Level 1 Cost Behaviour and Costing slides.pptx
- 1. Financial Planning and Control – Costs Advanced Financial Management Module
- 3. Objective • Define and illustrate a cost. • Cost- sacrifice of a resource for immediate or future benefit • Explain and distinguish the following costs • variable and • fixed costs. • Semi variable and semi fixed • Direct and indirect costs • Apply and describe the different methods of estimating costs. • What is the high-low method and when do we use it.
- 4. Cost Classifications Costs and cost behaviour underpins a lot of the theory of management accounting. The classification of a cost will determine how it is treated in different situations. In the business world, understanding the costs of the company and how they behave allows management to respond appropriately to control these cost, ensure that revenue is sufficient to cover these costs and make effective decisions.
- 6. Direct and Indirect Costs • Direct costs - Are those costs that can be specifically and exclusively identified with a particular cost object. Indirect cost – Cannot be identified specifically and exclusively with a given cost object. Classify the following costs : • Material • Wages of operatives • Supervisor salaries • Rent of factory
- 7. Categories of manufacturing costs • Direct Material xxx • Direct Labour xxx • Manufacturing overheads xxx • Total Manufacturing costs xxx
- 8. Categories of manufacturing costs • Direct Material xxx • Direct Labour xxx • Manufacturing overheads xxx • Total Manufacturing costs xxx
- 9. Cost Behavior • A knowledge of how costs and revenues will vary with different levels of activity is essential for decision making. • Activity maybe measured in term of units of production or sales, hours worked, km travelled, patients seen, or students enrolled. • Relevant Costs- WRT Students carrying a module: - Setting of examinations - Printing exams- number of copies - Marking - Lecturer allowances - Lecture venue
- 10. Cost Behavior- cont Examples of decisions that require information on how costs and revenues will vary with different level of activity. • What should the planned level of activity be for the next year • Should we reduce the selling price to sell more units? • How will costs and revenue change if output is increased by 15%.
- 11. Classification by cost behaviour • Important to predict costs and revenues at different activity levels for many decisions. • Variable costs vary in direct proportion with activity. Fixed costs remain constant over wide ranges of activity. Semi-fixed costs are fixed within specified activity levels, but they eventually increase or decrease by some constant amount at critical activity levels. • Semi-variable costs include both a fixed and a variable component (e.g. telephone charges). • Note that the classification of costs depends on the time period involved. In the short term some costs are fixed, but in the long term all costs are variable.
- 12. Cost Behavior – Variable costs • Short term variable costs vary in direct proportion to the volume of activity, ie doubling the level of activity will double the total variable costs. • Give examples of variable costs ?
- 13. Cost Behavior – Fixed Costs • Fixed costs remain constant over a wide ranges of activity for a specified time period. Examples of fixed costs?
- 14. Cost Behavior – Stepped fixed costs • In practice, it is unlikely that fixed costs will remain constant over the full range of activity. A certain level of activity may trigger a change in the fixed costs.
- 16. Cost Behavior – Total costs
- 17. Summary • The distinction between fixed and variable costs must be made relative to the time period under consideration. Over a sufficiently long time virtually all costs are variable. • Within shorter time periods, costs will be fixed or variable in relation to changes in activity. The shorter the time period, the greater the probability that a particular cost will be fixed.
- 18. Class Exercise • Assume that you are a management accountant at ZUPCO. You want to analyse the costs involved in the Harare Byo route. Req: • List the costs incurred in operating the Hre Byo route • Classify as whether fixed or variable
- 19. Example Ruwa Town Council incurs the following costs for the refuse collection departments: Fuel for the refuse trucks Environmental Management Agency (EMA) environmental fees Licences for refuse trucks Salaries and wages for the garbage collectors and drivers Vehicle services and maintenance Awareness campaigns on refuse disposal Toll gate fees to the dumping site Classify the costs above as either variable or fixed. Provide rationale for your classification.
- 20. Decision Making • Relevant Costs • Sunk cost • Opportunity costs
- 21. Avoidable and unavoidable costs •Avoidable costs are those costs that can be saved by not adopting a given alternative, whereas unavoidable costs cannot be saved. •Avoidable/unavoidable costs are alternative terms sometimes used to describe relevant/irrelevant costs.
