A knowledge of cost prices is indispensable in running a firm. They are at the root not only of sale prices but also of the entire commercial and industrial policy of the business.
A business' prime objective is to ensure maximum profitability, bearing in mind production capacity or the potential to supply raw materials.
There are “choices” to be made - short-term and long-term choices and decisions to be taken - and all are based on a prior analysis of costs and cost prices.
Once the decisions have been made, it is essential to see that they are carried out in accordance with objectives and projections. This is the pivotal problem of cost control.
The concept of cost price is always somewhat arbitrary and conventional no matter how much care is taken to work out allocations and invoicing.
These calculations are of course based on certain assumptions:
assumed distribution
assumed activity
There is no exact
cost price
Any concern needs to know the final costs of a given type of product before deciding to develop and distribute one product rather than another.
It has a general accounting section which reports on overall plant performance. There are, however, two major drawbacks:
returns (loss or profit) become apparent at the end of the fiscal year (too late);
the presentation is not conducive to a cost breakdown by product type - nor does it show eventual losses of raw materials, or of steam, electricity, chemical products, packing materials, etc., or under-use of material and labour.
The data from the general accounting section are indispensable for the tax auditor and for people external to the firm such as shareholders and bankers but they are insufficiently detailed for engineers and administrators. General accounting must therefore be paralleled by cost control.
The establishment of a system for calculating manufacturing costs should enable a business to:
2.2.1 Determine sale prices
Before launching a new manufacturing line, perhaps making fresh investment, the head of the concern needs to know whether the market situation and the competition are going to allow him to sell at a price which fully covers his expenditure.
The determination of a sale price or the decision to launch a manufacturing line is therefore based on the cost price forecast.
It is not enough to know that the sale price is higher than the cost price forecast. Since the goal is also maximum profitability, it is preferable to produce and sell articles which bring the highest return.
This all requires a thorough, systematic analysis of manufacturing costs and cost prices to determine just how firm are the assumed returns - particularly those from assumed activities.
2.2.2 Cost control
The decision to manufacture or to sell is preceded by a cost breakdown of the manufacturing cost forecast.
It is therefore sensible, indeed probably essential to smooth operations, to ensure that forecasts will be realistic and to note eventual gaps between true costs and pre-established costs - as these normally have an impact on returns.
Basically, the audit ascertains such gaps so as to:
detect anomalies
identify the cause of such anomalies and eventual responsibilities
take action to remedy losses and improve performance
ascertain production gains due to new techniques or procedures, to improve future forecasts.
An audit of the fixed costs of periodic (usually annual) budgets does not require the same expenditure of effort as an audit of such variable costs as raw materials, labour, and activity-specific manufacturing costs.
2.2.3 Investment policy
The decision to purchase or replace equipment is usually preceded by a pre-investment profitability study. Such a study investigates the impact of the new equipment on costs and cost prices.
2.2.4 Evaluating assets
A stock inventory - the stock is usually assessed at cost price - is a prerequisite to totting up fiscal year returns. Cost price calculations are accordingly very important in working out returns.
The articles in stock (cheeses in the process of being cured) have not all been purchased or manufactured at the same time under the same cost price conditions. Calculations are based on assumptions derived from prior events, thus leaving a wide margin of uncertainty.
Evaluations of assets can vary considerably in accordance with prior assumptions and so an accurate assessment demands the application of consistent rules.
2.2.5 A greater interest in work
One important advantage of identifying cost prices and cost controls is that this kind of calculation is worked out at the section chief level. In other words, the head of the cheese section is responsible for the variable charges attributable to the cheese section; the head of the laboratory is responsible for laboratory analyses and quality control costs.
The system is meant to make each individual feel responsible for a share of the overall cost and make the work more interesting and stimulating. A clearly-spelled-out policy on identifying costs and on management audits is a business imperative.
2.3.1 Direct and indirect charges
Charges may be:
direct (the term allocation is reserved for direct charges)
or
indirect. Here we use the term charging; charging is preceded by distribution.
Direct charges
Direct charges are those which can be unambiguously identified and attributed to a cost or a cost price. They may be fixed or variable.
Indirect charges
There are also other charges which cannot easily be attributed to some activity of the enterprise, and which are very difficult or impossible to identify at this level. Administrative (management) costs, for example, fall into this category.
Charges which have to be distributed somewhat arbitrarily among the various cost prices and manufacturing costs are categorized as indirect charges. Such charges most often correspond to fixed or structural charges and are sometimes termed “general expenses”.
