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Costing 1

Dr. Clive Vlieland-Boddy

FCA FCCA MBA

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Functions of Management

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Strategy of

Management

The Past

Annual Report

Annual Report

Annual Report

The Present

EnvironmentalScanning of current product/service mix

BudgetsForecasts

The Future

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Strategy Evaluation

Feedback

Planning

The Functions of Management

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Decentralised Operations

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© 2000 Colin Drury

Functional organizational structure

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Companies decentralize as they growSplit operations into different divisions or

operating unitsTop management delegates decision-making

to unit managersDecentralization may be based on:

Geographic areaProduct lineCustomer baseBusiness function

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Decentralization in Organizations

Benefits ofDecentralization Top management

freed to concentrateon strategy.

Top managementfreed to concentrate

on strategy.Lower-level managers

gain experience indecision-making.

Lower-level managersgain experience indecision-making. Decision-making

authority leads tojob satisfaction.

Decision-makingauthority leads tojob satisfaction.

Lower-level decisionoften based on

better information.

Lower-level decisionoften based on

better information.

Improves ability toevaluate managers.

Improves ability toevaluate managers.

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Decentralization and Segment Reporting

A segmentsegment is any part or activity of an

organization about which a manager

seeks cost, revenue, or profit data. A

segment can be . . .

Canadian TireCanadian Tire

An Individual Store

A Sales Territory

A Service Centre

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Advantages of Decentralization

Better information leading to superior decisions

Managers can respond quicker to changing circumstances

Increased motivation of managers Provides excellent training for future top-level

executives Frees top management time

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Disadvantages of Decentralization

Costly duplication of activities Lack of goal congruence

Management pursues personal goals Personal goals are incompatible with the

company’s goals To control goal congruence, companies evaluate

the performance of subunit managers

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Copyright (c) 2009 Prentice Hall. All rights reserved.

Advantages of decentralization

Disadvantages of decentralization

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Why Companies Evaluate the Performance of Subunits and Subunit Managers

A company evaluates subunits in order to decide if it should expand or contract them or change their operations

A company evaluates subunit managers in order to motivate them to take actions that maximize the value of the firm

Reasons for evaluating subunit managers: Identifies successful operations and areas

needing improvement Influences the behavior of managers

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Responsibility Accounting and Performance Evaluation

Responsibility accounting is a technique that holds managers responsible only for costs and revenues that they can control

To implement responsibility accounting in a decentralized organization, costs and revenues are traced to the organizational level where they can be controlled

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Responsibility Centres

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Cost, Profit, and Investment Centres

ResponsibilityCentre

ResponsibilityCentre

CostCentreCost

CentreProfit

CentreProfit

CentreInvestment

CentreInvestment

Centre

Cost, profit,and investmentcentres are allknown asresponsibilitycentres.

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Cost Centre A segment whose manager has control

over costs, but not over revenues

or investment funds.

CostCost

Cost

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Profit Centre A segment whose manager has control over both costs and

revenues, but no control over

investment funds.

RevenuesSalesInterestOther

CostsMfg. costsCommissionsSalariesOther

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Investment Centre

A segment whose manager has control

over costs, revenues, and investments in

operating assets.

Corporate Headquarters

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Cost Centres

Parts of the business to which particular costs can be attributed

In large businesses this can be a particular location, section of the business, capital asset or human resource/s

Enable a business to identify where costs are arising and to manage those costs more effectively

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Subunit of an organization whose manager is accountable for specific activities

Copyright (c) 2009 Prentice Hall. All rights reserved.

