FINANCIAL ANALYSIS (AC6913)

MBA, MSc in Management Practice

September 2014

Practical Examples

Dublin Business School

Example 1:
Practical Example of the Value of Financial V Management Accounting
(a)

The Financial Accountant has prepared a basic Income Statement for the year.

Revenue
Less: Cost of Sales
Materials
Salaries
Design Expenses
Gross Profit (20%)
Less: Expenses
Administration Expenses
Distribution Expenses
Net Profit (10%)

30,000

15,000
7,000
2,000
2,000
1,000

24,000
6,000
3,000
3,000

Based on the information shown above, it would appear that the enterprise is operating
successfully and is profitable. There are no warning signs that problems might exist and
that action is needed to safeguard future success. In simple terms this information is too
broad to be of general use to management.
(b)

The management accountant has done some further analysis of the financial records for the
year and by analysing costs to each of the three services provided, can produce a cost
statement as follows:-

Materials
Salaries
Design Overhead
Administration
overhead
Distribution overhead
Total Cost

4,800
1,500
500
6,800
700

3,700
2,500
600
6,800
800

6,500
3,000
900
10,400
500

TOTAL

15,000
7,000
2,000
24,000
2,000

300
7,800

400
8,000

300
11,200

1,000
27,000

If this additional information is compared to the sales revenue for each

product the following Operating Statement can be produced:
A

10,240

10,800

8,960

Total Cost

7,800

8,000

11,200

27,000

Profit/(Loss)

2,440

2,800

(2,240)

3,000

Sales

Profit (%)

24%

26%

Loss

TOTAL

30,000

10%

Based on the further analysis conducted in (b), a very different picture emerges. The overall
profitability is still 10% however; Service C appears to be losing money due to the high
level of cost it incurs. This loss is being disguised by the other two services which would
appear to be far more profitable than at first thought.
A number of courses of action might be considered:
(a)
(b)
(c)
(d)

Investigate each cost for C to establish why they are so high

Stop providing service C
Increase Cs fee/charge out rate to recover the additional cost
Provide C as a loss leader (Offer C to encourage customers to consider using service
A or B).

The Management Accountant provides the additional information and suggested solutions
to assist in planning, control and decision making. However, it is important to remember
that it is the senior management who must make the decision on what action to take.

Example 2
A SWOT Checklist - (Suitable for use in Analysing a Case Study)
Potential Internal Strengths

Potential Internal Weaknesses

Many product lines?

Broad market coverage?
Manufacturing competence?
Good marketing skills?
Good materials management systems?
R&D skills and leadership?
Information system competencies?
Human resource competencies?
Brand name reputation?
Portfolio management skills?
Cost or differentiation advantage?
New-venture management expertise?
Appropriate management style?
Appropriate organisational structure?
Appropriate control systems?
Ability to manage strategic change?
Well-developed corporate strategy?
Good financial management?
Others?

Obsolete, narrow product lines?

Rising manufacturing costs?
Decline in R&D innovations?
Poor marketing plan?
Poor materials management systems?
Loss of customer good will?
Inadequate information systems?
Inadequate human resources?
Loss of brand name capital?
Growth without direction?
Bad portfolio management?
Loss of corporate direction?
Infighting among division?
Loss of corporate control?
Poor organisational structure and control?
High conflict and politics?
Poor financial management?
Others?

Potential Environmental Opportunities

Potential Environmental Threats

Expand core business(es)?

Exploit new market segments?
Widen product range?
Extend cost or differentiation advantage?
Diversify into new growth businesses?
Expand into foreign markets?
Apply R&D skills in new areas?
Enter new related businesses?
Vertically integrate forward?
Vertically integrate backward?
Enlarge corporate portfolio?
Overcome barriers to entry?
Reduce rivalry among competitors?
Make profitable new acquisitions?
Apply brand name capital in new areas?
Seek last market growth?
Others?

Attacks on core business(es)?

Increases in domestic competition?
Increase in foreign competition?
Change in consumer tastes?
Fall in barriers to entry?
Rise in new or substitute products?
Increase in industry rivalry?
New forms of industry competition?
Potential for take-over?
Existence of corporate raiders?
Increase in regional competition?
Changes in demographic factors?
Changes in economic factors?
Downturn in economy?
Rising labour costs?
Slower market growth?
Others?

