Thursday, February 16, 2012

Benefits of Unit Cost Analysis

I worked for Monsanto in the Agricultural division as a young accounting assistant. I was transferred from corporate to agricultural, entering a whole new world. At that time, the agricultural division was the most profitable division in the organization. What made it a new world for me is that there were no computers.

My first responsibility was to compose the domestic gross profit statement. I asked where I could find the computer to begin setting up the spreadsheet. My boss laughed and handed me a columnar pad with thirteen columns and a calculator.

Each month I would use a 20-pound report for each product and transfer the respective products gross sales, freight, quantity sold and cost related expense onto my paper. I would calculate the sales and cost unit by product, add up all the information and produce a gross profit statement. During this process, I needed to clearly explain why any sales or cost unit deviated from budget down to $.005.

I realized I was the computer. In this accounting environment, the belief was that computers are good, but people are smarter. A spreadsheet can't tell you why. And to know why, you have to understand the nature and components of unit cost.

A unit cost reflects the costs incurred to produce, store and sell one unit of a particular product. Unit costs include:

· Fixed costs - depreciation, monthly rents, organizational cost allocations, and any cost incurred whether or not production occurs; and
· Variable costs - labor, materials, electricity, any cost that increases or decreases depending on the output produced.

Total cost/total output equals unit cost. The total cost and total output is usually derived from a budget or forecast and can change annually, quarterly or monthly. The static unit cost is a "best guess" based on past results, used to analyze the variance between static unit cost and actual unit cost. This variance analysis creates an awareness of input costs, planned output and planned productivity.

Input costs are products and services used to create output. Examples of variances are:
· Increase/decrease in cost of material,
· Increase/decrease in freight in,
· Loss of vendor discounts,
· Missed vendor discounts.

Planned output is the estimated number of units. Examples of variances are:
· Material shortages,
· Decrease in available labor,
· Equipment breakdown,
· Raw materials spillage,
· Production for a customer who later canceled the order,
· Over production based on incorrect scheduling,
· Overtime required due to unscheduled production,
· Overtime required due to a labor shortage,
· Increase/decrease in labor benefits,
· Increase in hourly wage.

Planned productivity is the number of units produced by the current employees. Examples of variances are:
· Acquisition of new machinery that is less labor intensive,
· Improvements in the production process.

A change in fixed costs can also contribute to the variance. For example,
· Change in fixed cost allocations,
· Increase/decrease in support staff costs,
· Change in monthly depreciation or rents.

Unit cost variance analysis can reveal these changes. In some instances, poor communication results in a standard cost unit that is over or understated. These variances also alert management to changes that can be address quickly before the end of the next monthly cycle, such as addressing discounts with vendors or finding vendors to supply materials at a lower cost. Monthly cost variance analysis completed within the short monthly closing cycle can lead to increased profit and efficiencies.

To help you understand unit cost, the various components, and profit implications:
The Preservation Manager's Guide to Cost Analysis
Cost Reduction Analysis: Tools and Strategies


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