Managing Financial Principles and

Techniques

Topic 1
Application of Cost Concepts to
the Decision Making Process

Fathimath Rasheed
MBA 7
Assessment Methods
Assessment Component Percentage Marks

Final Exam (3 hrs) 70%

Assignment 30%
 Learning Outcomes
1.1 Costs and Prices
1.2 Cost Systems
1.3 Responsibility and control of systems
 Introduction
Cost Behaviour is the relationship between a cost and the level
of activity or cost driver.
Cost estimation is the process of determining the cost behaviour
of a particular cost item.
Cost prediction uses knowledge of cost behaviour to forecast the
level of cost at a particular level of activity.
Cost driver is any activity or factor that causes costs to be
incurred.
Volume-based cost driver assumes that all costs are driven, or
caused by the volume of production.
Contemporary view of costs
and cost drivers
Activity-based costing is a contemporary approach to costing which
classifies costs and cost drivers into four distinct levels:
1. Unit level costs relate to activities that are performed for each unit
produced such as the direct material cost.
2. Batch level costs relate to activities that are performed for a group of
product units, such as a production batch or a delivery load.
3. Product level costs relate to activities that are performed for a specific
products or product families and include the costs of researching,
designing and supporting products.
4. Facility level costs are costs that are incurred to run the business but
are not caused by any particular product.
Cost behaviour patterns
1. Variable costs;
A variable cost changes, in total, in direct proportion to a change in
activity.
Cost functions are equations that are used to describe cost behaviours.
2. Fixed Costs;
Fixed costs is a cost which remains unchanged in total despite change in
the level of activity.
The total cost is not affected by the number of products produced, nor
the number of customers, nor any other activity.
3. Step-fixed cost;
Step-fixed cost is a cost which remains fixed over a wide range of
activity levels, but jumps to a different amounts for levels outside
the range.
4. Semi-variable cost;
A semi-variable cost has both fixed and variable components.
Cost Estimation
Cost estimation is determining how a particular cost behaves.
There are three approaches;
1. Using managerial judgment to estimate costs
In many businesses, managers estimate costs using their experience
rather than any formal analysis.
Sometimes they simply make intuitive estimates of costs based on their
knowledge of the company.
2. The engineering approach to estimating costs;
The engineering method of cost estimation is the study of the processes
that result in the incurrence of a cost.
Engineering studies identify the relationships that should exist between
inputs and outputs.
Industrial engineers often conduct time and motion studies (also called
task analysis or work measurement), in which employees are observed as
they undertake work tasks.
Costs behaviours are then estimated based on this analysis.
There is some doubt as to whether employees will “act naturally” when
they know they are being observed.
Over recent years, methodologies have developed, as part of activity-
based costing, to analyze the cost of activities.
In some ways, these procedures are similar to engineering studies,
especially task analysis.
3. Estimating costs using quantitative analysis;
Analyze past data to identify the relationship between cost and
activities.
Examining the relationship between past costs and activity levels is
useful in stable environments, but it is not appropriate in rapidly
changing circumstances because past data will provide poor basis for
estimating current or future costs behaviour.
Two methods are used
i) The high-low method
Ii) Regression analysis
Practical issues in cost
estimation
Regardless of the method used, the resulting cost estimates will only be
as good as the data on which they are based.
1. Missing data; Misplaced source documents or failure to record a
transaction can result in missing data.
2. Outliers: Extreme observations of cost/activity relationships. Should
be eliminated.
3. Mismatched time periods: The units of time for which the dependent
variables are measured may not match.
4. Trade-offs in choosing the time period: In choosing the period of
analysis, often there is a trade-off between the number of observations
and their reliability as predictors of future cost behaviour.
5. Allocated fixed costs; Fixed costs are sometimes allocated on a per
unit basis
6. Inflation; During periods of inflation, historical cost data may not
reflect future cost behaviour.
Product Costing
A product costing system accumulates product-related costs and
uses a series of procedures to assign them to the organization’s
final production.
Product-related costs include the costs incurred during the
production process called the production costs.
In some organizations upstream costs of research and
development, product design and supply, and downstream costs of
marketing, distribution and customer service are also regarded as
product related cost.
Assigning manufacturing costs
to products
Process of allocating overhead
costs to products
As manufacturing costs are indirect costs, indirect route is used to
allocate these costs, which involves the following three steps.
1. Identify the overhead cost driver; the factor or activity that
causes overhead costs to be incurred.
2. Calculating a predetermined (or budgeted) overhead rate per
unit of cost driver. This is equal to the budgeted overhead divided
by the budged level of cost driver, for the coming year.
3. Applying manufacturing overhead costs to products at the
budgeted overhead rate multiplied by the quantity of cost driver
consumed by the product.
Disposing of under-applied or
over-applied overhead
As overhead is applied to products using a predetermined rate, overheads
could be under-applied (the overhead applied to production is greater
than the actual overhead costs incurred) or over-applied (overhead
applied is less than the actual overhead costs incurred).
At the end of the year two alternatives are used to dispose of this
difference;
1. Close the under or over applied overhead to cost of goods sold. This is
the most common technique.
2. Prorate; distribute proportionately the under or over applied overhead
to cost of goods sold, work in process inventory and finished goods
inventory.
Types of product costing
system
Job Costing System
This is used when products are produced in distinct batches and there is a
significant difference between those batches.
Used by printers, furniture manufacturers and machinery and equipment
manufacturers.
Given that service outputs differ from one client to the next, job costing
is appropriate for many service firms.
In job costing each distinct batch of production is called a job or job
order.
Process Costing Systems
Used by companies that produce a single product (or a very small range
of very similar products) in large quantities.
Producers of processed foods, chemicals plastics are among those who
use this.
Can also used by service firms where services are repetitive.
Involves two main steps;
1. Estimating costs of the production process
2. Calculating an average cost per unit by dividing the cost of the process
by the number of units produced.
Operation costing or Batch costing;
Businesses can use repetitive production processes to produce product
lines that differ because they require;
* Difference material input or
* Different combinations of specific production processes.
This type of production environment is described as batch manufacturing
processes, as individual product lines are produced in large batches, each
requiring a specific combination of direct materials and a specific
sequence of production process.
Operation costing, which is used to estimate product costs in a batch
manufacturing environment:
* Assigns direct material costs to individual batches- a job costing
approach.
* Accumulates conversion costs by departments (or operation or
process). These costs are allocated to all units passing through the
department- a process costing approach.
Variable costing and
Absorption costing
Product costs under variable and absorption costing

