Costing for the Fashion Industry: Second edition 9781350078901, 9781350078895, 9781350078918, 9781350078970

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Costing for the Fashion Industry

BLOOMSBURY VISUAL ARTS Bloomsbury Publishing Plc 50 Bedford Square, London, WC1B 3DP, UK 1385 Broadway, New York, NY 10018, USA BLOOMSBURY, BLOOMSBURY VISUAL ARTS and the Diana logo are trademarks of Bloomsbury Publishing Plc First published in Great Britain by Berg 2011 This edition published by Bloomsbury Visual Arts 2020 Copyright © Nathalie Evans, Michael Jeffrey and Susan Craig, 2020 Nathalie Evans, Michael Jeffrey and Susan Craig have asserted their right under the Copyright, Designs and Patents Act, 1988, to be identified as Authors of this work. For legal purposes the Acknowledgements on p. 226 constitute an extension of this copyright page. Cover design: Charlotte Daniels Cover image © MirageC/Getty Images All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or any information storage or retrieval system, without prior permission in writing from the publishers. Bloomsbury Publishing Plc does not have any control over, or responsibility for, any third-party websites referred to or in this book. All internet addresses given in this book were correct at the time of going to press. The author and publisher regret any inconvenience caused if addresses have changed or sites have ceased to exist, but can accept no responsibility for any such changes. A catalogue record for this book is available from the British Library. A catalog record for this book is available from the Library of Congress. ISBN: HB: 978-1-3500-7890-1 PB: 978-1-3500-7889-5 ePDF: 978-1-3500-7897-0 eBook: 978-13500-7892-5 Typeset by Deanta Global Publishing Services, Chennai, India To find out more about our authors and books visit www.bloomsbury.com and sign up for our newsletters.

Costing for the Fashion Industry SECOND EDITION

Nathalie Evans, Michael Jeffrey and Susan Craig

Contents

Introduction  viii

1 Small and medium-sized (SMEs) clothing businesses  1 Introduction  1 Leadership in SMEs  1 Business strategy  2 Processes, products and services  4 Exercises  5

2 Risk management  10 Introduction  10 Business risk management  11 Financial risk management  13 Developing a risk management plan  14 Specific risks affecting the fashion industry  15 The industry response  17 Key performance indicators  19 Exercises  23

3 Global awareness and new markets  27 Introduction  27 The global supply chain  27 Barriers and facilitators in market-entry strategies  28 Contemporary issues  29 Purchase order  30 Lead times  34 Critical path  35 Exercises  38

4 Product cost when sourcing  39 Introduction  39 Global sourcing  39

Range planning  40 Factories  41 Shipping terms  41 Exercises  43

5 The nature of clothing manufacture and the need for costing  47 Introduction  47 What is clothing manufacture?  47 Two important questions  48 Definition of cost  49 The need for costing  49 From manufacturing to sourcing  51 Exercises  52

6 The elements of cost  54 Introduction  54 Classification of cost  54 Direct costs  55 Indirect costs – the overheads  61 Exercises  64

7 Costing over periods of time  69 Introduction  69 Period cost reports  69 Capital equipment costs  70 Depreciation – the straight-line method  71 Period cost report  72 Stocks and inventory  75 Value of the work-in-progress  77 Period end adjustments  78 Exercises  82

8 Product cost – job costing  85 Introduction  85 What is job costing?  85 Treatment of the direct costs  86 Treatment of the overheads  88 Absorption of production overheads  88 Cost centres  91 Absorption of non-production overheads  92 Contents 

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Example of a job cost  93 Over-/underabsorption of overheads  94 Process costing  96 Exercises  97

9 Marginal costing  102 Introduction  102 Variable costs  102 Fixed costs  103 Semi-variable costs  104 Contribution  104 Treatment of the semi-variable costs  107 Case study  109 Exercises  111

10 Break-even analysis  114 Introduction  114 Establishing the break-even point  114 Break-even tabulation  115 Break-even chart  117 Margin of safety  118 Profit/volume chart  119 Break-even point by calculation  120 Break-even illustration  121 Exercises  123

11 Budgeting and standard costing  125 Introduction  125 Budgeting  125 The cash budget  126 Sales lag  129 Flexible budgets  130 Zero-based budgeting (ZBB)  131 Standard costing  132 Variance analysis  132 Direct material  134 Causes of direct materials variances  136 Direct labour  137 Causes of direct labour variances  140 Overhead in standard costing  141

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Advantages and disadvantages of standard costing  142 Exercises  143

12 The changing nature of cost  150 Introduction  150 From traditional to advanced manufacturing technology  151 Just-in-time  152 Component manufacture and assembly  152 Summary of changes in costs with the move into advanced technology  153 Cost behaviour change  155 Service industries  156 Activity-based costing  156 Exercises  157

13 Activity-based costing  158 Introduction  158 Activity-based costing  158 Advantages and disadvantages of ABC  164 Activity-based budgeting  165 Exercises  166

14 Capital investment decisions  170 Introduction  170 The capital cost  171 Accounting rate of return (ARR)  171 Net cash inflows  172 Payback period  174 Discounted cash flow (DCF)  175 Discounted payback period  177 Conclusions  181 Exercises  181 Bibliography  188 Answers to exercises  190 Acknowledgement  226 Index  227

Contents 

vii

Introduction

Students are attracted to the fashion industry for a whole host of reasons – they like fashion, they are enthusiastic about clothes and fabrics, they see it as a vibrant global industry that they want to be involved in and they have a desire to be a part of this industry. This has been fuelled by glossy magazines, television programmes, online resources and influencers such as bloggers. Universities who keep up with the trends, offer placement programmes and develop contemporary courses receive a healthy number of student applications. While not all graduates will end up as high-end fashion designers, a high proportion will find employment in the industry in a range of jobs throughout the fashion supply chain. Parents and advisors of students often think that because clothing manufacture in the UK has declined significantly that this is a twilight industry. Nothing could be further from the truth; the fashion industry is a vibrant multi-billion-dollar global industry with exciting national and international job opportunities. We all have more clothes in our wardrobes than ever before, and there are more and more specialist performance garments available than ever before. The challenges that the industry faces are also significant and will bring a new perspective to employment. Some of these challenges relate to the environment and its protection, ethical issues, rapidly changing technology and the shifting base of the fashion industry but all will provide new graduate entrants to the industry with a varied and potentially fascinating career. Once students start their studies, they often find the technical parts of the programme difficult – specializing is more exacting than they expected. Many new skills need to be learned, for example: technical knowledge of fabric construction and performance, pattern construction, computer aided design (CAD), garment construction and supply chain management. They also find that fashion is a hard-nosed industry that has to make profits and

part of that profit making is in the containment of costs. That might be the containment of manufacturing costs or of sourcing costs, but either way it will impact on the final price point of the garment and the profit margins to be obtained. Some students will seek employment and others will start their own business. As many students start businesses while at university and continue their entrepreneurial activities after graduation, it is essential to have commercial acumen to flourish in this margin-driven sector. This book is intended for those wanting an understanding of costing in relation to the clothing/fashion industry. Jones (2006) provided a background that helped to contextualize the terminology used. He defined the term supply chain as companies independent of each other but working towards a common goal (such as producing garments). However, terms such as clothing, fashion, apparel and garment are used in turn and whenever appropriate in a specific context and, unlike in Jones, will not be grouped under one umbrella. The objective of the book is to introduce the reader to the principles of costing and the terminology used to give them an understanding of the composition of cost and a vocabulary of terms that will be useful when considering costing issues. It is intended to do this in a non-confrontational way and to introduce the numeracy gradually. We would stress that there are no complicated mathematical processes involved in the work; an ability to add, subtract, multiply and divide will be sufficient, though a pocket calculator will be useful in dealing with the numerical applications. In this revised edition, we felt that it would be useful to add some context in Chapter 1 – ‘Small and Medium-sized (SMEs) Clothing Businesses’ – and some advice on how to manage risk in a business using key performance indicators (KPIs). The first chapter provides an overview of entrepreneurs/owner managers and how they grow their businesses. This chapter summarizes findings from three case studies on SMEs clothing suppliers. The case studies are presented at the end of the chapter. The focus on SMEs in this sector arose from the fact that their numbers in the UK is increasing. Some of the critical success factors are examined in the first two chapters. Chapter 2 in particular focuses on KPIs in this sector. The book also includes chapters that relate to the global nature of the fashion industry and the costs incurred when sourcing garments overseas to reflect the current nature of the industry in the UK and abroad. Another chapter discusses what is involved in garment manufacture. This is essentially the

Introduction 

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conversion of fabric and cloth into wearable garments, and it is important that design and buying students have a concept of these processes. The manufacture may not take place in the UK or Europe and garments are most likely to be sourced from far-flung places around the world. However, the manufacturing processes are broadly the same but facilitated by technological advancements. The costing aspect of the book starts with the elements of cost and product cost but also looks at other issues like marginal costing, standard costing, the changing nature of cost and new ideas relating to product cost such as activity-based costing. It also gives an introduction to capital investment appraisal as this is also an area where students may become involved once in employment in the industry. However, this is presented entirely within the context of the clothing/fashion industry with examples that reflect this. Each chapter also has a small bibliography of additional reading and references that will enable students to read further about topics of interest or topics that are essential to their programme. A more detailed bibliography is given at the end of the work. It is intended that this book will be of use to clothing and fashion students who will find it easier to relate to than the standard textbooks on cost accounting. The book does not contain the detailed technical issues that might be found in a standard cost accounting text; if more detail in these areas is required, then the student should refer to standard accounting texts, some of which are detailed at the end of the chapters. This book may also be of use to those already employed in the fashion industry to give them a better understanding of the principles of costing applied to their industry and to provide a formal structure for what they have learned in practice. The book is not specifically written for students of accountancy, though those involved in the apparel industry may find it useful to help put their generic studies into a specific industry context. The book contains some information on recording costs but does not go into the detail of cost accounts and their reconciliation with the financial accounts of the business. Nor, on a technical point, does it deal with the issue of over-/underabsorption where absorption costing systems are in use. Similarly the book does not concern itself with detailed computer applications; it is essentially about the principles. The book does not concern itself with financial accounting or taxation issues. These are different subjects and would require different texts and a different focus.

x Introduction

The chapters in the book contain activities and exercises to enable the student to understand the content of each chapter and to practise the methods shown. Doing these activities and exercises will assist the learning process. Model answers to most of the exercises are given at the end of the book, but do not look at these until you have attempted the exercise yourself. In addition to the reading detailed at the end of chapters in the book, we also suggest that reading journals and magazines is a good way to be up to date with the latest developments in the industry. The following periodicals and online resources will help with the global context of your broader studies of the fashion industry and also give you a concept of the extent of jobs available in the industry: Drapers GlobalData Just-Style.com Retail Week Textiles Intelligence Textile Technology Index The Business of Fashion The Journal of Fashion Marketing and Management We wish you well with your studies and hope that this book sheds light on what might otherwise seem a daunting topic.

Introduction 

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xii 

1 Small and mediumsized (SMEs) clothing businesses

Introduction The literature on UK entrepreneurs and SMEs is abundant; however, none of it focuses on clothing suppliers. Clothing suppliers in this context are businesses who buy goods from factories/agents overseas and sell them to the retailers either directly or via agents/distributors. This chapter combines findings from case study research on three UK SMEs clothing suppliers with common themes presented in the literature. The results of the studies revealed that individuals start and manage businesses for various reasons such as wanting more independence, seeking personal achievement, achieving financial gain and/or earning recognition. However, the need for a regular income, fear of loss of or having no capital, aversion to risk and doubts about one’s own ability to succeed can be off-putting. A business start-up may not be suited to everyone because it requires resilience, confidence, self-reliance, business acumen and specific characteristics. One thing is for sure: entrepreneurs are tenacious and resourceful. As SME is the focus of this chapter, it is necessary to be clear on what is meant by micro, small and medium-sized enterprises. There is no absolute definition; however, the consensus is that micro-sized enterprises employ no more than ten people, small-sized enterprises employ no more than fifty people and medium-sized enterprises employ no more than 250 people.

Leadership in SMEs The SME sector is diverse and characterized by individuals with different personalities, skill sets and practices. This means that leadership and

management styles vary, affecting business performance. This section examines some entrepreneurs’ main traits, while the next focuses on strategy. Entrepreneurs pursue opportunities irrespective of the resources available and often overcome obstacles because they see possibilities rather than problems. They are agents for change who combine people, money and other resources to create openings. Additionally they have an agile mindset; they are opportunistic, are strong networkers and possess an ability to employ the right people. They build dynamic capabilities because they recruit and nurture talent so when new prospects occur, they can focus and relinquish some responsibilities while remaining fully in control of their business. The workplace tends to be informal and can appear chaotic but because entrepreneurs are intuitive and possess an inherent sense of who should work in their business, this set-up appears successful. Entrepreneurs are reactive which, combined with their networks, enables them to take advantage of opportunities quickly. Because of these abilities, they can build strong relationships with people such as suppliers. For example, they can negotiate reduced lead times and costs, because of the trust established which creates competitive advantages. Not all entrepreneurs are born managers and vice versa. Entrepreneurs are innovative and risk-takers but do not always possess an in-depth knowledge of all aspects of their business as they often rely on their staff to deal with the day-to-day enquiries. They tend to focus on the big picture rather than the detail, which can lead to haphazard decision-making. Two entrepreneurs with the same resources, threats and opportunities will not have the same level of success because internal and external environments differ. This means that entrepreneurs need to manage change but acknowledging that there may be a need for change will depend on the entrepreneur leadership style. Some entrepreneurs are authoritative and adopt a top-down approach, others create informal structures which encourage collective efforts and still others believe that employees should be empowered and rewarded based on their performance. The leadership style affects the business performance, staff turnover and strategy for growth.

Business strategy It is common for SME clothing suppliers to seek opportunities outside the UK. The economic climate within the domestic market, the need for growth or

2  Costing for the Fashion Industry

market saturation may trigger overseas expansion plans. Some SMEs start up with global ambitions and export goods from their inception; this is facilitated by e-tailing. However, most traditional SMEs clothing suppliers operate in the domestic market for many years then gradually progress into international markets. This pattern is changing because more and more students and graduates start businesses. This is because they are familiar with the latest technology, they possess a business global mindset and their universities support their entrepreneurial endeavours. For traditional businesses, however, one popular market-entry mode is via intermediaries such as agents or distributors. This is because they are local and familiar with the culture, they understand their home market and how product ranges will fit within it, which provides a significant business advantage. Interestingly, these business contacts are often made haphazardly, perhaps during a chance encounter at a specialist trade fair, and are seen as a low-risk opportunity. SMEs owners have ambitions and goals that are set through strategic planning; however, decision-making is affected by volatile trading environments. Even though the global market place is increasingly homogenized, selling goods abroad necessitates a degree of adaptation to meet local market conditions. Packaging and labelling and occasionally product ranges need altering necessitating additional resources, which is why adaptations should be minimized. Bricks-and-mortar fashion retailers are struggling and so they are more demanding with their suppliers. On the one hand, retailers have to satisfy consumers’ appetite for constant wardrobe updates by selling exciting product ranges. On the other hand, they have sales targets and margins to achieve to afford to keep their shops running. SME clothing suppliers are suffering because retailers are placing smaller order quantities; they are demanding shorter lead times and are more aggressive with price negotiations. As a result, clothing suppliers need to make strategic management decisions to evaluate where they are, where they want to be and how they will get there. As part of their strategic planning, they may decide to internationalize their operations. To do this, they could carry out a PESTEL (Political, Economic, Social, Technological, Environmental and Legal) analysis to scan the market environments of the countries they wish to enter. Specialized organizations such as AT Kearney and Euromonitor provide KPIs (key performance indicators) on market attractiveness, ease of doing business, corruption, GDP, technological advancements and so forth. This knowledge, combined with a SWOT (strength/weaknesses [internal]

Small and Medium-sized (SMEs) Clothing Businesses  3

opportunities/threats [external]) analysis of the organization, will help businesses achieve their internationalization goals. Additionally, businesses can maintain a competitive advantage and extend their products’ longevity through innovative designs, packaging and branding.

Processes, products and services This relates to the SMEs clothing suppliers’ design, management and improvement of processes to satisfy and generate increasing value for customers. Research shows that business objectives and processes are developed in accordance with sales forecasts extracted from past and present performances. The business strategy is often developed with and communicated to sales teams but not necessarily to other employees who tend to find information out via word-of-mouth. To inform the sales strategy, the entrepreneur keeps abreast of current affairs and monitors labour costs, exchange rates, cotton prices, development on the high street, mergers and acquisitions. Consultations with customers facilitate the forecasting of order sizes so that factories’ capacity can be booked in advance. This initiative enables businesses to prepare cash flow forecasts. This is key because financing and cash flow are areas where small businesses struggle. Getting hold of the correct sampling is another issue for fashion SMEs. The difficulty relates to obtaining salesman samples that are commercially viable to be presented to buyers. Initially the sales team will show buyers computer aided designs (CADs) of the collection; buyers will select some products and request samples before finalizing orders. If samples are not almost identical to the goods that will be sold, buyers will not select them in their range plan resulting in no orders being placed. It is not uncommon for factories to send size set samples (sizes of samples are checked against the size specification chart) instead of salesman samples to avoid the costly production of additional samples. If samples do not reflect the CADs produced by designers, sales opportunities will be lost. Typically samples take four to six weeks to arrive in the UK; they are often in the incorrect fabric, colour and with trims clashing with the rest of the garment. Factories often complain that they cannot produce correct samples because production has not started leaving them with little choice other than purchasing components from the market. Samples are not free of charge but they are an investment that can generate sales. However, factories are reluctant to produce them because they necessitate high labour 4  Costing for the Fashion Industry

costs and are not profitable but if they got their sampling strategy right, more orders would follow resulting in a win-win situation. One of the businesses scrutinized in the case studies had great difficulties supplying a well-known online retailer who required an average of 300 samples per season. This was difficult to manage because the business relied on the factories to produce photographable samples for their customer’s transactional websites. They did not have control of the supply chain, as they were reliant on intermediaries to pressurize factories to produce sales samples. Additionally, this situation was time-consuming for the over-deployed staff force who had to constantly follow, return or order additional samples. Therefore businesses should implement a sampling strategy to increase sales opportunities, decrease staff workload and improve cash flow. The other company examined understood that top-quality sales samples would result in sales increase and better relationships with existing customers. Therefore, the business strategy was to set up offices in the manufacturing country where they had better control of the supply chain. In doing so, they gained a competitive advantage by producing sales samples within two weeks, resulting in improved sales figures. Fashion business owners multitask, and therefore lack time, resources and cash flow. Also, they do not always have time to strategize, particularly if the market is so uncertain that they need to be reactive. For example, Paul from Company A is an opportunist who constantly looks for avenues to sell his stock. Because of the different leadership styles and set-up of the three businesses, not all owner-managers recognized and endorsed the need for change in their organization (Hoyle, 2006).

Exercises This section contains case studies relating to three SMEs clothing suppliers located in the UK; one is referred to as Company A, the other as Company B and the last as Company C. These exercises are to be considered for discussion purposes only. Points for consideration are available in the ‘Answers to Exercises’ section. The case studies questions should be considered once you have read Chapters 1–4.

Company A The business was founded in the early 1990s as an importer of value-formoney clothing in the sportswear and childrenswear sector. The business supplied babywear and childrenswear clothing both within and outside the Small and Medium-sized (SMEs) Clothing Businesses  5

UK. The manufacturing process was overseen by intermediaries operating mainly in the Far East. The company had relationships with partners who included retail chains, agents, licensees and distributors. Licensed products extended into a diverse range of categories including clothing, footwear, eyewear, stationery, sports equipment, giftware and toys. In 1997 sportswear company was created to manufacture and distribute internationally renowned brands (having acquired licences) as well as brands created in-house. The Group had an experienced management team as well as staff whose focus was building brand distribution in the UK and worldwide. In 2002, another company was created to manufacture and distribute babywear and childrenswear brands created in-house. The business employed twenty-seven people full-time plus two freelance designers. At that point, the business became a Group and comprised three companies. It employed 100 people and had a turnover of £38 million. It traded with the value and discounted end of the high street as well as mail order catalogues. Goods were sold in many retail outlets in the UK and other parts of Europe. They supplied TK Maxx, Ethel Austin, Intersport, Auchan, Carrefour, The Burton Group, C&A, Matalan, Galleries Lafayette, JD Sports, Littlewoods, Tesco and Topshop. Over the years, the company acquired a reputation for excellent customer service and strived to maintain strong relationships with agent manufacturers. The business lost focus and direction and started to struggle. It regained success for a short period mainly because it obtained the licence for a high-profile clothing brand. The group no longer trades but its babywear and childrenswear business still does. The remaining company has a partnering approach and its resources include a highly focused design department equipped with the latest IT and CAD systems. A flexible in-house reprocessing department and warehousing facilities means that customers’ wants and needs can be served rapidly.

Questions 1. Determine why the Group dissolved while one of their businesses carried on trading? 2. Suggest strategies for growth for the remaining company. Review the AT Kearney report listed in the recommended reading section at the end of this chapter to guide your decisions. 3. Review the list of retailers the group supplied and determine which one/s would be a strategic fit for the remaining company and why. 6  Costing for the Fashion Industry

Company B Company B was established in 1999, and has accumulated many years of experience supplying mainly childrenswear as well as some ladieswear and menswear to many high street retailers. It employs a team of designers, garment technologists, merchandisers and account managers. The business is medium-sized and employs a total of twenty-one people full-time. The business supplies childrenswear to the likes of Boden, The White Company and John Lewis. It also manufactures its own in-house childrenswear and babywear brand distributed through a transactional website and at trade fairs such as Bubble in London. Despite the overheads incurred in exhibiting at trade fairs, it is a worthwhile selling strategy because small independent boutique owners attend and place orders. This saves the account manager travelling to many, small, independent boutiques. The role of managing this brand falls to one person who is also responsible for photographing the garments and uploading them onto the website. Additionally, products have to be dispatched to individual buyers or small boutiques and the trade fairs need to be planned and attended. Despite all the sales executive efforts, the business carries too much stock, which affects cash flow. Company B has a low staff turnover and no regular appraisals are carried out. Sales staff are, as expected, target driven and receive bonuses if the business can afford it. The owner does not solely reward the sales team based on sales volume/targets; he also considers the number of accounts managed. When there are spare funds, he is generous with those he values. He gives cash bonuses at Christmas and expensive gifts at other times to reward his workforce. Salaries are reviewed annually. Newcomers are not trained and are expected to learn on the job. Their abilities to fit in the team and do the job are assessed on a daily basis until staff are deemed suitable for the position. Apart from the Christmas party, staff organized their own social events suggesting that there is camaraderie in the office. The owner operates an open-door policy and is happy to speak to staff personally or for them to contact their line manager. Company B sells products directly to the EU by supplying retailers directly and has done so for the past eight years. Therefore the business is not in direct contact with the market. Their customers are, for the most part, multichannel retailers such as Boden and Cath Kidston. The management of the supply chain is a merchandising and logistics challenge. This is because it required adapted packaging, garment labelling, Small and Medium-sized (SMEs) Clothing Businesses  7

carton markings and deliveries to national satellite warehouses. The packing and shipping requirements for EU orders are complicated because the order sizes are smaller than the UK ones. However, the company cannot turn the business down, as it would have affected the UK business.

Questions 1. What solutions would you propose to reduce the amount of stock the in-house brand carries? 2. Determine which parts of Company B are standardized and which are adapted. 3. Evaluate the style of management cultivated by the owner and suggest changes that you would implement if you were the owner of the business.

Company C The business became a subsidiary of a large American manufacturing and retail Group in 2012. Before that, in 2005, it opened an office in China and moved the bulk of its operations there to reduce staff overheads and achieve an agile supply chain. This business strategy impressed the Group which led to the acquisition. As the Group is a multi-channel retailer which sells products in Europe via a transactional website and through a network of distributors, this acquisition meant that the business gained access to warehousing and distribution facilities within Europe. The Group designs, manufactures and distributes goods in its retail stores in America and worldwide through its website and intermediaries. The Group’s worldwide locations include a corporate headquarters in New York as well as operations throughout Asia, Europe, the Americas and Australia. It operates seven state-of-the-art distribution centres throughout the world and six manufacturing facilities in the United States. In 2011, the business identified maintaining margins as a major issue, recognizing that it operated in a highly competitive market with regard to pricing and promotional activities. The business tried to mitigate against low margins by supplying stock on an FOB (Incoterms® rules) basis, which avoided the requirement for holding stock and stock obsolescence due to changing customer preferences. In 2012, they factored their debts, which was a way of releasing cash and minimizing the risk due to slow payments by

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debtors, ensuring a reasonable cash flow. It stated that it was developing new overseas markets and was leveraging its sourcing capabilities in the Far East. The acquisition had a significant impact on the business; it became more corporate. There were monthly newsletters and Facebook was banned at work. In the UK staff redundancies and relocation packages were offered. However, becoming part of an international business meant increased international revenues and this strategy has paid off for the business.

Questions 1. Determine the advantages and disadvantages of the business being acquired by the Group. 2. Evaluate the different shipping methods (listed in Chapter 4) and highlight the positives and negatives for the seller and the buyer. 3. Do you think that the business could have carried on trading without the Group’s acquisition? Justify your answers and suggest a sales internationalization strategy if it had not been acquired.

Further reading AT Kearney (2017) The Age of Focus. The 2017 Global Retail Development Index™. [online] https://www.atkearney.com/documents/10192/12766530/The+ Age+of+Focus%E2%80%93The+2017+Global+Retail+Development+Index. pdf/770c5a53-d656-4b14-bc6c-b0db5e48fdc1 Bell, J., McNaughton, R., Young, S. and Crick, D. (2003) ‘Towards an integrative model of small firm internationalisation’. Journal of International Entrepreneurship, 1(4) pp. 339–62. Bolton, B. and Thompson, J. (2004) Entrepreneurs: Talent, Temperament, Technique (2nd ed.), Oxford: Elsevier Butterworth-Heinemann. Burns, P. (2011) Entrepreneurship and Small Business: Start-up, Growth and Maturity (3rd ed.), Hampshire: Palgrave Macmillan. Burns, P. (2014) New Venture Creation: A Framework for Entrepreneurial Start-ups, Hampshire: Palgrave Macmillan. Hines, T. (2013) Supply Chain Strategies: Demand Driven and Customer Focused (2nd ed.), London; New York: Routledge. Hollensen, S. (2014) Global Marketing (6th ed.), Harlow: Pearson Education Limited.

Small and Medium-sized (SMEs) Clothing Businesses  9

2 Risk management

Introduction Risk, something that threatens, harm or damage, is an inherent part of business, regardless of the industry type involved. It comes in different forms and with different levels of seriousness and each industry will have some very particular issues or approaches depending on the specific factors that affect its operations, its competitive environment and the speed of response required. Businesses need to identify the potential risks that could affect their operations if they are to formulate responses to avoid or mitigate their impact. These responses can vary from monitoring to direct action and interventions, depending on the perceived level of risk and the degree of control over it. This is known as risk management. This chapter aims to provide a general introduction to risk and the way that it is being managed within the global fashion industry. It is impossible to identify and describe all types of risk and the section is not intended to be comprehensive – just to consider some of the major risks currently impacting the retail fashion industry. Key performance indicators (KPIs) are also introduced, explaining how they are used to monitor, appraise and improve the financial performance of a company, when considering its current and future level of success.

The importance of risk management The global fashion industry is more exposed to risk than many others, as the purchase of clothing, and especially fashion clothing, is seen as discretionary, with many purchases being made on the basis of want, rather than need. Therefore, at times of economic difficulty or uncertainty, individuals quickly cut their consumption of fashion products.

The fashion industry is becoming increasingly globalized and the implications of fashion retailers expanding their sales reach, outsourcing more and generally extending their global supply chain, need to be carefully considered from a risk perspective. Operators within the industry need to be mindful of the cultural, economic, social, technological, political and natural factors impacting throughout the whole of their selling and supply chain. Each one of these carries with it varying degrees of risk, which may or may not be within the control of the retailers and suppliers. Not considering the potential risks or having a plan to deal with them could potentially be very damaging to the business, including significant losses of profit and even administration or liquidation. Like businesses, you too need to be able to recognize risk if you are intending to work within the fashion industry. This starts with an understanding of the different types of risk that affect businesses.

Risk management Risk management can be broken down into two broad strands: general business risk management and financial risk management. Each of these two main strands is considered in further detail in the following section, including examples of how they might manifest themselves within the fashion industry.

Business risk management General business risk management is concerned with the whole of the business and its operating environment, including a consideration of its strategic plans, competitive environment and ways of operating, and factors such as cultural, social, technological and legal changes. These risks are usually subdivided into four main categories: strategic risk; compliance risk; operational risk; and reputational risk.

Strategic risk Every business will have a plan setting out where it expects to be in the long term. This is known as its business strategy. Strategic risk arises when something interferes with this plan, such as a major political or economic problem. For example, an unexpected slowdown of the Chinese economy has caused many luxury brands to reappraise their long-term strategy and

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to shift their focus to other, growing markets within South East Asia, to try to fulfil their strategic aims.

Compliance risk Fashion businesses have a rack of legislation to comply with, including, among other things, law or regulations relating to consumer protection, employment, environmental protection and product safety. Compliance risk arises when a business fails to comply with current requirements, generally through a lack of understanding or knowledge of those requirements. An example of this would be where a business failed to meet the minimum wage requirements, perhaps leading to accusations of modern slavery, as has been seen in allegations made about production within some UK clothing factories.

Operational risk This type of risk arises when the day-to-day operations of a business fail, such as a supplier failing to deliver products or raw materials to schedule, or the loss of key personnel. For example, a high-profile luxury brand recently dismissed its creative director following a racist rant, in an effort to distance itself from his comments and protect the brand’s reputation. This then created an operational risk as the brand was suddenly left without a creative director.

Reputational risk Fashion businesses depend on establishing connections with their customers to develop brand loyalty and encourage repeat purchases. Reputations can take years to establish, but can be quickly and easily destroyed, particularly due to the exposure made possible through social media. Mistakes and misconceptions can quickly spread, and businesses can be forced into making strategically difficult decisions to try to limit brand damage. For example, some suppliers of children’s dressing-up outfits suddenly found their business affected when an accident revealed that, although fully compliant with existing standards, their products only had to meet the lower safety standards for toys, not clothing. To try to minimize the damage to their reputation, many stockists of these products adopted more robust flammability measures under a voluntary code of practice.

12  Costing for the Fashion Industry

Financial risk management Each of the risk strands considered previously is likely to result in a financial impact, either through lost revenue or through additional costs. Financial risk management, though, is concerned with the effect of changes in cash flow in and out of the business. Regardless of the reason, a fall in revenue or an increase in costs resulting in a sudden and significant loss of cash could leave it with insufficient funds to pay debts as they fall due or to be able to trade on a day-to-day basis. This would represent a liquidity problem, leaving it at risk of being placed into administration or being liquidated. There have been several high-profile examples of this within the fashion industry in recent years (see the ‘Answers to Exercises’, later in the text).

Key causes of financial risk There are many potential causes of financial risk within the global fashion industry, but four of the key ones are exchange rate fluctuations, reliance on a few major customers, the loss of a major supplier or other failure within the supply chain and the impact of high levels of debt. Trading internationally increases financial risk due to the exposure of the business to exchange rate fluctuations as a large proportion of clothing purchases worldwide are transacted in non-local currencies. The difference between the value of the transaction, converted using the exchange rates ruling at the times of the purchase and the payment, is called the exchange rate difference. Over the accounting period, this can accumulate to a significant amount and therefore it is seen as being a big financial risk.

Example Let us consider an example with Company A, a UK retailer working in pounds Sterling (£), and Company B, its Chinese supplier, working in US dollars ($), with the transactions following depicted in Table 2.1. On 1 January, Company B supplies dresses to Company A at a total price of $1,000. The exchange rate at this time is £1 = $1.3123 On 31 January, Company A pays Company B $1,000 for the dresses. The exchange rate at this time is £1 = $1.2757

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Table 2.1  Illustration of exchange rate differences Date

Transaction

Cost in $

Exchange rate £1 = $

Cost in £

1,000.00

1.3123

762.02

1 January

Company A buys the dresses

31 January

Company A pays for the dresses

1,000.00

1.2757

783.88

31 January

Exchange loss

 

 

(21.86)

It is very common in manufacturing within the fashion industry for businesses to have a few key customers that account for a significant proportion of their sales revenues. If one of these major customers delays payment, goes into administration or goes completely out of business, then the supplier will not be paid as expected. Similarly, sales create cash flows into a business. If the supply chain fails, perhaps because a supplier goes out of business, or raw materials are late or cannot be obtained, then the business has nothing to sell. Far-shore sourcing creates a risk of delays or loss of product through adverse weather conditions and the further the geographical distance from the selling destination, the greater the possibility of interruption to the supply chain. Political unrest or terrorist activity can similarly disrupt the supply chain. All of these scenarios could cause a major financial risk, through the loss or interruption of cash flow into the business. High level of loans increases financial risk in two ways, the first through having a high level of loans to repay (the capital element) and the second through the interest charged on these loans, where the business must have sufficient cash to cover this as well. Businesses also need to think about their ability to cover interest payments should they suddenly increase due to an unexpected hike in the interest rates.

Developing a risk management plan Risks vary from business to business, even for those within the same sector of the fashion industry, as their means of operating will be different. Tolerance to risk will also vary depending on what the business is trying to achieve. What is important is that risk is actively managed. This involves identifying the principal risks, categorizing their severity (e.g. as high, medium or

14  Costing for the Fashion Industry

low) and then combining this with historical knowledge to determine the likelihood of the risk arising and the estimated financial impact. More importantly at this point, a business can develop a specific plan to respond to these risks, depending on whether it wishes to avoid the risk, minimize it, mitigate it or accept it, to ensure that long-term strategies are achieved, value is delivered to stakeholders and the brand is protected. The start point has to be identifying the way key business activities could be affected, along with a consideration of how much control the business has over the risk, what the financial impact on the business is likely to be and who will be affected. A series of ‘what if?’ questions are often used to deal with this and it is important that businesses think about the possible, not just the probable and certainly not just the normal.

Specific risks affecting the fashion industry Consumer demand and forecasting issues Consumer demand affects every industry, but it is of particular significance within the fashion industry. Fashion retailers plan ranges several months ahead of the selling season and then have a very limited period in which to maximize sales in terms of both volumes and revenues, thus making accurate forecasting essential. The internet, however, has transformed the fashion marketplace, making it increasingly difficult to predict the demand for the season. Consumers can browse for product information and prices and gain comparative information almost instantaneously, making them more informed than ever before, transferring the balance of power from the retailer to the customer. This is exacerbated by open and real-time access to fashion shows, facilitated through livestreaming, coupled with social media access to celebrity looks and lifestyles (referred to in Chapter 3) and the sharing of all aspects of life on social media. Consumers use fashion choices to express their individual style and personality, especially those promoting ‘brand me’ on social media. The traditional two-season offer is no longer seen as enough, with consumers demanding new products throughout the whole year. This creates a problem for fashion retailers as many consumers are looking for more exclusive pieces to differentiate themselves, forcing up the desire for trend-led ever more rapidly changing styles, while still demanding affordable prices.

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Changes in consumer lifestyles create further uncertainty and risk, through the rise and fall of micro-trends that are notoriously difficult to predict, but which require an instant response from the fashion industry. The retail fashion market is over-saturated and customer loyalty, fuelled by choice, is low. Expectations for each of the traditional drivers of loyalty – price, product and service as a minimum – are high, but if a retailer fails to deliver on any of these requirements, then the customer will simply go elsewhere, causing cash inflows to fall.

Big data, personalization and privacy The temptation to expand product offer to meet the increased demand from consumers carries with it the increased risk either of offering too many lines in too small a quantity with the potential for lost sales or of holding excess stock with the likelihood of having to discount. From an industrial perspective, to provide a more personalized service, more data is required, but this carries an increased risk of exposure to data breaches, creating problems relating to privacy, data protection and loss of consumer trust. Consumers are generally willing to provide more data in exchange for a better shopping experience, but they are increasingly concerned about privacy given the recent spate of high-profile company and social media data breaches.

Managing global relationships To reduce the risk of reliance on a small supply chain, retailers are tending towards the use of an extensive global supply network, presenting retailers with exposure to risk through the potential for varying production standards and design consistency across the supply chain. To meet consumer demand for lower prices, much of the supply chain is being forced into developing countries, where labour costs are low, to keep production costs down. This exposes the retailer to the risk of being accused of engaging with unethical practices if workers in the supply chain appear not to be fairly treated. The depth and complexity of the supply chain make it more difficult for the retailer to monitor effectively, but in the event of ethical problems arising consumers, and the public in general, tend to perceive responsibility as lying with the business whose name is on the product, regardless of how much control the organization actually has.

