Lean Enterprise Accounting

In Chart 3, we show product cost. Moving from left to right, each additional product adds cost. The end point of each line corresponds to a cost on the financial statement.

Direct Cost (Red)-- This is the sum of direct materials and direct labor. Since products and margins are similar, these costs increase in proportion to sales and the curve parallels the sales curve in Chart 1. The total is $10,500,000.

Factory Overhead (Purple)-- Here, the trouble starts. Traditional accounting systems allocate overhead with a simple formula, often based on direct labor. If this were correct, the overhead curve would mirror the sales and direct cost curves.

For a variety of reasons, low volume products attract far more overhead activity per unit than do high volume products. (see examples at "Why Low Volume Costs More).

One can well argue that the factory overhead curve should be a straight line or even a line with increasing slope.

To be conservative, we assume a somewhat linear curve that partly parallels direct cost. We know the staring point ($0.00) and the endpoint ($6,300,000) from the income statement. These final numbers are usually reliable, only the shape of the curve between them is open to question.

Sales Cost--These are the costs of sales salaries, commissions, advertising and other sales-related activities. These costs must also be added to each product cost. The rationale is similar that for factory overhead.

G & A--This is corporate administrative costs and other overhead not directly related to the factory. The total is $1,400,000 and the shape of the curve is similar to factory overhead.

Asset Cost-- This is the cost of assets used, directly or indirectly, for the product. It includes inventory, equipment and facilities. We estimated 6% per year and allocated the assets similar to overhead. The total is $1,000,000.

Note that 50% of the total cost is allocated rather than collected directly. In addition, the allocation is made on a component representing 20% of the total cost. In most companies, the allocated portion is even higher.

Our next chart shows the profit (before taxes) with increasing product variety. Profit equals cumulative sales (blue) minus cumulative product cost (red). The total product cost in Chart 3 is the sum of all costs in Chart 2 at each point.

Note that the profit curve peaks at Product C. Only Products A, B and C are profitable! Products D and E almost breakeven and the remainder lose money.

Simplicity Electronics makes a lot of money ($6,600,000) on three products and then gives over half of it away on six low volume products.

This is not an exact analysis and the precise breakeven point might be questioned. However, there should be no doubt that at least 3-4 of the lowest volume products are money losers.