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Case Herttas Ketchup
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Cost and Profitability Accounting
Content of the course
1. Introduction
• Review of business operations and processes
• Basics of Excel
• Basics of percentage calculations
• Case: Hertta’s Ketchup
• Introduction to accounting
2. Cost-volume-profit analysis
3. Cost accounting
4. Pricing
5. Controlling in small and medium sized enterprises
Content
Financial accounting course is the prerequisite
for this course. Hertta’s ketchup is an
introduction example where the key
terminology is reviewing.
Terminology is including all relevant terms
from company starting point to analyzing
profitability of the company.
Company
Hertta is going to establish an own company.
Business idea is to produce and sale ketchup to
the companies on wholesale and restaurant
industry on the domestic market.
Hertta has bought already the ketchup
production machine. Machine is half automatic
which is mixing the raw materials, heating and
packing the ketchup. Machine is able to pack
60 ketchup packs per hour.
Products
CAPACITY
=
Maximum performance of a company,
machine, device etc. on the certain period of time.
Products
Hertta’s company’s capacity is 10.080 ketchup
packs per month.
21 days x 8 hours per day x 60 packs per
hour.
Even thought Hertta is estimating that first year
production and sales is only 7.500 packs per
month. Ketchup pack’s weight is 1 kilo.
Products
LEVEL OF ACTIVITY (utilized capacity)
=Actual performance of a company,
machine, device etc. on the certain period of time
• Hertta was estimating that company’s level of
activity in the first year would be 7.500 packs
per month.
Products
• When comparing the level of activity to the
capacity, are speaking about Utilization Ratio
• Utilization ratio is showing how many percent of
the capacity is now in use.
UTILIZATION RATIO
=
LEVEL OF ACTIVITY / CAPACITY X 100
Products
• Hertta’s company Utilization Ratio is 74,4 %
• In that case machine operating hours are 125
hours per month
• Hertta employs a new assistant to use the
machine. Hertta is concentrating to work of
marketing and administration.
Sales revenues
• Hertta’s target price per ketchup pack is 1 €
(without VAT). Hertta benchmarked own price
with competitors’ prices.
• Company’s total sales revenues are calculating
as follows:
SALES REVENUES
=
VOLUME OF PRODUCTION X PRICE PER PACK
Sales revenues
• Hertta’s total sales revenues with planned level
of activity (production volume) is 7.500 € per
month
7.500 produced packs per month x sales price
of 1 € per pack
Factor of production
• To be able to produce ketchup, Hertta needs following factors of production:
– Premises
– Machine
– Insurances
– Phone and telecommunication network
– Marketing services
– Office supply (papers and other materials)
Factor of production
– Entrepreneur’s contribution of work and knowledge
– Self-employed person’s pension
– Raw material
– Packs
– Electricity
– Devices and other material
– Assistant’s contribution of work
Cost of production
• Using factor of production in production process
is causing costs.
COST OF PRODUCTION
=
VOLUME OF FACTOR OF PRODUCTION X
UNIT PRICE OF FACTOR OF PRODUCTION
Cost of production
• Premises are rental premises
– Rent of premises is 118 € per month
• Price of machine was 22.200 €
– Hertta is estimating that machine’s operating time is 5 years (= machine is in use)
– Divide purchasing price by the operating years (straight-line depreciation)
Annual depreciation cost
Cost of production
– Machine depreciation is then 370 € per
month
• Hertta needed 22.200 € bank loan for
machine purchase. Annual interest cost of
the loan is 8 %
– Interest cost is then 148 € per month
• Insurances 51 € per month
Cost of production
• Phone and telecommunication network costs
are 150 € per month
• Cost of marketing and sales actions are about
202 € per month
• Office supply costs are about 80 € per month
• Hertta estimates that her own hourly target
salary would be 10 € per hour
Cost of production
– Hertta’s monthly salary is 1.680 €
• Self-employed person’s pension costs are
about 16 % of her salary
– Pension cost is then 269 € per month
• Raw material cost is 0,30 € per kilo
• Packs are 0,10 € per piece
Cost of production
• Machine is using electricity 6 kW per hour
– Price per kWh is 0,07 €
Electricity cost is then 53 € per month
• Costs of machine materials are about 50 € per
month with the planned level of activity
Cost of production
• Assistant salary is paid by performance
– Agreed pay is 0,10 € per pack
• Indirect employee cost is about 50 % of the
salary
• IS HERTTA’S BUSINESS PROFITABLE?