16  Costing for the Fashion Industry

Returns Issues with excess stock, largely created by rapidly changing demand, short product life cycles and rapid obsolescence of trends, are being exacerbated by the increase in online sales, which typically carry a rate of returns in the region of 20 per cent above offline sales. This exposes retailers to increased financial risk through the need to discount products.

Sustainability Many consumers list sustainability and ethics as key considerations in purchasing decisions, although their actual shopping behaviour is not always consistent with this. Consumers state they are looking for more meaningful retail relationships and seek to align their personal values with those of their selected retailers. The ‘take-make-dispose’ approach underpinning many business models operated by fashion retailers is not viewed as good practice by millennials in particular, who will be looking at the sustainability initiatives being instigated by retailers before purchasing, again exposing retailers to the risk of significant lost sales.

The industry response The fashion industry has adapted its global sourcing strategy to accommodate these risk factors, focusing much of its production of short- or unexpectedtrend items on near-shore or re-shored production facilities, where the higher price of production should be offset by the level of full price sales generated by capturing the trend. Although ‘cost’ remains a key issue, the fashion industry has recognized the need for a shift towards initiatives that speed up the supply chain to accommodate changes in market trend, and that the cost of this should be met by operational cost savings elsewhere. Some retailers, especially those operating within the fast-paced fashion sector, are utilizing ‘test and learn’ methods, where data analytics are used to identify which products are selling well and then using this information to scale up production to maximize benefits. With consumer tastes changing rapidly, the fashion industry is turning to the use of big data to more accurately predict consumer demand, with reduced risk of surplus stock. The use of data analytics allows the potential to drive both loyalties and revenue growth through targeted, more personal and relevant communications, creating an improved customer experience.

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The use of big data is also helping the industry to improve responsiveness by using specific customer insight to support a shift from a long end-to-end product development model to a more agile supply chain. This includes exploring new locations to base production, such as Ethiopia, which are close to geographical end markets, but which also provide close access to raw material sources and to a low-cost labour force. Analysis of data also facilitates better merchandising, allowing products to be allocated more appropriately to regions or individual stores, where proximity warehousing can be used to ensure better product availability for consumers. As noted, the use of big data brings with it increased risk of data breaches. Retailers are currently ramping up their data monitoring and security in an effort to prevent this and Data Protection legislation has been modified in part as an acknowledgement of the global explosion of data generation, collection and usage. Fashion retailers are becoming more innovative in addressing the increasing returns issue, including the implementation of reverse logistics strategies, whereby returns are channelled through the most cost-effective route. One example of this is the introduction of dedicated in-store areas, supported by advanced AI technology, for both online and offline returns and the collection of online orders. An advantage of this is that online customers, going into store to process a free return, may be tempted to make additional purchases while there. Improved technology is also being used to allow online customers to virtually try on products to check fit and suitability prior to purchase. Omni-channel initiatives, such as these, should improve both operating profit margins and customer satisfaction, reducing the financial risk posed by the increasing rate of returns. Extended CSR reporting within company Annual Reports is providing many retailers with an opportunity for transparency relating to ethical and sustainability issues. Where this can be linked to visual evidence of sustainability initiatives, such as collection points for clothing recycling, it is more likely to reinforce the view of the company’s practices and mission being in alignment with consumers’ personal values, reducing the risk of negative perceptions. There will always be risks, such as adverse weather conditions and terrorist attacks, which are outside the control of the company. Nevertheless, these risks will require action to mitigate their impact. This emphasizes the importance of developing an agile supply chain that is not dependent

18  Costing for the Fashion Industry

on a very limited supply chain, to allow flexibility in response to an unexpected event.

Key performance indicators KPIs are analytical tools and measures used to monitor and improve business performance and competitiveness. These measures can be either quantitative (e.g. profit margins) or qualitative (e.g. perceptions on brand ethics). Quantitative measures can include financial ratios, but also measures such as average basket size and click-through rates. Focus here is only on the financial KPIs (FKPIs) of the Current and Quick Ratios (liquidity measures) and the Gross and Operating Profit Margins (performance measures). The figures used in the calculation of these are all readily available in the Trading, Profit & Loss Account and Balance Sheet for a business. What is essential when using FKPIs is to remember their limitations. FKPIs are calculated based on historical accounting data; this means that they are backwards looking and used to explain past performance as a means of identifying where improvements may be needed going forward. The financial data on which they are based are always retrospective, so the view given is out of date and therefore they must always be used in conjunction with a detailed knowledge of the business to assess their value and relevance to its current operating situation. Correctly used by a business, on an ongoing basis, they will at least indicate when performance or liquidity issues may be arising so that corrective action can be taken on a timely basis.

Beyond costing In simple terms, if the income of a business is higher than its expenditure, it has made a profit; if its expenditure is higher than its income, it has made a loss. A business needs to generate enough gross profit to cover all its operating costs. The higher the gross profit in currency units, the more money there is available to cover the operating costs and the higher the operating profit that should result. Good operating profit tends to translate into good liquidity (cash flow); therefore, the higher the level of operating profits, the more likely the business is to generate sufficient funds to support its long-term strategy. As gross profit is simply the difference between the selling price of a product and what it was bought, or manufactured for, this highlights the importance of costing within the fashion industry. The higher

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the costs are relative to the selling price, the lower the gross profit margin will be and the lower cash flow likely to result, leading to increased financial risk.

Performance measures Gross profit margin (GPM) Gross profit is in part a measure of the value of a product to a consumer: the higher its perceived value, the more they are willing to pay relative to its cost. It is also a measure of a retailer’s strength relative to its suppliers: the stronger it is, the more likely it is to be able to push down the cost of buying in its products. It only takes into consideration the buying and selling price of a product. Gross profit is simply calculated as ‘Turnover (Sales) minus the Cost of Goods Sold’, and the GPM is calculated as: Gross profit ×100 Turnover ( sales )

Operating profit margin (OPM) Operating profit is a measure of the amount of profit left after deducting the cost of operating, or running, the business for the period. The OPM assesses the level of profit generated at this stage from the sales. It is calculated as: Operatingprofit ×100 Turnover ( sales )

Industry expectations Average profit expectations for the fashion industry are published periodically via a number of sources but can also be calculated using information available from Companies House, from Annual Reports published online and from summarized information presented on databases such as FAME and OSIRIS. Figures obtained in this way support the minimum gross profit targets currently used for the retail fashion industry of 20–25 per cent for value retailers, 50–60 per cent for mid-market retailers and 70–75 per cent for luxury retailers, and average operating profits of 7 per cent for value retailers, 10–11 per cent for mid-market retailers and 17 per cent for luxury retailers, as summarized in Table 2.2.

20  Costing for the Fashion Industry

Table 2.2  Summary of minimum target margins by market level Market positioning

Gross profit minimum target (per cent)

Operating profit average (per cent)

Value

20–25

7

Mid

50–60

10–11

Luxury

70–75

17

Liquidity measures Solvency is the term used for a business’ ability to pay its short-term debts as they fall due. Liquidity gives us a way to measure solvency. It is indicative of a business’ cash position: the higher the liquidity, the stronger the cash flow appears to be, giving greater confidence in its ability to use its liquid resources to support its short- and long-term strategies. In other words, the more solvent we feel the business to be. There are two key measures used to measure liquidity: the Current Ratio and the Quick Ratio.

The current ratio This measure shows how many units of current asset cover a business has for every unit of current liability that it owes. It is simply calculated as: Current assets Current liabilities This ratio shows the overall liquidity position, but it is limited in that it does not take into account the current asset mix. For example, if the business’ current assets are mainly stock, then it might not actually have sufficient cash available to pay creditors as they fall due. For this reason, we calculate the Quick Ratio, which is a much more stringent measure of liquidity.

The quick ratio (also known as the acid test) This measure excludes stock from the calculation, meaning that it only looks at the availability of cash or near cash assets to cover liabilities. The reasons for this are that: ●●

‘cash and bank’ assets are actual cash that can be used immediately to cover liabilities; Risk Management 

21

●●

●●

‘debtors’ are effectively cash, as assets have been sold and therefore converted into cash, just not yet collected in, but could be collected quickly if required; and stock, however, is not ‘cash’ until sold, and the business does not know whether it is going to be able to sell it or, if it can, how much the stock will be sold for.

It is simply calculated as: Quick assets Current liabilities (Where quick assets = current assets-stock) The result gives a much clearer indication of a business’ ability to cover its short-term liabilities as they fall due.

Comparison If there is little difference between the Current and Quick Ratios, it suggests that the business is holding very little stock (as little has been deducted). In this case, the business probably needs to buy more stock to ensure that it still has products to sell, is offering its customers enough choice and can keep on trading. If there is a big difference between the two ratios, it suggests that the business is holding too much stock (as there was a large amount to be deducted) and it needs to take action to reduce stocks to minimize the risk of being left with excess stocks that it has to discount. If the Current Ratio is too low, the business should go on a sales drive, converting as much stock as possible into ‘cash’, then using the proceeds to buy more stock and selling that, too. If the Quick Ratio is too low, the business needs to go on a sales drive, but then use the proceeds to pay off creditors rather than investing in any more stock (as it probably had too much in the first place).

Industry parameters There are numerous tolerances published for the Current and Quick Ratios, but the ones used here are 1.5–2.5:1 for the Current Ratio and 1:1 for the Quick Ratio, for industry in general, including fashion wholesale, and 1.3–2.5:1 for

22  Costing for the Fashion Industry

the Current Ratio and 0.9:1 for the Quick Ratio, for the retail fashion industry. The reason that a lower starting level is tolerated for retail fashion is that it is considered to be a much more liquid industry because: ●●

most sales are transacted in cash;

●●

stock is turned over comparatively quickly; and

●●

trade debtors are low.

The Current Ratio is measured against a range. If the level is below the minimum for the range, it suggests that liquidity is too low and that the business might (but not will) struggle to pay its debts as they fall due. If the level is above the maximum for the range, it suggests that the business is not using its liquid assets as effectively as it could to drive its long-term strategy. Perhaps the business could use the excess cash to run an advertising campaign, to re-fit stores or to invest in AI technology. The Quick Ratio is a simple value, not a range, as businesses aim to hold stock at a set proportion of their total current assets.

Benchmarking and interpretation Benchmarking is simply a means of evaluating by comparison. Once KPIs have been calculated, they can be compared to budgets, results for previous years, competitors and industry norms, expectations or tolerances. There may be several reasons why a business’ KPIs are not in line with these, including deliberate strategic reasons and simple timing differences, as well as being indicative of problems such as product not being aligned with the needs of the target consumer, major problems within the economy or stock levels being poorly managed. For this reason, KPIs should always be interpreted taking into account detailed knowledge of the business and its operations. The four KPIs explained before, used in conjunction with a detailed knowledge of the business, give a simple way to measure financial risk, as they indicate whether the business is making sufficient profit to cover running costs and generate enough cash flow to meet liabilities as they fall due.

Exercises This chapter has introduced risk within the global fashion market and illustrated some of the specific factors currently impacting the industry. Many

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risks are not anticipated, and a business may not be at fault in any way, but action will still be required to limit damage. You are required to go to the ‘Answers to Exercises’ section at the end of the book and do the following: a) Read the six examples relating to issues faced by specific companies within the fashion industry. b) Review the table of risks and responses/resolutions. Once you have done this, apply the knowledge to exercises 1 and 2 provided next.

Exercise 1 Think about your favourite retailer and how each of the risk types outlined in the chapter might apply to its business. Could it face any of the specific issues described? You should consider: ●● ●●

●●

●●

●●

what countries your retailer operates in, either as a buyer or a seller; its operating format (bricks-and-mortar only, online only or a combination of the two?); any social, technological or other changes it has had, or may have, to adapt to; the laws and regulations it has to comply with (what issues might it have with these?); any reputational issues it has faced (and how it has dealt with them); and any financial risks it faces.

Exercise 2 Consider what your strategy might be in the following scenarios. a. You are a luxury retailer known for your exclusive designs. You have just seen near copies of two of your statement jumpers for sale by an online value retailer. b. You have been named in a programme as a retailer using sweatshops for production. You have never knowingly used that supplier. Would your response be any different if you had?

24  Costing for the Fashion Industry

c. You have made large sales of a product based on your Christmas campaign. You have now seen that a competitor is offering a cutprice version. d. A major customer has collapsed owing you significant debts. You are unlikely to receive any payment from the liquidator. What issues might you face and what action might you need to take?

Exercise 3 The case studies presented in Chapter 1 illustrate fashion business in action. All the companies operate within the value market. Using the data from the case studies provided, calculate the GPM, the OPM and the Current and Quick Ratios and comment on whether you think the level of each is adequate. If not, what action could you take? 2XX4

2XX3

2XX2

2XX1

2XX0

£000

£000

£000

£000

£000

Company A Sales

27,200

25,106

26,796

27,965

-

Gross profit

7,767

6,808

5,919

7,283

-

Operating profit

3,778

2,482

837

1,158

-

13,826

12,524

12,561

11,816

-

Stock

6,599

9,078

8,128

7,658

-

Current liabilities

9,359

11,209

13,078

11,055

-

Current assets

Company B Sales Gross profit Operating profit Current assets Stock Current liabilities

(8 months)

(16 months)

10,493

11,193

7,751

9,180

12,546

2,452

2,726

2,012

2,819

3,158

572

639

696

843

495

5,482

4,782

4,250

3,115

2,244

583

422

614

269

206

3,349

3,398

2,146

985

927 (Continued)

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2XX4

2XX3

2XX2

2XX1

2XX0

£000

£000

£000

£000

£000

Sales

43,547

41,507

48,363

54,140

52,359

Gross profit

10,114

7,725

7,989

8,157

9,344

2,255

277

(43)

(672)

421

32,999

31,622

38,143

34,935

35,307

9,865

7,894

14,666

8,680

7,347

11,275

11,510

18,180

15,026

14,861

Company C

Operating profit/ (loss) Current assets Stock Current liabilities

Further reading Lynch, R. (2006) Corporate Strategy (4th ed.), Harlow: Pearson Education Ltd. Industry reports are produced every year by organizations such as Deloitte (reports on the luxury market and on the retail outlook) and Business of Fashion-McKinsey & Company (the state of fashion), among others. These reports are free for download over the internet and they give a comprehensive view of the industry or sectors within it, discussing specific issues currently affecting it and actions being taken or required. It is recommended that you read these reports each year to support and extend your industry knowledge.

26  Costing for the Fashion Industry

3 Global awareness and new markets

Introduction Many companies already operate globally and those who are not will probably have ambitions to do so. The aim of this chapter is to provide some practical background knowledge to offshore garment costing and production. The aim is to equip the readers with a broad knowledge of the ‘rag trade’ and to help them complete the practical exercises. Working in this industry is exciting and challenging; what makes it so are the various ways in which companies operate in their bid to dominate the marketplace. This business environment is unique in that no two businesses operate in exactly the same way, even though some of the processes are identical, which can be attributed to owners’ traits and characteristics.

The global supply chain The global supply chain is in a constant state of flux and encompasses longstanding businesses alongside emerging ones. To facilitate discussions, the retail environment will be split into three main categories: high (luxury brands), middle (mid-market retailers) and low (value retailers and discounters). The volatile economy combined with a competitive retail environment means that more than ever, businesses need to be innovative and commercially aware to prosper. Social media and the internet allow easy access to the latest fashion trends, fuelling the public’s desire for the latest competitively priced garments. This phenomenon has driven retailers to rethink their distribution strategies at home and globally.

To satisfy consumer’s demands and to survive, retailers need to react fast and frequently. Global players use marketing tools to raise brand awareness and strengthen their position in the market. UK clothing businesses can be considered global by either importing into the home market or distributing internationally. Competition is becoming more global or at least intra-country activity is increasing whether it be measured by trade flows, investment flows or people flows. One route for expansion chosen by many companies is overseas distribution. This requires reputable contacts in the local market who are well connected and have marketing strategies in place.

Barriers and facilitators in market-entry strategies Clothing businesses that have plans for growth and expansion often choose to enter new markets as part of their internationalization plan. Their marketentry strategy will be dictated by the size of the business, whether a brand is being distributed, the targeted countries, the objectives of the business and the timing. Further, to enter unknown markets, exporters need to understand the market environment of the countries they target. One of the popular choices is to seek partners that are already established in these markets. With minimum financial exposure exporters acquire an exclusive insight into the market and are able to overcome obstacles such as culture and language, regulations and logistical barriers. Businesses need to devise their market-entry strategy and concentrate on the markets, the products, the positioning and the competitors. As previously discussed, to operate in an international context, businesses must forge alliances with trustworthy foreign partners. This could be a serious business advantage, particularly in an environment where price and quality are of the essence. Dealing with already-established intermediaries in an unknown market provides supplementary security. However, finding the right partners to be the ‘voice and ears’ of the business is not an easy task and is a risk that needs to be managed. Market-entry strategies alone will not facilitate the internationalization process. Indeed a number of factors affect operations and require consideration. For instance, it is important to have a responsive supply chain to meet customers’ demands, to implement quality systems to achieve 28  Costing for the Fashion Industry

Internationalization environmental audit (PESTEL)

Market entry Market-entry modes focus on finding suitable partners based on possible relationship types with cost and risk evaluation. Modes of entry are linked to firms’ Strengths and Weaknesses (SW). Market-entry strategies have to be based on 'strategic fit' and this is an outcome of the SWOT analysis.

Identifying external factors (cultural differences, suitable partners, customer’s requirements, market demands) to assess Opportunities and Threats (OT). Analysis of internal factors (firms’ capabilities and Determinants in ambitions) to identify Strengths and businesses Weaknesses (SW). internationalization goals: Leadership, resources, management strategies, competencies, goals, partners, customers and Quality systems systems. Supply chain Meeting customer demand through Firms must develop responsive strategies customer focus, continuous improvement, to meet customer’s requirements through employees’ empowerment and use of the management of the supply chain to quality. This is driven by the firm's desire achieve customer satisfaction. This includes to improve quality at every level and aim creating value for all supply chain partners. for business excellence.

Figure 3.1  The internationalization of clothing businesses.

excellence and to carry out environmental audits to understand the markets (as summarized in Figure 3.1).

Contemporary issues The supply chain involves different players: the retailers who sell the garments; the manufacturers who produce the garments and occasionally the agents or distributors who act as intermediaries between the factories and the retailers. Agents and distributors are increasingly cut out of the equation because retailers and manufacturers deal with each other directly to maximize profitability, speed up the manufacturing process and increase margins. Businesses often face communication issues and develop systems of working with partners overseas by trial and error. Email and mobile phones have facilitated communication but are not the panacea to resolving the language and cultural barriers faced by those dealing in the global marketplace. As discussed in Chapter 1, sampling is a big issue for businesses but there are solutions to this problem. One is to set up an office(s) in the manufacturing country or countries to work in partnership with manufacturers. This would result in better control of product development and manufacturing; however, a feasibility study would need to be carried out to establish if such a strategy would be profitable for the business. The other option is to set up sampling facilities in the home market; this is costly and requires a skilled workforce. Global Awareness and New Markets  29

It is hard to imagine for those now entering the workforce that the UK was once a prosperous clothing manufacturing country employing millions of people. This industry started to die down in the early 1980s when the trend for offshoring gained traction. Fortunately, some retailers are starting to bring manufacturing back to the UK (re-shore). This is because there is a growing demand for UK-produced clothing, the costs of overseas production are rising and there is an increasing need for supply control and flexibility. To rekindle UK manufacturing necessitates skills and these were lost during the offshoring trend. Fortunately, some universities have continued to emphasize technology in their fashion courses, which will equip graduates with technical abilities. When selecting your university course and going to open/visit days, look out for state-of-the-art clothing production facilities, fabric testing laboratories and innovation zones where you will be able to trial the latest manufacturing techniques during your studies. Other significant fashion debates are taking place in relation to fast fashion, circular economy, sustainability, innovation and technology such as virtual reality (VR). Indeed, there is plenty of media coverage in regard to the environmental impact of fashion production and consumption. The fashion supply chain is traditionally linear, meaning that products are manufactured and then sold to consumers, who eventually discard them. The alternative is to keep products in use for as long as possible to gain maximum value and, at the end of their life cycle, recover and regenerate new products and materials. Consumers are increasingly concerned with sustainability issues and so retailers are under pressure to respond. It is common for them to publish manifestos to demonstrate that their supply chain is traceable and sustainable. These positive steps will hopefully result in responsible sourcing, production and distribution of clothing. The next sections will focus on the processes of shipping goods and the timing of the operations.

Purchase order Once the final selection of the product range has been completed, businesses will raise a purchase order (PO). The PO (Figure 3.2) is a contractual agreement between the purchaser and the supplier. Its purpose is to provide as much information about the product purchased prior to

30  Costing for the Fashion Industry

PURCHASE ORDER FORM (PO FORM) SIZE SPECIFICATION REFERENCE NUMBER: RAISED SUPPLIER NAME: BY:

ISSUE DATE:

CUSTOMER NAME:

ORDER NO:

ACCOUNT No:

TO BE DELIVERED TO:

DESPATCH DATE:

BUY PRICE Per garment:

TOTAL ORDER QUANTITY:

STYLE DESCRIPTION:

STYLE No:

ADDITIONAL COMMENTS: SHIPMENT SCHEDULE/COMMENTS/SPECIAL INSTRUCTIONS FREIGHT FORWARDER: PACKAGING DETAILS: NOMINATED SUPPLIERS FOR HANGERS/LABELS/STICKERS/PACKAGING: CUSTOMER REFERENCE NUMBER: PACKING LIST/ASSORTMENT SIZES

PRODUCT CODE

QTY

VALUE

CUSTOMER REF

Figure 3.2  Example of a PO for goods shipped to the UK.

the start of production. Its layout and contents are subject to variations but generally it will state the following: ●●

Order number and account number.

●●

Price per garment in the negotiated currency.

●●

Total order quantity.

●●

Size specification reference number, which might refer to a basic size chart that can be amended accordingly. If the order was to be repeated because it has proved popular in store, the same reference number would be stated.

Style number – relates to the product stated in the PO, whereas the order number could include several items in the collection, each with its own order number.

Global Awareness and New Markets  31

Customer reference number – if an agent is acting on behalf of a retailer, it will be necessary to stipulate their reference number. Brief description of the product – sometimes a front and back sketch of the item is attached to the PO. Supplier name – name of the manufacturer producing the goods. Issue date – the date the PO has been raised. Name of the person who has raised the PO. Name of the customer (it could be either an agent or a retailer). Freight forwarder – the role of the forwarder is to ensure the smooth transit of goods internationally. Delivered to – specifies the final destination. Despatch date – indicates when the goods will be ready to be shipped. Packaging details – states how the garment should be presented, for example, on a hanger, in a poly bag, with care label, size label, back neck label, swing tickets and so on. Positioning of these labels is also specified. Nominated suppliers – some retailers may want the supplier to use specific companies for their hangers, labels, swing tickets and hanger stickers and as such the PO states where these should be purchased from and their reference numbers. Packing list/product assortment – once the production is complete, goods will need to be packed in marked cartons and occasionally inner cartons. The final packing list is usually sent to the customer once the goods are packed and carton numbers have been allocated. Initially the number of pieces per carton, the ratio of sizes and colours are communicated. (You will have an opportunity to calculate the ratio packing in the ‘Exercise’ section at the end of this chapter.) Additional comments – can contain information such as fabric and garment testing requirements, factory audits and ethical requirements. An example of a PO for products (e.g. brands widely distributed) imported to the UK and then distributed to mainland Europe is shown in Figure 3.3. The information is similar to that discussed in Figure 3.2 but it contains

32  Costing for the Fashion Industry

PRODUCT INFORMATION SHEET LOGO/NAME AND CONTACT DETAILS OF THE RETAILER 3/ PRODUCT SPECIFICATIONS Type of packaging: _________________________________________________ (if polybag: please ensure it carries a warning against risks of suffocation in the specified language and that the thickness of the polybag is above 0.038 mm.) Dimension of the item with its packaging: _________________________________________________ Unit weight of the item with its packaging: _________________________________________________ Age recommended by the manufacturer on the packaging: _________________________________________________ Multilingual packaging?: _________________________________________________ Instruction for use in specified language?: _________________________________________________ If not, can you insert a translation?: _________________________________________________ Does the packaging bear the green dot?: □ Yes □ No Minimum quantity for packaging?: _________________________________________________ CD-rom and program specification for our agency to send you the artwork (for packaging development): _________________________________________________ 4/ SHIPMENTS Product origin (manufacturing country): _________________________________________________ Custom identification number: _________________________________________________ Warehouse address: _________________________________________________ _________________________________________________ Port of departure: _________________________________________________ THE BELOW INFORMATION IS COMPULSORY TO CONSIDER REFERENCING YOUR PRODUCTS: please also indicate the measuring unit (inches/cm/pound or kilogrammes) Units per master carton: _________________________________________________ Dimension of a master carton: _________________________________________________ Weight of a master carton: GROSS _____________________ NET_______________ Volume of a master carton: _________________________________________________ Quantity per pallet: _________________________________________________

Figure 3.3  Example of a PO of goods shipped to the UK and then distributed to the EU.

Global Awareness and New Markets  33

additional points relating to pricing and exclusivity to the country to which it is sold.

Lead times To ensure that garments will be available in store on time, buyers need to calculate how long each process will take. The total amount of time (normally quantified in number of weeks) is the lead time which can be defined as ‘the time required from placement to completion of an order’. It is important to note that the lead times will vary according to the number of processes and should be pre-agreed between the purchaser and the manufacturer at the time of negotiations. The word completion is subject to variations because shipping terms vary (these will be discussed in the next chapter): one party might assume that an order is complete once it is packed in a carton ready to be shipped, while another might deem the order complete once it is delivered to a given address. It is therefore important to give and receive clear directives at the outset to avoid misunderstandings. Purchase orders are raised once the lead times have been agreed between the two parties, who are then bound in a contractual agreement. To further strengthen the legal aspect of the order, a Letter of Credit (LC) is raised by the purchaser to the attention of the manufacturer. An LC is a promise to pay and is raised by the purchaser’s bank as a way to ensure that the supplier will get paid as long as he/she does what has been agreed. Failure to respect the terms of the PO and the LC will result in penalization or litigation. Depending upon the severity of the problem, common penalties imposed on suppliers are requests for a price discount, a demand for goods to be air- instead of sea-freighted or cancellation of the order. Figure 3.4 illustrates how a twelve-week lead time might be calculated and is not dissimilar to the PO in terms of the information it contains. However, delays are common because the purchasers frequently reject lab dips, size set samples, fabrics and trims or the fabrics are rejected by the testing labs. This means that the supplier has to re-submit thus leading to delays. Adding to that the high street is characterized by quick response because it is dominated by fast fashion and so time management is essential. Therefore, a margin for errors should be built in the crit path. Additionally, shipment

34  Costing for the Fashion Industry

delays are common and so the ETD (estimated time of departure), the ETA (estimated time of arrival) date and shipping vessel’s name should be provided by the supplier or the freight forwarder so that the transit of the goods can be monitored.

Critical path Once the lead times have been calculated and the PO has been raised, systems need to be implemented to monitor the progress of production. The system is known as critical path or crit path and can be defined as ‘a sequence of key deadlines that need to be met to achieve a predetermined delivery date’. Several software packages are available in the marketplace, and therefore the crit path layout is likely to vary in appearance. It is a pre-emptive tool used to track the progress of production and can draw attention to shipment delays earlier in the process. The number of columns will reduce or expand depending on the number of features contained within the garment, the order quantity and whether the delivery is staggered or in one drop. The following shows an example of the processes: Week 1: The customer sends out the order/PO to the supplier; the supplier can then place the fabric/trim order with their supplier/s and starts to produce size set samples in fabrics that are closely matched to the production requirements. Week 2: Fabric trim/production starts (often without the customer’s approval); the customer receives the size set samples (so that garments can be checked against the size specification sheets) and sends back comments. The supplier orders trims/accessories so that the delivery of fabric, accessories/trims is coordinated. Week 3: A LC is opened by the customer’s bank and the team comments (approves or rejects) on the lab dips, trims and accessories. Weeks 4 and 5: Fabric, trims and accessories are in production. Week 6: Fabric, trims and accessories are shipped to the supplier. The supplier sends pre-production samples in the correct fabric, trims and accessories (it is not uncommon for the supplier to have started production at this stage). Week 7: The customer comments on the pre-production sample. Week 8: The supplier starts the production.

Global Awareness and New Markets  35

Weeks 9 and 10: Garment production continues. The production length will vary pending on the order quantity and the complexity of the garment. It is common to stagger shipments if quantities exceed 1000 pieces which gives customer the opportunity to trial the garment in store. If the product is not selling, the fabric may be stored to be used for a different style. Week 11: Production finishes and inspections are carried out on a percentage of garments selected randomly to establish if the quality of goods is right. It is commonly referred to as an AQL (Acceptable Quality Level). If the tolerance threshold is met, then the AQL is granted (there are varying degrees of acceptability). Week 12: The buyer checks the production sample and allows the shipment of goods. The critical path will extend beyond twelve weeks to allow for transit (duration will vary pending upon the country of manufacture and freight method) and custom clearance. Sea freight is typically three weeks plus one-week customer clearance and air freight can be completed within one week. Order number: Order quantity: PO raised date: (Week 1) Number of weeks 1 Size set sample received Size set sample comments sent Lab dips received Lab dips comments sent Accessories/trims received Accessories/trims comments sent Production of fabric, labtesting and approval finalised Labels/swing tickets/hangers received Labels/swing tickets/hangers comments sent Pre-production samples received and comments sent back Production samples received and comments sent back Production AQL carried out Estimated time of departure (ETD) Shipping details Estimated time of arrival (ETA) UK ETA UK warehouse

2

Figure 3.4  Example of a twelve-week lead time.

36  Costing for the Fashion Industry

3

4

5

6

7

8

9 10 11 12

A vertically integrated supply chain is a way of improving communication, reducing lead times and transport costs and minimizing risk. Broadly speaking, some retailers have control of the whole process: from fabric production to selling in store. The degrees of integration vary and so it is a bit of a grey area; the idea is to carry out as many operations as possible ‘inhouse’. For example, a retailer’s strategy to overcome global manufacturing barriers might be to design, dye, cut, sew, finish and distribute garments directly into stores. An example of the lead times in garment production is shown in Figure 3.4 (the yellow boxes the receipt and production weeks and the red ones show the approval week and shipping times). The empty squares would normally be filled with comments recording dates and key events such as lab dip rejection date and supplier resubmission date. Upon consideration, it is evident that for such short lead times the margin for errors is very small. One way to reduce lead times in this instance would be to air-freight the goods which would save two weeks but would be far more costly.

Global Awareness and New Markets  37

Exercises When raising a PO, the buyer needs to specify how many pieces are to be packed in each carton and to what ratio. It will also be necessary to specify how the goods are to be packaged individually: hangers, poly bags, labelling and swing tickets. Consider the following order and calculate the quantities per size and per colour: Embroidered T-shirt Reference: 0045L Quantity: 3,600 pieces Colours: Navy, white, black, red Sizes: 10, 12, 14, 16 Ratio: Navy and red: 1 : 1 : 1 : 1 White and black: 1 : 2 : 2 : 1 Have a go and change the total order quantity, add extra colourways and change the ratios. Practice makes perfect!

Further reading Common Objective [Online] [Accessed 19 March]. https://www.commonobjective. co/search/resources?sort=desc Jones, R. M. (2006) The Apparel Industry (2nd ed.), Oxford: Blackwell Publishing Ltd. Mintzberg, H., Quinn, J. B., and Ghoshal, S. (1998) The Strategy Process: Revised European Edition (2nd ed.), Harlow: Prentice Hall. Wrap [Online] [Accessed 19 March]. http://www.wrap.org.uk/sustainable-textiles

38  Costing for the Fashion Industry

4 Product cost when sourcing

Introduction Garments mass-produced for the high street are often embellished with prints, embroideries and intricate finishes which can cause varying degrees of complications during the manufacturing process. These intricate details, along with the fabric costs, represent a large portion of the total cost of garments and need to be closely monitored. The high street is fickle and driven by consumer’s search for designer looks at a fraction of the price commanded by luxury brands. This necessitates a quick response from retailers in order to maximize financial gain from latest trends. A global sourcing strategy necessitates finding and evaluating suitable manufacturers to achieve sales targets and increased profit margins.

Global sourcing The shift of production from the UK to overseas has been significant to the range and variety of products available in the high street. Further, low labour production costs in some parts of the world have enabled retailers to increase profitability while offering a broader product range to the customers because manufacturers are able to quote competitive prices. In addition to the cultural differences, some of the disadvantages of global sourcing are lengthy travelling; communication in different time zones; freight and shipping costs; legal and administrative costs; and the risk of copyright infringements, particularly when distributing a brand name. As discussed previously, the UK is no longer known as a large manufacturer of clothing. However, this is slowly changing with some high street retailers bucking the trend and bringing production back to the UK. CMT (cut, make

and trim) factories, small design companies and bespoke tailors have always had a place in the marketplace, and with current developments they will hopefully increase in numbers. High street retailers (bricks and mortar) initiated the trend for mass manufacturing, and are selling competitively priced garments. This is fuelled by consumers’ addiction to shopping and their quest for the latest trends. Despite this, the high street is dying because consumers favour online shopping which has spurred the growth of online retailers (pure players).

Range planning The rapid changes in fashion trends, their effect on the retail environment and the need for quick response times have been discussed. To take advantage of unforeseen trends, to repeat buy successful products or to add new products to the range in season, retailers hold back funds, known as open-to-buy (OTB). This is because having too much or the wrong type of stock during certain periods can affect businesses’ cash flow or result in the goods being put in the sales. Inventory control is crucial to ensuring an adequate level of stock is available for the number of sales being generated. However, if retailers buy too little products (under-buy), they miss sales opportunities, which means profit is not maximized and customers are left disappointed. To achieve the right balance and minimize risk, retailers allocate an OTB budget. The development of a product range is time critical, necessitates in-depth research and above all should appeal to loyal customers while attracting new ones. Designers develop product ranges twelve months ahead of the season and are often asked to rework best-sellers. Designers keep up to date with trends through glossy magazines, trade shows, competitive shopping (comp shop), trend forecast websites (such as WGSN) and browsing catwalk shows on the internet. With new ideas in mind they travel within the UK and abroad to comp shop, which entails purchasing garments representative of the types of products proposed for the oncoming season and to find the latest, most innovative products. A range plan meeting is scheduled to kick-start the selection process whereby bought samples, mood boards, CAD drawings and illustrations are reviewed by the buying and product development teams. The outcome of the meeting will necessitate further work from the design team until the range is signed off and budgets have been allocated to purchase the range. 40  Costing for the Fashion Industry

Buyers, operations managers and product developers (depending on the structure of the business) will establish the country of manufacture, which is determined by the product type, and decide which factories will be invited to tender for the business. In preparation for the negotiations that will take place during the buying trip, it is necessary to establish, for each garment, the order quantity, the buying price, the retail selling price and the lead times. Once prices have been agreed with the supplier, a request for sales samples is made in preparation for the range preview. Purchase orders will be raised immediately: the production process will start and be monitored using the critical path.

Factories Before placing orders with a factory overseas it is necessary to carry out an environmental scan to possess an in-depth knowledge of the politics, economics, climate (such as countries prone to flooding), exchange rates and infrastructure and so on. Buyers and their team will frequently monitor and rate the performance of their suppliers. They deal with a number of factories some of which will have been trialled and tested over a number of years and so monitoring is easier. When sourcing new factories, buyers will be concerned with several issues relating to the following: performance (based on previous seasons; if the factory is new trial order/s will be placed), prices (to obtain best possible margins), product types (some countries/factories excel in specific areas), ethics (adherence to the code of ethics/conduct) and sampling (ability to produce all the right samples on time). The code of ethics is particularly important as no one wants to trade with factories which have poor records in terms of forced and/or child labour.

