MODULE 17 : COST ANALYSIS

ACCOUNTING VERSUS MARKETING COSTS

Accounting costs are computed to provide a historical record of the company’s
operations. The marketing perspective is like an economist’s perspective because it is
future-oriented.

Although many costs reflect the result of some particular activity – such as production –
marketing costs are directed at producing some benefit. Thus, in controlling production
costs, management focuses on the effect of volume on costs. In controlling distribution
costs, it looks at the effect of costs on volume. Moreover, there is less certainty about the
effect marketing costs have on volume than about the effects volume changes have on
production costs.

FULL COST VERSUS CONTRIBUTION MARGIN

(a) Direct Costs versus Indirect Costs
A direct cost can be specifically identified with a product or a function. The cost is
incurred because the product or function exists or is contemplated.

An indirect cost is a shared cost because it is tied to several functions or products. Even if
one of the products or functions were eliminated, the cost would not be.

Cost versus Expenses

The term costs is often restricted to the materials, labour, power, rent, and so on used in
making the product. The cost of goods sold on the following conceptual net income
statement reflects these costs.

Sales – Cost of Goods Sold = Gross Profit

Gross Profit – General administrative & selling expenses = Net Profit

The expenses reflect the other costs incurred in operating the business, such as the cost of
advertising and of maintaining branches. Expenses cannot be tied nearly as well as costs
to specific products, since they are general expenses associated with doing business. In
marketing cost analysis, the distinction between costs and expenses is not nearly so clear,
and the terms are often used interchangeably.

Specific versus General Expenses

A specific expense is just like a direct cost – it can be identified with a specific product or
function. The function would be eliminated if the product or function were eliminated.

A general expense is like an indirect cost – it cannot be identified directly with a specific
object of profit measurement such as territory, salesperson, or product. Thus, the expense
would not be eliminated if the specific object were eliminated.
Measurement objective affects classification
A particular cost or expense may be direct for some measurement purposes and indirect
for others. The object for measurement determines how the cost should be treated.

Which to use – full cost or net profit approach or the contribution margin approach
Proponents of the full-cost or net profit approach argue that all costs should be assigned
and somehow accounted for in determining the profitability of any segment (eg.
Territory, product, salesperson) of the business. Under this approach, each unit bears not
only its own direct costs that can be traced to it, but also a share of the company’s costs
of doing business, referred to as indirect costs. Full costing advocates argue that many of
the indirect costs can be assigned to the unit being costed on the basis of a demonstrable
cost relationship. If a strong relationship does not exist, the cost must be prorated on as
reasonable a basis as possible. Under the full-costing approach, a net income for each
marketing segment can be determined by matching the segment’s revenue with its direct
and its share of indirect costs.

Contribution margin advocates argue, on the other hand, that it is misleading to allocate
costs arbitrarily. They suggest that only those costs that can be specifically identified with
the segment of the business should be deducted from the revenue produced by the
segment to determine how well the segment is doing. Any excess of revenues over these
costs contributes to the common costs of the business and thereby to profits. The
contribution margin approach does not distinguish where the costs are incurred, but rather
simply whether they are variable or fixed. Thus, the difference between sales and all
variable costs, whether they originate in manufacturing, selling or some administrative
function, are subtracted from revenues or sales to produce the contribution margin of the
segment.

The net profit approach does attempt to determine where the costs were incurred. Not
only is the segment net income derived differently in the two approaches, but also
advocates of the contribution margin approach do not even focus on net income when
evaluating the profitability of a segment of the business. Rather, they focus on the
contribution produced by the segment after subtracting the costs directly traceable to it
from its sales.

Differences in perspective between full-cost and contribution margin approaches to

marketing cost analysis
Full Cost Approach
Sales – Cost of Sales = Gross Profit

Gross Profit – Operating expenses = Net Profit

Contribution Margin Approach

Sales – (Variable Manufacturing Costs + Other variable costs directly traceable to the
segment) = Contribution Margin
Contribution Margin – (Fixed costs directly traceable to the products + Fixed costs
directly traceable to the market segment) = Net Profit

The contribution margin approach is preferred to the full cost approach. This method
advocates that if the costs associated with the segment are not removed with the
elimination of that segment, why should they be arbitrarily allocated? The costs still have
to be borne after the segment is eliminated, but they must be borne by other segments of
the business. This can simply tax the ability of these other segments to remain profitable.

