In this part, we will study an example. And the example will be very simple. It's ABC for a retail store. So, we have a small store. And this store sells soft drinks, packaged foods, and fresh produce, just a corner store. And the owner of the store has a system of tracing direct cost and also the system within direct cost, that is very simple and looks like this. [inaudible] old cost system. We talk about both direct and indirect cost. So, we have here indirect cost pool, just one, then cost allocation base, then here direct cost, and here in below, I'll put just cost object, and here it will be the product line. Now, see what they got. They have just one indirect cost pool that is called store support. And as a cost allocation base, they take the cost of goods sold, better to say cost of goods purchased for sale, but clearly only those that have been sold. And as for direct costs, they use the same. This is cost of goods sold. So basically, if they purchase a pack of coffee, then they say, that was purchased, let's say for two dollars. And then, they use some measure of indirect cost and that contributes to the overall pool here. So the top part is indirect cost and here we have direct cost. So the scheme is clear, the only thing that is so far missing is, how much do we charge over this cost allocation base? And historically, they said if this is cost of goods sold, then 30% of that in monetary terms goes here. For example, if we purchase a pack of coffee for two dollars, then 60 cents go to store support. And that is the system that has been used, and like I said, they sell three product lines, they sell soft drinks that I will further call just SD, then fresh produce that will be FP, and then packaged food and that will be PF. And on the next page, we will see what is the result of this old system. Well, I'll put some numbers here. I will count in thousands, not to put so many zeros. This is soft drinks, this is fresh produce, this is packaged food, and then in blue, I will put totals. Now, see what we have. First of all, we have revenues and then, we have costs of which this is the cost of good sold, the direct one. Now, we have the next thing is gross margin and then, we have indirect costs that are 30% of cost of good sold. And that leads to total costs, then operating income, and the final line will be operating income as percentage of revenue because we would like to study the profitability of product lines. Let's see what our system gives us, just not to mix things up. Let's say revenues. This is 40,000 for soft drinks, 85 for fresh produce, 55 for packaged foods, and the total will be 180. Now costs, so we put first cost of good sold, that's 30 here, 60, 40, the total of 130, and gross margin comes as 10, 25, 15, the total of 50. And now comes the part that is interesting, but for us it's clear because we take these numbers. And 30% of that, we assign as indirect cost. So here, we will have 9, 18, 12, the total of 39, and the total cost here will be, this direct plus indirect so that will be 39, 78, 52, the total is 169. And then, we have operating income that I will put in black here; it is just 1,000 here; 7,000 for fresh produce; three for packaged food; and the total of 11. But the interesting thing is that if we divide that by revenues, then we see the following numbers. So, this is 2.5% for soft drinks, 8.24% for fresh produce, 5.45% for packaged food, and the total is 6.11. Now, if we looked at these numbers, what managerial decisions come to our mind? We can see that the highest profit margin is on fresh produce. So, why wouldn't we order more strawberries? And the lowest is on soft drinks. And it seems kind of strange. It's easy to sell soft drinks. They arrive in a small truck by these boxes and big packs, so you put them, you don't have to put them in the fridge, you don't have to move them around, they all have very long best before terms, so they really don't take up much of your resources. When you sell them, people normally don't buy can, but buy a pack of cans, maybe a dozen or two dozen. So, it's easy to order, deliver, put on your shelves, and then control like I said, you don't have to really throw them away because they are always prepared to be sold and used. So, it seems strange that the product line of that sort of takes least resources for it, is the least profitable. And all that leads to the idea that maybe we can refine the system and reveal certain important things that in this rough system that just assigns 30% on the cost of good sold, that really it masks some of the important cause of the fact things. That's what these people in this small retail store decided to do and that is what we'll start doing in the next episode.