Shipping terms The trademark ‘Incoterms®’ is copyright protected by the International Chamber of Commerce and refers to International Commercial Term which was first published in 1936. Knowledge of these terms is most important to import and export agents and staff working in the shipping departments of a fashion business. While many students will not follow this career path, knowledge of the Incoterms® rules can be an advantage. These rules are revised periodically to keep up with international trade and are defined by terms that clarify the role of the seller and the buyer in the transport process. Product Cost When Sourcing  41

The shipment of goods on an international scale is a complicated and laborious process which usually involves a great number of administrative, consular, fiscal and custom formalities. Businesses will either possess an import/export department or use a freight forwarder to deal with these formalities. Freight forwarders play an integral part in that they will provide the documentation for transportation, work out the best routing, book freight on appropriate vessels/airlines, deal with customs officers, liaise with the shipping agent and ensure that the information is transmitted to the purchaser for better control of the lead times. They also provide help and advice on freight cost, documentation and regulations; book space with freight carriers; oversee customs clearance; book and pack containers and organize cargo insurance, all of which come with additional cost. In timecritical situations, their services are often invaluable. The Incoterms® rules clarify when the ownership of the goods takes place. The points to remember are as follows: ●●

●●

●● ●●

Terms beginning with E: Seller’s responsibility fulfilled when goods are ready to leave their facility. Terms beginning with F: Seller does not pay for the primary cost of shipping. Terms beginning with C: Seller pays for shipping. Terms beginning with D: Seller’s responsibility ends when goods arrive at a specific point.

Not all terms listed will be used in the fashion industry; the ones to remember are CIF, FOB, DDP and EXW. Some of the Incoterms® rules are outlined next and are fairly extensive (source: http://library.iccwbo.org/clp/clp-incoterms. htm?AGENT=ICC_HQ): ●●

●●

EXW ex works (Incoterms® rules): The seller places the goods at the disposal of the buyer at the seller’s premises or at another named place (e.g. works, factory, warehouse). The seller does not need to load the goods on any collecting vehicle, nor does it need to clear the goods for export, where such clearance is applicable. FOB free on board (Incoterms® rules): The seller delivers the goods on board the vessel nominated by the buyer, at the named port of shipment. The risk of loss of or damage to the goods passes when the goods are on board the vessel, and the buyer bears all costs from that moment onwards.

42  Costing for the Fashion Industry

●●

●●

CFI Cost, Insurance and Freight (CIF) (Incoterms® rules): The seller delivers the goods on board the vessel. The risk of loss of or damage to the goods passes when the goods are on board the vessel. The seller must contract for and pay the costs and freight necessary to bring the goods to the named port of destination. DDP Delivered Duty Paid (Incoterms® rules): The seller delivers the goods, cleared for import on the arriving means of transport ready for unloading at the named place of destination. The seller bears all the costs and risks involved in bringing the goods to the place of destination and has an obligation to clear the goods not only for export but also for import, to pay any duty for both export and import and to carry out all customs formalities.

The Incoterms® rules are schematized in Figure 4.1 to demonstrate at what stage the buyer and the seller are responsible for transit of goods.

Exercises Given that we have discussed the processes involved in sourcing garments in a global context, this exercise illustrates how one might set out to calculate costs from a non-UK perspective (see Figure 4.1). Had the garments been EXW FCA (Truck)

Buyer Seller

Buyer

FAS (Vessel)

Seller

FOB (Vessel)

Buyer Seller Buyer

CFR

Seller Buyer

CIF

Seller Buyer

DEQ

Seller Buyer

DDP

Departure point Seller's factory

Seller

Delivery to dock Exporting country

Alongside vessel

Dock

Dock

Unloaded on dock Importing country

Delivered to Buyer's warehouse

Figure 4.1  Incoterms® rules highlighting the responsibilities for buyer and seller.

Product Cost When Sourcing  43

manufactured in the UK, the costing sheet would be different and highlight production and non-production overheads, not rates of exchange (ROE). The exercise you are advised to carry out emulates a scenario where garments have been purchased from the Far East in US dollars and will be sold in euros to a distributor. The costing sheet is prepared prior to the buying trip and in preparation for negotiations – once prices are negotiated and POs raised, it can be revised to give a true reflection of margins. It is common to allocate estimated costs for freight, labels, swing tickets, packaging and testing. The cost sheet contains for each item (from left to right) a style description, total order quantity, shipping/freight date, date of delivery to the customer’s warehouse, price the garment is sold at in euros and its conversion into UK pounds, factory name, factory selling price in US dollars and its conversion into UK pounds, labelling/packaging/testing cost in UK pounds, freight/shipping cost in UK pounds, cost per garment in UK pounds, gross profit per garment in UK pounds, percentage margin, total value of the sales generated in UK pounds and total gross profit in UK pounds. The cost sheet contains numbers in bold ranging from 1 to 11 that have been inserted at the tops of columns or inside individual cells to provide stepby-step guidance on how to calculate the costing sheet; see the following detailed working outs. 1 Selling prices £ = (selling prices to distributor euro) ÷ 1.17 2 Buying prices £ = (factory selling prices US$) × 1.33 3 Cost per style £ = (buying prices £) + (pack & test costs £) + (freight cost £) 4 Gross profit per style £ = (selling prices £) − (cost per style £) 5 per cent margin per garment = (gross profit per garment £ : cost per garment £) × 100 6 Total sales per style £ = (order quantity per style) × (selling prices £) 7 Total gross profit per style £ = (order quantity per style) × (gross profit £ per garment) 8 Total order quantity = add order quantity per style 9 Total value of sales = add total sale per style £ 10 Total gross profit per style £ = add total gross profit per style £

44  Costing for the Fashion Industry

1

Style description

Order quantity per style

Ship date

Delivery date

Selling prices to distributor euros

Selling prices £

2

Factory names

Factory selling prices US$

Buying prices £

Pack & test costs £

Freight cost £

Product Cost When Sourcing  45

Embroidered blouse

7,600

30 Jun

29 Jul

8.5

D

3.50

 

0.55

0.50

Pearl button blouse

3,000

30 Jun

29 Jul

8.35

C

3.20

 

0.55

0.50

Bow blouse

4,800

30 Jun

29 Jul

7.95

C

3.50

0.55

0.50

Gathered hem blouse

2,000

30 Jun

29 Jul

8.15

C

4.00

0.55

0.50

Applique blouse

5,600

30 Jun

29 Jul

8.2

D

3.75

0.55

0.50

0.55

0.50

Totals

8

ROE 1.33 US$ ROE 1.17 EURO (Exchange rates – March 2019)

3

4

5

6

7

Cost per style £

Gross profit per style £

% Profit margin per style

Total sale per style £

Total gross profit per style £

9

10

Further reading Cooklin, G. (2006) Introduction to Clothing Manufacture, revised by Hayes, S. G. and McLoughlin, J., Oxford: Blackwell Science. International Chamber of Commerce (no date) Incoterms® and Commercial Contracts [online] [accessed 19 March]. https://iccwbo.org/resources-for-business/

46  Costing for the Fashion Industry

5 The nature of clothing manufacture and the need for costing

Introduction This chapter seeks to explain the nature of clothing manufacture and the need for costing in the industry. It introduces the student to the basic processes and some basic terminology used in clothing manufacture.

What is clothing manufacture? At the outset, we should perhaps take a little time to consider exactly what we mean by clothing manufacture and the processes involved. This may be important for those readers who have not worked in a clothing factory or not even had the opportunity to visit a clothing manufacturer. If you are not familiar with the processes involved in clothing manufacture, then it’s advisable to visit a factory, as this would put into perspective the issues considered in this book. In very simple terms, clothing manufacture is the conversion of fabrics (cloth) into wearable garments. In order to effect this conversion the fabrics have to be cut into component parts, which are passed through a series of processes in order to produce the garment. Broadly speaking the following are the processes in clothing manufacture: ●●

●● ●●

The pattern pieces are planned to form a marker – this indicates how the component parts of the garment will be cut out of the fabric. The fabric is spread often several plies high to form a lay. The pattern pieces that form the component pieces of the garment are cut out of the fabric.

●●

●●

●●

●●

Some of the component pieces are fused with a fusible interlining to give reinforcement. The pieces then pass through a series of sewing operations; during these operations other materials may be introduced (e.g. zips, buttons, lace). The completed garment is pressed, has loose threads removed and is inspected for quality. The finished garment is then packed.

While this is to some extent an oversimplification of the processes involved, it at least gives an idea of what the average factory will be involved in. From this, the reader can see that the factory will have to provide three things: ●●

materials – fabric, thread, etc;

●●

labour – workers to perform the various manufacturing tasks; and

●●

an environment, equipped with the right machinery, to enable the processing to be done.

Not all factories will be involved in all the processes; for example, a factory just making denim jeans will not have a fusing operation as this garment does not have any fused parts. However, a jeans factory might have a stonewashing operation to give the jeans a fashionable look or alternatively the stonewashing might be done by an outside contractor. Similarly not all the processes need to be done in the same factory and very large manufacturers sometimes rationalize their operations by cutting the fabrics in one factory and that cutting operation supplies several other factories with cut parts to make into garments. This may particularly be the case where a manufacturer has invested in high-tech equipment at a high capital cost and needs to maximize the use of such equipment. Students wanting a more detail picture of clothing manufacture are referred to one of the standard textbooks on clothing production – a reading list is given at the end of this chapter.

Two important questions For a book dealing with costing in relation to the clothing industry, the following two questions would seem important:

48  Costing for the Fashion Industry

●●

What is cost?

●●

Why do we need to cost our garments?

Before reading on in the chapter you should think about these two issues and perhaps jot down how you would explain the meaning of ‘cost’ and why you think a manufacturer should be concerned with cost and the process of costing.

Definition of cost Cost is the economic value placed upon the resources consumed to make a product. By economic value, we mean that it is a monetary value expressed in terms of the appropriate units of currency. That might be pounds sterling (£) in the United Kingdom, dollars ($) in the United States and in other parts of the world or the euro (€) more widely in Europe. In order to make a product, and remember that clothes or garments are products, the manufacturer will have to use resources – materials, labour and a variety of services and other capital resources like the use of premises. The quantity of these resources used, expressed as a monetary value, is the cost of the product. Cost might be expressed as relating to individual products, that is, individual garments (unit cost), or it might be expressed as relating to a number of products (batch cost) or a specific order from a customer producing perhaps several thousand garments (job cost). Alternatively, cost can be expressed relating to time, the costs incurred for a month or a quarter or a half year or a full year.

The need for costing Cost also has a relationship to the price of the product, the price being what the manufacturer’s customer or client will pay for the garments produced. Clearly in order to make a profit the manufacturer will need the price to be more than the cost. Thus, when determining the price or negotiating the price of a garment, the manufacturer will need to have a good understanding of his costs in order to ensure that the price covers the costs.

The Nature of Clothing Manufacture and the Need for Costing  49

The following are the main reasons why a clothing manufacturer needs to be involved in costing and have an understanding of the costs. It is useful if designers, pattern cutters and garment technologists also have an understanding of the costs. Pricing Decisions – If the manufacturer produces a branded product or sells directly to the end user of the garment, that is, direct to the public, then they may determine the selling price of the garment. The most commonly used method of pricing is full-cost pricing; this is where a percentage profit or mark-up is added to the cost of the product. The percentage profit, or mark-up, may be determined based on an agreed company policy taking into account what the market will bear in terms of price for that product. Thus in order to make pricing decisions the manufacturer needs to know the cost of the product. Acceptance Decisions – This is probably more common in clothing manufacture and is the situation where a retailer instructs a manufacturer to make a particular garment but is only prepared to pay a stated price. Here the retailer is in the driving seat in terms of fixing the price that will be paid thus in order to decide whether to accept this work the manufacturer needs to know what it will cost him to make that garment. This is an acceptance decision – do I take this work at this price and if I do will I make any profit or do I try and renegotiate the price knowing what my costs are? Thus in order to make the acceptance decision the manufacturer needs to know the cost of the product. Tendering – Though this is less common in the clothing industry than in the building industry, for example, it is a situation that may arise. Here the customer advertises in the trade press for a manufacturer to make a specific garment or job of garments. The work will have to be carried out to a detailed specification and manufacturers will be invited to submit a ‘tender’ (i.e. a price for doing the job). The customer, subject to checking that the manufacturer can do the job, will usually select the lowest tender. Thus in order to make a viable tender the manufacturer will need to know his costs. Cost Control – It is also important for manufacturers to keep control of their costs. The profit margins in clothing manufacture tend to be rather slim; thus ensuring that excessive cost does not erode those margins is important. The manufacturer who does not measure his costs cannot hope

50  Costing for the Fashion Industry

to control them thus measuring, recording and comparing costs is all part of the control process to ensure the ongoing profitability of the business. Profit – People are in business essentially to make a profit. There may be other laudable reasons for being in business, such as making use of one’s talents, providing employment for the family and so on, and small craft businesses may not always place the profit motive at the top of their list of priorities. However, the profit motive is important if the business is to provide a living for those running it and those that are employed by it. The profit of a business is measured over periods of time, usually a year, in the financial accounts of the business. There is, however, a link between the costing and the financial accounts in that if the product costing is done badly and jobs are accepted at or under cost, then at the end of the year the business will not make any profit. It may be expedient for a manufacturer to accept some work at cost or even under cost but generally this should be the exception. This book does not deal with the financial accounts of the business – the Trading and Profit and Loss Accounts – students wanting a more detailed understanding of this aspect of accounting should consult one of the standard accounting texts; see references at the end of the chapter.

From manufacturing to sourcing At one time clothing manufacture was widespread in the UK with many types of garments being produced for both the domestic and overseas markets. This was also the case throughout much of Europe, but this is no longer the situation as rising labour costs in the UK and Western Europe have tended to force the retailers to seek garments produced by low-cost manufacturers overseas. The retail houses are much less concerned with the manufacturing costs and are more concerned with the costs of sourcing garments from suppliers. Nowadays, apart from some specialist suppliers and other suppliers who may be prepared to produce short runs of garments, it is likely that those suppliers will be based overseas. This introduces new elements into the costs relating to sourcing the garments – including issues like freight, warehousing and insurance. These developments in the industry and this aspect of costing will be dealt with in more detail in Chapters 3 and 4.

The Nature of Clothing Manufacture and the Need for Costing  51

Exercises ●●

●●

●●

●●

If you have not been in a clothing factory, it would be useful to arrange a visit to a clothing manufacturer. If you are following a course of study, visiting several factories of different types over the duration of your course would be useful. This is particularly important for fashion students, as well as technology students, as it will give you an understanding of how a manufacturer will put your designs into production. Read the earlier chapters of one of the clothing production textbooks; see references at the end of this chapter to assist with your understanding of clothing manufacture. Check through your own wardrobe; examine how garments are constructed and the different materials used in their construction. If possible, have a look at the origin of the garments to see which countries they have been sourced from. Think about clothing manufacture and then list the resources required to make garments under the three headings – materials, labour and other. Use the following table if you like. Remember that costing is essentially about placing a value on the use of these resources.

Materials

52  Costing for the Fashion Industry

Labour

Other

Further reading Production Brown, P. and Rice, J. (2014) Ready Wear Apparel Analysis (4th ed.), Colombus: Pearson. Cooklin, G. (2006) Introduction to Clothing Manufacture, revised by Hayes, S. G. and McLoughlin, J., Oxford: Blackwell Science. Fairhurst, C. (Ed) (2008) Advances in Apparel Production, Cambridge: Woodhead Publishing. Myers-McDevitt, P. J. (2011) Apparel Production and Management and the Technical Package, New York: Fairchild. Rajkishore, N. and Padhye, R. (2015) Garment Manufacturing Technology, Burlington: Elsevier Science.

Financial accounting Ryan, B. (2017) Finance and Accounting for Business (3rd ed.), Manchester: Manchester University Press. Wood, F. and Sangster, A. (2018) Frank Wood’s Business Accounting 1 (14th ed.), New York: Pearson.

Broader fashion industry Kunz, G., Karpova, E. and Garne, M. B. (2016) Going Global: the Textile and Apparel Industry (3rd ed.), New York: Fairchild Books.

The Nature of Clothing Manufacture and the Need for Costing  53

6 The elements of cost

Introduction This chapter seeks to explain the elements of cost as a means of classifying cost that can be used in cost accounting. At the end of the chapter, the student should be able to identify the main elements of cost and relate those to a clothing manufacturing situation.

Classification of cost There are a number of ways in which costs can be classified. There are three methods of classification used in this book: ●●

The detailed breakdown of cost into their elements – the elements of cost

●●

The behaviour of cost – fixed and variable costs (see Chapter 9)

●●

The activities that generate cost – activity-based costing (see Chapter 13).

This chapter is concerned with the elements of costs. This is used extensively in recording costs over periods of time and is used in the traditional methods of product costing. The detailed elements of cost give a good understanding of the costs within our manufacturing business and you should become familiar with them. The terminology used in the elements of cost will also give you a good vocabulary of terms that are used in manufacture and costing. Cost can be summarized into three main categories (see Figure 6.1): ●●

Direct Materials – the materials that become the garment

●●

Direct Labour – the wages cost of the operators that make the garments

●●

Overheads – all the other costs of running the business

Figure 6.1 also shows the approximate split of these costs in garment manufacture.

Approximate percentage of cost in UK Direct materials

50%

Direct labour

20%

Overheads

30%

Figure 6.1  The three main categories of cost.

The important thing to note from this diagram is that the direct materials cost forms about half the cost of the finished garment. Thus the control and the costing of the direct material are vital as these represent such a large element of the cost. These three main elements can be analysed into a more detailed picture, known as the elements of cost, which is illustrated in Figure 6.2. You should study this diagram with the text and become familiar with the elements of cost.

Direct costs Direct material cost Essentially this is the cost of the materials that form the finished garments and in clothing manufacture it is the largest element of cost, representing between 45 per cent and 60 per cent of the garment cost. Thus on average it is about half the total cost and while the following is not a comprehensive list, it gives a good guide to the extent of the direct materials: ●●

Fabric (cloth), linings, thread, interlinings, buttons, zips, trimmings, shoulder pads, sleeve head roll, batting (fibre filling), elastic, studs, hook-and-eye fasteners, lace, press-studs, Velcro, seam binding, labels and so on. The Elements of Cost  55

All materials that form part of the garment need to be accounted for in the cost and this is usually done ‘at cost’ (i.e. the price paid for the material). It normally includes any carriage costs incurred in transporting the materials from the supplier to the manufacturer; this is sometimes referred to as carriage inwards. Take a close look at the garments in your wardrobe and take note of the extent of the different materials that make the garment. Clearly the main fabric of the garment will be the biggest part of the cost but all the other materials also need to be accounted for. In shirt manufacture the small white pearl buttons may only cost fractions of a penny each but with eight buttons on each shirt where tens of thousands of shirts are being produced this becomes a significant figure.

Fabric Of the direct materials, cost of the fabric and lining cost will be the largest component of the cost. If savings are to be made it will usually be in this area. The initial costing of fabrics and linings is based on lay plans, that is, plans of how the pattern pieces will be spread on the fabric. Once the fabric goes into production, however, this initial costing will be improved upon because the production lay planners and cutters will usually get better utilization of the fabric than can be done at the design stage. The utilization of the fabric is the degree of economy that is achieved in cutting the pattern pieces out of the fabric. This needs to be done with minimal wastage and it is usually expressed as a percentage, a high percentage indicating good utilization of the fabric. The fabric will usually be cut several plies high and the industry takes great care in drawing the configuration of pattern pieces that will be placed upon the plies of fabric. The drawing of the pattern pieces is known as the marker plan and the planner may try a number of placements seeking to get the best positioning of the pattern pieces to give the most efficient use of the fabric. Computer-based lay-planning systems are available, with a view to assisting the planner in maximizing the efficiency of the marker plan. See ‘Further Reading’ for more information on the lay planning and cutting of the fabrics.

56  Costing for the Fashion Industry

Thread Most garments will be sewn together with thread and while the consumption of thread in the construction of a garment is not the major part of the direct material cost of the individual garment it may represent a significant amount of cost where large quantities of garments are being made. Garments that have seams constructed using three, four and five thread machines will require significantly more thread than garments sewn together on a lockstitch machine and thus the cost of such garment will be higher. Garments that have smocking on them will also require large quantities of thread and this will increase their cost. Factories often estimate the thread cost; however, care should be taken to ensure that the cost is neither underestimated nor significantly overestimated. The major sewing thread manufacturers publish guidance on thread consumption; see ‘Further Reading’ at the end of this chapter. Guttermanns, the German thread manufacturer, has also developed a computer programme to enable manufacturers to calculate with some accuracy the extent of the thread consumption. However, a manufacturer would have to consider whether expenditure on such software was cost effective for what in many cases is a small amount of the cost. The figures quoted by the manufacturers are only a guide and may be adversely affected by the density of the fabrics. However, to illustrate the point made earlier, two plies of fabric sewn at 7 stitches per centimetre consumes: ●● ●●

Lockstitch machine 2.5 centimetres of thread per centimetre of seam 5-Thread Safety Stitch machine 20 centimetres of thread per centimetre of seam

Based on such figures a standard ladies blouse might require upwards of 70 metres of thread.

Interlinings Interlinings are used as reinforcement in parts of garments such as collars, cuffs, waistbands and the fronts of jackets. They may be sewn in or attached by fusing to the garment using a fusing press. Interlinings are available in a wide variety of weights and types and although per garment they may

The Elements of Cost  57

be used in relatively small quantities, the amount may be significant when producing a run of garments. In respect of stock control, fusible interlinings have a limited shelf life and therefore their purchase and control arrangements are important. Again, care needs to be taken in costing out the interlinings and this should not be underestimated.

Fastenings Most garments will have some forms of fastening; these might include: ●●

Buttons, zips, press-studs, hook and loop fasteners, Velcro.

Individually these may represent a small amount of cost but in quantity form a significant cost and need inclusion. Special buttons and fastenings purchased for a specific job may be relatively expensive and therefore need careful costing (e.g. horn buttons, large zips).

Other direct materials All other direct materials costs need to be included in the costing and care needs to be taken in ensuring all materials used in the construction of the Direct materials cost

Direct labour cost

Prime cost

Direct expenses

Indirect material

Indirect labour

Indirect expenses

Production overhead Production cost Administration, selling & distributions, finance costs Total cost

Figure 6.2  The elements of cost.

58  Costing for the Fashion Industry

Non-production overhead

garment are accounted for. This may include the cost of maker or brand labels and care labels and in some cases the cost of the packaging materials. Where the garment is sold as a packed product, for example, a boxed men’s shirt, then the packaging cost forms part of the direct material cost of the product. In conclusion, remember that approximately half the cost of the garment is in the direct materials; thus this is the most important element of the cost.

Direct labour cost Labour cost is essentially the wages cost of those people who work in the business. By direct labour, we mean the wages cost of those people who are engaged in the making of the garments. Thus, it is the wages cost of: ●●

Lay planners and cutters, fusing press operators, sewing machine operators, press room staff and in some cases those involved in packing the garment.

The lay-planning and cutting staff may take several hours to do their part of the manufacturing process. The production manager will probably have a good idea of how many staff will need to be involved and how much time will be required for specific jobs. Thus the labour hours required multiplied by the hourly wage rate will give the amount of direct labour cost. Remember that if three people are involved in the cutting, and a job takes them 3 hours, then that represents 9 direct labour hours (3 hours × 3 people). The lay planners and cutters will usually be the most highly paid direct labour operatives as this has traditionally been seen as a very skilled job. The fusing and sewing operations are also based on the time required to perform the operation. As some of these tasks can be performed very quickly, they will have time values attached to them expressed in minutes or fractions of a minute. These time values are known as standard minute values, or SMVs. These standard minute values can be achieved by using work-study techniques, in which timings of the operation are taken by a trained work-study assessor. Alternatively, the timings of the sewing operations can be assessed by using one of the commercially available database systems, General Sewing Data (GSD) or some similar system. The extent of the standard minutes required for a job are converted into hours, often referred to as standard hours, and then multiplied by the

The Elements of Cost  59

appropriate hourly rate to achieve the direct labour cost. The hourly rates will vary for different operators; for example, a fusing press operator will be paid less than a trained sewing machine operator and experienced machinists will usually be paid more than newly trained operators. Thus a range of direct labour wage rates may have to be used in order to achieve the total direct labour cost. Most factories, other than the smallest ones, will be organized into departments often called cost centres (more will be said about this in Chapter 8). In the factory, these departments will be based around the manufacturing processes that need to be performed. In clothing these will broadly be laying up and cutting, fusing, sewing, pressing and packing. Thus the direct labour cost for a job passing through the factory will be calculated department by department depending on the direct labour processes required for that job. In the UK, we would usually expect the direct labour cost to represent about 20 per cent of the total cost. However, as greater mechanization is introduced into the industry this percentage may be eroded. Many garment retailers in recent years have sought to reduce the production costs of their garments and this has often meant seeking production overseas usually to areas of lower direct labour cost with a view to containing this element on cost.

Direct expenses This is the last of the direct costs and the least significant in terms of percentage of cost. A direct expense is a cost that is incurred without which that specific garment cannot be manufactured. Examples of direct expenses include the following: The cost of stonewashing denim garments to achieve a fashionable look where this work is contracted out to an external factory. The cost of putting embroidery on to a garment where it is contracted out to an external factory. The cost of a licence to produce a garment that has a copyrighted figure or motif on it such as a sweatshirt with ‘Bart Simpson’ on it. The royalty payable to a designer for the use of their design work – though this is much less common in the fashion industry.

60  Costing for the Fashion Industry

Prime cost The Prime Cost is the basic cost of producing the garment and it is the sum total of the Direct Costs. Thus: Direct Material + Direct Labour + Direct Expenses = Prime Cost

Indirect costs – the overheads Clearly in running a factory there are many other costs beyond the direct costs of producing the garments. These are often referred to as the indirect costs or more commonly the overheads. In the United States these costs are called the burden. The indirect costs or overheads as they are usually called are all the other costs of running the factory and the business. These represent about 30 per cent of the total cost, though in some cases this may be more. The changing nature of these costs is considered in a later chapter. The overheads are usually split into two groups (see Figure 6.2), those concerned with manufacture and can be identified with the factory, known as production overheads, and those that relate to the administration, marketing and finance of the business, known as non-production overheads. In small manufacturing units the non-production overheads will be a relatively small amount of cost; however, large manufacturers often find that their nonproduction overheads do become significantly large as the management and administration of the business increase.

Production overheads These are the indirect costs of running the factory or production unit. From Figure 6.2 it can be seen that they involve indirect materials, indirect labour and indirect expenses.

Indirect materials These are the cost of any materials consumed in the factory that do not form part of the completed garment. They might include: ●●

Small replacement component parts for machinery (needles, belts etc.), lubricants, coolants, cleaning materials, food for the staff canteen and so on. The Elements of Cost  61

Indirect labour As already mentioned, labour costs are the wages costs of employing staff. In the case of indirect labour, it is the wages cost of those people who are employed in the factory but they do not actually work on producing garments. They might include: ●●

Caretaking (janitorial) staff, maintenance men, cleaners, work study officers, supervisory management, store room staff, the factory personnel officer, factory management and so on.

Indirect expenses These are the other costs of providing the factory, its equipment and its running costs. They might include: ●●

The rent of the factory unit, the business rates on the factory,1 insurance of the factory, the services to provide the heat, light and power (i.e. gas, water, electricity), telephone, the capital costs of the machinery and equipment and so on.

Production cost The Production Cost comprises the Prime Cost plus the Production Overhead; see Figure 6.2. Thus: Prime Cost + Production Overhead = Production Cost

Non-production overheads From Figure 6.2 it can be seen that the non-production overheads broadly include the selling, distribution, administration and finance costs of the business.

Selling and distribution costs These might include: ●●

Sales staff wages and salaries, warehousing costs, rent of a showroom, the large-scale packing of the product, freight and haulage costs, sales promotion and advertising costs, exhibition costs and so on.

62  Costing for the Fashion Industry

Administration costs These might include: ●●

Office staff salaries, rent of the offices, business rates of the offices, stationery, accountancy fees, office machinery costs, heat light and power costs of the office and so on.

Finance costs These might include: ●●

Bank charges, loan interest, overdraft interest, cost involved in arranging loans and so on.

Total cost In conclusion, the Total Cost is the Production Cost plus the Non-Production Overheads (see Figure 6.2). Thus: Production Cost + Non-Production Overheads = Total Cost Elements of cost Prime cost

Direct material cost

Direct labour cost

Direct expenses cost

Production overheads

Indirect material

Indirect labour

Indirect expenses

Production cost

Non production overheads

Selling & distribution

Admin & finance

Total cost Figure 6.3  Summary of the elements of cost.

The Elements of Cost  63

Exercises Exercise 1 Using the following table, group the following direct costs into their respective elements of cost. The first one has been done as an example. (a) cutters wages

(k) fusing press operators wages

(b) woollen worsted cloth

(l) royalty to a designer

(c) lockstitch machinists wages

(m) sleeve lining

(d) thread

(n) linen cloth

(e) licence to use a copyright motif

(o) lace trimming

(f) interlining

(p) button-holers wages

(g) melton for collars

(q) fabric finishing treatment done externally

(h) press room staff wages

(r) hire of a specialist machine required for a specific job

(i) specially sourced bone buttons

(s) packing material for a packed shirt

(j) stonewashing done externally

Direct material

Direct labour a

64  Costing for the Fashion Industry

Direct expenses

Exercise 2 Using the following table, group the following costs into their appropriate classification. The first one has been done as an example. (a) fabric for dresses

(n) thread used in production

(b) sewing machinists wages

(o) staff canteen costs

(c) interlinings

(p) pressing staff wages

(d) rent of factory unit

(q) maintenance of office machinery

(e) cutters wages

(r) royalty for a ‘Snoopy’ motif used on a T-shirt

(f) fusing press operators wages

(s) cleaning staff wages

(g) factory managers’ salary

(t) work-study staff wages

(h) factory maintenance staff wages

(u) stonewashing done externally

(i) administration staff salaries

(v) business rates on factory

(j) packing costs

(w) rent of office premises

(k) loan interest

(x) zips used in production

(l) buttons for a blouse

(y) button-holers wages

(m) delivery van drivers’ wages

(z) bank charges

Direct materials

Direct labour

Direct expenses

Production overhead

Nonproduction overhead

a

The Elements of Cost  65

Exercise 3 Using the following table, classify the following Production Overheads into their respective indirect elements of cost. The first one has been done as an example. (a) sewing machine needles

(i) supervisors’ wages

(b) factory manager’s salary

(j) factory power, heat and light

(c) work-study officers’ wages

(k) cleaning materials

(d) cleaning staff wages

(l) factory personnel officers’ wages

(e) rent of the factory unit

(m) maintenance staff wages

(f) lubricants for machinery

(n) designer/pattern cutters’ wages

(g) business rates on the factory

(o) pattern paper

(h) factory insurance

(p) parts required to repair vacuum press

Indirect material

Indirect labour

a

66  Costing for the Fashion Industry

Indirect expenses

Exercise 4 Using the following table, classify the following non-production overheads into their respective indirect elements of cost. The first one has been done as an example. (a) salesmen’s salaries

(i) delivery van drivers’ wages

(b) warehouse costs machinery

(j) maintenance of office

(c) administration staff salaries

(k) exhibition costs

(d) receptionists’ wages

(l) rent of showroom

(e) bank charges

(m) office manager’s salary

(f) audit fees

(n) mortgage interest

(g) rent of the offices

(o) stationery costs

(h) debenture interest

(p) photocopying

Selling and distribution costs

Administration costs

Finance expenses

a

The Elements of Cost  67

Note 1 Business rates are a tax on business premises in the UK, collected by the local authority and are intended as a contribution towards local services (e.g. refuse collection, street cleaning).

Further reading Boyd, K (2013) Cost Accounting or Dummies, Hoboken, New Jersey: Wiley. Cooklin, G. (2006) Introduction to Clothing Manufacture, revised by Hayes, S. G. and McLoughlin, J., Oxford: Blackwell Science. Drury, C. (2015) Management and Cost Accounting (9th ed.), Australia: Cengage Learning. Rajkishore, N. and Padhye, R. (2015) Garment Manufacturing Technology, Burlington: Elsevier Science.

68  Costing for the Fashion Industry

7 Costing over periods of time

Introduction This chapter seeks to explain costing over periods of time – monthly, quarterly, half-yearly and so on. It shows the development of costs over periods of time based on the elements of cost and these are referred to in the chapter as period cost reports. The chapter deals with the treatment of stocks of direct materials, work-in-progress, accruals and prepayments and depreciation.

Period cost reports A period cost report is where the costs of the business are reported over time. They are usually analysed based on the elements of cost and are reported monthly. These monthly reports are also often summarized quarterly, halfyearly and annually. The report enables the business to see, at a glance, its costs for the respective period and compare those costs with budgeted figures and with similar periods of time. Some period cost reports might show the difference between the actual costs recorded for the period and the budgeted costs set for the period. These differences are often referred to as variances.

The uses of period cost reports Control – As mentioned in Chapter 1 the profit margins in clothing manufacture are often slim, thus if costs are not controlled they may easily erode the profits. This regular reporting of the costs enables management to keep a close watch on the costs and their possible escalation. This is important for all costs incurred but particularly the overhead costs which are often

more difficult to control. By examination of the period cost reports the manufacturer will be able to see that costs are falling within budgeted levels (i.e. planned levels). If costs are going over budget, then the period cost report gives early warning and action can be taken. Thus cost control is an important feature of the period cost reports. Comparison – Still on the theme of control the period cost report enables management to make comparisons of costs with other months or other periods. This too is part of the control process and the process of making management cost conscious. Profit – Costs analysed in this way relate closely to the profitability of the business. The total cost for the period when compared with the sales revenue for the same period gives the net profit. The measurement of profit over periods of time is outside the scope of this book and interested students are referred to one of the standard financial accounting textbooks; see ‘Further Reading’ at the end of Chapter 5. Process Costing – Where a clothing manufacturer makes the same type of garment, again and again, as in the case of a jeans factory or a shirt factory, then they may adopt a form of unit costing known as process costing. Note that unit costing is where you find the cost of making just ‘one’ of a product – thus in process costing the manufacturer is trying to establish the cost of one garment. In this system of costing the manufacturer calculates an ‘average unit cost’ (i.e. an average cost per garment produced). This is done by taking the total cost for the period and dividing by the number of garments produced in that period – resulting in an average cost per garment produced. Total Cost for the Period = Average Cost per Garment Garments Produced Process costing is really only applicable where large quantities of the same, simple garment are produced.

Capital equipment costs The costs in the period cost report are supposed to reflect as far as possible the costs for that period. However, businesses will inevitably purchase some

70  Costing for the Fashion Industry

items that are intended to be used for very long periods of time – in particular the purchase of equipment, furniture, machinery and so on – this is known as capital expenditure. Examples of capital expenditure in a clothing factory might be pattern tables, cutting equipment, sewing equipment, pressing equipment and so on. Generally speaking, it will be the purchase of things with a life exceeding one year. Often the purchase of such equipment involves large sums of money and clearly if all that capital cost is put into the period cost report for one month, then the total cost figure in that month will be highly inflated. Months with capital cost when compared with months that do not include any capital cost will be wildly different. Thus the cost of such equipment is not included as such in the cost report, instead the cost of capital equipment is spread out so that each month of its useful life bears a little of its cost. This share of the capital cost is known as the ‘depreciation’. While inevitably the calculation of the depreciation involves some estimation and therefore a degree of inaccuracy, at least a consistent attempt is being made to spread the capital cost over the useful life of the equipment. The depreciation is treated as part of the overhead cost and if it relates to the factory and production it will be part of the production overhead. If, however, the depreciation relates to the administration, selling and distribution aspect of the business, then it will be part of the non-production overhead. There are a number of ways in which the capital equipment costs can be spread over their useful lives, but a common method is the Straight-Line Method or Equal Instalment Method.

Depreciation – the straight-line method In this method of depreciation, the annual amount of depreciation of the capital equipment is calculated as follows: Cost of the Equipment less Estimated Scrap Value Estimated Life Having obtained an annual amount for depreciation in this way, the figure can be divided by 12 to give an amount per month.

Costing Over Periods of Time  71

Example A clothing manufacturer purchases some new sewing equipment at a cost of £12,000. The equipment has an estimated life of 8 years and an estimated scrap value of £480.

£12, 000 - £480 £11520 , = 8 8 = £1,440 depreciation cost per annum £1,440 = depreciation cost per month 8 The period cost report each month would include £120 for the depreciation of this equipment, over the equipment’s life.

Period cost report The period cost report follows the elements of cost described in detail in Chapter 6, taking into account the adjustments described in this chapter. Thus it analyses the costs in the following way (Table 7.1): Table 7.1  £ Direct materials cost Direct labour cost Direct expenses Prime cost Production overhead Production cost Non-production overhead Total cost

The amount of detail and the layout of the report will depend on the management of the business and how much detail and clarity they require. The following illustrations are typical of how the report might be constructed.

