Let’s say you own a business that sells three different products or services. Cash flow has been tight for the past year, and is reaching a point where you’ll need to dip into your Line of Credit to continue operating.
You call your accountant into your office and say, “Once and for all, I need to know where we’re making money, and where we’re losing it.” Your mousy little accountant mutters something inaudible, and ambles off in a huff.
One would think that this Cost Accounting Assignment or what is also known as Managerial Accounting, would be something relatively easy for anyone to do. But as you’ll learn, it’s almost impossible to do properly.
The accountant goes back to their office and pulls up the most current income statement for the company. They have no problem separating the income for the three different products or services. They then split up the Cost of Goods Sold including direct labor, purchases, and every other variable expense on the P&L.
This takes them to a Gross Profit Margin, and now they’re stuck. How can they possibly split up General Expenses that aren’t tied directly to producing only one of the products or services?
Let’s say that the company pays their executive, administrative, and marketing staffs a total of $1M annually. How do you split that up between the three separate profit centers?
How do you split up insurance, auto, or interest expenses? The list goes on.
What many will try to do is to split up the general expenses based on a sales percentage. An example would be if profit center #1 accounts for 40% of the company’s sales, they’ll then assign 40% of the general expenses to this category.
Others might assign the general expenses based on the Gross Profit Margin. An example would be if Profit Center #1 has a Gross Profit Margin of 25%, then they’d assign 25% of the General Expenses into that column.
Either of these are the biggest mistake that anyone could make.
This is something called, “Pushing the Numbers.” In other words you’re just pushing the numbers in one direction or another and not actually giving management what they need to make reasonable decisions.
The fact is that no one has any idea what percentage of any of the General Expenses should be assigned to any of the Profit Centers. Lots of firms make enormous amounts of money doing this incorrectly, and it’s simply wrong.
So what’s our humble accountant going to do? The best that anyone can do in this situation is to come up with Contribution Margins for the individual profit centers.
We take the sales less the cost of goods sold, which provides the amount of money left which is contributed to covering the General Expenses, or what’s more commonly known as the Contribution Margins. The accountant then finds out that Product Center #1 contributes $700,000 annually, #2 contributes $575,000 annually, and #3 only provides $130,000.
Management now has the only decent information they can possibly get to do what is necessary to turn the situation around. It’s not a perfect world, but it’s the only thing that’s reasonable.
If the accountant had “pushed the numbers”, then all three of the products might have looked unprofitable and poor decision making probably would have resulted.
Let me leave you with this.
We run into situations like this all the time with larger and smaller clients. My point is that no matter how prestigious or large the accounting firm happens to be, there’s only so much that any of us can do.
When you have these problems, we all know what you want, We even know what you want to hear in order for you to give us the accounting job.
But there are only a few of us that are strong and independent enough to actually be honest about it.
If we “push the numbers” it could lead to disastrous decision making. But if we get you to a proper contribution margin, then you can make the decisions necessary to get your business back in the black.
You can increase your prices, decrease your costs, or any permutation of those two in between. But at least you’ll have the right idea what to do to fix your company and where to employ your scarce resources.
Before you sign an agreement with the prestigious accounting firm of Dewey, Cheatum, and Howe, that will cost thousands of dollars for them to do a Cost Study, please think again. There’s a sucker born every minute in Managerial Accounting, and two born to take them.
Choose wisely. If you have issues in this regard, we ‘d love to help. Please call today.
We’re all going to get through this. Let’s get through it together.
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Chris Amundson
President
Accounting Solutions Ltd.
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