- 22. Relevant and irrelevant costs • For decision making costs and revenues can be classified according to whether they are relevant to a particular decision. • Relevant costs and revenues are those future costs and revenues that will be changed by a decision, • Irrelevant costs and revenue – are those that will not be affected by the decision. • Give examples of relevant and irrelevant costs,
- 23. Sunk costs and opportunity costs • Sunk costs – These are costs already acquired where the total will not be affected by the choice between various alternatives. • Opportunity costs – is a cost that measures the opportunity that is lost or sacrificed when one course of action that requires that an alternative course of action be given up. • Give an example of both
- 24. Cost Estimation • Determining how a cost will change with output or other measurable factors of activity is of vital importance for decision making, planning and control. The preparation of budgets, the production of performance reports, and the provision of relevant costs for decisions all depend on reliable estimates of costs and distinguishing between fixed and variable costs at different activity level. • Many costs are fairly easy to classify as purely variable, fixed, or step- fixed but others fall into a mixed costs category.
- 25. Cost Estimation Methods • The following approaches to costs estimation will be examined : • engineering methods • Inspection of the accounts methods • Graphical or scatter-graph method • High-low method*** • Least squares method • (within our scope)
- 26. High Low Method • The high-low method consists of selecting the periods of highest and lowest activity levels and comparing the changes in costs that result from the two levels. • Variable cost/unit = Cost at highest Activity- cost at lowest Activity Highest Activity – Lowest Activity Lowest Output- 8000 Cost= 80 000 Highest Output-35000 Cost = 180 000 (180-80)/(35000-8000) = 100 000/ 27000= 3.70 8000x3.70= total variable costs =29600 FC=80000-29600=50400 Y= 50400 + 3.7X
- 27. High-low method Marti ltd presents the following monthly information for various production levels : Total production 12000 25 000 30 000 35 000 Total overhead 276 000 380 000 420 000 390 000 Required : Determine the variable overhead tariff and total fixed overhead costs
- 28. Least squares method Cost estimation method like high low method. It is a method of determining the regression line of best fit. Assume the following Hours (x) Cost (y) 90 1500 150 1950 60 900 30 600
- 29. Least squares method Hours (x) Cost (y) x2 xy y2 90 1500 8 100 135 000 2 250 000 150 1950 60 900 30 600 A=∑y /n –b∑x/n B = n∑xy - ∑x∑y n∑x2 – (∑x)2
- 30. Financial Planning and Control – Variable and Absorption Costing Advanced Financial Management Module
- 32. Objective • Explain the difference between absorption and variable costing system • Prepare profit statements based on a variable costing and absorption costing system • Explain arguments for and against variable and absorption costing • Describe the different denominator levels that can be used with an absorption costing system • Justify why budgeted overhead rates should be used instead in preference to actual overhead rates • Calculate and explain the accounting treatment of the under/over recovery of overheads.
- 33. Cost Accumulation systems Cost accumulation systems Variable costing Absorption Costing Tradition costing system Activity based Costing
- 34. Variable/Direct Costing • Turnover xxx • Less Variable cost of sales (xxx) (No fxd man overheads) • Less other variable costs (non manfrng) (xxx ) • Contribution xxx • Less Fixed costs xxx • Profit and loss xxx
- 35. Absorption Costing • Turnover xxx • Less cost of sales (xxx) (inc fxd man overheads) • Over/(Under) recovery of man o/heads (xxx ) • Expenditure variance xxxx • Gross Profit xxx • Less All non-manufacturing o/heads (xxx) • Profit and loss xxx
- 36. • Direct costs can be specifically and exclusively identified with a given cost object – hence they can be accurately traced to cost objects. • Indirect costs cannot be directly traced to a cost object – therefore assigned to cost objects using cost allocations. • Cost allocations = process of assigning costs to cost objects that involve the use of surrogate rather than direct measures. • Surrogates known as allocation bases or cost drivers. • For accurate cost assignment, allocation bases should be significant determinants of the costs (i.e. cause-and-effect allocations). Assignment of direct and indirect costs
- 37. • Allocation bases that are not significant determinants of the costs are called arbitrary allocations (.result in inaccurate cost assignment). • T additional costing systems use arbitrary allocations to a significant extent whereas more recent (ABC)systems rely mainly on cause-and-effect allocations Assignment of direct and indirect costs
