Cost and Profitability Accounting

Content of the course

1. Introduction

• Review of business operations and processes

• Basics of Excel

• Basics of percentage calculations

• Case: Hertta’s Ketchup

• Introduction to accounting

2. Cost-volume-profit analysis

3. Cost accounting

4. Pricing

5. Controlling in small and medium sized enterprises

Content

Financial accounting course is the prerequisite

for this course. Hertta’s ketchup is an

introduction example where the key

terminology is reviewing.

Terminology is including all relevant terms

from company starting point to analyzing

profitability of the company.

Company

Hertta is going to establish an own company.

Business idea is to produce and sale ketchup to

the companies on wholesale and restaurant

industry on the domestic market.

Hertta has bought already the ketchup

production machine. Machine is half automatic

which is mixing the raw materials, heating and

packing the ketchup. Machine is able to pack

60 ketchup packs per hour.

Products

CAPACITY

=

Maximum performance of a company,

machine, device etc. on the certain period of time.

Products

Hertta’s company’s capacity is 10.080 ketchup

packs per month.

21 days x 8 hours per day x 60 packs per

hour.

Even thought Hertta is estimating that first year

production and sales is only 7.500 packs per

month. Ketchup pack’s weight is 1 kilo.

Products

LEVEL OF ACTIVITY (utilized capacity)

=Actual performance of a company,

machine, device etc. on the certain period of time

• Hertta was estimating that company’s level of

activity in the first year would be 7.500 packs

per month.

Products

• When comparing the level of activity to the

capacity, are speaking about Utilization Ratio

• Utilization ratio is showing how many percent of

the capacity is now in use.

UTILIZATION RATIO

=

LEVEL OF ACTIVITY / CAPACITY X 100

Products

• Hertta’s company Utilization Ratio is 74,4 %

• In that case machine operating hours are 125

hours per month

• Hertta employs a new assistant to use the

machine. Hertta is concentrating to work of

marketing and administration.

Sales revenues

• Hertta’s target price per ketchup pack is 1 €

(without VAT). Hertta benchmarked own price

with competitors’ prices.

• Company’s total sales revenues are calculating

as follows:

SALES REVENUES

=

VOLUME OF PRODUCTION X PRICE PER PACK

Sales revenues

• Hertta’s total sales revenues with planned level

of activity (production volume) is 7.500 € per

month

7.500 produced packs per month x sales price

of 1 € per pack

Factor of production

• To be able to produce ketchup, Hertta needs following factors of production:

– Premises

– Machine

– Insurances

– Phone and telecommunication network

– Marketing services

– Office supply (papers and other materials)

Factor of production

– Entrepreneur’s contribution of work and knowledge

– Self-employed person’s pension

– Raw material

– Packs

– Electricity

– Devices and other material

– Assistant’s contribution of work

Cost of production

• Using factor of production in production process

is causing costs.

COST OF PRODUCTION

=

VOLUME OF FACTOR OF PRODUCTION X

UNIT PRICE OF FACTOR OF PRODUCTION

Cost of production

• Premises are rental premises

– Rent of premises is 118 € per month

• Price of machine was 22.200 €

– Hertta is estimating that machine’s operating time is 5 years (= machine is in use)

– Divide purchasing price by the operating years (straight-line depreciation)

Annual depreciation cost

Cost of production

– Machine depreciation is then 370 € per

month

• Hertta needed 22.200 € bank loan for

machine purchase. Annual interest cost of

the loan is 8 %

– Interest cost is then 148 € per month

• Insurances 51 € per month

Cost of production

• Phone and telecommunication network costs

are 150 € per month

• Cost of marketing and sales actions are about

202 € per month

• Office supply costs are about 80 € per month

• Hertta estimates that her own hourly target

salary would be 10 € per hour

Cost of production

– Hertta’s monthly salary is 1.680 €

• Self-employed person’s pension costs are

about 16 % of her salary

– Pension cost is then 269 € per month

• Raw material cost is 0,30 € per kilo

• Packs are 0,10 € per piece

Cost of production

• Machine is using electricity 6 kW per hour

– Price per kWh is 0,07 €

Electricity cost is then 53 € per month

• Costs of machine materials are about 50 € per

month with the planned level of activity

Cost of production

• Assistant salary is paid by performance

– Agreed pay is 0,10 € per pack

• Indirect employee cost is about 50 % of the

salary

• IS HERTTA’S BUSINESS PROFITABLE?

