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MBA: MANAGERIAL MBA: MANAGERIAL ACCOUNTING ACCOUNTING

Lecture 7 & 8Lecture 7 & 8

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Objectives of Lecture 1:Objectives of Lecture 1:

Define Managerial AccountingDefine Managerial AccountingGeneral Costs ClassificationsGeneral Costs ClassificationsCosts Classifications on Financial Costs Classifications on Financial StatementsStatementsThe importance of Cost ClassificationsThe importance of Cost Classifications

··for predicting behaviorfor predicting behavior

··forfor allocating costs to ‘cost objects’ allocating costs to ‘cost objects’

··forfor decision Making decision Making

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The Role of Managers and the vital The Role of Managers and the vital support of Managerial Accounting support of Managerial Accounting

to this roleto this role• Managers manage the company on behalf of Managers manage the company on behalf of

the owners and act for the best of owners’ the owners and act for the best of owners’ interestsinterests

ROLE:ROLE: Planning & Deciding: Planning & Deciding: setting goals and define - setting goals and define -

identify techniques to realize the specific identify techniques to realize the specific objectivesobjectives

Direct & Motivate employees:Direct & Motivate employees: supervision and supervision and treatment of personneltreatment of personnel

Controlling company systems and procedures: Controlling company systems and procedures: operation ofoperation of departments, advertising and departments, advertising and marketing, customer satisfaction, accounts marketing, customer satisfaction, accounts payables and receivables, dealing with risks payables and receivables, dealing with risks changes, challenges e.t.c changes, challenges e.t.c

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Managerial AccountingManagerial Accounting also called also called Cost Cost AccountingAccounting is the procedure of is the procedure of identifying, measuring, analyzing and identifying, measuring, analyzing and providing information for the pursuit of providing information for the pursuit of an organization's goals. .an organization's goals. .

Managerial Accounting, in contrast to Financial Accounting, is aimed to help managers inside the organization to take decisions with the information it provides. . Financial Accounting is aimed to provide information to parties outside the organization e.g. Stockholders, Banks, Creditors, Government e.t.c   

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Compared to financial accounting, managerial accounting is a young regulation. As a result, managerial accounting concepts and tools are still developing as new ways are found to provide information that assists management. Moreover, the business environment is changing rapidly. For managerial accounting to be as useful a tool in the future as it has been in the recent past, managerial accounting information must be adapted to reflect those changes. Several changes in the business environment that are especially relevant to managerial accounting are discussed briefly here. The effect of these changes on various topics in managerial accounting will be explored in subsequent lectures.

Objectives of Managerial Objectives of Managerial Accounting Accounting

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A. Providing information for decision making and planning: Practically all major decisions by internal users (i.e., managers) rely largely on managerial accounting information.

Type of data: This information includes financial and nonfinancial data to help managers with strategic planning and decision-making (e.g., the cost of products, budgets, cash flows, amount of materials used and inventories).

B.B. Assisting in directing and controlling: Directing and Assisting in directing and controlling: Directing and controlling day-to-day operations requires a variety of controlling day-to-day operations requires a variety of data about the process of providing a good or servicedata about the process of providing a good or service. .

Directing operational activities: Directing operational activities: The The management team needs data about the cost of management team needs data about the cost of providing goods or services in order to set fees providing goods or services in order to set fees and prices. and prices.

Controlling operations: Controlling operations: Management Management compares actual costs incurred with those compares actual costs incurred with those specified in the budget (specified in the budget (e.g.e.g., analyzing and , analyzing and comparing actual performance to budget plans). comparing actual performance to budget plans).

Attention-directing functions: Attention-directing functions: The attention-The attention-directing function of managerial accounting directing function of managerial accounting information directs managers’ attention to issues information directs managers’ attention to issues that need their attention (that need their attention (i.e.i.e., it highlights , it highlights successful or problem areas). successful or problem areas).

No solutions, only information: Managerial accounting reports No solutions, only information: Managerial accounting reports rarely solve a decision problem, however, these reports often rarely solve a decision problem, however, these reports often direct managers’ attention to an issue that requires their direct managers’ attention to an issue that requires their skills. skills.

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C.C. Motivating managers and employeesMotivating managers and employees: A key : A key purpose of managerial accounting is to motivate purpose of managerial accounting is to motivate managers and other employees to direct their efforts managers and other employees to direct their efforts toward achieving the organization’s goals. This toward achieving the organization’s goals. This motivates managers to achieve the organization’s motivates managers to achieve the organization’s goals by communicating the plans, providing a goals by communicating the plans, providing a measurement of how well the plan was achieved, measurement of how well the plan was achieved, and offering on time an explanation of differences and offering on time an explanation of differences from the plan. from the plan.

