03/09/2010
Management Accounting
Joy Chan ESSCA Angers
Fall 2010
Overview of Session 1 Traditional cost accounting methods • Review of different types of cost behavior • Direct/indirect costs, Variable/Fixed costs, Volume-Profit relationship, Contribution Margins • Using Break-even analysis for better planning
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Cost Accounting Cost Accounting is a branch of accounting that keeps track of the cost of the many things that go directly or indirectly into the production of each unit of goods and services sold by the company. Managers use this information for several purposes: To develop reasonable selling prices for the goods and services they produce To identify costs that are getting out of control To target particular costs for gradual reduction To determine which products and services are profitable and which are not
The behaviour of costs
Costs may be broadly classified as:
Fixed
Those that stay fixed (the same) when changes occur to the volume of activity
Variable
Those that vary according to the volume of activity
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Fixed Costs A business operates a small chain of hairdressing salons. Can you give some examples of costs that are likely to be fixed for this business? • Rent • Insurance • Cleaning costs • Staff salaries These costs seem likely to be the same irrespective of the number of customers having their hair cut or styled. Staff salaries/wages – sometimes assumed to be variable costs but in practice, they tend to be fixed. People are generally not paid according to the volume of activity, and it is not normal to dismiss staff when there is a short term downturn in activity.
Graph of fixed cost(s) against the volume of activity Cost (£)
F
0
Volume of activity (units of output)
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Fixed Costs Clarifications about fixed costs: •
“Fixed” does not mean set in stone for all time, it usually means fixed over the short to medium term
•
“Fixed” means only that costs are not altered by changes in the volume of activity
•
Fixed costs are likely to be affected by inflation
•
Fixed costs are almost always time-based, ie they vary with the length of time concerned. For example, rental charge for 2 months is normally twice that for one month but not with the volume of activity that the firm has. Hence, when we look at fixed costs, we must add the period concerned.
Stepped Fixed Costs At lower volumes of activity, fixed costs would be the level OR (as indicated on the next slide). As the volume of activity expands, the premise becomes inadequate and further expansion requires an increase an increase in the size of premise and therefore, cost. Eventually, additional costs will need to be incurred if further expansion is to occur. Fixed costs that behave like this are often referred to as stepped fixed costs.
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Graph of rent cost against the volume of activity
Rent cost (£)
R
0
Volume of activity
Variable Costs Variable costs are costs that vary with the volume of activity. At zero volume of activity, the variable cost is zero. The cost increases in a straight line as activity increases. The straight line implies that the variable cost will normally be the same per unit of activity, irrespective of the volume of activity concerned.
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Graph of variable costs against the volume of activity
Cost (£)
0
Volume of activity
Semi-fixed (semi-variable) costs Some costs have an element of both fixed and variable cost. These are semi-fixed (semi-variable) costs. An example might be electricity costs where part is fixed, at least until the volume of activity expands to a point where longer operating hours are required, or larger premises needed. How do we determine the how much is fixed or variable? For example, for electricity costs • Look at past experience - obtain data over several months • Plot electricity charge against volume of activity (measured by sales revenue). • Find the best fit line • Fixed element- vertical distance from the origin at zero • Variable element – gradient of the line
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Graph of electricity cost against the volume of activity Electricity cost (£)
The slope of this line gives the variable cost per unit of activity
Fixed cost element 0
Volume of activity
Break-even Analysis With total fixed costs and total variable cost per unit, we can produce the total cost line in the following slide. If we superimpose the total cost line on the total revenue line, we obtain the break-even chart. The profit (loss) is the difference between total sales revenue and total cost, for a particular volume of activity, it is the vertical distance between the total sales revenue line and the total cost line at that volume of activity. The break-even point (BEP) is where there is no profit or loss. At BEP, Total sales revenue = Total costs Total sales revenue = Fixed costs + Total variable costs If b is the number of units of output at BEP, b x Sales revenue per unit = Fixed costs + (b x Variable costs per unit) b=
Fixed costs Sales revenue per unit – Variable costs per unit
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Graph of total cost against the volume of activity Cost (£)
Total cost
Variable costs F Fixed costs
0
Volume of activity (units of output)
Break-even chart Total sales revenue
Cost (£)
Break even point Total cost Variable costs
F Fixed costs 0
Volume of activity (units of output)
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BEP – Cottage Industries Cottage industries expects to sell 500 baskets a month. The business has the opportunity to rent a basket-making machine. By doing so, • total fixed costs of operating the workshop for a month will increase from $500 to $3,000 • each basket requires materials that cost $2 • using the machine would reduce the labor time from one hour to half an hour per basket. The basket markers are paid $10 an hour. All basket makers are on contracts and if they don’t work, they are not paid. • all baskets are sold to a wholesaler for $14 each a. b. c.