72  Costing for the Fashion Industry

Period cost report – a simple illustration Arkan Fashions – The following cost information was extracted from the records of this clothing manufacturer for the month of October. This information can now be analysed over the elements of cost to produce a simple period cost report. If you examine the preceding report, you will see that it takes the cost data for Arkan Fashions and analyses it over the elements of cost. Note the business rates * this cost has been split between the production overheads and the non-production overheads. You will often find costs like this in business where some of the cost relates to the factory and others to the nonproduction functions of the business. Management has to decide how these costs will be split in order to give a suitable analysis of the costs.

Table 7.2 £ Fabric

30,200

Buttons, trimmings etc.

1,580

Thread

1,650

Wages and salaries: Cutters Machinists Pressers Supervisors Factory management salaries Administration staff salaries

2,400 6,400 3,000 3,200 3,600 2,600

Factory rent

8,000

Office rent

1,000

Business rates (75% factory, 25% office)

2,400

Sundry factory expenses

680

Bank charges and interest

250

Depreciation: Factory machinery Factory furniture Office furniture

150 100 50

Costing Over Periods of Time  73

Table 7.3  Arkan Fashions period cost report – October £ Fabric

£

£

30,200

Buttons, trimmings

1,580

Thread

1,650

D. materials cost

33,430

Cutters wages

2,400

Machinists wages

6,400

Pressers wages

3,000

Direct labour cost

11,800

Prime cost

45,230

Supervisors’ wages

3,200

F. mgt salaries

3,600

Indirect lab. cost

6,800

Factory rent

8,000

Business rates

1,800*

Sundry expenses

680

Depreciation: Machinery

150

Furniture

100

250

Prod. overhead

17,530

Production cost

62,760

Admin. Salaries

2,600

Office rent

1,000

Business rates

600*

Bank charges

250

Depreciation: Office furniture Non-production overheads Total cost

74  Costing for the Fashion Industry

50 4,500 67,260

This statement has analysed the costs using three columns but it could involve more or fewer columns depending on the extent of the data and the degree of analysis that the management of the business requires. In the preceding statement, you can see that the main elements of cost – direct material, direct labour, prime cost and so on – are totalled in the right-hand column enabling management to see these costs easily. The composition of these costs is shown in the inner columns. If you turn to the end of this chapter, you can see that Exercise 1 presents a similar data set. Practise producing a simple period cost report before reading on.

Stocks and inventory The illustration of Arkan Fashions is useful for us to see the basic analysis of the period cost report but in practice the issue of the direct materials cost is more complex. Most manufacturers will maintain some stocks of materials for use in production at a later stage. Direct materials bought in one month may not always go into production in that month but may be stored until they are required at a later date. Some materials may be bought specifically for certain jobs in the factory but other common materials may be kept in stock all the time ready for use when required. In our period cost report we will endeavour to show the cost of the materials used in production – that is cost of direct materials consumed – and not the cost of the direct materials purchased in that period. In order to do this the period cost report has to take account of the cost of the direct materials held in stock at both the beginning and the end of the period. The stocks of materials held at the beginning of the period are known as opening stock and the stocks left at the end of the period are known as closing stock. The cost of the direct materials consumed in the period is calculated as follows: Value of the Opening Stock of Direct Materials ADD The Cost of Direct Materials Purchased in the Period LESS Value of the Closing Stock of Direct Materials = Cost of Direct Materialls Consumed

Costing Over Periods of Time  75

Example A jeans manufacturer uses large quantities of blue denim fabric and makes regular purchases of this fabric maintaining stocks ready to go into production. At the beginning of January he was holding 13,000 metres of blue denim, which had cost £18,200. During the month of January a further 39,000 metres were purchased at a cost of £52,650. At the end of January the factory was holding in stock 19,000 metres of the fabric which had cost £25,650. The cost of the blue denim fabric consumed in the January period is: £ Opening stock of direct materials

18,200

Add Purchases of direct materials

52,650 70,850

Less Closing stock of direct materials

25,650

Cost of direct materials consumed

45,200

The value of the stocks of materials or inventory is generally done based on the cost of those materials, that is, what the manufacturer paid or will have to pay for them. If the manufacturer has to pay a delivery cost on materials, this is usually included in the cost of those materials – such a cost is often referred to as carriage inwards.

In the preceding illustration, only one direct material, blue denim, was considered but clearly in a clothing factory many fabrics and materials will be used. The following illustrates how the direct materials cost might be handled where a number of materials are involved. Table 7.4 illustrates the situation where a range of direct materials is used – even this has been simplified. In Table 7.4, the values of the opening stocks of direct materials at the beginning of the month are shown in column 1. The purchases of the direct material in the month are shown in column 2. Column 3 is the opening stock plus the purchases of direct materials. Column 4 shows the value of the closing stock and column 5 the direct materials consumed. At the bottom of the table, the totals for the month are shown and it is these figures that would appear in the period cost report. They would appear in the period cost report as: A final point to mention about stock is that the closing stock for one period becomes the opening stock for the next period. If a factory values its stock at the close of business on 31st January, the figure determined will be the

76  Costing for the Fashion Industry

Table 7.4  Material

Col 1

Col 2

Col 3

Col 4

Col 5

Blue denim

1,200

8,400

9,600

1,650

7,950

Grey denim

800

6,700

7,500

1,500

6,000

Stone corduroy

4,300

0

4,300

1,200

3,100

Green corduroy

850

5,700

6,550

2,100

4,450

Grey polycotton

750

4,400

5,150

800

4,350

Calico

230

3,500

3,730

350

3,380

8,130

28,700

36,830

7,600

29,230

Table 7.5  £ Opening stock of direct materials

8,130

Add Purchases of direct materials

28,700 36,830

Less Closing stock of direct materials Cost of direct materials used

7,600 29,230

closing stock for January and it will also represent the stock available ready to start work on the 1st February. Thus January’s closing stock figure is the opening stock figure for February.

Value of the work-in-progress A further complication in the period cost report is that for most factories at the beginning and end of periods there will be some partially completed garments in the factory. Thus the costs for any period will include costs relating to completing garments started in the previous period and starting garments that will not be completed until the next period. This is known as work-in-progress and it is customary to value it at the end of each period. Different factories have different methods for valuing the work-in-progress but essentially the part completed garments are counted

Costing Over Periods of Time  77

at different stages of production and a value placed on them representing their material content and other costs incurred to get them to that stage of completion. To simplify this, factories will break the factory down into stages – all garments at stage 1 are 10 per cent complete, at stage 2 are 20 per cent complete, at stage 3 are 30 per cent complete and so on. The valuation of the work-in-progress at the end of one period becomes the value of the opening work-in-progress for the next period. The period cost report is usually adjusted for the value of the work-in-progress and this adjustment is made to the production cost.

Work-in-progress adjustment The work-in-progress adjustment will be done in the following way: Table 7.6  Prime cost Add Production overheads Add Opening value of the work-in-progress Less Closing value of the work-in-progress Production cost

Period-end adjustments As already mentioned the object of the period cost report will be to show the costs for that period and we have seen that this may mean adjusting the report for the value of stocks of direct materials and work-in-progress. However, other costs are often also adjusted to make them reflect the cost for the period in question. For example, business rates in the UK are usually paid in two halves in April and October. The payment for business rates in April will cover the business right through until the end of September. The period cost report for each month will only contain business rates appropriate for one month.

78  Costing for the Fashion Industry

Example A business has received its property insurance account for the coming year; it is £4,800, to be paid immediately and will cover the business from January to December. When property insurance as a cost is put into the monthly period cost report it will appear as £400 each month (£4,800 ÷ 12).

When the payment made is not the issue, it is the period for which the cost is incurred that is important. There now follows a more detailed example of a period cost report, you should consider the data and then look at the report to see how it has been analysed. Note how the analysis follows the elements of cost.

Period cost report – a detailed illustration Alpha Garments Ltd – The following costs for the month of January were recorded. Factory wages and salaries: ●●

Cutters

58,100

●●

Fusing press operators

●●

Sewing machinists

●●

Press room

●●

Packing 8,045

●●

Supervisors 13,700

●●

Work study

●●

Cleaning 8,344

●●

Factory management

4,320 134,100 29,200

3,575 12,800

Direct materials: ●●

Stocks at the start of the period

178,800

●●

Stocks at the close of the period

215,000

●●

Purchased in the period

575,000

●●

Carriage inwards

5,960

Business rates (2/3rds factory)

27,000

Power, light and heat (2/3rds factory)

36,000 Costing Over Periods of Time  79

Insurance (3/4 factory)

16,000

Sales and Administration salaries

63,000

Telephone, postage and stationery

5,060

Interest on loans and overdrafts

5,660

Distribution costs

11,600

Depreciation: ●●

Factory machinery

20,800

●●

Factory furniture and fittings

5,500

●●

Office furniture and equipment

3,800

Value of the work-in-progress: ●●

At the start of the period

12,660

●●

At the end of the period

14,300

Table 7.7  Alpha Garments Ltd period cost report – January 20XX Direct material

£

£

Opening stock

178,800

Add purchases

575,000

Add Carriage inwards

£

5,960 759,760

Less Closing stock

215,000 544,760

Cost of materials used Direct labour Cutters Fusing press operators Sewing machinists Press room Packing

58,100 4,320 134,100 29,200 8,045

Direct labour cost

233,765

Direct expenses

-

Prime cost

80  Costing for the Fashion Industry

778,525

Table 7.7 (Continued) Direct material

£

£

£

Production overhead Supervisors

13,700

Work study

3,575

Cleaning

8,344

Factory management

12,800

Indirect labour cost

38,419

Business rates

18,000

Power light and heat

24,000

Insurance

12,000

Depreciation: Machinery Furniture and fittings

20,800 5,500 26,300 118,719

Production overhead cost

897,244 Add Opening work-in-progress

12,660 909,904

Less Closing work-in-progress

14,300

Production cost

895,604

Distribution costs

11,600

Sales and admin salaries

63,000

Office business rates

9,000

Heat light and power

12,000

Insurance

4,000

Telephone postage and stationery

5,060

Depreciation on office furniture

3,800

Interest on loan and overdrafts

5,660

Non-production overheads

114,120

Total cost

781,484

Costing Over Periods of Time  81

Exercises Exercise 1 From the following data, prepare a period cost statement for Bern Heart Fashions for the month of August analysed over the elements of cost. £ Direct materials purchased

86,700

Cutting room wages

2,300

Sewing room wages

3,500

Press and finishing wages

2,580

Depreciation of factory equipment

350

Depreciation of office equipment

230

Factory supervisors wages

3,800

Heat light and power (3/4 factory)

4,200

Insurances (3/4 factory)

250

Administration salaries

2,680

Opening stock of direct materials

2,500

Opening value of work-in-progress

4,250

Closing stock of direct materials

2,800

Closing value of work-in-progress

4,350

Bank charges

82  Costing for the Fashion Industry

120

Exercise 2 From the following data relating to Spring Garments for the month of May prepare a detailed analysed period cost report. £ Opening value of work-in-progress

5,600

Closing value of work-in-progress

6,200

Opening stock of direct materials

7,800

Closing stock of direct materials

9,200

Purchases of Direct Materials in May

88,000

Carriage inwards for May

230

Returns of direct materials

340

Bank charges and interest

420

Depreciation: Office furniture and equipment Factory machinery furniture and fittings

120 1,500

Factory supervisors wages

4,500

Cleaning costs (3/4 factory)

6,400

Sewing machinists wages

8,600

Cutting room wages

4,400

Press and finishing wages

3,200

Administration wages

2,250

Rent and business rates (80% factory)

5,600

Insurances (80% factory)

250

Postage and stationery

380

Sundry expenses factory

130

Costing Over Periods of Time  83

Exercise 3 From the following details relating to direct materials for a manufacturer, produce a report – analysed over each of the stock lines carried by the manufacturer, showing the total opening stock, the total purchases for the month, total closing stock and total cost of the materials consumed in the month. October 20XX £ Purchases for the month: Grey polycotton Blue denim Plain calico White cotton Interlining Buttons Thread

3,500 4,200 2,500 2,500 1,600 680 1,200

Opening stock at 1st October: Grey polycotton Blue denim Plain calico White cotton Blue cotton Interlinings Buttons Thread Zips

320 2,100 2,200 2,100 1,350 3,400 1,050 860 380

Closing stock at 31st October: Grey polycotton Blue denim Plain calico White cotton Blue cotton Interlinings Buttons Thread Zips

480 1,200 860 1,400 1,250 2,250 340 250 380

Carriage inwards costs for October: On grey polycotton On blue denim

125 80

Further reading Boyd, K. (2013) Cost Accounting for Dummies, Hoboken, NJ: Wiley. Drury, C. (2015) Management and Cost Accounting, Australia: Cengage Learning. 84  Costing for the Fashion Industry

8 Product cost – job costing

Introduction This chapter seeks to explain the costing for individual jobs of work passing through the factory. It is based around the elements of cost and introduces the concept of overhead absorption into costing. By the end of the chapter the student should be able to understand the principles of job costing and be able to produce job costs from given information.

What is job costing? Job costing is the system of costing jobs of work passing through the factory. Thus if a factory is approached by a retailer to make a quantity of garments, then it is by job costing that the manufacturer can see what it will cost to make the ‘job’ of garments and see if he can make any profit based on the contract price offered. The job cost is built up based on the elements of cost considered in the earlier chapters. The principle is to build the cost of the job up starting with the direct materials cost, then the direct labour cost and then the direct expenses (if there are any). This would then give the prime cost of the job, to this is added a ‘share’ of both the production overheads and the nonproduction overheads. This traditional system of building up the cost is known as ‘absorption’ costing and the share of the overheads allocated to each job are known as the overheads absorbed. This system of job costing is illustrated in Figure 8.1.

Direct materials cost

(actual cost)

Direct labour cost

(actual cost)

Direct expenses (if any)

(actual cost)

Production overheads

(pooled and shared)

Non-production overheads

(pooled and shared)

Job cost

Figure 8.1  The job costing process.

Treatment of the direct costs With the direct costs, direct material, direct labour and direct expenses, actual cost is used as far as possible. Thus with the direct materials in garment manufacture the actual cost of the fabrics, linings, threads, buttons, zips and so on that form the garment is used. The amount of fabric required per garment is taken from the lay plans; where computerized lay planning is used the computer will give an accurate figure for fabric per garment. Example A factory making a job of 20,000 dresses has done its lay plan and it shows an average fabric usage of 1.25 metres at the standard width. The fabric was purchased for £2.30 per metre, thus the fabric cost in this job will be:

1.25 ´ 20, 000 ´ £2.30 = £2, 500.30 Other direct materials used to make the garment will also be costed using the actual cost of those materials. There may have to be some estimation in this;

86  Costing for the Fashion Industry

for example, with the thread there is no easy or accurate way to cost the thread used on a garment so the factory will estimate this cost. However, as far as possible the manufacturer will use actual cost for the direct materials. Care needs to be taken with the direct materials to make sure that all the materials used are included in the job cost; this may include the cost of labels and care labelling. Keep in mind that direct materials are likely to represent 50 per cent of the cost of the job.

Similarly, with the direct labour, the wages cost of those operators that make the garments will be the direct labour cost in the job. This is usually based around the time taken to perform the various manufacturing functions – including laying up and cutting, fusing, a range of sewing operations, pressing and in some cases packing the garments. The costs are based around the time taken for the production activities multiplied by the hourly rates of pay. Here an allowance has to be made to take account of operators who work a little faster or slower and the fact that best performance will not be achieved all the time. An allowance to cover employer’s contributions to national insurance and possibly pension schemes – known as ‘on-cost’ – may also be included. Many of the labour operations will be based around what are referred to as standard minute values or SMVs. These are the standard times for performing that manufacturing process. For a job of garments these times can be totalled, converted to hours and then multiplied by the appropriate wage rate. Example A skirt has an allowance of 12 standard minutes for its sewing operations. The job involves making 20,000 skirts and the current hourly wage rate for a machinist is £6.10; thus the direct labour cost of the sewing operations will be:

(12SM ´ 20,000 ) ¸ 60 = 4,000 direct labour hours 4,000 ´ £6.10 = £24,400 direct labour cost of the sewing operations.

In situations where direct expenses arise, royalties or specific costs that relate just to that job of garments these too are costed based on actual cost. These costs are nearly always quoted per garment or per piece so they are usually easy to cost.

Product Cost – Job Costing  87

Example A jeans manufacturer has a job of 20,000 pairs of jeans and these require a stonewashed finish. The manufacturer does not do the stonewashing in his own factory but subcontracts the work at £0.20 per pair. Thus this direct expense would be: 20,000 ´ £0.20 = £4,000 direct expense cost of stonewashing.

Treatment of the overheads As has been shown in the earlier chapters the overheads of the business are grouped into two categories, ‘Production Overhead’ and ‘Non-production Overhead’. A share of both of these needs to be costed in with the costs of each job. The problem with the overheads is that unlike the direct costs they do not relate to the jobs of work passing through the factory. The overheads are the broader costs of running the factory and the business and tend to relate to periods of time rather than the product passing through the factory. They nonetheless need to be covered in job costing process. A further problem with the overheads is that they are not all paid at one time; they are paid at various times during the year – water and electricity quarterly, business rates half-yearly, rent monthly in advance, management salaries monthly in arrears, supervisors wages weekly and so on. Thus at stages through the year the full extent of the overheads is not fully known. To deal with these problems, absorption costing estimates the overheads in advance usually for the whole year and then shares them among the job on an agreed basis. This sharing process is known as overhead absorption or overhead recovery.

Absorption of production overheads There are several methods of absorbing the production overheads into the job cost; however, in this text we will consider four common methods that are widely used. 1. In proportion to the output of the units of product – Unit Rate. 2. In proportion to the direct labour hours – Direct Labour Hour Rate.

88  Costing for the Fashion Industry

3. In proportion to the direct labour cost – Percentage of Direct Labour Cost. 4. In proportion to the machine running times – Machine Hour Rate.

Unit rate In this method, the total production overheads are estimated for the year and divided by the number of estimated garments to be produced in the year. This gives a rate of overhead to be absorbed per unit of output. The calculation can be summarized as: Total Estimated Overheads = Overhead Rate per Unit Estimated Total Units Produced Example A garment manufacturer estimates his overheads to be £125,500 for the year and anticipates an output of 48,000 garments in the year. Thus his production overhead absorption rate will be: £125, 500 = £2.61 48, 000

Thus for each garment in the jobs the manufacturer will add £2.61 to the cost to cover the production overheads. In a job to make 20,000 skirts the production overhead figure will be: 20,000 ´ £2.61= £52,200 overhead absorbed.

This method suffers from the fact that not all the garments manufactured are necessarily the same and some complex garments may spend more time in manufacture than other garments. However, for the small manufacturer who makes similar products this may prove to be a simple way to absorb the overheads.

Direct labour hour rate In this method, the total production overheads are estimated for the year and divided by the estimated total direct labour hours for the year. This gives an

Product Cost – Job Costing  89

amount of production overhead to be absorbed for every direct labour hour in the job. The calculation is: Estimated Production Overhead = Direct Labour Hour Rate Estimated Direct Labour Hours Example A manufacturer estimates his production overheads to be £125,500 for the year and estimates that there will be 19,600 direct labour hours in the year. The calculation of the direct labour hour rate will be:

£125, 500 = £6.40 19, 600 Thus in a job where the direct labour hours amount to 4,020, the overhead cost to be absorbed into the job cost will be:

4,020 ´ £6.40 = £25,728 overhead absorbed.

Percentage of direct labour cost This is a variation on the direct labour hour rate method in that it is essentially the same except that the divisor is the estimated direct labour cost rather than the estimated direct labour hours. In situations where the direct wages are the same across the factory or manufacturing department the result should be similar. The calculation of the percentage of direct labour cost will be: Estimated Production Overhead ×1100 = Percentage of Direct Labour Cost Estimated Direct Labour Cost Example A manufacturer estimates his production overheads to be £125,500 for the year and estimates that the direct labour cost will be £88,200 for the year. Thus the percentage to be used in absorbing the overheads will be:

£125, 500 ´ 100 = 142.3% £88, 200

90  Costing for the Fashion Industry

The percentage, 142.3 per cent, applied to the direct labour cost in the job to obtain the amount of production overhead is to be absorbed in the job cost.

Machine hour rate This method of absorbing the production overheads lends itself to factories or manufacturing departments that are largely automated, where the throughput of the product is not controlled by the operator. An automated fusing section or an automated cutting operation might be good examples. In this method the machine hours, that is, the machine running time is used in the computation of the overhead absorption rate. The calculation of the machine hour rate is: Estimated Production Overheads = Machine Hour Rate Total Estimated Machine Hourss Example A clothing manufacturer has a fusing section that is largely automated. The production overheads in this section are estimated to be £42,500 for the year and the machine running time to be 2,000 hours for the year. Thus the machine hour rate is:

£42, 500 = £21.25 2, 000 Thus the rate of £21.25 per machine hour will be applied to each job that requires fusing work to be done on it.

Cost centres While it may be possible to calculate an overhead absorption rate for the whole factory that would be unusual, in all but very small operations. Most manufacturing units will be broken down into production sections or departments known as Production Cost Centres. Each production cost centre will have its own overhead absorption rate calculated as shown earlier and based on the estimated overheads in that cost centre, this will normally include a share of ‘service overheads’ like cleaning, maintenance, storekeeping, canteen services and so on.

Product Cost – Job Costing  91

Establishing cost-centre-based overhead absorption rates has the following advantages: ●●

●●

●●

Enables more accurate approach to the costing of overheads in the job costs Allows the factory to use a range of methods of calculating the overhead absorption rates – choosing ones most suitable for the department concerned Does not require all jobs to pass through every cost centre, thus allowing only overheads applicable to the job to be absorbed in the job cost

Absorption of non-production overheads The non-production overheads represent a much smaller proportion of the overhead cost but over an annual period; they still need to be accounted for in the job costing. It should be born in mind that though these costs are a much smaller proportion of the overheads they are still significant and in larger companies that tend to have larger administrative structures the nonproduction overheads may be very much higher. The treatment of the non-production overheads in the job costing is to add a small percentage to the production cost of each job. This percentage varies considerably with the size of the business, 2 per cent or 3 per cent in a small business to between 12 per cent and 15 per cent in very large organizations. In theory, estimating the non-production overheads for the year and taking them as a percentage of the estimated total production cost for the year the percentage can be calculated as: Estimated Non-Production Overheads × 100 Estimated Production Costt Example A manufacturer estimates that his non-production overheads for a year will be £89,350 and his estimated total production costs for the year will be £1,778,000. Thus the absorption of non-production overheads will be based on the following percentage:

£89, 350 ´ 100 = 5% £177, 8000

92  Costing for the Fashion Industry

Thus 5 per cent of production costs will be added to each job cost to represent the absorption of the non-production overheads. However, because the absorption of the non-production overheads tends to be a bit arbitrary some businesses just use a standard percentage and others do not try to absorb the non-production overheads.

Example of a job cost Let us now take an example of a job of garments to be made in a factory. Firstly, the extent of the job and the costs will be collated and from this, a job cost sheet can be compiled.

The job The job is to produce 50,000 pairs of jeans in a range of sizes. The costing is to include all the materials, packing label, direct labour, stone washing and so on and appropriate production and non-production overheads. Direct materials Main fabric – Denim – 1.285 metres per pair @ £1.80 per metre Thread £0.05 per pair Zip £0.50 per pair Button stud £0.03 each – one per pair Labels £5.00 per thousand Cardboard packer £5.00 per thousand. Direct labour The job requires 3 staff to work for 8 hour in laying up and cutting. The sewing operations take 12 SM per garment. The press and pack operations take 0.8 SM per garment. Direct labour rates cutting room - sewing operations - press and pack -

£7.20 per hour £5.80 per hour £5.75 per hour.

Product Cost – Job Costing  93

Direct expenses Stonewashing – contracted out at £50 per thousand items. Production overhead Overhead absorption (recovery) based on: laying up and cutting sewing operations press and pack

£6.80 per direct labour hour 200 per cent of the direct labour cost 180 per cent of the direct labour cost

Non-production overhead Overhead absorption (recovery) based on 5 per cent of production cost of the job. Table 8.1 shows the job cost sheet for the 50,000 jeans order broken down over the elements of cost. At the bottom of the sheet is the total cost, that is, the cost of producing this order based on the estimated overhead absorption rates. It also shows the unit cost of the job, that is, the cost on average of making one part of jeans in the order. Unit Cost =

Total Job Cost Garments Produced

£349, 355.29 ¸ 50, 000 = £6.99 Different manufacturers may lay out the costs differently and clearly this lends itself to a computer spreadsheet model but Table 8.1 illustrates the principles to be adopted. Similarly, the wage rates including the on-costs of employment may be higher and vary from different employers but the principles are illustrated here.

Over-/underabsorption of overheads It has been demonstrated in this chapter that overheads are treated in the product costing by absorbing them based on a predetermined rate. This will entail estimating the overheads in advance which for an established business should not be a major problem and if done with care can be reasonably accurate. However, it is likely at the end of the year that the overheads incurred will not exactly match those absorbed in the product costing. 94  Costing for the Fashion Industry

Table 8.1  Job cost sheet, jeans 50,000 pairs £p

£p

Direct material Fabric

1.285 × £1.80 × 50,000

115,650.00

Thread

£0.05 × 50,000

2,500.00

Zip

£0.50 × 50,000

25,000.00

Button stud

£0.03 × 50,000

1,500.00

Labels

£5 × 50

250.00

Card packer

£5 × 50

250.00 145,150.00

Direct labour Cutting room

3 × 8 × £7.20

172.80

Sewing room

[(12 × 50,000) ÷ 60] × £5.80

58,000.00

Press & pack

[(0.8 × 50,000) ÷ 60] × £5.75

3,833.33 62,006.13

Direct expenses Stonewashing

2,500.00

£50 × 50

Production overheads Cutting room

3 × 8 × £6.80

Sewing room

200% of £58,000

Press & pack

180% of £3,833.33

163.20 116,000.00 6,899.99 123,063.19

Production cost Non-Production overhead

332,719.32 5% of £332,719.32

Total cost Unit cost

16,635.97 £349,355.29

£349,355.29 ÷ 50,000

£6.99

The overheads absorbed might exceed the actual overhead costs – overabsorption: or the overheads absorbed might be lower than the actual overhead cost – underabsorption. The under- and overabsorption will feature in the profit and loss account for the business. In the case of overabsorption it increases the profit for the

Product Cost – Job Costing  95

year and in the case of underabsorption it reduces the profit for the year. Clearly, underabsorption needs to be kept to a minimum as this reduces the anticipated year-end profit of the business and may lead to the acceptance of unviable work – remember profit margins in clothing manufacture are slim. However, although overabsorption increases the year-end profit, it may result in lost work as job costs may not be competitive.

Process costing Process costing is a form of unit costing (i.e. establishing the cost of one garment). This approach was mentioned in Chapter 3 where it was suggested that the total cost for the period could be divided by the garments produced in the period to give an average unit cost. This approach is sometimes used by clothing manufacturers that continually produce the same product and they are all very similar – a shirt factory would be a good example. In such situations, the management will use the unit cost or process cost as the guide for making acceptance decisions. Care has to be taken in accounting for the work-in-progress in such systems and an appropriate allowance needs to be made for this. One method is to take the total costs for the period and divide by the completed garments plus the work-in-progress converted into wholes garments.

Table 8.2  Total costs for the period Complete garments produced Part garments: 1,000 20% complete (= 200) 1,000 50% complete (= 500) 1,000 75% complete (= 750) work-in-progress expressed as complete garment

£100,000 25,000 1,450

Total output for the period

26,450

Process cost per garment

£3.78

96  Costing for the Fashion Industry

Example It can be seen in the preceding example that the work-in-progress at the end of the period is expressed in terms of completeness – thus 1,000 garments 20 per cent complete represents 200 complete garments. The notional numbers of complete garments are then added to the actually complete garments to give the devisor to give the process cost. In the preceding example it is:

£100,000 = £3.78 per garment 26,450

Exercises Exercise 1 Mercia Fashions Mercia Fashions does its job costing based on the following rates: Cutting

Fusing

Sewing

Pressing

Packing

Direct labour

£11.05

£6.25

£6.75

£7.15

£6.25

Production overheads

DLHR

MHR

%DLC

DLHR

%DLC

Production overhead rate

£15.20

£6.70

180%

£7.60

150%

Additionally Mercia Fashions add 5 per cent of production cost to all jobs to cover the absorption of the non-production overheads.

Job to make 20,000 ladies dresses: Direct materials The lay plan shows that the average fabric requirement per dress is 1.4 metres at a cost of £5.20 per metre. Zip – one per garment – £0.45. Buttons – 3 per garment – £0.01each. Interlining – allow £0.25 per garment. Thread – allow £0.20 per garment

Product Cost – Job Costing  97

Direct labour Laying up and cutting will involve three operators for 6 hours. Fusing of the whole 20,000 dresses can be done in 3 machine hours; however, it will involve the operator in 4 hours of work. Sewing requires 10 SM per garment. Pressing 0.5 SM per garment. Packing 0.4 SM per garment. Provide a job cost sheet showing the total job cost and the unit cost.

Exercise 2 Frankfurt Fashions Frankfurt Fashions is a clothing manufacturing business producing ladies wear. The factory is organized into three production departments and each department is a cost centre with a separate overhead absorption rate for absorbing the overheads. The three departments (cost centres) are Cutting, Sewing and Press/Finish, and they absorb their production overheads: Cutting - Machine Hour Rate Sewing - Percentage of Direct Labour Cost Press/Finish - Direct Labour Hour Rate In addition to the overheads that relate to the production departments there are also some service overheads, like Maintenance, Cleaning, Factory Personnel and these are allocated to the production departments. The following table details the estimates for the coming financial period. Cutting

Sewing

Press/finish

£24,000

£96,000

£22,000

Maintenance

£6,500

£35,600

£6,700

Cleaning

£7,500

£23,400

£6,000

Personnel

£4,500

£25,500

£10,500

£42,500

£180,500

£45,200

Direct labour hours

5,500

18,240

5,000

Machine hours

3,600

Estimated overheads Service overheads:

Total

Direct Labour cost

£71,000

98  Costing for the Fashion Industry

–

–

£114,200

£33,500

Calculate the appropriate overhead absorption rates for the production overheads for the factory. The factory also adds 5 per cent on to the production cost to cover nonproduction overheads.

Exercise 3 Offas Fashions Ltd Offas Fashions Ltd, a garment manufacturer, uses job costing and in the current year is using the following wage rates and overheads absorption rates. Cutting

Fusing

Sewing

Pressing

Direct wage rate (per hour)

£8.80

£4.20

£4.50

£4.80

Overhead absorption

Machine hour rate

Machine hour rate

Percentage of DLC

Direct labour hour rate

Overhead rate

£10.50

£.4.50

180%

£5.50

Additionally Offas Fashions Ltd adds 5 per cent of production cost to all jobs to cover non-production overheads. You are required to produce a total job cost and a unit cost for the following job.

Job No: 1578/003 The job involves making 50,000 pairs of trousers in various sizes, in one fabric. Direct materials The lay plan shows that the average fabric requirement per pair of trousers is 1.29 metres, based on a fabric width of 150 centimetres. The cost of the fabric is £2.75 per metre. Zip – one per pair, cost £0.48. Waistband lining, allow £0.15 per garment. Product Cost – Job Costing  99

Fusible interlining, allow £0.20 per garment. Metal hook fastener, one per pair, cost £0.01 each. Thread allow £0.25 per garment. Direct labour Laying up and cutting will take three operators 10 hours, using 28 hours of machine time. Fusing the whole job can be done in 3 hours of machine time; however, this will involve 4 hours of operator time.

Exercise 4 Wessex Wear Ltd Wessex Wear Ltd, a garment manufacturer, uses job costing and in the current year is using the following wage rates and overhead absorption rates. Cutting

Sewing

Pressing

Direct wage rate (per hour)

£8.75

£4.50

£4.60

Overhead absorption

Direct labour hour rate

Percentage of DLC

Direct labour hour rate

Overhead rate

£10.50

175%

£5.50

Additionally Wessex Wear Ltd adds 5 per cent of production cost to all jobs to cover non-production overheads. You are required to produce a total job cost and a unit cost for the following job.

Job No: 1679/003 The job involves making 25,000 denim skirts in a small range of sizes, in one fabric. Direct materials The lay plan shows that the average fabric requirement per skirt is 0.85 metres, based on a fabric width of 150 centimetres. The cost of the fabric is £2.45 per metre.

100  Costing for the Fashion Industry

Zip – one per skirt pair, cost £0.45. Button, one per skirt, cost £0.01 each. Thread allow £0.20 per skirt. Direct labour Laying up and cutting will take three operators 6 hours. The sewing operations require 9.5 SMs per garment. Pressing requires 0.40 SMs. Direct expenses Stonewashing and ripping done externally at £0.36 per garment.

Further reading Bhimani, A. (2015) Management and Cost Accounting (6th ed.), New York; Harlow, England: Pearson. Boyd, K. (2013) Cost Accounting for Dummies, Hoboken, NJ: Wiley. Drury, C. (2018) Management and Cost Accounting (10th ed.), Australia: Cengage Learning.

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9 Marginal costing

Introduction At the beginning of Chapter 6, it was noted that there are a number of ways in which costs can be classified. It was also noted that one way to consider costs is based on their behaviour. If the costs of a manufacturing business are considered, it can be seen that some costs relate closely to the product being made, like the direct material used in the product and the direct labour used to make the product. Whereas some costs relate to the business as a whole, they are not product specific and are often based over periods of time, like rent of a factory unit, business rates or management salaries. This classification of costs is used in a system of costing called marginal costing and this can add to our overall understanding of costs and can provide a useful method of considering cost in the decision-making process.

Variable costs Those costs that relate specifically to the product being made are referred to as variable or marginal costs – they tend to increase in proportion to the output of the product being made. Thus the more garments that you make, the greater the amount of fabric that will be needed and on the whole the amount of fabric required will increase in proportion to the number of garments being produced and therefore the fabric cost will increase with the output. However, because each garment (of the same type) uses the same amount of fabric the unit cost of the variable costs is the same per garment.

In manufacture of fashion garments the following would be typical variable costs: Fabric Thread Trimmings Fastenings – buttons etc. Interlining Cutters’ wages Machinists’ wages Royalties Press room wages

Fixed costs Those costs that relate to the business as a whole and are not specifically related to the product being made are called fixed costs and as these often relate to periods of time they are also sometimes referred to as period costs. These costs are fixed over periods of time, like rent and business rates. That is not to say that rent and rates do not increase; indeed they usually increase from one year to the next but they do remain fixed over given periods of time and they do not increase with the output of the product. However, this means that the fixed cost per unit cost decreases as output increases. This can be illustrated with a simple example of rent for a factory unit. Suppose a manufacturer has to pay £100,000 per annum in rent – if he produced 50,000 garments in that period, then the unit cost would be £2 per garment, but if he produced 100,000 garments, then the unit cost would be £1 per garment. In the manufacture of fashion garments the following would be typical fixed costs: Rent of a factory unit, offices etc. Business rates Management salaries Certain types of loan interest Insurance premiums

Marginal Costing  103

Semi-variable costs Inevitably, in all businesses there are some complex costs that do not sit easily in either the ‘variable’ or ‘fixed’ categories; they often contain an element of both. These are known as semi-variable costs or semi-fixed costs. These costs have fixed and variable elements which can sometimes be identified but not always. A typical example of a semi-variable cost in clothing manufacture might be supervisors’ wages and salaries, where the supervisor is paid a fixed wage for supervisory work but may also be paid additionally for garments produced on the production line. In the manufacture of fashion garments the following would be typical semivariable costs: ●●

Power – electricity (standing charge and a charge for electricity units consumed)

●●

Depreciation of machinery

●●

Maintenance

Consider the following table and decide whether the costs listed are variable, fixed or semi-variable – tick the appropriate column. Answers are at the end of the chapter but do the exercise before looking. Having understood this method of analysing cost, we now need to consider how it can be used. It in fact has a number of uses – it can be used to produce marginal costs statements that are based on this classification of cost, it is used in break-even analysis (see Chapter 10) and it can be used in budgeting to produce what are called flexible budgets. This chapter considers the marginal cost statement and the contribution.

Contribution So far we have considered costs and we have made the connection, in the earlier chapters, between cost and profit – the revenue for the year less the costs giving the profit for the year. With marginal costs, we are concerned with the profit for the business as a whole but also the contribution that each product makes to the fixed costs of the business and the overall profit.