1. Budgeting1. Budgeting: : One means of achieving goals is One means of achieving goals is through budgeting. The budget indicates the top through budgeting. The budget indicates the top management’s desire to allocate resources and management’s desire to allocate resources and emphasize certain activities. emphasize certain activities.

Explain deviations-differencesExplain deviations-differences: When actual : When actual operations do not match to the budget, managers will operations do not match to the budget, managers will be asked to explain the reasons for the deviation. This be asked to explain the reasons for the deviation. This creates both an incentive to follow the principles of the creates both an incentive to follow the principles of the budget and avoid possible negative consequences. budget and avoid possible negative consequences.

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2.2. Empowerment (authorization)Empowerment (authorization): : Another way to Another way to motivate employees to assist in achieving the motivate employees to assist in achieving the organization’s goals is through empowerment. organization’s goals is through empowerment. Employee Employee empowerment –give permission to act -empowerment –give permission to act - is the concept of encouraging and authorizing is the concept of encouraging and authorizing workers to take the initiative to improve operations, workers to take the initiative to improve operations, product quality, customer service and reduce costs. product quality, customer service and reduce costs.

3.3. Measuring performance: Measuring performance: Another way of motivating Another way of motivating employees’ toward the organization’s goals is to employees’ toward the organization’s goals is to measure their performance in achieving their goals. measure their performance in achieving their goals. Managerial accounting measures performance for Managerial accounting measures performance for both the entire organization, as in financial both the entire organization, as in financial accounting, but also for many subunits as well (accounting, but also for many subunits as well (e.g.e.g., , divisions, departments, managers). divisions, departments, managers).

Rewarding performance:Rewarding performance: Many large corporations Many large corporations compensate their executives, in part, on the basis of compensate their executives, in part, on the basis of the profit achieved by the subunits they managethe profit achieved by the subunits they manage..

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4.4. Assessing the organization's competitive Assessing the organization's competitive position: position: A crucial role of managerial accounting A crucial role of managerial accounting is to continually assess how an organization is to continually assess how an organization compares with the competition, with an eye compares with the competition, with an eye toward continuously improving. toward continuously improving.

Evaluation:Evaluation: This allows the firm to evaluate its This allows the firm to evaluate its financial and internal performance, customer financial and internal performance, customer satisfaction, and innovation compared to other satisfaction, and innovation compared to other similar firms. similar firms.

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Major Themes of Managerial Major Themes of Managerial AccountingAccounting

A.A. Information and incentivesInformation and incentives: The need for : The need for information is the driving force behind managerial information is the driving force behind managerial accounting. accounting.

Two functionsTwo functions: Managerial accounting : Managerial accounting information serves two functions: a information serves two functions: a decision-decision-facilitatingfacilitating function and a function and a decision-influencingdecision-influencing function. function.

Information is usually supplied to a manager who is the Information is usually supplied to a manager who is the decision-maker to assist him/her in choosing an decision-maker to assist him/her in choosing an alternative. Often that information is also intended to alternative. Often that information is also intended to influence the manager’s decision. It should be noted, influence the manager’s decision. It should be noted, however, that the managerial accounting information however, that the managerial accounting information only facilitates and influences decisions, it does not only facilitates and influences decisions, it does not make final decisions for managers.make final decisions for managers.

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B.B. Behavioural issues: Behavioural issues: The reactions of both The reactions of both individuals and groups to managerial accounting individuals and groups to managerial accounting information will significantly affect the course of information will significantly affect the course of events in an organization. Everyone has behavioural events in an organization. Everyone has behavioural tendencies and intelligence - understanding tendencies and intelligence - understanding limitations that affect their use of information. The limitations that affect their use of information. The better a managerial accountant’s understanding of better a managerial accountant’s understanding of human behaviour is, the more effective he or she human behaviour is, the more effective he or she will be as a provider of information. will be as a provider of information.

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C.C. Costs and benefits: The attractiveness of any Costs and benefits: The attractiveness of any particular managerial accounting technique or particular managerial accounting technique or information must be determined in light of its information must be determined in light of its costs and benefits. costs and benefits.

Costs: Costs: The cost of providing managerial accounting The cost of providing managerial accounting information includes the cost of compensation for the information includes the cost of compensation for the controller and Accounting Department personnel, the controller and Accounting Department personnel, the cost of purchasing and operating computers, and the cost of purchasing and operating computers, and the costs of the time spent by the information users to costs of the time spent by the information users to read, understand, and make use of information. read, understand, and make use of information.

