ASSIGNMENT NO. 2

Topic: Analysis and application of various cost concepts for decision making.(1000 words)

Semester: Autumn 2010Course: Cost and Management Accounting Code: 5538 Level: MBA

Submitted to: Sir Waqar Akbar Allama Iqbal Open University Islamabad.

Submitted By: Ishtiaq Ahmed(0333-6824303)

Roll #: AH526270

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In the name of Allah, the most beneficent and the most merciful.

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Acknowledgements

All words of praise and gratitude to the sole Lord of universe, almighty Allah. I am

thank, first and foremost, Allah for having enable me to complete my effort of writing

such an assignment that would not have been possible for me to complete without his

help in all stages of its preparation. I revoke peace for Hazrat Muhammad (S.A.W) for

whom the earth and heaven is created. I am thankful for my parents, teachers, friends

and class fellows for having great courage and help during the report.

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Abstract

The topic assign to me was “Various cost concepts use in Decision Making”. I have

search the whole topic and select “Coca Cola” for practical study and show the

relationship between different costs and Decision making. I have found that the costs

concepts are so much important for an organization for its growth and for the increases

of its profit. “Coca Cola” management uses all the costs concepts for its

daily/weekly/monthly/annually decisions and running the organization in Profit.

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Table of Contents:

Contents Page No

Title page 01

Acknowledgement 03

Abstract 04

Table of contents 05

Introduction to the issue 06

Practical study of organization 13

Data collection methods 25

SWOT analysis 26

Conclusion 28

Recommendations 29

References 30

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Introduction to the issue

What is Decision Making?

”Decision making can be regarded as the mental processes resulting in the selection of

a course of action among several alternative scenarios. Every decision making process

produces a final choice. The output can be an action or an opinion of choice.” Decision

making is central to the management of an enterprise. The manager of a profit making

business has to decide on the manner of implementation of the objectives of the

business, at least one of which may well relate to allocating resources so as to maximize

profit. All organizations, whether in the private or the public sector, take decisions,

which have financial implications. Decisions will be about resources, which may be

people, products, services, or long term and short term investment.

What is Cost?

“Cost is the value of money that has been used up to produce something, and hence is

not available for use anymore”. In economics, a cost is an alternative that is given up as

a result of a decision. Decisions will also be about activities, including whether and how

to undertake them. Where the owners are different persons from the manager (for

example, shareholders of a company as separate persons from the directors), the

managers may face a decision where there is a potential conflict between their own

interests and those of the owners. In such a situation cost considerations may be

evaluated in the wider context of the responsibility of the managers to act in the best

interests of the owners.

Types of Costs:

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Manufacturing costs

Non-manufacturing costs

Fixed costs

Variable cost

Absorption costing

Opportunity costs

Product costs

Period costs

Differential costs

Standard cost

Direct cost & Indirect cost

Mixed cost.

Manufacturing costs:

Most manufacturing companies divide manufacturing cost into three broad categories.

Direct material, direct labor and Manufacturing overhead.

o Direct material:

Direct materials are those materials that become an integral part of the finished

product and that can be physically and conveniently traced to it. For example:

Panasonic use electric motor in it’s CD Players to make the CD spin.

o Direct labor:

The term direct labor is reserved for those labor costs that can be easily traced to

individual product. Direct labor is sometime called touch labor, since direct labor

workers typically touch the product while it is being made. For example the labor

cost of machine operator.

o Manufacturing overhead: 7

Manufacturing overhead the third element of manufacturing cost, includes all

cost of manufacturing except direct material and direct labor. So, we can say that

all costs associated with operating the factory are included in the manufacturing

overhead category. Such as indirect material, indirect labor, maintenance and

repairs on production equipment etc.

