«Paul M. Collier Aston Business School, Aston University Accounting for Managers Accounting for Managers: Interpreting accounting information for ...»
For most of these services (the exception is the loan, where a separate charge may be made) a single bank charge covers the bank’s administration costs. Some banks no longer charge fees to non-business customers as their costs are absorbed against the interest earned by the bank on their customers’ bank balances (less any, usually smaller, interest payment to the customer).
Given this complexity, banks need to understand the proﬁtability of different branch locations and different types of customers (market segments, see Chapter 8).
In order to do this, an activity-based approach can be used. The cost drivers for each major activity can be identiﬁed, e.g. the number of new customers (for account-opening costs); the number of cheque and deposit transactions (for the teller and data-entry costs); the number (or value) of loans (for loan-processing costs); and the number of accounts (for account-maintenance costs). The number of transactions for each branch and type of customer multiplied by the direct labour cost per transaction (see earlier in this chapter) can then be compared with the income earned from bank charges and interest.
In banking, understanding these costs has led to the introduction of automatic teller machines (ATMs) to reduce the cost of front-ofﬁce staff who previously cashed cheques in the bank branch. ATMs increased bank proﬁtability as many employees were made redundant, although more recently there has been an attempt (impeded by the competition authorities) to impose charges for the use of ATMs by customers.
The following case studies show the impact of an activity-based approach to labour costs and capacity utilization.
Case study: The Database Management Company – labourcosts and unused capacity
The Database Management Company (DMC) is a call centre within a multinational company that has built a sophisticated database to hold consumer buying preferences. DMC contracts with large retail organizations to provide information on request and charges a ﬁxed monthly fee plus a fee for each transaction (request for information). DMC estimates transaction volume based on past experience and recruits employees accordingly, to ensure that it is able to satisfy its customers’ demands without delay.
Employees are on a mix of permanent and temporary contracts. Labour costs are separated into variable (transaction-processing costs, which can be directly
HUMAN RESOURCE DECISIONS 149attributable to speciﬁc contracts) and ﬁxed elements (administration and supervision). DMC also incurs ﬁxed costs, the main items being for building occupancy (a charge made by the parent company based on ﬂoor area occupied) and the lease of computer equipment. As these costs follow stafﬁng levels that relate to speciﬁc contracts, they can be allocated with a reasonable degree of accuracy.
DMC’s budget (based on anticipated activity levels and standard costs) is shown in Table 10.4. As a result of declining retail sales the demand for transactions has fallen, but because of uncertainty in DMC about how long this downturn will last, it has only been able to reduce its variable labour cost by ending the contracts of a small number of temporary staff. DMC’s actual results for the same period are shown in Table 10.5.
Table 10.4 DMC budget
How can the poor performance compared with budget be interpreted?
DMC’s income has fallen across the board because of the reduced number of transactions on all its contracts. Because it has been unable to alter its variable labour cost signiﬁcantly in the short term, the contribution towards ﬁxed costs and proﬁts has fallen. Therefore, although the business treats these costs as variable, in practice they are ﬁxed costs, especially in the short term. The ﬁxed salary and non-salary costs are constant despite the fall in transaction volume and so proﬁtability has been eroded. DMC cannot alter its ﬂoor space allocation from the parent company or its computer lease costs despite having spare capacity.
What information can be provided to help in making a decision about cost reductions?
Calculating the variance (or difference) between the budget and actual income and variable costs shows how the difference between budget and actual proﬁt of £4,675 (£4,750 − £75) is represented by a fall in income of £6,925 offset by a reduction in variable labour costs of £2,250 (all ﬁgures are in £’000). This is shown in Table 10.6.
Calculating the cost of unused capacity identiﬁes the proﬁt decline more clearly, as can be seen in Table 10.7.
Table 10.6 DMC loss of contribution
Of the gap between budget and actual proﬁt, £3,280 is accounted for by the cost of unused capacity in variable labour. This gap has been offset to some extent by the reduction in variable labour costs of £2,250. There remains the capability to reduce variable costs to meet the actual transaction volume, as Table 10.8 shows.
What conclusions can be drawn from this information?
It is clear that DMC has either to increase its income or reduce its costs in order to reach its proﬁtability targets. The company has a signiﬁcant cost of unused capacity. However, it can only reduce this unused capacity based on sound market evidence or else it may be constraining its ability to provide services to its customers in future, which may in turn result in a greater loss of income. DMC needs to renegotiate its prices and volumes with its customers.
Case study: Trojan Sales – the cost of losing a customer
Trojan Sales is a business employing a number of sales representatives, each costing the business £40,000 per annum, a ﬁgure that includes salary, oncosts and motor vehicle running costs. Sales representatives also earn a commission of 1% on the orders placed by their customers. On average, each sales representative looks after 100 customers (one driver of activity) and each year, customers place an average of ﬁve orders, with an average order size of £2,500. Therefore, each
representative generates sales of:
100 × 5 × £2,500 = £1,250,000
and earns commission of 1%, amounting to £12,500.