Benefits: Benefits: The benefits include improved decisions, The benefits include improved decisions, more effective planning, greater efficiency of more effective planning, greater efficiency of operations at lower costs, and better directions and operations at lower costs, and better directions and control of operations. control of operations.

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General Cost ClassificationsGeneral Cost Classifications Business that produce-manufacture Business that produce-manufacture

goods have the Following main goods have the Following main 3 cost 3 cost categoriescategories which are included in the which are included in the Manufacturing AccountManufacturing Account and are called and are called Manufacturing CostsManufacturing Costs::

Direct MaterialsDirect Materials Direct LabourDirect Labour Manufacturing OverheadsManufacturing Overheads

The Manufacturing Account precedes the Trading The Manufacturing Account precedes the Trading Account when a manufacturing company prepares Account when a manufacturing company prepares the financial statements. Conversely a merchandise the financial statements. Conversely a merchandise - Retail company prepares directly the Trading - Retail company prepares directly the Trading AccountAccount..

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Direct MaterialsDirect Materials divided to divided to Direct Raw Materials:Direct Raw Materials:

basic material from which a product isbasic material from which a product is mademade,, and and Indirect Materials: Indirect Materials: any material that is not part of any material that is not part of the finished product and are treated as the finished product and are treated as manufacturing overheads. manufacturing overheads.

Direct Labour Direct Labour divided to divided to Direct workers Direct workers (touch (touch labour) who are directly involved with the labour) who are directly involved with the manufacture of goods and manufacture of goods and Indirect labour Indirect labour where where employees are not touching the product such as employees are not touching the product such as supervisors, security, cleaners, driver. Also treated supervisors, security, cleaners, driver. Also treated as manufacturing overheads.as manufacturing overheads.

Manufacturing OverheadsManufacturing Overheads that that is every cost which is every cost which is is notnot direct material or direct labour e.g: direct material or direct labour e.g:

Indirect LabourIndirect Labour Indirect Materials, Indirect Materials, for instance materials that repair machinesfor instance materials that repair machines

Electricity: heating and lightingElectricity: heating and lighting Depreciation & Insurance for manufacturing Depreciation & Insurance for manufacturing

equipmentequipment

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Prime Cost of ProductionPrime Cost of Production = =

Direct Raw Material+Direct Labour+Direct ExpensesDirect Raw Material+Direct Labour+Direct Expenses

Direct Expenses examples:Direct Expenses examples: **Royalties: Royalties: right to manufacture a productright to manufacture a product

**Subcontractors Subcontractors payments or outwork e.g. another payments or outwork e.g. another company or individuals not employed by thecompany or individuals not employed by the

company are paid for doing work on a productcompany are paid for doing work on a product

Conversion CostConversion Cost = = Sum of direct Labour costs + Manufacturing OverheadsSum of direct Labour costs + Manufacturing Overheads

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HOW WE CALCULATE THE COST OF RAW MATERIALS?HOW WE CALCULATE THE COST OF RAW MATERIALS?

Example1:Example1: The below is a Trial B/ce extract from The below is a Trial B/ce extract from G.X.N.E Manufacturing Ltd as at 31G.X.N.E Manufacturing Ltd as at 31stst May Y12. May Y12.

DR CR

Stock of Raw M. as at 1st May Y12 71.000

Raw Materials Returned 1.350

Purchases Raw Materials 138.000

Carriage Inwards (=costs to transfer R.M in the company) 6.200

Note : The stock of Raw Materials as at 31st May Y12 was € 65000

Required: Extract of the Manufacturing A/cRequired: Extract of the Manufacturing A/c

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DR Manufacturing account CR

           

Opening stock R/M 71.000Purchases of R.M Returned 1.350

Add: Purchases R/M 138.000 Closing Stock 65.000

Add: Carriage Inwards 6.200 Cost of R/M used c/d 148.850

215.200 215.200

Cost of R/M used b/d 148.850Trading Account- Transfer 148.850

€€ €€

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……continue of example 1:continue of example 1:Also the Trial B/ce includes: Also the Trial B/ce includes:

DR CR• Accrued Direct Wages on 1st May Y12 73,200 (wages of last week of AprilY12 not paid yet) • Direct wages paid 372,400

Note: Direct Wages accrued as at 31st May Y12 €68,300

Required : Continue the Manufacturing A/c.

Reminder: Only the Direct Wages that concerns the period ofproduction that we study are DEBITED to the Manufacturing a/c.The Accrued Direct Wages are credited or deducted at the debit Site.

