Cost & Management Accounting
The budgeting side of accounting
What are variable costs?
Cost that varies directly proportional with the level of output
Examples are cost per unit such as labour per unit
What are fixed costs?
Fixed costs are cost that remain constant for all levels of output for a specific range
Examples are rent and insurance and they are called period costs as they remain constant with in an agreed period
The reason why I say specific range is that it is not really realistic for fixed cost to be constant for all levels of output. If you consider for all levels of output then it becomes a stepped cost
What are Stepped Costs?
These are cost that increase as the capacity of the business increases. It remain fixed with in a relevant range of capacity and increases as it exceeds a particular capacity. Ex Salary of Quality Workers
What is fixed cost per unit and variable cost per unit
This is very self explainatory as it is the cost dividing over the number of units. It is really simple. Think about it! Fixed cost remains constant with in a range so when we increase the number of units then the fixed cost per unit decreases. This is called economic of scale
However, for variable cost per unit it must remain constant
In fact these are some of the limitations in break even analysis
What is sunk cost?
They are cost that have already occured in the past and is not relevant for future decision
Examples are last years rent
Uses of Marginal Costing
1. To determine the break even of a product
2. For make and buy decisions
3. Limiting factor decisions
4. To determine whether to discountinue or close a department or product if negative contribution
5. To accept or reject orders below normal price
6. To accept orders if spare capacity
7. For sensitivity analysis
6. To identify the turnover required to make a target profit
Advantages of Marginal Costing
1. Useful for short term decisions as fixed cost do not change and only considers variable cost
2. Good for special orders prices to be set accurately
3. Allows comparsions between make and buy
4. More easier to calculate, except dividing the cost to fixed and variable
5. Less time Consuming to Calculate as there is no adjustments for under or over absorption
Disadvantages of Marginal Costing
1. Not useful for long term decisions as fixed cost change
2. Not realistic for financial statements, as it understates the value of inventory
3. Harder to divide the cost to fixed and variable and more time consuming
This could be reasons for keeping or not using Marginal Costing
What is a Cost Centre?
A cost centre is a department with in the business in which cost can be apportioned or allocated to
What is a Cost unit?
A unit of production
What is allocation?
These are cost that can be clearly identified with a cost centre and the total amount is charged directly to it
Examples are direct materials and labour
What are Overheads?
Overheads are cost that can not be traced to a specific department or product so it is an indirect cost
What is apportionment?
The Cost that are not clearly identified with a specific cost centre and must be charged on an appropriate basis such as floor area
What is Absorption?
The process of charging the total allocated or apportioned fixed costs to the production units
A point to remember is that cost must be either allocated or apportioned no matter what
Cause for Over Absorption & Under Absorption of Overheads:
1. When the Actual Activity ( be specific ) is greater than the budgeted activity
2. When the Actual overhead is less than the budgeted overheads
1. When the Actual Overheads is greater than the budgeted
2. When the Budgeted Activity is less than Actual
The easiest way to remember is to use the formula. When the result is positive then it is over absorption...Vice versa
Under or Over Absorption = ( Overhead Absorption rate * Actual Activity ) - Actual Overheads
What is Overhead absorption rate?
Overhead attributed per machine or labour hour
Why are budgeted figures used to calculate the overhead absorption rate?
The actual values are not available and so the cost must be known in advance to determine the selling price so the overheads are fully recovered
How Under or Over Absorption of Overheads Affect Profit
1. Increases cost charged from the customer so profits increase
2. Due to increase selling price it could lead to lower in demand and less profits
1. Insufficient overheads charged by customers so reduction in profits
2. Decrease in selling price can cause an increase in demand and profits
Departmental vs Factory Wide Overhead absorption rates
Factory wide rate means the total cost of a business over the activity whereas the departmental rate is overhead per activity for each department
1. Easier and cheaper to calculate
2. Less accurate
1. More Accurate
2. Different products may spend different times in each department
3. Different products may require different amounts of labour or machine hours
How are direct cost charged to each department?
Direct costs are allocated to the department as they are directly attributed to the production units
Basis used for Apportionment
| Cost Pool | Basis |
|---|---|
| Insurance | Floor Area |
| Rent | Floor Area |
| Depreciation | Cost of an asset |
| Power or Electricity | Kilowatt |
| Heating & Lighting | See below |
| Maintainance Cost | Machine Hours |
| Supervisor's Salaries | Number of Workers |
| Canteen Cost | Number of Workers |
For Heating & Lighting it changes, if they have only given kilowatt then use that. If they have given only floor area then use that. If both are there use kilowatt
What is Job Costing?
