Managerial Accounting and Control Made
This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page - 2 - Session Plan for MAC II
Module 1 COST ACCOUNTING BASICS
Session 1 Introduction
Reading(s) 1. Basics of Cost Accounting (MACME) 2. Breezy Boat Company(MAC) Session 2 Cost terms, purpose& approach Reading(s) Classification of Cost(MACME) Case Cost classification exercise (IIMA/F&A 377) Session 3 Break Even Analysis
Reading(s) Break Even Analysis(MACME)
―Do you know where your "break even" point is?‖ By John H. Nardozzi, CPA
―Using Break-Even Analysis to Determine Your Company‘s Financial Health‖Arthur F. Rothberg, Managing Director, CFO Edge, LLC
Case: The Craddock Cup(MAC)
Module 2 COSTING SYSTEMS &METHODS
Session 4 Absorption Costing
Reading(s) Absorption Costing(MACME) Case Class Exercise(MACME)
Session 5 Job Costing and Process Costing
Reading(s) Job Costing and Process Costing(MACME) Wendy‘s Chili: A costing Conundrum(MAC)
Session 6 Activity Based Costing
Readings: Activity Based Costing(MACME)
Case: Classic Pen Company: Developing an ABC Model (HBS/9-198-117) Session 7 Activity Based Management and use of ABC in service industries Reading(s) ABM (MACME)
Activity Based Costing at UPS
2. Activity Based Costing & Capacity (HBS/9-105-059) Case Wilkerson Co (HBS/9-101-092)
This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page - 3 - Session 8 Cost allocation and Customer Profitability
Reading(s) Activity Based Costing(MACME) Case Dakota Office Products(HBS/9-102-021)
Module 3 COST ANALYSIS FOR DECISION MAKING
Session9 In-sourcing and Outsourcing decision analysis Reading(s) Marginal Costing and Decision Analysis(MACME) Case Fine print Company(A),(B) and (C)
Session 10 Product mix decisions with capacity constraints Readings(s) Marginal Costing and Decision Analysis(MACME) Case Moti Heera (P) Ltd (A) & (B) (IIMA/QM0003(A & B)) Session 11 Pricing and cost management
Reading(s) Pricing and Cost Management(MACME) Case Mridula Ice Cream Parlour (A) (IIMA/F&A 0315(A)) Session 12 Target costing & life cycle cost management
Reading(s) Target costing & life cycle cost management(MACME) 2. Achieving Full Cycle Cost management (SMR 153, Fall 2004) Case Toyota Motor Company: Target Costing (HBS/9-197-031) Module 4 BUDGETING & VARIANCE ANALYSIS
Session 13 Standard Costs and Budgets
Reading(s) Standard Costs and Budgets(MACME) Case Wilmont Chemical Corporation(MAC)
Session 14 Variance Analysis
Reading(s) Variance Analysis and Flexible Budget(MACME) 2. Variance Analysis and Flexible Budget (HBS/9-101-039) Case Entertainment now.com(MAC)
Session 15 Wrap-up * * *
This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page - 4 - 1. BASICS OF COST ACCOUNTING
Cost:
―A unit of product or service in relation to which costs are ascertained‖ Meaning of cost:
Cost is the resource foregone in order to receive anything of value.
Definition of Cost
CIMA (Chartered Institute of Management Accountants) defines cost as follows:
―the amount of expenditure(actual or notional) incurred on or attributable to a specified thing or activity‖.
Cost Unit
Costs need not always be incurred on output units. It can be incurred on hourly basis, it can be incurred on an activity, a department etc. Therefore a cost unit is any unit with respect to which cost can be ascertained. For example, in an aircraft, cost can be incurred per passenger and in a bottle manufacturing unit, it could be ascertained per bottle.
Composite cost units
Sometimes costs need not be incurred on a single output function, but could be a combination of two or more functions. For a tour operator, the cost could be calculated for a passenger mile, for a hotel it could be per guest per night.
Cost Centre
Cost centre refers to the point of accumulation of cost. A cost centre is a part of the company that does not generate any profit for the company, but they add cost to the company. The manager of a cost centre incurs costs and the centre is evaluated on how well they control their costs (Horngren, Sundem, Stratton, and Burgstahler, Schatzberg, 2008).
Unlike what the term sounds like, it has no reference to a physical place, it is an activity or set of activities that create costs. For example, an administrative office is a cost centre. An Engineering or product development function is a cost centre. This is because, performing that activity results in costs being incurred.
This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page - 5 - Other examples of cost centre are employees, support functions in an organisation and any other activity where costs can be meaningfully accumulated.
Cost pool
Costs are assembled into meaningful groups called cost pools (e.g., by type of cost or source). Similar activities that can be grouped together usually makes a cost pool. For example, repairs and maintenance of equipment is a cost pool. Quality control costs and inspection costs can be combined into a single cost pool.
Cost Driver
Any factor that has the effect of changing the level of total cost is called a cost driver. For example, number of machine hours worked will affect the equipment maintenance cost. Therefore machine hours is a cost driver for equipment maintenance.
This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page - 6 - 2. Classification of Cost
Cost can be classified on the basis of nature, behavior , traceability, inventoriability, controllability and marginality.
On the basis of nature of cost, we can classify cost as follows: Material Cost :
Cost incurred to obtain material and receive them within the organization. The cost of having them brought into the organization is called carriage inwards.
Labour costs are those that are incurred in respect to salaries and wages together with related employment costs
Overheads or indirect costs:
Broadly classified into:
Factory or manufacturing overheads Office or administrative overheads Selling and distribution overheads
Manufacturing overheads can be further sub divided into indirect material costs, indirect labour and indirect expenses.
Indirect Material Indirect Labour
Production overheads
Administration and selling overheads
On the basis of behaviour of cost with respect to volume, we can classify cost as follows: Fixed costs are those that remain constant within a level of activity
This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page - 7 - Mixed costs are those costs which vary partly on account of output and partly remain
constant
Step costs vary with the cost driver but do so in steps A word of caution :
Fixed costs need not be FIXED..It does not vary as a function of output- eg rent is a fixed cost. Rent could alter because of increase in floor space, rising cost of real estate, but, not because we produce more number of units. Hence, please note that fixed do not vary as a function of output, but could vary due to other factors.