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DR Manufacturing account CR

           

Opening stock R/M 71.000 Return Outwards 1.350

Purchases R/M 138.000 Closing Stock 65.000

Carriage Inwards 6.200 Cost of R/M used c/d 148.85

215.200 215.20

Cost of R/M used b/d 148.850 Accrued Dir wages of 1 May Y12 73.200

Direct Wages paid 372.400

Add: Direct Wages Acrued 68.300 Prime Cost of Production c/d 516.35

 

589.550 589550

Prime Cost of Production b/d 516.350 Trading Account - Transfer 516.35

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To Manufacturing a/c only goes the Production-To Manufacturing a/c only goes the Production-Manufacturing Overheads not Manufacturing Overheads not other overheadsother overheads such such as:as:

Selling expensesSelling expenses Administrative expensesAdministrative expenses Distribution expensesDistribution expenses Research & DevelopmentResearch & Development

expensesexpenses Financial Expenses Financial Expenses

(interests, bank Charges)(interests, bank Charges)

Non-ManufacturingNon-Manufacturing expsexps

also called also called Period Period expsexps

and goes to trading and goes to trading a/ca/c

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Two minor categories:Two minor categories:

Selling exps Selling exps are the costs incurred so as the final are the costs incurred so as the final product goes to the customer e.g. advertising , product goes to the customer e.g. advertising , shipping , sales commissions , sales salaries ,sales shipping , sales commissions , sales salaries ,sales traveltravel

Administrative exps Administrative exps are all costs linked with the are all costs linked with the overall general administration / management / overall general administration / management / operation of a business rather than with the operation of a business rather than with the manufacturing or selling the product e.g. General manufacturing or selling the product e.g. General accounting, secretarial, public relations, Executives’ accounting, secretarial, public relations, Executives’ compensation, rents of the administrative offices compensation, rents of the administrative offices e.t.c.e.t.c.

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Product Costs Versus Period CostsProduct Costs Versus Period Costs

Period Costs Period Costs are all the costs that are not are all the costs that are not product costs.product costs.Product Costs Product Costs include all costs involved ininclude all costs involved inmaking a product. It is the cost of Raw Materials making a product. It is the cost of Raw Materials Consumed, the cost of Direct Labour and all Consumed, the cost of Direct Labour and all manufacturing expenses. manufacturing expenses.

For e.g. the depreciation of a production machinery is product For e.g. the depreciation of a production machinery is product Cost (manufacturing overhead) but the depreciation of delivery Cost (manufacturing overhead) but the depreciation of delivery Vans is a period overhead.Vans is a period overhead.

Also the Also the product-manufacturing costsproduct-manufacturing costs are called are called Inventoriable Inventoriable

CostsCosts because they go directly to inventory accounts and not to because they go directly to inventory accounts and not to expenses accounts. Also they go to Balance Sheet as assets if expenses accounts. Also they go to Balance Sheet as assets if they are partially completed (Work In Progress) or unsold at they are partially completed (Work In Progress) or unsold at the end of period.the end of period.

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Cost Classifications on Financial Cost Classifications on Financial StatementsStatements

1. The1. The Balance SheetBalance Sheet

The Statement of Financial Position The Statement of Financial Position (Balance sheet)(Balance sheet) of a of a manufacturing company is similar to that of a merchandise manufacturing company is similar to that of a merchandise company. company.

However However Manufacturing companies have three classes of Manufacturing companies have three classes of inventories inventories (closing stocks)(closing stocks) - - raw materialsraw materials, , work in work in progressprogress and and finished goods- finished goods- in their balance sheet.in their balance sheet.

Raw MaterialsRaw Materials : materials used to make a product. : materials used to make a product.

Work in ProgressWork in Progress: products not yet completed fully but : products not yet completed fully but partially and require further work to be ready for sale. partially and require further work to be ready for sale.

Also called semi-finished goods.Also called semi-finished goods.

Finished goods: Finished goods: completed products not yet sold.completed products not yet sold.

In Balance Sheet is only shown the closing stocks of the above 3 In Balance Sheet is only shown the closing stocks of the above 3 inventories as CURRENT ASSETSinventories as CURRENT ASSETS..

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2.The Income Statement2.The Income Statement

The Income Statement is consisted of the The Income Statement is consisted of the Trading A/c Trading A/c

and the Profit & Loss A/cand the Profit & Loss A/c. In a Manufacturing company . In a Manufacturing company

the the Manufacturing A/cManufacturing A/c precedes the trading a/c and its precedes the trading a/c and its

result goes to trading a/c so as to determined the result goes to trading a/c so as to determined the costcost

of goods sold of goods sold . Also the opening and closing stock of . Also the opening and closing stock of

Finished goods is also key factor in order to determined Finished goods is also key factor in order to determined

the cost of sales.the cost of sales.

