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5. Finance and ACCOUNTING

Cost Information
Why businesses calculate Cost of Production?
Profit is the main aim of most private firms. Without the exact information of cost of production, firms cannot estimate the profit
of the given period. Profit is calculated as:
Profit = Total Revenue – Total Cost
Total Revenue (TR) = Price per unit × Units Sold
Total Cost (TC) = Cost per unit × Units manufactured

Sellers must receive a price high enough to cover production cost if they are to supply a good.
Setting prices requires accurate cost data. Inaccurate estimate of cost of inventory gives misleading information in Income
statement and Balance sheet. Cost information helps in estimating future cash outflow of business. Company can decide whether
to make a product or buy from outside supplier on the basis of cost information.

Types of Costs in Production

Total Fixed costs (TFC) does not change with an increase or decrease in the output level.
Rent of factory is paid whether output produced or not.

Total Variable costs (TVC) rises as production increases and fall as production decreases. Raw material and labour.
Total Cost =TFC + TVC
Average Total Cost=Total Cost /Units Produced

Marginal Cost is the increase or decrease in total cost due to the production of one additional unit.
It is the cost of adding one more unit to the production process.

Direct costs are those that can be traced directly to the products that are being produced.
 Raw materials that can be directly traced to products are called direct materials.
 Direct labor costs are any labor costs that can be traced easily to a product.

Indirect costs cannot be traced to a particular product. Indirect Costs/Factory Overheads/Manufacturing Overhead.
Factory overhead refers to all costs in the manufacturing activity which cannot be directly traced to physical units in an
economically feasible way.

Approaches to Costing: Full and Contribution

Costing methods are used ‘to measure the expenses incurred to produce a unit of product’.
Full/Absorption and Marginal Costing methods are commonly used.

Full Costing Method absorbs both fixed and variable production costs into the units produced.
Full costing does NOT include Selling and Administrative Expenses (both Fixed and Variable) into the cost of a product.

Illustration: Company ‘A’ reported the following costs:

Variable costs per unit: Fixed costs per unit:
 Direct materials cost: $25  Fixed manufacturing overhead of $300,000
 Direct labor cost: $20  Fixed selling and administrative of $200,000
 Variable manufacturing overhead cost: $10
 Variable selling and administrative cost: $5
Units Produced = 60,000 units, Units Sold = 50,000 units, Unit
Selling Price = $100.
Calculate Unit Product Cost under Full Costing Method?
Solution: Direct materials + Direct labor + Variable overhead + Fixed Manufacturing Overhead
$25 + $20 + $10 + $5 [$300,000 / 60,000 units] = $60 unit product cost under full costing

(Recall that selling and administrative costs (fixed and variable) are not included in the product costs.)
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Advantages:
Full costing is easy to calculate and understand. It is relevant for single-product businesses as there is no
uncertainty about what share of overheads should be allocated
to which product.
It is a good basis for pricing decisions in single product firms – if the full unit cost is calculated, this could then be used for mark-
up pricing.

Marginal Costing:
1. Marginal Costing method only absorbs Direct Costs to the cost of units of production.
2. Marginal Cost is the additional cost of producing an extra unit of the product.
3. The Marginal Cost of a product is the total of the variable costs. It includes:
Direct material Direct labor Variable manufacturing overhead
The Contribution Margin of a product is the revenue gained from selling a product less its marginal costs.

Contribution Margin per unit=Selling Price per unit−Variable Cost per unit

Total Contributi on=Contribution per unit × Units Produced

Contribution is an amount of money that is available to pay production overheads.
Contribution is not the profit. Profit is calculated as
Profit=Total Contribution−¿ Overheads
Illustration:
Cost information: D.M. $3, D.L = $6, Variable Production Overhead = $2,
Variable Selling Costs = $5, Selling Price = $21, Sales = 3000 units, Fixed Overheads = $25000.

Calculate Total Contribution and Profit/Loss?

Contribution per Unit = $21 - $(3+6+2+5) = $5.