Responsibility Center

Manager is responsible for:

Cost center Controlling costs

Revenue center Generating sales revenue

Profit center Producing profit by generating sales and controlling costs

Investment center

Producing profit and managing the division’s invested capital

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© 2000 Colin Drury

Functional organizational structure

IC= Investment Centre CC = Cost Centre RC = Revenue Centre

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Performance Management

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When companies decentralize, top management needs a system to communicate goals to subunit managers

Primary goals:Promoting goal congruence and coordinationCommunicating expectationsMotivating unit managersProviding feedbackBenchmarking

Copyright (c) 2009 Prentice Hall. All rights reserved. 24

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Financial Accounting measures tend to be lag indicators

“After the fact”

Management Accounting are lead indicators“Before the fact”

Copyright (c) 2009 Prentice Hall. All rights reserved. 25

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Trading Statement

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Total Revenue

Total Revenue = Price x Quantity Sold Price can be raised or lowered to change revenue –

price elasticity of demand important here Different pricing strategies can be used – penetration,

psychological, etc.

Quantity Sold can be influenced by amending the elements of the marketing mix

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Manufacturing Companies: Income Statement

Sales

- Cost of goods sold

Gross profit

- Operating expenses

Operating income

Opening Inventories

Add Purchases

Less Closing Inventories

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Manufacturing (Product) Costs

Direct Manufacturing Costs are easily traced to the product. These include: Direct Materials Direct Labor

Indirect Manufacturing Costs are not as easily traced to the product and are usually pooled together in Manufacturing Overhead (MOH)

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What is Contribution

Contribution is the management accounting term for gross profit.

In other words, sales less the cost of goods sold.

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Contribution

Contribution Margin Per Unit This is Gross Profit that each unit contributes

towards the general overheads and net income Contribution Margin Ratio

The contribution margin as a % of sales. (Same as Gross Profit Margin %.

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Costs and Budgeting

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Cost Behaviour

Costs can be a function of units of production or time.

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There are several different types of costs:

Fixed Costs

Variable Costs

Stepped Costs

Semi Variable Costs

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Fixed Costs

These costs do not vary with production levels.

Example: Property costs like rent Municipal taxes and insurance have to be paid even if you only produce one ice cream.

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Variable Costs

These are as it says, costs that will vary with production.

Example: A manufacture of Ice Cream will have costs of milk that are directly proportionate to the production. Ie say 10 gallons of milk to11 gallons of ice cream.

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Stepped Costs

These are costs that are variable but not directly proportionate to production.

Example:

Rental of a warehouse. Once full, another is required so costs step up

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Semi Variable Costs

Include a variable and fixed cost elements.

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Budgeting & Forecasting

Strategy needs to be taken and developed into a financial plan.

There needs to be objective for the future. Benchmarks need to be created so as to be

able to evaluate the business against its planned path

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Chapter 10

Operating Budget

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Chapter 10

Financial Budget

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Chapter 10

Budget Objectives

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Chapter 10

Budget Cycle

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COSTING Cost accounting system provides

information about cost Aim : best use of resources and

maximization of returns

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Costs

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Costs Anything incurred during the production of the

good or service to get the output into the hands of the customer

The customer could be the public (the final consumer) or another business

Controlling costs is essential to business success

Not always easy to pin down where costs are arising!

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Common Types Of Cost Behavior

Fixed Costs: Costs that fundamentally are not driven by changes in volume

Variable Costs: Costs that change directly and proportionately with the volume of activity

Semi Variable Costs: Costs that contain both a fixed and a variable component. Also called Semi Variable or stepped.

Others

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Traceable and Common Fixed Costs

FixedCosts

TraceableTraceable CommonCommon

Costs arise becauseCosts arise becauseof the existence ofof the existence of

a particular a particular segment.segment.

Costs arise becauseCosts arise becauseof overall operatingof overall operating

activities.activities.

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Traceable and Common Fixed Costs

FixedCosts

TraceableTraceable CommonCommon

Costs arise becauseCosts arise becauseof the existence ofof the existence of

a particular segment.a particular segment.

Costs arise becauseCosts arise becauseof overall operatingof overall operating

activities.activities.

Don’t allocateDon’t allocatecommon costs.common costs.