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Example 2Example 2

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The importance of Cost The importance of Cost Classifications for:Classifications for:

1. Predicting behavior1. Predicting behavior Cost Behaviour Cost Behaviour refers to how a cost refers to how a cost

reacts to changes in the level of activity. reacts to changes in the level of activity. As the activity level rises and falls, a As the activity level rises and falls, a particular cost may rise and fall as well – or particular cost may rise and fall as well – or it may remain constant.it may remain constant.

For For planning purposesplanning purposes, a manager must , a manager must be able to predict which of these will be able to predict which of these will happen, and if a cost can be expected to happen, and if a cost can be expected to change, the manager must be able to change, the manager must be able to estimate how much it will change.estimate how much it will change.

To help make such evaluations, costs are To help make such evaluations, costs are often categorized as variable or fixed. often categorized as variable or fixed.

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VARIABLE COSTS: VARIABLE COSTS: are those costs that vary-fluctuateare those costs that vary-fluctuate depending on a company’s level of activity. They rise depending on a company’s level of activity. They rise as production increases and fall as production as production increases and fall as production decreases. Examples could be direct materials and decreases. Examples could be direct materials and labor ,some manufacture overheads, shipping costs, labor ,some manufacture overheads, shipping costs, sales commissions e.t.csales commissions e.t.c

Activity LevelActivity Level is the is the production volumeproduction volume of a company of a company and it can be the units produced, units sold, hours and it can be the units produced, units sold, hours worked e.t.cworked e.t.c

FIXED COSTS: FIXED COSTS: are costs that tends to remain the same are costs that tends to remain the same

regardless of activity level. Such examples are rents, regardless of activity level. Such examples are rents,

advertising, insurance, office supplies e.t.cadvertising, insurance, office supplies e.t.c

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The importance of Cost The importance of Cost Classifications for: Classifications for:

2. Allocating costs to 2. Allocating costs to ‘cost objects’‘cost objects’‘‘Cost Object’ is any item or any input use in the productionCost Object’ is any item or any input use in the production

for which we are separately measuring costs and we directlyfor which we are separately measuring costs and we directlylink costs with it. link costs with it.

For instance labor is a ‘cost object’ because we determine For instance labor is a ‘cost object’ because we determine the cost of employment ‘per man per hour’ and we find a the cost of employment ‘per man per hour’ and we find a fixed rate of employment. Another example is materials: cost fixed rate of employment. Another example is materials: cost of fabrics used or plastic units. of fabrics used or plastic units. The company pays The company pays €€8 per worker per hour8 per worker per hour

Also ‘Cost Object’ can be a product manufactured by a Also ‘Cost Object’ can be a product manufactured by a company and for which a separate measurement of cost is company and for which a separate measurement of cost is desired.desired.

Examples: project, service, customer, jobs, departments Examples: project, service, customer, jobs, departments within organization (customer service call, design of a new within organization (customer service call, design of a new product)product)

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Costs are allocated to the ‘cost objects’ and Costs are allocated to the ‘cost objects’ and they are either direct or indirect coststhey are either direct or indirect costs

The reasons that we want to allocate costs to The reasons that we want to allocate costs to ‘cost objects’ includes : ‘cost objects’ includes :

the need to determine a price for a product,the need to determine a price for a product, the need to determine profitability,the need to determine profitability, the need to see if costs are reasonable and control the need to see if costs are reasonable and control

them,them,

and so forthand so forth

Direct costDirect cost

Indirect Indirect costcost

Cost ObjectCost Object

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Direct Costs:Direct Costs:

A direct cost is a cost that can be easily traced to a A direct cost is a cost that can be easily traced to a specific cost object, therefore direct labour and raw specific cost object, therefore direct labour and raw materials are direct costs.materials are direct costs.

Indirect CostsIndirect Costs::

An indirect cost is a cost that cannot be easily traced to An indirect cost is a cost that cannot be easily traced to

a specific cost object.a specific cost object.

For example the rent expense can not be allocated For example the rent expense can not be allocated

directly to the production department or the administrationdirectly to the production department or the administration

department and thus we allocate some to each one.department and thus we allocate some to each one.

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The importance of Cost The importance of Cost Classifications for Classifications for 3. Decision Making3. Decision Making

Costs are an important feature of many business Costs are an important feature of many business decisions.decisions.

