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Cost Concepts1PME0401-DR.G.M.BRAHMANANDHAN1Costing Systems/Methods

Historical AbsorptionDirectMarginalStandardUniform

2PME0401-DR.G.M.BRAHMANANDHAN2COST CLASSIFICATION Elements Behaviour Functions Normality Control Decision Making3PME0401-DR.G.M.BRAHMANANDHAN3ElementsMATERIAL

LABOUR

EXPENSES

4PME0401-DR.G.M.BRAHMANANDHAN4MATERIALDirect: traceable to one particular process, job or product identified with each unit of productExample: manufacturing an apparel Cloth, collar, buttons, cufflinks, threadPrimary packing material (e.g., carton, wrapping, cardboard, boxes, etc.)

Fuel, lubricating oil etc for operating & maintenance of machineSmall toolsMaterials used for repairs & maintenance

5PME0401-DR.G.M.BRAHMANANDHAN5LABOURInspectorsSupervisorsInternal transport staffStorekeeper, maintenance staff6PME0401-DR.G.M.BRAHMANANDHAN6EXPENSESExpenses leading to a job or contractTraveling expenses for negotiationSpecial pattern, designSpecial tools for executing the contract

RentInsuranceCanteen, hospital, power , lighting, maintenance7PME0401-DR.G.M.BRAHMANANDHAN7BehaviourFixed in short run & long run

VariableVaries with volume and constant per unit

Semi-variableA cost could be variable for one level of activity whereas it couldbe fixed for another.

Not inherently fixed or variableMany costs are semi-variable in nature 8PME0401-DR.G.M.BRAHMANANDHAN8Fixed CostCommitted Fixed Costs consists largely of those fixed costs that arise from the possession of planti, equipment and a basic organizational structure. For example, once a building is constructed and plant is installed, nothing much can be done to reduce the costs such as depreciation, property taxes, insurance and salaries of the key personnel, etc., without impairing the organization's competence to meet the long-term goals.Discretionary Fixed Costs : set at fixed amount, for specific time periods by the management, in the budgeting process. These costs directly reflect top management policies and have no particular relationship with volume of output. These costs can therefore be reduced or eliminated entirely, if the circumstances so require. Examples of such costs are: research and development costs, advertising and sales promotion costs, donations, management consulting fees, etc. these costs are also termed as managed or programmed costs.9PME0401-DR.G.M.BRAHMANANDHAN9FunctionsProduction CostAdministration CostSelling CostDistribution Cost

10PME0401-DR.G.M.BRAHMANANDHAN10Planning & ControlBudgeted Cost: estimate of expenditure for different business operations

Standard Cost: for prescribed set of operating conditions, labour, material and overheads are predetermined; budget translated into actual operation through standard costs11PME0401-DR.G.M.BRAHMANANDHAN11Decision MakingMarginal vs. Absorption Costing (with fixed cost and without FC)Sunk - irrelevantCommitted pre committedOpportunity Incremental / DifferentialAvoidable & Unavoidablecontrollable / uncontrollable

12PME0401-DR.G.M.BRAHMANANDHAN12Cont..Irrelevant cost: not relevant for decision makingExample: Sunk costs: Sunk cost is the cost of abandoned plant less salvage value. Not relevant for decision making.Imputed (Notional cost): Actually not incurred (interest on own capital, rent on owned building, etc.) Taken into account in capital budgeting decisions.Replacement cost: Cost of replacing at current market price.13PME0401-DR.G.M.BRAHMANANDHAN13Cont..Avoidable and unavoidable cost: Cost that can be avoided by eliminating a product or department is avoidable and that which cannot be, is unavoidable. Ex. Rent of factory is unavoidable if a product is discontinued.14PME0401-DR.G.M.BRAHMANANDHAN14Other costs:Future costs: cost to be incurred in futureProgrammed cost: Cost incurred as per policy of top management. Ex.- Donation to charity.Joint cost: cost of joint or by-products incurred before separation, which cannot be traced to particular products.Conversion cost: cost of converting raw material to finished goods = Production cost- direct material.Discretionary cost: not essential for decision on hand. Ex.- Training expenses of workers, R&D cost. Committed cost: Costs incurred due to past decisions and are not within control in the short run at present. Ex.- Depreciation on Plant, Rent, etc.15PME0401-DR.G.M.BRAHMANANDHAN15INVENTORIABLE COSTS AND PERIOD COSTSInventoriable cost/ product cost is that cost which is regarded as asset when incurred, but becomes a part of cost of goods sold when the product is sold. For MUL, all manufacturing cost is inventoriable cost. (Raw material to WIP to Finished goods) For a service sector unit, absence of inventory means all are period costs.

Period costs (non-product cost): all costs in P&L account except cost of goods sold. So, in a mfg. sector unit, all non-manufacturing costs are period costs. (Ex. Distribution cost, design cost, R&D costs, Marketing costs, customer-service costs, etc.)16PME0401-DR.G.M.BRAHMANANDHAN16Costs and Budgeting17PME0401-DR.G.M.BRAHMANANDHAN17Costs and Budgeting

18PME0401-DR.G.M.BRAHMANANDHAN18Costs

19PME0401-DR.G.M.BRAHMANANDHAN19CostsAnything incurred during the production of the good or service to get the output into the hands of the customerThe customer could be the public (the final consumer) or another businessControlling costs is essential to business successNot always easy to pin down where costs are arising!