Profit or loss

• Form of basic profit calculation:

SALES REVENUES- COST

= PROFIT OR LOSS

Profit

• On the last row will be profit if

– sales revenues > total cost

• There will be loss if

– sales revenues < total cost

• Organizations and clubs are also using terms

surplus or deficit

Profit statement

• Hertta’s company empty monthly and annual profit statement is

as follows:(EUR) Monthly Annual

INCOMES

Sales revenues

COSTS

Rent

Depreciation

Interest

Insurances

Phone and network

Marketing services

Office supply

Entrepreneur’s salary

Pension

Raw material

Packs

Electricity

Other material

Assistant’s salary

Indirect employee cost

TOTAL COST

PROFIT OR LOSS

Profit statement

• Hertta’s company monthly and annual profit statement is as

follows: (EUR) Monthly Annual

INCOMES

Sales revenues 7 500 90 000

COSTS

Rent 118

Depreciation 370

Interest 148

Insurances 51

Phone and network 150

Marketing services 202

Office supply 80

Entrepreneur’s salary 1 680

Pension 269

Raw material 2 250

Packs 750

Electricity 53

Other material 50

Assistant’s salary 750

Indirect employee cost 375

TOTAL COST 7 296 87 552

PROFIT OR LOSS 204 2 448

Profit

Why profit is necessary to be able to run the

business?

Profit

Why profit is necessary to be able to run the

business?

– Compensation of entrepreneurs’ contribution

of work

– Compensation of the invested money to the

company

– Compensation of company risk

– Money for new investments

– Reserve for possible coming losses

Contribution margin calculation

• It is necessary to understand costs and what drives and creates costs. Spliting costs between variable and fixed costs, helps to analyze the relationship of costs, volume and revenues.

SALES REVENUES- VARIABLE COST= CONTRIBUTION MARGIN- FIXED COST= PROFIT (OR LOSS)

Calculating the contribution margin

– Comparable to sales margin (and gross

margin)

– Is based on the split of costs into variable

and fixed costs.

– Indicates how many Euros a company has

to make to cover fixed costs and targeted

profit

Variable cost

• Part of the usage of factor of production are

depending straight on the company’s level of activity

• On that case level of activity is effecting also the

amount of the cost of factor of production

• Variable costs increase when production volume

increases, when production is in standstill, in

principle the are no variable costs

VARIABLE COST=

Cost that is directly depended on the level

of activity on the short run

Fixed cost

• Costs which are NOT depending on the fluctuations

on the usage of factor of production

• Will not vary with increase or decrease in

production, are more a function of time

• Are not expected to change in the short run, even

though fixed cost might not be on the same level

every month but reason is something else than

change on the level of activity.

FIXED COST=

Cost that is NOT depended on the level

of activity on the short run

Hertta’s contribution margin calculation

(EUR) Monthly Annual

INCOMES

Sales revenues 7 500 90 000

VARIABLE COST

Raw material 2 250

Packs 750

Electricity 53

Other material 50

Assistant’s salary 750

Indirect employee cost 375 4 228 50 736

CONTRIBUTION MARGIN 3 272 39 264

FIXED COST

Rent 118

Depreciation 370

Interest 148

Insurances 51

Phone and network 150

Marketing services 202

Office supply 80

Entrepreneur’s salary 1 680

Pension 269

TOTAL COST 3 068 36 816

PROFIT OR LOSS 204 2 448

Structure of contribution margin

calculation

Total sales

- Variable cost

= Contribution margin

- Fixed costs

= Profit

Sales

revenues

Variable

costs

Contri-

bution

Fixed

costs

Profit

Note: Fixed costs include

depreciations, interests and taxes.