In making decisions, it is essential to have In making decisions, it is essential to have awareness and understanding of the concepts:awareness and understanding of the concepts:

differential cost, differential cost, is a broader term, including both cost is a broader term, including both cost increases (incremental costs) and cost decreases increases (incremental costs) and cost decreases (decremental costs) between alternatives. (decremental costs) between alternatives.

opportunity cost opportunity cost is the potential benefit that is given up is the potential benefit that is given up when one alternative is selected over anotherwhen one alternative is selected over another..

and sunk cost. and sunk cost. is a cost that has already been incurred is a cost that has already been incurred and that cannot be changed by any decision made now or in and that cannot be changed by any decision made now or in the future.the future.

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Cost BehaviorCost Behavior Cost Behavior: is how a cost will react – change – as Cost Behavior: is how a cost will react – change – as

changes take place in the activity base. changes take place in the activity base. As the As the activity level rises and falls, a particular cost may rise activity level rises and falls, a particular cost may rise and fall as well – or it may remain constant.and fall as well – or it may remain constant.

A cost behavior is a key tool in the hands of managers who are request to A cost behavior is a key tool in the hands of managers who are request to predict the costs that will be occurred under various activity levels. predict the costs that will be occurred under various activity levels.

In order to predict costs we use 3 cost behavior patterns: In order to predict costs we use 3 cost behavior patterns: Variable costsVariable costs Fixed CostsFixed Costs Mixed (semi variable) CostsMixed (semi variable) Costs

Cost Structure is the percentage of each type of cost in Cost Structure is the percentage of each type of cost in an organization’s total cost of productionan organization’s total cost of production. .

Variable CostsVariable Costs

3434Minutes Talked

To

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Tel

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Your total long distance telephone bill is increasing as the

minutes you talk are increasing.

Are those costs that vary-fluctuate directly as the company’s Are those costs that vary-fluctuate directly as the company’s level of activity changes. They rise as production increases level of activity changes. They rise as production increases and fall as production decreases. and fall as production decreases.

If activity level by 50% total variable cost by 50% If activity level by 50% total variable cost by 50%

If activity level by 10% total variable cost by 10%If activity level by 10% total variable cost by 10%

Variable CostsVariable Costs

3535Minutes Talked

Per

Min

ute

Tel

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har

geThe per minute

cost of long distance calls is

constant, for example, 10¢ per

minute.

A variable cost remains constant if expressed on a A variable cost remains constant if expressed on a

per unit basis.per unit basis.

So a variable cost is constant per unit but varies in total with the activity level.

Variable CostsVariable Costs

For a cost to be variable it must be variable in For a cost to be variable it must be variable in respect to respect to something,something, that is the activity base. that is the activity base. Activity baseActivity base or or cost drivercost driver is whatever causes is whatever causes the rise and fall of a variable cost.the rise and fall of a variable cost.

For example the direct materials for the For example the direct materials for the production of a ford car is a variable costs. As production of a ford car is a variable costs. As the output of ford increases, car increases, the the output of ford increases, car increases, the direct materials needed increases.direct materials needed increases.

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The Activity BaseThe Activity Base

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A measure of what causes the

fluctuation of a variable cost.

A measure of what causes the

fluctuation of a variable cost.

UnitsUnitsproducedproduced

UnitsUnitsproducedproduced

Miles driven

Miles driven

Labor hours

Labor hours

Machine hours

Machine hours

VARIABLE COSTSVARIABLE COSTS

Extent of Variable Costs:Extent of Variable Costs: The proportion of variable costs in a firm differs across organizations. For example . .

A service company : audit, consulting, A service company : audit, consulting, medical, architectural companies have medical, architectural companies have very large fixed costs (salaries etc)very large fixed costs (salaries etc)

A manufacturing company or a restaurantA manufacturing company or a restaurantwill often have manywill often have manyvariable costs.variable costs.

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True Variable CostsTrue Variable Costs. Direct materials is a . Direct materials is a true or true or proportionatelyproportionately variable cost because the amount used during a variable cost because the amount used during a period will vary in direct proportion to the level of production period will vary in direct proportion to the level of production activityactivity,, moreover any amounts purchased but not used can be moreover any amounts purchased but not used can be stored and carried forward to the next period as inventory.stored and carried forward to the next period as inventory.