How much profit would the business make each month from selling baskets, with and without the basket making machine? What is the BEP if the machine is rented? Comment about the figures calculated
BEP – Cottage Industries Without machine
With machine
7000
7000
Materials (500*$2)
(1000)
(1000)
Labor (500x1hrx$10)
(5000)
Sales (500*$14) Less:
Labor (500x0.5hrx$10)
(2500)
Fixed costs
(500)
(3000)
PROFIT
500
500
BEP (in number of baskets) with machine: = FC/(Sales per unit – VC per unit) = 3000/(14 – (2+5)) = 429 baskets a month BEP (in number of baskets) without machine = 500/(14 – (2+10)) = 250 baskets a month
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Break-even chart for Cottage Industries’ basket making activities without the machine Cost ($000)
5 Break-even point
Total costs
4
3
2 Total revenue
1
0
Fixed costs
100
200
300
400
500
Volume of activity (number of baskets)
Break-even chart for Cottage Industries’ basket making activity with the machine Cost ($000) 6
Total costs
5
Break-even point
4 3
Fixed costs 2
Total revenue
1 0
100
200
300
400
500
Volume of activity (number of baskets)
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Contribution Margin The denominator in the BEP formula (Sales revenue per unit – Variable costs per unit) is known as the contribution margin. b=
Fixed costs Contribution Margin
It is called contribution because it contributes to meeting the fixed costs and, if there is any excess, it also contributes to profits. Knowing the contribution margin generated by a particular activity can be valuable in making short-term decisions of various types.
BEP-Profit Planning With a simple adjustment, the Breakeven Point formula can be modified to become a Profit Planning tool •
Sales – VC – FC = Operating Income (OI)
•
(SP x Q) – (VCu x Q) – FC = OI
•
Q (SP – VCu) – FC = OI
•
Q (CMu) – FC = OI
•
Q = (FC + OI) CM
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Sensitivity Analysis CVP provides structure to answer a variety of “what-if” scenarios “What” happens to profit “if”: – Selling price changes – Volume changes – Cost structure changes • Variable cost per unit changes • Fixed cost changes
Contribution Margin vs. Gross Profit Comparative Statements Contribution Margin Income Statement (Internal-Use Only) Revenues: Less: Variable Cost of Goods Sold Variable Operating Costs Contribution Margin Fixed Operating Costs Operating Income
Financial Accounting Income Statement IFRS - Based $200
$120 45
165 35 20 $15
Revenues: Less: Cost of Goods Sold Gross Margin (Profit) Fixed & Variable Operating Costs Operating Income
$200 $120 80 65 $15
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Margin of Safety The margin of safety is the extent to which the planned volume of activity or sales lies above the BEP. Without
With
Machine
Machine
Expected Volume of sales (baskets)
500
500
BEP (baskets)
250
429
Number of baskets
250
71
Percentage of estimated volume of sales
50%
14%
Difference (margin of safety):
Margin of Safety The relative margins of safety are directly linked to the relationship between the selling price per basket, the variable costs per basket, and the fixed costs per basket. Without the machine, The contribution per basket is $2, whilst FC is $500 per month With machine, The contribution per basket is $7, whilst FC is $3000 per month This means that with the machine, the contributions have more fixed costs to overcome before the activity becomes profitable. However, the rate at which the contributions can overcome fixed costs is higher with the machine, because variable costs are lower. This means that one more or one less basket sold has a greater impact on profit than it does if there was no machine.
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Effects of Sales-Mix on CVP •
The formulae presented to this point have assumed a single product is produced and sold
•
A more realistic scenario involves multiple products sold, in different volumes, with different costs
•
For simplicity’s sake, only two products will be presented, but this could easily be extended to even more products
Effects of Sales-Mix on CVP •
A weighted-average CM must be calculated (in this case, for two products) Weighted ( Product #1 CMu x Product #1 Q ) + ( Product #2 CMu x Product #2 Q ) Average = CMu Total Units Sold (Q) for Both Products
•
This new CM would be used in CVP equations Multi-
Fixed Costs
Product = Weighted Average CM per unit BE
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Limitations of Break-even Analysis
It assumes that fixed costs (FC) are constant. Stepped fixed costs – most fixed costs are not fixed over all volumes of activity. Problems are heightened because most activities will probably involve fixed costs of various types (rent, salaries, administration costs), all of which are likely to have steps at different points
It assumes average variable costs are constant per unit of output, at least in the range of likely quantities of sales. (i.e. linearity)
It assumes that the quantity of goods produced is equal to the quantity of goods sold (i.e., there is no change in the quantity of goods held in inventory at the beginning of the period and the quantity of goods held in inventory at the end of the period).
In multi-product companies, it assumes that the relative proportions of each product sold and produced are constant (i.e., the sales mix is constant).
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