The Finance Gem 💎 Week #62: Strategic Cost Intelligence

This week’s issue at a glance:

• 4 Finance Gems 💎 remember to vote your favorite in the poll section

  • Cost - Volume - Profit Analysis

  • 20 Cost KPIs 

  • 14 Types of Costs you Should Know

  • 16 Powerful Cost Saving Strategies

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LET’S DIVE INTO THIS WEEK’S FINANCE GEMS

1. Cost - Volume - Profit Analysis

It will also help you maximize your Profits.

Optimize Cost Management.

And manage your Risks.

➡️  CVP is an extremely valuable management accounting tool used to analyze the relationship between your company's sales volume, costs, and profits.

The underlying assumption of CVP is that costs can be either fixed or variable, depending on whether they vary with changes in sales volumes or not.

➡️  The CVP Analysis relies on 2 concepts: Contribution Margin and Break Even.

🎯 𝗕𝗮𝘀𝗶𝗰 𝗖𝗩𝗣 𝗔𝗻𝗮𝗹𝘆𝘀𝗶𝘀

1️⃣ The Contribution Margin (CM) is the sales price of your product or service, less all its variable costs

Contribution Margin = Sales Revenue - Variable Costs

Contribution Margin Ratio = Contribution Margin / Sales Revenue

2️⃣ You Break Even once you are able to use the Contribution Margin from your sales to cover all your Fixed Costs

Break-Even Point (in units) = Fixed Costs / Contribution Margin per Unit

Break-Even Point (in dollars) = Fixed Costs / Contribution Margin Ratio

➡️  After covering fixed costs, each new dollar of Contribution Margin will become straight-up profit, because fixed costs for the period have already been covered.

🎯 𝗔𝗱𝘃𝗮𝗻𝗰𝗲𝗱 𝗖𝗩𝗣 𝗔𝗻𝗮𝗹𝘆𝘀𝗶𝘀

3️⃣ To earn a specific amount of Profit, add that to the total fixed burden  to cover with your calculated Contribution Margin Ratio.

Profit Target = (Fixed Costs + Target Profit) / Contribution Margin Ratio

4️⃣ To understand how much your sales value can decline before you start losing money, calculate your Margin of Safety (difference to your break even point).

Margin of Safety = Expected or Actual Sales - Break-even Point

Margin of Safety % = (Margin of Safety / Expected or Actual Sales) x 100

5️⃣ To perform CVP on multiple products

> determine contribution margin per product

> determine sales mix

> determine weighted average contribution margin

> calculate break-even point in units and allocate it by product based on your sales mix

2. 20 Cost KPIs

Here are 20 Cost KPIs to choose from, benchmark, forecast, monitor and manage.

Cost of Goods Sold (COGS) 

COGS = Direct Materials + Direct Labor + Manufacturing Overhead

COGS = Opening Inventory + Purchases - Ending Inventory

🎯 Your direct costs associated with producing a product or delivering a service, expressed in absolute terms or as a percentage of revenue

Operating Expense Ratio:

Operating Expenses / Net Sales x 100

🎯 Evaluates how much of the total sales is consumed by operating expenses.

Variable Cost Ratio:

Variable Costs / Sales x 100

🎯 Assesses the proportion of sales that is consumed by variable costs.

Fixed Cost Ratio:

Fixed Costs / Sales x 100

🎯 Evaluates the proportion of sales that is consumed by fixed costs.

Direct Labor Cost %:

Direct Labor Costs / Sales x 100

🎯 Measures the percentage of sales that goes towards compensating the labor directly involved in producing a product.

Sales & Marketing Ratio:

Sales & Marketing Expenses / Sales x 100

🎯 Indicates the percentage of sales spent on sales and marketing activities.

Research & Development (R&D) Ratio:

R&D Expenses / Sales x 100

🎯 Measures the percentage of sales invested in research and development activities.

General & Administrative (G&A) Ratio:

G&A Expenses / Sales x 100

🎯 Evaluates the percentage of sales consumed by general and administrative expenses.

Inventory Turnover:

Cost of Goods Sold / Average Inventory

🎯 Indicates how many times a company's inventory is sold and replaced over a period.

Days in Inventory:

365 / Inventory Turnover

🎯 Measures the average number of days items stay in inventory before being sold.

Depreciation Ratio:

Annual Depreciation / Total Fixed Assets x 100

🎯 Assesses the annual depreciation rate relative to the total value of fixed assets.

Maintenance Ratio:

Maintenance Expenses / Total Fixed Assets x 100

🎯 Evaluates the proportion of the value of fixed assets that is spent on maintenance.

Markup Percentage:

(Selling Price - Cost Price) / Cost Price x 100

🎯 Measures the difference between the cost of producing a product and its selling price.