Total Contribution = $5 * 3000 units = $15000
Profit or Loss = $15000 - $25000 = ($10000)
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Breakeven Analysis
Breakeven is the point of production where firm’s revenue (TR) is equal to the total costs (TC) of production.
¿ Cost
Breakeven point ∈units=
Contribution Per Unit
Contribution Margin per Unit = Sales Price Per unit – Variable Cost per unit

Illustration:
Sales price of cars = $24, variable cost per unit of cars = $9, total fixed expenses = $2400

Contribution margin per unit=Sales price−Variable cost per un¿

$ 15=$ 24−$ 19
¿ costs
Breakeven∈units=
contribution margin per unit
$ 2400
160 cars per week=
$ 15
The following schedule confirms that the break-even point is 160 cars per week:
Sales (160 cars @ $24 per car) $3840
Variable Expenses (160 cars @ $9) (1440)
Contribution Margin 2400
Fixed Expenses (2400)
Net Income 0

Breakeven∈$=Breakeven∈units × Sales price

$ 3840=160 cars × $ 24
The break-even point in units is the number of cars a workshop needs to service in order to cover the fixed and variable expenses.

Desired Profit in Units

The owner needs to earn a profit of $1200 per week. The fixed expenses will now be $3,600 per week (the $2,400 listed earlier
plus the required $1,200 for the owner).
¿ Expenses
Breakeven point ∈cars=
Contributionmargin per car
$ 3600
240 cars=
$ 15
Check calculations:
Sales (240 cars @ $24 per car) $5760
Variable Expenses (240 cars @ $9) (2160)
Contribution Margin 3600
Fixed Expenses (2400)
Net Income 1200
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Margin of Safety is the difference between the firm’s current level of output and break-even output.
If breakeven level of output is 500 units. Current production is 700 units. 200 units are margin of safety.
After 200 units, Profit will be Zero.

In the graph, margin of safety is the difference between current or projected sales volume (60 units) and break-even sales volume
(34 units), or 26 units. Sales would have to drop by 26 units for existing net income of $240 to completely dry up.

Assumptions of breakeven analysis:

Breakeven analysis relies on several key assumptions:
 The price per unit of product sold remains constant regardless of the number of units sold.
 Fixed costs do not change with the level of production or sales within the relevant range.
 The variable cost per unit produced is consistent, meaning it does not change with the level of production.
 The analysis either considers only one product or assumes a constant sales mix for multiple products.
 There are no changes in inventory levels; every unit produced is sold within the same period.
 Both total costs and total revenue change linearly with the level of production and sales.
 The efficiency of production and sales processes remains constant, with no improvements or declines.
 External factors such as market demand, competition, and economic conditions remain stable during the
analysis period.

Limitations of Breakeven Analysis:

 In a competitive market sales price can fluctuate in market.
 It is difficult for a manager to estimate that how long a specific cost remains fixed. Rent, supervisor salary
and other fixed expenses may change any time. Fixed costs can change due to factors like inflation.
 It is assumed variable costs per unit are constant, but these costs can vary with supplier pricing, or
efficiency improvements.
 Firms can produce multiple products. Some products can be discontinued or a new product can be
introduced. The analysis often assumes a single product or a constant sales mix, which is not always the
case for firms producing multiple products.
 Breakeven analysis assumes that all units are sold, however there is unsold stock.
 Both output and production cost can change in different proportion. There is no linear relationship in output
and costs.
 External factors such as market demand, competition, and economic conditions are not considered, which
can significantly impact sales and costs.
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 It is difficult to separate ‘Fixed’ and ‘Variable’ costs clearly. Some examples of fixed expenses are as
follows:
Rent or Lease Payments:
Costs for factory space, warehouses, and office buildings.

Salaries:
Regular payments to management and administrative staff.

Depreciation:
The reduction in value of machinery and equipment over time.

Insurance:
Coverage for property, liability, and other risks.

Utilities:
Fixed portions of utility bills such as basic charges for electricity, water, and gas.

Property Taxes:
Taxes on property owned by the business.

Interest on Loans:
Regular payments on borrowed capital.

Maintenance and Repairs:

Routine upkeep of equipment and facilities.

Marketing and Advertising:

Fixed expenditures on long-term campaigns.

Licensing and Permits:

Costs for required business and operational licenses.

Office Supplies:
Regular expenses for necessary office materials.

Professional Services:
Fixed fees for services like accounting and legal advice.