- 38. Manufacturing organizations assign costs to products for: 1. Inventory valuation and profit measurement. 2. Providing information for decision-making. • For inventory valuation and profit measurement the aim is to allocate costs between cost of goods sold (COGS)and inventories: 3. Accurate individual product costs are not required – only an accurate allocation at the aggregate level between inventories and COGS. Different costs for different purposes
- 39. • For decision-making more accurate product costs are required. • Different cost information is required for inventory valuation and decision-making but most companies use a single database and extract different costs for different purposes. • Companies can choose to maintain their database using costing systems that vary on a continuum from simplistic to sophisticated (the choice should be based on costs versus benefits criteria . Different costs for different purposes
- 42. • Some firms use a single overhead rate (i.e.blanket or plant-wide) for the organization as a whole. Example Total overheads = £900 000 Direct labour (or machine hours) = 60 000 Overhead rate = £15 per hour Assigning indirect costs using blanket overhead rates
- 43. • Assume that the company has 3 separate departments and costs and hours are analysed as follows: • Product Z requires 20 hours (all in department C) Separate departmental rates should be used since product Z only consumes overheads in department C. Absorption Costing
- 44. • A blanket overhead rate can only be justified if all products consume departmental overheads in approximately the same proportions: Product X spends 1 hour in each department and product Y spends 5 hours in each department (Both blanket and departmental rates would allocate £45 to X and £225 to Y). • If a diverse range of products are produced consuming departmental resources in different proportions separate departmental (or cost centre)rates should be established.
- 45. Cost centre overhead rates • Where a department contains a number of different centres (each with significant overhead costs)and products consume overhead costs for each centre in different proportions,separate overhead rates should also be established for each centre within a department. • The terms cost centres or cost pools are used to describe allocation to which overhead costs are initially assigned. • Frequently cost centres/cost pools will consist of departments but they can also consist of smaller segments within departments.
- 46. The two-stage allocation process • To establish departmental or cost centre overhead rates a two-stage allocation procedure is required: Stage 1 – Assign overheads initially to cost centres. Stage 2 – Allocate cost centre overheads to cost objects (e.g.products)using second stage allocation bases/cost drivers.
- 47. Under-and over recovery of overheads •If actual activity or overhead spending is different from that used to compute the estimated overhead rates there will be an under or over recovery of fixed overheads. Example Estimated fixed overheads = £2 million Estimated activity = 1 million direct labour hours Overhead rate = £2 per DLH Under-and over recovery of overheads
- 48. • Assume actual activity is 900 000 DLH ’s and actual overheads are £2 million: Overhead allocated to products = £1.8 million (900 000 × £2) Under-recovery = £200 000 • Assume actual overheads are £1 950 000 and actual activity is 1 million DLH ’s: Overhead allocated to products = £2 million (1 million ×£2) Over-recovery = £200 000 • External financial accounting principles (IFRS) require that under/over recoveries are treated as period costs.
- 49. Labor – Fixed or variable costs Why is labour in most instances a fixed cost? Should I treat labour the same way that I treat other fixed manufacturing production overhead? “Labour costs have traditionally been regarded as variable on the assumption that management can retrench workers in the event that production levels decline. In practice, downsizing and retrenching workers is not a unilateral decision and negotiations are required with unions before wide-scale retrenchments can be implemented. In any event, retrenchments are not an everyday occurrence. To assume that labour costs are variable because of the potential to reduce these may be inappropriate.” Machines or plant can also be taken out of production. That does not make costs relating to machines or plant variable! Furthermore, in many production facilities, employees oversee automated machines. Their labour effort cannot be traced to individual units. This type of labour would then also be classified as overhead and usually fixed due to the same reason as explained above. Therefore labour is often a fixed cost and should then be treated in the same manner as fixed overheads. In scenarios presented to you, we will clearly indicate if some labour is variable, i.e. Piece work. In the absence of this you may assume that the manufacturing labour component is included in fixed production overheads.
- 50. Exercise • Variable costing Exercise
- 51. Home work • Explain arguments for and against variable and absorption costing • Justify why budgeted overhead rates should be used instead in preference to actual overhead rates • Explain the accounting treatment of the under/over recovery of overheads.
- 52. Questions.