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Module 11ModuleModuleModule 111111 Costs for Decision Making Omar ElKheshen – omar@arabacademy.com 1
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Learning Objectives By the end of this module you should understand: 1. The distinction between full and variable costing 2. The impact on reported profit between the two cost systems 3. The concept of relevant cost for special decisions 4. The analytical framework surrounding relevant costs 5. The application of relevant costs to: − the make or buy decision − opportunity cost − sunk cost − the special sales order − further processing Omar ElKheshen – omar@arabacademy.com 2
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Agenda 11.1 Introduction 11.2 The Dilemma of the Denominator 11.3 Managerial Implications of Absorption versus Variable Costing 11.4 Cost Information for Management Decisions 11.5 Routine and Non-Routine Decisions 11.6 Developing an Analytical Framework 11.7 Finding the Relevant Costs 1111..88 The Pitfalls of Full CostingThe Pitfalls of Full Costing 11.9 Opportunity Costs 11.10 Department versus Company 11.11 Sunk Costs 11.12 Management Decisions in Action 11.13 Closing Down a Unit 11.14 The Special Sales Order 11.15 Should we Process Further? Review Questions Case Studies Omar ElKheshen – omar@arabacademy.com 3
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In module 9, we’ve covered the behavior of different types of cost; where costs are broken down into variable and fixed costs Variable Costs Fixed Costs Costs that change in magnitude with Costs that do NOT change as production production or sales levels or sales move up or down provide: Useful ManagerialUseful ManagerialUseful ManagerialUseful Managerial InformationInformation e.g. break-even points & the impact on profit of changing sales mixes Omar ElKheshen – omar@arabacademy.com 4
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Module 10 described various procedures for spreading those costs using plantwide and departmental overhead rates Plantwide RatesPlantwide Rates DepartmentalDepartmental RatesRates based on: Predetermined Overhead Rate Budgeted overhead for accounting period Budgeted Production Units expressed in:expressed in: either or Units producedUnits produced AppropriateAppropriate activity basesactivity bases To determine the cost per unit of production or service This calculation is required before actual production and sales take place so that management can make decisions on output levels and prices Omar ElKheshen – omar@arabacademy.com 5
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This module explores the implications of combining the desirable features of both of these topics 1 Calculating the full cost per unitCalculating the full cost per unit Managerial decisions which lie outsideManagerial decisions which lie outside 2 normal routine proceduresnormal routine procedures So that:So that: FundamentalFundamental management choicesmanagement choices can be made oncan be made on appropriate costingappropriate costing systemsystem Omar ElKheshen – omar@arabacademy.com 6
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Agenda 11.1 Introduction 11.2 The Dilemma of the Denominator 11.3 Managerial Implications of Absorption versus Variable Costing 11.4 Cost Information for Management Decisions 11.5 Routine and Non-Routine Decisions 11.6 Developing an Analytical Framework 11.7 Finding the Relevant Costs 1111..88 The Pitfalls of Full CostingThe Pitfalls of Full Costing 11.9 Opportunity Costs 11.10 Department versus Company 11.11 Sunk Costs 11.12 Management Decisions in Action 11.13 Closing Down a Unit 11.14 The Special Sales Order 11.15 Should we Process Further? Review Questions Case Studies Omar ElKheshen – omar@arabacademy.com 7
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In the DVD cabinet example, we’ve allocated the share of manufacturing overhead and that of non-manufacturing overhead through the predetermined rate Predetermined Budgeted overhead for accounting period Overhead Allocation = Rate Budgeted Production Units Such a calculation must be made in advance of production so that the desired selling price can be calculated Omar ElKheshen – omar@arabacademy.com 8
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The determination of both numerator and denominator is fraught with problems, but that of the denominator is usually more unpredictable Numerator Denominator Sometimes overheads fluctuate as their The denominator is not so readily market prices may vary during the predictable accounting period But if: Business may plan to produce and sell 1,000 units per year based on experience, The estimation process has been handled a figure determined by market research carefullycarefully exercises and production capacityexercises and production capacity then but The variations at the end of the period A sudden upsurge in demand can cause are usually small the actual number produced and sold to go to 1,200 units and/or An unforeseen shortage in raw materials could reduce production to 800 units The denominator would cause the predetermined allocation rate to be either too low or too high Omar ElKheshen – omar@arabacademy.com 9
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1) Example showing that when actual production equals planned production, no denominator volume variances will occur Example A business manufacturing designer fountain pens planned to produce and sell 10,000 in 20x2. Costs of manufacture per pen were: Here the allocation of fixed production overheads was based on the budgeted total expenditure and the budgeted volume of output of pens for 20x2, namely 10,000. Each pen sells for €100 yielding a gross profit of €40 per pen from which selling, administrative and financial costs would be deducted. Assume these costs to amount to €200,000. Omar ElKheshen – omar@arabacademy.com 10
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Example (Continued) If in 20x2 everything went according to plan the business would produce a P/L account like this: This form of accounting is called full or absorption cost accounting because each unit is asked to absorb its share of fixed production overhead, a reasonable requirement Omar ElKheshen – omar@arabacademy.com 11
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