Having done this analysis, you will have generated both an analysis of the companys
environment and a list of opportunities and threats. The above table also lists some common
environmental opportunities and threats that you might look for, but the list you generate will be
specific to your company.

Example 3
World Class Manufacturing (WCM) An Illustration
A company has called you in as consultant on cost reduction. Currently, the Chief Executive has
refused to become involved in WCM because he considers it will cost too much to implement.
From the following list of costs you have drawn up, calculate the costs of production in total and
show what the total cost will be under a WCM system. Then calculate the product cost under
each system to persuade the Chief Executive that his view is mistaken.

Data Provided:
Annual production

10,000 units

Materials

50,000

Wages
Idle time
Losses due to poor training
Scrapped WIP
Cost of delays in production due to delivery of
non-quality materials from suppliers
Inventory-holding costs

30,000
5,000
2,500
10,000
2,500
10,000

Additional employee training and supplier liaison will cost 15,000 if WCM is introduced.

Suggested Solution:
You should have two columns, which summarise costs as follows:
Cost classification

Original Costs

WCM Costs

Materials
Wages
Idle Time
Losses from Poor Training
Scrapped WIP
Production Delays
Inventory Holding Costs
Additional Training and liaison

50,000
30,000
5,000
2,500
10,000
2,500
10,000
-

50,000
30,000
15,000

Total Cost Allocation

110,000

95,000

11.00

9.50

Unit Cost (10,000 units)

Explanation and discussion:

Materials and wages will remain the same for both methods (assuming that improved training of
the workforce does not result in improved productivity and motivation, thereby reducing wages
cost) as both will require inputs of materials and labour.
However, due to WCM's waste reduction features, the costs of idle time losses due to poor
training, ie. scrapped WIP and delays together with the reduction of inventory-holding costs to
nil (due to the implementation of a Just in Time manufacturing system) will result in substantial
savings, only partially offset by the training costs.
Therefore, the quality improvement and cost reduction aims of WCM will be met by adopting
the features outlined. These in turn will make production more efficient, thus reducing lead-time
and will improve customer service with the provision of quality products.

Example 4

Direct V Indirect
How might the following costs be classified?
(a)

Primary packing materials like cartons and boxes

(b)

Employees engaged in altering the condition or composition of a product

(c)

The hire of tools or equipment for a particular job

(d)

Rent and insurance of a factory

(e)

Depreciation of office equipment

(f)

Market research

(g)

Wages of despatch staff

(h)

Wages of maintenance staff and stores staff

(i)

Cost of glue in box-making

(j)

Depreciation of factory buildings.

Solution
(a)

Direct material cost

(b)

Direct labour cost

(c)

Direct expense

(d)

Production overhead or indirect expense

(e)

Administration overhead or indirect expense

(f)

Selling overhead or indirect expense

(g)

Distribution overhead or indirect labour cost

(h)

Indirect labour cost or production overhead

(i)

Indirect materials cost or production overhead

(j)

Indirect expense or production overhead.

Example 5
Space Ltd is considering the introduction of one new product to its existing range. The product
design team has come up with two options and has provided the following forecast information:
Product 1 Jupiter
Sales price
Variable cost

40 per unit
32 per unit

Annual sales
Fixed costs (directly associated with the product)

10,000 units
50,000 per annum

Product 2 Venus
Sales price
Variable cost

20 per unit
15 per unit

Annual sales
Fixed costs (directly associated with the product)

10,000 units
30,000 per annum

Space Ltd does not have the capacity to produce both products.
Required
Calculate each of the following for each of the two products:
(a) (i) Annual forecast profit/loss.
(ii) Contribution/sales ratio.
(iii) Break even point in units.
(iv) The level of sales required to produce a profit of 40,000 to pay back the original
investment.
(b) Advise the company on which product it should introduce.