104  Costing for the Fashion Industry

Contribution is calculated by taking the revenue generated by the product and deducting the variable costs. The revenue the product(s) generate is generally referred to as the sales – therefore the calculation of the contribution is: Contribution = Sales − Variable Costs Example Modus Shirts, a garment manufacturer, has three products – sweatshirts, polo shirts and T-shirts – and they sell with varying degrees of success. Sales

Sweat Shirts £140,000: Polo Shirts £100,000: T- Shirts £50,000 They incur direct material and direct labour costs that form their variable costs for each product. Variable costs

Sweat Shirts £72,000: Polo Shirts £56,000: T-Shirts £48,000 The factory also incurs rent and business rates and a range of other fixed costs that amount to £44,000 for the year. Their Marginal Cost Statement would look like: Table 9.1  Modus shirts marginal cost statement Sweat shirts £’000

Polo shirts £’000

T-shirts £’000

Total £’000

140

100

50

290

Less Variable costs

72

56

48

176

Contribution

68

44

2

114

Sales

Fixed costs

44

Net profit

70

It can be seen in Table 9.1 that the information for Modus Shirts has been put into a marginal cost format and that the contribution for each product

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has been calculated. You will note that the fixed costs have only been deducted from the total contribution in order to obtain the profit for the business as a whole.

The contribution shows how much each product will add or contribute to the business in order to meet the fixed costs of the business and increase the profits. In the Modus Shirts example it can be seen that each of the products makes a positive contribution; thus they all contribute something to the fixed costs of the business and the overall profitability. The objective is to increase the contribution that the products make to ensure meeting the fixed costs and increasing the profits. Products that show a negative contribution need to be considered carefully by management and if their position cannot be improved to give a positive contribution, then they may need to be eliminated from the range and the capacity used for something else. Had the variable costs for producing the T-shirts in the Modus Shirts example been £52,000, then this would have produced a negative contribution for T-shirts and a very different outcome for the business, as illustrated in Table 9.2. In this situation, Modus Shirts would have to decide what to do with a product range that gives a negative contribution and therefore reduces the overall profit of the business. Under certain circumstances management may be prepared to accept a negative contribution if it enables them to sell more of their other products but as ‘a rule of thumb’ negative contributions should be eliminated. Before reading on you should now consider what action the management of Modus could take in these circumstances. Table 9.2  Modus shirts marginal cost statement Sweat shirts £’000

Polo shirts £’000

T-shirts £’000

Total £’000

140

100

50

290

Less Variable costs

72

56

52

180

Contribution

68

44

(2)

110

Sales

Fixed costs

44

Net Profit

66

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These are some of the options available to the Modus management: 1. See if the T-shirts would stand an increase in price to increase the sales revenue; 2. Look at controlling the costs of the T-shirts to reduce the variable costs and give a positive contribution – perhaps better fabric utilization; 3. 1 and 2 could be done in tandem to give a positive contribution; 4. Eliminate the T-shirts from the product range and see if the spare capacity could be used for a product that would give a positive contribution – perhaps making hoodies; 5. Eliminate the T-shirts from the product range and use the spare capacity to make more sweat shirts and polo shirts if the market exists for the increased output; 6. Do some combination of 4 and 5.

Treatment of the semi-variable costs As mentioned earlier most businesses will have some costs that do not easily fit into the variable/fixed categories. They usually have an element of both in them and the variable/fixed elements are often not easy to separate. The treatment of the semi-variable costs in marginal costing is to split them into their respective fixed and variable elements. This can be done with varying degrees of success depending on the nature of the cost but may require some estimation. A typical and relatively simple example would be supervisors’ wages where the supervisor is paid a fixed wage for her supervisory work but receives additional payment in proportion to work done on the production line contributing to making garments. Thus this semi-variable cost would be simple to apportion between its fixed and variable elements. A more complex semi-variable cost would be Power or Electricity as this may have a fixed standing charge and a rate for electricity consumed though there may, in some circumstances, be several rates for the units consumed. Clearly the standing charge is fixed cost and the running of machinery will probably be the major user of the units of electricity consumed but electricity will be used in other parts of the business – the offices, for lighting, heating

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and so on. Thus the power charge is not a simple divide between its fixed element and the charge for units of electricity consumed. A similar problem could well arise with maintenance. In these circumstances management will have to make decisions about the proportion of semi-variable cost to be considered fixed and variable. Example This example shows how the semi-variable costs might be treated in a Marginal Cost Statement. The following table shows the costs for a small manufacturer over a coming period. The intention is to produce 10,000 standard garments in this period at a selling price of £6.50 each (£65,000).

Table 9.3  Cost

Type of cost

Amount of cost

Cost at 10000 garment output

Direct materials

Variable

£2.85 per garment

£28,500

Direct labour

Variable

£2 per garment

£20,000

Rent/business rates

Fixed

£4,000 for the period

£5,000

Supervision

Semi-variable

£4,000 fixed plus £0.25 per garment

Fixed £6,000 Variable £2,500

Heat/light / power

Semi-variable

£500 fixed plus £0.5 per garment

Fixed £500 Variable £5,000

Table 9.4  Marginal cost statement £ Sales (10,000 × £6.50)

65,000

Less variable costs (£5.60* × 10,000)

56,000

Contribution

9,000

Fixed costs (£4,000+£4,000+£500)

8,500

Net profit

500

In the marginal cost statement all the variable costs will be grouped together (under their respective products if there are several) and all the fixed costs are grouped together.

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The variable costs are made up of the direct material, direct labour and the variable elements of the supervision and the heat, light and power.

(£2.85 + £2.00 + £0.25 + £0.50 = £5.60* )

Case study Country Style is a rather conservative business, making men’s ‘hacking’ style jackets and gillets. The company has analysed its cost and anticipated sales for the next half year and came up with the following figures: Table 9.5  Jacket styles

The dale

The glen

The gillet

Selling price to retailers

£28.50

£40.00

£25.00

Variable costs per style

£25.50

£37.00

£21.50

Estimated sales (based on orders in garments)

24,000

13,500

10,000

The fixed costs for the period have been calculated at £150,000.

Table 9.6  Marginal cost statement existing business The dale £

The glen £

The gillet £

Total £

Sales

684,000

540,000

250,000

1,474,000

Less variable costs

612,000

499,500

215,000

1,326,500

72,000

40,500

35,000

147,500

Contribution Fixed costs Net profit (loss)

150,000 (2,500)

Given that business has contracted in recent years the factory does have some spare capacity and additional business would be welcome. They have another potential order for the period for a significant number of jackets but it would require producing the Glen style with some modifications to

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suit an overseas buyer and this would increase the variable costs of these jackets by £0.50. The order is potentially for 5,000 in the period and may lead to further work. However, in addition to the increase in the variable costs for these special Glen jackets the customer wants a reduced price and is only prepared to pay £38.00 per jacket.

Issues raised 1. Management need to consider their current position given the business they have. 2. Management need to consider the impact of the new order and whether increased costs and a lower selling price are viable – assuming that they have the capacity for the order. Table 9.7  Marginal cost statement existing plus potential business The dale £

The glen £

The glen modified £

The gillet £

Total £

Sales

684,000

540,000

190,000

250,000

1,664,000

Less variable costs

612,000

499,500

187,500

215,000

1,514,000

72,000

40,500

2,500

35,000

150,000

Contribution Fixed costs

150,000

Net profit

–

It can be seen that on the basis of the existing business they would show a small loss for the period. However, notably all the product lines show a positive contribution. The figures for Table 9.6 are calculated by multiplying the sales and variable costs figures given in the case study by the estimated number of garments to be sold. Thus sales for the Dale are £28.50 × 24,000 = £684,000. The figures for the modified Glen are calculated by taking the original Glen figures and adjusting them to take account of the revised data relating to the potential order. Thus the selling price becomes £38.00 per garment and the variable cost £37.50 per garment. Thus the contribution on the potential business is very slim – only £0.50 per garment but it can be seen

110  Costing for the Fashion Industry

(Table 9.7) that this would be enough to enable the business to breakeven (i.e. make no profit and no loss) in the coming period. Hopefully if fulfilled satisfactorily it will lead to more overseas business with bigger contributions.

Cost

Fixed

Variable

Semi-variable

Thread Building insurance premiums Heat/light/power Interlining Shirt buttons Factory manager’s salary Fusing press operators’ wages Business rates Stationery Telephone Cutting room wages Receptionists’ wages Press Room wages Zips for trousers Boxes for a boxed shirt Delivery vehicle costs Canteen staff wages Bank loan interest Bank charges Fabric for dresses

Exercises Exercise 1 Fixed/variable/semi-variable From the list of costs given in the following table, indicate whether they are likely to be fixed, variable or semi-variable costs for a clothing manufacturer.

Marginal Costing  111

Cost

Variable

Fixed

Semi-variable

Fabric for garments Lining for garments Fusing press operators’ wages Electricity costs Debenture interest Zips for inclusion in trousers Van drivers’ wages Sewing machinists’ wages Managing directors’ salary Thread costs Buildings insurance premiums Stonewashing costs Salesman’s salary Packers’ wages Batting for anoraks Receptionists’ wages Business rates Depreciation on machinery Maintenance of factory machinery Cleaners’ wages

Exercise 2 Fallowfield Fashions From the following data for Fallowfield Fashions, prepare a Marginal Cost Statement clearly showing the contribution made by each product. The fixed overheads for the period are estimated to be £140,000. Shirts (longsleeved) £’000

Shirts (shortsleeved) £’000

Direct materials (variable)

90

72

60

60

Direct labour (variable)

50

40

30

40

5

3

2

3

200

160

90

150

Variable overheads Sales

112  Costing for the Fashion Industry

Blouses style A £’000

Blouses style B £’000

The management of Fallowfield Fashions had considered dropping the Blouse Style A product. Suggest what effect this would have on the business if this was followed through as an action.

Exercise 3 Melton Fashions Melton Fashions makes ladies dresses and for the coming four-week period have three styles in production. The following table shows the costs for the period and the orders received. The fixed costs for the period are estimated at £20,000. Style A

Style B

Style C

£16,800

£13,000

£11,680

Direct labour costs

£7,700

£7,000

£7,840

Variable overheads

£2,100

£2,400

£2,080

Sales in garments (orders)

700

1,000

800

Selling Price

£50

£32

£34

Direct materials cost

They have received an enquiry about a further order for 500 Style C dresses but the customer wants the price reduced to £31. Prepare a Marginal Cost Statement for the confirmed business for the period. Prepare a revised Marginal Cost Statement to include the new order at the reduced price assuming that the business has the capacity to meet this order. Comment on whether the new business should be accepted and why.

Further reading Bhimani, A. (2015) Management and Cost Accounting, (6th ed.), Harlow: Financial Times Prentice Hall. Boyd, K. (2013) Cost Accounting for Dummies, Hoboken, NJ: Wiley. Drury, C. (2018) Management and Cost Accounting (10th ed.), Australia: Cengage.

Marginal Costing  113

10 Break-even analysis

Introduction This chapter focuses on break-even analysis and uses the same classification of costs as the previous chapter on marginal costing. Indeed, it is an extension of the marginal costing and the use of the fixed and variable cost concept. The objective of break-even analysis is to establish the point at which the business will reach its break-even point. The break-even point is the point at which the business will make neither a profit nor a loss – the revenues will exactly cover the costs. In the short term, this is a useful piece of information as it gives management an understanding of what level of business that they need to achieve to at least cover their costs. Beyond the break-even point the business will go into profit; thus the sooner the business passes through its break-even point, the sooner it will become profit earning.

Establishing the break-even point There are a number of ways in which the break-even point can be established: 1. By tabulating the output, costs and revenues of the business and seeing where the break-even point will fall in the table. 2. By construction a break-even chart and graphically establishing where the break-even point falls or a variation on this like a profit/ volume chart. 3. By calculating the break-even point.

Break-even tabulation The tabulation essentially matches the fixed costs and the variable costs at different levels of output with the revenues generated at those levels of output. Example Morning Breaks Ltd have received an order to make 5,000 dresses and the customer is prepared to pay £15 for each dress making the total order worth £75,000. The fixed costs for the period are as follows: £ Rent

9,000

Business rates

1,200

Loan interest Insurance Other fixed costs Total

250 300 1,250 £12,000

The variable costs of making the dresses are as follows: £.p Direct materials

6.00

Direct labour

3.00

Power

2.00

Other variable costs

1.00

Per dress

£12.00

The data for Morning Breaks Ltd can now be analysed in a table, taking the mentioned costs data at different levels of output activity up to completion of the 5,000 dresses – the table starts at zero dresses produced and goes to 5,000 in 1,000 dress steps. The fixed costs are for the whole period so they are not affected by the level of output – thus the fixed cost column is the same (£12,000) at whatever level of output. The variable costs increase with output; thus it is the output times the variable cost per dress. The sales value increases with output so it is the output times the selling price per dress.

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115

Table 10.1  Garments produced no:

Fixed costs (for period) £

Variable costs (per dress) £

0

12,000

0

12,000

0

(12,000)

1,000

12,000

12,000

24,000

15,000

(9,000)

2,000

12,000

24,000

36,000

30,000

(6,000)

3,000

12,000

36,000

48,000

45,000

(3,000)

4,000

12,000

48,000

*60,000

*60,000

BEP

5,000

12,000

60,000

72,000

75,000

3,000

Total costs (FC + VC) £

Value of sales £

Profit (or loss) £

£y¢000

Cost (£)

Variable costs

0

0

Output

x¢000 units Thousands of units

Figure 10.1  Theoretical shape of the variable costs.

At 4,000 dresses produced the total costs (£60,000) and the value of the sales (£60,000) are the same – the revenues cover the costs – this is the break-even point. Beyond this point the business goes into a profit situation and it can be seen that on the completed order of 5,000 dresses a modest profit of £3,000 is achieved. A tabulation will not always exactly show where the break-even point falls; however, it will give a close indication. Figure 10.1 presents a gentle rising curve, which may fall off at the limits of output.

116  Costing for the Fashion Industry

Break-even chart The break-even chart is a graphical method of achieving the break-even point. It is based on the behaviour of the fixed and variable costs. In theory, the variable costs if plotted on to a graph would give a curve as in Figure 10.1 and the fixed costs a straight line as in Figure 10.2. Accountants have a model of these, which show the variable costs plotted as an ascending line; see Figure 10.3.

Cost (£)

£y¢000

Fixed costs

0

0

Output

x¢000 units Thousands of units

Figure 10.2  Fixed costs. £y¢000

Cost (£)

Total cost

Variable cost

Fixed costs

0

0

Output (units)

x¢000 units

Figure 10.3  Components of total cost.

Break-even Analysis 

117

A straight line indicating that the fixed costs are the same at zero output as they are at ×’000 garments produced. This is the accountants’ model of the costs, which shows the variable costs as a straight line – a rationalization for modelling purposes. Thus the break-even chart for Morning Breaks Ltd would look like:

Morning Breaks LTD 80,000

Sales

70,000

Total cost

Costs and sales (£)

60,000

Break-even point

50,000 40,000

Variable costs

30,000 20,000 10,000 0

Fixed costs 0

1,000

2,000

3,000

4,000

5,000

Output (in garments)

Figure 10.4  Break-even chart.

The break-even point can be read off at 4,000 garments produced or £60,000 sales.

Margin of safety Additionally the break-even chart also shows the Margin of Safety in the business (see Figure 10.4) – this is the difference between the break-even point and the target level of activity. In this case the margin of safety is 1,000 garments or £15,000 of sales. The greater the margin of safety the better, as this indicates a longer period of profitability once the business has

118  Costing for the Fashion Industry

broken even before reaching the target level of activity and will enable the business to survive better in times of recession. Thus businesses that break even quickly will have long margins of safety and stand a better chance of remaining profitable even in more difficult times. However, certainly in UK garment manufacturing, the margins of safety are often short thus such businesses are vulnerable in more difficult time. The margin of safety can be calculated as: Profit ÷ Contribution/Sales In the case of Morning Breaks Ltd MoS = (£3,000 ´ £75,000 ) ¸ £15,000 = £15,000

Profit/volume chart A variation on the break-even chart is the profit/volume chart that plots profit against output and shows the break-even point in respect of output activity – see Figure 10.5. Both the break-even chart and the profit/volume chart are useful in presentations to management when discussing breakeven situations.

Morning Breaks LTD

Loss (£)

Profit (£)

12,000 10,000 8,000

Break-even point

6,000 4,000 2,000 0 –2,000 –4,000

1,000

2,000

3,000

4,000

5,000

6,000

Output (in garments)

–6,000 –8,000 –10,000 –12,000

Figure 10.5  Profit/volume chart.

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119

Break-even point by calculation The break-even point can also be calculated though this does not give any additional information – both the tabulation and the break-even chart are useful in terms of the other information that they provide relating to the costs of the business. The following formula will give a calculation of the: BEP ( of Sales ) = FC ¸ ( Contribution/Sales ) You will see in Chapter 11 that Contribution is Sales less Variable Costs. This formula will work at any level of sales or variable costs but for ease use the sales figure and variable cost figure at one garment (i.e. the selling price per garment and the variable costs per garment). In the Morning Breaks Ltd example: BEP = £12,000 ¸ (15 - 2/15) BEP = £12,000 ¸ ( 3/15) BEP = £12,000 ¸ 0.2 BEP = £60,000 ( Sales ) OR BEP = £12,000 ¸ (15 - 2/15) BEP = £12,000 ¸ ( 3/15) BEP = £12,000 ¸ (1/5) then invert and multiply BEP = £12,000 ´ 5 BEP = £60,000 If you want the break-even point in output, then divide by the selling price: BEP of Sales ¸ Selling Price = BEP in output In the Morning Breaks Ltd example: £60,000 ¸ £15 = 4,000 garments

120  Costing for the Fashion Industry

Break-even illustration Isolo Shirt Co can produce 20,000 men’s shirts per week in a range of colours and standard sizes and have a market for that kind of output – over a 48 week year this amounts to an annual output of 960,000 shirts. The selling price of their shirt varies a little with discounting but is based on an average of £3.00 per shirt. The variable costs also vary slightly with colour and size but on average are: Table 10.2  Direct material

£1.50

Direct labour

£0.40

Variable overheads

£0.60

Total per shirt

£2.50

The fixed costs for the factory are budgeted at £250,000 per annum. Over the whole 48-week year the picture would look like: Table 10.3  Output in shirts

Fixed costs £

Variable costs £

Total costs £

Value of sales £

Profit (loss) £

0

250,000

0

250,000

0

(250,000)

20,000

250,000

50,000

300,000

60,000

(240,000)

100,000

250,000

250,000

500,000

300,000

(200,000)

200,000

250,000

500,000

750,000

600,000

(150,000)

400,000

250,000

1,000,000

1,250,000

1,200,000

(50,000)

500,000

250,000

1,250,000

1,500,000

1,500,000

BEP

750,000

250,000

1,875,000

2,125,000

2,250,000

125,000

800,000

250,000

2,000,000

2,250,000

2,400,000

150,000

960,000

250,000

2,400,000

2,650,000

2,880,000

230,000

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121

Margin of safety would be: MoS = (£230,000 ´ 3.00 ) ¸ £0.5 = £1,380,000

Isolo shirt company

Costs and sales (£)

3m

Sales Total cost

2m 1.5m

Break-even point Variable costs

1m

0.25m 0

Fixed costs 0

100,000

500,000 Output

1,000,000 960,000

Figure 10.6  Break-even chart.

Isolo shirt company

Profit (£)

300,000 200,000

Break-even point

100,000

960,000

0

Loss (£)

100,000 100,000 200,000 300,000

Figure 10.7  Profit/volume chart.

122  Costing for the Fashion Industry

500,000

1,000,000

Exercises Exercise 1 Your Event Ltd have the following fixed and variable costs in a period when they hope to make between 6,000 and 7,000 garments. Their average selling price is £56 per garment. Fixed costs: Rent

£18,000

Business rates

8,800

Loan interest

4,000

Other fixed overheads

1,200

Total

£32,000

Variable costs per garment: Direct materials

£25

Direct labour

13

Variable overheads

10

Total

£48

You are required to: ●●

Construct a table showing the output from 0 to 7,000 garments in 1,000 garment intervals.

●●

Construct a break-even chart.

●●

Calculate the break-even point.

Using the data obtained construct a profit/volume chart.

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123

Exercise 2 A business making and selling specialist riding jackets incurs fixed costs of £70,000 for a period and variable cost per jacket of £24.00. Their selling price falls between £30.00 and £36.00 per jacket depending on the customer. Consider the situation where one large customer pays £25.00 per jacket and all others pay £32.00 per jacket. The large customer represents 75 per cent of the sales in the period. What would the level of sales has to be to break even in the period? Construct a profit/volume chart for the business showing it going into profit for the period.

Exercise 3 A boot maker is seeking to sell 14,000 pairs of boots in a period. The boots have a variable cost of £15 per pair to make and the fixed costs for the period are £47,000 with a required profit of £23,000. At what figure should he set the selling price? At this selling price at what point will he break even?

Further reading Bhimani, A. (2015) Management and Cost Accounting, (6th ed.), Harlow: Financial Times Prentice Hall. Boyd, K. (2013) Cost Accounting or Dummies, Hoboken, NJ: Wiley. Drury, C (2018) Management and Cost Accounting (10th ed.) Australia: Cengage.

124  Costing for the Fashion Industry

11 Budgeting and standard costing

Introduction This chapter provides an introduction to standard costing and budgeting. The topics are closely related to each other in that budgeting is a planning process intent on producing a financial plan for the business for a future period of time. Standard costing is a system of costing based on using predetermined costs that are prepared in advance. There can be standard costs for direct material, direct labour and fixed and variable overheads. It is then customary to use the standard costs in the costing process and compare the standard costs to the actual costs incurred – the difference is known as the variance. This process of comparison, standard cost to actual cost, is referred to as variance analysis and in businesses where standard costing is used it forms an important part of the cost management of the business.

Budgeting A budget is a financial plan for a future period and budgeting is the process of achieving that plan. Note that the budget is a plan – not just an estimate or a forecast but a plan of action. It is expressed in financial terms, that is, money with targets for sales and production being converted into money. Lately it is for a future period of time, normally the coming year, though businesses may have longer-term plans particularly for capital expenditure. All businesses should produce budgets and have plans of where the business is going. Often small businesses do not plan well and sometimes when they are forced to plan, as say when they apply for a bank loan, having

produced the plan they do very little with it. Bigger businesses are better at planning and better at budgeting and students going into the employ of larger organizations will almost certainly have to work to the budgetary requirements of that business. The budget needs to be integrated across the business – separate departments cannot produce their budgets in isolation as one element of the business impacts on another. Thus the sales budget needs to fit with the production budget and this will be key to determining the amounts of direct materials required and the budgeted costs of direct labour. Crucial to the whole operation of the business will be the cash budget – the plan of the cash flow of the business. Essentially this shows the anticipated cash coming into the business month by month and the scheduled expenditure month by month. Thus the balances of cash at the end of each can be seen and the need for additional funding or overdraft facilities can be anticipated.

The cash budget The cash budget is usually organized on a monthly basis as shown in Table 11.1 and summarizes the budgeted receipts and budgeted payments. At the end of each month the balance (positive or negative) is calculated and carried forward to the next month. The net cash is the difference between the budgeted receipts and the budgeted payments. This means that on a month-by-month basis it can be seen whether the business receipts are covering the budgeted payments.

Example of a cash budget Osborne Trading Ltd has the following budgeted receipts and payments for the coming six-month period – at the beginning of January they have £960 cash in the bank. The figures have been simplified to illustrate the principle.

Osborne Trading Ltd The budgeted receipts in this case are not total as there is only one figure in each month the budgeted sales income. The budgeted payments are totalled and deducted for the budgeted receipts to give the net cash

126  Costing for the Fashion Industry

Table 11.1  April £

May £

June £

July £

August £

Sept £

Budgeted receipts: Sales (debtors) Loans Total budgeted receipts Budgeted payments: Creditors Wages & salaries Business rates Utilities Capital expenditure Loan repayments Taxes Total budgeted payments Net cash* Balance b/fwd Balance c/fwd

figure – if the budgeted payments are greater than the budgeted receipts, this will be a negative figure and is shown in brackets. For January £1,800 - £2,350 = £ ( 550 ) net cash The balance of cash from the previous month (the balance brought forward) is then added to the net cash to give the closing balance for the month. For January £ ( 550 ) + £960 = £ ( 410 ) balance carried forward. The balance carried forward at the end of the month then goes into the next month as the balance brought forward.

Budgeting and Standard Costing  127

Table 11.2  Jan £

Feb £

Mar £

Apr £

May £

June £

1,800

1,800

2,500

3,600

3,800

4,200

600

1,000

1,000

1,400

1,200

1,200

Rent & rates

1,200

1,200

1,200

1,600

1,200

1,200

Rates Wages Electricity Insurances Sundries

1,800 600 1,200 500

1,800 1,000 1,200 500

2,500 1,000 1,200 500 300

3,600 1,400 1,600 500

3,800 1,200 1,200 500

4,200 1,200 1,200 500

Receipts from customers Creditors

Electricity

300

Insurances Sundries

280 200

50

50

50

50

50

50

Table 11.3  Cash budget statement Jan £

Feb £

Mar £

Apr £

May £

June £

1,800

1,800

2,500

3,600

3,800

4,200

600

1,000

1,000

1,400

1,200

1,200

1,200

1,200

1,200

1,600

1,200

1,200

500

500

500

500

500

500

Budgeted receipts: Sales Budgeted payments: Creditors Rent & rates Wages Electricity

300

Insurances Sundries

280 200

50

50

50

50

50

50

Total budgeted payments

2,350

2,750

3,050

3,750

2,950

3,230

Net cash

(550)

(950)

(550)

(150)

850

970

Balance b/fwd

960

410

(540)

(1,090)

(1,240)

(390)

Balance c/fwd

410

(540)

(1,090)

(1,240)

(390)

580

128  Costing for the Fashion Industry

Sales lag When the business has prepared its sales budget, the budgeted income from this cannot just be put into the cash budget. The cash budget is a plan of receipts and payments and it is unlikely that sales made in one month will result in their income being received in that month. As most businesses operate on trade credit from the time when sales are made the income will not be received for one, two or even up to three months later – this is known as the sales lag. The sales budget needs to be converted into a plan showing when the income will be received and the easiest way of doing this is to use sales lag analysis. Example The following table shows, down the left-hand column the sales budget for the coming period. In the analysis columns going across the page from left to right it shows when the budgeted sales will be received by the business, assuming that the normal trade credit rules are followed. In this situation the business operates on two months’ trade credit being extended. It is the figures on the bottom line of Table 11.4 that will go into the cash budget as the budgeted receipts.

Table 11.4  Sales lag analysis Budgeted sales Jan £4,500

Jan £ Feb £

Mar £

Apr £

May £

June £

July £

Aug £

4,500

Feb £5,000

5,000

Mar £5,200

5,200

Apr £5,600

5,600

May £5,800

5,800

June £6,800

6,800

July £6,800 Budgeted receipts

4,500

5,000

5,200

5,600

5,800

6,800

Budgeting and Standard Costing  129

Flexible budgets Flexible budgeting is a system of budgeting sometimes used in manufacturing where a series of budgets are produced dependent on different levels of output activity. It uses the fixed and variable behaviour of costs outlined in Chapter 9 and recognizes that some costs remain fixed for periods of time while others increase with output. A flexible budget enables management to see the effect of over- or undershooting the output targets and the associated costs. Example A clothing manufacturer has the following budgeted costs: Direct materials £3.00 per garment (variable) Direct labour £1.20 per garment (variable) Fixed overheads £20,000 for the period (fixed) The target in the period is 25,000 garments. For the variable costs the budgeted cost per unit is multiplied by the level of output – direct materials £3.00 × 25,000 and so on. The fixed costs remain so for the period and are not affected by the level of output. The process of examining the costs at different levels of output is known as flexing the budget. In this type of budgetary exercise the issue of semi-variable costs often arises; this is a cost that has within it a fixed and a variable element. In such circumstances, management has to have decided how they will disaggregate the elements of such costs.

Table 11.5  Flexible budget Output 23,000 £

Output 24,000 £

Target output 25,000 £

Output 26,000 £

69,000

72,000

75,000

78,000

Direct labour cost

27,600

28,800

30,000

31,200

Fixed overhead

20,000

20,000

20,000

20,000

116,600

120,800

125,000

129,200

£5.07

£5.03

£5.00

£4.97

Direct material cost

Total budget Budgeted unit cost

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Example Supervision might be seen to be a semi-variable cost with the fixed element being £15000 over the period with £0.25 per unit of output. Thus the cost in a similar flexible budget to the one mentioned would look like:

Table 11.6 

Supervision £15,000 + £0.25 per unit

23,000

24,000

25,000

26,000

£20,750

£21,000

£21,250

£21,500

Zero-based budgeting (ZBB) The traditional way of preparing budgets was on an incremental basis, that is, taking the existing budget and adjusting it for the coming year. This would take account of inflation (or deflation), new activities, declining activities and so on but would essentially be a revised version of the existing budget. This methodology though still widely adopted suffers in that the business does not take a real look at its activities and tends to perpetuate the budget classifications it has always used. With changing patterns of business this may become inappropriate and make the budget less of a strategic plan. Zero-based budgeting has been in existence for some time and is gradually gaining in recognition. Essentially in ZBB each budget category has an expenditure level of zero until the responsible budget holder makes a case for the budget and justifies the activity that causes the cost. Thus in ZBB the activities are re-evaluated each year when the budget is created providing a very proactive approach to budgeting. In theory ZBB should result in a better allocation of resources and should focus attention on value for money. In practice it may be time-consuming and may require a better training in order to operate the system. As a system, it is widely used in the United States and is used by many businesses, public authorities and non-profit-making organizations in the UK and Europe.

Budgeting and Standard Costing  131

Standard costing A standard cost is a predetermined cost for an activity required to make a product. It is normally expressed on a unit basis; thus in garment manufacture there might be a standard cost for direct material in a particular garment and similarly for direct labour and overhead costs. In setting the standard costs the business will take into account current costs for materials, labour and so on and may take into account reasonable estimates for changes in the economic environment like inflation (or deflation), pay awards pending and so on and try to achieve a realistic attainable cost. So that when the standard costs are compared to the actual costs, any difference (variance) is significant and may have come about through working practices and if more than a few per cent may require investigation. Some textbooks suggest that a system of standard costing brings about a synergy between the management accounting function and production managers because in order to achieve realistic standard costs they must work together. Certainly standard costing does require different parts of the business to cooperate in achieving the standard costs. Standard costs do need to be periodically reviewed and this should be done at least annually. Standard costing tends to lend itself to larger manufacturing organizations that make a fairly uniform product involving similar amounts of direct material and direct labour with uniform processes. A shirt factory or a nightwear factory might be examples where it could be used in clothing manufacture. It would probably not be suitable for a factory making, say, men’s suits with relatively short runs and big variations in styles.

Variance analysis Variance analysis is the comparison of the standard costs with the actual costs incurred. Any differences in this comparison process are known as variances. Clearly variances may be to the advantage or disadvantage of the business – that is, costing less than standard or more than standard.

More than standard These variances are known as ADVERSE variances where the actual costs incurred are greater than the standard cost set. The cost to the business is greater than the planned or predetermined costs and means that the business is moving adversely away from its targets. 132  Costing for the Fashion Industry

Less than standard These variances are known as FAVOURABLE variances where the actual costs incurred are less than the predetermined standard cost set. The cost to the business is less than the planned or predetermined costs and means that the business has made savings on its targets set. The usefulness of the variances to management in controlling costs does rely on realistic, attainable standards being set. Therefore, the variance analysis will only be as good as the standards, and poor or loosely set standards will give variances that are of little use. Both the adverse and favourable variances should be reported to management. Management may need to act upon adverse variances to correct matters that are going wrong and steer the business back to its planned costs. If savings have been made, management may also want to try and see if these have come about through improved practices that could be more widely used. However, favourable variances in one area of the business and therefore cost savings there might throw up adverse variances in another area. Management will want to make careful scrutiny of all variances, adverse or favourable, in order to better manage the costs of the business. Example The fabric buyer for a factory purchases a quantity of fabric from a supplier and is able to get it at a reduced price. Consequently his variance in terms of price is favourable – seemingly a saving having been made. However, the production manager finds that he has to use more of the fabric in production than is normally required because the fabric, which was bought cheap, has rather more faults in it than usual. The variance in terms of the amount used is therefore adverse – giving an overspending on fabric used in the production department. Management have to decide on what variances (adverse and favourable) are significant because with this type of costing system there will nearly always be some variance. The following diagram Figure 11.1 illustrates a system that might be adopted by management though the percentages shown here are just a guide and different businesses may have different views on this. It can be seen from Figure 11.1 that there is a band of variances between –5 per cent and +5 per cent where no action is taken. However, above or below this band action is required as these would be significant variances. Different businesses may operate to different levels of tolerance and the percentage figures shown here are just to illustrate the principle.

Budgeting and Standard Costing  133

Above 10% - Requires urgent attention ______________________________________________________________ +5% to +10% - Requires investigation – the costing should be better than this ______________________________________________________________ 0% to 5% No action required 0%---------------------------------------------------------------------------------------------------0% to -5% No action required _____________________________________________________________ -5% to -10% - Requires investigation – the costing should be better than this _____________________________________________________________ Below -10% - Requires urgent attention

Figure 11.1 

Direct material For the elements of cost there will be a net variance that can be split into the respective price variance and a usage variance. In the case of direct materials relating to a garment, there will be a variance between the standard cost and the actual cost. This can then be further analysed to see how much relates to differences in the price paid for the material and how much relates to the amount of the material used to produce the garment. Example Job No: AB123 Direct Material: Standard Cost 120 metres fabric @ £3.50 per metre Actual Cost 125 metres @ £3.45 per metre

Table 11.7  £.p Standard cost

120 × £3.50

420.00

Actual cost

125 × £3.45

431.25

Variance

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(11.25) ADVERSE

It can be seen in this example that the £11.25 adverse variance is caused by two factors: 1. The price paid for the fabric is lower (£3.45 against £3.50) 2. The amount of fabric used is higher (120 metre against 125 metre). Materials Price Variance:

ActualUsage ( StandardPrice - ActualPrice ) = Materials Price Variance 125 ( 3.50 - 3.45) = £6.25FAVOURABLE (paid less for the material than expected) Materials Usage Variance:

StandardPrice ( StandardUsage - ActualUsage ) = Materials Usage Variance 3.50 (120 − 125) = £ (17.50 ) ADVERSE (usedmore than expected)

Table 11.8  Materials price variance

£6.25 FAV

Materials usage variance

£(17.50) ADV

Net variance

£(11.25) ADV

In this example the net variance of £11.25 adverse represents 4 per cent of the standard cost (£11.25/£420×100) and therefore may not be considered to that significant. Example Job No: AB124 Direct Material: Standard Cost 120 metres fabric @ £3.50 per metre Actual Cost 125 metres @ £3.60 per metre

Budgeting and Standard Costing  135

Table 11.9  Materials price variance

125 (£3.50 – £3.60)

£ (12.50) Adv

Materials usage variance

£3.50 (120 – 125)

£ (17.50) Adv

Net variance

£420 (Std) – £450 (Act)

£ (30.00) Adv

In the second example it can be seen that both the price and the usage variances are adverse reflecting that the business has paid more for the fabric and used more of it than planned. In this example the variance is much more significant at 7.14 per cent (£30.00/£420×100) and probably worthy of investigation.

Causes of direct materials variances Where the actual price of the direct material is less than the standard price set the variance is said to be favourable.

Materials price variance – vavourable 1. Bulk buying discounts or cash discounts obtained but not considered in setting the standards; 2. Favourable exchange rates where sourcing overseas produce a saving on the original standard price set; 3. A glut of the material has caused the price to come down; 4. The textile industry has been hit by recession and reduces its prices; 5. Cheaper, perhaps substandard, materials purchased. Where the actual price of the direct material is greater than the standard price set the variance is said to be adverse.

Materials price variance – adverse 1. Inflation has pushed up the price and this was not taken into account in setting the standards; 2. Unfavourable exchange rates have caused the real cost of the material to be increased;

136  Costing for the Fashion Industry

3. The price has risen owing to a shortage of the material; 4. The material purchased is more expensive because a higher specification than required has been bought. Where the actual usage of the direct material is less than the standard amount set the variance is said to be favourable.

Materials usage variance – favourable 1. Good marker making and lay planning giving better utilization of the material; 2. Fewer rejects in the factory than anticipated; 3. Materials purchased of a slightly higher specification gives less wastage. Where the actual usage of the direct material is greater than the standard amount set the variance is said to be adverse.