Variable product cost Absorption product cost

Product cost includes; Product cost includes;

• Direct materials • Direct materials
• Direct labour • Direct labour
• Variable manufacturing • Both variable and fixed
overhead costs. manufacturing overheads
 Trading and profit ans loss account

Absorption costing Marginal costing

$ $
Sales X Sales X
Less: Cost of goods sold X Less: Variable cost of
Goods sold X
Gross profit X Product contribution margin X

Less: Expenses Less: variable non- manufacturing

Selling expenses X expenses
Admin. expenses X Variable selling expenses X
Other expenses X X Variable admin. expenses X
Other variable expenses X
Variable and fixed manufacturing Total contribution expenses X

Less: Expenses
Fixed selling expenses X
Fixed admin. expenses X
Other fixed expensesX
Net Profit X Net Profit X
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A company started its business in 2005. The following information
Was available for January to March 2005 for the company that produced
A single product:
$
Selling price per unit 100
Direct materials per unit 20
Direct Labour per unit 10
Fixed factory overhead per month 30000
Variable factory overhead per unit 5
Fixed selling overheads 1000
Variable selling overheads per unit 4

Budgeted activity was expected to be 1000 units each month

Production and sales for each month were as follows:
Jan Feb March
Unit sold 1000 800 1100
Unit produced 1000 1300 900

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 Wk1:
Standard fixed overhead rate
= Budgeted total fixed factory overheads
Budgeted number of units produced

= $30000
1000 units
= $30 units

Wk 2:
Production cost per unit under absorption costing:
$
Direct materials 20
Direct labour 10
Fixed factory overhead absorbed 30
Variable factory overheads 5
65

Back
29
Wk 3:
(Under-)/Over-absorption of fixed factory overheads:
January February March
$ $ $
Fixed overhead 30000 39000 27000
Fixed overheads incurred 30000 30000 30000
0 9000 (3000)

1000*$30
1300*$30 900*$30

No fixed factory overhead

Wk 4:
Variable production cost per unit under marginal costing:
$
Direct materials 20
Direct labour 10
Variable factory overhead 5
35

Back
30
Absorption
costing

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 January February March
$ $ $
Sales 100000 80000 110000
Less: cost of good sold ($65) 65000 52000 71500
35000 28000 38500
Adjustment for Over-/(under)
Absorption of factory overhead 9000 (3000)
Gross profit 35000 37000 35500
Less: Expenses
Fixed selling overheads 1000 1000 1000
Variable selling overheads 4000 3200 4400
Net profit 30000 32800 30100

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Marginal costing

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 January February March
$ $ $
Sales 100000 80000 110000
Less: Variable cost of good
sold ($35) 35000 28000 385500
Product contribution margin 65000 52000 71500
Less: Variable selling overhead 4000 3200 4400
Total contribution margin 61000 48800 67100
Less: Fixed Expenses
Fixed factory overhead 30000 30000 30000
Fixed selling overheads 1000 1000 1000
Net profit 30000 17800 36100

