Most standard cost systems give a misleading picture of customer profitability. For example, overhead is often distributed based on labor hours, machinery hours or some other uniform index or formula.  But the overhead costs per product or customer are driven more by transaction rates than by production rates.  So when product or customer profitability is looked at through only a production lens the information is misleading and often flat-out wrong. The end-result is an arbitrary cost figure that has nothing to do with reality.

Instead organizations should look at profitability through a lean manufacturing or lean accounting perspective where overheads are allocated according to the product or customer transactions that drive them.  Looking at the world through this lens results in a different type of analysis.  While the true exact costs may never be known due to the myriad of factors involved, this type of analysis will provide a reasonable picture of the real cost and profit margins for both customers and products.

A simple analysis would look like this:

Average sales price for a product or to a particular customer or customer group

Less:
            Cost of materials

            Cost of labor (at standard)

            Outside processing costs

            Any unique costs attributable to that product (e.g., scrap, engineering, energy…)

(A unique cost should, at a minimum, amount to more than 10%  of the overall expenditure for that particular line item to be worth attributing to a product or product family.  Anything less than this and you simply begin the game of allocations.)

The remaining difference is Product Profitability.  This is your contribution margin or dollars to cover remaining overhead and SG&A expenditures that are not part of the direct production costs.

Continuing on to Customer Profitability - subtract out specific customer related cost from the above number.  These could include: product returns, customer promotions, unique product features, unique distribution or other special services demanded by customer.  You also do not need to build a complex tracking system to keep an eye on this information.  Simple methods will work just fine.

One reason to look at these costs is if something happens to this customer or product grouping, then the company has a significant cost decision to make, in terms of the coverage activities included in the overheads associated with that product or customer.  It also provides much better information for management decision making.

Better customer and product profitability analysis is one of the goals of Lean Accounting.  Other actions can be taken to further reduce unnecessary accounting transactions and improve performance reporting.

Please contact us if you would like to learn more about your customers’ or products’ profitability or if you would like a copy of our Lean Accounting Assessment instrument to ascertain how lean your accounting practices are.

Call Rainmakers at 847/251-3327 for information or assistance.