On the basis of traceability, cost can be classified as follows: Direct and indirect cost:
Direct costs are those costs that can be related to a unit of output or to a cost object (example- product, division, department etc)
All costs that are not direct costs are called indirect costs
On the basis of inventoriability cost can be classified as follows: Inventoriable and Period costs:
Costs that are assets when they are incurred and become expenses as they are consumed are called as inventoriable costs
Period costs are those that are incurred as a function of a period of time On the basis of Controllability cost can be classified as:
Controllable and Uncontrollable costs:
Controllable costs are those that can be controlled at a responsibility centre
Uncontrollable costs are those that are incurred at a responsibility centre, but cannot be controlled at the level of that responsibility centre
This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page - 8 - Marginality
Marginal and Absorption cost:
The additional cost to produce an additional unit is called as marginal cost Marginal costing is formally defined as:
‗the accounting system in which variable costs are charged to cost units and the fixed costs of the period are written-off in full against the aggregate contribution. Its special value is in decision making‘
Absorption Cost:
The cost that includes all direct costs as well as the absorbed overheads in the cost is called as absorption cost or full cost
The basic difference between the two costs is that under marginal costing the stock is valued at variable cost, whereas, under absorption costing, stock is valued at marginal cost and a proportion of manufacturing fixed overheads
The following is an illustration of how entire costs of a product are factored into a cost sheet:
Particulars Amount Amount
Direct material 100 Direct labour 50 Direct expenses 10 PRIME COST 160 Production overhead Indirect material 10 Indirect labour 15 Indirect expenses 35 60
FACTORY COST/PRODUCTION COST 220
Selling Distribution and Administration overhead
30
COST OF GOODS SOLD 250
SELLING PRICE 300
PROFIT 50
This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page - 9 - 3. Break even Analysis
Meaning
Break even analysis occupies an important place in economic theory. It analyses the relationship between cost of production, revenue and profit.
Breakeven point is that point at a particular level of output at which total revenue is equal to total cost. It implies a no profit no loss zone. At this point, the firm neither makes a profit nor loss. Here, total revenue is exactly equal to total cost.
Definition
According to Matz, Curry and Frank‖ A break even analysis indicates at what level of output cost and revenue are in equilibrium‖
Elements of Break even analysis
Fixed costs:
It is a cost incurred even at zero production. Fixed costs do not change with the change in the quantity of output. For example, rent, insurance, research and development etc. Variable cost:
These expenses vary directly with the level of output. For example, labor cost, raw materials etc.
Contribution Margin
The revenue net of variable expenses is called as contribution margin. The contribution margin is available to cover fixed expenses of a business.
Break even Point
When the contribution margin covers the fixed cost, it is called as break even point-that is, the sales that generates just enough contribution to cover the fixed cost. At this point the firm makes neither profit nor loss.
Margin of Safety
The sales achieved over and above the Break even Sales is called Margin of Safety. It is expressed as Actual Sales-Break even sales.
This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page - 10 - A Break Even Chart is shown below for better understanding:
Illustration 1
A German Biscuit Company plans to sell 50000 units at Rs. 20 per unit. They incur a fixed cost of Rs.80000 and variable cost Rs.10 per unit. Calculate breakeven point in sales, and margin of safety and profit.
Solution:
BEP in sales = FC/ CM ratio
CM ratio or the Contribution Margin ratio is calculated as Contribution/Sales and is usually expressed as percentage.
CM ratio = 1000000 – 500000/1000000 = 50% BEP in sales = 80000/ 50% = 160000
Margin of safety = Sales – BEP in sales = 1000000 – 160000 = 840000
This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page - 11 - = 1000000 – 500000
= 500000 Profit = contribution – Fixed cost Profit = 500000 – 80000
= 420000
Explanation: The breakeven point in sales, margin of safety and profit calculation depends upon the number of units, fixed cost and variable cost.
The breakeven point in sales, margin of safety and profit will change if there is a change in any of these variables.
Readings
DO YOU KNOW WHERE YOUR "BREAK EVEN" POINT IS?
by
John H. Nardozzi, CPA Nardozzi Consulting, LLC
Is your business profitable? Most oilheat dealers can answer that question with a fair degree of accuracy-for last year. You know how the numbers added up, and whether or not the ink on the books was black or red. But what about this year? Are you making money now? How many gallons will you have to sell this year before you turn a profit? At what price? Knowing your "break even" point is a relatively uncomplicated yet important business planning tool. Having an idea of when your costs will be covered and profits begin can help you make better purchasing decisions, and is a vital part of the price setting process. There is a way to determine your break even point without consulting a crystal ball or palm reader.Through a simple analysis of three key factors, you can know what it will take this year for your company to make money. The first factor is the number of gallons you expect to sell this season. Analyzing your company's past history and factoring in predicted weather patterns will provide a fairly accurate gauge of what you'll be delivering this year. Your state oilheat dealers association can help you with degree day estimates and weather history. By determining how many customers you expect to have this year, and the average use per customer, you can come up with a total gallons figure.
The next factor is your margin per gallon. Like all retailers, oilheat dealers continually struggle with pricing. The object is to price your product - in this case, a gallon of heating oil - low enough to be competitive, yet as high as possible to make the maximum profit. Too often, this becomes an exercise in hand wringing, guesswork and gut reaction. Worse, many oilheat dealers simply copy the next guy up the Yellow Pages list, without regard to the differences in the two
This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page - 12 - businesses. It need not be that way. Our break even analysis can help make this decision more clear cut.
The third factor in our break even equation is overhead (administration) costs. Again, an examination of your overhead costs (including payroll, rent, equipment, interest payments, insurance, taxes, etc.) from previous years will provide an indication of what your expected overhead will be for the upcoming season. We do not include the cost of product (oil) or owner's salary in this analysis.
At this point you have the information available to establish your break even point for two critical areas: gross margin and minimum gallons. Your break even point comes when total overhead cost is met by total gross margin. How would this work in practice? What are you trying to establish?
First, you want to know how many gallons you need to sell at your expected margin in order to break even.
Second, you want to determine the minimum margin you need to achieve when you sell the expected gallons so that you will cover costs.
Let's take a simple set of facts. Your company expects to sell five million gallons, and your gross margin (sale price less the cost of product and delivery) is targeted at 30¢ per gallon. Finally, your overhead/administrative expenses run about $1 million.