Solution
Tutorial Note:
Answering this question requires knowledge of Cost-Volume-Profit (CVP) Analysis (also known
as Break-Even Analysis). The basic principles underlying CVP analysis are that the variable cost
per unit remains constant and total variable costs increase or decrease in line with the volume of
goods sold. Fixed costs on the other hand, are unaffected by the volume of goods sold. In other
words, fixed costs remain the same (fixed) no matter how many units of product are sold.
The general format for a CVP statement is Sales less Variable Costs = Contribution; less Fixed
Costs = Profit. An example of a typical layout is included below for illustration purposes:
Sales
Variable Costs
Contribution
Fixed Costs
Profit

800
500
300
200
100

Note: These figures are fictitious and have nothing to do with the Space Ltd question which will
be dealt with below.
(a) (i) The calculation of the annual forecast profit/loss is calculated as follows:
Product 1 Jupiter

Sales
10,000 units @ 40 per unit
Variable costs
10,000 units @ 32 per unit
Contribution
Fixed costs
Profit

400,000
320,000
80,000
50,000
30,000

Product 2 Venus

Sales
10,000 units @ 20 per unit
Variable costs
10,000 units @ 15 per unit
Contribution
Fixed costs
Profit

200,000
150,000
50,000
30,000
20,000

(ii) The Contribution/Sales Ratio

Tutorial Note:
The Contribution/Sales Ratio (C/S Ratio) is the relationship between contribution and sales

10

expressed as a
ratio. Some textbooks refer to it as the Profit/Volume ratio. These terms are
usually interchangeable. It is calculated by dividing the contribution by the sales. The C/S Ratio
is usually expressed as a percentage.
The C/S Ratios for Jupiter and Venus are as follows:
Product 1 Jupiter
(Information taken from calculations in (a) (i) above)
(Contribution/Sales) x 100 = C/S Ratio
(80,000/400,000) x 100 = 20%
Product 2 Venus
(Information taken from calculations in (a) (i) above)
(Contribution/Sales) x 100 = C/S Ratio
(50,000/200,000) x 100 = 25%
(iii) The Break-even Point
Tutorial Note:
The break-even point is the point where the profit is zero. It is the sales level at which there is no
profit or no loss. In other words the firm is breaking-even. The break-even point can be
calculated in units or in monetary terms. In this question you are specifically asked to calculate
the break-even point in units.
The break-even point, in units, is calculated by dividing the fixed costs by the contribution per
unit. The contribution per unit is calculated by subtracting the variable cost per unit from the
sales price per unit.
The break-even points for Jupiter and Venus are as follows:
Product 1 Jupiter
Contribution per unit
Sales price per unit variable cost per unit = contribution per unit
40 per unit - 32 per unit = 8 per unit
Break-even point
Fixed costs/contribution per unit = break-even point
50,000/8 = 6,250 units
Product 2 Venus
Contribution per unit
Sales price per unit variable cost per unit = contribution per unit
20 per unit - 15 per unit = 5 per unit
Break-even point
Fixed costs/contribution per unit = break-even point
30,000/5 = 6,000 units

11

(iv) Level of sales required to produce a profit of 40,000

Tutorial Note:
This question does not state whether the level of sales is to be expressed in monetary terms or in
units although it is understood that either would be acceptable. For the purpose of this solution,
we will calculate the level of sales in units. To do this we will divide the fixed costs and the
target profit (in this case 40,000) by the contribution per unit.
The calculations are as follows:
Product 1 Jupiter
Sales required to produce a profit of 40,000.
(Fixed costs + Target profit)/Contribution per unit
(50,000 + 40,000)/8 = 11,250 units
Product 2 Venus
Sales required to produce a profit of 40,000.
(Fixed costs + Target profit)/Contribution per unit
(30,000 + 40,000)/5 = 14,000 units
(b) Advise the company
Some of the points which might be considered could include the following:Jupiter generates a larger profit than Venus (30,000 v 20,000).
Jupiter has a higher break-even point than Venus (6,250 units v 6,000 units). The break-even
point is often used as a measure of risk. The higher the break-even point the greater the level of
risk involved. In other words more units of Jupiter have to be sold before the company moves
into a profit-making situation. If sales do not reach this level the company would make a loss on
the product. This means that the risk associated with the investment in Jupiter is greater than the
risk of investing in Venus. The difference is not great and so Jupiter could be considered to be
only slightly riskier than Venus.
Neither product will produce the desired level of profit at the projected sales level of 10,000
units. However, Jupiter would produce the desired level of profit if sales were to increase to
11,250 units. In the case of Venus sales would have to increase to 14,000 units.
Based on the information provided, Jupiter seems to represent a better investment opportunity
than Venus. However, before a final decision is made additional information is required. The
additional information could cover such areas as marketing research, competitor analysis,
reliability of information provided etc.

12

Example 6
A manufacturer of light fittings is preparing budgets and has provided the following draft
figures:
Sales Forecast (units)
January
February
March
April
May

6,000
7,500
8,500
7,000
6,500

The standard selling price per unit is 50.

