Accounting for decision-making

Department Business Management

Faculty of Economics and Business Studies

COURSE GUIDE DOCUMENT

(check updates on online campus)

Prof. D. David Guijarro Melguizo

[email protected]
 TOPIC 5
NON-FULL COST MODEL

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 TOPIC 5
NON-FULL COST MODEL

THEORETICAL PROGRAM:
TOPIC 5. NON-FULL COST MODEL

5.1. Variable Cost or Direct Costing model: Analysis of cost-volume-benefit.

5.2. The variable cost model in making short-term decisions about product and price
5.3. Rational Imputation model: The level of capacity and the costs of subactivity.

• EDUCATIONAL RESOURCES FOR THIS TOPIC (check online campus)

– Teaching guide for this course
– Practical excersises
– Additional documents for this topic

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 THE VARIABLE COST MODEL

OBJECTIVE OF THE VARIABLE COST MODEL

Is a model based on the cost incorporation in the product or service of variable costs
only, establishing that all fixed costs are considered costs of the period, being
independent of the level of production.

WARNING
There is a high degree of subjectivity when differentiating a fixed or variable cost.

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 VARIABLE vs FIXED COSTS

Requirements for classifying costs into fixed and variable:

1. Benchmark
• Occupation or activity
• Production volume
• Productivity

2. Appropriate limits

3. Period

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 VARIABLE vs FIXED COSTS
Fixed Cost:
– One that does not fluctuate in the face of variations in the level of activity, within
appropriate limits, throughout the period under study.

Total costs

Activity level

Types of fixed costs:

• Downtime costs (production or business processes come to a halt due to
application unavailability, technical glitch, network outage or natural disaster).
• Production preparation costs (machinery set up)
• Reversible and irreversible fixed costs

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 VARIABLE vs FIXED COSTS
Variable Cost:
• One that fluctuates with the level of activity, within appropriate limits,
throughout the period under study.

Total costs

Activity level

Types of variable costs:

• Proportional costs
• Progressive costs
• Degressive costs

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 VARIABLE vs FIXED COSTS
Semi-fixed cost:
– The one that remains constant for a certain level of activity, are
costs that vary by steps.
Total costs

The vast majority of costs

are semi-fixed or semi-
variable costs

Activity level

Semi-variable cost:
– One that has a fixed component and a variable component.

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 VARIABLE vs FIXED COSTS

In conclusion, there is a high degree of subjectivity when

differentiating a fixed or variable cost, given that the vast
majority are semi-fixed or semi-variable costs

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 REMINDER: FULL COST MODEL
(from Chapter 4)

LOADS NOT
INCORPORATED
.

PRODUCTS
• STARTING DATA
DIRECT C. MAIN
•FINANCIAL ACCO
LOADS CENTRE
•ANALYTIC ACCO S
INCORP.
•COMPANY DATA THE. BASE

EXTRA INDIRECT AUX

CHARGES C. CENTRES

Both kind of costs, Direct and Indirect, were allocated to products.

We never distinguished between variable and fixed costs.

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 THE VARIABLE COST MODEL

It advocates the inclusion in the cost of products or services

only of variable costs, establishing that all fixed costs are
considered costs of the period, as they are independent of the
level of production.

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 THE VARIABLE COST MODEL

VARIABLE
DIRECT COSTS

FIXED

RESULTS
FIXED PRODUCT

INDIRECT COSTS

VARIABLE

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 THE VARIABLE COST MODEL

FUNCTIONAL ACCOUNT
P1............ Pn…...TOTAL
REVENUE……………..………......... x............... x........ x
- VARIABLE COGS………………....(x)............(x)......(x)
= VARIABLE G.M............................. x............... x........ x
- Variable distrib costs....................(x)............(x)......(x)
= CONTRIBUTION M........................ x.............. x........ x
- FIXED C……………………………............................(x)
= RESULT OF THE PERIOD........................................ x
± Difer. in Incorporation……...................................... (x)
= NET RESULT (from FIN ACC. before taxes)............x