BREAK EVEN GALLONS - If you divide your overhead expenses ($1 million) by your targeted margin ($0.30), you establish the minimum number of gallons you need to sell before you show any profit. In our example, this would be 3,333,000 gallons ($1 million ÷ $0.30). This tells you that the margin on every gallon after 3,333,000 goes directly to the bottom line of the company. BREAK EVEN MARGIN - Here we are trying to establish the smallest margin you can get away with for all five million gallons you expect to sell. Once this level is set, you'll know that every penny added to the margin goes directly to the bottom line. If you divide your overhead/administrative expenses ($1 million) by your total expected gallons (5 million) you show that your minimum margin per gallon is $0.20.
In our analysis we do not include the owner's salary in the overhead expenses, as we consider company profit and any salary drawn by the owner to be part of the overall benefit of ownership. In your analysis, you might decide to include some part of your salary in the calculation.
This break even analysis is not complex. To be more accurate, we factor in degree days and market trends. But even in its simplest form, a break even analysis can be a powerful tool to help you plan your season's buying, and in determining a selling price for your product. You have the information on hand to make this analysis, and should take the time to sit down with your financial officer or accountant to locate your own "break even" point.
USING BREAK-EVEN ANALYSIS TO DETERMINE YOUR COMPANY’S FINANCIAL HEALTH
This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page - 13 - Arthur F. Rothberg, Managing Director, CFO Edge, LLC
Determining the break-even point is crucial to determining margins, which, in turn, aid in financial
planning for the next year. Break-even analysis determines both the minimum amount of sales required to avoid a loss or to ―break-even‖ at the end of the fiscal year and permits you to adjust sales estimates accordingly. While there are a number of different variations on break-even analysis, they are all useful in determining the lower limits of profits for calculating margins. These variations are all dependent on a number of cost factors, which should be determined before attempting any kind of break-even analysis.
Cost Components of Break-Even Analysis
Break-even analysis is primarily dependent on a few key factors. First and foremost, it is necessary to have the capacity to accurately forecast your company‘s costs and sales. The result will then be
dependent on fixed costs, average per-unit variable costs, and per-unit revenue as allocated across the whole business. With these numbers, break-even analysis becomes a matter of simple math: Break-Even Point = Fixed Costs / (Unit Selling Price - Variable Costs).
As mentioned, there are several types of costs that must be considered when conducting break-even analysis. Among these, the most relevant are fixed costs, which are those expenses that are the same regardless of the number of items sold. Fixed costs also generally would remain the same, even if the company discontinued all sales. The most common fixed costs are rent and insurance. The cost of maintaining corporate property would be the same, no matter the amount of product sold. However, labor should also be considered as a fixed cost, since replacing a skilled labor force is extremely difficult to do. In-place labor will usually not vary with moderate changes in volume.
The other main category of cost to be considered while conducting break-even analysis is variable
costs. These are expenses that are based on the number of units processed. As such, they will fluctuate depending on the volume of the business. As the business and sales grow, variable costs will also increase. The most common variable costs are those pertaining to raw materials necessary for manufacturing products.
The Margin of Safety
The margin of safety is a notable outcome of break-even analysis as it is indicative of the strength of the business. For any level of sales, the margin of safety indicates specifically the amount of sales dollars above or below the break-even point. In essence, this number makes it possible for the company to determine the exact amount of money it may have gained or lost during the period in question.
When sales are above the break-even point, then the margin of safety is positive, typically indicating
overall gains. However, when sales are below the break-even point, then the margin of safety is considered negative, which indicates an overall loss for the period.
This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page - 14 - Contribution Margin Analysis
When conducting a break-even analysis, it is helpful to keep in mind the concept of Contribution Margin, which is defined as revenue less variable costs. Contribution margin differs from gross profit, as only variable costs are taken into account, whereas in gross profit analysis all costs of sales are considered.
Typically a company‘s optimal output lies where the contribution margin exceeds variable marginal cost, meaning that the revenue from selling a product exceeds the variable cost of production. However, if a lower price than normal is offered, all other factors being equal, that offer ought to be considered so long as the price still exceeds variable costs. Such a price, which still covers all variable costs, may yet be considered profitable since it will help to absorb any fixed costs. Only when the contribution margin is positive will any losses imbued through the acceptance of a lower offer be compensated through increases in the volume of sales. In Summary
Break-even analysis is an exceptionally useful tool for assessing the state of the company‘s finances. However, in order to successfully conduct break-even analysis, there are a few figures that must first be
ascertained:
_ Fixed costs are those expenses that remain the same regardless of company success. They must be factored in when determining overall gains or losses.
_ Variable costs are also important to consider during break-even analysis. These are expenses that will fluctuate in accordance with company sales figures, such as primarily raw materials. _ The margin of safety is a useful tool in the analysis process as it supports assessment of long-term investments.
_ Contribution margin analysis is an indispensable part of price setting, as it allows setting lower than normal price, especially when volume considerations are taken into account.
The break-even process is invaluable in assessing the financial health of your company. Los Angeles CEOs and CFOs who feel that they do not have the internal expertise or bandwidth to conduct a breakeven analysis can benefit significantly from consulting with an outsourced CFO services firm. A professional services firm of this nature can lend their expertise to your financial analysis and provide an objective report for your use.
References and Further Reading
Chapter 11: Conventional Linear Cost Volume Profit Analysis; James R. Martin; Management Accounting: Concepts, Techniques, & Controversial Issues
http://maaw.info/Chapter11.htm#The%20Margin%20of%20Safety Break-Even Analysis; Tim Berry; Business Know-How; 2003 http://www.businessknowhow.com/startup/break-even.htm What is Process Analysis; University of Central Florida http://oeas.ucf.edu/process_analysis/what_is_pa.htm Case: The Craddock Cup(MAC)
This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page - 15 - Section 2- Costing Systems and Methods
4. ABSORPTION COSTING Meaning
Absorption costing means that all of the manufacturing costs are absorbed by the units produced. In other words, the cost of a finished unit in inventory will include direct materials, direct labor, and both variable and fixed manufacturing overhead. As a result, absorption costing is also referred to as full costing or the full absorption method.
Definition
A managerial accounting cost method of expensing all costs associated with manufacturing a particular product. Absorption costing uses the total direct costs and overhead costs associated with manufacturing a product as the cost base. Generally accepted accounting principles (GAAP) require absorption costing for external reporting.\
Difference between Absorption and Marginal Costing
When absorption costing is used all stock items are valued at their full production cost. This includes fixed production overheads which have been absorbed into cost.
In contrast, marginal cost values all stock items at their variable or marginal costs only. Fixed costs are treated as period costs and are written off in full against the contribution earned in that period.