Each light fitting uses 2kg of steel at a cost of 15 per kg and it is company policy to
have stocks of steel at the end of each month to cover 50% of next months production
requirements. At the start of January there are 5,800kg of steel in stock.
At the start of January there are 750 units of light fittings in stock and it is policy to have
stocks at the end of each month to cover 10% of the following months sales.
Required:
(a) Prepare a production budget (in units) for the first four months of the year.
(b) Prepare raw material (steel) usage and purchases (in kgs and values) budgets for the
first three months of the year.

13

Solution:
Part (a) - Production budget (in units) for the first four months of the year.
Sales
Closing Stock

Jan
6,000
750

Feb
7,500
850

Mar
8,500
700

Apr
7,000
650

Opening Stock

(750)

(750)

(850)

(700)

Production

6,000

7,600

8,350

6,950

Part (b) - Raw material usage and purchases budgets for the first three months of the year.

Usage (kg)

Jan
6,000
@ 2 kg
12,000

Feb
7,600
@ 2 kg
15,200

Mar
8,350
@ 2 kg
16,700

Closing Stock
Opening Stock

7,600
(5,800)

8,350
(7,600)

6,950
(8,350)

Purchases (kg)

13,800
@ 15

15,950
@ 15

15,300
@ 15

Purchases ()

207,000

239,250

229,500

Production

Apr
6,950
@ 2 kg
13,900

14

Example 7
THE CASH BUDGET COMPANY LIMITED
The monthly forecast of the income and expenditure of Cash Budget Company Limited is given
below:-

Materials used
Depreciation of plant and
equipment
Factory expenses
Rent and rates
Clerical wages and office
expenses
Advertising and stationery
Wages
Salesmens commission (June 4)
Sales income
Raw material stocks at end of
month

July
40

Aug
50

000s
Sept
Oct
60
80

8
10
2

8
10
2

8
10
2

28
14
30
6
138
120

28
16
40
7
161
140

70

80

Nov
100

Dec
90

8
10
2

8
10
2

8
10
2

28
10
30
8
156
160

28
12
30
10
180
240

28
20
40
12
220
280

28
14
40
9
201
250

90

100

80

60

You may assume the following:

(1) Suppliers of materials are paid on average a month after delivery of goods.
(2) Factory expenses are paid in the month incurred.
(3) Rent and rates are paid quarterly on the first day of January, April, July and October.
(4) Clerical wages and office expenses are paid in the month in which they occur.
(5) Advertising and stationery is paid monthly taking one months credit.
(6) The lag in the payment of wages is one week (assume four weeks per month).
(7) Salesmens commission is paid one month in arrears.
(8)

Sales income is split 50:50 as to cash and credit. On average, debtors take two
months credit.

(9) The cash balance at 1 July is 42,000.

(10) In October new plant will be purchased for 38,000. Government grants on this
plant will be received in November amounting to 6,000.
(11) Corporation tax of 6,000 is to be paid in October.

15

(12) (a)
(b)
(c)
(d)
(e)
(f)

Materials used in June were 40,000.

Advertising and stationery in June amounted to 12,000.
Wages in June amounted to 30,000.
Salesmens commission earned in June amounted to 4,000.
Sales income was 80,000 in both May and June.
Raw material stocks at the end of May amounted to 60,000 similar to those on
hand at the end of June.

(13) The taxation provision for the six months can be taken at 40,000 payable in full in
December of next year.
Required:
Prepare a cash budget for the six months to 31 December (figures to the nearest 000
should be used).

16

Solution:
THE CASH BUDGET COMPANY LIMITED
July

Aug

000s
Sept
Oct

60
40
-

70
40
-

80
60
-

120
70
-

140
80
6

125
120
-

100

110

140

190

226

245

40
10
6
28

50
10
28

60
10
28

70
10
6
28

90
10
28

80
10
28

12
30
4
-

14
37
6
-

16
33
7
-

10
30
8
38
6

12
37
10
-

20
40
12
-

Total outflow

130

1,435

154

206

187

190

Net movement

-30

-35

-14

-16

+39

+55

Opening balance

+42

+12

-23

-37

-53

-14

Closing balance

+12

-23

-37

-53

-14

+41

Inflow
Sales receipts - Cash
- Credit
Government grant
Total inflow
Outflow
Materials (Note 1)
Factory expenses
Rent and rates
Clerical wages and office
expenses
Advertising and stationery
Wages
Salesmens commission
Capital expenditure
Corporation tax