Change Effect on Contribution per unit Breakeven

Higher Selling price Higher Lower
Lower Selling price Lower Higher
Higher V.C. Lower Higher
Lower V.C. Higher Lower
Increase Fixed Cost No change Higher
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Decrease Fixed Cost No change Lower

Cost Information and Decision-Making.

Marginal costing shows which product is generating greater contribution among the product line.
If a business stops the production of a particular product that produces positive contribution, then the overall profits will be
reduced. The reason is fixed costs still have to be paid.
Illustration:
An electrical assembly firm produces three products. The following data in dollar are available:
Products X Y Z
Labour Costs $ 5 7 9
Materials Costs $ 4 12 10
Selling Price $ 20 30 21
Output (Units) 500 1000 400
Total Overhead Costs $10000

Each product is apportioned a proportion of overheads on the basis of floor space taken up: X=30%, Y=50%, Z=20%
Contribution per unit X = $20-$9 = $11. Y =$11 Z = $2
Total Contribution X = 500 × $11 = $5500 Y = $11000 Z =$800
Calculate the Profit or Loss made by each product using Full Costing at the current output level.
X Contribution: $5500 Allocated Overheads: [30% of $10000] = $3000 Profit = $2500
Y Contribution: $11000 Profit = $6000
Z Contribution: $800 Loss = $1200
Calculate the impact on the total profit of the business if production of Product Z is stopped.
(The overhead costs allocated to product Z will have to be paid).

Marginal costing assists whether to Accept or Reject an Order if price is below the total cost of the product.

Illustration:
Joseph is a dressmaker who pays $45 a day to use a workshop. This covers all the fixed costs.
He makes three dresses a day and sells them for $30 each. Materials costs $8 per dress.
A new customer orders to buy a dress only for $20. On that day he makes only 2 dresses.

Should he accept this order?

Revenue = $60 ($30 × 2 dresses)
Total Cost = $61((2 × $8) + $45)
Revenue−Total Cost (¿+Variable )
$60 – $61 = ($1) loss
If he does not accept the order, she will make a loss of $1 today.
If the order is accepted:
Revenue = $80 ($60 + $20)
Total Cost = $61(3 × $8 + $45)
$80 – [$24 + 45] = $11
Contribution from new order is used to cover the fixed cost of $45.
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In ‘make or buy’ decision the variable cost of production is compared with the Market Price at which the product can be
bought from market. Variable/marginal Cost < Purchase Price = MAKE it otherwise BUY it.
Fixed Expenses remain same whether make or buy.

Illustration:
The cost of manufacturing product X is £8 per unit. In market it is available at £6.50.
Other information: Materials = £3, Direct Labor = £2, Other Variable Expenses = £1, Fixed Expenses = £2
Decide whether to make or buy this component.

Solution:
Marginal Cost of product X: £ (3+2+1) = £6 < £6.50.
It is not advisable to buy the component from outside. Every unit manufactured will give a contribution of 50c.

Illustration:
LMN Ltd. purchases 20,000 bells per year from market at £5 each. The management decides to manufacture these bells.
A machine costing £50,000 is required to manufacture.
Machine details: annual capacity of 30,000 units, life is 5 years, estimated depreciation expense £10000 annually.

Other Information:
Material per bell = £2, labour per bell = £1, Variable Overheads = £100% of labour cost.
Requirement:
The company should continue to purchase the bells from outside supplier or should make them in the factory.

Solution:
Marginal Cost of Manufacture per bell: £ (2+1+1) = £4
If bells are manufactured there will be a savings of £1
Manufacturing will however result in an additional fixed cost of £10,000 p.a. Hence the total saving will have to be compared
with this additional cost.
Total Savings for 20000 bells@£1 £20000
Less: Additional Fixed Costs £10000
Profit (Net Savings) £10000
It is advisable to manufacture these bells within the factory.

Limitations of Contribution Costing:

In marginal costing, costs are classified into fixed and variable. Segregation of costs into fixed and variable is rather difficult and
cannot be done with precision.

There are cases where the marginal cost of two outputs is the same, yet one takes twice the time to produce as the other.
However, in reality, jobs that take more time are more costly.

