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Using Costs inUsing Costs inDecision MakingDecision Making

Chapter 3

Management Accounting Management Accounting Supports Decision MakingSupports Decision Making

Cost information is pervasive throughout decision-making situations– Pricing– Product planning– Budgeting– Performance evaluation– Contracting

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Cost BehaviourCost BehaviourCost Driver an activity which influences how a cost is incurred kilometers traveled is a cost driver for gasoline costs

Volume

Volume

$

$

Variable Cost• a cost which changes in direct proportion

to changes in the cost driver• is constant per unit as volume changes

Fixed Cost• a cost which is not influenced by changes

in the cost driver over the relevant range• per unit fixed costs change as volume

changes

Cost Classifications for Cost Classifications for Predicting Cost BehaviourPredicting Cost Behaviour

Behavior of Cost (within the relevant range)

Cost In Total Per Unit

Variable Total variable cost changes Variable cost per unit remainsas activity level changes. the same over wide ranges

of activity.

Fixed Total fixed cost remains Average fixed cost per unit goesthe same even when the down as activity level goes up.

activity level changes.

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Cost-Volume-Profit (CVP) Cost-Volume-Profit (CVP) AnalysisAnalysis

CVP uses variable and fixed costs to identify the profit generated at various levels of activity

Contribution Margin is the difference between total revenue and total variable costs

Contribution Margin per Unit is the contribution each unit makes to covering fixed costs and providing a profit

Contribution Margin Ratio is the ratio of contribution margin per unit to selling price per unit

BEP: Graph MethodBEP: Graph Method

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The CVP EquationThe CVP Equation Profit

= Revenue - Total Costs

= Revenue - Variable Costs - Fixed Costs

= (Units Sold x Revenue per Unit) - (Units Sold x Variable Cost per Unit) - Fixed Costs

= (Units Sold x [Revenue per Unit - Variable Cost per Unit]) - Fixed Costs

= (Units Sold x Contribution Margin per Unit) - Fixed Costs

Variations of CVP EquationVariations of CVP Equation To calculate sales needed to achieve target profit:

Required Unit Sales

= (Target Profit + Fixed Cost) / Contribution Margin per Unit

Impact of income taxes

Required Unit Sales

= [Target Profit / (1 – Tax Rate) + Fixed Costs] / Contribution Margin per Unit

© 2012 Pearson Prentice Hall. All rights reserved.

© 2012 Pearson Prentice Hall. All rights reserved.

CVP Analysis for Multiple CVP Analysis for Multiple ProductsProducts

There are many combinations of sales levels for multiple products that would allow the organization to break even or reach a target profit

An extension of basic CVP analysis called the Bundle Approach assumes a constant product mix

A $5

A$5

B$10

B$10

B$10

Sales Mix in units Relative mix based on the # of units sold A = 40%; B = 60%

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CVP AssumptionsCVP Assumptions

Assumptions underlying CVP analysis:– The unit selling price and variable cost remain the

same over all levels of production– All costs are either variable or fixed– Fixed costs remain the same over all levels of

production– Sales equal production

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Other Useful Cost DefinitionsOther Useful Cost Definitions Mixed Cost—a cost that has variable and fixed

components Step Variable Cost—a variable cost that increases

in steps as the quantity increases Incremental Cost—the cost of the next unit of

production Sunk cost—a cost that results from a previous

commitment and cannot be recovered

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Other Useful Cost DefinitionsOther Useful Cost Definitions Relevant Cost—a cost that will change as a result

of a decision Opportunity Cost—the maximum value forgone

when a course of action is chosen Avoidable Cost—a cost that can be avoided by

taking a specific course of action

Equipment-Replacement Equipment-Replacement DecisionsDecisions

Sometimes difficult due to amount of information at hand that is irrelevant:– Original cost, accumulated amortization and book

value of existing equipment – these are sunk costs Concentrate on relevant information:

– Current disposal price of old machine– Cost of new machine

Both are future cash flows and differ between alternatives

Equipment Replacement Equipment Replacement Irrelevance of Past CostsIrrelevance of Past Costs

Costs incurred in the past are sunk Only expected future costs & revenues are relevant

Example: Consider replacing an old machine with a new machine with expected lower operating costs

Keep Old Buy New DifferenceRelevant costs:Operating costs $1,600,000 $920,000 $680,000

Disposal value ofold machine (40,000) 40,000

Cost of new machine 600,000 (600,000)

Difference 120,000

Make-or-Buy: The Make-or-Buy: The Outsourcing DecisionOutsourcing Decision

The financial focus in the make-or-buy decision is whether the costs avoided internally are greater than the added external costs when purchasing a product or service from a supplier

Internal costs that can be avoided– Typically all variable costs– Any avoidable fixed costs

Make-or-Buy: The Make-or-Buy: The Outsourcing DecisionOutsourcing Decision

External costs incurred to buy

– Cost to purchase the product or service– Any transportation costs– Costs involved with dealing with a supplier such as

ordering, receiving, and inspection

Manufacturing CostsManufacturing Costs Direct Material—materials that can be traced

easily to a unit of output and are of significant economic consequence to final product

Direct Labor—labor costs that can be traced easily to the creation of a unit of output

Manufacturing Overhead—all other costs incurred by a manufacturing facility that are not direct material or direct labor

Drop a Product or a DivisionDrop a Product or a Division Relevant costs to consider when dropping a

product or a division– Incremental revenues forgone– Incremental costs avoided

Note that there are usually strategic considerations in addition to the economic (relevant cost) analysis

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Special Order CharacteristicsSpecial Order Characteristics The special order problem considers the situation

where an organization receives a one-time offer to buy a product (good or service). The assumption is that accepting or rejecting this offer will have no future consequences other than the incremental cash flows it creates.

For example, accepting a special order to supply a product for $40 that is sold to existing customers for $50 may create problems with existing customers and expectations on the part of the new customer that the special order price of $40 will consider.

For this reason, many people believe the assumptions underlying the special order analysis are seldom met in practice.

19

StepsSteps Is there sufficient idle capacity to meet this order?

– If so, there are no opportunity costs associated with this order

– If not, compute the opportunity cost associated with this order

Ensure that the special order price covers incremental (variable) costs and opportunity costs

20

Decision FlowDecision Flow

21

Is the organization operating at capacity?

Ensure that the offer price at least covers the variable cost of filling the order (the

floor price)

Compute the opportunity cost of

filling the order

Ensure that the offer price at least covers the variable

costs and the opportunity costs of filling the order

(the floor price)Yes

No

Allocating a Scarce ResourceAllocating a Scarce Resource The relevant cost concept contributes insight into

effective short run resource allocation by focusing on the idea that we should evaluate and compare the incremental benefits of allocating a scarce resource to its alternative uses and making the allocation that provides the highest incremental benefit.

This decision is often called the product mix decision because it results in choosing the short run product mix

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Product Mix Decisions Under Product Mix Decisions Under ConstraintConstraint

Snowmobile BoatEngine Engine

Contribution margin per unit $240 $375Machine hours required per unit 2 5Contribution margin per

machine hour $120 $75

If machine hours are constrained, maximize income by first producing as many snowmobile engines as can be sold and then shift production to boat engines