– Contribution margin €

= Total Sales – Variable costs

– Contribution margin-%

–Relative contribution margin

= Contribution margin / Total sales x 100

Contribution margin

Profit

– Profit (Profit or loss)

= Contribution margin – Fixed costs

– Profit-%

– Relative profit

= Profit / Total sales x 100

Formats of contribution margin

calculation

(sold 10 units) € per unit € total %TOTAL SALES 10 100 100%- VARIABLE COST 4 40 40%= CONTRIB. MARGIN 6 60 60%- FIXED COST 5 50 50%= PROFIT 1 10 10%

Exercises: structure of contribution

margin calculation

A) Travel Agency’s sales revenues in 2010 were

40 000€, variable costs 30 000€ and fixed

costs 6 000€. Prepare contribution margin

calculation (€ and %) for the company.

B) Viuh Ltd sells skates. Purchasing price of the

skates is 60 €/pair. Fixed costs are 4500

€/month. In May Viuh Ltd sold 150 pair of

skates to the price of 100 €/pair. Prepare

contribution margin calculation (€ per pair, €

total and %). What are the contribution margin-

% and profit-%?

Exercises: structure of contribution

margin calculation

C) Sales is 215 000 €, variable costs are 75 000 €

and fixed costs are 98 500 €. What is

contribution margin and profit in Euros and

percentage format (prepare contribution margin

calculation)?

D) Company’s sales is 150 units per month, sales

price is 80 €/unit. Variable costs are 48 €/unit

and fixed costs 3 000 € per month. Calculate

profit per unit, monthly profit in Euros and in

percentage format. Use the model of

contribution margin calculation.

Profitability

• How can we affect the profitability? Options to

increase the profitability?

Profitability

• Different options to affect profitability:

– Increase the level of activity

– Increase the sales price

– Decrease the variable costs

– Reduce the level of fixed costs

– Change the product mix

Cost – Volume – Profit graph

• Good form to analyze the factors which have effects on

profitability is Cost – Volume – Profit graph

CostsRevenues

€

Level of activity

Total sales revenues

Cost – Volume – Profit graph

Fixed cost

CostsRevenues

€

Total sales revenues

Level of activity

Cost – Volume – Profit graph

Total costs

Variablecost

CostsRevenues

€

Level of activity

Total sales revenues

Fixed cost

Partial and Total Adjustment

• If Hertta wants to change the level of activity in the future, she is doing total or partial adjustments.

• Partial adjustment = Change the Level of activity

– Adjustment on time

– Adjustment on productivity

– Adjustment on volume

– Temporary adjustment on level on action

• Total adjustment = Change the capacity

– Permanent change on level of activity

Partial and Total Adjustment

• Example of partial adjustment:

– Adjustment on time:

• Running the ketchup machine in two shift

– Adjustment on productivity:

• Machine improvement, machine is able to produce and pack 70 pieces per hour (original 60 pieces per hour)

– Adjustment on volume

• Rent temporarily an other machine for a major order

• Example of total adjustment :

– Hertta’s Ketchup purchases an other machine to double the capacity

Exercises: capacity, level of activity

and utilization ratio

1. Pizza Girls Ltd sales in 2007 was 12.000

pizzas. A) What was capacity, if utilization ratio

was 60%. B) What is the level of activity in

2006, if utilization ratio was 50%.

2. Utilization ratio of Shoes Ltd was in 2005 85%

and in 2006 75%. Reduction in amount of

production was 2.596 shoes. What is

company’s capacity?

Exercises, solutions

1. A) Capacity 20.000 pizzas

(12.000 / 60% x 100%)

B) Level of activity 10.000 pizzas

(20.000 x 50%)

2. Capacity 25.960 shoes

(2.590 / 10% x 100%)

Key terms

Capacity

Level of Activity

Utilization ratio

Sales revenue

Factor of

production

Cost

Profit or loss

Profit Statement

Contribution margin

Variable cost

Fixed cost

Cost-Volume-Profit

graph

Profitability

Partial and total

adjustment