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 Difference between absorption and marginal costing

Absorption costing Marginal costing

Treatment for Fixed Fixed manufacturing
fixed manufacturing overhead are treated
manufacturing overheads are as period costs. It is
overheads treated as product believed that only the
costing. It is variable costs are
believed that relevant to decision-
products cannot be making.
produced without Fixed manufacturing
the resources overheads will be
provided by fixed incurred regardless
manufacturing there is production or
overheads not
 Absorption costing Marginal costing
Value of High value of Lower value of
closing stock closing stock will be closing stock that
obtained as some included the variable
factory overheads cost only
are included as
product costs and
carried forward as
closing stock
 Absorption costing Marginal costing
Reported If the production = Sales, AC profit = MC Profit
profit
If Production > Sales, AC profit > MC profit
As some factory overhead will be deferred as
product costs under the absorption costing

If Production < Sales, AC profit < MC profit

As the previously deferred factory overhead
will be released and charged as cost of goods
sold

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Argument for absorption
costing
Compliance with the generally accepted accounting
principles
Importance of fixed overheads for production
Avoidance of fictitious profit or loss
◦ During the period of high sales, the production is small
than the sales, a smaller number of fixed manufacturing
overheads are charged and a higher net profit will be
obtained under marginal costing
◦ Absorption costing is better in avoiding the fluctuation of
profit being reported in marginal costing
Arguments for marginal
costing
More relevance to decision-making
Avoidance of profit manipulation
◦ Marginal costing can avoid profit manipulation by
adjusting the stock level
Consideration given to fixed cost
◦ In fact, marginal costing does not ignore fixed costs in
setting the selling price. On the contrary, it provides useful
information for break-even analysis that indicates whether
fixed costs can be converted with the change in sales
volume
Controlling Costs
All control systems have three basic parts
* A predetermined or standard performance level.
* A measure of actual performance, and
* A comparison between standard performance and actual
performance.
Setting standards
Analysis of historical data
One guide to future costs is historical cost data.
In a mature production process where there is much production
experience, historical costs can provide a good basis for future
costs.
Direct material standards
The standard material quantity is the total amount of direct
material normally required to produce one unit of product.
The standard material price is the total delivered cost of that
material after subtracting any discounts.
Direct labour standards
The standard direct labour quantity is the number of labour hours
normally needed to manufacture one unit of a product.
The standard labour rate is the total hourly cost of wages.
Allowances for wastage, inefficiency or normal spoilage.
Some accountants argue that, when developing standard for direct
material and direct labour, allowances should be made for material
wastage and labour inefficiency.
However, these practices are becoming less common as many managers
consider that wastage, allowances for inefficiency or normal spoilage
should not be included in the standard cost.
Direct Material variances
Direct material price variance; Measures of the effect on cost, of
purchasing inventory at a price different from standard.
Direct material price variance = Quantity purchased (Actual price-
Standard price)
Direct material quantity variance; a measure of the effect on cost,
of using a different quantity of material in production with the
standard quantity that should have been used for the actual
production output.
Direct material quantity variance= Standard price (actual quantity
– standard quantity allowed).
Direct labour variances
Direct labour rate variance; measure of the effect on cost, of
paying a different labour rate, compared with standard.
Direct labour rate variance = Actual hours used (Actual rate per
hour – Standard rate per hour)
Direct labour efficiency variance; the effect of using a different
number of direct labour hours compared with the number of
standard hours that should be used for the actual production
output.
Direct labout efficiency variance = Standard rate (Actual hours-
standard hours)
Investigating significant variances
and taking corrective actions
The process of reporting and following up only significant cost
variances is called management by exception.
Significant cost variances may be investigated to determine their
causes and corrective action can be taken when needed.
Significant variances;
Size of variance
Recurring variances
Controllability
Favourable variances
Decentralisation
Benefits of decentralization;
1. Managers of the organisation’s sub-units have better local information
about their particular market.
2. Allowing managers decision making autonomy provides managerial
training for future higher-level managers.
3. Managers with decision-making authority may have greater
motivation than do those who merely execute the decisions of others.
4. Delegating some decisions to lower-level managers allows corporate-
level managers to devote more time to strategic issues.
5. Delegating decision making to operational levels allows an
organisation to react quickly to opportunities and problems as they arise.
Costs of decentralization;
1. Managers in a decentralized organisation may focus narrowly
on their own sub-units, rather than on the attainment of the
organisations overall goals.
2. In a decentralised organisation, some tasks or services may be
duplicated unnecessarily.
Responsibility centres
Responsibility centres; a sub-unit in an organisation where the manager
is held accountable for the sub-units’s activities.
Investment centres; a sub-unit, where the manager is held accountable
for profit generated and invested capital used generate profit in that sub-
unit.
Profit centre; a sub-unit where the manager is held accountable for the
profit of that sub-unit.
Cost centre; a sub-unit where the manager is held accountable for costs
incurred in that sub-unit.
Revenue centre; A sub-unit where the manager is held accountable for
revenue generated by that sub-unit.
Cost Estimation Methods
Account Analysis

