Cost analysis for planning and decision making Session 1-3.
Transcript of Cost analysis for planning and decision making Session 1-3.
Cost analysis for planning and decision makingSession 1-3
Cost classification and approach • Marginal costing
▫variable and fixed Variable cost is charged to the product unit Fixed cost is charged against the profit
period as expense.•Absorption costing
▫Direct and indirect cost Variable and fixed cost are charged to unit
output or activity.
Cost behavior
Fixed cost
Step fixed
Variable cost
Total cost
Calculate the cost per unitProduction 5,000 unit
Fixed cost $200,000
Variable cost per unit $300
Relevant range
•is the range of activity for which our assumptions about constant fixed and constant unit variable hold true
Determining the variable and fixed cost
• High and low method• Assessing cost through scatter graph
High and low method• Identify the highest and lowest production•We subtract the cost of the highest level of
production with the cost of the lowest level of production.
•We assume that the increase is the variable cost.
•we divide the additional cost against the additional units. To give us the variable per unit.
•We test it against any month production to get the fixed cost.
Example
•pg 13
Assessing costs using the scattered graph
•We plot the data into graph and try to draw a line that passes into all the points “best fit”
•We set out the fixed cost at the level were the line meets the vertical axis which the activity is zero.
•Its better that the high and low because high and low test the relationship only by two points
•Drawing pg 14
Scatter graph method
Direct and indirect cost
•Direct cost ▫All costs that can be directly attributed to a
cost object and that can be traced to it in an economical feasible way.
•Indirect cost “overhead”▫All costs that cannot be directly traced to a
cost object in an economical feasible way.
Example: direct and indirect cost XYZ company produces calculators. Decide
whether these cost are direct or indirect•Component parts - direct cost•Production labor - direct cost•Administration labor – indirect cost•Depreciation of equipment – indirect cost
Cost and decision making• Organizations should be aware of its cost structure
and cost control, to help them in decision making.• Cost can be classified according to:
▫Nature “subjective”: ex. Material , labor, expenses▫Purpose “objective” : is direct and indirect▫Function: ex. Production , administration▫Behavior: ex. Fixed , variable , semi variable , stepped
fixed▫Normal/abnormal: whether unusual event have effected
cost▫Controllable/non-controllable: could manager influence
cost▫Relevant/ irrelevant: this is used for decision making
Cost center cost objective
•Cost center:▫Defined as where in the company cost are
gathered and then attributed to the unit “usually department”
•Cost objective:▫Refers to any thing or activity for which a
separate measurement of cost us desired
The importance of accurate measurement of cost
•Provide basis of assessing past performance
•Planning for future operations•Monitoring actual performance against
budget •Assisting decision basis•Assisting cost reduction and control
The nature of production costs in terms of material, labor and overhead • Cost cards is used to record all elements of cost in a unit
produced.• Production cost can be classified to the following:
▫ Material▫ Labor
Two method we can calculate wages: Time related method:
▫ time spent on job needed▫ Hours * per hour
Performance method:▫ relevant to the units produced▫ Minimum wage plus performance rate pay
Cost can be allocated to cost center or a unit It can be direct and indirect, fixed and variable.
▫ Overhead Its relate to expenditure on labor, material or services which
cannot be economically identifies with specific sellable cost of unit. (rent, insurance)
The concept of contribution
•Contribution means the contribution every unit sold makes first toward covering fixed cost and the towards profit.
•Contribution per unit=selling price per unit – variable cost per unit
Example: selling price $100 per unit variable cost $60 per unit.
Break even• Break even occurs when there is neither a
profit nor a loss.• Breakeven point (units) =
total fixed cost/ contribution per unit• Breakeven point (dollars) =
total fixed cost/ contribution to sales ratio• If we want to know the effect of change in sales
to the contribution we use “contribution to sales ratio”
=(contribution per unit/ sale revenue per unit)*100
Break even – sales mix•Breakeven point (units) =
total fixed cost/ weighted average contribution per unit•Breakeven point (dollars) =
total fixed cost weighted average contribution per unit ratio
•Weighted average CM:Sum of (CM * sales mix%)
•Sales mix % = sales mix of a product/ total sales mix
•Target profit =total fixed cost+ target profit/ weighted average contribution per
unit
Break even – sales mixProduct A
Product B
Sale price per unit
50 40
Variable cost per unit
20 15
Sales mix 3 4
Total fixed cost
15,000
• Calculate the Break even in units with proof
• The company wants to earn net income of 20,000 how many units the company needs to sell.
Break even graph
Profit volume graph
Margin of safety
•Indicates by how much sales may decrease before a loss occurs :((expected sales- breakeven sales)/expected sales) *100
•Targeted profit=(Targeted profit + fixed cost)/contribution per unit
Limitation of break-even analysis•The relationships between the variables
are assumed to remain constant.•Profits are calculated on marginal costing
basis.•Linearity is assumed , variable cost and
sales revenue change in direct proportion and in the same direction as changes in activity level.
•Relevant range need to be consider•A constant sales mix or single product is
assumed
Limiting factor analysis “key factor”
•When any recourse is scarce management should maximize the contribution per unit of that scarce resource.
•Which means to ensure that the resource used most effective and efficient way.
exampleA company produces 3 product and have limited 12,000 machine hours. How much of each component the company should manufacture:
Absorption costing• It seeks to absorb all production cost whether fixed
or variable, direct or indirect into a given cost object.• It assumes• Absorption rate is used to allocate the indirect cost.• The basis used for absorbing indirect cost into
product units include:▫Direct labor hours▫Direct production hour/machine hour▫Units produced▫Percentage of sales value ▫Percentage of direct cost▫Activity consumption (ABC)
Absorption costing
•Absorption cost attempts to take into account the cost of all resources needed to make a unit, while marginal cost takes into account only the variable cost
•Absorption costing is used to estimate the price of a unit, while marginal cost is used to estimate the extra job / production contribution.
