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operations. Similarly, to deploy the firm’s salespeople most effectively, the sales
manager needs to appreciate the output/input relationships by product, territory,
customer, channel of distribution, and so on. Marketing cost analysis estimates
these relationships.
C OS T ANAL Y S IS DEVELOPMENT
Sales management has been somewhat slower to adopt cost analysis (or as it is
sometimes called, profitability analysis) than sales analysis for managing the sales
function. The empirical evidence indicates that if they do it at all, firms are more
likely to conduct product profitability analyses and less likely to do it for customers.
Only about half of all companies do it at all, and less than a third analyze costs by
products, territories, salespeople, and customers. Interestingly, companies do focus
on a salesperson’s pricing authority which is a key factor in determining the overall
profitability of each customer.2
Historically, one reason for this was that most accounting systems were not
designed to meet the needs of marketing management but, rather, to report the
aggregate effects of a firm’s operations to creditors and stockholders. They were
subsequently modified to provide a better handle on the production operations of
the firm. Even today many accounting systems are still oriented toward external
reporting and production cost analysis.
However, the integration of company information systems over the last 10 years
enable accounting systems to identify and include the types of cost and profitability data needed by sales executives. For a sales manager, the key is to understand
how costs are allocated so that the true profitability of any particular customer,
geographic area, product, or market can be determined. Any accounting system can
take the direct cost of supplies and components and add those together to come up
with the cost of a product. The challenge is adding management costs, office supplies, warehousing, IT, and so forth. There are three approaches to cost allocation:
full costing, contribution analysis, and activity-based costing (ABC). The choice of
which costing approach to use is very important to sales managers. For example,
territories have been mistakenly cut because the accounting information used by
managers didn’t allocate costs appropriately.
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Full Cost versus Contribution Margin
The more popular and traditional accounting methods are the full-cost (or as it is
sometimes called, net profit) approach and the contribution margin approach.
The argument over which should be used has generated controversy through the
years.3 To appreciate the controversy fully, it is helpful to understand the differences between direct and indirect costs as well as specific and general expenses.
A direct cost can be specifically identified with a product or a function.4 The cost
is incurred because the product or function exists or is contemplated. If the product
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COST ANALYSIS
or function were eliminated, the cost would also disappear. An example is inventory carrying costs for a product.
An indirect cost is a shared cost because it is tied to several functions or products.
Even if one of the products or functions were eliminated, the cost would not be.
Rather, the share of the cost previously borne by the product or function that was
eliminated would shift to the remaining products or functions. An example of an
indirect cost is the travel expenses of a salesperson selling a multiple product line.
Even if one product the rep sells is eliminated, the travel cost would not be.
The profit/loss or net income statement typically distinguishes between costs and
expenses. The term cost is often restricted to the materials, labor, power, rent, and
other miscellaneous items used in making the product. The cost of goods sold on
the following conceptual net income statement reflects these costs.
Sales
Less:
Cost of goods sold
Equal: Gross margin
Less:
General administrative and selling expenses
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Equal: Profit or net income before taxes
The expenses reflect the other costs incurred in operating the business, such as the
cost of advertising and of maintaining branches. Expenses cannot be tied nearly
as well as costs to specific products, since they are general expenses associated
with doing business. In marketing cost analysis, the distinction between costs and
expenses is not nearly so clear, and the terms are often used interchangeably.
Just like costs, expenses can be classified into two broad categories: specific and
general expenses. A specific expense is just like a direct cost—it can be identified
with a specific product or function. The expense would be eliminated if the product
or function were eliminated. If the product were eliminated, for example, the specific expense of the product manager’s salary need not be incurred.
A general expense is like an indirect cost—it cannot be identified directly with
a specific object of profit measurement such as a territory, salesperson, or product.
Thus, the expense would not be eliminated if the specific object were eliminated.
An example is the sales manager’s salary when the object of measurement is a
product in a multiple-product company. The elimination of the product would not
eliminate this salary.
A particular cost or expense may be direct for some measurement purposes and
indirect for others. The object of the measurement determines how the cost should
be treated.
If it is a product line, costs directly associated with the manufacture and sales of
the product line are direct. All other costs in the business are indirect. If the object of
measurement shifts to a sales territory, some of the costs of product-line measurement,
which were direct, will remain direct costs now associated with the territory; some will
become indirect; and others that were indirect will become direct. For example,5
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EVALUATION AND CONTROL OF THE SALES PROGRAM
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Object of Measurement
Cost
Product
Territory
Sales promotion display
Sales rep compensation
Product-line manager’s salary
Corporate president’s salary
Direct
Indirect
Direct
Indirect
Direct
Direct
Indirect
Indirect
As mentioned, there is controversy about whether one should use a full-cost or
contribution margin approach in marketing cost analysis. Proponents of the fullcost or net profit approach argue that all costs should be assigned and somehow
accounted for in determining the profitability of any segment (e.g., territory, product, and salesperson) of the business.
Under this approach, each unit bears not only its own direct costs but a share
of the company’s cost of doing business, referred to as indirect costs. Full-costing
advocates argue that many of the indirect costs can be assigned to the unit being
assessed on the basis of a demonstrable cost relationship. If a strong relationship
does not exist, the cost must be prorated on a reasonable basis. Under the full-costing approach, a net income for each marketing segment can be determined by
matching the segment’s revenue with its direct and indirect costs.6
Contribution margin advocates argue, on the other hand, that it is misleading to
allocate costs arbitrarily. They suggest that only those costs that can be specifically
identified with the segment of the business should be deducted from the revenue
produced by the segment to determine how well the segment is doing. Any excess
of revenues over these costs contributes to the common costs of the business and
thereby to profits. The contribution margin approach does not distinguish where
the costs are incurred but rather simply whether they are variable or fixed. Thus,
the difference between sales and all variable costs, whether they originate in manufacturing, selling, or some administrative function, are subtracted from revenues or
sales to produce the contribution margin of the segment.