2.3.2 Fixed and variable charges
If we look at costs in connection with production we see that some costs vary with the volume of production. These are called variable costs (e.g.: quantity of milk, production workforce). Others are constant. These are called fixed costs, e.g.: rent, executives' salaries, etc.
A closer look at the question prompts the following remarks:
Virtually all of the so-called fixed charges are actually variable, but the coefficient of variation is not the same as for the so-called variable charges.
The so-called variable charges do not all vary in accordance with the same factor of production; some vary in accordance with machine running time.
Variable charges differ from fixed charges in that they only arise as and when the undertaking is actually producing. They represent activity costs or perhaps operational expenses whereas fixed charges are structural costs.
As a base minimum, sale prices must cover variable costs and leave some margin. The contribution of each product to the coverage of fixed charges differs in accordance with sales potential but structural costs must in any case be absorbed by overall production for a given period.
Figure 1. Breakdown of total expenditure into fixed and variable costs as a function of units produced.
Note 1
Write-off or depreciation is the loss in value of goods over time or with use. These two essential factors of depreciation should include a third: technological ageing (obsolescence) in which depreciation is part of the manufacturing cost. Neither land nor animals are written off in a dairy production unit as these goods do not drop in value over time.
But depreciation also plays a role in the financial management of the enterprise. It is the main source of self-financing to the extent that write-off is tax-deductible. As a result, tax-deductible write-off is virtually never linked to depreciation in the strict sense of the word.
The write-offs to keep in mind in calculating manufacturing costs, frequently termed “technical” or “industrial” depreciations, are calculated in terms of the probable and real use to which investments will be put, and often differ greatly from accountable, fiscal depreciations.
Depreciation varies in length from one plant to the next and even more from one country to the next. In civil engineering terms, the usual length of depreciation is from 15 to 20 years. Twenty years can be considered a top figure for industrial buildings which depreciate faster than, say, office buildings. Building maintenance costs are included under variable costs when the amounts of money involved are small. Major expenses are earmarked and amortized.
As for equipment, many firms make a distinction between static machinery and machines which have moving, electrical, electro-mechanical or electronic parts. In the first category, which includes fermenting rooms and heat-exchangers, the period of depreciation usually varies from 10 to 15 years. For the second category, which includes pumps, and automization, the period of depreciation is shorter, usually from 3 to 8 years.
There are three main ways of calculating depreciation:
Straight-line depreciation. The purchase cost is distributed equally over a given number of years.
Sliding-scale fiscal depreciation. This is a depreciation method of fiscal origin whereby investment is favoured by applying a high rate of depreciation for the first years.
The first period runs from the day of purchase to when the rate dips below the straight-line rate.
Coefficient c = 1.5 for a period of 2 – 4 years
2 for a period of 5 – 6 years
2.5 for a period of + 6 years
During the second period, when the annuity drops below the annuity calculated by dividing the residual value by the number of years remaining, the latter figure is used.
Example: depreciation over a period of five years at an amortizable 200 000 francs.
| Fiscal year | Amortizable | Annuity | Residual | t rate used | t straight-line rate |
|---|---|---|---|---|---|
| 1985 | 200 000 | 80 000 | 120 000 | 40 | 20 |
| 1986 | 120 000 | 48 000 | 72 000 | 40 | 25 |
| 1987 | 72 000 | 28 800 | 43 200 | 40 | 33.5 |
| 1988 | 43 200 | 21 600 | 21 600 | 50 | 50 |
| 1989 | 21 600 | 21 600 | 0 | 100 |
An updated value of the good can form the basis of the depreciation rate, which has the effect of not substantially modifying cost prices when a fully amortized good is replaced, the cost of repurchase value generally being much higher than the original cost.
Note 2
“Auxiliary charges”, though ignored by general accounting, may be taken into account in calculating cost price. By “auxiliary charges” is meant the battery of charges for factors of production wholly owned by the head of the enterprise or exploitation, and made available to it by him.
This involves, in particular:
Remuneration for the labour of the owner and his family (manual and perhaps managerial work).
Such remuneration must be calculated as a lump sum on the basis of the remuneration which would have been granted to equally qualified employees.
Conventional remuneration of the “owner capital” of the enterprise.
In the case of milk production costs, rather than remunerating all of the owner capital at one time in one lump sum, it is preferable to pay off the two components of this item singly, i.e.:
Net farm assets, i.e. the working capital less any debts which may have been contracted to finance it.
The sum is paid off by applying a lump sum rate of interest corresponding to the average rate on eventual loans to finance working capital.
