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Contribution margin accounting for small business.

Contribution Margin Accounting for Small Business

Consultants and academic gurus are bounding about the country these days decrying the antiquity of certain accounting practices while advocating the desirability of "newer" methods. One of the techniques receiving pejorative attention is the contribution margin approach to decision making. For up to $5,000 per day, these critics will contend that contribution margin analysis no longer provides relevant information for product costing and decision making. They cite, in generalities, the experience of Japanese manufacturers, very large mass production operations and other complex production companies as proof of their claims and then buttress these claims with anecdotal corroboration normally drawn from a case study in a large complex corporation.

These critics imply that strategies for large, complex firms apply equally to all manufacturers and distributors. Contribution margin accounting, however, is more useful than ever to many small to medium sized manufacturers who find that they inherit the inventory problem from their large customers and to companies too small to gain any advantage from "cell group production" organization.

For these smaller producers, the entire production facility comprises a more tightly knit unit than many cell groups in the larger companies. As a new job starts, the production elements work together to produce the items ordered performing the tasks needed to complete the job. Elaborate reporting requirements prove unnecessary and often nonexistent for these small manufacturers. Support functions tend to exist at the shop floor within close proximity to the production facility. While multiple jobs may run simultaneously, the work force typically knows the various jobs, their importance to the organization and what resources and effort are required to complete the job.

Support services associated with smaller companies tend to be streamlined. Restructuring into cells, rather than simplifying support services, would add to support services and increase overhead. In short, practically everything the production cell accomplishes in the large mass production environment already exists on the factory floor of the small producer.

Furthermore, just-in-time (JIT) inventory concepts do not work as well for small companies as for large mass production facilities. These larger facilities can forecast with reasonable accuracy the activities and materials needed. They can schedule months in advance of the production activity. Most small producers and distributors find that precision in forecasting specific activities often proves impossible. Activities for the small producer or distributor typically follow the whims of the marketplace and prove fairly erratic.

Each shipment of parts received for short-term production (daily or weekly) at the large producer constitutes a large quantity (truckload, rail car load or train load) in the shipment. The small producer or distributor faces daily or weekly quantity needs comprising a small shipment. The transportation costs associated with the shipments may prohibit the elimination of inventories of raw materials, parts and finished products for these producers. Likewise, set-up costs for the small job shop may be significant enough to justify single runs of production and warehousing of overproduction of finished goods inventory.

Dangers of Full Costing in Small Manufacturing

A small manufacturer in Ohio recently had its cost accounting system evaluated to determine requirements for bringing it inline with JIT-type cost measures. The chief operating officer (COO) complained that overhead costs were 800% of direct labor, whereas just two years prior those costs were running 120% of direct labor. The investigation revealed that the cost system measured overhead in pools and allocated both fixed and variable overhead to the products based on direct labor dollars at all stages of production.

Two years ago, the COO evaluated the fabrication operations and, based on the full cost analysis, determined that the company should buy rather than make all the parts used in production. The company proceeded to farm out all the fabrication operations to other producers while still maintaining the same operations facility. The result was fewer labor dollars to spread fixed costs over, while fixed costs remained the same.

Had that COO considered a contribution margin approach to unit costs when comparing the make-vs-buy option, the company would still be fabricating all of its parts. In every case, the variable costs and incremental fixed costs associated with the fabricated parts were significantly less than the option to purchase outside. With this information, the COO would have made the decision to make rather than buy.

Since the decision was made to buy, freight charges on the finished parts increased as the packing required to protect finished parts bought increased. The unpacking and receiving activities increased dramatically, driving up handling costs. With full cost analysis, all these factors were ignored when the COO arrived at the decision to buy rather than make the parts used in the final assembly.

Small manufacturers find competition tight and difficult, while their large customers continue to put pressure on them to produce to specifications and to a time schedule that may prove difficult. Contribution margin accounting provides information essential for the small manufacturer to balance these factors and continue profitably.

How Contribution Margin Helped a Distributor

Elsden Electronics (name and figures changed at request of the company) is a $20 million distributor of industrial, service and consumer electronic products. The divisional income statement shown in Figure 1 was prepared by its accountants.

Note that it is impossible to analyze the full cost statement and answer some very basic entrepreneurial questions about Elsden. At best, the information in Figure 1 yields a gross profit analysis such as Figure 2. Figure 2 indicates the cost of goods sold but ignores the activities of the distribution operation entirely.

At worst, the information in Figure 1 yields a profitability schedule such as that contained in Figure 3. Figure 3 depicts the consumer products division as an unprofitable operation which should be eliminated as soon as possible. Yet many of the costs associated with the amounts charged to the consumer division are fixed in nature and result from full absorption allocations. These costs do not go away if Elsden eliminates the consumer products division. The firm as a whole would become even less profitable.

