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Module 9ModuleModuleModule 999 Cost Characteristics and Behavior Omar El-Kheshen – omar@arabacademy.com 1
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Learning Objectives By the end of this module you should understand: 1. Why cost information is important 2. The distinction between different categories of cost and how these costs behave: Variable and fixed costs Product and period costs Direct and indirect costs Standard and actual costs Controllable and nonControllable and non--controllable costscontrollable costs Engineered and discretionary costs Traceable and common costs 3. The dangers surrounding unitizing fixed costs 4. The construction, and underlying assumptions, of the break-even chart 5. How to calculate the break-even point, and the contribution margin ratio in single-product and multi-product businesses 6. The managerial significance of these techniques Omar El-Kheshen – omar@arabacademy.com 2
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Agenda 9.1 Introduction 9.2 Cost: A Deceptively Simple Word 9.3 Variable and Fixed Costs 9.4 Beware the Unitizing of Fixed Costs! 9.5 Direct and Indirect Costs 9.6 Traceable and Common Costs 9.7 Product Costs and Period Costs 99..88 Controllable and NonControllable and Non--Controllable CostsControllable Costs 9.9 Standard and Actual Costs 9.10 Engineered and Discretionary Costs 9.11 Another Look at Variable and Fixed Costs: The Break-Even Chart 9.12 Profit from Different Cost Structures 9.13 The Break-Even Chart: An Alternative Display 9.14 Other Ways of Calculating Break-Even Points 9.15 Break-Even Analysis and the Multi-Product Firm 9.16 Contribution and Limiting Factors of Production 9.17 Assumptions Underpinning Cost–Volume–Profit Analysis Review Questions and Case Studies Omar El-Kheshen – omar@arabacademy.com 3
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This module addresses the cost collection process and cost allocation process Cost Collection Cost Allocation The ingathering of costs The spreading of these costs over the goods and services produced by thegoods and services produced by the organizationorganization The need to determine cost is universal; the difficulties surrounding the determination of cost are considerable Omar El-Kheshen – omar@arabacademy.com 4
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Why is cost information so important? With a knowledge of cost, managers can: 1 Control actual performance against planned performance and take corrective action 2 Plan next year’s costs carefully, making due allowance for inefficiencies and unforeseen events which distorted last year’s performance 3 Determine a desirable selling price (whether in terms of ticket price in the market or subsidy sought from local or central government), even though that price may not besubsidy sought from local or central government), even though that price may not be achievable 4 Track the consumption of the organization’s resources to ensure that all employees are carrying out their duties efficiently and honestly 5 Choose among alternative courses of action (while recognizing, of course, that decisions are made on many more criteria than cost) Cost is one of the most fundamental control mechanisms in a management information system Omar El-Kheshen – omar@arabacademy.com 5
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Agenda 9.1 Introduction 9.2 Cost: A Deceptively Simple Word 9.3 Variable and Fixed Costs 9.4 Beware the Unitizing of Fixed Costs! 9.5 Direct and Indirect Costs 9.6 Traceable and Common Costs 9.7 Product Costs and Period Costs 99..88 Controllable and NonControllable and Non--Controllable CostsControllable Costs 9.9 Standard and Actual Costs 9.10 Engineered and Discretionary Costs 9.11 Another Look at Variable and Fixed Costs: The Break-Even Chart 9.12 Profit from Different Cost Structures 9.13 The Break-Even Chart: An Alternative Display 9.14 Other Ways of Calculating Break-Even Points 9.15 Break-Even Analysis and the Multi-Product Firm 9.16 Contribution and Limiting Factors of Production 9.17 Assumptions Underpinning Cost–Volume–Profit Analysis Review Questions and Case Studies Omar El-Kheshen – omar@arabacademy.com 6
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To understand how costs move we have to first define what our costs are Defining Costs There has to be an adjective before the Specify what we are costing: word ‘cost’ to define it the cost item Fixed Costs Passenger-mile Variable CostsVariable Costs Tin of PaintTin of Paint Direct Costs Tons of Material Indirect Costs Number of Hours Omar El-Kheshen – omar@arabacademy.com 7
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Agenda 9.1 Introduction 9.2 Cost: A Deceptively Simple Word 9.3 Variable and Fixed Costs 9.4 Beware the Unitizing of Fixed Costs! 9.5 Direct and Indirect Costs 9.6 Traceable and Common Costs 9.7 Product Costs and Period Costs 99..88 Controllable and NonControllable and Non--Controllable CostsControllable Costs 9.9 Standard and Actual Costs 9.10 Engineered and Discretionary Costs 9.11 Another Look at Variable and Fixed Costs: The Break-Even Chart 9.12 Profit from Different Cost Structures 9.13 The Break-Even Chart: An Alternative Display 9.14 Other Ways of Calculating Break-Even Points 9.15 Break-Even Analysis and the Multi-Product Firm 9.16 Contribution and Limiting Factors of Production 9.17 Assumptions Underpinning Cost–Volume–Profit Analysis Review Questions and Case Studies Omar El-Kheshen – omar@arabacademy.com 8
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We will use last module’s example of the DVD cabinets company in our study for costs in this module Example for Discussion The cost of one shelved DVD unit would be stated thus: Omar El-Kheshen – omar@arabacademy.com
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To understand what fixed and variable costs are, we have to define at first the overhead costs; that’s in light of last module’s example of the DVD company Overhead Costs incurred by a business in support of the cost items being made but not easily identified in the product as materials and labor Manufacturing Overhead Non-Manufacturing Overhead Depreciation on saws, lathes, Depreciation on office turners and power screwdriversturners and power screwdrivers equipment, computers and motorequipment, computers and motor Lubricants and energy costs for vehicles the above equipment Rent, rates and other space costs Rent and rates and other space associated with office and costs associated with the showroom workshop Salaries of office staff and general Salaries of foremen, supervisors, management quality inspectors and production management team A close examination of all of these costs indicates that some increase with production levels while others do not Omar El-Kheshen – omar@arabacademy.com