Net land assets, i.e. the total land capital, less eventual debts to finance it.
The conventional remuneration of land assets, more commonly called the rental value, is calculated by deducting the land charges already accounted for in the books from the amount of rent which could normally be anticipated from the land. This would include:
Land taxes and duties
Such land maintenance expenses as drainage
The write-off for land improvements
The financial charges on eventual loans to finance the purchase of land.
These charges are incorporated for maximum comparability of manufacturing costs and cost prices, particularly to compare two enterprises with different legal structures. In any case these charges can only be estimated by inference and are inevitably partly subjective.
Consider that in the average enterprise:
several types of products are produced;
several different functions are performed e.g. processing, administration, purchases, etc., each of which in turn can be divided into sub-functions wherein a specific job is performed. For instance, milk processing may be subdivided into reception, pasteurization, standardization, and packaging.
The different functions of an enterprise from which its global costs can be figured are called “cost centres”, or sections. Conventionally, these cost centres correspond to real, natural divisions of the enterprise and are headed by a physical person.
Cost forecasts and a knowledge of the operating costs of each cost centre are basic to management audits.
Dividing an enterprise into “cost centres” has two advantages:
It facilitates the distribution of indirect costs and the determination of the overall cost, as each cost centre behaves like a small enterprise.
It helps pinpoint responsibilities and differences between projected and actual figures.
Cost centres are generally divided into three broad categories:
Main centres - activities directly involved with the production and distribution phases, such as milk reception or pasteurization.
Auxiliary centres - which unlike the preceding, work for the benefit of other sections. An auxiliary section may well work for other auxiliary sections - producing steam or electricity, for example. Such costs need to be broken down among the various main sections.
Structural costs centres. These costs correspond to functions whose costs are independent of production (management, the accounts department, etc.).
There are three major classes of differentials or deviations:
on goods
on direct labour
cost differentials.
2.5.1 On goods
These are due to consumption (the audit of goods) and prices (value differentials).
Quantitative differentials
Quantitative differentials are checked daily by tallying the quantities of milk received and the plant output. Milk reception and manufacturing slips provide the basis for the daily audit. Quantitative differentials should also be checked regularly for all goods in store and used at some stage of processing.
Quantitative differentials can usually be attributed to some “lapse” of one or several services;
processing (carelessness, misuse of equipment);
maintenance (equipment in poor running order);
management audit (forecasting error).
Exceptionally, there may be differentials of external origin which cannot be laid at the feet of some subsection of the enterprise. Examples are qualitative variations in the milk received, substantial variations in atmospheric conditions, and so forth.
Value differentials
Value differentials will be noted by the milk supply service or by the purchasing service for all articles in store.
Value differentials may be either internal or external.
internal
Purchasing Service - unfavourable sales conditions or excessive maintenance charges.
Processing Section - abnormal consumption forced the service to resupply at higher cost.
Commercial Section - the volume of sales did not match forecasts, and the purchasing programme had to be modified.
external
Price fluctuations due to monetary depreciation, changing international rates, and the like.
2.5.2 Manpower differentials
Quantitative differentials
These are due to downtime from stoppages (mechanical breakdowns, shortage of materials) or poorly-organized work. They are basically internal and virtually any section or service may be involved.
Value differentials
These can be picked up from the wage rolls, and may be of internal or external origin.
2.5.3 Cost differentials
A distinction may be made between:
variable cost differentials, usually perceived in quantity and in value.
Actual consumption may be picked up from:
meter readings of consumption (e.g. water, electricity);
issue vouchers from stores or current purchases, taking into account inventory differences such as consumables;
charges accounted for during the current period, e.g. maintenance expenses.
Theoretical consumption is calculated from standards applied to some measurement of the activity such as the number of litres of milk received or the number of units produced.
In practice, cost differentials are ascertained monthly. The relative importance of these costs is usually not such as to justify setting up quasi-permanent checks on consumption.
Fixed cost differentials
This is the difference, which usually shows up in the books, between budgeted costs and actual ascertained costs.
Cost differentials are broken down into:
budget differential
operation or activity differential
yield differential
Breakdown is by cost centres.
Budget differential
Cost centre budgets are designed to be adaptable at different levels of activity, given the importance of fixed costs. Cost centre budgets are “flexible” budgets.
The differential analysis is made on the basis of the “adapted” budget in order to eliminate the activity differential at an early stage.
The budgetary differential can be analyzed in variable component differentials by distinguishing quantitative and value differentials and fixed charge component differentials for each one.