Nov

Dec

Note 1: Payments to suppliers of materials

Closing stock
Add: Usage
Less: Opening
stock
Purchases

June

60
40
100

July

70
40
110

Aug

80
50
130

60
40

60
50

70
60

000s
Sept
Oct

90
100
60
80
150
180
80
70

90
90

Nov

80
100
180

Dec

60
90
150

100
80

80
70

17

Interpretation:
The cash budget indicates that the company has some serious cash deficits between
August and November before returning to a cash surplus in December.
The management should assess methods of coping with this position e.g. can short term
funds be obtained through a bank overdraft. They should also consider postponing the
capital expenditure from October to December. This would significantly improve the
deficit position in October and return the company to a surplus in November, one month
earlier than planned.

18

Example 8
Lynchberg Ltd. has provided you with the following budgeted and actual data for the period
ending 30th April 20X7.
The standard cost information at the beginning of the period was based on an expected activity of
10,000 units
Direct Material :

The specification per unit produced is 12kg @ 10 per kg.

Direct Labour :

The standard time allowed per unit is 8 hours @ 6 per hour.

Overheads :

All Overheads are variable in nature and for the period they
are budgeted at 160,000. Company policy is to absorb
overheads at a predetermined rate per labour hour.

Selling Price is expected to be 200 per unit.

At the end of the period the actual results were as follows;
Sales Revenue:
Material:
Labour:
Overheads:

2,880,000 representing 12,000 units sold

160,000 kg were used at a cost of 1,440,000
108,000 hours were worked at a cost of 756,000
Actual expenditure 240,000

Required:
(a)

Prepare a standard cost card showing the cost and profit per unit and the overall budgeted
profit for the period.

(b)

Calculate the actual profit for the period.

(c)

Explain what you understand by the term inter-relationship between variances and
provide a simple example.

(d)

Prepare a statement reconciling the budgeted profit and the actual profit and in doing so,
calculate, in as much detail as possible, relevant variances for Material, Labour,
Overheads and Sales.

19

Solution:
Part (a)
Standard Cost Card for Lynchberg Ltd.
Sales Price
Less:
Materials (12 kg @ 10)
Labour (8 hrs @ 6)
Overheads (8 hrs @ 2)

200
120
48
16

Standard Profit per unit

184
16

Budgeted Profit (16 x 10,000 units)

160,000

Part (b)
Actual Profit
Sales
Less:
Materials
Labour
Overheads
Actual Profit

000
2,880
1,440
756
240
2,436
444

Part (c)
Variances, like ratios, should never be viewed in isolation when being interpreted. Interrelationship between variances means that there is often a natural connection between variances
which are calculated. This connection may become apparent when management are seeking
explanations to variances which have arisen in a period. Identifying these connections helps
provide assurance that the reasons being suggested are logical and are more likely than not to be
correct.
Examples might include:

A favourable labour efficiency variance being linked to an adverse rate variance. The
reason behind these might be the introduction of a bonus scheme which improved
productivity but increased the amount paid in wages.
A favourable material price variance may be due to buying a lower grade (and hence
cheaper) material. This would logically be linked to an adverse usage variance as a result
of higher wastage due to the poorer quality of the raw material.
20

Part (d)
Profit Reconciliation Statement with Variance Analysis
Budgeted Profit per Part (a)
Sales
Price
Actual
Expected
Volume
Materials

Labour

Actual
Expected

Price

Actual
Expected

Usage

Actual
Expected

Rate

Actual
Expected

Efficiency Actual
Expected
Overhead

Rate

Actual
Expected

Efficiency Actual
Expected
Actual Profit per Part (b)