Example
Material 20 kg $4
Labor 4 hours $6
Production over head 4 machine hours $2
Fixed overhead $500
Unit produced 50 units
Over and under absorption of overheads
•Budgets are used to implements plans but they must be checked against the actual data to insure that they are reliable and valid.
•At the end of the period actual cost and the level of activity has to be checked against the plan.
•Plans has to be adjusted to under-recovery or over-recovery of indirect cost.
ExampleDescription Budget Actual
Activity level in units 10,00 10,560
Indirect cost $76,000 $77,340
Marginal costing• Marginal costing is the cost of supplying one more
unit. • Marginal costing is concerned with the behavior of
costs at different level of activity and it distinguishes between variable and fixed.
• We check the marginal costing if the total cost change as the level of activity change by one unit.
• Marginal costing is used internally and useful for decision making, while absorption external users.
• Marginal costing is used to calculate the impact of changes in volume on contribution and in profit to be calculated readily.
Example• Review the below information and give judgment if we should discontinue
Product line A using absorption costing income statement? Adjust it to marginal costing income statement?
Description Product A
Product B
Product C
Total
Sales revenue 200,000 300,000 500,000 1,000,000
Direct and indirect cost (230,000) (290,000) (460,000)
(980,000)
Net Profit /(loss) (30,000) 10,000 40,000 20,000Direct and indirect cost is allocated as follows
Product A
Product B
Product C
Total
Variable cost 150,000
220,000
330,000
700,000
Fixed cost 280,000
Description Level of activity Advantage disadvantage
Absorption •Reasonably stable
•It calculated the total cost of a unit of output is established.•Can be directly related to revenue generated
•It has a problem in allocating fixed indirect cost which is subjective and lead to different answers.•Change in volume of activity have to be dealt with by calculating over or under recovery of indirect cost
Marginal Less predictable •Recognize the effect of changing in volume on the total cost•avoid arbitrary method of allocating fixed indirect cost
It does not recognize the full impact of fixed cost
Absorption and marginal costingAbsorption income statement
Marginal income statement
Sales revenueLess: Production cost:
Direct materialDirect laborproduction overhead
Gross profitLess: non production: selling and
administrativeDistribution overheadR & D expense
Net profit
Sales revenueless: Direct materialless: Direct laborLess: variable productionContribution Less: fixed cost:
production overheadselling
&administrativeDistribution overheadR & D expense
Net profit
Absorption and marginal costing•Page 44 question 4.3 / 4.5
Absorption and marginal costing• Absorption costing approach rewards production
activity by including share of the fixed cost in closing inventory.
• Marginal costing take in account the variable cost and the closing inventory adjustment
• Inventory valuation and the balance sheet value of closing inventory will be lower in a marginal costing statement.
• Absorption and marginal costing differ in profit due to:▫ Closing inventory fixed indirect production cost
• The marginal costing recognize all cost in financial period which they are incurred
• Absorption costing recognize indirect cost in the period which the product is produced
Allocating of indirect cost to production and service departments•Allocate indirect non production cost to
specific service department.•Reallocate the total indirect cost of each
service department to production department.
• cost per unit is calculated.
•Page 49 example 4.6
Reciprocal allocation of indirect costs and service department• Allocation of indirect costs when service
departments carry out work for each other.• This type of support activity is known as
reciprocal support and a reciprocal allocation method and used to allocate indirect costs.
• This approach allows the allocation method to reflect the mutual nature of inter- departmental activities.
• Reciprocal approach is an accurate measure but it depend on decision of management (subjective)
• Page 52
Pricing decision using absorption and marginal costing approaches•Cost plus price is the price decided by
adding an amount to the costs to arrive to sales price.
•There is two method to calculate the price of a product :▫Cost plus price
Total cost / (1 – Profit margin %)▫Mark up
Total cost * ( 1 + % of markup)•Page 54
Relevant and irrelevant cost•A relevant cost is one that will occur only if
the course of action in question is undertaken. •Cost that can be avoided.• Irrelevant cost can be categories to:•Sunk cost•Committed cost•Non cash cost•Relevant cost is used for decision making and
all irrelevant cost has to be neglected in time of taking a decision
Decision making analysis
•Ignore Sunk cost•Ignore Committed cost•Ignore Non cash cost•Use remaining cash cost for decision
making including any opportunity cost
Calculation of relevant cost for material labor and overhead•Pg 58
Keep or buy non current asset
•Loss from selling old machine is irrelevant
•Investment amount of old machine is sunk cost
•Total revenue and cost of keeping an asset is relevant
•New asset value is consider relevant•Page 60
Opportunity cost
•Opportunity cost represent the cost of opportunity forgone as a result of taking one course of action.
•Page 61
Purpose of information in business •Decision making•Planning•Controlling•Recording transaction•Performance measure
Organization structure• Business consist of different functional areas:
▫Sales and marketing▫Purchasing▫Finance▫Accounting ▫Human resource
• Also the decision making is made in different level:▫Strategic▫Tactical ▫operational
Accounting information system and business transaction•Business transaction•Sales and purchasing•Non current asset (capital expenditure)•Overhead expense (revenue expenditure) •Payoll
Accounting information system and finance function•The finance function•Raise funds