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Variable costs are the costs that vary directly with volume produced Example Take chipboard: Each unit may require two square meters of timber at a cost of €5 per square meter Therefore total cost of €10 per cost item If the firm manufactures 10 units the material cost for chipboard will be €100; if 20 units then €200 If the business manufactures zero units the chipboard costs will be zero The slope of the VC curve Omar El-Kheshen – omar@arabacademy.com
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There are plenty of other variable costs in the DVD unit like veneer, metal trim and labor; labor costs need explanation in this context as it can be treated in 2 ways Labor Non-Variable Cost Variable Cost Employment legislation prevents Companies can recruit and dispose of companies from firing labor at operatives to reflect production plans random and without warning As production increases the demandAs production increases the demand Short-term for labor increases; as production falls away so too do labor costs Long-term Omar El-Kheshen – omar@arabacademy.com
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Fixed costs are the costs that are indifferent to the production level Example Managerial salaries: Such costs are paid regardless of volume level Even if production fell to zero (e.g. during a strike) managers would still expect to receive their salaries At the other end of the production scale, the same salary would be paid when output reached maximum capacity Omar El-Kheshen – omar@arabacademy.com
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Depreciation is treated as a fixed cost although there are some people that argue that it should not be Variable Cost Argument vs. Fixed Cost Argument: Variable/ Argument But ? Fixed Machinery depreciates more Scenario of zero Variable Cost quickly if the usage is greater production rarely happens X Machines are used on a relativelyMachines are used on a relatively Depreciation does not varyDepreciation does not vary Fixed Cost predictable pattern with production line What causes depreciation is the passage of time that brings it to obsolescence Omar El-Kheshen – omar@arabacademy.com
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Some costs such as the telephone or some energy supplies or certain suppliers of photocopying facilities have features of both variable and fixed costs Example The telephone: A fixed charge per annum for the use of the service Plus a variable charge that depends on the number and duration of calls made The slope of the line is at the rate charged per call fixed charge even when no calls are made Accountants tend to disregard semi-variable costs and work with only the two principal categories because of the low number of costs involved Omar El-Kheshen – omar@arabacademy.com
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Managers can therefore read the total costs involved at any given production level from the total costs chart The total costs for a period of time Omar El-Kheshen – omar@arabacademy.com
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Agenda 9.1 Introduction 9.2 Cost: A Deceptively Simple Word 9.3 Variable and Fixed Costs 9.4 Beware the Unitizing of Fixed Costs! 9.5 Direct and Indirect Costs 9.6 Traceable and Common Costs 9.7 Product Costs and Period Costs 99..88 Controllable and NonControllable and Non--Controllable CostsControllable Costs 9.9 Standard and Actual Costs 9.10 Engineered and Discretionary Costs 9.11 Another Look at Variable and Fixed Costs: The Break-Even Chart 9.12 Profit from Different Cost Structures 9.13 The Break-Even Chart: An Alternative Display 9.14 Other Ways of Calculating Break-Even Points 9.15 Break-Even Analysis and the Multi-Product Firm 9.16 Contribution and Limiting Factors of Production 9.17 Assumptions Underpinning Cost–Volume–Profit Analysis Review Questions and Case Studies Omar El-Kheshen – omar@arabacademy.com 17
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When total variable costs and total fixed costs are split into individual products; variable costs seem fixed while the fixed costs vary Example The management of a business is considering the level of production to select for the next quarter-year. Sales are buoyant and any of the production levels set out below can be sold When management calls for the unit costs the following numbers are presented: Each unit of product contains the same amount of materials and labor regardless of production level, while the fixed burden of overhead is shared out more and more as the production level increases Omar El-Kheshen – omar@arabacademy.com
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In practice it is not always obvious when fixed costs have been ‘unitized’ –in terms of when they do stop varying Example (Continued) Suppose management selects the upper Suppose that the business wants to push level of 300 for the next quarter up production to 400 for the succeeding quarter-year €1 variable cost €1 variable cost + €2 fixed cost + €1.5 fixed cost €€33 Unit cost per itemUnit cost per item €€22..55 Unit cost per itemUnit cost per item 300 units x €3 400 units x €2.5 €900 €1,000 Some managers would multiply 400 by €3 to determine total cost for the next quarter which is wrong as fixed costs of €600 would be spread even over 400 units (€1.50 per unit) Omar El-Kheshen – omar@arabacademy.com
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Managers have to fully understand the concept of unitizing fixed costs, the following case study shows why Case You have been approached by a friend who works for a local company manufacturing metal housing boxes for heavy duty electric meters. Over the past two months he has been in charge of a department that makes four styles of casing on one assembly line for use by another department. He was appointed acting manager while the full-time manager recovered from illness. The chief executive, in giving him his first managerial responsibility, charged him with ‘keeping costs to the lowest possible level’. He tells you that shortly after taking over responsibility he was presented with a product cost statement revealing the numbers below. Coincidentally he received a competitor’s price list which revealed that product X would be cheaper to buy in. Omar El-Kheshen – omar@arabacademy.com
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