Profit or loss
• Form of basic profit calculation:
SALES REVENUES- COST
= PROFIT OR LOSS
Profit
• On the last row will be profit if
– sales revenues > total cost
• There will be loss if
– sales revenues < total cost
• Organizations and clubs are also using terms
surplus or deficit
Profit statement
• Hertta’s company empty monthly and annual profit statement is
as follows:(EUR) Monthly Annual
INCOMES
Sales revenues
COSTS
Rent
Depreciation
Interest
Insurances
Phone and network
Marketing services
Office supply
Entrepreneur’s salary
Pension
Raw material
Packs
Electricity
Other material
Assistant’s salary
Indirect employee cost
TOTAL COST
PROFIT OR LOSS
Profit statement
• Hertta’s company monthly and annual profit statement is as
follows: (EUR) Monthly Annual
INCOMES
Sales revenues 7 500 90 000
COSTS
Rent 118
Depreciation 370
Interest 148
Insurances 51
Phone and network 150
Marketing services 202
Office supply 80
Entrepreneur’s salary 1 680
Pension 269
Raw material 2 250
Packs 750
Electricity 53
Other material 50
Assistant’s salary 750
Indirect employee cost 375
TOTAL COST 7 296 87 552
PROFIT OR LOSS 204 2 448
Profit
Why profit is necessary to be able to run the
business?
Profit
Why profit is necessary to be able to run the
business?
– Compensation of entrepreneurs’ contribution
of work
– Compensation of the invested money to the
company
– Compensation of company risk
– Money for new investments
– Reserve for possible coming losses
Contribution margin calculation
• It is necessary to understand costs and what drives and creates costs. Spliting costs between variable and fixed costs, helps to analyze the relationship of costs, volume and revenues.
SALES REVENUES- VARIABLE COST= CONTRIBUTION MARGIN- FIXED COST= PROFIT (OR LOSS)
Calculating the contribution margin
– Comparable to sales margin (and gross
margin)
– Is based on the split of costs into variable
and fixed costs.
– Indicates how many Euros a company has
to make to cover fixed costs and targeted
profit
Variable cost
• Part of the usage of factor of production are
depending straight on the company’s level of activity
• On that case level of activity is effecting also the
amount of the cost of factor of production
• Variable costs increase when production volume
increases, when production is in standstill, in
principle the are no variable costs
VARIABLE COST=
Cost that is directly depended on the level
of activity on the short run
Fixed cost
• Costs which are NOT depending on the fluctuations
on the usage of factor of production
• Will not vary with increase or decrease in
production, are more a function of time
• Are not expected to change in the short run, even
though fixed cost might not be on the same level
every month but reason is something else than
change on the level of activity.
FIXED COST=
Cost that is NOT depended on the level
of activity on the short run
Hertta’s contribution margin calculation
(EUR) Monthly Annual
INCOMES
Sales revenues 7 500 90 000
VARIABLE COST
Raw material 2 250
Packs 750
Electricity 53
Other material 50
Assistant’s salary 750
Indirect employee cost 375 4 228 50 736
CONTRIBUTION MARGIN 3 272 39 264
FIXED COST
Rent 118
Depreciation 370
Interest 148
Insurances 51
Phone and network 150
Marketing services 202
Office supply 80
Entrepreneur’s salary 1 680
Pension 269
TOTAL COST 3 068 36 816
PROFIT OR LOSS 204 2 448
Structure of contribution margin
calculation
Total sales
- Variable cost
= Contribution margin
- Fixed costs
= Profit
Sales
revenues
Variable
costs
Contri-
bution
Fixed
costs
Profit
Note: Fixed costs include
depreciations, interests and taxes.