Materials usage variance – adverse 1. Poor lay planning and poor utilization of the material; 2. Poor cutting; 3. More rejects in the factory than anticipated; 4. Cheap or substandard material proving difficult to work in the factory.

Direct labour Similar to direct materials variances can also be calculated for direct labour and the net variance can be split down into two sub-variances – one relating to the rate of pay and the other to the amount of direct labour used. The variance that relates to the rates of pay is referred to as the wage rate variance and the variance that relates to the usage of direct labour the labour efficiency variance. Example Job No: AB123 Direct Labour Standard Cost – 50 hours @ £6.20 per hour Actual Cost – 52 hours @ £6.40 per hour

Budgeting and Standard Costing  137

Table 11.10  £.p Standard cost

50 × £6.20

310.00

Actual cost

52 × £6.40

332.80

Variance

£(22.80) ADVERSE

It can be seen that the variance in total is adverse – actual cost is greater than the standard cost and that this is caused by both the rate per hour being higher and the hours required being higher. This can be broken down into its respective wage rate and efficiency variances. Wage Rate Variance

ActualHours ( StandardRate - ActualRate ) = Wage Rate Variance 52( 6.20 − 6.40 ) = £ (10.40 ) Adverse Labour Efficiency Variance

Standard Rate ( StandardHours - ActualHours ) = Labour Efficiency Variance 6.20 ( 50 − 52) = £ (12.40 ) Adverse

Table 11.11  Wage rate variance

£(10.40) Adv

Labour efficiency variance

£(12.40) Adv

Net variance

£(22.80) Adv

In total this represents a variance of 7.35 per cent adverse (£22.80/£310.00 × 100) and therefore is significant and probably worthy of further investigation. A further consideration with direct labour is that occasionally idle time may occur. Idle time is where the labour force are unable to get on with the job because of some factor that prevents them working – power cut, machine breakdown, materials have not arrived and so on. In such cases the idle hours will be part of the actual hours but they need to be identified separately and

138  Costing for the Fashion Industry

an idle time variance calculated so that management can see the cost of the lost production – idle time variances are always adverse; they are lost or minus hours. Idle Time Variance

StandardRate ´ Idle Hours = Idle Time Variance ( Always ADVERSE )

Example 4 Job No: AB124 Direct Labour Standard Cost – 50 hours @ £6.20 per hour Actual Cost – 55 hours @ £6.40 per hour However, included in the actual hours are 3 hours of idle time (i.e. minus hours wherein no production could take place).

Table 11.12  £.p Standard cost

50 × £6.20

310.00

Actual cost

55 × £6.40

352.00

Variance

£(42.00) ADVERSE

Wage Rate Variance

ActualHours ( StandardRate - ActualRate ) = Wage Rate Variance 55( 6.20 − 6.40 ) = £ (11.00 ) Adv Labour Efficiency Variance

Standard Rate ( StandardHours - Actual [ working]Hours ) = Labour Efficiency Variance 6.20 ( 50 − 52) = £ (12.40 ) Adv

Budgeting and Standard Costing  139

Idle Time Variance

StandardRate × Idle Hours 6.20 × ( 3) = £ (18.60 ) Adv NB: Where idle time is included in the calculation the idle hours are not included in the actual hours for the calculation of the labour efficiency – only the production actual hours are included. In this example, it can be seen that the net adverse variance is made up of an increase in the wage rate, more time being taken in production than anticipated and the loss of three hours idle time. This would be a significant variance of 13.5 per cent (£42/£310 × 100) and management would almost certainly want to investigate it. It may be that there is some linkage between the variances – having been forced to be idle for 3 hours perhaps it was difficult to get back to full production speed thus further extending the time the job took.

Table 11.13  Wage rate variance

£(11.00) Adv

Labour efficiency variance

£(12.40) Adv

Idle time variance

£(18.60) Adv

Net variance

£(42.00) Adv

Causes of direct labour variances Where the wage rate paid is less than the standard wage rate set the wage rate variance is said to be favourable.

Wage rate variance – favourable 1. Pay rises not as high as anticipated when setting the standards; 2. The job was completed without extra working in overtime as expected; 3. Less skilled labour used on a lower wage rate.

140  Costing for the Fashion Industry

Where the wage rate paid is more than the standard wage rate set the Wage Rate Variance is said to be adverse.

Wage rate variance – adverse 1. Pay rise higher than anticipated when setting the standards; 2. Extra working required in overtime to complete the job – not anticipated; 3. More highly skilled labour used thus the wage rate was higher; 4. Productivity bonus paid for doing the job in less than the standard time – should be reflected in a saving on the labour efficiency. Where the time taken for the job is less than the standard time set for the job the labour efficiency variance is said to be favourable.

Labour efficiency variance – favourable 1. Productivity bonuses have reduced the time taken; 2. A better skilled workforce have done the job in less time. Where the time taken for the job is less than the standard time set for the job the labour efficiency variance is said to be favourable.

Labour efficiency variance – adverse 1. Lower skilled workforce used, taking more time; 2. Sickness absence affecting production; 3. Technical problems arise in production; 4. Industrial action where the workforce have withdrawn their labour for periods of time or deliberately reduced their productivity.

Overhead in standard costing Variances can also be calculated for the overheads but these broadly do not provide management with the same kind of control information that is

Budgeting and Standard Costing  141

apparent with the direct cost variances. It is customary to take an absorption cost approach for overheads in standard costing similar to the approach seen in Chapter 8 but calculating a standard rate for fixed and variable overheads. The variances are then the actual overhead costs incurred against these standard rates.

Advantages and disadvantages of standard costing As with all systems standard costing has both advantages and disadvantages and these can be summarized as: Advantages 1. It provides for management by exception and gives management indicators or areas to investigate to improve performance; 2. In theory is should produce some synergy with the management accounting function and the production management team; 3. It facilitates target setting and working towards targets; 4. Once the standards are set the process of costing should be simpler; Disadvantages 1. It really only suits large organizations which make fairly homogeneous products; 2. It can be time-consuming in its implementation and maintenance with the setting and revision of standards; 3. Managers may not fully understand the significance of variances; 4. In situations where the business is moving into advanced manufacturing technology it may not provide a good basis for costing – see Chapters 12 and 13.

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Exercises In your own time, explain what you understand by the terms budget and standard cost.

Exercise 1 From the following information relating to Debidall Ltd, prepare a cash budget for the six months April to September. The bank balance at the beginning of April is expected to be £1,800. April £

May £

June £

July £

August £

Sept £

Receipts from debtors

6,400

5,400

7,400

6,800

6,300

6,500

creditors

3,500

3,600

2,600

4,200

3,400

3,100

Wages & salaries

1,900

1,900

2,100

1,900

1,900

1,900

Heat, light & power

500

560

Insurance Sundries

180 140

140

140

140

140

140

Exercise 2 Flare Fashions Ltd have extracted the following budget information.

Month

Budgeted sales £’000

Budgeted wages and salaries £’000

Budgeted purchases (of stock) £’000

Budgeted overhead £’000

October

1200

60

335

560

November

1100

60

405

500

December

1000

60

365

640

January

1400

60

335

560

February

1200

60

370

500

March

1100

60

360

560

Budgeting and Standard Costing  143

●●

Sales are either for cash/cheque, debit or credit card. For cash/cheque and debit card sales there is no sales lag, but for credit card sales there is a one-month sales lag and the credit card company retains 8 per cent of the value of the sales. The company expects that half its sales will come from customers using credit cards.

●●

Wages and salaries are paid within the month they are incurred.

●●

Creditors for purchases are paid in the month following purchase.

●●

●●

●●

●●

Of the overheads 35 per cent of the figure represents variable expenses which are paid in the month after they were incurred. The remaining 65 per cent is fixed costs of which £164,000 is depreciation; the other part of the fixed costs is paid within the month in which it is incurred. Corporation tax of £750,000 is due in January and a dividend payment of £500,000 is payable in March. Capital expenditure commitments of £1,000,000 and £700,000 are due in January and March respectively. The bank balance at 31 December is expected to be £1,450,000.

You are required to: (a) Produce a sales lag analysis as far the data will allow. (b) Prepare a cash budget, in the net cash format, for the months January, February and March.

Exercise 3 Calculate the direct materials variances and direct labour variances from the following data: Direct materials Standard Price per garment £3.25 Actual Price per garment £3.30 Standard Usage 450 metres Actual Usage 420 metres Direct labour Standard Wage Rate £6.20 per hour Actual Wage Rate £6.25 per hour Standard Hours 75 Actual Hours 76 144  Costing for the Fashion Industry

Exercise 4 Collars Ltd make men’s shirts of a fairly standard design in a range of colours. Calculate the materials and labour variances for the following job.

Job No: DE 2367 Direct Materials: Standard price £1.25 per garment Standard usage 980 metres Actual price £1.30 Actual usage 1000 metres Direct Labour: Standard Wage Rate £6.30 per hour Standard Hours 3000 hours Actual Wage Rate £6.20 per hour Actual Hours 3010 including 3 hours of idle time.

Exercise 5 Relax and Go Alan Lewis is planning to give up his job and start a small retail business selling sports/leisurewear from a small retail unit in his local shopping centre. The business is to be called ‘Relax and Go’. The unit is situated in the Spindles Shopping Centre in Oldham and is available on a rental of £2,000 per calendar month paid in advance, with a service charge of £250 per month to cover water charges, heating, the cleaning of the communal areas and security – business rates are additional. Information regarding Oldham can be sourced from the Oldham Council website and from National Statistics where the Ward profiles can be accessed. There is no similar shop in the shopping centre but J&B Sports have an outlet in Oldham, as do Primark and TK Maxx. There is also the value retailer of TJ Hughes in Oldham. Alan Lewis has extensive retail experience, much of which was in the clothing trade but he has never been self-employed though he does come from a family of self-employed people. Budgeting and Standard Costing  145

Alan is also in a stable relationship and he and his partner have a house and while the family budget will suffer without his income, they can manage (with some belt tightening) for about one year. He has approached his bank regarding finance and they are reluctant to give him an overdraft of more than £1,500 but are prepared to advance him a £12,000 loan repayable over three years – monthly instalments. He also intends to put £2,000 of his own money into the business. Alan has done some research and believes there is a market for his business idea but sees that there are three different sales patterns that could arise if he is able to start the business from 1 April. Pattern 1 – A straightforward pattern representing around £10,500 per month for the first six months. This being the case his purchases of stock would need to be in the order of £6,000 to £6,500 per month. Pattern 2 – A slower start while the business builds up and becomes known in the town. Starting at £3,500 per month in April and building gradually to £10,500 in six months. In this case, the purchase pattern might initially be £6,000 but would have a lull in purchases in, say, May to July but building to between £6,000 and £6,500 for August and September. Pattern 3 – A good start in April with sales approaching £12,000 then a lull in May dropping back to, say, £7,000 and building to £10,500 by the end of the six months. The purchasing pattern would have to reflect this with the initial purchases being about £7,500 then dropping in May but building to £6,000/£6,500 by the end of the six months. Other projected expenditure NOT included in the case study so far: Budgeted expense

Budgeted amount

Payable

Business rates

£600 per half year

April & October

Telephone

£180 per quarter

June and September

Insurance

£160

April

Motor expenses

£350

April

Motor expenses

£100

May to September

Stationery

£250

April

Stationery

£50

May to September

146  Costing for the Fashion Industry

Budgeted expense

Budgeted amount

Payable

Bank: Loan repayment* Interest on loan Bank charges

£334 £125 £85

Per month Per month June and September

Capital expenditure: Fixtures & shop fitting Motor van Cash register

£7,000 £6,500 £500

April April April

*Bank loan is based on £12,000 over 3 years

Required: THREE cash budgets for the three different patterns of sales and purchasing.

Exercise 6 Twinkle toes cash budget Janet Bradshaw was planning to start a children’s shoe shop business in Tadcaster. She has been along to see her ‘friendly’ (well local) bank manager who listened to her plans, nodded and made at least some encouraging noises. He suggested that the bank would probably lend an amount equivalent to about one-third of her own capital input, plus a small overdraft facility of about £2,500. The bank will allow her the loan over three years to be repaid by monthly instalments plus interest of just over 8 per cent. They suggest that her other bank charges would be about £100 per quarter. Janet has £15,000 of her own capital, so she works on the basis of the bank lending her £5,000, which will mean repayments of £139 plus about £35 interest per month – £174. She intends to start the business on 1 November in time for the Christmas period and has located a suitable shop unit in the Muse Shopping area at a rent of £2,000 per month and business rates of £650 for the 1 November to 31 March period and then £1620 from 1 April for the next half year, that will be payable in April. She estimates her expenses as: Water and electricity – £200 per quarter Wages to part-time assistant – £240 per month

Budgeting and Standard Costing  147

Advertising – £100 in November Stationery and sundries – £30 per month Transport – £50 per month Shop fitting in November £10,000 Cash register in November £500 She estimates her sales for the first six months of trading as: November £2,000

December

January

February

March

April

£10,000

£4,000

£4,500

£5,000

£6,000

And the purchases of stock, payments to suppliers as: November £10,000

December

January

February

March

April

£4,000

£2,000

£2,000

£3,000

£1,500

Assuming that Janet starts with a nil balance in her budget, on 1 November, construct her cash budget, in the net cash format, for the six months November to April.

148  Costing for the Fashion Industry

Exercise 7 Jean’s Jeans Ltd The following budgeted cost data relate to a jeans manufacturing business for the month of May. The management have split the costs into their fixed, variable and semi-variable elements. The target output for the month is 25,000 pairs of jeans. Budgeted cost at target output of 25,000 garments £

Cost

Nature of cost

Cost function

Direct materials

Variable

100,000

£4x

Direct labour

Variable

40,000

£1.60x

Indirect labour

Semi-variable

42,000

£12,000 + £1.20x

Heat, light, power

Semi-variable

10,000

£3,750 + £0.25x

Fixed overheads

Fixed

9,500

£9,500 + £0x

You are required to: Produce a flexible budget to show the costs at 24,000, 25,000 and 26,000 garments produced respectively.

Further reading Bhimani, A. (2015) Management and Cost Accounting (6th ed.), Pearson. Boyd, K. (2013) Cost Accounting or Dummies, Wiley. Drury, C. (2018) Management and Cost Accounting (10th ed.), Cengage Learning.

Budgeting and Standard Costing  149

12 The changing nature of cost

Introduction Businesses and methods of manufacture and sourcing are constantly changing. High-tech methods of manufacture (known as advanced manufacturing technology, or AMT) have been introduced into the manufacturing process; component manufacturing is being done in some parts of the industry and garments are being made in diverse parts of the world and shipped into their markets using an array of different logistical systems. Other systems like justin-time (JIT) and total quality have also been introduced, and system and methods of production and handling are constantly being improved. Typically, investment in high-tech equipment means that the usage of such equipment needs to be maximized. Investment in, say, laser cutting technology may mean that a cutting operation has to supply cut parts to several sewing factories thus bringing component manufacture into the industry. In logistics the conventional methods of transport are being superseded; vacuum packing and other innovations mean that airfreighting can be more cost effective. With constantly changing methods of manufacture, product handling and logistics it would be wrong to think that methods of costing can stand still and not take account of these changes. The changing nature of the manufacturing processes and its effect on cost accounting were first identified by two American professors Kaplan and Cooper in the 1980s and they began to develop costing methods to deal with the changing nature of cost. This chapter explores the changing nature of cost and examines why the traditional methods of costing might not always be appropriate.

From traditional to advanced manufacturing technology In traditional methods of manufacture, the processes were usually driven by the direct labour. The direct labour were the skilled workforce who produced the product and the cost of the workforce – the direct labour cost – would be a significant element of the cost. As processes become more mechanized the costs of such mechanization increase and the direct labour costs are reduced – fewer operators are needed and skilled workers can be replaced by semi-skilled or even unskilled workers. Not all manufacturers or industries are at the same stage of development – some industries a very much more high-tech than others. For example the electronics industry with robot assembly is at the sharp end of technology and will employ fewer skilled direct labour operatives than a clothing factory where development might be hampered by the nature of fabric and cloth, which is not so easy for robots to handle. The pathway here shows on the left low technology businesses using skilled direct labour. We are moving away from this to the right where on the far right we have high technology users with less use of skilled direct labour. Most businesses are somewhere in between these two extremes and will employ some technology and retain some skilled direct labour. So as manufacturers become more mechanized and adopt more technology in the production methods, we see a reduction in the direct labour costs. The once, all-important skilled workers are being replaced by fewer semi-skilled and unskilled operators thus reducing the direct labour costs. At the same time the overheads of the business increase. Advanced technology does not come cheap and it will have to be financed, often out of borrowed finance. This kind of debt needs to be serviced and will often have high-interest costs associated with it. The advanced machinery itself needs attention in terms of setting-up incurring set-up costs, it will need In times gone by

Progress over time

Now and the future

Low tech

High tech

High direct labour content and high labour cost

Low direct labour content and cost but higher overhead cost

Figure 12.1  The changing nature of cost.

The Changing Nature of Cost  151

to be cleaned and maintained, it will incur power costs and it may have to operate in a specially controlled environment and it will depreciate. So although the direct labour costs are reduced, the overheads and specifically the production overheads may be significantly increased. The indirect labour costs may also increase with the use of advanced technology as there may be greater use of machine minders and maintenance staff in place of skilled direct labour who drive the throughput of the product.

Just-in-time The move into using advanced manufacturing methods is also often linked to just-in-time systems. In JIT systems it is intended that the product be produced to the correct quality specification at the time that it is required. Linked with this is a desire to reduce inventories (stocks of materials) so that raw materials needed in production are supplied just-in-time to go into production. This clearly requires some confidence in the supplier to meet the delivery date with the right materials of suitable quality but it does reduce inventories and the amount of capital invested in stock. It may also provide space savings, as large storage areas for stock are no longer required and such areas can be redeployed. These systems are also often linked to Total Quality Control (TQC) where a high level of quality is sought. The emphasis in JIT is placed on finding out why poor quality infiltrates into production and correcting the factors that cause poor quality and rejected products. The reduction (perhaps elimination) of rejected products does in itself produce a significant cost saving and means that quality standards permeate the whole manufacturing process.

Component manufacture and assembly Component manufacture and assembly have been a feature of some industries for many years. The motorcar industry was probably the first industry to adopt component manufacture in the 1950/60s. Other industries, particularly electronics, have also adopted component manufacture and assembly. Essentially this is where components for a product are made in different places and then sent to one plant for assembly. So in the motorcar industry,

152  Costing for the Fashion Industry

the chassis is made in one place, the body shell in another, the engine block somewhere else and so on. Finally, all the components are brought together in one place and assembled into a motor car. While this is not necessarily widespread in garment manufacture, it has been practised to some extent where advanced technology has been introduced but some functions still require high direct labour inputs. An example might be a lingerie manufacturer who has decided that the expensive satin and silk fabrics they use need to be carefully laid up and cut and they have invested in a computer-driven laser-guided cutter for the purpose to get that precision. However, in terms of laying up and cutting this piece of advanced equipment can cut and supply several sewing factories. So that is what they do – they receive and test the fabrics at one location and cut all the component parts at that location using their high-tech cutter. The cut parts are then boxed up and sent to the sewing factories to be made up into garments. The sewing factories may be overseas in order to take advantage of lower labour costs for the direct labour-driven elements of the manufacturing.

Summary of changes in costs with the move into advanced technology ●● ●●

Direct labour costs are reduced Production overheads are increased – power, maintenance, depreciation, environmental costs, indirect labour

●●

Non-production overheads are increased – interest on finance

●●

Inventories (stock holding) is reduced

The once-dominant direct labour cost becomes less significant compared to the increased overhead costs; the following diagram illustrates this point. This raises two questions: 1. Is it therefore appropriate to absorb overheads into the job costing based on direct labour costs as has been the traditional method (look back on Chapter 8) when the direct labour becomes a much less important element of the cost? 2. Should we be looking at what causes the overheads in order to identify their allocation to product and job costs rather than just absorbing them in an arbitrary way?

The Changing Nature of Cost  153

Cost (£)

Direct labour

Overhead

High tech

Low tech The changing nature of cost Figure 12.2  The changing nature of cost.

Illustration In thinking about the two questions raised here, consider this illustration. A company produces two products X and Y. Product X is a new product recently introduced and uses some newly purchase advanced manufacturing equipment. This new state-of-the-art equipment produces an excellent product but at a cost – high finance charges, high set-up and maintenance costs, depreciation and cost relating to environment like air conditioning and so on – whereas product Y is more traditional and still relies on a large direct labour input. The two products incur the same amount of direct material costs but product X has very little requirement for direct labour so its direct labour cost is low, whereas product Y, the traditionally made product, has high reliance on direct labour and significant direct labour costs. The company bases its product costing on traditional absorption cost methods based on direct labour hour cost. For each £1.00 of direct labour cost they absorb £1.50 in overhead. The direct costs for the two products X and Y are: Table 12.1  Product X

Product Y

Direct material

£8.50

£8.50

Direct labour

£1.00

£4.00

154  Costing for the Fashion Industry

The total costs for each product based on traditional absorption costing would mean that product X would get £1.50 of overhead per unit (£1 × £1.50) and product Y would get £6.00 of overhead per unit (£4 × £1.50). This makes the total costs look like:

Table 12.2  Product X £.p

Product Y £.p

Direct material

8.50

8.50

Direct labour

1.00

4.00

Overheads

1.50

6.00

Total cost

£11.00

18.50

It can be seen from this illustration that the low-tech product Y gets four times the share of the overhead allocated to product X yet it is product X, the high-tech product, that creates the high overheads in the business because of its use of advanced manufacturing technology. Product Y bears a disproportionate amount of the overhead costs and is therefore overcosted and product Y gets a small share of the overhead and is undercosted. Thus what we can see is that traditional product costing methods in some cases may cause some products to be overcosted and others to be undercosted. Taken to its fullness this may cause management to make bad acceptance or pricing decisions.

Cost behaviour change With the move into advanced manufacturing technology and the increase in overhead cost that is associated with this move it should be appreciated that this inevitably increases the fixed cost element of the business. Once advance technology equipment has been invested in, the business will have significant depreciation cost, significant finance cost and the cost of maintaining the environment for the equipment and these will be fixed costs and these fixed overheads will have to be met from the output of the

The Changing Nature of Cost  155

equipment. Thus a better understanding of the market, market share, new markets and so on may be even more important where investment is made in advanced technology.

Service industries Traditional costing methods were routed in manufacturing and thus gave little thought to costing in the service sector. In the later part of the twentieth century, we saw a reduction in manufacture in the UK and a rise in the service sector. In the fashion industry the extent of manufacture in the UK has dropped massively over the last 25 years to be replaced by a service industry fuelled by fashion retailers sourcing fashion products from around the globe (see Chapters 3 and 4). In these circumstances, costs are important but they do not relate to traditional systems of costing based on the elements of cost and the use of absorption costing. Thus in service industries, because that is what we are essentially talking about, different methods of treating the overhead cost are needed to ensure appropriate acceptance and pricing decision are made by management.

Activity-based costing The point has been made so far in this chapter is that changes in manufacturing and changes in the way business operates in some cases may mean that traditional methods of costing are inappropriate. This is particularly the case where overheads have become a much more significant element of the cost. There is therefore a need for a different approach to costing and one solution put forward has been Activity-Based Costing (ABC). In ABC the activities that the business engages in that create the costs are used as the drivers for driving the cost into the product with a view to giving a more balanced result in terms of product cost. The system, though developed for manufacturing, also seems to lend itself to service industries and provides them with a system of costing hitherto not available. ABC is described, with illustration and exercises, in Chapter 13.

156  Costing for the Fashion Industry

Exercises ●●

●●

●●

If you are unfamiliar with some of the concepts mentioned in this chapter, like advanced manufacturing technology and just-in-time, read around these topic areas. Outline what you understand by advanced manufacturing methods and list some of the features of such methods. Where a clothing business has adopted a more advanced technology approach to manufacture explain what are likely to be the effects on their costs.

Further reading Kaplan, R. S. and Cooper, R. (1998) Cost and Effect, Boston: Harvard Business School Press.

The Changing Nature of Cost  157

13 Activity-based costing

Introduction This chapter considers the system of costing devised by Kaplan and Cooper to address the issues of product costing in situations where there have been changes in the nature of costs. Although this system of costing was devised for manufacturing industries, it is also applicable to service industries. Thus in fashion sourcing where manufacture is less of a consideration and the costs relate to sourcing and transporting of the garments activity-based costing (ABC) may be appropriate. It was demonstrated in Chapter 12 that as businesses change and advanced manufacturing technology come into use the traditional systems of product costing become less appropriate because of their reliance on direct labour cost as a driver of overheads. Once manufacturing systems change and the overheads become a much more significant element of the costs, the business needs to look closely at the overheads and what drives them. This is also clearly the case with service businesses and those engaged solely in sourcing as, other than the cost of the product that they buy (garments), all their other costs are effectively overheads. Thus some ways of driving those costs into the product are required, as overhead absorption, based on direct labour or even machine hours, is simply not an option.

Activity-based costing The essence of ABC is that products or services themselves do not create cost; it is the activities that the business engages in that create cost. The product or service is a user of those activities and the more activities a product uses, the more cost it will have to bear. ABC tries to relate overhead to the activity that causes or drives the cost, referred to as cost drivers. Costs with the same cost driver are grouped

Cost pool > Overhead >>

Cost driver rate > Cost driver rate > Cost driver rate > Cost driver rate > Cost driver rate > Cost driver rate >

Cost pool > Cost pool > Cost pool > Cost pool > Cost pool >

Product cost

Figure 13.1  Activity-based costing process.

together in cost pools and an appropriate cost driver rate is then used to develop the product cost. This is in contrast to traditional absorption costing where overheads are allocated to departments or cost centres where a single cost centre rate is used for all overheads in that cost centre to achieve the product costs irrespective of what activity has caused the overhead. Typical activities and their possible cost drivers: Table 13.1  Typical activity

Possible cost driver

Machine activity

Machine hours

Supervision

Machine hours

Set-ups

Number of set-ups required

Inspection

Number of inspections

Receiving of materials

Number of receipts required

Illustration comparing ABC to traditional absorption costing Auto Wear Overalls manufacture disposable overall in an advanced manufacturing environment with minimal direct labour input. They produce three grades of overall (White, Green & Blue) in the factory on the same equipment – the machine times for the different grades vary slightly. Activity-based Costing 

159

Table 13.2  White

Green

Blue

100,000

80,000

60,000

Direct materials cost (per garment)

£2.00

£2.50

£3.00

Direct labour cost (per garment)

£0.35

£0.35

£0.35

Machines hours (per garment)

0.20

0.25

0.30

50

30

20

Planned production

Number of set-ups

The Total overheads for the period are estimated at £500,000. There are ten receipts of stock in the period, nine covering all grades and one delivery just for the White overall. Using traditional absorption costing, absorbing the overheads based on the percentage of direct labour cost the overhead absorption rate would be 595.24 per cent.

Calculation of overhead absorption rate White - direct labour cost £0.35 ´ 100,000 = £35,000 Green - direct labour cost £0.35 ´ 80, 000 = £28,000 Blue - direct labour cost £0.35 ´ 60, 000 = £21,000 TotalDirect Labour Cost = £84,000 £500,000/£84,000 ´ 100 = 595.24% Table 13.3  Activity cost pool Set-ups /changeovers Machine activity Supervision Total

Amount of Overhead £55,000 £150,000 £200,000 £350,000

Cost driver Number of set-ups Machine hours

Receiving and storage

£45,000

Number of receipts

Packing

£50,000

Output of product

160  Costing for the Fashion Industry

Overheads absorbed by each grade of overall: White - £35,000 ´ 595.24% = £208,334.00 Green - £28,000 ´ 595.24% = £166,667.20 Blue - £21,000 ´ 595.24% = £125,000.40 It can be seen from Table 13.4 that because the direct labour cost is uniform across the three grades the only difference in the final unit cost is the difference in the direct material cost – Green is £0.50 more than White and Blue is £1.00 more than White. The traditional costing does not take into consideration that Green and Blue require more machine time per garment than White or that White will require more set-ups. Using ABC the costing of the overheads requires more attention but gives a better result taking into account the different cost drivers of the different activities. This example uses just four cost drivers but it will be seen it produces a more plausible product cost (some of the figures have been rounded in this example). Set-ups White 50, Green 30, Blue 20 = 100 in total £55,000/100 = £550 per set-up White - £550 ´ 50 = £27,500 Green - £550 ´ 30 = £16,500 Blue - £550 ´ 20 = £11,000

Table 13.4  Traditional costing – using percentage of direct labour cost White £.p

Green £.p

Blue £.p

200,000.00

200,000.00

180,000.00

35,000.00

28,000.00

21,000.00

Overheads absorbed

208,334.00

166,667.20

125,000.40

Total cost

443,334.00

394,667.20

326,000.40

Unit cost (rounded)

£4.43

£4.93

£5.43

Direct materials Direct labour

Activity-based Costing 

161

Machine activity supervision White - 100,000 overalls ´ 0.20 = 20,000 machine hours Green - 80,000 overalls ´ 0.25 = 20,000 machine hours Blue - 60,000 overalls ´ 0.30 = 18,000 machine hours Total machine hours = 58,000 £350,000/58,000 = £6.034 per machine hour White = 20,000 ´ £6.034 = £120,680 Green = 20,000 ´ £6.034 = £120,680 Blue = 18,000 ´ £6.034 = £108,612 Receiving and storage £45,000/10 = £4,500 per receipt £45,000 - £4,500 ( justWhite ) = £40,500 £40,500 / 3 = £13,500 White = £4,500 + £13,500 = £18,000 Green = £13,500 Blue = £13,500 Packing Output = White100,000 + Green 80,000 + Blue 60,000 = 240,000 50,000 / 240,000 = £0.208per overall White = 100,000 ´ £0.208 = £20,800 Green = 80,000 ´ £0.208 = £16,640 Blue = 60,000 ´ £0.208 = £12,480 It can be seen from Table 13.5 that a much more balanced product cost is achieved with the various uses of the activities being reflected in the cost. It is not just the difference in the direct material cost that gives the difference in product cost.

162  Costing for the Fashion Industry

Table 13.5  Activity-based costing White £

Green £.p

Blue £.p

Direct material

200,000

200,000

180,000

Direct labour

35,000

28,000

21,000

Overheads: Set-ups Machine/supervision Receiving Packing

27,500 120,680 18,000 20,800

16,500 120,680 13,500 16,640

11,000 108,612 13,500 12,480

Total cost

£421,980

£395,320

£346,592

£4.22p

£4.94p

£5.78p

Unit cost (rounded)

Table 13.6  Summary – comparison of tradition costing vs. ABC White

Green

Blue

Traditional costing

£4.43

£4.93

£5.43

ABC

£4.22

£4.94

£5.78

Illustration of ABC for a service provider Sancho Ltd source men’s tailor suits from factories in the Shanghai region of China and supply them to retailer in the UK. Although they supply a product, they essentially provide services – sourcing, quality management, warehousing, transport and distribution. They purchase from integrated factories in China which are producing an ‘Italian look’ to their tailoring. In the coming period they are sourcing four styles in a range of fabrics and sizes with a negotiated price per style for retail operations across the UK. Style A

Style B

Style C

Style D

Purchase price

£20.00

£25.00

£28.00

£30.00

Volume in the period

25,000

20,000

15,000

5,000

20

10

6

4

Customers

Activity-based Costing 

163

Other costs incurred: Table 13.7  Activity

Amount

Sourcing in China: Transportation/warehousing/air freight from China: UK warehousing and distribution: Total Quality inspections

£45,500 £80,000

£80,000

Currency transfer costs Currency exchange costs

Per quantity of garments purchased

£50,000 £175,500 £7,800

Staff and associated costs in UK

Cost Driver

£5,000

Number of inspections (1 per 500 garments) Per customer In proportion to cost of garment purchases

Table 13.8  Costs based on an ABC Approach

Purchases Sourcing/transportation etc. Quality inspection UK staff etc. Currency transfer etc. Total cost Unit cost

Style A £

Style B £

Style C £

Style D £

500,000

500,000

420,000

150,000

67,500

54,000

40,500

13,500

3,000

2,400

1,800

600

40,000

20,000

12,000

8,000

1,592

1,592

1,338

478

612,092

577,992

475,638

172,578

£24.48

£28.90

£31.71

£34.52

Advantages and disadvantages of ABC Advantages ●●

ABC provides a means of relating overheads to product where methods of manufacture have become more advanced and production is not so reliant on direct labour.

164  Costing for the Fashion Industry

●●

●●

●●

●●

It enables the business to see the activities that create overhead cost rather than just allocate those costs. It provides a system of costing that is relevant to services industries as well as manufacturers. It allows the business to be creative in determining its cost drivers. It may assist in the budgeting of the business by using the activity cost pools.

Disadvantages ●●

●●

●●

●●

Deciding when the business should change from a traditional costing system to ABC is not clear-cut and may involve something of a leap in faith – taking on a hitherto untried system – parallel running may be needed for a period of time. Determination of the cost drivers for a service industry might be difficult as making the relationship to the service provided may not be easy. At the outset there may be a temptation to use a lot of cost drivers that make the costing rather complex though it should be born in mind that a restricted number of cost drivers are unlikely to have the desired improvement. It may be necessary to change the budgeting system used by the business to fall in line with the activity cost pools.

Activity-based budgeting Where a business has adopted ABC it will make sense to bring their budgeting in line with activity cost pools and cost drivers. If, as mentioned in Chapter 11, a budget is a financial plan of action, then that plan needs to reflect the other accounting methods that are being adopted by the business. By monitoring the overheads related to their cost drivers in the longer term, this will enable the business to control its costs by identifying non-valueadded activities that are engaged in by the business.

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165

Exercises Give reasons why ABC may give more realistic product costs in a manufacturing situation.

Exercise 1 A clothing manufacturer has identified the four following cost pools with their respective cost drivers: Cost pool

Cost driver

Machine activity

Machines hours

Quality inspection/control

Number of inspections required

Receiving of materials and handling

Number of receipts

Distribution

Per customer

Analyse the following list of activity costs into their appropriate cost pool: Activity cost Depreciation of machinery Van drivers wages Receiving department wages Van running costs Quality control staff wages Machine maintenance costs Spare part required for machine Quality control staff training Packing costs Power costs of machinery Machine supervision costs Material storage costs Fabric testing costs Machine cleaning costs

166  Costing for the Fashion Industry

Cost pool

Exercise 2 A clothing manufacturer has identified the following support activity costs. Suggest suitable cost drivers. Cost

Cost driver

Machine maintenance Set-up and recalibration costs Quality inspection Purchasing costs Machine supervision

Exercise 3 Great Activity Ltd produces four ranges of garments (ABCD) in various sizes, colours and quantities. The following table shows the schedule for the coming period. A

B

C

D

4

5

3

3

Output

10,000

8,000

6,000

5,000

Direct material per garment

£4.50

£3.80

£6.20

£5.60

Direct labour cost per garment

£1.30

£1.30

£1.65

£1.65

Machine hours per garment

0.15

0.20

0.25

0.25

Number of production runs

A set-up is required each time a new production run is started. Overhead Costs: Cost

Amount £

Cost driver

Set-up costs

19,500

Number of set-ups

Machine activity

35,000

Machine hours

Materials receiving and handling

12,000

Number of production runs Packing/despatch

15,000

Output

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167

1. Calculate the total cost for each range over the period and the unit cost of each of the garments using absorbing the overheads based on the percentage of direct labour cost. 2. Calculate the total cost for each range over the period and the unit cost using an ABC approach. 3. Show the comparison of unit costs, traditional with ABC.

Exercise 4 Ranjan Ltd operate in the UK sourcing high-quality silk fabrics from the Far East for use in the high-end fashion garment industry in the UK and Europe. In the coming period they are sourcing five different silk fabrics in various colours for sale to manufacturers across Europe. For simplicity these five products are referred to by their code names, given in the following table, with the quantities to be sourced in the period, the negotiated price per metre and the number of batches that will make up the total demand for each product. Ven

Wen

Xen

Yen

Zen

50,000

30,000

25,000

20,000

20,000

Purchase Price per Metre in the Far East

£5

£5

£8

£10

£12

Number of batches to achieve the demand

3

2

1

1

1

Customers per product

20

20

10

5

5

Metres to be sourced (the demand)

Overheads in the Period Activity Logistics in Far East: transport warehousing etc. Administration in Far East

Cost £120,000

Cost driver Total number of batches to be collected and shipped to meet the demand

£50,000

Per metre of fabric sourced

Shipping

£150,000

Per metre of fabric sourced

Logistics in Europe: warehousing transport etc.