000
160
240
200
40
12000
10000
2000
1440
1600
160
160k
144k
16
756
648
108
108
96
12
240
216
24
108
96
12

x 12000

480 (F)

x 16

32 (F)
160(F)

x 10

160(A)
108(A)

x6

72(A)
24(A)

x2

24(A)
444

21

Example 9
(a) The management accountant of Gatling Ltd has produced a print-out showing the variances
for production activity for March 20X8. Unfortunately, he has just been taken ill and has
been confined to hospital. However there is a meeting of the Board of Directors shortly and
an interpretation of the variance print-out is expected to be delivered at the meeting.
Required:
Prepare a formal report to the Board explaining each variance listed in the print-out below
and identifying one possible reason for the variance in question.
Ensure that the possible reasons you provide are consist with all the information given and
are not likely to be contradicted by any of the other variances in the print-out.
Reconciliation Report with Variances for March 20X8
Budgeted Profit
Sales Volume Variance
Sales Price Variance
Material Price Variance
Material Usage Variance
Labour Rate Variance
Labour Efficiency Variance
Actual Profit

000
6,000
242(A)

225 (F)
42 (F)
23(A)
37(A)
27(F)
294 (F)

302 (A)
8(A)
5,992

22

Solution:
REPORT

To:

Board of Directors, Gatling Ltd

From:

Management Accountant

Subject:

Interpretation of Variance Report

Date:

xxth April 20X8

Further to your request for information on the Reconciliation Report for March 20X8. The profit
was 8,000 less than expected for month as a result of the following variances. In each case I
will explain the meaning of the variance and suggest a plausible reason as to why it occurred. In
each case (A) indicates an Adverse result and (F) indicates a favourable result.
Variance
Sales Volume

Sales Price

Material Price

Material Usage

Labour Rate

Labour Efficiency

Amount 000
Meaning
242(A) Profits are lower as
a result of selling
fewer units of the
product.
225 (F) Profits are higher
as a result of
getting a better
margin on each
unit.
42 (F) Profits are higher
as a result of
paying less per unit
of raw material
than we expected.
23(A) Profits are lower as
a result of using
more raw material
than we expected.

Possible Cause
Market demand for
the product may
have fallen.
There may have
been an increase in
selling price.

We may have
received a bulk
discount or used a
lower grade of raw
material.
There may have
been greater waste
due to the lower
quality of raw
material.
37(A) Profits are lower as We may have
a result of paying
introduced a bonus
more wages than
scheme or worked
we expected.
overtime.
27(F) Profits are higher
A bonus scheme
as a result of the
may have created
workers performing an incentive to
better than
work harder.
expected.

23

It should be noted that the causes indicated above are merely one plausible explanation for the
variance calculated. In all cases further investigation and enquiry should be undertaken prior to
any drastic corrective actions being implemented.
If you have any further queries in this regard, please do not hesitate to contact me.
Yours sincerely,
M. Accountant.

24

Example 10
Activity Based Costing V Traditional Absorption Costing
Aye Ltd. manufactures two products, Ics and Wye, using the same equipment and similar
production processes. An extract of production data for Period 1 is shown below for each
product:

Quantity Produced (units)

Direct Labour Hours per Unit
Machine Hours per Unit
Production Set-ups in Period
Orders handled in Period
Overhead Costs Identified
Relating to Machine Activity
Relating to Production Set-ups
Relating to Order Handling

Product Ics
5,000
1
3
10
15

Product Wye
7,000
2
1
40
60

220,000
20,000
45,000

Required:
Calculate the production overheads to be absorbed by one unit of each product using the
following costing methods:
(a)

A traditional absorption costing approach using a direct labour hour basis to trace
overheads to products.

(b)

An activity based costing approach using suitable cost drivers to trace overheads to
products.

Suggested Solution:
(a) Traditional Absorption Costing Approach
Product Ics (5,000 units @ 1 hour)

5,000

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Product Wye (7,000 units @ 2 hours)

Total Labour Hours
Overhead Absorption
Rate:

14,000
19,000
285,000
19,000
= 15 per hour

Overhead Absorbed:
Product Ics
(1 hour @ 15)
Product Wye
(2 hours @ 15)

15 per unit
30 per unit

(b) Activity Based Costing Approach

Product Ics (5,000 units @ 3 hours)
Product Wye (7,000 units @ 1 hour)

15,000
7,000
22,000

Using ABC, overhead costs are absorbed using the concept of cost drivers:
Costs driven by machine hours
Costs driven by production set-ups
Costs driven by order handling

220,000 over 22,000 hrs

20,000 over 50 set-ups
45,000 over 75 orders

= 10 / mch hr
= 400 / set-up
= 600 / order

Overheads are then distributed as follows:

Machine costs
Set-up costs
Order costs
Units produced
Overhead cost / unit

Product Ics
(15,000hrs x 10) = 150,000
(10 x 400) = 4,000
(15 x 600) = 9,000
163,000
5,000
32.60