Step – Variable CostsStep – Variable Costs. A resource that is acquire in large . A resource that is acquire in large amount and that increases or decreases only in response to amount and that increases or decreases only in response to wide changes in activity is known as a step – variable cost. For wide changes in activity is known as a step – variable cost. For example, the wages of skilled repair technicians are often example, the wages of skilled repair technicians are often considered to be a step – variable costs. considered to be a step – variable costs. Small changes in the level of production are not likely to have any effect on the number of maintenance workers employed.

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Volume

Co

st

Step-Variable CostsStep-Variable Costs

Co

st

Volume

True Variable Cost

4141Volume

Co

st

Volume

Co

st

Small ChangesWide Changes

Step variable cost

FIXED COSTSFIXED COSTSAAre costs that tends to remain the same regardless of re costs that tends to remain the same regardless of

production volume. Such examples are rents, advertising, production volume. Such examples are rents, advertising,

insurance, depreciation e.t.cinsurance, depreciation e.t.c

Average fixed costs per unit decrease as the activity level Average fixed costs per unit decrease as the activity level

increases.increases.

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Total Fixed Cost ExampleTotal Fixed Cost Example

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Number of customers

Total

Cost of Ren

t

Total Fixed Cost of Rent

Number of customers

Per Unit Cost of

Rent

Fixed Cost of Rent per customer

Fixed costs decreases on a per unit basis as the activity level – customers increases

Fixed Cost Per Unit ExampleFixed Cost Per Unit Example

4444Number of Local Calls

Mo

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Average fixed costs per unit decreaseas the activity level increases.

The fixed cost per local call

decreases as more local calls are

made.

11. . Committed Fixed Costs. Committed Fixed Costs. Investments in facilities, Investments in facilities, equipment, and the basic organisation structure. equipment, and the basic organisation structure.

Examples: depreciation on buildings and equipment, real Examples: depreciation on buildings and equipment, real estate taxes, insurance expenses, salaries of managers estate taxes, insurance expenses, salaries of managers and operational staff e.t.cand operational staff e.t.c

They have long-term nature and they can not be They have long-term nature and they can not be significantly reduced even for short periods of time significantly reduced even for short periods of time without affecting seriously the goals and profitability of without affecting seriously the goals and profitability of the company. E.g. if we discharge a manager because the company. E.g. if we discharge a manager because operation lowers the cost of re-employment a new is operation lowers the cost of re-employment a new is greater than the short-run saving realized.greater than the short-run saving realized.

As it is difficult to change committed costs management As it is difficult to change committed costs management should make such engagements only after careful should make such engagements only after careful thoughts. thoughts.

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2.Discretionary Fixed Costs2.Discretionary Fixed Costs. Discretionary Fixed . Discretionary Fixed Costs usually arise from annual decisions by Costs usually arise from annual decisions by management to spend on certain fixed cost items.management to spend on certain fixed cost items.

Examples: advertising, research, public relations, Examples: advertising, research, public relations, internship for students, training of employees etc.internship for students, training of employees etc.

Differences with committed fixed costs:Differences with committed fixed costs: 1. Are planning for the short run not for many 1. Are planning for the short run not for many yearsyears 2. They can be alter or cut-down without serious impact 2. They can be alter or cut-down without serious impact

on profitability and goals.on profitability and goals. 3. They are optional costs and not practically necessary 3. They are optional costs and not practically necessary

for the operation of the firm. for the operation of the firm.

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Is Labor a Variable or a Fixed Is Labor a Variable or a Fixed Cost? Cost?

The behavior of wage and salary costs can differ across countries, depending on labor regulations, labor contracts and custom.

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In France, Germany, China, and Japan,management has little flexibility in adjustingthe size of the labor force.Labor costs are more fixed in nature. Most companies in the United States continueto view direct labor as a variable cost.

The demand for knowledge workers has grown extremely and most companies consider their employees as a valuable asset. As a result knowledge workers are relatively a fixed cost. On the other hand direct workers are a variable cost because managers prefer to recruit temporary or part-time workers when sales increases rather than keep them permanently at the company and keep payroll budget in a cost-effective level.

Labor costs a mixture of fixed and variable costs

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IN GENERAL FIXED COSTS CAN CHANGE BUT NOT WHEN SMALL CHANGES OCCUR.THEY ALTER IN LONG RUN WHEN LARGE CHANGES REALIZED IN ACTIVITY BASE.

Mixed CostsMixed Costs A mixed cost has both fixed and variableA mixed cost has both fixed and variable

components. components.