Non-manufacturing costs:

Generally non-manufacturing costs are sub-classified into two categories, (1) Selling

costs, (2) Administrative costs

o Selling costs: Selling cost include all costs necessary to secure customer orders

and get the finished product on service into the hand of the customer. This cost is

also known as marketing cost. Example: Advertising, Shipping, Sales travel etc.

o Administrative costs: It includes all executive, organizational and clerical costs

associated with the general management of an organization rather than with

manufacturing and selling. Example: Secretarial, compensation, public relation

and other this types of costs

Fixed costs:

A fixed cost is a cost that remains constant in total, regardless of changes in the level of

activity. As the activity level rises and falls, the fixed cost remains constant in total

amount unless influenced by some outside force, Such as price changes. There are two

types of fixed cost.

o Committed fixed cost: Committed fixed costs relate to the investment in

facilities, equipment and the basic organizational structure of a firm. Example:

Rent.

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o Discretionary fixed cost: Discretionary fixed cost usually arise from annual

decisions by management to spend in certain fixed cost areas. Example:

Advertising.

Variable cost:

A variable cost is a cost that varies in total, in direct proportion to changes in the level of

activity. The activity can be expressed in many ways, such as units produced, units sold,

miles driven, lines of print and so forth. A good example of variable cost is direct

material. It is important to note that when we speak of a cost as being variable, we

mean the total cost rises and falls as the activity level rises and falls. There are two types

of variable cost.

o True variable cost:

Direct material is a true variable cost because the amount used during a period

will vary in direct proportion to the level of production activity.

o Step-variable cost:

A cost that is obtained only in large chunks and that increases or decreases only

in response to fairly wide changes in the activity level is known as step-variable

cost. Maintenance cost is an example of step-variable cost.

Absorption costing:

A costing method that includes all manufacturing costs, direct materials, direct labor

and both variable and fixed overhead as part of the cost of a finished unit of production.

For example in this method the unit cost is as follows:

o Unit cost

Direct material: Rs.03

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Direct labor: Rs .02

Variable MOH: Rs .03

Fixed MOH: Rs .02

Total Rs. 10 per unit

Here fixed and variable MOH both are considered.

Variable costing:

In variable costing, only variable costs of production are allocated to products and the

unsold stock is valued at variable cost of production. Fixed production costs are treated

as a cost of the period in which they are incurred. For example in this method the unit

cost is as follows:

o Unit cost

Direct material: Rs. 03

Direct labor: Rs. 02

Variable MOH: Rs. 03

Total Rs. 08 per unit

Here fixed MOH is not considered.

Opportunity costs:

Opportunity cost is the potential benefit that is given up when one alternative is

selected over another. For example: Suppose I worked in a company and it gives me

20,000 Rs. per month. But suddenly I leave that job and get admitted in North-South

University for M.B.A. Then my salary 20,000 Rs. is my opportunity cost which I sacrificed

for further education.

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Product costs:

Product costs include all the costs that are involved in acquiring or making a product. In

the case of manufacturing goods these costs consist of direct material, direct labor and

manufacturing overhead. Product costs are initially assigned to inventories. So, they are

known as inventor-able costs.

Period costs:

Period costs are all the costs that are not incurred in product costs. These costs are

expensed on the income statement in the period in which they are incurred, using the

usual rules of accrual accounting. Period costs are not included as part of the cost of

either purchase or manufactured goods. Example: Sales commission, Office rent.

Differential costs:

A difference in costs between any two alternatives is known as differential cost. A

differential cost is also known as incremental cost. Technically an incremental cost

should refer only to an increase in cost from one alternative to another. Decreases in

cost should be referred to as decremented costs. So here we see that differential cost is

broader term consist of both incremental cost & decrement cost.

Standard costs:

Standard costs are target costs, which should be attained under specified operating

conditions. They are expressed as a cost per unit. For example: Hospitals have standard

cost (for food, laundry and other items) for each occupied bed per day, as well as

standard time allowance for certain routine activities, such as laboratory

test.

Direct cost:

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A direct cost is a cost that cannot be easily and conveniently traced to the particular cost

object under consideration. The concept of direct cost extends beyond just direct

material and direct labor. Example: Suppose Coca Cola Company is assigning costs to its

various regional and national sales offices. Then the salary of the sales manager in its

Karachi office would be a direct cost of that office.

