Cost analysis for planning and
decision making
Session 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 unit
Production
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 mix
Product 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.
example
A 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
Labor
Production over head
20 kg
$4
4 hours
$6
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.
Example
Description
Activity level in units
Indirect cost
Budget
Actual
10,00
10,560
$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
Sales revenue
Direct and indirect cost
Net Profit /(loss)
Product
A
200,000
(230,000)
(30,000)
Product B
Product
C
300,000
500,000
1,000,000
(290,000) (460,000)
(980,000)
10,000
Direct and indirect cost is allocated as
follows
Product
A
Variable cost
150,000 220,00
0
Fixed cost
Product
B
40,000
Product
C
330,00
0
Total
20,000
Total
700,0
00
280,0
00
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 It does not recognize
changing in volume on the full impact of fixed
the total cost
cost
•avoid arbitrary
method of allocating
fixed indirect cost
Absorption and marginal costing
Absorption income statement
Marginal income statement
Sales revenue
Less: Production cost:
Direct material
Direct labor
production overhead
Gross profit
Less: non production:
selling and administrative
Distribution overhead
R & D expense
Net profit
Sales revenue
less: Direct material
less: Direct labor
Less: variable production
Contribution
Less: fixed cost:
production overhead
selling &administrative
Distribution overhead
R & 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