Generally speaking, the budget differential expresses a variation in expenses due to a weakness in implementation or an error in forecasting.
Activity differential
This is a way of measuring the impact of the activity on the coverage of structural charges.
If there is some sub-activity, the fixed costs are never completely covered. The difference between budgeted fixed costs and absorbed costs represents the cost of the sub-activity.
On the other hand, if real activity exceeds planned activity, there is excess coverage which is expressed as an over-activity bonus.
The activity index is the ratio of real to planned activity
The responsibility for the activity differential lies at the very top, with management, who uses the basic data to set business policies, chooses among the various possible options, and sets activity targets.
Yield differential
The yield differential is the difference between the production expected from real activity and what is actually produced. The productivity index is the ratio between real production and “normal” or expected production
Figure 2 Establishment of budget estimates in terms of production.
Comments on the above diagram
The forecasts established a given production level P1. A regular budget was therefore determined for this estimated activity, including fixed and variable costs. For this level of activity the enterprise will cover all costs and make a profit EF. The forecasts also show that if the only differentials are activity differentials, the break-even point (no profits, no losses) of the enterprise will be reached at production P4.
True production was only P2 and total costs OA. In this case the budgetary differential is a malus - AB.
The quantity of milk received led to production forecast P3. True production, however, was P2. This made possible a bonus on the yield differential - CD.
The milk processing service chief will be responsible only for malus AB and bonus CD. On the other hand, malus BC will be attributed to management who made the wrong assumptions concerning activity.
Estimated profits EF thus ended up as estimated loss AG. Actual losses will depend on actual sales.
If production exceeds P1 (and assuming the plant turns out only one product) there are two possibilities:
Consider that profit is higher than estimated, as in the preceding case.
Consider profit and estimated profit to be equal and make it play a greater part in covering fixed costs.
Profit is shown by the ratio:
Profit = P (S - Cv) - Cf
in which:
P = True production
S = Unit sale price
Cv = Variable unit costs
Cf = Fixed costs
Break-even production (BE) is shown by the ratio:
with UMCv equalling unit margin (profit) on variable costs.
Action on fixed costs (Figure 3)
Any substantial percentual reduction of fixed costs entails an equal reduction of break-even production.
Irrespective of the amounts sold, profits rise to the extent that fixed costs fall. Saving on fixed costs is therefore real, immediate saving, unlike economies on variable costs which materialize only in accordance with sales (Figure 2).
Action on variable costs (Figure 4)
A reduction in variable unit costs lowers the break-even point. The impact on break-even production increases as the initial margin on variable costs narrows.
The impact on profit, of course, depends on the volume of sales.
Action on sale prices (Figure 5)
A rise in sale prices will lower the break-even point. There again, the impact on break-even production increases as the initial margin on variable costs narrows. The impact on profit is also directly affected by volume of sales.
Figure 3. Action on fixed costs
Figure 4. Action on variable costs
Figure 5. Action on sales prices
The purpose of a management audit is to:
prepare estimates (budgets);
periodically compare performance to forecasts;
analyse differentials and zoom in on anomalies.
Budgetary techniques are complex operations which the enterprise should introduce cautiously. There are certain pre-conditions:
Appointment of an officer in charge
Someone needs to be put in charge of budget preparation, monitoring and analysis. The problem is to find someone who has both the necessary technical background and the book-keeping skills.
The management auditor is usually a staff member working directly under the top management. In small- and medium-size businesses, it is not always possible to create a post just for this purpose and so the job is done by the head accountant, the technical director or the head of the business himself.
Initial organization and structuration of the enterprise
A clearly spelled-out organizational chart designating responsibilities and outlining the organization of work stations is one essential pre-condition for setting up the system.
In particular, the enterprise must be broken down into cost centres once the technical context has been reviewed. Each cost centre should be headed by one person who will help to prepare and subsequently modify budgets.
Paving the way
In order to create a favourable climate, the people in charge will need to have some prior information. The notion of auditing is not easily and readily accepted. To secure the active cooperation of all involved, the purpose of the exercise must first be explained.
Once this has been done, it would be a good idea to plan a review of how to implement the system, detailing:
how forecasts and estimates are made;
which items are to be audited;
the procedure to be used;
how the information is to be disseminated.
It is prudent to envisage a “breaking in” period as it takes some time to learn to make budgetary estimates - from a few months to a few years depending on the business enterprise. This is a precaution against the transmission of unusable or erroneous data. The system may also be introduced in successive stages.