Scattergraphs

High-Low Method

Regression Analysis
High-Low Method
Utilization of cost information from previous periods
Connect straight line from lowest activity level to highest activity
level.
Cost Estimations
◦ Variable cost equals the slope of the line
◦ Fixed cost equals the intercept of cost axis

Estimates used to find total production costs at

various production levels
Cost Volume Profit (CVP)
Analysis
One of the most important decisions that needs to be made before
any business even starts is ‘how much do we need to sell in order
to break-even?’ By ‘break-even’ we mean simply covering all our
costs without making a profit.
CVP analysis looks primarily at the effects of differing levels of
activity on the financial results of a business. The reason for the
particular focus on sales volume is because, in the short-run, sales
price, and the cost of materials and labour, are usually known with
a degree of accuracy.
Why CVP
when we ask the question: ‘Will the company make a profit in that
year?’, the answer is ‘We don’t know’. We don’t know because
we don’t know the sales volume for the year.
However, we can work out how many sales the business needs to
make in order to make a profit and this is where CVP analysis
begins.
Methods for calculating the break-even point
There are three methods for ascertaining this break-even point:
1 The equation method
Total revenue – total variable costs – total fixed costs =
Profit
2 The contribution margin method
This second approach uses a little bit of algebra to rewrite
our equation above, concentrating on the use of the ‘contribution
margin’.
3 The graphical method
CVP Analysis
Contribution Margin (CM)
◦ Difference between selling price and variable cost per unit

Profit = (SP – VC)(x) – TFC

OR

Profit = CM per unit(x) - TFC

Definition
Breakeven analysis is also known as cost-volume profit analysis
Breakeven analysis is the study of the relationship between selling
prices, sales volumes, fixed costs, variable costs and profits at
various levels of activity.
Breakeven analysis can be used to determine a company’s
breakeven point (BEP)
Breakeven point is a level of activity at which the total
revenue is equal to the total costs
At this level, the company makes no profit

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Assumption of breakeven
point analysis
Relevant range
◦ The relevant range is the range of an activity over which the
fixed cost will remain fixed in total and the variable cost per
unit will remain constant
Fixed cost
◦ Total fixed cost are assumed to be constant in total
Variable cost
◦ Total variable cost will increase with increasing number of units
produced
Sales revenue
◦ The total revenue will increase with the increasing number of units produced

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Break-Even Chart
Calculation method
Breakeven point
Target profit
Margin of safety
Changes in components of breakeven analysis
Contribution is defined as the excess of sales revenue over the variable
costs
Contribution = SP-VC
The total contribution is equal to total fixed cost

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Formula
Breakeven point
Fixed cost
=
Contribution per unit

Sales revenue at breakeven point

= Breakeven point *selling price

Profit Equation (utilizing CM Ratio)

Sales($) = Profit + TFC

CM Ratio

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Alternative method:

Sales revenue at breakeven point

Contribution required to breakeven
=
Contribution to sales ratio
Contribution per unit
Selling price per unit
Breakeven point in units
Sales revenue at breakeven point
=
Selling price

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Limitations of breakeven
analysis
Breakeven analysis assumes that fixed cost, variable costs
and sales revenue behave in linear manner.
However, some overhead costs may be stepped in nature.
The straight sales revenue line and total cost line tent to
curve beyond certain level of production
It is assumed that all production is sold. The breakeven chart
does not take the changes in stock level into account
Breakeven analysis can provide information for small and
relatively simple companies that produce same product. It is
not useful for the companies producing multiple products

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CVP Analysis
“What If” Analysis
◦ Utilize profit equation to determine impact of managerial
decisions

◦ Change in Fixed and Variable Costs

◦ Change in Selling Price

Multi-product Analysis
Contribution Margin Approach
◦ Used if products are similar

◦ Identify number of units needed to be sold to break even

◦ Calculate weighted average contribution margin based on

expected units sold
Assumptions in CVP Analysis
Costs can be accurately separated into fixed and variable
components

Fixed costs remain fixed

Variable costs per unit do not change

Constraints
Constraints on how many items can be produced

Shortage of space, equipment, or labor

Utilize contribution margin per unit to analyze situations

Short-term decision making
Def. - Analyzing the different costs and revenues for different
alternatives.
Relevant cost and revenue
Sunk costs
Opportunity costs
Fixed costs;
◦ -Committed
◦ -Discretionary
Question and Answer Session

Q&A