PANPA Print Cost Technical Workshop

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PANPA Print Cost Technical Workshop
Nigel Finch Director, Centre for Managerial
Finance Macquarie Graduate School of Management
(MGSM)
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Agenda

• Industry Challenges Profit Trends
• Cost Behaviour Type
• Cost Allocation Methods Limitations
• Activity Based Costing (ABC)
• The Cost of Capacity Pricing
• Recommendations

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Industry challenges
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A daunting array of challenges...
The print industry is a mature industry and as
such will likely grow at a slower rate than the
overall economy. The industry still remains
highly fragmented, and suffers from chronic
overcapacity, and intense competition. Rapid
technological improvements demand larger and more
frequent capital investments. New media and
communications platforms are challenging the
primacy of commercially printed materials.
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A daunting array of challenges...
Coupled with other economic factors, these
challenges converge to place print industry
profits under constant pressure. To remain
competitive in this environment, and maintain
profitability, it is crucial to have a clear
picture of the real economic cost for producing
print jobs, providing other ancillary services,
and servicing individual customers needs.
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Profitability trends
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USA study profit margin
Printing Industries of America (PIA) conducted a
broad cross section study of financial
performance of U.S. firms. The sample was
categorised into different groups based on
operational diversity (such as volumes,
geography, product speciality and manufacturing
process). Within each group, firms were rated
as either profit leaders or profit laggers
based on pre-tax profitability. Over a ten-year
period average profit leaders earned 9.7, and
profit laggers earned 0.7.
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Dodd, Lavelle Margolis, (2002), "Driving
Improved Profitability With Activity-Based
Costing", Point Balance Publishing, Philadelphia.
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Profit leaders vs. profit laggers
So what distinguishes a profit leader from a
profit lagger? One significant financial
characteristic is that, on average, they spend
fewer dollars on support expenses for each dollar
of revenue. Support expenses include overheads
but exclude direct production costs, interest and
depreciation.
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Analysis of support costs ( of sales)
Adapted from Printing Industries of America,
"2001 PIA Ratios Management Guide to the PIA
Ratios", Vol. 1, Printing Industries of America,
Virginia,
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Questioning support expenses
How do profit leaders gain control of support
expenses to achieve superior financial
performance? Are some support expenses more
important than others? What activities and
processes are responsible for generating and
consuming support expenses? How much does it
cost to perform each of these activities and
processes? Gaining visibility into support
expenses is therefore critical to managing and
improving profitability.
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Cost Behaviour
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Understanding Cost Behavior TOTAL Cost
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Understanding Cost Behavior TOTAL Cost
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Understanding Cost Behavior TOTAL Cost
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Understanding Cost Behavior TOTAL Cost
Total amount of fixed costs remains constant over
the period, irrespective of changes in quantity
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Understanding Cost Behavior TOTAL Cost
Total amount of fixed costs remains constant over
the period, irrespective of changes in quantity
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Understanding Cost Behavior TOTAL Cost
Total amount of fixed costs remains constant over
the period, irrespective of changes in quantity
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Understanding Cost Behavior TOTAL Cost
Total amount of variable costs increases in
proportion to changes in quantity
Total amount of fixed costs remains constant over
the period, irrespective of changes in quantity
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Understanding Cost Behavior UNIT Cost
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Understanding Cost Behavior UNIT Cost
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Understanding Cost Behavior UNIT Cost
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Understanding Cost Behavior UNIT Cost
Cost per unit decreases as quantity increases
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Understanding Cost Behavior UNIT Cost
Cost per unit decreases as quantity increases
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Understanding Cost Behavior UNIT Cost
Cost per unit decreases as quantity increases
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Understanding Cost Behavior UNIT Cost
Cost per unit is constant irrespective of changes
in quantity
Cost per unit decreases as quantity increases
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Understanding Cost Behavior
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Understanding Cost Behavior
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Direct vs. Indirect Cost
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Direct Costs vs. Indirect Costs
Direct costs are costs that can be traced back to
a product. Indirect costs are costs that a
common to many products. Indirect costs cannot
be traced, rather they must be allocated
(guessed) to each product. Indirect costs are
also called overhead e.g. support
expenses. Total cost Direct costs Indirect
cost
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Total Cost
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Total Cost
Total Cost?
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Total Cost
Total Cost?