Illustration
.ABC Company sells its products for Rs 66 each. The current production level is 25000 unit, although only 20000 units are sold.
Calculate value of closing stock using a. Marginal Cost
b. Absorption Cost
Other information are as follows: Unit manufacturing cost
This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page - 16 -
Direct labour Rs.18
Variable manufacturing overhead Rs.9 Variable marketing overhead Rs.6
Fixed manufacturing overheads are Rs.175,000/- and fixed marketing overheads are Rs.60,000/- for the period.
Solution
Value of closing stock using absorption cost:
Absorption cost uses all variable costs and the proportion of fixed expenses relating to production.
So cost per unit will be calculated as follows:
Direct material Rs.12
Direct labour Rs.18
Variable manufacturing overhead Rs.9 Proportion of fixed overhead absorbed will be =175,000/25000
Rs.7
Cost per unit Rs.46
Value of closing stock= 46*5000=Rs.230,000/- Value of closing stock using marginal cost: Calculation of cost per unit
Direct material Rs.12
Direct labour Rs.18
Variable manufacturing overhead Rs.9
Cost per unit Rs.39/-
Value of closing stock=39*5000=195,000/-
Note: Marketing overheads are treated a speriod costs and are consequently written off in the same year under both the methods.
This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page - 17 - Absorption costing allows companies to clearly and completely show information about their financial condition. It also allows companies to price more accurately, ensuring that the final price of a product or service takes into account the actual costs that went into them. This is particularly useful for small businesses which need to give more consideration to overhead expenses.
Absorption costing is taken in opposition to variable costing. Under variable costing, which may also be referred to as direct costing, only variable expenses are included in the computation. Therefore, fixed manufacturing costs are not included in the computation.
Since variable costing focuses more on expenses which can be modified or adjusted, it helps management plan and make decisions on how expenses can be minimized. Data taken from absorption costing shows the entire picture, together with fixed costs, so does not conveniently provide this information. On the other hand, since variable costing only shows part of the picture, it may not be taken by investors as reliable information. Also, since fixed costs are included in the computation of absorption costing, it might be more beneficial to use this information when sales change, since the figures won‘t fluctuate too much.
Due to the huge differences between the two costing methods, it is important to specify which method is being used. One way in which absorption costing can be helpful is when a company wants to make sure that a retail price accurately reflects the costs involved in the production of a good. This can be especially critical with small companies which lack financial reserves, and therefore cannot afford to take a loss or to sell products without accounting for overhead. For example, a garment manufacturer might think not just about the cost of wool and labor for making a sweater, but also the costs of knitting machines, the factory where the machines are installed, the cost of running the machines, insurance, and other types of overhead costs.
This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page - 18 - 5. JOB AND PROCESS COSTING
Specific order costing:
The choice of method of costing to be used by an organization depends upon the nature of activity undertaken by the organization
Specific order costing methods are appropriate for organizations which produce cost units which are separately identifiable from one another
Job costing , batch costing and contract costing are all types of specific order costing
We would, in the following section, cover job costing in detail.
Job Order Costing
Job Costing is method of costing in which we calculate the cost of each job. Job here means a small work or group of small activities which we can identify in any product‘s production.
A job order costing system is used when a job or batch is significantly different from other jobs or batches .Cost accounting is usually fairly simple in these systems. Labour and materials are entered on a job ticket
Overhead is usually added to the amount the customer will be charged for labour and materials
Job costing involves keeping an account of direct and indirect costs. Overhead is added to the price customers will be charged for labor and material. Such method is used in construction, motion picture, and shipping industries, in fabrication, repair, and maintenance works, and in services such as auditing etc.
If you go to an auto repair shop, they will start a job ticket just for the work to be done on your car Your job ticket will show charges for labour and materials, just for your job. Let's say they charge you Rs.350 per hour for labour. This charge includes the mechanic's payroll cost.
This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page - 19 - But it also includes an overhead charge - which is generally not stated separately .The overhead charge covers the costs of operating the garage - tools and equipment, rent, insurance, maintenance, utilities, etc. It is a way to allocate overhead (discussed below), and build it in to the amount charged to customers
The garage will also make a gross profit on the parts they use to repair your car. This gross profit covers the cost of buying and maintaining a parts inventory, including department employee wages, insurance and warehousing costs
Allocating overheads
Let's look at a typical product -Before production starts, no costs have been incurred. Workers stand ready to make the product, inventory waits patiently in the warehouse and the manufacturing plant contains all the resources necessary to perform the manufacturing operation.
We first add materials into production, from the inventory. At the same time the accounting department transfers the cost of inventory items to the ‗Work in Process‘ account, and the product or job now has a value.
Next the workers start to convert the raw inventory into a product. As labour is added, the accounting department transfers payroll costs to the Work in Process account, increasing the value of the product or job.
Overhead costs are allocated to the product or job, based on the costing method used. As work progresses on the product or job, it accumulates labour, materials and overhead costs. Finally, the total finished product or job cost is transferred to Finished Goods, and when it is sold the cost is transferred to Cost of Goods Sold
Accounting for Overhead Costs
Overhead is allocated to products or jobs using a reasonable allocation method. We try to find some part of the manufacturing process that is regular and predictable, which is called as cost driver
Labour hours used is the most popular allocation method. The number of labour hours in a year is fairly predictable. Differences in employees pay rates are not relevant when using hours. The information is readily available from existing payroll records. There is usually a direct correlation between labour and the production process
This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page - 20 - Labour cost is the second most popular allocation method. It is used by very large companies, with large work forces operating under labour contracts The labour costs are fairly predictable, and are closely linked to production. Because of the large number of employees, labour costs tends to be a very stable and predictable measure of the progress of production
Other overhead (simpler) methods include: number of units produced
machine hours use (jet engines, diesel locomotives),
square footage of floor space (heating, cooling & janitorial costs) miles (taxis, trucking)
Some companies use a sophisticated method involving service departments such as maintenance and computer processing. These departments provide services to other departments. Service departments are widely used in hospital accounting.
Simple Overhead Allocation
The simplest form of overhead allocation is to treat all annual overhead as a single cost pool, and allocate it to one annual cost driver
Some terminology that would be useful in the discussion of distribution of overheads are discussed as follows:
Cost allocation: Allocation is the process of identifying and attributing a cost to a specific cost centre-eg. product development cost for a new product can be allocated to that product.