A contribution margin approach versus a full-cost profitability analysis is also supported

by the recognition that most marketing phenomenon are highly interrelated. They have
interdependant effects. The contribution margin approach implicitly recognises this
synergy through its emphasis on the contribution of each segment or part.

In sum, allocation of indirect costs for segments performance allocation are generally
inappropriate. That is, any measure of segment performance that includes allocated
shares of indirect costs includes factors that do not really reflect performance in the
segment as a separate entity. Hence, indirect costs allocations should not be made if the
purpose is to measure true performance.

PROCEDURE
The general procedure followed in conducting a cost or profitability analysis first
involves specifying the purpose for which the cost study is being done. This helps to
determine the functional cost centres.

The next step is to spread the natural account costs to these functional cost centres.

Then the functional costs are allocated to appropriate segments using some reasonable
basis.

Finally, the allocated costs are summed, and the contribution of the segment is
determined.

Here, segment means a portion of the business, not in the normal sense of the market
segment.

Purpose
It is necessary to determine the purpose of the marketing profitability analysis because
the treatment of the various costs and expenses depends on the purpose. Ideally, the firm
would want to break all its costs into small building blocks or modules. These elements
would be as small as possible and yet still meaningful. This allows the firm to aggregate
these building blocks as needed to produce profitability analysis for various segments of
the business.

Thus, good profitability analyses require that the various costs be partitioned into direct
and indirect expenses so the proper aggregations can be made. Sales managers are
typically concerned with the profitability of various regions, branches, salespeople, and
customers; they are only remotely concerned with the profitability of various products.
What is properly treated as direct and what should be treated as indirect or general
depend on the study’s purpose.

Natural Accounts versus Functional Accounts

In the second step of a profitability analysis, natural account costs need to be spread to
the functional cost centres.

Natural Accounts are the categories of cost used in the normal accounting cycle. These
costs include such things as salaries, wages, rent, heat, light, taxes, auto expenses, raw
materials, and office supplies. They are called natural accounts because they bear the
name of their expense categories.

However, this is not the way of classifying costs. In manufacturing cost accounting, costs
are often reclassified according to the purpose for which they were incurred. Thus,
production wages might be broken into the cost categories, forging, turning, grinding,
milling, polishing and assembling. These categories are functional account categories
because they recognise the function performed, which is the purpose of incurring the
cost.

Marketing cost analysis recognises that costs are incurred for some purpose, and it
recognises general selling and administrative expenses according to their purposes or
functions.

Allocate Functional Costs

The third step in conducting a cost or profitabilty analysis is to allocate the functional
costs to various segments of the business. One needs to recognize immediately that the
bases for allocation are not fixed. Rather they depend on the discretion of the decision
maker and what he or she feels are reasonable bases.

One basis often used is to divide the expenses according to volume attained. This is often
used because of simplicity.

It is erroneous, however, in that it fails to recognise the purpose for which the costs were
incurred, which is the reason for a functional cost analysis.

Major functional accounts useful in marketing cost analysis

- direct selling
- advertising and sales promotion
- product and package design
- technical product services
- sales discounts and allowances
- credit extension
- warranty costs
- marketing research
- warehousing and handling
- inventory
- packaging, shipping and delivery
- order processing
- customer service
- billing and recording of accounts receivable
- returning merchandise