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 THE VARIABLE COST MODEL

FUNCTIONAL ACCOUNT
P1............ Pn…...TOTAL
REVENUE……………..………......... x............... x........ x
- VARIABLE COGS………………....(x)............(x)......(x)
= VARIABLE G.M............................. x............... x........ x
- Variable distrib costs....................(x)............(x)......(x)
= CONTRIBUTION M........................ x.............. x........ x
- OWN FIXED COSTS……………..(x)…....... (x).......(x)
= CONT. M. W/OWN FIXED……....... x.............. x........ x
- FIXED COSTS……................................................... (x)
= RESULT OF THE PERIOD........................................ x
± Difer. in Incorporation……...................................... (x)
= NET RESULT (from FIN ACC. before taxes)............x
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 THE VARIABLE COST MODEL
ADVANTAGES OF THE MODEL
• It is the most suitable model for short-term decision-making.

• Facilitates the break even point (or deadlock) analysis.

• It provides adequate information for making pricing decisions.

• It allows to analyze the performance by products.

• It provides useful information about cost behavior.

DISADVANTAGES OF THE MODEL:

• High degree of subjectivity when differentiating fixed and variable costs.

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 DEADLOCK ANALYSIS

Deadlock / Break-even
Volume of production and sale (units & $) with which the company covers all its costs.

Net result = FC + VC - R = 0
FC + VC= R
R – Revenue
FC + (n x vc) = n x p FC – Fixed costs
VC – Variable costs
FC = (n x p) – (n x vc) n – number of units produced
p – unitary price
FC = n x (p – vc) vc – unitary variable costs
cm – unitary contribution margin
n*= FC/(p-vc) = FC/cm
CM – Contribution margin
R*= n* x p = p x FC/(cm) = FC/(cm/p)=FC/(CM/R) n* - deadlock number of units
R* - deadlock Revenue

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 DEADLOCK ANALYSIS

A company dedicated to the manufacture of aircraft engines, presents the following income
statement for a given period (in € million):

Sales revenue............................ 6.375 100% (8.500units x 750.000 €./unit)

- Variable costs ......................... 4.250 66,6%
= Contribution Margin................ 2.125 33,3%
- Fixed costs of the period........ 1.000 15,69%
= Period Result.......................... 1.125 17,65%

With this information we would get:

R* = FC/(M/R) = 1,000/0,3 = €3,000 Million.

n* = R*/p = 3.000 MM / 750.000 €./unit.= 4.000 units.

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 DEADLOCK ANALYSIS – OTHER RATIOS

Fixed load absortion rate

FLAR = (Deadlock / Revenue) x 100
% of current sales to reach deadlock.

Commercial efficiency index

% in which current sales could fall without CEI = (Revenue - Deadlock) x 100
the company entering into losses Revenue

Fixed cost safety index

% at which fixed costs could increase FCSI = (Net result / FC) x 100
without incurring in losses

Variable cost safety index

% at which variable costs could increase VCSI = (Net result / VC ) x 100
without incurring in losses.

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 DEADLOCK ANALYSIS – OTHER RATIOS
Operating leverage
% variation of EBIT against a variation of one % in the units sold

OL= % VARIATION EBIT / % VARIATION UNITS SOLD

OL = ( EBIT/EBIT) / ( u/u) = (u x  EBIT) / (EBIT x  u) (1)

EBIT = (cm x u) - FC
EBIT' = (cm x u') - FC
OL – Operating leverage
EBIT – earnings before ints. & taxes
 EBIT = cm x (u' - u) - FC + FC = cm x  u FC – Fixed costs
u –units sold and produced
when substituting in (1) we get cm – unitary contribution margin
CM – Contribution margin
D - delta - increase
OL = (CM / EBIT) x 100 u’ – u +  u
EBIT’ – EBIT +  EBIT
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 VARIABLE COST MODEL
APPLIED TO DECISION MAKING PROCESS
SCENARIO A SCENARIO B