Under marginal costing, stock and work-in-progress are valued based on the marginal cost, and fixed costs are taken into account.
Thus, these expenses are a lesser charge.
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Budgeting and Variance Analysis

Budgets are Planned Revenues and Planned Expenditures for a specific time period.
Importance:
Budgets help in financial planning. It enables managers to allocate the business resources effectively among different
departments. Budgets enable managers to determine clear departmental goals that motivate employees and enhanced their
productivity. If no targets are set, then an organisation cannot review its progress, therefore, budgets measure the performance of
each department of the organization. Managers make realistic future targets with the help of budget. With a clear sales budget, for
example, departments in the business will know how much to produce or how much to spend on sales promotion.
Each department work to achieve its targets. They maintain coordination and work effectively. This encourage teamwork.
Once the budgeted period has ended, variance analysis will be used to compare actual performance with the original budgets.
This is an important way of assessing managers’ performance.

Variance Analysis:
Actual results are compared with original/budgeted figures. Difference between Budget and Actual is called a Variance.
Reasons for differences must be investigated. This process is known as variance analysis.

Adverse variances (any difference that reduces PROFIT)

Difference between the budgeted and actual figure leads to a lower-than-expected Profit.
1. Sales revenue is below budget: Units Sold were Less. Selling Price had to be lowered due to competition.
2. Actual Raw Material Costs are higher: Output was Higher than budgeted. Cost per unit of Materials increased.
3. Labour Costs are Higher than Budgeted: Wage rates had to be raised due to shortages of workers, Labour took longer
time to complete the work.
4. Overhead Costs are Higher than budgeted: Annual rent rise was higher.

Favorable Variances: (any difference that increases PROFIT)

Difference between the budgeted and actual figure leads to a higher than expected Profit.
1. Sales revenue is above budget due to higher-than expected economic growth or problems with one of the competitor’s
products.

2. Raw material costs are lower either because output was less than planned or the cost per unit of materials was lower
than budget.

3. Labour costs are lower than planned for either because of lower wage rates or quicker completion of the work.

4. Overhead costs are lower than budgeted, perhaps because advertising rates from TV companies were reduced.

Zero-based Budgeting:
In Zero-based budgeting, departments estimate their expenses and revenues from the scratch or with zero base.
The base of current year’s budget is taken as zero. Activities of departments are analyzed for the upcoming period..
Based on the priority, the available resources are allocated to each activity without considering the past budgets.
Zero-based budgeting makes every department analyze each and every item of the operation costs.
It ensures that all activities have been evaluated by the manager.
It eliminates the unnecessary activities/expenses.
It also improves coordination and communication within the department and motivates employees by involving
them in decision-making.
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Flexible Budgeting:
Fixed budgeting is based on the assumption that the level of output remains at the Budgeted Level. If actual output
fell or rose above this level, then this could lead to obvious variances.
Flexible Budgets are prepared so that cost budgets are allowed to vary if Sales/Production levels vary from budgeted
levels.
Flexible Budget adjusts/flexes for the changes in the Production level. A flexible budget uses the revenues and
expenses produced in the current production.

Illustration: ABC Company incurred the following costs.

Selling Price = $14.6,

material cost per unit = $2.50,
labor cost per unit = $3,
Factory overhead per unit = $2.4.
Budgeted units sold = 15,000
Actual units sold = 18,000
Management flexes the static budget for the activity level of 18,000.

How to flex budget:

Actual Quantity × Budgeted Prices
[18000 * $14.6 = 262800]. [18000 * $2.50 = 45000]. [18000 * $3 = 54000]. [18000 * $2.40 = 43200]

Flexible budgets are an appropriate tool for performance measurement.

If the volume is fixed, then the managers can later claim that the demand and cost forecasts significantly changed
from the budgeted levels and they were unable to achieve the budget. With a flexible budget, such situations will
rarely occur.
Flexible budgets are most appropriate for organizations that operate with an increased variable cost structure where
the costs are mainly associated with the level of activity. On the other hand, flexible budgets are time-consuming
and require more planning due to the alterations in activity levels.

Flexible budgets are more motivating for middle and lower-level managers as they will not be criticized for adverse
variances that might occur just because output was lower than budgeted. The flexed targets they are given are more
realistic. Also, flexible budgets make it easier to produce valid and accurate variance analyses as they will now
highlight changes in efficiency, not changes in output.