In a highly competitive economic context, SME owners need more relevant information to help them in their decision-making processes in order to improve their value chain and increase their business agility.
Alain Dupont, owner of a manufacturing SME serving the North American market with its flagship product, has been wondering for some time whether he should launch a new product or consolidate his market by improving the profitability and competitiveness of his current product.
To answer these kinds of questions, we will be presenting a number of management accounting concepts in four articles, with a view to enabling business owners and managers to familiarize themselves with these concepts, as well as with their use and usefulness in the process of making business decisions about discontinuing or adding products. More specifically, we will cover the following concepts:
- Company cost structure and the concept of costing;
- Costing methods;
- The concept of product profitability;
- Decisions to add or discontinue products.
In this first article, we’ll take Mr. Dupont through the general categories of manufacturing costs for his product, as well as the concept of product costing. Knowledge of product costing is essential for setting sales prices and analyzing product profitability. Business managers use costing to assess the various options available to them for optimizing costs.
As a general rule, as illustrated in figure 2, manufacturing companies consider the following main cost categories[1][2]:
The cost of raw materials consists of the cost of all materials used in the manufacture of the product, and which form an integral part of the finished product. However, the economic effort involved in determining this cost must be reasonable. For example, small items such as glue or screws used in assembly can be categorized as indirect materials or supplies, which are included in indirect manufacturing costs.
Direct labor is made up of all the company’s labor costs directly linked, in a concrete and practical way, to the manufacture of the product. This is the labor force that works directly, manually or with the help of machines, on the transformation of the raw material into the finished product. Here again, the economic effort required to allocate labor costs must be reasonable. Raw materials used and direct labor constitute the basic cost of production.
Indirect manufacturing costs are all the costs incurred by the company in manufacturing that cannot be categorized as direct labor or raw materials. For example[3]:
- Indirect labor costs such as salaries paid to supervisors, machine maintenance employees, engineering employees and all employees performing activities related to product manufacturing. We can also include in this category idle or unproductive time and overtime premiums;
- The cost of services associated with manufacturing, such as lighting, heating and motive power;
- Employee benefits paid by the employer, such as contributions to employment insurance, the Quebec Pension Plan, the Quebec Parental Insurance Plan…
Non-manufacturing costs are made up of sales and marketing costs, as well as administrative expenses. These costs are incurred in obtaining customer orders, delivering finished products to customers, remunerating management and administrative staff, purchasing office equipment, depreciating buildings, and so on.
After this brief presentation of the company’s various cost categories, Mr. Dupont is now in a position to determine the actual cost of his product for the fiscal year ending March 31, 2017, and also for the two half-years of this same fiscal year. The actual data relating to his company’s manufacturing activities are recounted in the table below:
The actual unit costs calculated are shown in the following table:
Mr. Dupont wonders what actual calculated unit cost he should consider in making his decision? He also wonders if there are other methods that could reduce these variations.
In fact, we note that the actual full unit cost established during the financial year may not be significant, as it shows variations. These are mainly due to indirect manufacturing costs and the difficulty of defining which expenses are included in these costs.
In the next article, we’ll look at the different methods of costing, and how to choose the most appropriate method for the economic challenges facing Mr Dupont’s company.
Our references:
[1] Réjean Brault and Pierre Giguère, Comptabilité de management 5th edition, 2003
[2] Garrison et al, Fundamentals of Management Accounting,2nd edition, 2010
[3] Réjean Brault and Pierre Giguère, Comptabilité de management 5th edition, 2003