Product Wye
(7,000hrs x 10) = 70,000
(40 x 400) = 16,000
(60 x 600) = 36,000
122,000
7,000
17.43

Example 11
Customer Profitability Analysis
Sound Wizard Ltd, manufactures a variety of sound equipment and sells one particular item, a
compact speaker, to sound centres and three HI-FI chain shops.
The speaker is sold for 40 per unit and has a variable production cost of 12 per unit.
Delivery costs vary according to the distance travelled and the cost has been estimated at 5 per
Kilometre. In addition, if a customers stock falls to a dangerously low level, an emergency
delivery, which is outside normal delivery schedules, is required. These emergency supplies cost
500 per delivery. Each customer also negotiates an individual trade discount on sales prices.
Order taking costs are estimated at 200 per order. Publicity costs are specific to each customer
as all publicity occurs on site in the shops and Sound Centres.
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Data relating to each of the customers are as follows:

HI-FI X

HI-FI Y

HI-FI Z

Other Sound Centres

Sales in units

10,000

5,000

3,000

6,000

Km travelled

1,000

500

1,200

7,500

Emerg. Deliv.

No. Orders

10

Discounts

20%

15%

20%

6%

Sales Comm.

10%

10%

10%

10%

27,000

49,000

45,000

57,000

Publicity
Required:

What is the profitability generated by each customer segment? Advise Sound Wizard Ltd if they
should consider dropping any customer?

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Solution and Discussion:

Sound Wizard Limited
Customer Account Profitability Statement
HI-FI X
10,000
000
400.0
(120.0)
280.0

HI-FI Y
5,000
000
200.0
(60.0)
140.0

HI-FI Z
3,000
000
120.0
(36.0)
84.0

Other
6,000
000
240.0
(72.0)
168.0

Total
24,000
000
960.0
(288.0)
672.0

Delivery cost
Emergency delivery
Order costs
Trade Discount
Sales commission
Publicity costs

(5.0)
(1.0)
(80.0)
(40.0)
(27.0)

(2.5)
(0.6)
(30.0)
(20.0)
(49.0)

(6.0)
(1.0)
(1.4)
(24.0)
(12.0)
(45.0)

(37.5)
(2.0)
(14.4)
(24.0)
(57.0)

(51.0)
(1.0)
(5.0)
(148.4)
(96.0)
(178.0)

Profit

127.0

37.9

(5.4)

33.1

192.6

C/S %
Profit/Sales %

70%
32%

70%
24%

70%
(5%)

70%
14%

70%
20%

No of units sold
Sales
Variable prod cost
Contribution

Commentary:
The C/S ratio for all outlets is a constant 70%. However, the net profit to sales ratio varies from
32% for HI-FI X to a 5% for HI-FI Z. There are several reasons for this range in profitability.
HI-FI Z, though a small customer compared to the others, has managed to negotiate very
favourable terms (a 20% trade discount) and high publicity expenditure allowance. It also places
several small orders and is the only outlet in need of emergency deliveries.
Customer HI-FI X on the other hand, (Sound Wizards largest customer) is prudent in the number
of orders it places and publicity expenses are relatively low making it the most profitable of all
the customers. The profitability of Other Sound Centres is 14% as delivery costs are high. This
could be due to several deliveries being made to various Sound Centres rather to one central
warehouse.
A customer profitability analysis highlights loss-making customers such as HI-FI Z and enables
organisations to have the necessary information when negotiating new contracts.
Conclusion:

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From the financial analysis above Sound Wizard may decide to drop customer Z as it makes a
loss.
They should however consider other important qualitative factors before such a serious decision
is made:
- Can they renegotiate the discount policy?
- Will they be able to reduce publicity expenditure in relation to customer Z?
- Should they start charging for emergency deliveries outside the normal delivery
schedule?
- Can the spare capacity that becomes available be put to better use?
Sound Wizard should also consider any impact this decision may have on the sale of its other
products and its long-term relationship with customer Z.
Remember it may be possible to hypothesise that Z is in fact a relatively new customer with
high future growth potential.
This might explain the high publicity costs and more erratic ordering history not to mention the
very favourable discounts granted and the apparent willingness of Sound Wizard Ltd to
accommodate the needs of this potential future Cash Cow.

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