Cost Apportionment: When it is not possible to allocate a cost to a particular cost centre, since the cost has been incurred for the joint benefit of several cost centres, a reasonable estimation of the benefits received by each of the cost centre is made and cost is apportioned accordingly.
Cost Absorption: The last stage of distribution of costs where overheads are absorbed into the production units of a cost centre
This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page - 21 - We determine the predetermined overhead absorption rate as the budgeted overheads divided by the budgeted cost driver.
Illustration 1
Assume Johnson's Bakery produces 2,000,000 loaves of bread per year, and incurs Rs60,000 in annual overhead cost. How much overhead cost must Johnson allocate to each loaf of bread?
Total Annual Overhead --- Units of Cost Driver
= cost per unit of cost driver
Rs60,000
--- 2,000,000 loaves
= 30 paise per loaf
In addition to direct costs (labour & materials), Johnson will allocate 30 paise per loaf to overhead costs
Decision making using overhead costs
Illustration 2
Assume Johnson's Bakery must lease a new oven for Rs20,000 per year, to replace an old oven. Direct costs per loaf will not change. Johnson charges all lease costs to the Overhead account All other overhead costs will stay the same How will the new oven lease
change Johnson's overhead costs?
60,000 + 20,000 --- 2,000,000 loaves = 40 paise per loaf
This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page - 22 - Johnson's overhead cost per loaf will increase 10 paise, from 30 to 40 paise
Illustration 3
Sonia Auto parts has 8 mechanics working full time, 1,500 hours per year each, for a total of 12,000 hours that will be billed to jobs They incur Rs120,000 per year in overhead costs Sonia allocates overhead costs to car repair jobs, based on the number of hours worked on each job How much will Sonia allocate per labour hour?
120,000
--- 12,000 hours
= Rs10/- overhead per labour hour
Sonia Auto parts will allocate Rs10/- per labour hour for overhead
Illustration 4
Example of Overhead Allocation to a Job
Sonia Auto parts works on the delivery truck belonging to Johnson's Bakery. The job takes 200 hours How much overhead cost will Sonia allocate to this job?
Overhead per labour hour X labour hours on job = overhead allocated to job 10 x 200 = Rs.2000
Sonia Auto parts will allocate Rs2000 in overhead costs to the repair job
Why don't you see Overhead costs listed separately on repair tickets? Customers usually don't understand what overhead costs are, or why they are important for a business Overhead costs are generally "built in" to other costs. Sonia Auto parts will add the overhead cost to it's regular labour rate .Since overhead is allocated by labour hour, this is an easy method for a garage, or similar types of businesses Overhead costs are generally "hidden" from customers in this way, but the company must charge the customer for these costs in some way
Under/Over Absorption of overheads
We discussed in the preceding sections that direct expenses are fairly easy to trace. However, a lot of approximation is used in predicting and subsequently distributing over heads to a job. While overheads are predicted(this predicted overheads is called the budgeted overheads) and
This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page - 23 - allocated to jobs, the actual overheads incurred at the end of an accounting period may be more or less than the budgeted overheads.
When the budgeted overheads is less than the actual overheads, then there is an under absorption of overheads and when budgeted overheads is more than the actual overheads, there is over absorption of overheads.
Illustration 5
In the example discussed above, suppose Sonia Auto parts works a budgeted 3000 labour hours across several jobs including that of Johnson‘s Bakery. At the end of the accounting period, the total overheads incurred by Sonia totals Rs.32,000/- Calculate under/over absorbed overheads.
Solution
Budgeted overheads= Budgeted labour hours*over head allocation rate =3000*10=Rs.30,000/-
Actual overheads=Rs.32,000/-(given)
Since the budgeted overheads (this is also referred to as absorbed overheads in some texts) is less than the actual overheads, there is an under absorption of overheads by Rs.2000/-
Illustration 6
X ltd follows job order costing. The following are the details of jobs during the period October 2010 to March 2011.
Particulars Opening WIP Material Labor
Job 101 240000 400000 160000
Job 102 90000 300000 400000
Job 103 --- 500000 300000
Job 104 --- 220000 240000
Job 105 --- 240000 260000
Production Overheads charged to job is 50% of labor cost and administration overhead charged to jobs is 50% of material.
This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page - 24 - Administration overheads are charged after completion of job.
During March, Job 101, 102 and 105 were complete. Job no 103 and 104 were still in process. Selling price is determined after marking up 33.33% profit on Cost.
Calculate the following:
(1) Cost of completed jobs.
(2) Value of closing work in process.
(3) Under absorption/Over absorption of production overheads assuming that actual overheads incurred during the period is Rs.500000/-
(4) Selling price of Job 101,102 and 105. Solution
(1) Cost of completed jobs.
Particulars 101 102 105 Opening WIP 240000 90000 0 Material 400000 300000 240000 Labor 160000 400000 260000 Production Overheads 80000 200000 130000 Works Cost 880000 990000 630000 Administration Overheads 200000 150000 120000 Total Cost 1080000 1140000 750000
(2) Value of closing work in process.
Particulars 103 104 Opening WIP 0 0 Material 500000 220000 Labor 300000 240000 Production Overheads 150000 120000 Closing WIP 950000 580000
(3) Under absorption/Over absorption of production overheads assuming that actual overheads incurred during the period is Rs.500000/-
This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page - 25 - Budgeted Overhead:- 80000+200000+130000+150000+120000=680000 Actual Overhead:-500000. Over Absorption:- 680000-500000=180000.
(4) Selling price of Job 101,102 and 105.
Total Cost 1080000 1140000 750000
Profit 359964 379962 249975
SP 1439964 1519962 999975
PROCESS COSTING - METHOD AND TECHNIQUES
Process costing is a costing methodology that arrives at an individual product cost through the calculation of average costs for large quantities of identical products.
A process costing system is used when a business is producing a large number of identical products. In this situation, it is most efficient to accumulate costs at an aggregate level for a large batch of products, and then allocate them to the individual units produced.
