Cost Accounting For Dummies. Kenneth W. Boyd
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you manage a lumberyard that sells two types of wood to furniture makers: Pristine wood and Sturdy wood. A unit is one board of wood. (If you’re selling first-class hardwoods, the sample prices are pretty close to reality. There’s some serious money in a board
Pristine wood is used to make beautiful tabletops and sells for $50 per unit. Variable costs are $30 per unit, and fixed costs total $30,000. The breakeven formula is
Profit ($0) = sales – variable costs – fixed costs
Profit ($0) = (units × $50) – (units × $30) – $30,000
Profit ($0) = units × ($50 – $30) – $30,000
Profit ($0) = units × $20 – $30,000
To finish the calculation, add $30,000 to both sides of the equation. Then divide both sides by $20:
$30,000 = units × $20
$30,000 / $20 = units
1,500 = units
You sell 1,500 units of Pristine wood to break even.
Sturdy wood is used to make pretty good tabletops and sells for $25 per unit. Variable costs are $18 per unit, and fixed costs total $25,000. Here’s the breakeven formula:
Profit ($0) = sales – variable costs – fixed costs
Profit ($0) = (units × $25) – (units × $18) – $25,000
Profit ($0) = units × ($25 – $18) – $25,000
Profit ($0) = units × $7 – $25,000
To finish the calculation, add $25,000 to both sides of the equation. Then divide both sides by $7:
$25,000 = units × $7
$25,000 / $7 = units
3,572 = units
You sell 3,572 units of Sturdy wood to break even.
Pristine wood’s breakeven point in units is less than half of the Sturdy wood’s (1,500 units versus 3,571 units).
A contribution margin of $20 (Pristine wood) beats a contribution margin of $7 (Sturdy wood) any day of the week. The difference in fixed costs is $5,000 — not a big difference. Pristine has a much larger contribution margin to cover fixed costs. That’s why Pristine wood’s breakeven point is so much lower.
Applying target net income to two products
After you compute the breakeven points on two products, you can decide on target net income for the period. Assume again that you sell Pristine and Sturdy wood, and your target net income for both types of wood is $10,000. You target a $5,000 profit for each product type.
Pristine wood’s calculation is
$5,000 = sales – variable costs – fixed costs
$5,000 = (units × $50) – (units × $30) – $30,000
$5,000 = units × $20 – $30,000
Finish the calculation, and you see that it takes 1,750 units of Pristine wood to reach target net income of $5,000.
For Sturdy wood, plug in the variables. You need to sell 4,286 units to reach target net income.
The total profit for both products is $10,000 ($5,000 + $5,000).
Adjusting product sales to reach target net income
If one product’s sales are lower than planned, you can still reach your target net income. Higher sales in one product can make up for lower sales in another product.
For example, say the economy is bad, and customers aren’t eager to buy Pristine wood, so you sell only 1,600 units. The profit calculation is
Profit = $50 × (1,600) – $30 × (1,600) – $30,000
Profit = $80,000 – $48,000 – $30,000
Profit = $2,000
Your target net income for Pristine wood is $5,000, so you’re $3,000 short of your goal. To reach your total target net income, maybe you can shift that $3,000 profit “burden” to Sturdy wood.
To determine how much more you need to sell, just change the Sturdy wood profit to $8,000, and compute the new number of units sold:
$8,000 = (units × $25) – (units × $18) – $25,000
$8,000 = units × $7 – $25,000
Finish the calculation. The number of units to reach your profit goal is $33,000 divided by $7. Therefore, if you sell 4,715 units of Sturdy wood, you generate $8,000. Your total target net income of $10,000 is based on $2,000 from Pristine wood and $8,000 from Sturdy wood.
Costing and pricing a new product
Financial planning for a new product is really difficult, because so many variables are unknown. Product costs, prices, and units sold are based mainly on research and management’s business experience. In spite of these challenges, many businesses successfully launch new products. With careful thought and proper planning, you can introduce a new product and earn a decent profit.
Starting with your product idea
The best products and services solve an urgent problem for a customer. Want an example? I’m charging my iPhone using a portable charger, because my power is out at home. That’s my definition of solving an urgent problem!
OK, it’s time to find that super useful product idea…
Assume that you manufacture and sell mountain bikes and outdoor gear. Your customers are serious riders, who head out on rides in every kind of weather. To understand customer needs, you document customer services calls and conduct frequent surveys. What trends do you notice?
Increasingly, riders tell you that they can’t find a waterproof jacket that holds up to heavy use. Most jackets don’t repel water well, leaving riders in a cold wet jacket (sometimes far from home). Zippers tend to jam with frequent use, particularly in rainy weather. Riding in a light rain can be manageable, if you have the right jacket.
The next step is to design the product, complete a small production run, and have customers try the jacket.
Designing the new product
Your Thunder Proof jacket is designed with multi-layered, lightweight material. The zippers are high quality, and the zipper pockets are reinforced