The net profit approach does attempt to determine where the costs were incurred.
The difference in perspectives is highlighted in Exhibit 12.1. Not only is segment
net income derived differently in the two approaches, but also advocates of the
contribution margin approach do not even focus on net income when evaluating
the profitability of a segment of the business. Rather, they focus on the contribution produced by the segment after subtracting the costs directly traceable to it
from its sales.
The contribution margin advocates are winning the controversy. Although the
early emphasis in accounting for distribution costs was on full-cost allocation, the
recent emphasis is on the contribution margin approach.7 The contribution margin approach has unmistakable logic. If the costs associated with the segment are
not removed with the elimination of the segment, why should they be arbitrarily
allocated? That just confuses things and provides a blurred, distorted picture for
management decision making. The costs still have to be borne after the segment
is eliminated, but they must be borne by other segments of the business. Such
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COST ANALYSIS
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allocation can simply tax the ability of these other segments to remain profitable.
Exhibits 12.2 and 12.3 illustrate this phenomenon.
The example involves a department store with three main departments. The
administrative expenses in Exhibit 12.2 are all fixed costs; they were allocated to
departments on the basis of the total percentage of sales accounted for by each
department. This is a common allocation basis about which more will be said later.
Those who embrace the full-cost approach would argue that Department 1 should
be eliminated because of the net loss of $12,500.
Note what would happen if this were pursued. First, the sales of the department
would be lost, but $12,500 of selling expenses would also be eliminated. However,
the $25,000 of fixed costs must now be borne by the other departments. Allocating
Full-Cost Approach
Less:
Contribution Margin Approach
Sales
Cost of goods sold
Less:
Equal: Gross margin
Less:
Less:
Equal: Contribution margin
Less: Fixed costs directly traceable to products
Fixed costs directly traceable to the market
segment
Operating expenses (including the
segment’s allocated share of
company administration and
general expenses)
Equal: Segment net income
Sales
Cost of goods sold
Gross margin
Other expenses
Selling expenses
Administrative expenses
Total other expenses
Net profit (loss)
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Sales
Variable manufacturing costs
Sales
Cost of goods sold
Gross margin
Other expenses
Selling expenses
Administrative expenses
Total other expenses
Net profit (loss)
Other variable costs directly traceable to the
segment
EXHIBIT 12.1
Differences in
perspective
between full-cost
and contribution
margin approaches
to marketing cost
analysis
Equal: Segment net income
Totals
Department 1
Department 2
Department 3
$500,000
400,000
100,000
$250,000
225,000
25,000
$150,000
125,000
25,000
$100,000
50,000
50,000
25,000
50,000
75,000
25,000
12,500
25,000
37,500
(12,500)
7,500
15,000
22,500
2,500
5,000
10,000
15,000
35,000
Total
Department 2
Department 3
$250,000
175,000
75,000
$150,000
125,000
25,000
$100,000
50,000
50,000
12,500
50,000
62,500
12,500
7,500
30,000
37,500
(12,500)
5,000
20,000
25,000
25,000
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EXHIBIT 12.2
Profit and loss
statement by
department using a
full cost approach
EXHIBIT 12.3
Profit and loss
statement if
Department 1 were
eliminated
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these costs on the basis of percentage of sales suggests that Department 2 is unprofitable (see Exhibit 12.3). If one used the same argument as before, it too should be
considered for elimination. Then the $50,000 of administrative expenses would be
borne entirely by Department 3, making Department 3 (the entire store) unprofitable. That would suggest the store be closed, meaning management would close a
profitable store simply because one department displayed a small dollar loss—a loss
that could be attributed to an arbitrary allocation of fixed costs. Department 1, in
fact, makes a positive contribution to profits, as the contribution margin statement
in Exhibit 12.4 shows.
A contribution margin versus a full-cost profitability analysis is also supported
by the recognition that most marketing phenomena are highly interrelated. For
example, the demand for one product in a multiproduct company is often influenced by the availability of others, while the absence of a product may cause the
sale of another product to decline.
The entire product line may be greater than the sum of its parts in terms of sales
and profits. The same argument applies to other elements of the marketing mix. They
have interdependent effects. The contribution margin approach implicitly recognizes
this synergy through its emphasis on the contribution of each segment or part.
In sum, allocations of indirect costs for segment performance evaluation are
generally inappropriate. That is, any measure of segment performance that includes
allocated shares of indirect costs includes factors that do not really reflect performance in the segment as a separate entity. Hence, indirect cost allocations should not
be made if the purpose is to measure true performance.
ABC Accounting
Over the last decade there has been a significant shift in the way accountants and
managers view costs. Rather than focus on the reason for the cost (labor hours to
produce a product), this new approach identifies and delineates the cause-andeffect relationship between costs and desired organizational outcomes. As a result,
marketing decision makers can get answers to questions such as, How profitable is
it to do business with this customer? or What level of customer service will make
this customer unprofitable?
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EXHIBIT 12.4
Contribution
margin by
departments
Sales
Variable costs
Cost of goods sold
Selling expenses
Total variable costs
Contribution margin
Fixed costs
Administrative expenses
Net profit
Totals
Department 1
Department 2
Department 3
$500,000
$250,000
$150,000
$100,000
400,000
25,000
425,000
75,000
225,000
12,500
237,500
12,500
125,000
7,500
132,500
17,500
50,000
5,000
55,000
45,000
50,000
25,000
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