Process Costing may be adopted using any of the techniques of costing. The technique adopted would decide the procedure adopted in relation to various accounting aspects. For example, for the purpose of valuation of stocks:
Fixed costs will be considered along with Variable costs, if "Absorption Costing" is adopted as the technique
Only variable costs will be considered, if "marginal costing" is adopted as the technique
This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page - 26 - Example of an area where Process Costing is applied
A common example of an industry where process costing may be applied is "Sugar Manufacturing Industry‖
The processes in this industry are: Cane Shredding
The cane is broken/ cut into small pieces to enable easier movement through the milling machine
Milling
The shredded cane is passed through rollers which crush them to extract cane juice [Similar to the cane juice extracted by the vendors who sell you sugar cane juice]
Heating and Adding lime
The extracted juice is then heated to make it a concentrate and lime is added to the heated juice Clarification
Muddy substance is removed from the concentrate through this process Evaporation
This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page - 27 - Crystallisation and Separation
Sugar crystals are grown from the dry juice concentrate in this process Spinning
Molasses are separated from sugar using Centrifugals in this process Drying
Sugar is obtained by drying the wet raw sugar obtained in the spinning process The following features may be identified with process costing:
The output consists of products which are homogenous
Production is carried on in different stages (each of which is called a process) having a continuous flow
Production takes place continuously except in cases where the plant and machinery are shut down for maintenance etc Output is uniform and all units are identical during each process It would not be possible to trace the identity of any particular lot of output to any lot of input
The input will pass through two or more processes before it takes the shape of the output The output of each process becomes the input for the next process until the final product is obtained, with the last process giving the final product
The output of a process (except the last) may also be saleable in which case the process may generate some profit
The input of a process (except the first) may be capable of being acquired from the outside sources
The output of a process is transferred to the next process generally at cost to the process It may also be transferred at market price to enable checking efficiency of operations in comparison to the market conditions
Normal and abnormal losses may arise in the processes
Illustration 7
In a factory, process cost accounts are in use for a certain period the production of the commodity was 1000 tones. Three processes, viz., A, B, C and the raw material were added in all the processes. The costs were as follows:
Particulars Process A Process B Process C
Material 3000 1500 1500
This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page - 28 -
Mfg Expenses 1500 4500 5250
Assume that there was no work in process either at the beginning or at the end. Show the process costs for each cost of the finished product. The production is 1000 tones at the end of process.
Process A A/c
Particulars Amt Particulars Amt
To material 3000 By transferred out 6000
To Labor 1500 To Mfg Expenses 1500 Total 6000 Total 6000 Process B A/C
Particulars Amt Particulars Amt
To material 1500 By transferred out 9000
To Labor 3000 To Mfg Expenses 4500 Total 9000 Total 9000 Process C A/C
Particulars Amt Particulars Amt
To material 1500 By COGS 12000 To Labor 5250 To Mfg Expenses 5250 Total 12000 Total 12000
How Process Cost is Applied in Business
If you have ever spilled milk, there is a good chance that you used Bounty paper towels to clean up the mess. Procter & Gamble (P&G) manufactures Bounty in two main processing departments—Paper making and Paper Converting. In the Paper Making Department, wood pulp is converted into paper and then spooled into 2,000 pound rolls. In the Paper Converting
This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page - 29 - Department, two of the 2,000 pound rolls of paper are simultaneously unwound into a machine that creates a two-ply paper towel that is decorated, perforated, and embossed to create texture. The large sheets of paper towels that emerge from this process are wrapped around a cylindrical cardboard core measuring eight feet in length. Once enough sheets wrap around the core, the eight foot roll is cut into individual rolls of Bounty that are sent down a conveyor to be wrapped, packed, and shipped. In this type of manufacturing environment, costs cannot be readily traced to individual rolls of Bounty; however, given the homogeneous nature of the product, the total costs incurred in the Paper Making Department can be spread uniformly across its output of 2,000 pound rolls of paper. Similarly, the total costs incurred in the Paper Converting Department (including the cost of the 2,000 pound rolls that are transferred in from the Paper Making Department) can be spread uniformly across the number of cases of Bounty produced. P&G uses a similar costing approach for many of its products such as Tide, Crest toothpaste, and Pringles
Joint products and By-products
When a production process yields two or more products simultaneously out of common raw material, the output products are termed as joint products.
The joint products which arise out of common raw material may have wanted or unwanted value. Those which have insignificant value are termed as by-product. By- products are secondary products. For example, from crude oil, we get petrol and diesel which has high significant value and therefore known as joint products. At the same time we also get some lubricant which is unwanted, so it is termed as by-product.
CIMA(Chartered Institute of Management Accountants) defines joint product as ‗two or more product separated in processing each having a sufficiently high sale value to merit recognition as a main product‖ and by product as ―output of some value produce incidentally in manufacturing something else (main product)‖.
Some examples of Joints products are as follows:
1. Oil refining: Petrol, Diesel, Liquid Petroleum Gas, Kerosene, Paraffin, Lubricants 2. Meat Processing: Meat, Hides, Bones, Grease.
3. Mining: Iron, copper, Silver.
4. Sheep Rearing: Meat, Wool, Hides. Some examples of By- products are as follows:
1. Sugar manufacture: Molasses used for industrial alcohol
2. Iron and Steel manufacture: Furnace slag used in construction activities 3. Meat trade: Bones, Grease
This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page - 30 - Joint product costing- Joint product is defined as a costing of a production process that yields multiple products simultaneously.
By-products costing- By product costing is defined as, costing of products in the joint production process with low sales value. The costing is done at the time of production or at the time of sales.
Common costs: These costs cannot be identified with a particular joint product. By definition, joint products incur common costs until they reach the split-off point.
Split-off point: At this stage, the joint products acquire separate identities. Costs incurred prior to this point are common costs, and any costs incurred after this point are separable costs.
Separable costs: These costs can be identified with a particular joint product. These costs are incurred for a specific product, after the split-off point.
At or beyond the split off point, decisions relating to the sale or further processing of each identifiable product can be made independently of decisions about the other products. The characteristic feature of joint products is that all costs incurred prior to the split-off point are common costs, and cannot be identified with individual products that are derived at split-off.Distinction among main products, joint products and byproducts are not so definite in practice. For example some companies may classify kerosene obtained when refining crude oil as a byproduct because they believe kerosene has a low total sales value relative to the total sales values of gasoline and other products. Other companies may consider the vice versa. Moreover the classification of products can change over time depending on the price of the product in that year.
Illustration 8
Work out the estimated pre separation cost per ton of by - products Y & Z from the following data:
Costs of manufacturer before separation: 25, 60,000.
Main product is X. There are two by-products Y & Z whose normal selling price is as follows: Sales price of Y: 500 per ton
Sales price of Z: 800 per ton
Selling and distribution expenses have been estimated to be 25% of SP and the net profit is expected to be 10% of SP.
