Ch 1: Managerial Accounting and the Business Organization

CH 2: Introduction to Cost Behavior and C.V.P. analysis. 

Definitions:

·         Cost drivers: In activity based costing (which states that products consume activities and activities consume resources) any factor which causes a change in the cost of an activity. An activity can have more than one cost driver attached to it. For example, a production activity may have the following associated cost-drivers: a machine, machine operator(s), floor space occupied, power consumed, and the quantity of waste and/or rejected output.

·         Activity based costing:  Cost accounting approach concerned with matching costs with activities (called cost drivers) that cause those costs. It is a more sophisticated kind of absorption-costing and replaces labor based costing system. ABC states that (1) products consume activities, (2) it is the activities (and not the products) that consume resources, (3) activities are the cost drivers, and (4) that activities are not necessarily based on the volume of production. Instead of allocating costs to cost centers (such as manufacturing, marketing, finance), ABC allocates direct and indirect costs to activities such as processing an order, attending to a customer complaint, or setting up a machine. A subset of activity based management (ABM), it enables management to better understand (a) how and where the firm makes a profit, (b) indicates where money is being spent and (c) which areas have the greatest potential for cost reduction. Developed by professors Robert Kaplan and Robin Cooper of Harvard University in late 1980's.

                                I.            Variable and Fixed Cost behavior

When analyzing costs, you may find these two rules of thumb useful:

1.       Think of fixed costs on a total – cost basis. Total fixed costs remain unchanged regardless of changes in the cost driver.

2.       Think of variable costs on a per unit basis. The per unit variable cost remains unchanged regardless of changes in the cost driver. As a result the total variable cost varies proportionately with the level of the cost driver.

Relevant range: is the limit of cost driver level within which a specific relationship between costs and the cost driver is valid. Even within the relevant range, though, a fixed cost remains fixed only over a given period of time – usually the budget period. Fixed costs may change from budget year to budget year solely because of changes in insurance and property taxes rates, executive salary levels, or rent levels. But these items do not change significantly within a given year.

Difficulties in Classifying Costs:

It’s not always easy to classify costs as exactly variable or exactly fixed. Whether costs are variable or fixed depends heavily on the relevant range, the length of the planning period in question, and the specific decision situation.

                              II.            Cost volume profit analysis

Managers often classify costs as fixed or variable when making decisions that affect the volume of output. Consider the decision about how many units of a product to produce in the coming year. Managers realize that many factors in addition to the volume of output will affect costs. Yet a useful starting in their decision process is to predict how the choice of production level will affect costs.

The managers of profit seeking organizations usually study the effects of output wolume on revenue, expenses, and net income. We call this study the cost volume profit analysis.

  Margin of Safety:

  Contribution Margin

The difference between total sales revenue and total variable costs. The term is can be applied to a product or product lines and is generally expressed as a percentage.

In retail, the Gross Margin Percent is recognized as the Contribution Margin Percent. The contribution margin information can be used to add or remove products and product lines or to make informed pricing decisions.

Example:

After subtracting our total variable costs from our sales, we found our annual contribution margin was 42%. In other words, for each dollar of sales, 42 cents was left to contribute toward direct costs and profit.

Gross Margin

Definition: The difference between what an item cost and for what it sells.

Examples:

Total Sales - Cost of Goods Sold = Gross Margin

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Chpater 3 :  Measurement of Cost Behavior

        I.            Cost Drivers and Cost Behavior

·        Step Cost :   is a cost that change abruptly at different intervals of activity because the resources and their costs are only available in indivisible chunks. If the individual chanks of costs are relatively large and apply to specific, broad range of activity, we consider the cost a fixed cost over that range of activity.

·        SEMI-VARIABLE COST (MIXED COST)

Semi- variable cost has both a fixed cost element and a variable cost element. Best example is where sales representatives are paid a fixed salary plus commission on sales.

Total cost of production is the sum of fixed cost and variable cost.

Total costs = Fixed cost + Variable cost

      II.            Management Influence on cost behavior

Have to be read, but in short you only have to remember what is:

·         Capacity Costs: the fixed costs of being able to achieve a desired level of production or to provide a desired level of service while maintaining product or service attributes, such as quality.

·         Committed fixed costs are costs arising from the possession of facilities, equipment, and a basic organization. They cannot be deleted easily from the firm’s budget.

·         Discretionary fixed costs: costs determined by management as part of the periodic planning process in order to meet the organization’s goals. They have no obvious relationship with levels of capacity or output activity. They can be deleted from the budget easily.

    III.            Cost Functions

Cost functions are used to:

·         To accurately plan and control the activities of an organization and to estimate future fixed and variable costs.

·         Understand relationships between costs and their drivers to make better operating, marketing and production decisions, to plan and evaluate actions, and determine appropriate costs for short run and long run decisions.

The first step in estimating or predicting costs is cost measurement – measuring cost behavior as a function of appropriate cost drivers. The second step is to use these cost measures to estimate future costs at expected levels of cost driver activity.

·        Form of cost function

Y = F + VX

Y: Total cost

F: Fixed cost

V: Variable cost

X: cost driver activity

Developing cost functions:   managers should apply two criteria to obtain accurate and useful cost functions: Plausibility and reliability.

·        Choice of cost drivers through activity analysis

Activity analysis is the process of identifying appropriate cost drivers and their effects on the costs of making a product of providing a service.

One major question remains which is: how the estimate of fixed costs and variable cost per cost driver unit determined?

    IV.            Methods of measuring cost functions

Managers can choose from a broad selection of methods of approximating cost functions. These methods include:

·        Engineering analysis

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