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U.S. Sales Foreign Sales

Regular

U.S . Sales Foreign Sales

Big Screen

T elevisionDivision

Traceable Costs Can Become Common Costs

ProductProductLinesLines

SalesSalesTerritoriesTerritories

Webber’s Television Division

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Inappropriate Methods of Allocating Costs Among Segments

Segment3

Segment4

Failure to traceFailure to tracecosts directlycosts directly

Arbitrarily dividingArbitrarily dividingcommon costscommon costs

among segmentsamong segmentsInappropriateInappropriate

allocation baseallocation base

Segment2

Segment1

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Costing Methods

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Standard Costing

The forecasted expected cost per unit.

Example: A ball point pen manufacturer:Cost of Plastic case 0.07pCost of Cartridge 0.04pLabour to assemble 0.15pPackaging

0.01pStandard Cost 0.27p

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benchmarks formeasuring performance.

the expected levelof performance.

used for planning labourand material requirements.Standard

costs are

based on carefullypredetermined amounts.

Using Standard-Costing Systems for Control

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STANDARD COSTa budget for the

production of one unit of product or

service

STANDARD COSTa budget for the

production of one unit of product or

service

ACTUAL COSTincurred and

recorded in the production of the product or service

ACTUAL COSTincurred and

recorded in the production of the product or service

COST VARIANCE the differencebetween the

actual cost andthe standard cost

COST VARIANCE the differencebetween the

actual cost andthe standard cost

Using Standard-Costing Systems for Control

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Pro

du

ct c

ost

Standard

A standard cost varianceis the amount by which

an actual cost differs fromthe standard cost.

This variance is unfavorable because the actual cost

exceeds the standard cost.

Using Standard-Costing Systems for Control

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Directmaterials

Managers focus on quantities and coststhat deviate significantly from standards

(a practice known as management by exception).

Type of Product Cost

Am

ou

nt

Directlabor

Standard

Management by Exception

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Take the time to investigate only significant cost variances.

Take the time to investigate only significant cost variances.

What is significant?What is significant?

Depends on the size of theorganization

Depends on the size of theorganization

Depends on the type of the organization

Depends on the type of the organization

Depends on the production

process

Depends on the production

process

Management by Exception

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Prepare standard cost performance

report

Conduct next period’s

operations

Analyze variances

Identifyquestions

Receive explanations

Takecorrective

actions

Begin

Variance Analysis Cycle

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Analysis ofhistorical

data

Analysis ofhistorical

data

Taskanalysis

Taskanalysis

Used in a mature production process

Used in a mature production process

Analyze the processof manufacturing

the product

Analyze the processof manufacturing

the product

What DIDthe product

cost?

What DIDthe product

cost?

What SHOULD the

product cost?

What SHOULD the

product cost?

Combinedapproach

Combinedapproach

Analyze the process for the step thathas changed, but use historical datafor the steps that have not changed

Analyze the process for the step thathas changed, but use historical datafor the steps that have not changed

Setting Standards

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Marginal Costing

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The layman’s language

The only cost of driving my caron a 200 mile trip today is

$12 for gasoline.

MarginalCosting

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Marginal or Variable Costing

Used for internal planning and decision making

Does not include fixed factory overhead as a product cost

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Advantages of variable/marginal costing Variable costing is simple to understand It provides more useful information for decision-making Avoids fixed overheads being incorporated into the costs

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Disadvantages of variable/marginal costing

The separation of costs into fixed and variable is difficult and sometimes gives misleading results

It underestimates the importance of fixed costs Application of fixed overhead depends on estimates. There may be

under or over absorption of the same A system which ignores fixed costs is less effective since a major

portion of fixed cost is not taken care of under marginal costing In practice, sales price, fixed cost and variable cost per unit may vary.

Thus, the assumptions underlying the theory of variable/marginal costing sometimes becomes unrealistic. For long term profit planning, absorption costing is the only answer

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Absorption Costing

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No! You must consider these costs too!

