs services for three clients: Larry, Harry and Moe. The revenue in costs for the previous year appear on the screen. So with Larry we had consulting fees of $150,000, costs of services of $100,000, administration, salaries, rent and other costs $42,857, resulting in an operating profit of 7,143. For Harry we have consulting fees of $200,000 resulting in an operating profit of $92,857 while Moe generated consulting fees of $350,000 with an operating profit of $125,000. The company as a whole made $700,000 gross in consulting fees and $225,000 in operating profit. Fixed costs have been allocated on the basis of revenues so the administrative salaries, rent and other costs are allocated fixed costs that have been assigned to Larry, Harry and Moe based on the revenue proportions. 3

4 Decrease in profit of $50,000 not $7,143. Larry Harry Moe Total Consulting fees 200, , ,000 Cost of services (variable) Admin. S&W, rent, other (allocated fixed costs) (50,000) (125,000) (275,000) (72,727) (127,273) (200,000) Operating profit 77,273 97, ,000 Mandrake has decided to drop its least profitable customer. Which customer should be dropped? Well remember Larry had a profit of only $7143. If we drop Larry, what happens? If we take Larry out, now we ve got Harry and Moe generating fees of $200,000 and $350,000 and operating profits of $77,273 and $97,727 for a total for the company of 175,000. If you go back to the original screen, you ll see that you started off with an operating profit of 225,000 and now that we ve gotten rid of Larry with operating profits of $7,143, we ve dropped to $175,000. Our profit has decreased $50,000 not $7,143, how come? Well remember that Larry had consulting fees of $150,000 against costs of services of $100,000 so Larry was contributing $50,000 of CM to the entire company and that $50,000 was used to cover part of the fixed costs. The fixed costs of $200,000 have no decreased even though we dumped Larry. We still have $200,000 of fixed costs and now that Larry is gone we have to allocated those fixed costs between Harry and Moe which leads us to the next question: Is the allocation method appropriate? 3. Is the allocation method appropriate? Maybe! Maybe not! Allocation method can change apparent profitability! 4

5 Maybe, maybe not. But it s a question that you need to ask and you need to consider carefully because your choice of allocation method can change the apparent profitability of each customer. Now, it s fully possible that the fixed costs are most reasonably allocated to customers on the basis of their revenue contributions to the company, but it also could be that fixed costs are generated more by certain customers than others. So, again, it s a question that you need to ask because your choice of how you allocate those fixed costs changes whether or not a customer is considered profitable. 1. What other factors should Mandrake consider before the decision is made? Long-term potential? Closer look at cost of services? Maintaining expertise in specific area? What other factors should Mandrake consider before a decision is made? Well in addition to considering whether or not your allocation method is appropriate, you could look at things like long-term potential for the client. Perhaps Larry is a brand new client with a lot of potential for growth because Larry really likes the work that you do and is thinking of having you do more and more work where perhaps Moe, who is generating the largest amount of revenues, has pretty much tapped you out and is thinking about moving on to somebody else. So you need to think about stuff like that. You could take a closer look at the cost of services for each client, some clients may cost more than others to provide services to. You could also think about things like the need to do a minimum amount of work in order to maintain expertise in a certain area. So there are any number of factors that have to be considered. What you re really talking about here is the difference between a short term decision and a long term decision. If you decide to drop Larry based solely on the lowest amount of profit in a given year, you are making a decision with long-term impact based solely on short-term factors. 4. What if some of the fixed costs were traceable fixed costs while others were common fixed costs? Let s say that of the 200,000 in fixed costs, 50,000 were traceable to specific customers leaving 150,000 in common fixed costs. 5