A costing method used for single unique order that is made according to the customers preference
1. Single orders
2. Unique and made according to the customer's preference
3. Has a relative high Cost
4. Not available for stock
5. A quotation is charged for every customer on an hourly basis
Examples are tailoring, architecture or other single unique orders
What is Batch Costing?
A costing method applied to the production of identical items. The cost per unit is found by dividing the total cost of the batch by the number of units in the batch
A batch order is actually a special type of job costing or it could be a mix of both. For example, a business might have asked to make a large quotation on 100 products
Uses of Absorption Costing
1. Helps to set selling prices
2. Useful for long term decisions as fixed cost change
3. Realistic and acceptable in financial statements
Disadvantages of Absorption Cositing
1. Subjective as the basis used for apportionment are arbitary
2. Harder to calculate and managers may require training
3. Very time consuming especially when adjusting over and under absorption or overheads
4. If there is an increase in inventory, it can cause profits to be overstated
5. Not useful for short term decision as fixed cost do not change
Why profits calculated will be different for Absorption & Marginal Costing?
1. In Absorption costing, fixed cost are treated as production cost, where as in marginal costing they are treated as period cost
2. In Absorption cost, both variable and fixed cost are included in the inventory valuation whereas, marginal only includes variable
3. In Absorption Cost, only part of the fixed cost are charged against sale volume and the rest is carried to the next year where as in marginal costing the complete fixed cost is charged for the year
The only conditions when the profit of both methods are the same are when the production is equal to the sold units because there is no change in inventory
Should you accept orders below the normal selling price?
Yes, if the product has positive contribution as it will give additional profit if there is spare capacity
1. No, Because if the existing customers find out about the new selling prices they will not be satisfied and request for that selling price
2. This will lead to a reduction in profit
3. It may result overheads not being completely absorbed
Factors to Consider when changing Suppliers
1. Will the new supplier maintain the same price?
2. Will the new supplier allow the same credit systems?
3. Will the quality of products be acceptable?
4. Will the new supplier give the same trade discounts?
5. Is the new supplier realiable
What is Break Even Point?
The level of activity which the business makes neither a profit nor a loss. The total cost is equal to the ttotal revenue of the activity
What is Margin of Safety?
The difference between the predicted output and the break even point. It shows the activity the business can lose before a loss is made. This measure risk
1. This measures risk
2. Measures tha activity that can fall before a loss is made
3. It Shows the ability to withstand harsh trading conditions
What is Contribution?
The amount which each unit makes towards covering up the fixed cost and earning a profit. it is difference between the selling price and the total variable cost per unit
What is C/S Ratio?
The Contribution Earned for every 1$ for revenue earned
Advantages of Break Even Analysis & Graphs
1. Allows to determine the margin of safety and angle of incidence
2. Determines the number of units to be produced before a loss is made
3. Breaks cost in to variable and fixed
4. Forecasts profit and loss at different levels of output
Disadvantages of Break Even Analysis
1. Assumes fixed cost remains constant within a relevant range
2. Revenue and Cost are linear
3. Only applies for a single product or sale mix
4. Assumes variable cost per unit remains constant
5. Assumes total units produced are sold
6. Assumes cost can be easily broken down to variable and fixed cost
7. Only applies for a short and relevant period
8. Assumes selling price per unit remains constant for all levels of output
9. Can be time consuming to prepare charts and graphs
What is the purpose of cost-volume-profit analysis?
To forcast the changes in profit and revenue with the changes of cost and volume
Disadvantages of cost-volume-profit analysis?
Same as break even analysis
Advantages of Cost-volume-profit Analysis
1. Useful for planning
2. Provides Quick Estimates
3. Changes in cost can be easily coporated
4. Forecasts profit at various levels of output
5. Identifies break even point
6. Useful for making short term decisions. Example: spare capacity and special orders
What is budgetary control?
Controlling of the use of resources using budgets to achieve an overall objective
What are budgets?
A plan expressed in financial terms
Advantages of Budgetary Control
1. Aids Coordination and Communication between Employees
2. May motivate staff and managers by reaching the targets and the reward
3. Allow delegation to staff
4. Assist in decision making
5. Measures performance
6. Control and planning by comparing budgets with actual and finding variances
Disadvantages of Budgetary Control
1. Very time consuming and costly // may require a specialist staff to be employed
2. Budgets are estimates thus inaccurate
3. Can cause conflicts between departments
4. Can demotivate staff
5. Can restrict staff innovation
6. Budgets could be unrealistic and not look at the unforseeable circumstances..Ex: Recession