Functional Cost Groups and Bases of Allocation

Functional Cost Group To Product Groups To account size classes To sales territo
Selling – direct costs Selling time devoted Number of sales calls Direct
Personal calls by salespeople and to each product, as times average time per
supervisors on accounts and prospects. shown by special call, as shown by special
Sales salaries, incentive compensation, sales call reports or sales call reports or
travel, and other expenses. other special studies. other special sales
studies.
Selling – Indirect Costs In proportion to In proportion to direct Equal charge fo
Field supervision, field sales-office direct selling time or selling time or time each sales rep
expense, sales administration expenses, time records by records by project
sales – personnel training, sales project
management. Market research, new
product development, sales statistics,
tabulating services, sales accounting.
Advertising Direct or analysis of Equal charge to each Direct or analy
Media costs such as TV, radio, space and time by account or number of media circulati
billboards, newspaper, magazine, etc. media, other costs in ultimate consumers and records
Advertising production costs, proportion to media prospects in each
advertising department salaries. costs account’s trading area
Sales Promotion Direct; or analysis of Direct; or analysis of Direct; or analy
Consumer promotions, such as source records source records of source recor
coupons, patches, premiums, etc. Trade
promotions such as price allowances,
point-of0purchase displays, cooperative
advertising, etc
Transportation Applicable rates Analysis of sampling of Applicable rate
Railroad, truck, barge, etc, payments to times tonnages bills of lading times tonnages
carriers for delivery of finished goods
from plants to warehouses and from
warehouses to customers. Traffic
department costs.
Storage and Shipping Warehouse space Number of shipping Number of ship
Storage of finished goods inventories in occupied by average units units
warehouses. Rent (or equivalent costs), inventory. Number of
public warehouse charges, fire shipping units.
insurance and taxes on finished goods
inventories, etc. Physical handling,
assembling, and loading out of rail cars,
trucks, barges for shipping finished
products from warehouses and mills to
customers. Labour, equipment, space
and material costs.
Order processing Number of order Number of order lines Number of ord
Checking and processing of orders lines lines
from customers to mills for prices,
weights and carload accumulation,
shipping, dates, coordination with
production planning, transfer to mills,
etc. Pricing department.
Preparation of customer invoices.
Freight accounting.
Credit and collection.
Handling cash receipts.
Provision for bad debts.
Salary, supplies, space and equipment
costs (teletypes, flexowriters, etc).

Activity-based costing which attempts to itemize all costs associated with producing and
marketing a particular product for a particular market or even customer, represents a
popular, natural extension of the allocation of functional costs to the various segments of
the business. Activity-based costing can help managers see which products are profitable
and where reducing costs can have the most impact.

Sum allocated costs

The fourth step in the process is to sum the costs allocated to the segment. Costs for
which tehre is no direct casual relationship remain unallocated in determining the
contribution of the segment. A comparison of the contributions of like segments then
indicates the remedial action that might be taken, if any.

THE PROCESS ILLUSTRATED

SEE CASE STUDY IN THE TEXT

PROSPECTS AND PROBLEMS

The real benefit of a marketing cost analysis is the opportunity it provides managers to
isolate segments of the business that are most profitable as well as those that generate
losses. This information allows those involved to improve their planning and control of
the firm’s activities.

RETURNS ON ASSETS MANAGED

Sales and cost analysis provide the sales manager with two important financial techniques
for controlling the personal selling function. The first measures the results achieved and
the second the cost of producing those results. The important financial ingredient left out
of those analysis is the assets needed to produce those results. At a minimum, the
company will be committing working capital in the form of accounts receivable and
inventories to support the sales function. The return produced on the assets used in each
segment of the business provides sales managers with a useful variation of more
traditional cost analysis procedures for evaluating and controlling various elements of the
personal selling function.

Return on Assets Managed =

Contribution as a percentage of sales X Asset Turnover Rate

This formula indicates that the return to a segment of the business can be improved either
by increasing the profit margin on sales or by maintaining the same profit margin and
increasing the asset turnover rate. The formula can then be used to evaluate segments or
to select the best alternative from strategies being considered.

Contribution as a percentage of sales equals the ratio of net contribution divided by sales.

Asset turnover rate equals sales divided by the assets needed to produce these sales.

Assets managed adds another important dimension to the financial control picture. The
investment required for a venture needs to be recognized because long run profits can be
maximized only if the optimal level of investment in each asset is achieved.