This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page - 31 - Costs to manufacture each ton after separation from the main product are :
95 (Y) and 145 (Z).
Assume equal weight for Y and Z Solution:
Particulars Product Y Product Z
Selling Price 500 800
Less: Selling and Distribution Exps (25% of SP) 125 200
375 600
Less: Net profit(10% of SP) 50 80
325 520
Less: Post separation cost 95 145
Pre Separation Cost 230 375
Illustration 9
Two products P & Q are obtained in a crude form and require further processing at a cost of Rs.5 for P and Rs. 4 for Q unit before sale. Assuming a net margin of 25% on cost, their sales are fixed @ Rs.13.75 and Rs.8.75 per unit respectively. During the process, joint cost incurred was Rs. 88,000 and the outputs were:
P- 8,000 units, Q-6,000 units. Ascertain the joint cost per unit
Product Q Product P
This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page - 32 -
Selling Price 13.75 8.75
Less: Profit(25% on cost, ie.20% on SP) 2.75 1.75
Cost of Sales 11.00 7.00
Less:Further processing cost after separation 5.00 4.00
Pre Separation Cost 6.00 3.00
Share of Joint Cost(8:3)* 64,000 84,000
Joint Cost per unit 8.00 4.00
*Ratio in Apportioning Joint Costs: P = 8,000 units * 6 = 48,000 Q = 6,000 units * 3 = 18,000 Therefore, 48,000:18,000 = 8:3
This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page - 33 - 6. Activity Based Costing
Activity Based Costing (ABC) is a system that Assigns Overhead cost to the activities performed in a manufacturing or Services delivery process. –Leslie G.Eldenburg (2005) ABC is a costing that first assigns cost to activities and then to goods and services
based on how much each goods and service uses the activity. – Ronald W.Hilton, Michael W.Maher and Frank H Selto (2006)
We have already seen in the foregoing discussions in Job and Process Costing that traditional costing methods use a single base(Labour hours that we had seen in the job costing example) or at most, a combination of two bases of cost.
However, Activity based Costing is based on the principle that a single absorption base cannot justifiably reflect the behaviour of overhead costs.
Overhead costs are not always directly relatable to time or production volume. In a modern manufacturing environment, overheads are more dependent on the complexity of the production. An ABC approach attempts to ensure that overheads are traced to products in a way that more accurately reflects the overhead costs that have been incurred on their behalf. According to Ray H Garrison and Eric W Noreen, there are six basic steps required to implement an ABC system:
Identify and define activities and activity pools
Directly trace costs to activities (to the extent feasible) Assign costs to activity cost pools
Calculate activity rates
Assign costs to cost objects using the activity rates and activity measures previously determined
Prepare and distribute management reports
This analysis of overhead costs into activities and their absorption using a variety of cost drivers is believed to produce more accurate results in allocating overheads to product cost.
Activity based costing focuses on activities and costs are allocated to activities using resource drivers. Resource drivers show the cause of costs and are used to allocate costs to activities. Cost is allocated depending on how much of the resource driver is used in the activity. It increases awareness of cause and effect relationships and promotes performance improvement. It also helps to identify non-value added activities and motivates cost reduction.
This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page - 34 - .Illustration 1
XYZ Company is considering Activity based costing to allocate Overheads. Following information is given for the production of two products A and B.
Activity Cost
Set-up 200000
Machine maintenance 90000
Total Manufacturing Cost 290000
Product A B Total
Number of setups 40 60 100
Machine Hours 1500 3500 5000
XYZ Company plans to produce 350 units of product A and 250 units of product B. Compute the manufacturing cost for each product.
Solution
First, we will identify the activities performed by the company and assigning cost to each activity then choosing the cost driver for calculating the allocation rate.
After calculating the allocation rate we can allocate the coat to product.
In above case company performs two activities i.e. Setup and maintenance of machine. Now, we will calculate Allocation rate for each activity
1. Setup Cost:
Total Cost /Total No.of Setups = 2, 00,000 = Rs 2000 per setup 100
2. Machine Maintenance:
Total Machine Maintenance cost/ Total Machine Hour = 90000 / 5000 hrs = Rs 18 per hour
This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page - 35 - Since, we have calculated the Allocation Rate; next step is to allocation of cost to each product, Following table shows the allocation of cost.
Activity Product A Product B
Setup No.of Setup *cost per
Setup
40*2000 = 80,000 60*2000 = 1,20,000
Machine Maintenance Machine Hour*Cost per Hour
1500*18 = 27000 3500*18 =63000
Total Cost Rs 107000 Rs 183000
Number of units 300 250
Unit cost Rs.306/- Rs.732/-
This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page - 36 - 7. Activity Based Management
Activity-based management and activity-based costing (ABM/ABC) have brought about radical change in cost management systems. ABM has grown largely out of the work of the Texas-based Consortium for Advanced Manufacturing-International (CAM-I). No longer is ABM‘s applicability limited to manufacturing organisations. The principles and philosophies of activity-based thinking apply equally to service companies, government agencies and process industries.
The acronym itself has evolved from ABC to ABCM (activity-based cost management) to ABM, and the application of ABC evolved from a manufacturing product costing orientation to a management philosophy of activity management applied in industries and organisations other than manufacturing. Activity-based costing and activity-based management have been around for more than fifteen years. Most forward-thinking companies have implemented them, or are in the process of doing so.
ABM draws on ABC to provide management reporting and decision making. ABM supports business excellence by providing information to facilitate long-term strategic decisions about such things as product mix and sourcing. It allows product designers to understand the impact of different designs on cost and flexibility and then to modify their designs accordingly. ABM also supports the quest for continuous improvement by allowing management to gain new insights into activity performance by focusing attention on the sources of demand for activities and by permitting management to create behavioural incentives to improve one or more aspects of the business.
ABM is a fundamental shift in emphasis from traditional costing and performance measurement. People undertake activities which consume
resources – so controlling activities allows you to control costs at their source.
The real value and power of ABM comes from the knowledge and information that leads to better decisions and the leverage it provides to measure improvement.mABM enables management to make informed
decisions on the following: Lines of business, product mix,
process and product design, what services should be offered, capital investments, and
This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page - 37 - pricing.
ABM is more than an accounting tool; it's a system for continuous improvements. It is not a single answer but merely one of the many tools that can be used to enhance organisational performance management.