Indirect cost:

An indirect cost is a cost that cannot be easily and conveniently traced to the particular

cost object under consideration. For example, the Coca Cola Company makes soft drinks

the factory manager’s salary would be an indirect cost of a particular variety such as

Sprite cola.

Mixed cost:

A mixed cost is one that contains both variable and fixed cost elements. Mixed costs are

also known as semi-variable cost. The fixed portion of a mixed cost represents the basic,

minimum cost of just having a service ready and available for use. The variable portion

represents the cost incurred for actual consumption of the service. The account analysis

and the engineering approach is used to estimate the fixed and variable portion of a

mixed cost.

Practical study of the organization

Coca Cola

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Introduction:

Research & Development

Company places great emphasis on Research and Development. For this purpose it has

well equipped and modern laboratory run by qualified staff, which is responsible for the

development of new products and it carries extensive research to improve the quality of

the product. It is also entrusted with the jobs of testing the raw material to enforce the

compliance to standard specifications.

Quality Control:

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Company vigorously pursues the quality in all processes starting from procurement of

the raw material to shipment of finished products to customers.

Basic Products:

o Coca Cola

o Sprite

o Sprite 3G

o Fanta

o Saplaish Orange Juice

o Saplaish Mango Juice

o Other Soft drinks

History of Coca Cola

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(John Pemberton)

In May, 1886, Coca Cola was invented by Doctor John Pemberton a pharmacist from

Atlanta, Georgia. John Pemberton concocted the Coca Cola formula in a three legged

brass kettle in his backyard. The name was a suggestion given by John Pemberton's

bookkeeper Frank Robinson. The soft drink was first sold to the public at the soda

fountain in Jacob's Pharmacy in Atlanta on May 8, 1886. About nine servings of the soft

drink were sold each day. Sales for that first year added up to a total of about $50. The

funny thing was that it cost John Pemberton over $70 in expanses, so the first year of

sales were a loss. Until 1905, the soft drink, marketed as a tonic, contained extracts of

cocaine as well as the caffeine-rich kola nut. In 1887, another Atlanta pharmacist and

businessman, Asa Candler bought the formula for Coca Cola from inventor John

Pemberton for $2,300. By the late 1890s, Coca Cola was one of America's most popular

fountain drinks, largely due to Candler's aggressive marketing of the product. With Asa

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Candler, now at the helm, the Coca Cola Company increased syrup sales by over 4000%

between 1890 and 1900. Advertising was an important factor in John Pemberton and

Asa Candler's success and by the turn of the century, the drink was sold across the

United States and Canada. Around the same time, the company began selling syrup to

independent bottling companies licensed to sell the drink. Even today, the US soft drink

industry is organized on this principle.

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Practical study of the organization with respect to issue

Coca Cola is a manufacturing organization and they use the concept of costs while

decision making. The detail of the cost concepts used in decision making by the Coca

Cola Company are as under:

The Role of Manufacturing costs in Decision Making:

Manufacturing cost is used to determine the inventory valuation on the balance sheet

and cost of goods sold on the income statement of external financial reports. The total

manufacturing cost of one unit is Rs.85, where

Direct material: Rs. 40 Direct labor: Rs. 15 MOH: Rs. 30 Total Rs. 85

Now from this manufacturing cost the company can decide that how much they want to

make profit and set a selling price based on that. Suppose they want to make 20% profit

on manufacturing cost then their selling price will be Rs.102. But after setting selling

price they see that one of their competitor sales their product at Rs. 95. In this situation

the company can justify the manufacturing cost that where the wrong is going on. If

their material price is high then they can buy the raw material from other supplier at

low cost to reduce the access cost. If their labor cost is high, then they can hire labor

from other at low cost or can cut the number of employee to reduce the cost. By taking

this corrective action the company can maintain the manufacturing cost to stay in the

market.