6 Then what if some of the fixed costs were traceable fixed costs while others were common fixed costs? Let s say that of the 200,000 in fixed costs, 50,000 were traceable to specific customers leaving 150,000 in common fixed costs. So this is what you would now have: Larry Harry Moe Total Consulting fees 150, , , ,000 Cost of services (variable) (100,000) (50,000) (125,000) (275,000) Traceable fixed costs (5,000) (10,000) (35,000) (50,000) Common fixed costs (allocated) (32,143) (42,857) (75,000) (150,000) Operating profit 12,857 97, , ,000 Now you have 50,000 in traceable fixed costs which I ve assigned 5,000 are traceable to Larry, 10,000 are traceable to Harry, and 35,000 are traceable to Moe, leaving 150,000 in common fixed costs which are still allocated and they re still allocated on the basis of revenue proportion. Now Larry s operating profit is 12,857, Harry s is 97,143 and Moe s is 115,000. Larry Harry Moe Total Sales revenue 150, , , ,000 Cost of sales (variable) (100,000) (50,000) (125000) (275,000) Traceable fixed costs (5,000) (10,000) (35,000) (50,000) Operating profit (before allocated costs) 45, , , ,000 6

7 The point to be made here is that Larry, again as you saw in the previous slide, is still the least profitable client, but it made a difference when you took into consideration the traceable fixed costs. So when you have traceable fixed costs, those become relevant to the decision unlike allocated fixed costs which are not relevant because they will continue to be incurred regardless of whether the customer is there or not. So when you have fixed costs, you take those into consideration. Example 1: Division Division A Division B Division C Total Sales revenue 650, , ,000 1,300,000 Cost of sales (variable) (325,000) (175,000) (275,000) (775,000) Admin. S&W, rent, other (allocated fixed costs) (100,000) (100,000) (100,000) (300,000) Operating profit (before allocated costs) 175,000 25,000 (25,000) 225,000 Now let s change the example slightly and make it a decision to drop a division. Now, in this case, we have three divisions (A, B and C). Division a have sales revenue of 650,000 with cost of sales 325,000, administrative salary and wages, rent and other fixed costs of 100,000 for and operating profit of 175,000. Division B has an operating profit of 25,000 and Division C has a total operating loss of 25,000. The total operating profit for the company is 225,000. Note that the fixed costs, in this case, were allocated equally to each division. Example 1: Division Division A Division B Division C Total Sales revenue 650, , ,000 Cost of sales (variable) (325,000) (175,000) (500,000) 7

8 Admin. S&W, rent, other (allocated fixed costs) (150,000) (150,000) (300,000) Operating profit 175,000 (25,000) 150,000 If we say that all unprofitable divisions have to be dropped, then clearly we would drop division C and this is what will happen: If we take division C out of consideration, we now have 950,000 in sales revenues, 500,000 is cost of sales, we re still going to have our 300,000 in fixed costs because, remember, those were allocated fixed costs they will continue to be incurred regardless of whether Division C is there or not. So our operating profit is now down to 150,000 and not only is our operating profit down to 150,000, but now Division B is operating at a loss. What if we then say that all unprofitable divisions have to be closed? Which would sort of make sense, you don t want to keep an unprofitable division around. Example 1: Division [Picture of Death spiral Shown] Division A Division B Division C Total Sales revenue 650, ,000 Cost of sales (variable) Admin. S&W, rent, other (allocated fixed costs) (325,000) (500,000) (300,000) (300,000) Operating profit (25,000) (25,000) If you now close Division B, you have just Division A left: 650,000 in revenues, 325,000 cost of sales. Now all fixed costs must be borne by Division A throwing Division A into a loss situation. This phenomenon is known as the death spiral. The death spiral refers to a problem that can occur when a significant amount of fixed costs are allocated and there is falling demand. Management forgot to consider that the fixed costs were allocated costs and they went on to get rid of all of their unprofitable divisions, but allocated costs continue regardless of whether or not 8

9 a division is closed. Once a division is closed, the fixed costs must be allocated over a smaller number of divisions that action drives formerly profitable divisions into loss situations. Careful consideration must be given to the calculation and allocation of overhead it can mean the difference between profits and losses! 9