The contribution margin divisional income statement (Figure 4) was used to make several important planning decisions for Elsden as outlined in the following sections.

Cost-Volume-Profit

Elsden's owner/president was interested in how far sales could drop off in a softening economy and still cover total costs (break-even). Given the product mix, a weighted average variable cost percentage could easily be determined from Figure 4, and the resulting break-even sales of just over $18 million can be calculated (Figure 5).

In addition to the break-even point, the owner wanted to know what level of sales would produce an after-tax profit of $250,000 (Figure 6).

Evaluation of Product Lines

The contribution margin divisional income statement can also be used to determine the contribution margin percentages for the three product lines: Consumer -- 4%; Industrial -- 20%; and Service -- 32.5%. The resulting strategy recommendation is to stress sales volume in the service division, since this division provides more profit per dollar of sales than the other two divisions.

For example, if the service division increases revenues by $100,000 if it spends $25,000 on an additional sales person, the company would be ahead by $7,500.
Increase in Revenue $100,000
Variable Expenses 67,500
Contribution Margin 32,500


Incremental Fixed Cost 25,000 Contribution to Profit $7,500

Since this type of analysis does not flow readily from the full cost statements, it often is not performed.

In Elsden, the consumer division is suspect because of its reported losses. While this division has a very low contribution margin, it is surprisingly contributing $389,165 to overall profits -- even more than the industrial division. This division confirms Eli Goldratt's admonition concerning throughput, but its true profitability is hidden by the allocation of fixed costs in the full cost divisional income statement (Figure 1).

Short Run Pricing

As a general rule, for short-run pricing decisions the selling price of a product must at least cover variable and incremental fixed cost providing a positive contribution margin. Contribution analysis is extremely helpful in evaluating pricing decisions for special orders in the consumer division. The consumer division is continually approached by customers who offer to buy large quantities of products at prices that are less than those usually charged.

The manager of the consumer division, for example, often confronts the following type of pricing problem. He has spent considerable time "pitching" a large electronics system to a customer over a three-week period. The particular system was not readily available on the market and therefore carried a larger profit margin than the average sale. The manager was frustrated when the customer stated that if a price reduction of $2,000 was not granted, the purchase would be made from a competitor whose price was lower. While full cost analysis would have indicated to refuse the offer, contribution margin analysis showed how it would be profitable to accept the offer rather than pass up the opportunity.

Conclusion

Please note that we are not advocating the allocation of variable overhead costs to cost objectives utilizing inappropriate allocation bases. If direct labor hours are not driving either aggregated overhead accounts (pools) or individual overhead elements, then contribution analysis will be erroneous if such an allocation is employed. This problem is not alleviated, however, by using full costing but rather exacerbated when the allocation base is inappropriate. It is also true that as firms become more automated, there will be more indirect fixed costs and marginal contribution percentages will be higher. Machine hours, material costs and other bases may then be more highly correlated with variable overhead costs than labor hours. Labor may also be relatively more fixed. These facts of life, however, do not obviate the advantages of contribution reporting previously discussed.

It is often difficult to determine the fixed and variable element of costs. A good deal of judgment, for example, was involved in the transformation of the Elsden Electronic Company into a contribution format (Figure 4). Many costs, for example, are step-fixed costs and do not vary with production changes proportionally. Additional business could be accepted at reduced prices, therefore, that will not cover these support costs. As long as these additional fixed costs are identified, however, contribution reporting facilitates the analysis required. In essence, the mere fact that these step-fixed costs tend to increase as a result of increased activity in no way minimizes the importance of contribution reporting. Furthermore in smaller manufacturing environments, these step-fixed costs are much less likely to be a common occurrence because the product diversity and support functions are relatively limited.

For small and medium companies, the contribution margin approach to the analysis and reporting of costs continues to provide valuable information for owners and managers to assist in making intelligent decisions. Often the information needed proves impossible to obtain from traditional full-cost based income statements. The smaller firm faces critical problems with transportation costs and set-up costs that larger firms find insignificant. While contribution margin reporting may answer a limited set of questions, the questions answered by this approach to reporting often prove critical for the survival of the small manufacturer or distributor. [Figures 1 to 4 Omitted]

John P. Walker, CPA, PhD, is an associate professor of accountancy at Wright State University, Dayton, Ohio. His career includes serving as executive vice president of Data Spectrum, Inc., assistant corporate controller of UNC Resources, Inc., and consultant with Peat, Marwick in their Washington, D.C. office.
COPYRIGHT 1990 National Society of Public Accountants
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Copyright 1990 Gale, Cengage Learning. All rights reserved.

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Author:Walker, John P.; Gudort, Cheryl A.; Talbott, John C.
Publication:The National Public Accountant
Date:Sep 1, 1990
Words:1908
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