Working Capital Financing Cost:

Short Term Borrowing Interest Cost / Total Interest Cost

🎯 Indicates the proportion of interest cost incurred to finance working capital assets

Variable Costs Ratio:

Variable Costs / Revenue x 100

🎯 Assesses the proportion of Revenue that consists of variable costs.

Total Depreciation Expense:

Sum of Depreciation for All Depreciable Assets

🎯 Represents the total depreciation expense for a given period.

Customer Acquisition Cost (CAC):

Total Sales and Marketing Expenses / Number of New Customers Acquired

🎯 Represents the cost to acquire a new customer.

Overhead Rate:

Total Overhead Costs / Total Direct Labor Costs

🎯 Measures the overhead costs relative to the direct labor costs.

Average Cost of Equity

Cost of Equity (Re)=Risk Free Rate + Beta coefficient x Market Risk Premium

🎯 The return that equity investors expect to earn on their investment in a company

Average Cost of Debt

After Tax Cost of Debt (Rd)=Interest Rate on Debt × (1−Tax Rate)

🎯 Weighted average interest rate on all the company's outstanding debt

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3. 14 Types of Costs you Should Know

🎯 Costs by Relevance to Decision Making

- Relevant/Incremental Costs: Future costs that are relevant to decision-making

- Irrelevant/Sunk Costs: Past costs that are irrelevant to decision-making

🎯 Costs by Function

- Product Costs: Inventoried costs associated with the production of products or services

- Period Costs: Costs not related to production and expensed in the period

- Manufacturing Costs: total costs associated with the production of goods, including direct materials, direct labor, and manufacturing overhead

- Operating Costs: total costs associated with day to day operations

- Conversion Costs: costs incurred when converting raw materials into finished products

- Overhead Costs: indirect costs not tied to a specific product or service, often including items like rent, utilities, and administration costs (can be manufacturing or non-manufacturing)

🎯 Costs by Traceability

- Direct Costs: Costs that can be traced directly to a specific cost object

- Indirect Costs: Costs that cannot be traced directly to a specific cost object

🎯 Costs by Behavior

- Fixed Costs: Costs that remain constant regardless of the level of production or services

- Variable Costs: Costs that vary in direct proportion to the level of production

- Semi-variable Costs/Mixed Costs: Costs that contain both fixed and variable components

- Step Costs: Costs that remain fixed only for a certain volume or range of activity

BONUS:

🎯 Economic Costs: the total cost of producing your goods or services, including both explicit costs (such as wages and materials) and implicit costs (such as opportunity costs).

🎯 Allocated Costs: indirect costs that you cannot directly trace to a specific product or service, and which you instead distribute to products based on a pre-determined method ideally driven by a cause-effect relationship

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4. 16 Powerful Cost Saving Strategies

Sooner or later, you will need to start making strategic decisions in your company.

Here's a list of 16 powerful options you can consider to reduce your costs.

🎯 Just-In-Time Inventory System (JIT):

- Maintain minimal inventory

- Order as required

- Reduce holding costs

- Avoid overstocking

🎯 Vendor-Managed Inventory (VMI):

- Suppliers manage inventory

- Inventory off company balance sheet

- Needed for production

🎯 Consolidation of Suppliers:

- Reduce supplier numbers

- Streamline procurement

- Bulk-purchase discounts

🎯 Outsourcing Production:

- Don't own factories

- Outsource production

🎯 Offloading Fixed Assets & Leasing:

- Sell and lease back assets

- Convert fixed to variable costs

- Improve financial ratios

🎯 Operational Efficiency:

- Refine processes

- Use technology

- Lower operation costs

🎯 Switch to Variable Cost Models:

- Use contract employees

- Convert fixed to variable labor

🎯 Strategic Supplier Relationships:

- Strong supplier relationships

- Negotiate favorable terms

- Lock-in prices, priority access

🎯 Vertical Integration:

- Control supply chain

- Eliminate markup

- Cost savings

🎯 Adopting Technology and Automation:

- Automation solutions

- Reduce labor-intensive tasks

- Lower labor costs

🎯 Focus on Core Competencies:

- Spin off non-core segments

- Focus on primary competencies

- Reduce overhead costs

🎯 Shared Service Models:

- Centralize back-office

- Economies of scale

- Reduce redundancy

🎯 Energy Efficiency and Sustainability:

- Invest in energy efficiency

- Sustainable practices

- Long-term savings

🎯 Economies of Scale:

- Increase production volume

- Spread fixed costs

- Reduce cost per unit

🎯 Relocating Operations:

- Move operations

- Lower costs regions

- Tax incentives, favorable regulations

🎯 Product Simplification:

- Reduce product complexity

- Streamline operations

- Reduce diverse product costs

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