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The Role of Non-manufacturing costs in Decision Making:

Non-manufacturing cost is playing a great role in decision-making. In income statement

we deduct non-manufacturing cost or operating cost from gross margin to get net

profit. Suppose we expect “X” amount of money as net profit. But if the net income falls

below than our expectation, then we must reduce operating cost to gain more profit.

We can give one example to clear this idea. Suppose our net income is less than our

expectation. Now we have to reduce price. We can take advertising cost as a sample. In

case of advertising our first motive is to identify our target consumer then we have to

select the advertising media. Suppose we make one types of product and our target

consumers are fishermen. In this case we must use radio as an advertising media rather

than television and it will cost less. By this way we can save non-manufacturing cost. In

this purpose we can also reduce the cost of shipping, sales travel, compensation, public

relation cost, sales salary etc. to increase net profit.

The Role of Fixed costs in Decision Making:

Usually fixed cost is used to determine break-even point. Suppose our,

Fixed cost      = Rs. 20,000

                     Selling price  = Rs. 250

                     Variable cost = Rs. 150

Then break-even unit = 20,000 (250-150)

                                   = 200 unit

In the break-even point there is no profit as well as no loss at all. We have calculated

break-even point to determine the sales level and using this method we can also

calculate the number of unit to gain our expected profit Reduction of fixed cost is also

very important to increase net income. If we reduce fixed cost per unit then it will

contribute to net income. Suppose our production is not running in our full capacity

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level then we can increase production in order to reduce our fixed cost per unit. For

example

Capacity:        400 UnitsProduction:     300 UnitsFixed cost:      Rs.20,000Variable cost:  Rs.150Selling price:   Rs.250  

Current income statement Sales (300 250) =  Rs.75,000Less V.Cost  (150300) =  Rs.45,000             = Rs.30,000 Less Fixed cost          =  Rs.20,000 Net income             =  Rs.10,000                                        

Here we see that in the current situation we have a net income of Rs.10,000. Now we get an offer from outside to deliver 100 extra units at Rs.200. In this case our proposed net income as follows:

Sales (300 250+100200)  =  Rs.95,000 Less V.Cost  (150300+150100) =  Rs.60,000           = Rs.35,000 Less Fixed cost          =  Rs.20,000 Net income             = Rs.15,000

In this case we will accept the proposal because our proposed net income is greater

than the current net income.

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The Role of Variable cost in Decision Making:

Variable cost plays a great role in decision-making we know that if we increase our

production then our variable cost will also increase. So we have to concentrate on

reduction of total cost and in this case we must consider fixed cost also. If we increase

our production within our capacity, our unit cost of production will decrease. Because as

production increase variable cost will also increase but fixed cost per unit will decrease.

Suppose,

Variable cost = Rs.1 Fixed cost = Rs.10Capacity = 20 unit

    Production        Variable cost          Fixed cost           Total cost         unit              per unit             per unit                per unit

           5                     1                     2                    3          10                    1                     1                    2          15                    1                   .56                  1.56

Here we see that as production increases total cost per unit decrease because fixed cost

per unit continuously decreases. So, in case of reducing total cost we must increase the

production level. And as we know variable cost is constant so we must try to reduce the

total cost from other sector to generate more profit. Thus variable cost has a significant

impact on selling price. Variable cost is also used to calculate cm per unit, cm ratio,

margin of safety, degree of operating leverage and other this types of important things.

The Role of Absorption costing in Decision Making:

Absorption costing is the generally accepted method for preparing mandatory external

financial reports and income tax returns. Absorption costing treats fixed manufacturing

overhead as a product cost. If fixed costs are treated as period costs and there is a low

level of sales activity in a period then a low profit or a loss will be recorded. If there is a

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high level of sales activity there will be relatively high profit. Absorption costing creates

a smoothing of these fluctuations by carrying the fixed costs forward until the goods are

sold. Many firms use the Absorption approach exclusively because of its focus on full

costing of units of product.