– Contribution margin €
= Total Sales – Variable costs
– Contribution margin-%
–Relative contribution margin
= Contribution margin / Total sales x 100
Contribution margin
Profit
– Profit (Profit or loss)
= Contribution margin – Fixed costs
– Profit-%
– Relative profit
= Profit / Total sales x 100
Formats of contribution margin
calculation
(sold 10 units) € per unit € total %TOTAL SALES 10 100 100%- VARIABLE COST 4 40 40%= CONTRIB. MARGIN 6 60 60%- FIXED COST 5 50 50%= PROFIT 1 10 10%
Exercises: structure of contribution
margin calculation
A) Travel Agency’s sales revenues in 2010 were
40 000€, variable costs 30 000€ and fixed
costs 6 000€. Prepare contribution margin
calculation (€ and %) for the company.
B) Viuh Ltd sells skates. Purchasing price of the
skates is 60 €/pair. Fixed costs are 4500
€/month. In May Viuh Ltd sold 150 pair of
skates to the price of 100 €/pair. Prepare
contribution margin calculation (€ per pair, €
total and %). What are the contribution margin-
% and profit-%?
Exercises: structure of contribution
margin calculation
C) Sales is 215 000 €, variable costs are 75 000 €
and fixed costs are 98 500 €. What is
contribution margin and profit in Euros and
percentage format (prepare contribution margin
calculation)?
D) Company’s sales is 150 units per month, sales
price is 80 €/unit. Variable costs are 48 €/unit
and fixed costs 3 000 € per month. Calculate
profit per unit, monthly profit in Euros and in
percentage format. Use the model of
contribution margin calculation.
Profitability
• How can we affect the profitability? Options to
increase the profitability?
Profitability
• Different options to affect profitability:
– Increase the level of activity
– Increase the sales price
– Decrease the variable costs
– Reduce the level of fixed costs
– Change the product mix
Cost – Volume – Profit graph
• Good form to analyze the factors which have effects on
profitability is Cost – Volume – Profit graph
CostsRevenues
€
Level of activity
Total sales revenues
Cost – Volume – Profit graph
Fixed cost
CostsRevenues
€
Total sales revenues
Level of activity
Cost – Volume – Profit graph
Total costs
Variablecost
CostsRevenues
€
Level of activity
Total sales revenues
Fixed cost
Partial and Total Adjustment
• If Hertta wants to change the level of activity in the future, she is doing total or partial adjustments.
• Partial adjustment = Change the Level of activity
– Adjustment on time
– Adjustment on productivity
– Adjustment on volume
– Temporary adjustment on level on action
• Total adjustment = Change the capacity
– Permanent change on level of activity
Partial and Total Adjustment
• Example of partial adjustment:
– Adjustment on time:
• Running the ketchup machine in two shift
– Adjustment on productivity:
• Machine improvement, machine is able to produce and pack 70 pieces per hour (original 60 pieces per hour)
– Adjustment on volume
• Rent temporarily an other machine for a major order
• Example of total adjustment :
– Hertta’s Ketchup purchases an other machine to double the capacity
Exercises: capacity, level of activity
and utilization ratio
1. Pizza Girls Ltd sales in 2007 was 12.000
pizzas. A) What was capacity, if utilization ratio
was 60%. B) What is the level of activity in
2006, if utilization ratio was 50%.
2. Utilization ratio of Shoes Ltd was in 2005 85%
and in 2006 75%. Reduction in amount of
production was 2.596 shoes. What is
company’s capacity?
Exercises, solutions
1. A) Capacity 20.000 pizzas
(12.000 / 60% x 100%)
B) Level of activity 10.000 pizzas
(20.000 x 50%)
2. Capacity 25.960 shoes
(2.590 / 10% x 100%)
Key terms
Capacity
Level of Activity
Utilization ratio
Sales revenue
Factor of
production
Cost
Profit or loss
Profit Statement
Contribution margin
Variable cost
Fixed cost
Cost-Volume-Profit
graph
Profitability
Partial and total
adjustment