Companies have considered customer profitability and cost accounting to be luxuries, but that needs to change now! With the impacts of higher prices for labor and materials (inflation) and higher interest rates, companies are struggling with working capital management and profitability.
One basic tool to combat performance issues would be analyzing the product lines and customers for profitability. When a business is working with limited liquidity, putting resources toward the most profitable parts of the business can mean the difference between success and failure. In many situations, there is a tradeoff between size of the customer relationship and the ability to generate profits on the customer’s orders. Proving out the profitability by product line or customer evaluated in a matrix according to order size and fixed costs will allow a company to better decide how to structure its product line offerings or its customer base to achieve success.
When considering product line or customer profitability, the allocation of costs is the most important part of the evaluation process. Evaluate each line item in cost of goods sold and SGA expenses to evaluate fixed versus variable costs.
First, direct and indirect variable costs need to be assigned to each product line or customer. The key is allocating ALL variable costs to product lines or customers. These variable costs can be both cost of goods sold expenses to arrive at gross margin and SGA expenses. For example, if a salesperson is only assigned to one account or one product line, that is a direct variable cost allocation as the person can be eliminated if the customer or product line goes away. However, if the salesperson would simply be reassigned if a customer or product line was eliminated, then that individual’s cost needs to be considered a fixed cost. If costs for supplies and equipment can be identified for a product line or customer, that would be a variable cost. But remember, all costs need to be allocated; therefore, if there is shrinkage, that impact also needs to be considered in the cost allocation. Do not fall into the trap of using outdated bills of materials as the building block for costs.
Second, fixed costs need to be allocated by product line or customer, typically using different allocation methods for cost of goods sold expenses and SGA expenses. All fixed costs need to be allocated to product lines and customers. In some cases, the allocation could be based on units produced, while in other cases the allocation might be based on sales dollars. There are many allocation methods that would be appropriate, but in any analysis of product line or customer profitability, all costs need to be allocated to a revenue source.
The difficult part of product line and customer profitability analysis is in determining the volume through the operation that should be considered when assigning costs to product lines or customers.
Often businesses will talk about contribution margin and will argue that if an additional customer or product provides any level of positive gross profit, it is a desirable customer or product to add. It is this argument that requires the addition of a matrix analysis to consider different levels of output. For example, if a location can be eliminated if a customer or product line is dropped, what is the impact of removing that location on fixed and variable costs? If certain machinery and equipment or warehouse space could be eliminated, what is that impact?
The volume through the company discussion often becomes an argument between operations and sales. The way the CEO or executive committee handles those arguments makes the difference between success and failure.
Cost accounting skills are a key skill set all companies need, irrespective of whether they are service, distribution, manufacturing, or another identified type of company. If a company does not have that skill set currently, bringing in a team for a short period of time could provide the product line or customer profitability analysis base that a new cost accounting team could build from.
When Focus Management Group is brought in to assist a company with working capital management, the cost accounting analysis is a key deliverable in our process.