www.bradford.ac.uk/management

Revision Part 1

Lecture 23

Semester 1 topics• Absorption and marginal costing and the effect on profit• Job, batch, contract and process costing• Activity based costing• Cost volume profit issues• Business decision making• Decision making and uncertainty• Pricing decisions – accounting and economic• Investment decisions

Absorption and Marginal Costing

Traditional Method – absorption

New methodology – marginal

Differences between the two

How do the differences affect profit

Show this on the income statement

Why is marginal preferable?

Job, batch, contract and process costing

Understand the concept of costing for individual or one-off projects

Identify the key problem areas when costing one-off or short run production processes

Recognise that long term contracts may need costing more than once over their life-span, if profits are to be realised in the correct time-span

Understand the concept of “continual production” Identify the key problem areas when costing using either a

mid-point in the process to calculate costs, or at the very end of a production run

Understand that the realisation of profits is determined solely by how you apportion the common costs involved in the production runs

Activity Based Costing

Understand the shortcomings of traditional costing systems Limitations of traditional costing – normally based on some sort of

“volume driver” based allocation system

Appreciate the value of ABC generated information for decision-making purposes

ABC linked to specific activities in the manufacturing process – identifies specific areas that drive costs or materially affect costs

Contrast the traditional and activity based costing approaches of dealing with overhead costs

“Products cause activities that cause costs” - Types of cost drivers

Benefits and pit-falls

ExampleBradford plc manufactures product A and B. The following information is available from the company:

Product A Product B

Units produced 5,000 20,000Selling price 400 200Direct materials and labour per unit 200 80Direct labour hours 25,000 75,000Direct labour hours per unit 5 3.75

The company has a total budgeted overhead of £2 million. The following details are also available about overheads:

Budgeted cost Cost Driver A BEngineering £ 125,000 Engineering hours 5,000 7,500Set-ups 300,000 Number of set-ups 200 100

Machine running 1,500,000 Machine hours 50,000 100,000

Packing 75,000 Number of packing orders 5,000 10,000Total 2,000,000

You are required to allocate overheads using both traditional and ABC costing systems

Solution: Traditional costing system

1. Calculate the overhead rate per direct labour hour (predetermined absorption rate)= total overhead/total direct labour hours = £2,000,000/100,000

=£20 per hour.2. Calculate overhead cost per unitProduct A

Total overheads allocated = 25,000 hours x £20 = £500,000

Overhead cost per unit = £500,000/5,000 units= £100 per unit

Product BTotal overheads allocated = 75,000 hours x £20

= £1,500,000

Overhead cost per unit = £1,500,000/20,000 units= £75 per unit

Can be anything determined by

company – i.e machine rate, material usage, sales/OH ratio etc.

Solution: Activity Based Costing

1. Calculating the cost driver rate/ or the activity rate

(1) (2) (3) (4)=(2)/(3)

Cost driver Cost Cost driver usage Cost driver rate (total a + b)£ £

Engineering hours 125,000 12,500 10Number of setups 300,000 300 1,000Machine hours 1,500,000 150,000 10Number of packing orders 75,000 15,000 5

2,000,000

Solution: ABC

(1) (2) (3) (4)=(2)x(3) (5)= (4)/UnitsCost driver Driver Driver Total Overhead

rate Usage Overhead per unit

1. Product A: 5,000 units Engineering hours 10 5,000 50,000 10Number of setups 1,000 200 200,000 40Machine hours 10 50,000 500,000 100 No. of packing orders 5 5,000 25,000 5Overhead cost per unit 775,000 155

2. Product B: 15,000 unitsEngineering hours 10 7,500 75,000 3.75Number of setups 1,000 100 100,000 5.00Machine hours 10 100,000 1,000,000 50.00 No. of packing orders 5 10,000 50,000 2.50Overhead cost per unit 1,225,000 61.25

Remember

• ABC and traditional costing allow us to look at OH – we still need to account for direct costs such as material and labour costs etc.

• Sales/Revenue – Costs = Profit

• Costs: Materials, Labour, Overheads

Cost-Volume-Profit Issues

Break-even analysisBreak even = F/(USP-UVC) or F/UCM

Contribution USP-UVC

Calculating target profit

Profit = sales revenue - variable costs - fixed costs

Profit = USP*Q - UVC*Q - Fixed costs

Profit = (Units sold x UCM) – Fixed costs

Decision making 1Understand the special situations in which only

relevant costs are utilisedCalculate one-off ordersUnderstand how limiting factors affect decision

makingCan be hours or materialsProduct that give highest cont.

Understand problems involving product mix decisions and resource constrainsWhich product to produce first ?– cont. per limiting factor?

Understand and calculate make or buy decisionsWhich option gives the greatest contribution?

Decision making 2

Understand expected value and uncertainty.Probability of occurrence x expected profitRisk averse, risk neutral and risky approaches

Explain the limitations of expected value.Does not tell the whole storyBased on estimated valuesMultiple product analysis

Calculate/draw probability decision trees

• A company has a choice of producing 3 products each providing different rates of return as follows: Which should the company produce?

• Product A: Expected profit Probability EV 600,000 0.1 60,000 700,000 0.2 140,000 800,000 0.4 320,000 900,000 0.2 180,000 1,000,000 0.1 100,000 = 800,000

• Product B: 400,000 0.05 20,000 600,000 0.1 60,000 800,000 0.4 320,000 1,000,000 0.25 250,000 1,200,000 0.2 240,000 = 890,000

• Product C: (400,000) 0.5 (200,000) 2,200,000 0.5 1,100,000 = 900,000

• Product C has a higher EV than either products B or C, but it is subject to greater uncertainty.

• Attitudes towards risk

Pricing

Understand the importance of pricing decision makingWhat influences pricing – marketing, economic, legal

issues etc.Understand the time horizon of pricing decisions

Short term vs. long term pricingExplain product life cycle issues

Explain link of lifecycle costing to target costing

Life cycle costing

80 % of a products costs are locked in during the planning and design stage

Majority of costs are incurred at the manufacturing stage – as costs have already been locked in they are difficult to

alter.

Cost management can be most effectively exercised at the planning and design stage – LCC led to the emergence of target costing.

Investment Decision Making

Explain in Management Accounting terms the meaning of investment

Explain the major methods when reviewing strategic performance

Bring into your discussions on the subject other types of management theory about investment analysis

Understand the limitations of, and expand upon, the core theory of NPV/IRR