Example with expeditions company:

€25,000 per year for license

€3 per customer

If the company has 1000 customers this

year € 25000+ € 3x1000= € 28000

If the company has 0 customers this

year € 25000+ € 3x0= € 25000

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Mixed CostsMixed Costs

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Mixed CostsMixed Costs

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Fixed Yearly

license Charge

Variable

Cost per Customer

Customers

Co

st o

f st

ate

lice

nse

fee

s

X

Y

Total mixed cost

Example with expeditions company

Methods of MeasuringMethods of MeasuringCost Functions Cost Functions

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1. Engineering analysis1. Engineering analysis 2. Account analysis2. Account analysis 3. High-low analysis3. High-low analysis 4. Visual-fit analysis4. Visual-fit analysis

Cost estimation is the process of determining how a particular cost behaves

1.1. Account AnalysisAccount Analysis. Each account is classified as . Each account is classified as either variable or fixed based on the analyst’s prior either variable or fixed based on the analyst’s prior knowledge of how the cost in the account behaves.knowledge of how the cost in the account behaves.

2.2. The engineering ApproachThe engineering Approach Cost analysis involves Cost analysis involves a detailed analysis of what cost behaviour should a detailed analysis of what cost behaviour should be, based on an industrial engineer’s evaluation of be, based on an industrial engineer’s evaluation of the production methods to be used, the materials the production methods to be used, the materials requirements, labour requirements, equipment requirements, labour requirements, equipment usage and so on.usage and so on.

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3. High-Low Method3. High-Low Method

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The focus of this method is normally onThe focus of this method is normally on

the highest- and lowest-activity pointsthe highest- and lowest-activity points..

The first step is to plot the historicalThe first step is to plot the historical

data points on a table.data points on a table.

Difference between the costs corresponding

Variable Model = to the highest and lowest activity levels

Difference between the highest and lowest

activity levels

High-Low Method ExampleHigh-Low Method Example

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High month: AprilHigh month: April

Maintenance cost: $47,000Maintenance cost: $47,000

Number of patient-days: 4,900Number of patient-days: 4,900

Low month: SeptemberLow month: September

Maintenance cost: $17,000Maintenance cost: $17,000

Number of patient-days: 1,200Number of patient-days: 1,200

What is the variable cost?What is the variable cost?

High-Low Method ExampleHigh-Low Method Example

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($47,000 – $17,000) ÷ (4,900 – 1,200)($47,000 – $17,000) ÷ (4,900 – 1,200)

= $30,000 ÷ 3,700 = $8.1081= $30,000 ÷ 3,700 = $8.1081

What is the fixed cost?What is the fixed cost?Two ways to find thisTwo ways to find this

a)$47,000 = Fixed cost + ($8.1081× 4,900)a)$47,000 = Fixed cost + ($8.1081× 4,900)

$47,000 – $39,730 = $7,270$47,000 – $39,730 = $7,270

b)$17,000 = Fixed cost + ($8.1081× 1,200)b)$17,000 = Fixed cost + ($8.1081× 1,200)

$17,000 – $9,730 = $7,270$17,000 – $9,730 = $7,270

The mixed cost line equation in The mixed cost line equation in this case is:this case is:

Y = 7270 + 8.1081*XY = 7270 + 8.1081*X

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4. Visual-Fit Method4. Visual-Fit Method

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In the In the visual-fit method,visual-fit method, the cost analyst the cost analyst

visually fits a straight line through a plotvisually fits a straight line through a plot

of all of the available data, not justof all of the available data, not just

between the high point and thebetween the high point and the

low point, making it more reliablelow point, making it more reliable

than the high-low method.than the high-low method.

When the cost has been classified as a semi variable or When the cost has been classified as a semi variable or when the analyst has when the analyst has no clear idea about the behavior no clear idea about the behavior of a cost itemof a cost item it is helpful to use the it is helpful to use the visual fit method visual fit method to plot (design) recent observations of the cost at various to plot (design) recent observations of the cost at various activity levels. So first it makes a table and then a graph-activity levels. So first it makes a table and then a graph-a diagram which displays the results. The resulting a diagram which displays the results. The resulting diagram helps the analyst to diagram helps the analyst to visualize –see and visualize –see and understand-understand- the relationship between cost and the level the relationship between cost and the level of activity ( or the cost driver)of activity ( or the cost driver)

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Month Cost for month Dozen of bakery items sold per month (cost driver)

Jan 5100 75000

Feb 5300 78000

Then make a graph with these data

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e.g. $ 1500

The visual cost line cut off the vertical axis at $1500 so this give us the estimation of the fixed cost component in the semi variable cost approximation. To determine the variable cost per unit deduct the fixed cost from the total cost at any activity level.

THANK YOUTHANK YOU

QUESTIONS?QUESTIONS?

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