£120,000

In proportion to customers per product

Administration in Europe

£75,000

Equally per product

Finance and currency costs

£25,000

In proportion to the purchase price of the products

168  Costing for the Fashion Industry

You are required to: 1. Provide a total cost for each of the five products to be sourced using an activity-based costing approach. (60 per cent) 2. Show the unit cost per product. (20 per cent) (Work to two decimal places)

Further reading Bhimani, A. (2015) Management and Cost Accounting, (6th ed.), Pearson. Boyd, K. (2013) Cost Accounting or Dummies, Wiley. Drury, C. (2018) Management and Cost Accounting (10th ed.), Cengage Learning. Kaplan, R. S. & Cooper, R. (1998) Cost and Effect, Boston MA: Harvard Business School Press.

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169

14 Capital investment decisions

Introduction Capital investment decisions are usually the preserve of senior management in an organization as they involve the spending of large sums of money. That is not to say that other, more junior staff may not be involved, particularly in assembling the initial information and data upon which the final decision will be made. So it is useful in a text of this type to give at least an outline of capital investment decisions and their appraisal. Essentially capital investment decisions relate to the expenditure of large sums of money to fund capital projects; such projects will have a life of at least one year but more usually several years and may be for extensive periods of time. This might be the purchase of new equipment, or a new computer system, or opening a new distribution centre, or a new retail outlet, or topically converting from diesel vehicles to electric – the types of project are endless. The issue is that they involve spending large amounts of the company’s capital and/or borrowing large sums of money. In most cases such projects will have some kind of technical assessment made of them and the technical specification will be important in the decision-making process. However, projects will usually also require some kind of financial appraisal made to assess their financial viability. This is known as capital investment appraisal and there are several methodologies that can be adopted but all rely on good information about the project and good estimates of how the project will perform.

The capital cost The capital cost of the project is essentially the outlay to be made, though it may be a composite cost and although is often made at the outset of the project may be paid in stages. The capital cost would include all the costs involved in getting the project up and running. Example A company has decided to invest in a new integrated computer system. In order to get the system up and running the following costs would be incurred: ●●

The hardware costs – PCs, VDUs, keyboards, server and so on;

●●

Installation costs – wiring for the network and so on;

●●

Building alterations costs to accommodate the network server;

●●

Software and programming costs;

●●

Staff training costs to enable staff to operate the system.

Where a project involves large-scale building works, the capital cost may be paid in stages as the work progresses and the plan will usually indicate the stages at which payments are to be made. The final payment not being made until the building has been handed over and any initial problems (known as ‘snags’) are resolved.

Accounting rate of return (ARR) This is one of the simplest methods of appraising capital investment decisions; however, it does have limited application. This method considers the average profit that a project will generate over its life and compares that profit with the capital outlay. Example It is intended to spend £12,000 on a project that has a four-year life. Over the four years the project is expected to generate profit in each year: Average profit for the project are £5,600 ¸ 4 = £1,400 ARR of the Project = (£1,400 ¸ £12,000 ) ´ 100 = 11.67%

Capital Investment Decisions  171

Table 14.1  Year

Profit £

1

1,200

2

1,400

3

1,600

4

1,400

Total

£5,600

In making the decision based on this method management would be looking for the highest percentage return. It should be noted that there is no standard way of calculating the ARR; here is just an illustration of one method. The figures have been kept simple in this example in order to illustrate the method but in reality, capital investment decisions are usually for very large sums of money. This method of appraisal is clearly simple and has a logic that we can all relate to in that we want a higher return from our capital outlay. However, as it has limited application for most projects it will be difficult to assess how much profit the individual project has earned because profit tends to be calculated for the whole business or individual operations and not single projects. So if a manufacturer decided on a new laser cutter, it might be difficult to establish how much profit that single piece of equipment has generated. It may have application where the project is to open a new outlet that will generate identifiable profits but it then calls into question whether ‘profit’ is the best measure of capital investment.

Net cash inflows Other than the Accounting Rate of Return most other methods of capital investment appraisal use cash flows as the measure rather than profit. These have the advantage of being much more identifiable with the project both in terms of inflows and outflows. The cash inflows are the revenues that the project generates, whereas the cash outflows are the expenses and costs of the project. These are netted off to give net cash inflows. The shape of the net cash inflows over the life of the project is interesting in that they are similar to the shape of product life cycles and tell us something about the project in question.

172  Costing for the Fashion Industry

Net cash inflows

Figure 14.1 illustrates the net cash inflows for a project; they take a little time to get going but once the project is underway they plateau out and eventually fall as the project comes to the end of its useful life. The steeper the initial rise, the quicker the project gets underway – little lead time; the flatter the initial rise, the longer the lead time. A long plateau would indicate a project with a long life span, whereas a short plateau would indicate a short project that quickly comes to the end of its useful life. See Figures 14.2 and 14.3.

Time

Net cash inflows

Figure 14.1  General shape of the net cash inflow.

Time

Net cash inflows

Figure 14.2  Shape where the project has minimal lead time.

Time

Figure 14.3  Shape where the project has a long lead time.

Capital Investment Decisions  173

Payback period This method of capital investment appraisal uses net cash inflows as described in this chapter and is probably the most commonly used method of investment appraisal. The thinking behind the method is, ‘how quickly will the business get the capital investment back from the project’. So again we have a method that has an easily understandable logic that we can all relate to. The decision rule in payback period is to look for the shortest payback period (i.e. the project that will repay the capital outlay the quickest). This is done by estimating the net cash inflows over the life of the project and making them cumulative year on year. It is then established when the cumulative net cash inflows will reach the capital cost.

Example A clothing manufacturer has decided to invest in a computer-controlled laser cutter at a capital cost of £150,000. It is estimated that this system will serve the company for six years at the end of which it will be obsolete. It is estimated that it will produce the following net cash inflows over the six-year period. Table 14.2  Inflows £

Cumulative inflows £

Year 1

45,000

45,000

Year 2

65,000

110,000

Year 3

80,000

190,000

Year 4

80,000

270,000

Year 5

80,000

350,000

Year 6

65,000

415,000

It can be seen from the cumulative column in Table 14.2, that the capital cost is not matched by net cash inflows until sometime during the third year of the project. By the end of year 3 the cumulative net cash inflows will have reached £190,000 exceeding the capital cost. Thus the payback period is 2 years plus a fraction of year 3.

174  Costing for the Fashion Industry

It can be seen that at the end of year 2 the cumulative net cash inflows are £110,000 thus a further £40,000 is required to match the capital cost of £150,000 and that £40,000 will come from the £80,000 generated in year 3. The fraction is therefore:

£40,000 ¸ £80,000 = 0.5 The payback period is therefore 2.5 years Where this laser cutter is compared with other similar systems the shortest payback period would be selected. It can be seen that this is also a simple method of calculation and is based on the concept that the business would want to know how quickly they would get their investment back. However, it has two major shortcomings in that it does not take account of the changing value of money nor does it recognize that some projects take much longer to get established but in the longer term may be more profitable than one with a short lead time.

Discounted cash flow (DCF) A better way to look at capital investment appraisal is to use discounted cash flow (DCF) and to calculate the Net Present Value for the project. DCF works on the basis of compounded interest only in reverse. If you had £100 to invest and you could get 5 per cent per annum interest on your investment, then after 1 year you would have £105. DCF works on the basis that future income given at a rate of interest will be worth less today than in the future. Thus in my example if we take the £105 as future income, then today (at the beginning of the investment) it is worth £100, known as its present value. The present values of future income and expenditure can be calculated using present value factor tables; here is an extract, and a more detailed table is given at the end of the chapter. Take the appropriate rate of interest and read off the factor against the year. The factor is multiplied by the future income (or expenditure) to give the present value of that income (or expenditure). £105 ´ 0.9524 = £100

Capital Investment Decisions  175

Table 14.3  Present Value Factors Year

3%

4%

5%

6%

10%

12%

1

0.9709

0.9615

0.9524

0.9434

0.9091

0.8929

2

0.9426

0.9426

0.9070

0.8900

0.8264

0.7972

3

0.9151

0.8890

0.8638

0.8396

0.7513

0.7118

4

0.8885

0.8548

0.8227

0.7921

0.6830

0.6355

5

0.8626

0.8219

0.7835

0.7473

0.6209

0.5674

6

0.8375

0.7903

0.7462

0.7050

0.5645

0.5066

A decision has to be made in respect of the interest rate to use and many businesses would choose their current rate of interest on their borrowing or perhaps an average rate if they have several loans at different rates of interest. There is, however, a school of thought that suggests that the weighted average cost of capital (WACC) should be used taking into account any notional dividends on share capital as well as rates of interest of borrowed money. Alternatively more than one interest rate could be used to show a range of circumstances. Example Taking the example of the laser cutter used in the section on payback period at a capital cost of £150,000 and assuming a rate of interest of 10 per cent would give the following results. Table 14.4  Inflows £

PV factor at 10%

Present value £*

Year 1

45,000

0.9091

40,910

Year 2

65,000

0.8264

53,716

Year 3

80,000

0.7513

60,104

Year 4

80,000

0.6830

54,640

Year 5

80,000

0.6209

49,672

Year 6

65,000

0.5645

36,693

*kept in round £

176  Costing for the Fashion Industry

The present values of the net cash inflows are then totalled up for the whole project and the capital cost is deducted to give the Net Present Value of the project. In this example that would be: Table 14.5  Total present values

£295,735

Capital cost made at start

£150,000

Net present value

£145,735

The decision rule in using NPV is to choose the highest NPV where choices are to be made and to rule out any negative NPVs. The highest NPV indicates the highest return against the capital cost once future income has been converted to its present value.

Discounted payback period Payback period and discounted cash flow can be combined in Discounted Payback Period. Here the simplicity of payback period is tempered with the harder edge of discounted cash flow. The inflows are discounted to give their present values and the present values made cumulative to see when the cumulative present values match the capital cost.

Table 14.6  Inflows £

PV factor at 10%

Present value* £

Cumulative present values £

Year 1

45,000

0.9091

40,910

40,910

Year 2

65,000

0.8264

53,716

94,626

Year 3

80,000

0.7513

60,104

154,730

Year 4

80,000

0.6830

54,640

209,370

Year 5

80,000

0.6209

49,672

259,042

Year 6

65,000

0.5645

36,693

295,735

Capital Investment Decisions  177

It can be seen from the table that the project’s discounted net cash inflows will match the capital cost in year 3, as before but much nearer to the end of the year. At the end of year 2 a further £55,374 is required to match the capital cost (£150,000 – £94,626) that will have to come out of the discounted inflows for year 3. £55,374 ¸ £60,104 = 0.92 Therefore the Discounted Payback Period is 2.93 years (almost 3 years). Though this is better than the straight payback period the decision rule is the same, that is, look for the shortest discounted payback period and therefore it does not take into account projects that have long lead times but are ultimately more profitable for the business.

Illustration Progressive Ltd is a fashion design house and is considering investment in some high-tech equipment. They are considering two alternative plans: Plan 1 – the Micro-Spot System Plan 2 – the Gruber System Table 14.7  Plan 1 Micro-Spot

Plan 2 Gruber

Cost

£230,000

£280,000

Life

5 years

5 years

Net cash inflows Year 1

40,000

60,000

Year 2

80,000

100,000

Year 3

100,000

100,000

Year 4

60,000

60,000

Year 5

50,000

60,000

178  Costing for the Fashion Industry

Table 14.8 

Year

Net cash inflows Micro-Spot

Cumulative

Net cash inflows Gruber

Cumulative

1

£40,000

£40,000

£60,000

£60,000

2

£80,000

£120,000

£100,000

£160,000

3

£100,000

£220,000

£100,000

£260,000

4

£60,000

£280,000

£60,000

£320,000

5

£50,000

£330,000

£60,000

£380,000

They both have different capital costs and because they work in slightly different ways have different lead times – hence different net cash inflows in years 1 and 2. However, they are both estimated to have a life of around five years after which something new is likely to have become available. At the end of the five years the supplier of the Gruber System guarantees a minimum residual value (scrap value) of £10,000 – this has been added to the final year’s net cash inflows. The companies’ current average capital cost is running at 12 per cent per annum and it is decided to discount at this rate.

Payback period Micro-Spot System – Payback Period is 3.17 years At the end of year 3 the cumulative net cash inflows are £220,000 leaving a further £10,000 required from year 4 to match the capital cost. 10,000 ¸ 60,000 = 0.17 thus 3.17 years Gruber System – Payback Period is 3.33 years At the end of years 3 the cumulative net cash inflows are £260,000 leaving a further £20,000 required from year 4 to match the capital cost. 20,000 ¸ 60,000 = 0.33 thus 3.33 years

Capital Investment Decisions  179

It can be seen that Plan 1 the Micro-Spot System has marginally the shortest payback period of 3.17 years, whereas Plan 2 the Gruber System is 3.33 years. So on the basis of that methodology the Micro-Spot System would be chosen. On the basis of Net Present Value the Micro-Spot System has a positive NPV of £7,168, whereas the Gruber System in a negative NPV of £(3,352). So on the basis of NPV the Micro-Spot System would also be preferable. You could now use this illustration to establish the discounted payback period for the two plans.

Table 14.9  Net Present Value: Micro-Spot System Net cash inflows Micro-Spot

PV factor at 12%

Present value £

1

£40,000

0.8929

35,712

2

£80,000

0.7972

63,776

3

£100,000

0.7118

71,180

4

£60,000

0.6355

38,130

5

£50,000

0.5674

28,370

Year

Total present values

237,168

Capital cost

230,000

Net present value

7,168

Table 14.10  Net Present Value: Gruber System Net cash inflows Micro-Spot

PV factor at 12%

Present value £

1

£60,000

0.8929

53,574

2

£100,000

0.7972

79,720

3

£100,000

0.7118

71,180

4

£60,000

0.6355

38,130

5

£60,000

0.5674

Year

34,044

Total present values

276,648

Capital cost

280,000

Net present value

180  Costing for the Fashion Industry

(3,352)

Conclusions Capital investment decisions are about spending large sums of money on equipment, facilities, buildings and so on that will have a life over several years. The objective is to estimate which plan will provide the business with the most financially viable option. The calculations used will only be as good as the estimated data provided and therefore care needs to be taken in assembling the information. In this chapter four methods of capital investment appraisal have been considered: 1. Accounting Rate of Return 2. Payback Period 3. Discounted Cash Flow using Net Present Value 4. Discounted Payback Period The decision rules for the four methods are: 1. Accounting Rate of Return – select the highest average percentage return on the capital expenditure. 2. Payback Period – select the shortest. 3. Net Present Value – eliminate any negative NPVs and select the highest positive NPV. 4. Discounted Payback Period – select the shortest.

Exercises Exercise 1 Ambladec Ltd are working on a project that will last three years at a capital cost of £400,000. The net cash inflows are estimated to be: Year 1 £100,000 Year 2 £200,000 Year 3 £300,000

Calculate the payback period and NPV assuming a discount rate of 15 per cent.

Capital Investment Decisions  181

Examine the following net cash inflows for three capital projects and then answer the questions that follow: Project 1 net cash inflows

Project 2 net cash inflows

Project 3 net cash inflows

1

40,000

80,000

60,000

2

65,000

100,000

70,000

3

68,000

90,000

70,000

4

70,000

80,000

70,000

5

60,000

70,000

70,000

6

40,000

50,000

50,000

Year

1. Sketch the shape of the net cash inflows for the three projects 2. Which projects have the shortest lead time? 3. Which project maintains its revenues the longest? 4. Which project barely plateaus out in terms of revenues?

Exercise 2 Provinces Ltd are considering opening a new fashion store in Merborough. They are looking at two possible town centre venues with the following costs and revenues. Location 1 – a unit in the new Merborough shopping centre Capital costs

£

Cost of three years lease (paid up front) Initial legal fees

3,500

Shop fitting Revenues and revenue expenses

234,000

120,000 Revenues £

Revenue expenses £

Year 1

280,000

100,000

Year 2

400,000

110,000

Year 3

440,000

120,000

182  Costing for the Fashion Industry

Location 2 – a shop unit on King Street Capital costs

£

Cost of three years lease (paid up front)

255,000

Initial legal fees

4,500

Shop fitting

130,000

Revenues and revenue expenses

Revenues £

Revenue expenses £

Year 1

280,000

120,000

Year 2

420,000

140,000

Year 3

480,000

150,000

You are required to make an appraisal of the two options being considered using: 1. Payback Period 2. Net Present Value based on discounting at 10 per cent 3. Discounted Payback Period also based on discounting at 10 per cent Outline which location gives the best appraisal with your reasons.

Exercise 3 Ember Holdings are considering purchasing a new computer-driven machine. The company supplying the machine have suggested that Ember Holdings could have it for four years after which they would buy it back for £4000. Alternatively the machine could be productive for six years but at the end of six years the supplier would not want it back and it would have no scrap value. The capital cost of the machine is £24,000 and the estimated net cash inflows are: Year 1

£4,000

Year 2

£6,500

Year 3

£10,000

Year 4

£9,000

Year 5

£2,000

Year 6

£1,500

Capital Investment Decisions  183

a) Evaluate the two options using both payback period and NPV. A discount rate of 12 per cent should be used. b) Ember Holdings having done some more research have found another similar machine, known as ‘Q’, that would do the job and has a lower initial capital cost of only £16,800. However, the Q machine has only an expected life of 3 years at the end of which it would have to be scrapped. If the project is to continue for six years, an identical machine will have to be purchased at the beginning of year 4 at an estimated cost of £18,000. Evaluate machine Q using a discount rate of 12 per cent and compare your result to the ones obtained from the previous question.

Exercise 4 Zenco AG are intending buying a new computer system for their factory and have been considering the various options. Three systems seem possible, identified as system A, B and C. The systems have different specifications and consequently would require differing installation and set-up times – the installations costs have been deducted from the year 1 net cash inflows. The machines also operate at different rates and with differing levels of output also accounted for in the net cash inflows. System A

System B

System C

£ 34,000

£ 36,000

£ 28,000

Year 1

5,500

8,000

6,000

Year 2

8,500

9,000

8,400

Year 3

12,000

10,000

10,000

Year 4

10,000

10,500

9,600

Year 5

8,200

6,000

6,500

Capital cost Net cash inflows:

Additional information: a) Systems A and B have relatively low scrap values at the end of year 5, say £1,000. Machine C has no scrap value at the end of year 5 and will cost £2,000 for safe disposal.

184  Costing for the Fashion Industry

b) Machine C is cheaper to purchase and has lower installations costs but is less efficient in terms of output. c) The interest rate applicable to the company is 12 per cent. You are required to: 1. Comment critically on the net cash inflows for the machines – consideration of the shape of the inflows might be useful. 2. Evaluate the three machines based on Net Present Value and Discounted Payback Period, and indicate from a financial perspective which seems to be the best option.

Exercise 5 Hostigen AG, a German company, are evaluating two new machines for their factory in Cologne. In the evaluation to avoid being influenced by the maker’s name and reputation the two machines are simply referred to as ‘Machine A’ and ‘Machine B’. Their technical department has compiled the following estimates of the net cash inflows that each machine will produce over their five-year life – the main variant in the net cash inflows being the servicing and maintenance requirements of the two different machines. The capital cost of the machines used in any evaluation needs to include the installation and staff training costs. The relevant costs and inflows are shown in the following table. For the purposes of the evaluation, the company has decided to ignore any residual or scrap values. Machine A

Machine B

€ 120,000 10,500 6,000

€ 140,000 8,500 5,000

€

€

Year 1

36,000

35,000

Year 2

38,000

40,000

Year 3

40,000

40,000

Year 4

40,000

40,000

Year 5

36,000

38,000

Capital cost: Purchase price of system Installation costs Training costs Net Cash Inflows:

Capital Investment Decisions  185

The company’s capital structure can be summarized as: €m Ordinary share capital (a recent dividend was 12.5%)

400

Reserves

200

Convertible loan 6.25%

160

Bank loan 12.5%

240

Total Capital

1,000

This gives a WACC of 9 per cent and this will be used in capital investment appraisal. You are required to: 1. Calculate the payback period for the two machines. 2. Evaluate the two machines based on NPV calculating the NPV for both systems using the WACC given here. 3. Indicate from a financial perspective, based on your calculations, which machine appears to be the best option.

Further reading Bhimani, A. (2015) Management and Cost Accounting (6th ed.), New York; Harlow, England: Pearson. Boyd, K. (2013) Cost Accounting for Dummies, Hoboken, NJ: Wiley. Drury, C. (2018) Management and Cost Accounting (10th ed.), Australia: Cengage Learning.

186  Costing for the Fashion Industry

Present Value Factors Year

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

12%

14%

15%

1

0.9901

0.9804

0.9709

0.9615

0.9524

0.9434

0.9346

0.9259

0.9174

0.9091

0.8929

0.8772

0.8696

2

0.9803

0.9612

0.9426

0.9426

0.9070

0.8900

0.8734

0.8573

0.8417

0.8264

0.7972

0.7695

0.7561

3

0.9706

0.9423

0.9151

0.8890

0.8638

0.8396

0.8163

0.7938

0.7722

0.7513

0.7118

0.6750

0.6575

4

0.9610

0.9238

0.8885

0.8548

0.8227

0.7921

0.7629

0.7350

0.7084

0.6830

0.6355

0.5921

0.5718

5

0.9515

0.9057

0.8626

0.8219

0.7835

0.7473

0.7130

0.6806

0.6499

0.6209

0.5674

0.5194

0.4972

6

0.9420

0.8880

0.8375

0.7903

0.7462

0.7050

0.6663

0.6302

0.5963

0.5645

0.5066

0.4556

0.4323

7

0.9327

0.8706

0.8131

0.7599

0.7107

0.6651

0.6227

0.5835

0.5470

0.5132

0.4523

0.3996

0.3759

8

0.9235

0.8535

0.7894

0.7307

0.6768

0.6274

0.5820

0.5403

0.5019

0.4665

0.4039

0.3506

0.3269

9

0.9143

0.8368

0.7664

0.7026

0.6446

0.5919

0.5439

0.5002

0.4604

0.4241

0.3606

0.3075

0.2843

10

0.9053

0.8203

0.7441

0.6756

0.6139

0.5584

0.5083

0.4632

0.4224

0.3855

0.3220

0.2697

0.2472

Year

16%

18%

20%

21%

22%

24%

25%

28%

30%

32%

34%

35%

40%

1

0.8621

0.8475

0.8333

0.8264

0.8197

0.8065

0.8000

0.7813

0.7692

0.7576

0.7463

0.7407

0.7143

2

0.7432

0.7182

0.6944

0.6830

0.6719

0.6504

0.6400

0.6104

0.5917

0.5739

0.5569

0.5487

0.5102

3

0.6407

0.6086

0.5787

0.5645

0.5507

0.5245

0.5120

0.4768

0.4552

0.4348

0.4156

0.4064

0.3644

4

0.5523

0.5158

0.4823

0.4665

0.4514

0.4230

0.4096

0.3725

0.3501

0.3294

0.3102

0.3011

0.2603

5

0.4761

0.4371

0.4019

0.3855

0.3700

0.3411

0.3277

0.2910

0.2693

0.2495

0.2315

0.2230

0.1859

6

0.4104

0.3704

0.3349

0.3186

0.3033

0.2751

0.2621

0.2274

0.2072

0.1890

0.1727

0.1652

0.1328

7

0.3538

0.3139

0.2791

0.2633

0.2486

0.2218

0.2097

0.1776

0.1594

0.1432

0.1289

0.1224

0.0949

8

0.3050

0.2660

0.2326

0.2176

0.2038

0.1789

0.1678

0.1388

0.1226

0.1085

0.0962

0.0906

0.0678

9

0.2630

0.2255

0.1938

0.1799

0.1670

0.1443

0.1342

0.1084

0.0943

0.0822

0.0718

0.0671

0.0484

10

0.2267

0.1911

0.1615

0.1486

0.1369

0.1164

0.1074

0.0847

0.0725

0.0623

0.0536

0.0497

0.0346

Bibliography

Bhimani, A., Horngren, C. T. and Datar, S. M. (2008) Management and Cost Accounting (4th ed.), Harlow: Prentice Hall. Bromwich, M. and Bhimani, A. (1997) Management Accounting: Pathways to Progress, London: CIMA. Brown, P. and Rice, J. (2001) Ready-to-Wear Apparel Analysis (3rd ed.), Harlow: Prentice Hall. Carr, H., Latham, B. and Tyler, D. J. (2008) Carr and Latham’s Technology of Clothing Manufacture (4th ed.), Oxford: Blackwell. Chuter, A. J. (1995) Introduction to Clothing Production Management (2nd ed.), London: Blackwell Scientific. Cooklin, G. (2006) Introduction to Clothing Manufacture, revised by Hayes, S. G. and McLoughlin, J., Oxford: Blackwell Science. Drury, C. (2015a) Cost and Management Accounting: An Introduction (8th ed.), Andover: Cengage Learning. Drury, C. (2015b) Management and Cost Accounting (9th ed.), Australia: Cengage Learning. Drury, C. (2016) Management Accounting for Business (6th ed.), Andover: Cengage Learning. Easey, M. (2009) Fashion Marketing (3rd ed.), Oxford: Wiley-Blackwell. Fairhurst, C. (2008) Advances in Apparel Production, Cambridge: Woodhead Publishing Ltd. Hayes, S., Dr, McLoughlin, J., Fairclough, D. and Cooklin, G. (2012) Cooklin’s Garment Technology for Fashion Designers (2nd ed.), Chichester: Wiley. Horngren, C. T. (2014) Introduction to Management Accounting (16th ed., Global ed.), Harlow: Pearson Education Limited. J. & P. Coats Limited (1996) The Technology of Seams and Threads (3rd ed.), Glasgow: Coats Ltd. Jackson, T. and Shaw, D. (2006) The Fashion Handbook, London: Routledge.

Jackson, T. and Shaw, D. (2009) Mastering Fashion Marketing, Basingstoke: Palgrave Macmillan. Jones, R. M. (2006) The Apparel Industry (2nd ed.), Oxford: Blackwell. Lucey, T. (2005) Management Accounting (5th ed.), London: Continuum. Lucey, T. (2009) Costing (7th ed.), London: Cengage Learning. Lynch, R. (2006) Corporate Strategy (4th ed.), Harlow: Pearson Education Ltd. Mintzberg, H., Quinn, J. B. and Ghoshal, S. (1998) The Strategy Process: Revised European Edition (2nd ed.), Harlow: Prentice Hall. Russell, D., Patel, A. and Wilkinson-Riddle, G. J. (2001) Cost Accounting: An Essential Guide, Harlow: Financial Times Prentice Hall. Ryan, B. (2008) Finance and Accounting for Business (2nd ed.), London: South-Western Cengage Learning. Tyler, D. (1991) Materials Management in Clothing Production, Oxford: Blackwell Science. Wood, F. and Sangster, A. (2015) Frank Wood’s Business Accounting 1 (13th ed.), Upper Saddle River: Pearson.

Bibliography 189

Answers to exercises

Chapter 1 Company A – Points for Consideration Question 1 ●●

Difficulties in obtaining high-profile brands

●●

Strategic decision to only keep the most profitable business

●●

The business lost its way

●●

Too many strands to the business and the need to refocus

Question 2 ●●

Online trading

●●

Sampling speed

●●

Market attractiveness vs. risk management

Question 3 ●●

TK Maxx for stock clearance

●●

Tesco for high volume but the downside will be low margins

●●

Auchan/Carrefour could help develop the brand outside the home market

Company B– Points for Consideration Question 1 ●●

Sell to discounters

●●

Reduce order quantities

●●

●●

Look into UK production to reduce lead times and thus increase the opportunities for repeat business Hold fabric as stock and produce goods based on sales figures

Question 2 ●●

Standardized: their in-house brand (sold to boutiques and online)

●●

Adapted: their retail customers

Question 3 ●●

●●

The management style is informal, open-door policy, being part of a family, rewards pending on business performance Improvements: communication with employees, regular appraisals, staff socials organized by management, training and mentoring so that new staff feel supported

Company C – Points for Consideration: Question 1 ●●

●●

Advantages: access to international networks, knowledge and experience, global supply chain Disadvantages: more adaptions to enter new markets, global corporate business practices, corporate company culture, staff relocation or redundancies

Question 2 ●●

Review Chapter 4 and do this exercise in class as a group or in your own time

Question 3 ●●

●●

Yes, they could because they were already successful and appeared to have a successful business strategy which led to the acquisition If they had not been acquired, they could have developed their own in-house brand which requires a significant marketing budget and aimed to set up an online selling platform

Answers to Exercises  191

Chapter 2

a) Examples of issues faced by specific companies within the fashion industry (for use with Exercises 1 and 2)

Example 1 Company A was a fast-growing online company. Although sales were being driven by the dynamic personality of the business founder, the appeal of the brand’s USP was limited. As a business start-up, it invested heavily in advertising (significant cash outflow), which drove sales initially but failed to build brand loyalty as quality and choice were perceived to be low in comparison to other brand offerings. When a business is starting up certain strategic questions arise, a key one being around warehousing and logistics. Does the brand build up its sales profile and use third-party facilities for fulfilment and distribution (low initial cash outflow), or does it invest in its own fulfilment and distribution facilities (high initial cash outflow) and then start to build sales to cover the cost of these? In this case, the business chose the latter, meaning that it was incurring high costs in relation to its distribution facilities, but its sales were falling as initial interest in the brand started to wane and it was unable to replicate the level of interest in the products across a wider geographical area. In short, there were significant cash outflows that were not matched with correspondingly high cash inflows, leading to increased financial risk. E-commerce brands are known to be notoriously difficult to scale up, which proved to be the case here and, unable to secure loan finance due to its poor cash flow and high financial risk, the business went into administration.

Example 2 Company B is an international mid-market high street fast-fashion retailer. Customer analysis suggested that its target demographic still preferred to shop instore, but that this pattern was starting to change.

192  Answers to Exercises

In response the retailer started to build its online presence and to reduce its programme of store openings. Within the space of a single year the shopping habits of its target demographic changed more rapidly than the retailer had predicted, and it was unprepared for this, still holding too many bricks-and-mortar stores, along with the high levels of stock required to service these. It had also not raised its online offer enough to attract sufficient sales to compensate for the reduction in footfall instore. This presented a significant financial risk through the fall in turnover. The important point is that the retailer analysed the risk and identified that the two biggest threats lay in the number and productiveness of its stores, and the level of stock being held. Immediate action was therefore taken by the retailer to close underperforming stores, to reduce the level of stock significantly and to continue to invest in its online platform. Although the risk has not been completely eliminated, it has been significantly reduced and the specific risk from holding unproductive stores has been mitigated by selective closures and strategic openings.

Example 3 Companies C and D are two affordable luxury brands operating within the UK. Company C was part of a group, which included effecting change within the supply chain, through taking responsibility for problems within it, as part of its declared vision. Company D, an independent retailer, had a similar view. Both companies found that one of their suppliers had subcontracted their production to another, unethically operating, factory. Company C instantly walked away from the supplier, vowing never to work with it again. Company D announced that it was going to continue to work with the supplier, keeping it under scrutiny and taking responsibility for improving the supply chain. In the eyes of a consumer group with a powerful voice, all it could see was that Company D was continuing to work with an unethical supplier and eventually Company D was forced to walk away. This, however, meant that nothing changed within the supply chain.

Answers to Exercises  193

Example 4 Company E is an international mid-market high street fashion retailer focusing on stylish but trend-led clothing for a customer base purchasing outside the youth fashion market. It developed the concept of fast-response within the supply chain, through the vertical integration of its production. This enabled it to offer a high degree of customization in a small-batch production format, enabling it to both respond to the desires of its customers in terms of the product, while having a much tighter control over stock. This business model gave it a competitive advantage over its rivals, enabling it to offset its higher near-shore production costs through full price sales driven by its ‘see-it-buy-it-or miss-it’ message, but it also led to a blurring of the line between fastresponse and fast-fashion in the mind of many consumers. The requirement to offer ever-changing trends to meet customer demand is now being met by some large, online true-fast-fashion brands. These, likewise, are working with small-batch production in nationally based factories, as production proximity to end market is key to their ability to meet this consumer demand. Furthermore, these online brands are offering more consumer-friendly delivery options, generally seen as key to attracting custom from cash-poor but trend-led customers. This greatly reduces Company E’s competitive advantage, increasing financial risk through reduced sales coupled with the higher cost of domestic or near-shore production. In response to the risk, Company E has sought to build up its online business and to use technology to seamlessly incorporate this into its in-store environment, partly through highly automated in-store collection points for online orders, significantly reducing its exposure to financial risk by driving both on- and offline sales.

Example 5 Company F was a major sportswear plc within the UK. The directors embarked on a major expansion plan, funded by debt, just as the Great Recession hit (2008–2009) leading to a significant, and unpredicted, fall in sales. At the same time, a major strategic issue for the retailer was that it was more expensive than some of its competitors and less fashion forward than others. The brand saw itself as the sportswear retailer that was most serious about sport and yet this was not reflected in

194  Answers to Exercises

the offer of products, especially technology based, to secure this niche positioning. Consumers therefore had no particular reason to shop there and, without a clear USP, sales started to reduce dramatically. In the five years leading up to its liquidation, the company had managed to juggle its finances sufficiently to cover its liabilities as they fell due, and at the year-end prior to liquidation its Current Ratio (see Chapter 2) was only marginally below the desired industry level. A review of the more stringent Quick Ratio (see Chapter 2), however, showed that the business had too many assets tied up in stock – the result of the decision to close unprofitable stores, but to retain the stocks, which it was subsequently unable to sell – and its cash reserves were too low to cover its financial obligations. In 2010, the value of the company was in the region of £500 million; by 2012 this had collapsed to just £1.2 million. Unable to secure any further loans due to the high financial risk, and unable to meet the repayment obligations of its existing ones, the company was forced into administration and eventual liquidation, leaving debts in the region of £150 million and with the total loss of around 7,000 jobs. This created a serious financial risk for all the unpaid suppliers.

Example 6 Company G was a small luxury brand, headed by a designer who struggled with the business side of her company but was unable to secure an effective manager to carry out this work on her behalf. In common with many small designer brands, the company shared production facilities with much larger, high-profile designer brands, meaning that its products were low down in the production queue. The pressure remained to pay suppliers of raw materials, however late receipt of the products from the factories affected the sales potential and, in combination, these negatively affected cash flow significantly raising the level of financial risk. Despite a loan from the American parent company, the UK accounts showed that assets were greatly exceeded by liabilities and the company was not profitable in the UK. Restructuring was considered as an option, although it would have been difficult to improve the cash flow far enough to reduce the financial risk to an acceptable level. Following some additional major negative issues, after just seven years in existence, the company was dissolved in 2015.