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Total Cost Direct Indirect
Total Cost?

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Total Cost
Total Cost?
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Total Cost
Total Cost?

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Total Cost Fixed Variable
Total Cost?

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Cost Certainty
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Cost Certainty
Fixed cost per unit is unknown as it is a
function of quantity
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Cost Certainty
Fixed cost per unit is unknown as it is a
function of quantity Indirect cost per unit is
unknown and is based solely on allocation
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Cost Certainty
In determining cost per unit, direct variable
cost is the only cost type that can be known with
certainty.
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Cost Allocation Methods
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How we understand total cost


Traceable
Allocated
Estimated
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Cost allocation methodology
Most of the features seen in todays cost
accounting systems were established in the
1930s. While the business environment has
undergone dramatic change since the 1970s, very
little change has occurred in the fundamental
principles used in estimating cost (and
price). The basic premise in business is to sell
at a price above cost. To determine cost (and
hence set price), two approaches are generally
used direct cost and absorption cost.
Lockamy A., (2003), "A constraint-based framework
for strategic cost management", Industrial
Management Data Systems, 103(8), pp. 591 599.
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Direct cost vs. Absorption cost
Under direct costing, direct cost margins will
accumulate to build up the necessary contribution
to pay overheads before taking account of
profit. For example in setting price we might
approach it using the adage people, paper and
profit. However, this assumes that jobs with a
high proportion of direct costs consume an
equally high proportional amount of indirect
costs. Q Does printing on thicker stock consume
more rent?
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Direct cost vs. Absorption cost
Under absorption costing, an allocation of
indirect costs is added to the direct costs for
each job. A mark up is then added to the total
cost to arrive at a price, say cost plus
30. Absorption costing relies upon an
allocation methodology to apportion an amount of
indirect cost to each job. In principle this is
a user-pays system. Understanding this
methodology is critical to understanding the
reliability of the cost estimate.
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Cost allocation methodology
Under absorption costing, the proportion of
indirect costs added to each job is based on the
formula Estimated cost / Estimated
activity Estimated activity is generally defined
as the planned activity of the cost driver. A
cost driver is an event associated with an
activity that results in the consumption of the
firms resources, for example labour hours.
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Cost allocation methodology
General Ledger
Budget
Estimated Overhead
Estimated Labour Hours
Overhead per Labour Hour
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Limitations in cost estimates
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Why budgeted hourly rates are inadequate
Most firms use a Budgeted Hourly Rate (BHR) model
to estimate costs, however BHR has 3 major
limitations. Firstly, there is no attempt to
identify or define support activities, nor does
it trace or assign costs to support
activities. By ignoring these support activities
BHR systems make it impossible to see what
activities and processes are causing support
expenses to exist. Without visibility into cost,
there is no way to prioritise initiatives aimed
at process improvement.
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Why budgeted hourly rates are inadequate
Secondly, BHR systems force all support cost to
be allocated to only one cost object the
individual print job. Not all print jobs will
consume all support costs. For example the salary
of the manager has no causal relationship with
the cost of any print job. This process distorts
the real economic cost of producing that job
especially problematic with transfer
pricing. This process assumes that all print
jobs consume the support activities on the same
proportion.
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Why budgeted hourly rates are inadequate
Thirdly, by using estimated activity rates in
calculating BHR values, this process not only
fails to measure the costs of unused capacity,
but actually conceals such costs. Given the high
levels of overcapacity, this makes it challenging
to tackle the critical task of managing capacity
and making capacity related decisions. Without
information on excess capacity and how much that
excess is costing, managers cannot make capacity
decisions on an economically rational basis.
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Activity Based Costing (ABC)
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Introducing ABC
The primary purpose of ABC is to provide accurate
information about the cost of resources consumed
by individual products, services, customers,
processes, and channels... ...not just print
jobs. ABC allows support expenses such as
indirect plant expenses, administration expenses,
sales expenses, to be traced back to the
activities that consume them.
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Introducing ABC
ABC systems provide information to more reliably
answer questions such as What activities are
being performed by the companys resources? How
much does it cost to perform these
activities? Why does the company need to perform
these activities? How much of each activity is
required to produce individual print jobs,
deliver non-print services, or to serve specific
customers?
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Traditional vs. ABC costing
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Translating functional to activity
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ABC Activity Hierarchy
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The Cost of Capacity
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Costing for Capacity Management
Organisations have little insight and
understanding about the location and cost of
unused (non-productive) capacity. BHR costing
loads all costs onto products delivered so it
hides these costs, losing the opportunity to
decrease them. ABC systems help understand the
link between increasing shareholders wealth and
minimising unused capacity. Targets continuous
improvement by focusing on most constrained
activity (i.e. activity with no unused
capacity). Assists with long term decisions,
e.g. acquiring or disposing.
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What about pricing?
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Pricing and the relationship with cost
Estimating cost and pricing are distinctly
different concepts. Estimating is a science,
pricing is an art. Pricing should be customer
specific not job specific. One price doesnt fit
all customers. Should a dozen roses on January 14
be priced the same as on February 14? Consider
treating estimating and pricing as separate
activities, involve senior management in pricing,
and becoming more active in the logic of the
estimating process.
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Recommendations
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5 Key Recommendations
Many factors are threatening print industry
profits. To remain competitive it is critical to
have a clear picture of the real economic cost
for the activities you are investing in. Long
term studies indicate that profit leaders, on
average, spend fewer dollars on support
expenses. One objective to build improved
profitability is to focus on better understanding
(and therefore controlling) these indirect
support expenses, by...
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1. Costing based on capacity
Cost allocation should be based on available
capacity not planned activity. Spare capacity
foregone should be shown as an expense in the
management reports and developed to manage this
cost line. This ensures spare capacity has
visibility and is not hidden. It ensures that
the true economic cost is being used and avoids
penalising internal users in transfer pricing.

