Improving Profitability with Cost Accounting

How to harness cost data to drive business success.

Unless you are in a unique circumstance, you have probably used some version of the following phrase recently to describe your industry’s landscape: “it is as competitive as ever.” With Covid-19 increasing the use of ecommerce as a sales channel, companies are finding themselves in an incredibly competitive environment. While this will likely create an increased focus on reducing costs, or on finding the right market price, one thing is clear when it comes to profitability for your organization – you are after margin.

Measuring margin on your products is not a new concept. There is likely a line on the P&L that calls out your margin on products sold. But how accurate is that number at projecting what your margin will be?

Consider the following simple scenario: A customer requests a large order but asks for a discount due to the size. Do you give the customer the discount? You could compare the average product margin against the discount and make the decision, but there is certainly more to it than that. Per unit, what is the percentage of fixed costs, and what dollar value should be applied?  How does this impact capacity for other products, and therefore opportunity cost? What if the customer wants a unique color or variation that requires a separate production run; what is the cost of a special order?

Cost Accounting 101

In order to answer the questions above and make the right decision, it is necessary to have an effective cost accounting system in place.

Cost accounting refers to the reporting and analysis of costs incurred in the production of products or delivery of services. It is used to provide insights—often by assigning costs to individual products, services, or customers—around where and how a company earns profits (not just revenue) or suffers losses. Unlike financial accounting, which records the financial data of an organization in order to exhibit the position of the business, cost accounting is not mandatory for most organizations. Nonetheless, it provides quantitative data to inform leaders’ operational and financial strategies in areas such as selling price, labor management, capital expenditure, forecasting, and marketing.

The main categories to consider when undertaking a cost accounting exercise are materials and conversion costs (labor plus overhead), which are the expenses required to convert the raw materials into finished products.

  • Material costs are the costs of materials used to manufacture a product or provide a service.
  • Direct labor costs are the variable wages and associated expenses that are directly involved in the manufacture of a specific product or in performing a specific service.
  • Overhead costs refer to the indirect expenses of running a production floor including rent, utilities, insurance, depreciation, and indirect labor. While direct labor and materials can more easily be traced to a specific product, there are multiple methodologies to allocate indirect conversion costs, some more accurate than others.

Many companies may know the total of these costs, but effective cost accounting allows you to allocate these costs to individual products and services. As it relates to the large order request outlined above, cost accounting can help you understand how these costs should be adjusted across various SKUs, changes in sales volume, or even for specific customer orders.

Getting Started and Maintaining Your Cost Accounting Process

There are a few things to consider if your organization wants to begin allocating your direct and indirect costs in order to better understand what drives the profitability of your organization:

  • Reliable data – Does your organization have reliable data to properly allocate these costs? This is where you should first focus your efforts. Do you have accurate and up-to-date time studies for how long it takes a laborer to assemble a product? What is the cost of materials, including scrap, used in a product? What is machine downtime?
  • Identification of cost allocation pools – A cost pool consists of individual costs that are grouped together for allocation purposes. For example, a manufacturing company’s various maintenance costs, including materials and labor, may be grouped together and then allocated based on the products / departments served by the maintenance department. Thus, when deciding how many cost pools you want to use, you need to determine how sophisticated you want your allocation structure to be. If this is your first time performing this exercise, we recommend fewer cost pools in order to simplify the allocation process.
  • Allocation base for each cost pool – What will the allocation base be for each identified cost pool? We typically recommend using a cause-and-effect criterion for evaluating and selecting a particular allocation base because this approach is less subjective and more widely used. For example, in the maintenance scenario referenced earlier, maintenance labor and materials costs may be aggregated into a cost pool and then allocated to products based on maintenance labor hours.
  • Change management – Do you have support from management to utilize the data collected for enhancing decision-making purposes? Without buy-in from key stakeholders in the organization, it will be difficult to fully wield your data.

This work is very tactical, and it cannot be done solely from the confines of the C-suite. It will require getting into the operational details, analyzing available materials and process data, e.g. procurement costs per product and production reports. And where data reporting does not already exist, you will need to collect it. For the time study mentioned above, you will likely need to observe on the production floor, and time applicable activities. You will need to have conversations with your frontline workers, as they have critical, firsthand knowledge. How does the production run time change when you change from product A to product B? What are the switching costs? Are there process changes when running product A in blue, rather than yellow?

If you have never had a clear view of your product costs, going through a thorough cost accounting exercise will not be a waste of time.  While there is a significant amount of work that may be required to capture this data, determine an appropriate cost allocation, and comprehend the impact on your business, this improved understanding of the margin you make for each product will prove immensely valuable.

You will need to revisit your data and processes periodically for cost accounting to remain useful. And you also need to have a process whereby you test previously established allocations based on new/updated inputs. Perhaps your methodology needs to change based on continuous improvement efforts, new way of manufacturing a product, introduction of new products, or some other reason. In our experience, organizations often create a cost model, but allow it to become stale over time. Considering cost accounting processes as ongoing activities, rather than a one-and-done, will significantly increase the value of the exercise to your organization.

Using Cost Accounting to Improve Your Business

Once you have implemented your cost accounting efforts, the insights you glean will enable you to make sound strategic decisions. An obvious benefit of having a firm handle on your costs is being able to inform margin on various prices and volumes for your products and services. Especially in today’s dynamic environment, the ability to understand how pricing decisions in the market will impact your business on a forward-looking basis is invaluable. Additionally, as volumes shift, the fixed cost allocation to each product should also shift, driving different margin assumptions to inform your forecasts.

The benefits of cost accounting also extend to other areas of your business, such as labor. A clear view of how your team’s labor hours are allocated will assist in calculating efficiency and setting an incentive structure, and it will allow you to be more proactive when it comes to hiring employees to meet growing demand. Understanding which products have the highest margins might inform how you spend your marketing dollars, or how you segment your customers and focus your sales efforts. You can identify which products are not profitable, and then have the data necessary to decide if they warrant further investment, reworking, or discontinuation.

Ultimately, the goal of a cost accounting system is to allow you to harness data to make well-informed, timely decisions. Having this insight into profitability across products, services, and customers will give you a more holistic view of your company. And, when you are evaluating whether to take on that new customer’s business, you will have a very clear picture of exactly what that business is worth.

We Can Help

Implementing a cost accounting system can be complicated. Elliott Davis is here to help. Our Management Consulting practice is poised to help your team think about your business differently and transform your team’s actions to those that will maximize profits and minimize costs. Contact us for an exploratory discussion to define your needs and mobilize action.

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