Answers to Exercises  195

b) Key risks and responses/resolutions identified relating to retailers within the fashion industry (for use with Exercises 1 and 2) The following table provides a summary of the main types of business and financial risk seen from a review of the Annual Reports of a selection of UK and international fashion businesses, with different market positionings and different operating platforms. The vast majority of risk factors appear to be common across the industry, but the perceived severity of the risk varies according to the operating circumstances of the business and many ways are taken to address them. General risk(s)

Specific risk(s)

Exchange rate losses

●●

Many costs and revenues in non-local currencies, therefore affected by factors such as global economic trends and political issues

●●

Hedging of foreign currencies to minimize negative exchange differences

Cyber attacks

●●

System outage leading to business disruption Major data loss leading to reputational damage, financial loss and loss of consumer confidence

●●

Extended investment in cyber security Security monitoring of systems Disaster recovery plan for data loss Enhanced employee training to spot risk of attack

●●

Response(s)/resolution(s)

●●

●●

●●

Business interruption

●●

●● ●●

Loss of critical talent or inability to recruit or motivate appropriate staff

●●

●●

●●

Fires, floods and terrorist attacks Loss of key suppliers Need for significant product recall

●●

Gaps in knowledge and skills Unmanageable attrition rates Unhappy staff known to be less productive

●●

●●

●●

●●

●●

Disaster recovery plan in place Production spread to reduce reliance on a few key suppliers Quality control procedures in place to review suppliers and products to try to pre-empt problems Use of capability maps to identify skills gaps Staff surveys to identify areas of contention Introduction of effective performance management and rewards schemes (including non-financial rewards) (Continued)

196  Answers to Exercises

General risk(s)

Specific risk(s)

Failure to meet consumers’ expectations and technological requirements

●●

●●

Failure to offer appropriate products to meet consumer needs, including failure to recognize cultural differences

●●

Risk of product obsolescence

●●

●●

Loss of revenue due to failure to meet expectations at all consumer touch points or to provide the technology platforms, online service or support demanded by customers Missed opportunities for customer engagement leading to lower growth

●●

Loss of turnover through lack of understanding of consumer wants and needs Products inappropriate to cultural market

●●

●●

●●

●●

●●

●●

Social and environmental sustainability

Response(s)/resolution(s)

●●

●●

●●

●●

●●

Reduced profits through inability to sell at full price Ethical issues through disposal of unsold products

●●

Increasing demand leading to resource scarcity could affect availability, production, quality and cost Unseasonal, and extreme, weather patterns leading to disruption in the supply chain and unpredictability of demand Increased regulation affecting production costs and flexibility Increasing transparency and accountability being demanded by consumers Increased brand exposure due to social media

●●

●●

●●

●●

●●

●●

●●

More effective IT teams to support operations Development of omnichannel functions to ensure consistency of service across online and in-store formats Innovation in technology used to meet/address consumer needs

Implementation of strategic partnerships to benefit from local/specialized knowledge Continuous product innovation Alignment of products with key markets

Ongoing order process to improve stock control and minimize waste Matching of delivery dates and quantities to market Introduction of sustainability initiatives relating to carbon emissions, waste production and power use Introduction of global frameworks focusing on fair treatment of workers and protection of rights Exploration of the use of alternative, sustainable, materials Development of clothes recycling programmes Increased transparency being practiced through the Annual Reports Monitoring of social media sites to keep consumers notified, build brand loyalty and identify negative issues

Answers to Exercises  197

General risk(s)

Specific risk(s)

Non-compliance with regulations/ ethical standards

●● ●●

●●

Compliance failure Internal or external failure to comply with business ethical policies, including labour and environmental standards Failure to comply with data protection requirements

Response(s)/resolution(s) ●●

●●

●●

●●

Breaches of intellectual property through counterfeiting, copyright, trademark and design infringements

●●

Macro-economic or geopolitical instability

●●

●●

●●

●●

●●

●●

●●

Competition

Can reduce demand for genuine products Damage to brand image and profits

●●

●● ●●

●●

198  Answers to Exercises

Volatility in external environment may impact operations and financial performance Disruption of supply chain and/or consumer purchasing patterns Trade interventions, including quotas, restrictions, subsidies and duties, can lead to reduced sales and increased prices

●●

Increasingly competitive environment Low barriers to entry Reduced effectiveness of key business drivers, including brand and digital marketing activities Smaller tech-enabled companies offering something more unique

●●

●●

●●

●●

Monitoring of external suppliers and partners for compliance with internal codes of conduct Restrictions placed on subcontracting by suppliers Training programmes for all staff on requirements and responsibilities Establishment of whistleblowing procedures Pursuit of civil or criminal actions or negotiated settlements Trademarks registered globally Disruption of the flow of counterfeit products

Risk spread by not focusing on one particular market Political activity monitored in specific areas to pre-empt threats to the business

Focus on specific target group Ensure product offer is relevant to the market Use knowledge and experience to drive innovation and efficiencies beyond capability of new entrants

Exercises 1 and 2 These exercises are self-directed and can be done in class as a group or in your own time.

Exercise 3 2XX4

2XX3

2XX2

2XX1

2XX0

£000

£000

£000

£000

£000

Company A

-

Gross Profit Margin %

28.56

27.12

22.09

26.04

-

Operating Profit Margin %

13.89

9.89

3.12

4.14

-

Current Ratio:1

1.48

1.12

0.96

1.07

-

Quick Ratio:1

0.77

0.31

0.34

0.38

-

Company B Gross Profit Margin %

(8 months)

(16 months)

23.37

24.35

25.96

30.71

25.17

Operating Profit Margin %

5.45

5.71

8.98

9.18

3.95

Current Ratio:1

1.64

1.41

1.98

3.16

2.42

Quick Ratio:1

1.46

1.28

1.69

2.89

2.20

23.23

18.61

16.52

15.07

17.85

Operating Profit Margin %

5.18

0.67

–0.09

–1.24

0.80

Current Ratio:1

2.93

2.75

2.10

2.32

2.38

Quick Ratio:1

2.05

2.06

1.29

1.75

1.88

Company C Gross Profit Margin %

Answers to Exercises  199

Gross profit margin (GPM) The results for Companies A and B suggest that they are overperforming against expectations, as they are above the industry target of 20–25 per cent for a value company. Company C’s margin was too low in 2XX0–2XX3, but the Company then improved and rose above the target level in 2XX4. When the GPM is too low, it suggests either that the companies were having problems selling their products at full price or that they did not have a strong voice in the supply chain and so the cost of their product was too high compared to what they could be sold for. Company B had the greatest control of its supply chain and this is reflected in its consistently higher margins.

Operating profit margin (OPM) The average OPM for a value retailer is 7 per cent. In every case, the Companies’ best OPMs were in the years when GPMs were higher, suggesting that the fall in OPM was a knock-on effect of falling GPMs. When the results were below average it could suggest that the Companies had poor control over their operating costs. It is not possible, however, to say for sure that the profits are unacceptably low, because the KPIs can only be fully interpreted in the light of the business’ strategies. It is possible that each company was trying to expand or to reposition and that would involve additional operating expenses that they would ultimately hope would drive sales and generate more profits. The apparent underperformance would therefore be due to a deliberate strategic decision and not to a loss of control.

Current Ratios (CR) and Quick Ratios (QR) Each of these companies acted as suppliers of products, rather than selling in their own right. As such the general liquidity tolerances should be applied, not the specific retail fashion ones. The parameters for the Current Ratio are therefore 1.5–2.5:1 and the Quick Ratio should have been 1:1. Based on this, Company A’s liquidity was all right in 2XX4, but was too low in all the other years. The main issue was with the QR, where the level was too low in 2XX4, and far too low in all the other years. Clearly it managed to pay its debts as they fell due, but it suggests that some juggling of cash would have been needed to do this. The differential between the two ratios suggests that stock levels were possibly too high and the Company perhaps needed to go on a sales drive to reduce stock levels and to improve cash flow into the business.

200  Answers to Exercises

Company B’s CR was too high in 2XX1, but was otherwise all right, suggesting that it had sufficient liquidity to meet its debts as they fell due. The QR, however, was too high in every year, suggesting that Company did not have enough stock to really satisfy customer demand, which could explain why sales were falling in some years. Company C’s CR was towards the top end of the range from 2XX0 to 2XX2 and exceeded the level in 2XX3 and 2XX4. This suggests good liquidity and an ability to pay debts as they fall due. Like Company B, however, the QR looks too high, suggesting that the company was holding too little stock and sales were falling again, in general, suggesting that customer demand was not really being met due to a lack of stocks. This suggests that, although neither company needed to take action to improve their liquidity, both needed to consider their level of stock and improve the balance between stock levels and total current assets. Note When interpreting KPIs it is really important to bear in mind what a business is trying to achieve strategically. If the business is internationalizing or globalizing then the main thing that it will be trying to achieve in the early years is to raise brand awareness and it may need to use a lot of its cash resources in setting up its stores, developing its website or promoting the brand, for example. It would therefore not expect to achieve its usual level of sales growth, profitability and liquidity in these years and much lower levels would probably be seen.

Chapter 3 To calculate the number of garments per colour and size based on a given ratio follow these steps: 1. Take the total order quantity (3,600 pieces). 2. Add up all the ratios (20). 3. Divide the total order quantity by the total ratio (3,600/20 = 180). 4. Therefore a ratio of 1 equals 180 pieces and a ratio of 2 equals 360 pieces. Colour/Size Navy Red White Black

10

12

14

16

180 pieces 180 pieces 180 pieces 180 pieces

180 pieces 180 pieces 360 pieces 360 pieces

180 pieces 180 pieces 360 pieces 360 pieces

180 pieces 180 pieces 180 pieces 180 pieces

Answers to Exercises  201

202  Answers to Exercises

Chapter 4 Delivery Date

Selling Prices to Distributor Euros

Factory Names

Factory Selling Prices US$

Selling Prices £

30 Jun

29 Jul

8.50

7.26

D

3000

30 Jun

29 Jul

8.35

7.14

Bow blouse

4800

30 Jun

29 Jul

7.95

Gathered hem blouse

2000

30 Jun

29 Jul

Applique blouse

5600

30 Jun

23000

 

Order Quantity per Style

Ship Date

Embroidered blouse

7600

Pearl button blouse

Style Description

Totals

Note: calculations have been rounded up US $1.33 Euros 1.17

Freight Cost £

Cost per Style £

Gross Profit per Style £

% Profit Margin per Style

Total Sale per Style £

Total Gross Profit per Style £

0.55

0.50

5.71

1.55

21

55,176.00

11,780.00

4.26

0.55

0.50

5.31

1.83

26

21,420.00

5,490.00

3.50

4.66

0.55

0.50

5.71

1.08

16

32,592.00

5,184.00

C

3.20

4.26

0.55

0.50

5.31

1.66

24

13,940.00

3,320.00

7.01

D

3.75

4.99

0.55

0.50

6.04

0.97

14

39,256.00

5,432.00

 

 

 

 

 

 

 

 

 

1,62,384.00

31,206.00

Buying Prices £

Pack & Test Costs £

3.50

4.66

C

3.20

6.79

C

8.15

6.97

29 Jul

8.20

 

 

Chapter 5 These exercises are self-directed and can be done in class as a group or in your own time.

Chapter 6 Exercise 1 Direct Materials

Direct Labour

Direct Expenses

b

a

e

d

c

j

f

h

l

g

k

r

i

p

m n o q s

Exercise 2 Direct Materials

Direct Labour

Direct Expenses

Production Overhead

Non-Production Overhead

a

b

r

d

i

c

e

u

g

j (material for a packed product)

f

h

j (packing large scale for distribution)

o

k

s

m

l

j (labour for a packed product) p

t

o

n

y

v

q

x

s w z

Note some costs may be in more than one category

Answers to Exercises  203

Exercise 3 Indirect Materials

Indirect Labour

Indirect Expenses

a

b

e

f

c

g

k

d

h

o

i

j

p

l m n

Exercise 4 Selling and Distribution Costs

Administration Costs

Finance Expenses

a

c

e

b

d

f

i

g

h

k

j

n

l

m o p

204  Answers to Exercises

Chapter 7 Exercise 1 Bern Heart Fashions Period Cost Report August 20xx £

£

Opening stock of direct materials

2,500

Add purchases of direct materials

86,700

Less closing stock of direct materials

89,200

Cost of Materials consumed

2,800

Cutting room wages

2,300

Sewing room wages

3,500

Press and finishing wages

2,580

Direct labour cost

8,380

Prime cost

94,780

Factory supervisors’ wages

3,800

Heat, light and power (factory)

3,150

Insurances (factory)

86,400

188

Depreciation: Factory equipment

350

Production overheads

7,488

Add opening work-in-progress

102,268

Less closing work-in-progress

4,250

Production cost

106,518

Administration salaries

2,680

4,350

Heat, light and power (office)

1,050

102,168

Insurance (office) Bank charges Non-production overheads Total cost

62 120 3912 £106,080

Answers to Exercises  205

Exercise 2 Spring Garments period cost report May 20XX £

£

Opening stock of direct materials

7,800

Add purchases of direct materials

88,000

Add carriage inwards

230 96,030

Less returns of direct materials

340 95,690

Less closing stock of direct materials

9,200

direct materials consumed

86,490

Cutting room wages Sewing machinists’ wages

4,400

Press and finish wages

8,600

Direct labour costs

3,200

Prime cost

16,200 102,690

Factory supervisors’ wages

4,500

Cleaning costs (factory)

4,800

Rent and business rates (factory)

4,480

Insurances (factory)

200

Sundry expenses

130

Depreciation: Factory machinery, furniture & fittings

1,500

Production overhead Add opening work-in-progress

15,610

Less closing work-in-progress

118,300

Production cost

5,600

Administration wages

2,250

123,900

Cleaning costs (office)

1,600

6,200

Rent and business rates (office)

1,120

117,700

Insurance (office)

50

Postage and stationery

380

Bank charges and interest

420

Total cost

206  Answers to Exercises

5,820 £123,520

Exercise 3 Analysis of direct materials October 20XX

  Opening stock Purchases Carriage in Closing stock Direct materials consumed

Grey PC £

Blue Denim £

Plain Calico £

White Cotton £

Blue Cotton £

Inter £

Buttons £

320

2,100

2,200

2,100

1,350

3,400

1,050

860

380

3,500

4,200

2,500

2,500

—

1,600

680

1,200

—

125

—

80

—

—

—

Thread £

Zips £

—

—

—

3,945

6,380

4,700

4,600

1,350

5,000

1,730

2,060

380

480

1,200

860

1,400

1,250

2,250

340

250

380

3,465

5,180

3,840

3,200

100

2,750

340

250

—

Chapter 8 Exercise 1 Mercia Fashions Direct materials Fabric

20,000 × 1.4

@ £5.20

145,600.00

Zips

20,000

@ £0.45

9,000.00

Buttons

20,000 × 3

@ £0.01

600.00

Interlining

20,000

@ £0.25

5,000.00

Thread

20.000

@ £0.20

Direct material costs

4,000.00 164,200.00

Direct labour Laying up & cutting

3×6

@ £11.05

198.90

Fusing

4

@ £6.25

25.00

Sewing

20,000 × 10/60

@ £6.75

22,500.00

Pressing

20,000 × 0.5/60

@ £7.15

1,191.67

Packing

20,000 × 0.4/60

@ £6.25

833.33

Direct labour cost

24,748.90

Production overhead Laying up & cutting

3×6

@ £15.20

273.60

Fusing

3 (MHR)

@ £6.70

20.10 (Continued)

Answers to Exercises  207

Production overhead Sewing

£22,500

@ 180%

40,500.00

Pressing

20,000 × 0.5/60

@ £7.60

1,266.67 1,250.00

Packing

£833.33

@ 150%

Production overhead cost

43,310.37

Production cost

232,259.27

Non-production overheads

£232,259.27

@ 5%

Total cost

1,162.96 £233,422.23

Unit cost

£11.67

Exercise 2 Frankfurt Fashions

Estimated overheads

Cutting

Sewing

Press/Finish

£24,000

£96,000

£22,000

Service overheads:

£6,500

£35,600

£6,700

Maintenance

£7,500

£23,400

£6,000

Cleaning

£4,500

£25,500

£10,500

£42,500

£180,500

£45,200

Direct labour hours

5,500

18,240

5,000

Machine hours

3,600

Total

Direct labour cost

£71,000

—

—

£114,200

£33,500

Production overhead absorption rates Cutting room Total overheads £42,500 = £11.83per machine hour Machine hours 3, 600 Sewing room Total overheads £180,500 ´ 100 = 158.06 % of direct labour cost Direct labour hours £114,200

208  Answers to Exercises

Press/Finish Total overheads

£45,200

Direct labour hours

5, 000

= £9.04 per direct labour hour

Exercise 3 Offas Fashions Ltd Job Cost – Job No: 1578/003 £p Direct Material Cost

221875.00

Direct Labour Cost

46280.80

Production Overheads

72641.20

Production Cost Non-production Overheads Total Cost Unit Cost

340797.00 17039.85 357836.85 7.16

Exercise 4 Wessex Wear Ltd Job Cost – Job Number 1679/003 £p Direct Material Cost

68562.50

Direct Labour Cost

20154.17

Production Overhead

32107.26

Production Cost Non-Production Overhead Total Cost

120823.93 6041.20 126865.15 5.07

Answers to Exercises  209

Chapter 9 Exercise 1 Fixed/Variable/Semi-Variable Cost

Fixed

Variable

Semi-Variable

Thread

 

✓

 

Building insurance premiums

✓

 

 

Heat/Light/Power

 

 

✓

Interlining

 

Shirt buttons

✓

✓

 

Factory manager’s salary

 

 ✓

 

 

Fusing press operator’s wages

 

Business rates

✓

 ✓

Stationery

✓

 

Telephone

 

Cutting room wages

 

✓ ✓

 

Receptionists’ wages

✓

✓

 

Press room wages

 

✓

 

Zips for trousers

 

✓ 

Boxes for a boxed shirt

 

 

Delivery vehicle costs

 

✓

Canteen staff wages

✓

Bank loan interest

✓

 

 

Bank charges

✓

✓

 

Fabric for dresses

 

 

 

210  Answers to Exercises

 

Exercise 2 Fallowfield Fashions Shirt LS £’000

Shirt SS £’000

Blouse A £’000

Blouse B £’000

Total £’000

Sales

200

160

90

150

600

Less variable costs

145

115

92

103

455

Contribution

55

45

(2)

47

145

Fixed costs

140

Net profit

5

If Fallowfield Fashion eliminate Blouse A from their range based on the current information they will lose the sales revenue of £90,000 but will also eliminate the variable costs of £92,000, thus eliminating the negative contribution of £2,000 and increasing the profit from £5,000 to £7,000.

Exercise 3 Melton Fashions  

A£

B£

C£

Total £

Confirmed business Sales

35,000

32,000

27,200

94,200

Less variable costs

26,600

22,400

21,600

70,600

8,400

9,600

5,600

23,600

Contribution Fixed costs

 

 

20,000

Net profit

 

 

3,600

Possible additional business Sales (500 × £31)

 

 

15,500

Less variable costs (500 × £27*)

 

 

13,500

Additional contribution

 

 

 

2,000

Net profit if additional order accepted

 

 

 

5,600

*Variable cost per garment £21,600/800 = £27

Answers to Exercises  211

Chapter 10 Exercise 1 Production

Fixed Costs £

Variable Costs £

Total Costs £

Value of Sales £

Profit (Loss) £

0

32,000

0

32,000

0

(32,000)

1,000

32,000

48,000

80,000

56,000

(24,000)

2,000

32,000

96,000

128,000

112,000

(16,000)

3,000

32,000

144,000

176,000

168,000

(8,000)

4,000

32,000

192,000

224,000

224,000

BEP

5,000

32,000

240,000

272,000

280,000

8,000

6,000

32,000

288,000

320,000

336,000

16,000

7,000

32,000

336,000

368,000

392,000

24,000

BEP = £32, 000 ¸ (8 / 56) = £224, 000 sales Or £224, 000 / £56 = 4, 000 garments

Exercise 2 For every four garments that the business sells, three would raise £75 and one would raise £32. This would give a sales figure of £107 for each four garments (3 × £25 = £75 plus 1 × £32 = £107). The variable costs of these four garments would be £24 × 4 = £96. Therefore the contribution would be £107 – £96 = £11. BEP = £70,000 ÷ (£11/£107) = £680,910 sales, or approximately 25,456 jackets (figures rounded). Production

FC

VC

TC

Sales

Profit (Loss)

25,456

70,000

610,944

680,944

75% 477,300 25% 203,648 Total 680,948

£4 Close

212  Answers to Exercises

Exercise 3 £ Variable costs (14,000 × £15)

210,000

Fixed costs

47,000

Total costs

257,000

Required profit

23,000

Sales

280,000

sellingprice per price = £280,000/14,000 = £20per pair

Chapter 11 Exercise 1 Debidall Ltd April £

May £

June £

July £

Aug £

Sept £

6,400

5,400

7,400

6,800

6,300

6,500

Creditors

3,500

3,600

2,600

4,200

3,400

3,100

Wages & salaries

1,900

1,900

2,100

1,900

1,900

1,900

Budgeted receipts: Debtors Budgeted expenses:

Heat, light, power

500

500

Insurance Sundries

180 140

140

140

140

140

140

5,540

6,140

4,840

6,420

5,940

5,140

860

(750)

2,560

380

360

1,360

Balance b/fwd

1,800

2,660

1,910

4,470

4,850

5,210

Balance c/fwd

2,660

1,910

4,470

4,850

5,210

6,570

Total expenses Net cash

Answers to Exercises  213

Exercise 2 Flare Fashions Ltd

(i) Sales lag analysis Budgeted Sales October

1,200

November

1,100

December

1,000

January

1,400

February

1,200

March

1,100

To cash budget

Oct Nov Dec Jan Feb £’000 £’000 £’000 £’000 £’000 600

Mar £’000

Apr £’000

552 550

506 500

460 700

644 600

552 550

1,102

1,006

1,160

1,244

506

1,102

(ii) Cash budget January £’000

February £’000

March £’000

1,160

1,244

1,102

60

60

60

Creditors

365

335

370

Variable overheads

196

175

196

Fixed overheads

200

161

200

Corporation tax

750

Budgeted receipts—sales Budgeted expenses: wages & salaries

Dividend

500

Capital expenditure

1,000

Total budgeted expenses

2,571

731

2,026

(1,411)

513

(924)

Balance b/fwd

145

(1,266)

(753)

Balance c/fwd

(1,266)

(753)

(1,677)

Net cash

214  Answers to Exercises

700

Exercise 3 Materials price variance 420 ´ (£3.25 - £3.30) = £(21) Adverse £3.25 ´ ( 450 - 420) = £97.50 Favouraable Net variance = £76.50 Favourable Wage rate variance 76 ´ (£6.20 - £6.25) = £(3.80) Adverse Labour efficiency variance £6.20 ´ (75 - 76) = £(6.20) Adverse Net variance = £(10.00) Adverse

Exercise 4 Collars Ltd This is a self-practice exercise. Use previous exercises to guide you.

Exercise 5 Relax and Go – Pattern 1 Apr

May

Jun

Jul

Aug

Sep

£

£

£

£

£

£

Budgeted Income Capital

2,000

Bank Loan

12,000

Budgeted Sales

10,500

10,500

10,500

10,500

10,500

10,500

24,500

10,500

10,500

10,500

10,500

10,500

Total Budgeted Income

Answers to Exercises  215

Apr

May

Jun

Jul

Aug

Sep

£

£

£

£

£

£

Suppliers for stock purchases

6,500

6,500

6,000

6,000

6,000

6,000

Rent & Service Charge

2,250

2,250

2,250

2,250

2,250

2,250

100

100

100

100

100

Business rates

600

Insurance

160

Motor Expenses

350

Telephone

180

180

Stationery and sundries

250

50

50

50

50

50

Bank Loan (repayment & Interest)

459

459

459

459

459

459

Bank charges

85

MotorVan

6,500

Shop fitting

7,000

Cash register Total Budgeted Expenses Net Cash Balance b/fwd Balance c/fwd

216  Answers to Exercises

85

500 24,569

9,359

9,124

8,859

8,859

9,124

–69

1,141

1,376

1,641

1,641

1,376

0

–69

1,072

2,448

4,089

5,730

–69

1,072

2,448

4,089

5,730

7,106

Relax and Go – Pattern 2 Apr

May

Jun

Jul

Aug

Sept

£

£

£

£

£

3,500

5,500

6,500

7,500

8500

10,500

17,500

5,500

6,500

7,500

8500

10,500

Suppliers for stock purchases

6,000

2,000

2,500

3,000

5000

6,000

Rent & Service Charge

2,250

2,250

2,250

2,250

2250

2,250

Business rates

600

Insurance

160

Motor Expenses

350

100

100

100

100

100

£ Budgeted Income Capital Bank Loan Budgeted Sales Total Budgeted Income

2,000 12,000

Telphone

180

180

Stationery and sundries

250

50

50

50

50

50

Bank Loan (repayment & Interest)

459

459

459

459

459

459

Bank charges

85

MotorVan

6,500

Shop fitting

7,000

Cash register

85

500

Total Budgeted Expenses

24,069

4,859

5,624

5,859

7859

9,124

Net Cash

–6,569

641

876

1,641

641

1,376

0

–6,569

–5,928

–5,052

–3,411

–2,770

–6,569

–5,928

–5,052

–3,411

–2,770

–1,394

Balance b/fwd Balance c/fwd

Answers to Exercises  217

Relax and Go – Pattern 3 Apr

May

Jun

Jul

Aug

Sept

£

£

£

£

£

£

Budgeted Income Capital

2,000

Bank Loan

12,000

Budgeted Sales

12,000

7,000

7,000

7,500

8,500

10,500

26,000

7,000

7,000

7,500

8,500

10,500

Suppliers for stock purchases

8,500

3,500

4,000

4,000

6,500

6,000

Rent & Service Charge

2,250

2,250

2,250

2,250

2,250

2,250

Business rates

600

Insurance

160

Motor Expenses

350

100

100

100

100

100

Total Budgeted Income

Telephone

180

180

Stationery and sundries

250

50

50

50

50

50

Bank Loan (repayment & Interest)

459

459

459

459

459

459

Bank charges

85

MotorVan

6,500

Shop fitting

7,000

Cash register Total Budgeted Expenses

85

500 26,569

6,359

7,124

6,859

9,359

9,124

–569

641

–124

641

–859

1,376

0

–569

72

–52

589

–270

–569

72

–52

589

–270

1,106

Net Cash Balance b/fwd Balance c/fwd

218  Answers to Exercises

Exercise 6 Twinkle Toes Cash budget statement Nov

Dec

Jan

Feb

Mar

Apr

£

£

£

£

£

£

Budgeted Income Capital

15,000

Bank Loan

5,000

Budgeted Sales

2,000

10,000

4,000

4,500

5,000

6,000

Total Budgeted Income

22,000

10,000

4,000

4,500

5,000

6,000

Suppliers for stock purchases

10,000

4,000

2,000

2,000

3,000

1,500

2,000

2,000

2,000

2,000

2,000

2,000

Rent Business rates

650

810

Water/Electricity

200

Wages to part-time staff

240

Advertising

100

200

240

240

240

240

240

Stationery and sundries

30

30

30

30

30

30

Transport

50

50

50

50

50

50

174

174

174

174

174

174

Bank loan (repayment &interest) Bank charges Shop fitting Cash register Total Budgeted Expenses Net Cash Balance b/fwd Balance c/fwd

100

100

10,000 500 23,744

6,494

4,794

4,494

5,494

5,104

–1,744

3,506

–794

6

–494

896

0

–1,744

1,762

968

974

480

–1,744

1,762

968

974

480

1,376

Answers to Exercises  219

Exercise 7 Jean’s Jeans Ltd 24,000 gts £

25,000 gts £

26,000 gts £

Direct Materials

96,000

10,0000

104,000

Direct Labour

38,400

40,000

41,600

Indirect Labour

40,800

42,000

43,200

9,750

10,000

10,250

Heat Light Power Fixed Overheads Total Costs

9,500

9,500

9,500

194,450

201,500

208,550

Chapter 12 These exercises are self-directed and can be done in class as a group or in your own time.

Chapter 13 Discuss why ABC may give more realistic product costs in a manufacturing situation in class as a group.

Exercise 1 Activity Cost

Cost Pool

Depreciation of machinery

Machine activity

Van drivers’ wages

Distribution

Receiving department wages

Receiving

Van running costs

Distribution

Quality control staff wages

Quality inspection

Machine maintenance costs

Machine activity

Spare part required for machine

Machine activity

Quality control staff training

Quality inspection

Packing costs

Distribution

Power costs of machinery

Machine activity

Machine supervision costs

Machine activity

Material storage costs

Receiving

Fabric testing costs

Quality inspection

Machine cleaning costs

Machine activity

220  Answers to Exercises

Exercise 2 Cost

Cost Driver

Machine maintenance

Machine hours

Set-up and recalibration costs

Number of set-ups

Quality inspection

Production/Output

Purchasing costs

Volume of orders

Machine supervision

Machine hours

Despatch costs

Output

Exercise 3 Great Activity Ltd

(1) Absorption cost—based on percentage of direct labour A£

B£

C£

D£

Direct materials cost

45,000

30,400

37,200

28,000

Direct labour cost

13,000

10,400

9,900

8,250

Overheads

25,506

20,405

19,424

16,187

Total cost

83,506

61,205

66,524

52,437

Unit cost

£8.35

£7.65

£11.09

£10.49

(2) ABC approach A£

B£

C£

D£

Direct materials cost

45,000

30,400

37,200

28,000

Direct labour cost

13,000

10,400

9,900

8,250

Overheads:

5,200

6,500

3,900

3,900

Set-up

8,974

9,573

8,974

7,479

Machine activity

3,200

4,000

2,400

2,400

Receiving

5,200

4,160

3,120

2,600

Packing & dispatch

80,574

65,033

65,494

52,629

Total cost

£8.09

£8.13

£10.92

£10.53

Unit cost

Answers to Exercises  221

(3) Comparison A

B

C

D

Absorption basis—traditional

£8.35

£7.65

£11.09

£10.49

ABC

£8.09

£8.13

£10.92

£10.53

Absorption cost based on the following: Percentage of direct labour cost of 196.2%(£81,500 / 41,500 ´ 100) ABC overheads based on: Set-ups

£19,500/15

£1,300 per set-up

Machine activity

£35,000/5,850

£5.983 per machine hour

Materials receiving

£12,000/15

£800 per production run

Packing and dispatch

£15,000/29,000

£0.52 per garment

Exercise 4 Ranjan Ltd Ven£p

Wen£p

Xen£p

Yen£p

Zen£p

250000.00

150000.00

200000.00

200000.00

240000.00

Logistics (Far East)

45000.00

30000.00

15000.00

15000.00

15000.00

Admin (Far East)

17250.00

10350.00

8625.00

6900.00

6900.00

Shipping

51700.00

31020.00

25850.00

20680.00

20680.00

Logistics (Europe)

40000.00

40000.00

20000.00

10000.00

10000.00

Admin (Europe)

15000.00

15000.00

15000.00

15000.00

15000.00

3125.00

3125.00

5000.00

6250.00

7500.00

422075.00

279495.00

289475.00

273830.00

315080.00

8.44

9.32

11.58

13.69

15.75

Fabric Cost

Finance & Currency Total Cost Unit Cost (per metre)

222  Answers to Exercises

Chapter 14 Exercise 1 Ambladec Ltd Payback period is 2.67 years. Net present value Net Cash Inflows

Discount Factor 15%

Present Value £

Year 1 £100,000

0.8696

86,960

Year 2 £200,000

0.7561

151,220

Year 3 £300,000

0.6575

197,250 435,430

Capital cost

400,000

Net present value

£35,430

Exercise 2 Provinces Ltd Location 1 Payback Period: 1.61 years Net Present Value: £286210 Discounted Payback Period: 1.81 years Location 2 Payback Period: 1.82 years Net Present Value: £235277 Discounted Payback Period: 2.05 years On the basis of the data provided Location 1 would appear to be the best option with a lower payback period than Location 2, a higher NPV than Location 2 and a lower discounted payback period than Location 2.

Answers to Exercises  223

Exercise 3 Ember Holdings

a) Two option using both payback period and NPV

Machine retained for the full six years. Net Cash Inflows

Discount Factor 12%

Present Value £

Year 1 £4,000

0.8929

3,571.60

Year 2 £6,500

0.7972

5,181.80

Year 3 £10,000

0.7118

7,118.00

Year 4 £9,000

0.6355

5,719.50

Year 5 £2,000

0.5674

1,134.80

Year 6 £1,500

0.5066

759.9 23,485.60

Capital cost

24,000.00

Net present value

£(514.40)

This gives a negative NPV, suggesting the project is unviable.

Machine kept for four years only. Net Cash Inflows

Discount Factor 12%

Present Value £

Year 1 £4,000

0.8929

3,571.60

Year 2 £6,500

0.7972

5,181.80

Year 3 £10,000

0.7118

7,118.00

Year 4 £9,000

0.6355

5,719.50

Year 4 £4,000 (scrap)

0.6355

2,542.00 24,132.90

Capital cost Net present value This at least produces a small positive NPV.

224  Answers to Exercises

24,000.00 £132.90

b) Ember Holdings—Machine Q For the full six years: Initial capital cost = £16, 800.00 Capital cost at the end of year 3 = £18,000 ´ 0.7118 = £12,812.40 Total capital cost = £29, 612.40 Note. Where the capital cost is made later in the project, it too is discounted. Total present values from (4) £23,485.60 less capital cost £29,612.40 give a negative NPV of £(6,126.80); unviable. For three years: First three years’ inflows discounted = £15,871.40 less capital cost £16,800 also gives a negative NPV £(929), therefore also unviable.

Exercise 4 Zenco AG This is a self-practice exercise. Use previous exercises to guide you.

Exercise 5 Hostigen AG Payback Period: Machine A = 3.56 years Machine B = 3.96 years Weighted Average Cost of Capital: 9 per cent Net Present Value: Machine A = €11,131 Machine B = €(3803) Decision: Machine A has the lowest payback period and the highest positive NPV; therefore it would be the preferred option. Machine B has the longer payback period of almost 4 years and significantly a minus NPV; therefore Machine B would be rejected.

Answers to Exercises  225

Acknowledgement

The preparation of a textbook can be a lonely job and it is therefore useful to have the assistance of colleagues who offer help and advice. We are indebted to and would like to thank all those (too numerous to mention) at the Manchester Metropolitan University who have supported us in the production of this work.

Index

absorption costing  88, 155 absorption of non-production overheads  92 absorption of production overheads  88 acceptance decisions  50, 96 accounting rate of return (ARR)  171, 181 activity-based budgeting  165 activity-based costing  54, 156, 158, 163, 169 administration costs  63, 68 advanced manufacturing technology  142, 150 adverse variance  132, 135 agent  6, 30, 42 average cost per garment  70

cost behaviour change  155 cost centres  60, 91 cost control  50 critical path  35, 41 Current Ratio (CR)  21

benchmarking  23 break-even analysis  114 break-even chart  114, 117 break-even point (BEP)  114, 116–17, 119–20 break-even point by calculation  120 break-even tabulation  115 budgeting  125, 130, 165

elements of cost  54, 63 entrepreneur  1

capital cost  48 capital equipment costs  70–1 capital expenditure  71, 125 capital investment decisions  170 carriage inwards  56, 76 cash budget  126, 129 changing nature of cost  150, 154 clothing manufacture  47, 50, 55, 104 component manufacture and assembly  151 computer aided design (CAD)  4, 6, 40 contribution  104 cost  49, 51

depreciation  71, 104, 153 direct costs  55, 60, 86 direct expenses  60, 63, 85 direct labour  54, 85, 89 direct labour hour rate  88 direct labour variance  140 direct materials  54, 69, 75, 78 discounted cash flow (DCF)  175, 177 discounted payback period  177–8

fabric  34, 39, 48, 55 factories  4, 41 factory audit  32 fastenings  58 favourable variance  133 finance costs  58, 63 fixed costs  103, 117 flexible budgets  104, 130 fusible  48, 58 global sourcing  17, 39 global supply chain  11, 27 gross profit margin (GPM)  20 idle time  138 idle time variance  138 indirect costs  61 indirect expenses  62 indirect labour  61, 152

indirect materials  61 interlinings  55, 57 internationalization  28–9 job cost  49, 85 job costing  85 job costing process  88 job cost sheet  93 just-in-time (JIT)  152, 157 key performance indicators (KPI)  3, 10, 19 labour efficiency variance  137–9 leadership  1–2 lead times  34, 37 liquidity  21 machine hour rate  91 marginal costing  102, 108 marginal cost statement  104 margin of safety  118–19 market entry strategies  3, 29 materials price variance  133, 136 materials usage variance  133, 136 net cash inflows  172, 175 net present value (NPV)  175 non-production overheads  61–3, 86, 92, 153 operating profit margin (OPM)  19–20 overhead absorption  85, 88, 92 overheads  54, 61, 85, 88 overheads in standard costing  141 over/under absorption  94 payback period  174, 177, 181 percentage of direct labour cost  90 period cost reports  69–70 period end adjustments  78 periods costs  103 present value  175 present value factors  176 pricing decisions  50

228 Index

prime cost  61, 63, 78, 85 process costing  70, 96 product cost  85 product cost when sourcing  39 product information sheet  33 production cost  58, 62, 91 production overhead  58, 61, 63, 76, 85 product specifications  33 profit  19 profit/volume chart  119, 122 purchase order (PO)  30 purchase order form  31 Quick Ratio (QR)  21–3 range planning  40 risk management  10–14 sales lag  129 selling and distribution costs  62 semi-variable costs  104, 108 service industry  156, 165 shipments  33, 36 shipping and incoterms  41–2 size set samples  34–5 Small and Medium Sized (SME)  1–3 sourcing  9, 14, 17, 30, 51, 158 standard costing  125, 132, 141–2 stocks and inventory  75 straight-line method  71 strategy  2, 4, 11 sustainability  17, 30 thread  57 total cost  55, 63 traditional costing  156, 161, 165 variable costs  114, 117 variance analysis  132–3 wage rate variance  137, 140 work-in-progress  69, 77, 96 Zero-based budgeting  131