ADDITIONAL AVAILABLE RESOURCES SCARCE RESOURCES

SUBACTIVITY  FULL CAPACITY 

Real activity < Normal activity Real activity = Normal activity

INCREMENTAL ANALYSIS. Scarce resources: man hours, machine

Alternatives are feasible if: hours, number of tests…

Contribution margin > 0

Maximize Contribution Margin /
Contribution margin over Own Fixed Costs > 0 Units of scarce resource

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 VARIABLE COST MODEL
APPLIED TO DECISION MAKING PROCESS

Ex. 1:
The Alfa company is working below its normal capacity, receiving, under these conditions, an order for 200,000
units at a price of €200/unit. To decide whether to accept the order, a report is requested to the Finance
department, the summary of which is as follows:
a) Sale price in the market: €240/unit, the new order not having an impact on this value.
b) Complete production cost of the product:
Raw materials (DM)...................80 €./ud.
Direct Labour …………..............40 €./ud.(CV)
MOH (fixed + variables)............100 €./ud

TOTAL................................220 €./UD.
c) Variable cost rate of indirect production costs: 10%.

Based on this report, what decision should ALFA make?

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 VARIABLE COST MODEL
APPLIED TO DECISION MAKING PROCESS

Solution
Doing an incremental analysis of the two possible alternatives:
Do not accept and do accept the order

- Incremental revenue…………………… 200 €/unit

- Incremental cost ………………………. 130€/unit
 DM ……… 80€/unit
 DL ……….. 40€/unit
 MOH …….. 10€/unit
- Contribution margin …………………….. +70€/unit

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 VARIABLE COST MODEL
APPLIED TO DECISION MAKING PROCESS

Solution

• Accepting that sales order represents an additional benefit of €70 for each unit sold. Therefor, it is important
to accept the order, although at first glance, it may seem otherwise since the complete cost of the product
exceeds €20 its selling price.

• When making this decision, it is important not to impact the current market price since, otherwise, the
decision would no longer be about the product but about the price.

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 VARIABLE COST MODEL
APPLIED TO DECISION MAKING PROCESS

Ex. 2:
A company manufactures products M and N, having a total of 1,200 machine hours per month for their
production.
Product M has variable costs of €150 per unit being sold at €275/unit; N's variable costs amount to €175/unit.
and its sale price is €430/unit.

Unable to absorb all the market demand, it has to choose to manufacture one of the two.

Which would you prefer if you know that 300 units/mh are obtained from M? and N 120 units/mh?.

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 VARIABLE COST MODEL
APPLIED TO DECISION MAKING PROCESS

Solution

PRODUCT M PRODUCT N
300 units/mh (1/300) mh/unit = (0.033 mh/unit) 120 units/mh (1/120) mh/unit = (0.0083 mh/unit)

Sale Price 275€/unit Sale Price 430€/unit

Variable cost 150€/unit Variable cost 175€/unit

Contribution margin 125€/unit Contribution margin 255€/unit

Cont Margin/mh = 125€/unit / 0.033mh/unit = 37.500€/mh Cont Margin/mh = 255€/unit / 0.0083mh/unit = 30.600€/mh

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 VARIABLE COST MODEL
APPLIED TO DECISION MAKING PROCESS

If there were no limited capacity of production, the company would manufacture both products since both have
a positive contribution margin.

However, when having to choose between the two, the classic differential analysis would lead us into
error since, according to it, we would have selected the product N since its unit contribution margin
exceeds that of M by:

€255/unit. - €125/unit. = €130/unit. (deferential benefit of N with respect to M).