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2. Introduce a capital allocation charge
Traditional asset holding costs (depreciation and
interest) can distort the true economic
cost. E.g. older equipment has a lower
depreciation expense, hence a lower allocated
cost. E.g. a decision to fund an expansion with
equity (rather than debt) also lowers the
allocated cost. To avoid these errors a capital
allocation charge should be used to reflect the
risks and cost of capital for holding fixed
assets, intangible assets and working
capital.
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3. Focus efforts on cost discovery
Develop a culture that promotes greater cost
awareness. Build an activity dictionary for each
new activity undertaken. Invest time in cost
discovery for each activity. Start process
mapping activities to assist in communicating
cost consumption and identifying opportunities
for continuous improvement.
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4. Move closer towards an ABC system
Move away from the traditional BHR cost
allocation method and closer to an ABC style
system. Prioritise cost pools based on their
relative size (the larger the indirect cost the
higher priority). Start with a periodic survey
of activity and a simplified modelling technique
to reduce the burden of data collection. Keep
investing in the ABC system, remembering cost
consumption by activity is not static, but
evolves as the business changes.
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5. Develop a targeted pricing strategy
Knowing the cost of an item doesnt change the
selling price the market sets that. Move away
from cost plus pricing towards value-based
pricing. Pricing should be opportunistic, not
prescriptive. Pricing is a strategic role and
should be separated from estimating. Pricing is
a key opportunity to generate a rate of return on
shareholders funds.
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5 Key Recommendations
1. Costing based on capacity 2. Introduce a
capital allocation charge 3. Focus efforts on
cost discovery 4. Move closer towards an ABC
system 5. Develop a targeted pricing strategy
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Questions
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Nigel Finch Director, Centre for Managerial
Finance Macquarie Graduate School of Management
(MGSM) Contact nigel.finch_at_mgsm.edu.au Tel (02)
9850 9030 Researchhttp//ssrn.com/author438461