The Role of Opportunity costs in Decision Making:

Opportunity cost is a very important item, which is playing an effective role in decision-

making. By considering opportunity cost we can determine the real cost of production.

We can give an example to clear this idea.

Let,Direct material : Rs.3 (Avoidable)Direct Labor : Rs.2 (Avoidable)Supervisor salary : Rs.1 (Avoidable)Factory rent : Rs.1 (Unavoidable)Depreciation : Rs.2 (Unavoidable)Allocated general Expense : Rs.3 (Unavoidable)Total cost per unit : Rs.12

Avoidable cost : (3+2+1) = Rs.6Unavoidable cost : (1+2+3) = Rs.6

Here we see that if we make the material the cost of per unit will be Rs.12. Now we get

an offer from outside at Rs.8 per unit. If we want to buy we have to consider some other

things because there are some unavoidable cost that we can’t ignore. It will add to the

buying cost. Now we see that if we buy it will costs (8+6) = Rs.14 per unit. So we can

easily determine that we will go for making not buying. In this case we have to consider

opportunity cost. Suppose the room, where we will make our production, the rent of

that room is Rs.20,000 and we get an offer for 5,000 unit.

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                                         Make                                    BuyUnit cost                            Rs.12                                  Rs.14For 5,000 unit                    Rs.60,000                            Rs.70,000(+) Opportunity cost          Rs.20,000                               ------Total cost                           Rs.80,000                            Rs.70,000

Here we see that if we go for making it will cost more and if we buy raw material from

outside we can generate Rs.10,000 as a profit. So, in this case we will definitely go for

buy not make.

The Role of Period costs In Decision Making:

Depending on period cost we can also take some corrective action. Normally sales

commission, office rent and other these types of cost are included in period cost.

Suppose our net income is lower than our expectation then we can increase our net

income by reducing period cost. Let’s take office rent. If our office rent is high then we

can reduce the rent by shifting office place. However for many decision-making

purposes the period costs are seen as being non-controllable in the short-term, so that

attention may focus on product cost.

The Role of Product costs in Decision Making:

If an organization wants to minimize their inventory cost they can fallow just in time

process. In this process the cost of inventory is less than the normal process. So, the

product cost is minimized and it will help to generate more profit. If an organization

follows normal process for manufacturing goods, then they must reserve material for

future and it will cost a lot. Such as rent for place, guard salary, maintenance cost. And it

will reduce net income. So, they must follow just in time process to increase the net

income.

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The Role of Differential costs in Decision Making:

Differential cost can be either fixed or variable. To illustrate assume that Coca Cola is

thinking about changing it’s marketing method from distribution through retailer to

distribution by door-to-door direct sale. Present cost and revenues are compared to

projected costs and revenues in the following table:

                                     Retailer                Direct sale             Differential cost

                                  Distribution            Distribution                and revenue

Revenue                      Rs.500,000             Rs.600,000                Rs.100,000

Deduct                      ======================================

Cost of good sold         Rs.150,000                Rs.200,000                  Rs.50,000

Advertising                  Rs.50,000                  Rs.25,000                    Rs.(25,000)

Commission                   - 0 -                        Rs.20,000                    Rs.20,000

Depreciation                Rs.25,000                  Rs.50,000                    Rs.25,000

Other expenses            Rs.20,000                  Rs.20,000                      -- 0 -- 

Total                           Rs.245,000                Rs.315,000                  Rs.70,000

Net income                Rs.255,000                Rs.285,000                  Rs.30,000

                                  =====================================

According to the analysis the differential revenue is Rs.100,000 and the differential cost

is Rs.70,000 leaving a positive differential net income Rs.30,000 under the proposed

marketing plan. From the given table the company can easily decide that which

marketing plan they should follow. As we see in the above analysis the net income

under door-to-door is Rs.30,000 higher than the previous one. And they can get it

simply focusing on differential cost, revenue and net income. By this way differential

cost helps in decision-making.