However, Trojan suffers from a loss to competitors of about 10% of its customer base each year. Consequently, only about 70% of each sales representative’s time is spent with existing customers, the other 30% being spent on winning replacement customers, with each representative needing to ﬁnd 10 new customers each year (a second driver of activity). The business wants to undertake a campaign to prevent the loss of customers and has asked for a calculation of the cost of each lost customer.
ACCOUNTING FOR MANAGERSA ﬁrst step is to calculate the cost of the different functions carried out by each
The cash cost of winning a new customer is £1,200. However, the opportunity cost provides a more meaningful cost. If there were no lost business and sales representatives could spend all of their time with existing customers, each representative could look after 142 customers (100 × 100/70) in the same time.
If each of the 142 customers placed the average ﬁve orders with an average order size of £2,500, each representative could generate income of £1,775,000 and earn commission of £17,750. The opportunity cost is the loss of the opportunity by the company to generate the extra income of £525,000 (£1,775,000 − £1,250,000) and the opportunity cost to the representative personally of £5,250 (commission of £17,750 − £12,500).
Each customer lost costs Trojan £1,200 in time taken by sales representatives to ﬁnd a replacement customer. However, on an opportunity cost basis, each lost customer potentially costs the company £52,500 in lost sales and the sales representative £525 in lost commission.
For this kind of reason, businesses sometimes adopt a strategy of splitting their salesforce into those representatives who are good at new account prospecting and those who are better at account maintenance.
Conclusion This chapter has calculated the cost of labour and developed relevant costs to include labour. It has introduced the concept of activity-based costing as a method by which the cost of business processes can be measured in order to improve business decision-making.
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HUMAN RESOURCE DECISIONS 153Cooper, R. and Kaplan, R. S. (1992). Activity-based systems: measuring the costs of resource usage. Accounting Horizons, 6(3), 1–13.
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This chapter explains how accountants classify costs and determine the costs of products/services through differentiating product and period costs, and direct
and indirect costs. The chapter emphasizes the overhead allocation problem:
how indirect costs are allocated over products/services. In doing so, it contrasts absorption with activity-based costing. The chapter concludes with an overview of contingency theory, Japanese approaches to management accounting and the behavioural consequences of accounting choices.
Cost classiﬁcation Product and period costs The ﬁrst categorization of costs made by accountants is between period and product. Period costs relate to the accounting period (year, month). Product costs relate to the cost of goods (or services) produced. This distinction is particularly important to the link between management accounting and ﬁnancial accounting, because the calculation of proﬁt is based on the separation of product and period costs. However, the value given to inventory is based only on product costs, a requirement of accounting standards (see later in this chapter).
Although Chapters 8, 9 and 10 introduced the concept of the contribution (sales less variable costs), as we saw in Chapter 6 there are two types of proﬁt: gross
proﬁt and net proﬁt:
The cost of sales is the product (or service) cost. It is either:
ž the cost of providing a service; or ž the cost of buying goods sold by a retailer; or ž the cost of raw materials and production costs for a product manufacturer.
Expenses are the period costs, as they relate more to a period of time than to the production of product/services. These will include all the other (selling,
ACCOUNTING FOR MANAGERSadministration, ﬁnance etc.) costs of the business, i.e. those not directly concerned with buying, making or providing goods or services, but supporting that activity.
To calculate the cost of sales, we need to take into account the change in inventory, to ensure that we match the income from the sale of goods with the cost of the goods sold. As we saw in Chapter 6, inventory (or stock) is the value of
goods purchased or manufactured that have not yet been sold. Therefore:
for a retailer, or:
cost of sales = opening stock + cost of production − closing stock for a manufacturer. For a service provider, there can be no inventory of services provided but not sold, as the production and consumption of services take place
Financial statements produced for external purposes, as we saw in Chapter 6, show merely the value of sales, cost of sales, gross proﬁt, expenses and net proﬁt.
For management accounting purposes, however, a greater level of detail is shown.
A simple example is:
Direct and indirect costs Accounting systems typically record costs in terms of line items. As we saw in Chapter 3, line items reﬂect the structure of an accounting system around accounts for each type of expense, such as materials, salaries, rent, advertising etc. Production costs (the cost of producing goods or services) may be classed as direct or indirect. Direct costs are readily traceable to particular product/services.
Indirect costs are necessary to produce a product/service, but are not able to ACCOUNTING DECISIONS 157 be readily traced to particular products/services. Indirect costs are often referred to as overheads. Any cost may be either direct or indirect, depending on its traceability to particular products/services. Because of their traceability, direct costs are generally considered variable costs because costs increase or decrease with the volume of production. However, as we saw in Chapter 10, direct labour is sometimes treated as a ﬁxed cost. Indirect costs may be variable (e.g. electricity) or ﬁxed (e.g. rent).
Direct materials are traceable to particular products through material issue documents. For a manufacturer, direct material costs will include the materials bought and used in the manufacture of each unit of product. They will clearly be identiﬁable from a bill of materials: a detailed list of all the components used in production.