Chewing Gum Profitability Case

Question

Dear all,

I have three questions about the cost branch of the profitability framework.
The first two questions are related to the Chewing Gum Case (see https://www.preplounge.com/en/management-consulting-cases/candidate-led-usual-style/beginner/chewing-gum-6) and the third one is a general question regarding drawing an issue tree for the cost branch.

1)

I struggle to get the root cause of cost increase if I use a classical issue true (costs = cost/unit * units).
I think that the root cause to the total cost increase is the "units" part of the cost equation above. The "Units" variable has increased in a way that just weighs stronger a more expensive product sold (i.e. that has higher costs/unit). From my point of view, costs/units do not increase: all that is given (direct/indirect) shows that there hasn't been a increase in cost/unit.
Is this correct?

2)

Regarding the cost segmentation, the interviewer gives a segmentation in direct and indirect costs. How can I use this information and include it in a cost issue tree of "units" times "costs/units", where "costs/units" are segmented into "variable costs/units" and "fixed costs/units". Are direct and indirect here both part of the "variable costs/units"?
3)
As a novice I kind of struggle with structuring the cost branch of my issue tree. If the interviewer has no prefered segmentation, Victor Cheng and the Preplounge tutorial recommend to structure costs into "costs/unit" and then into "fixed costs/unit" and "variable costs/unit". However, segmenting costs directly into "costs/unit" sounds kind of peculiar to me due to the counteracting forces of this equation: if from one year to the other, a company sells more "units" (assuming "variable costs/unit" stay the same, and total fixed costs did not change), the new "costs per units" will be less as "fixed costs/units" have gone down. Thus, its not really mece as "units" affects the "costs/units" via "fixed costs/units".
I'm kind of confused by this cost segmentation and how it should help me to identify root causes of profitability problems...

Thanks a lot!!

Answer 1

Hey there,

To answer your questions:

1) As you referenced, the costs per unit do not increase but the business is selling more of a lower profit margin good (flavoured chewing gum). As such, the profitability / profit margin of the business is decreasing.

2) In this case, direct and indirect costs are both variable costs. When thinking this through, it would be fair to ask the interviewer if the indirect costs vary with product. They will tell you no because the SG&A cost is given per unit.

3) Based on what you've written, you've got the right understanding of the standard type of cost segmentation. Costs are either variable or fixed (whether as a total or per unit). When you want to use this tree to diagnose the problem, you need to isolate how a new change affects either variable or fixed costs. In your example, you're saying that units sold has increased. Logically, fixed cost/unit decreases while variable cost/unit remains the same. This is correct! However, it would require that you can accurately sort what cost is fixed and what is variable.

What I would advise is taking each branch of a tree step-by-step. If you're observing a change, identify which branch that affects. The framework is MECE because you should be able to say "ah! Units sold are going up, which means unit fixed cost is going down." That is the power of this framework: allowing you to diagnose where to look to solve a problem.

Hope this helps!

Best,

Edmond