The Role of Standard costs in Decision Making:

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Standard cost is used to integrate costs in the planning and pricing and pricing structure

of a business. Once the Standard cost has been decided, the actual cost may be

compared with the standard. If it equals the standard then the actual outcome has

matched expectations. If the actual cost is different from the standard cost allowed,

then there will be variance to be investigated, whether it is favorable or unfavorable.

When the actual cost is less than the standard cost then it is called favorable and when

the actual cost is greater than the standard cost then it is called unfavorable. In case of

favorable term management will accept the proposal and in case of unfavorable term,

they will reject it. Direct cost & Indirect cost.

The Role of Direct and Indirect cost in Decision Making:

Direct cost includes direct material, direct labor; on the other hand indirect cost includes

indirect material and indirect labor. They are playing a great role in decision-making, but

not individually. They have a significant impact on manufacturing cost, because these

costs are included in manufacturing cost. So ultimately they are playing role in setting

selling price.

The Role of Mixed cost in Decision Making:

Mixed costs also have some role in decision-making because this cost is a combined

form of fixed and variable cost. As we know fixed costs are constant but variable cost

differs with the production level. So, by reducing the variable cost we can decrease total

unit cost and it will help to increase net income.

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Data collection methods

The Data is collected by

o Through Company visit

o Mr. Ishfaq Ahmed (Finance Manager Faisalabad Division)

o Online Articles

o Book of Cost Accounting

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SWOT Analysis

The Coca-Cola Company (Coca-Cola) is a leading manufacturer, distributor and marketer

of Non-alcoholic beverage concentrates and syrups, in the world. Coca-Cola has a strong

brand name and brand portfolio. Business-Week and Interbrand, a branding

consultancy, recognize Coca-Cola as one of the leading brands in their top 100 global

brands ranking in 2006. The Business Week-Interbred valued Coca-Cola at $67,000

million in 2006. Coca-Cola ranks well ahead of its close competitor Pepsi which has a

ranking of 22 having a brand value of $12,690 million The Company’s strong brand value

facilitates customer recall and allows Coca-Cola to penetrate markets. However, the

company is threatened by intense competition which could have an adverse impact on

the company’s market share.

Strengths

o Practical use of cost concepts for decision making

o World’s leading brand

o Large scale of operations

o Robust revenue growth in three segment

Weaknesses

o No Use of Differential cost

o Un-satisfacted performance by staff Managers

o Decline in cash from operating activities

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Opportunities

o Can earn more profit through Differential cost

o Growing bottled water market

o Growing Hispanic population in US

Threats

o Intense competition

o Un-satisfacted performance by staff Managers

o Dependence on bottling partners

o Sluggish growth of carbonated beverages

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Conclusion

If any Coca Cola wants to run its company successfully then the management needs to

take proper decision on time. Most decisions will at some stage involve consideration of

financial matters, particularly cost. Decisions may also have an impact on the working

conditions and employment prospects of employees of the organization, so that cost

considerations may, in the final analysis, be weighed against social issues. If the

management can control the cost then the company will generate more profit, on the

other way they will suffer loss. So, by going through this project we can easily

understand how different types of cost play role in decision-making and we can apply

these terms in practical life.

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Recommendations

o The finance manager has to be a enough knowledge about the cost concepts

used for decision making.

o A Fore-cost planning is essential for good results.

o The Company should have to give time to time training to Staff Managers.

o In order to avoid the misallocation of funds financial manager should have to

make the plan before of financial decision.

o To plan for the future the financial manger must assess the firm’s present

financial position and evaluate opportunities in relation to this current position.

o There is need of well-experienced financial manager, because inexperienced

financial manager cannot analyze the financial statement in an effective way.

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References

o Managerial Accounting

Ray H. Garrison

Eric W. Noreen

o Introduction to Management Accounting

Professor Pauline Weetman

Paul Gordon

o Class lecture

o www.the-cocacola-company.com.pk

o www.google.com

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