Explain the difference between “Full Cost” & “Contribution Margin”, marketing homework help

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Explain the difference between “Full Cost” & “Contribution Margin”. What is the value for the Sales Manager in knowing the difference?

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416 EVALUATION AND CONTROL OF THE SALES PROGRAM 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. © 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 Y Y 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 © 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 Y Y 417 418 EVALUATION AND CONTROL OF THE SALES PROGRAM © 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 Y Y COST ANALYSIS 419 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) © 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 Y 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 Y 420 EVALUATION AND CONTROL OF THE SALES PROGRAM 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? © 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 Y Y
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In full cost, all costs be it direct or indirect cost should be assigned and gradually accounted for
in determining the profitability of any segment...


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