This month’s newsletter continues our discussion of the income statement. Last month, we talked about how a cost behaves. This month, we will talk about how a cost is applied.
The Way a Cost Is Applied
The next way of discussing costs is by how they are applied to a product or service. The cost can be either directly applied to the product or service or indirectly applied.
Direct costs are costs that you can logically and easily trace to the creation of the product. Let’s say we are making birdbaths. The cost of the components (the wire and the cement) and the labor to create the birdbaths are direct costs. You can easily determine how much cement and wire goes into each birdbath. You can also determine how many labor hours it took to mold and finish the birdbaths. Direct link … direct costs.
Indirect costs are all the other costs incurred in marketing, selling, and designing the product. Here is a partial list of items that might be considered indirect costs:
These costs are harder to trace directly to the product. For instance, if you have seven product lines and you asked members of the executive team how they contributed to each product line, you would most likely get a blank stare in return or they would say that they contributed to each product line equally. Of course, this isn’t true.
So what we do in accounting to keep it simple is to allocate these indirect costs to the product using what we like to call an indirect cost allocation method. Some companies call it a burden rate.
We take all of the expenditures for the executive team and put them into what is called an indirect cost pool (a fancy way of saying “a lump of costs”). We then come up with a way to easily allocate them to the products or product lines. For instance, we might have allocated the costs based on volume of sales. Whichever product line generated the most sales got the largest chunk of the executive costs.
Is that fair and accurate? No. But it is easy for the accountant and normally how it works.
So, if you are a project manager and are trying to sell a particular project, you might hear back from the accounting department that, in addition to the direct costs of your project, such as the new equipment and additional labor, you must also add in a burden rate. They may say, “Yes, we understand that your project will cost the company $460,000, but we also want you to factor in an additional 20% to take into account organizational support.” That extra 20% might push you right over the edge and make your project seem unprofitable.
Know that this burden rate or indirect cost allocation rate is created by the accounting department and is subject to debate and change. The folks at one company I teach for seem to change both the rate and the components of their indirect cost allocation every six months. They keep refining it and adding different components or taking some out.
Something to be aware of here is that you may be able to successfully argue that your particular project should not be weighed down by all the costs that the accountants calculated. If you ask the accountants for their allocation methods, you may actually be able to find some costs that should not be attributed to your project.
Now why do we go through all this rigmarole anyway? Why calculate the direct and indirect costs of creating a product or service? Because we want to make sure that we are making a profit on each sale. If we don’t know the cost of our products or services, we might very well be selling them for less than it costs us to make them, and that would be bad.
Now that we have covered the two main ways that accountants talk about cost — in terms of how cost behaves and the way cost is applied — we can look more closely at the income statement and the way it is broken out.
The Significance of Gross Profit Margin and Operating Profit Margin
Notice that the income statement is subtotaled in two places before we get to the final profit figure.
Simple Income Statement Model
– cost of goods
= gross margin
– operating expenses
= operating margin
= net income
The first subtotal is the result of taking sales and subtracting out cost of goods sold. This subtotal is called gross profit margin. I have also heard it called a variety of other things, so check out your own company’s financials to uncover your company’s terminology.
The next subtotal is the result of taking gross margin and subtracting out operating expenses. This is called operating profit margin. This margin, too, has aliases, so check your own financials.
Where do you think direct costs go? In cost of goods sold or in operating expenses? If you said “cost of goods sold”, you’re right! Gross profit margin is the result of subtracting the direct costs of creating your product or service from total sales.
Indirect costs go in operating expenses. So, operating profit margin is the result of taking both indirect and direct costs out of sale revenue.
Operating profit margin is the line that most of us need to pay attention to and manage. It is the profit that we garner from operating, from the day-to-day creation and sales of our product or service.
Items below the operating profit margin line are generally out of the manager’s control — things like taxes and the gain or loss on the sale of a business segment. These are called non-operating items and are classified at the bottom of the statement. We put these at the bottom so we can trend operating profit margin from year to year without any strange, non-recurring, or unusual jumps.
For instance, I just read a company’s financials that revealed a negative operating profit but a positive net income because of a gain on a foreign currency transaction. Will they realize a gain on a foreign currency transaction next year? Who knows? Will they be able to pull their operating profit out of the dumper? We hope so.
Next month we will read an income statement with only profit in mind. Ever heard of EBITDA? We’ll define it next time!