AbsorptionCosting

Cost Per month Per day

Car Leasing 300.00$ 10.00$

Insurance 60.00 2.00

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Absorption/Costing

Includes direct materials, direct labour, variable factory overhead, and allocates fixed factory overhead as part of total product cost

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Absorption costing

Costing method which involves or “absorbs” all the costs necessary to produce the product into its saleable form.

It is both the marginal and the fixed costs Also known as “Full costing”

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Absorbing Overheads

Having fixed the overhead consumption rate based on forecast.

If we under produce we recover insufficient overheads.

If we overproduce we recover excessive overheads.

In essence we under or over absorb the overheads.

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Overview of Absorption and Marginal Costing

Direct Materials

Direct Labor

Variable Manufacturing Overhead

Fixed Manufacturing Overhead

Variable Selling and Administrative Expenses

Fixed Selling and Administrative Expenses

MarginalCosting

AbsorptionCosting

ProductCosts

PeriodCosts

ProductCosts

PeriodCosts

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Summary

Variable/Marginal Costing Solves the Forecasting Problem in Pricing

Variable/Marginal Costing focuses on Variable and Incremental Costs

With Variable/Marginal Costing you will be able to calculate: Floor Price Out of Pocket Price Break Even Price Target Profit Price Most profitable sales mix Profitable Sales Strategies

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Managements Use of Costing

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MANAGEMENT

DECISIONS

Controlling Controlling CostsCosts

PricingPricingPlanning Planning

ProductionProduction

Analyzing Analyzing Market Market

SegmentsSegments

Analyzing Analyzing Contribution Contribution

MarginsMargins

ACTUAL PLANNED

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Question 1

An investment center is responsible for:a. Investing in long term assets

b. Controlling costs

c. Generating revenues

d. All of the above

Answer:

d. All of the above

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Question 2

An cost center is responsible for:a. Investing in long term assets

b. Controlling costs

c. Generating revenues

d. All of the above

Answer:

b Controlling Costs

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Question 3

An profit center is responsible for:a. Investing in long term assets

b. Controlling costs

c. Generating revenues

d. B and C

Answer:

d. Controlling revenues and costs

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Question 4

An investment center is responsible for:a. Investing in long term assets

b. Controlling costs

c. Generating revenues

d. All of the above

Answer:

d. All of the above

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Question 5

Absorption Costing:a. Ignores all fixed costs

b. Is a better way to evaluate cost centres.

c. Includes variable and fixed manufacturing costs

d. B and c are correct.

Answer:

d.

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Question 6

Gross Profit is defined asa. Sales less cost of sales

b. Sales less purchases

c. Sales less overheads

Answer:

a.

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Question 7

Contribution is another expression of?:a. Net Profit

b. EBIT

c. Gross Profit

Answer:

c. It is the management accounting expression for gross profit

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Question 8

Why should be distinguish between Traceable and non traceable costs?:

a. To ensure we can correctly allocate costsb. To divide up Variable costsc. To divide up fixed costsd. All above are correct

Answer:d.

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Question 9

Standard Costing is creating?:a. A forecasted summary of expected costsb. A tool for evaluating performancec. Reveals a variance when actual is compared to

forecasted.d. All the above are correct

Answer:d.

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Question 10

A variance shows?:a. Either a Favourable or Unfavourable departure

from Budgeted activity.b. A tool for evaluating performancec. Enables management by exception.d. All the above are correct

Answer:d.

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Question 11

Marginal Costing?:a. Takes only the costs that vary with production.

b. Takes the variable and fixed costs that are traceable to production.

c. Only takes the Fixed costs.

Answer:

b.

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Question 12

Absorption Costing?:a. Takes all costs both variable and fixed.

b. Is a good management tool as it allocates all costs to the product.

c. Both a and b are correct

Answer:

c.