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 VARIABLE COST MODEL
APPLIED TO DECISION MAKING PROCESS

Since there is a capacity limitation, the choice between two products will be made based on the contribution
margin per unit of scarce resource of each product which, in our example, gives:

M = €37,500/mh………. N = €30,600/mh

That means that for every machine hour that we use in M ​we get a return of €37,500, while if we use it in N we
only get a return of €30,600, so the company must choose to produce M and that is because in one hour you
get 300 units which for the 1,200 hours available means being able to produce:

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 VARIABLE COST MODEL
APPLIED TO DECISION MAKING PROCESS

1,200 mh implies:

PRODUCT M PRODUCT N
300 units/mh 300 units/mh x 1.200mh = 360.000 units 120 units/mh 120 mh/unit x 1.200mh = 144.000 units

Contribution margin 125€/unit x 360.000 units = €45.000.000 Contribution margin 255€/unit x 144.000 units = €36.720.000

The application of this general rule in practice presents many difficulties since reality is always complex.
In fact, there may be more than one limiting factor simultaneously, one or more of these factors may be very
difficult to quantify, etc. but, in any case, used with intuition and common sense it can always give an idea, even
if it is not too exact, of where the direction should take its steps.

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 RATIONAL IMPUTATION MODEL

It advocates the inclusion in the cost of products or services of:

a) variable costs plus
b) a part of fixed costs (attributable fixed costs),
transferring the rest of the structural charges (non-attributable fixed costs) directly
to the income statement.

REQUIREMENTS:
• Differentiation between fixed vs variable costs for each activity center.
• Determination of the level of activity or capacity for each center .

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 RATIONAL IMPUTATION MODEL
3 LEVELS OF ACTIVITY:

• AVAILABLE ACTIVITY: Theoretical or installed capacity, without taking

into account usual and normal stoppages and interruptions.

• NORMAL ACTIVITY: Capacity that can be achieved with available

resources and taking into account regular stoppages.

• REAL ACTIVITY: Capacity effectively achieved by the center.

AA > NA > RAα

Activity under normal
circumstances
Theoretical available Actual level of
(considering
capacity activity
production hold for
maintenance)
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 RATIONAL IMPUTATION MODEL

ACTIVITY RATE:

α = RA/NA

α=1 AR = AN FULL COST

α< 1 AR< AN SUBACTIVITY COSTS = (1-α) * CF

α> 1 AR> AN INCOME FROM OVERACTIVITY = (α-1) * CF

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 RATIONAL IMPUTATION MODEL:
ATTRIBUTABLE FIXED COSTS

VARIABLE
DIRECT COSTS

FIXED
ATTRIBUTABLE

RESULTS
FIXED NON-

AFC = FC * α
ATTRIBUTABLE

FIXED NON-
ATTRIBUTABLE
PRODUCT

FIXED
INDIRECT COSTS ATTRIBUTABLE

VARIABLES

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 RATIONAL IMPUTATION MODEL

• STRUCTURE OF THE RECLASSIFICATION TABLE

CONCEPT CENTER 1 CENTER N

FIXED COSTS
VARIABLE COSTS

α = RA/NA
AFC = α * FC
ATTRIBUTABLE PRIMARY COSTS
APC= AFC + VC
Subtootal Auxiliary costs
Total Attributable costs
Unit of work
Nr of units of work
Unit Cost of the unit of work
Subactivity costs SUBTRACT FROM
(1- α) * FC RESULTS

Overactivity income SUM TO RESULTS

(α-1)* FC

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 RATIONAL IMPUTATION MODEL

FUNCTIONAL GENERATION OF INCOME ACCOUNT

P1.............TOTAL Pn
Revenue.........................................x............... x........ x
C.O.G.S.........................................(x)............(x)......(x)
= ACTIVITY GROSS MARGIN.......x.............. x........ x
- Distribut Costs...........................(x)...........(x)......(x)
= ACTIVITY CONTRIB. M..............X.............. x........ x
- ADMIN COSTS………………………………............(X)
=RESULT OF THE ACTIVITY................................... X
- SUBACTIVITY COSTS………............................ (x)
+ INCOME FROM OVERACTIVITY…………............ X
= RESULT OF PERIOD............................................. X

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 RATIONAL IMPUTATION MODEL

ADVANTAGES:
• It manages to keep the fixed unit cost of the work unit constant.

DISADVANTAGES:
• High degree of subjectivity when differentiating fixed and variable
costs.
• Difficulty in establishing the normal activity level of each center.

• Unrealistic and applicable when the activity coefficient is greater than

one.

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