20PME0401-DR.G.M.BRAHMANANDHAN20Cost Centres

21PME0401-DR.G.M.BRAHMANANDHAN21Cost CentresParts of the business to which particular costs can be attributed In large businesses this can be a particular location, section of the business, capital asset or human resource/sEnable a business to identify where costs are arising and to manage those costs more effectively

22PME0401-DR.G.M.BRAHMANANDHAN22Full CostingA method of allocating indirect costs to a range of products produced by the firm.e.g. if a firm produces three products - a, b, and c - and has indirect costs of 1 million, assume proportion of direct costs of 20% for a, 55% for b and 25% for cIndirect costs allocated as 20% of 1 million to a, 55% of 1 million to b and 25% of 1 million to c

23PME0401-DR.G.M.BRAHMANANDHAN23Absorption CostingAll costs incurred are allocated to particular cost centres direct costs, indirect costs, semi variable costs and selling costsAllocates indirect costs more accurately to the point where the cost occurred24PME0401-DR.G.M.BRAHMANANDHAN24Marginal CostingThe cost of producing one extra unit of output (the variable costs)Selling price MC = ContributionContribution is the amount which can contribute to the overheads (fixed costs)25PME0401-DR.G.M.BRAHMANANDHAN25Standard CostingThe expected level of costs associated with the production of a good/serviceActual costs Standard costs = VarianceMonitoring variances can help the business to identify where inefficiencies or efficiencies might lie26PME0401-DR.G.M.BRAHMANANDHAN26Total Revenue

27PME0401-DR.G.M.BRAHMANANDHAN27Total RevenueTotal Revenue = Price x Quantity SoldPrice can be raised or lowered to change revenue price elasticity of demand important hereDifferent pricing strategies can be used penetration, psychological, etc.Quantity Sold can be influenced by amending the elements of the marketing mix 7 Ps

28PME0401-DR.G.M.BRAHMANANDHAN28Break Even

29PME0401-DR.G.M.BRAHMANANDHAN29Break Even AnalysisOutput/SalesInitially a firm will incur fixed costs, these do not depend on output or sales.FCAs output is generated, the firm will incur variable costs these vary directly with the amount produced.VCThe total costs therefore (assuming accurate forecasts!) is the sum of FC+VCTCTotal revenue is determined by the price charged and the quantity sold again this will be determined by expected forecast sales initially.TRThe lower the price, the less steep the total revenue curve.TRQ1The break even point occurs where total revenue equals total costs the firm, in this example, would have to sell Q1 to generate sufficient revenue to cover its costs.30PME0401-DR.G.M.BRAHMANANDHAN30Break Even AnalysisCosts/RevenueOutput/SalesFCVCTCTR (p = 2)Q1If the firm chose to set price higher than 2 (say 3) the TR curve would be steeper they would not have to sell as many units to break evenTR (p = 3)Q231PME0401-DR.G.M.BRAHMANANDHAN31Break Even AnalysisCosts/RevenueOutput/SalesFCVCTCTR (p = 2)Q1If the firm chose to set prices lower (say 1) it would need to sell more units before covering its costs.TR (p = 1)Q332PME0401-DR.G.M.BRAHMANANDHAN32Break Even AnalysisCosts/RevenueOutput/SalesFCVCTCTR (p = 2)Q1LossProfit33PME0401-DR.G.M.BRAHMANANDHAN33Break Even AnalysisCosts/RevenueOutput/SalesFCVCTCTR (p = 2)Q1Q2Assume current sales at Q2.Margin of SafetyMargin of safety shows how far sales can fall before losses made. If Q1 = 1000 and Q2 = 1800, sales could fall by 800 units before a loss would be made.TR (p = 3)Q3A higher price would lower the break even point and the margin of safety would widen.34PME0401-DR.G.M.BRAHMANANDHAN34Costs/RevenueOutput/SalesFCVCTREurotunnels problemHigh initial FC. Interest on debt rises each year FC rise therefore.FC 1Losses get bigger!35PME0401-DR.G.M.BRAHMANANDHAN35Break Even AnalysisRemember:A higher price or lower price does not mean that break even will never be reached! The break even point depends on the number of sales needed to generate revenue to cover costs the break even chart is NOT time related!36PME0401-DR.G.M.BRAHMANANDHAN36Break Even AnalysisImportance of Price Elasticity of Demand:Higher prices might mean fewer sales to break even but those sales may take a longer time to achieveLower prices might encourage more customers but higher volume needed before sufficient revenue generated to break even37PME0401-DR.G.M.BRAHMANANDHAN37Break Even AnalysisLinks of break even to pricing strategies and elasticityPenetration pricing high volume, low price more sales to break evenMarket Skimming high price low volumes fewer sales to break evenElasticity what is likely to happen to sales when prices are increased or decreased?38PME0401-DR.G.M.BRAHMANANDHAN38Budgets

39PME0401-DR.G.M.BRAHMANANDHAN39BudgetsEstimates of the income and expenditure of a business or a part of a business over a time periodUsed extensively in planningHelps establish efficient use of resourcesHelp monitor cash flow and identify departures from plansMaintains a focus and discipline for those involved 40PME0401-DR.G.M.BRAHMANANDHAN40BudgetsFlexible Budgets budgets that take account of changing business conditionsOperating Budgets based on the daily operations of a businessObjectives Based Budgets - Budgets driven by objectives set by the firmCapital Budgets Plans of the relationship between capital spending and liquidity (cash) in the business

41PME0401-DR.G.M.BRAHMANANDHAN41BudgetsVariance the difference between planned values and actual valuesPositive variance actual figures less than plannedNegative variance actual figures above planned42PME0401-DR.G.M.BRAHMANANDHAN42