ABM will not reduce costs, it will only help you understand costs better to know what to correct.The process of ABM does consume resources, and the manpower costs can be significant. Companies considering or already implementing ABM should realise that although certain product or market factors might make it potentially beneficial, those same factors might not lead to a successful implementation. ABM gives us a much better chance of establishing a useful costing for outputs. But there is a price to pay. It can be difficult to find out what costs apply in a particular activity, and those involved may be suspicious of others charged with finding out. Some areas of activity overlap and are difficult to separate. And, of course, ABM is a costly exercise in its own right. Other priorities, top management commitment, IT capabilities, and integration with financial and budgeting systems should be considered before implementation.
Organisations have begun to look at ABM for a variety of reasons. Among the most commonly cited are:
— top-down pressure to reduce costs; — competitive pressure/market conditions; — organisation-wide programme;
— the introduction of benchmarking; — regulatory issues;
— seeking world-class status through process management.
ABC and ABM are a continuum of value. ABM is the application of ABC data to manage product portfolios and business processes better.
Reading: Activity Based Costing and Capacity By Robert.S.Kaplan Case Wilkerson Co (HBS/9-101-092)
This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page - 38 - 8. MARGINAL COSTING AND DECISION ANALYSIS
Some important definitions:
Relevant cost:
Cost that can be avoided if a decision is not implemented is called relevant cost Sunk Cost:
Costs that cannot be reversed or do not alter irrespective of any future decision Opportunity cost:
Cost of the opportunity foregone in order to select a decision option This presupposes two important factors- pre existence of an opportunity, and a reasonable possibility of accessing it Contribution:
Contribution margin is the amount remaining from sales revenue after variable expenses have been deducted. Thus it is the amount available to cover fixed expenses and then to provide profits for the period.
Contribution Margin Ratio (CM Ratio):
The contribution margin as a percentage of total sales is referred to as contribution margin ratio (CM Ratio). Contribution margin ratio can be used in cost-volume profit calculations.
Objectives of CVP Analysis:
Cost volume profit analysis (CVP analysis) is one of the most powerful tools that managers have at their command. It helps them understand the interrelationship between cost, volume, and profit in an organisation by focusing on interactions among the following five elements:
1. Prices of products
2. Volume or level of activity 3. Per unit variable cost 4. Total fixed cost 5. Mix of product sold
Because cost-volume-profit (CVP) analysis helps managers understand the interrelationships among cost, volume, and profit it is a vital tool in many business decisions. These decisions include, for example, what products to manufacture or sell, what pricing policy to follow, what marketing strategy to employ, and what type of productive facilities to acquire.
This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page - 39 - Applications of Cost Volume Profit (CVP) Concepts:
Now we can explain how CVP concepts developed on above pages can be used in planning and decision making. We shall use these concepts to show how changes in variable costs, fixed costs, sales price, and sales volume effect contribution margin and profitability of companies in a variety of situations.
Change in fixed cost and sales volume
Change in variable cost and sales volume
Change in fixed cost, sales price and sales volume
Change in variable cost, fixed cost, and sales volume
Change in regular sales price Importance of Contribution Margin:
CVP analysis can be used to help find the most profitable combination of variable costs, fixed costs, selling price, and sales volume. Profits can sometimes be improved by reducing the contribution margin if fixed costs can be reduced by a greater amount.
Break Even Analysis:
Break even is the level of sales at which the profit is zero. Cost volume profit analysis is some time referred to simply as break even analysis. This is unfortunate because break even analysis is only one element of cost volume profit analysis. Break even analysis is designed to answer questions such as "How far sales could drop before the company begins to lose money."
Cost Volume Profit (CVP) Consideration in Choosing a Cost Structure:
Cost structure refers to the relative proportion of fixed and variable costs in an organization. An organization often has some latitude in trading off between these two types of costs. For example, fixed investment in automated equipment can reduce variable labor costs. The purpose of management is to reduce the cost by choosing a blend of fixed and variable cost that maximizes the ultimate objective i.e.; profit.
Some illustrations on CVP analysis:
Make or Buy:
Illustration 1
Suppose Division A in Priyanka Products had a capacity to produce 1000 units a month and the break up of cost is as follows:
This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page - 40 - Particulars Amount Material cost 100 Labour 75 Variable overheads 25 Sales commission 5 Fixed overhead 20 Total 225
Division B wanted 400 units from Division A. Division A has the capability to produce these additional units without incurring additional fixed costs. Division A quotes Rs.250/- per unit and Division B has an offer from the market to buy these units @ 240 per unit. Should Priyanka decide to stop producing these products in house?
Solution
Cost of producing one unit(marginal cost)=100+75+25=200/- Cost of purchasing one unit=Rs.240/-
It is advisable to continue producing the products in house Shut Down or Continue:
Illustration 2
Rahul Enterprises is operating under difficult market conditions and are incurring monthly unavoidable costs of Rs.40,000/- Their contribution is showing the following trend:
January 60,000/-
February 50,000/-
March 55,000/-
April 45,000/-
Considering the volatile trend Rahul decides that it is better to suspend operations. Advise him. Solution
The unavoidable cost will continue to be incurred even after suspending operations
However, the contribution will not be earned if operations are suspended. Hence operations should be continued till contribution becomes zero.
This material is prepared by Prof.K.S.Ranjani for PGP/RAK MAC-II at IIM Indore Page - 41 - Illustration 3
Product mix decisions with capacity constraints
The following costs and other data apply to two component parts used by Bajaj Electricals limited.
Particulars Part X Part Y
Direct material 0.80 16.00
Direct labour 2.00 9.40
Overheads 8.00 4.00
Unit cost 10.80 29.40
Units needed per year 6,000 8,000
Machine hours per unit 2 1
Unit cost, if purchased 10 30
The company hitherto has been manufacturing all required components. However, in the current year, only 14,000 hours of otherwise idle machine time can be devoted to the production of component. Accordingly some of the parts must be purchased from outside suppliers. In producing parts, overheads are applied at Rs.4 per machine hour. Fixed capacity costs, which will not be affected by any make or buy decision represent 70% of the applied overhead.
Required:
1. Assuming that 14,000 hours of available machine time is to be scheduled so that the company realizes maximum potential cost savings, determine the relevant production costs that should be considered in the decision to schedule machine time.
2. Compute the number of units that Bajaj Electricals should produce if it allocates machine time on the basis of the potential cost savings per machine hour.
Solution
Whenever there is a limiting factor or capacity constraint, product mix should be decided so as to maximise the profits.
