Management Accounting

Chapter 3:
Using Costs in Decision Making
Supervisor: Dr. Khaldoun Al-Qaisi Prepared by ;:Fathi Radi

How Management Accounting Supports Internal Decision Making?

Cost info plays important role in development of strategy, monitoring the results and taking the decision is needed along with the other depts. In organization. The cost of info. can be made as follows: Pricing : to face market determined price and cost plus pricing. Product Planning: target costing. Budgeting : the most of widespread use of cost info Performance Evolution : mangers compare the estimated figure with the actual result. Contracting : the org. uses the in making the settlement required to pay the cost plus the good or service value.

Variable Costs
By definition, Variable Costs are costs that change (in total) in response to changes in volume or activity. It is assumed, too, that the relationship between variable costs and activity is proportional. That is, if production volume increases by 10%, then variable costs in total will rise by 10%. Examples include direct labor, raw materials and sales commissions.
Variable Cost =Variable Cost Per Unit X Cost Unit Per Qty Refer to an example that stated in text Book page 88 , the equation for wood would be : V.C of wood = $ 25 X No. of rocking chairs made
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Fixed Costs
By definition, Fixed Costs are costs that do not change (in total) in response to changes in volume or activity. Examples include Factory Rent , depreciation and, Insurance Fees , Factory Manager salary.
Example : if the Building rent of the factory is $ 400,000.00 so this amount will not be changed depending on the activities volume. Pls refer to page 89 Total Cost = V.C + F.C Total Cost = $ 80 X (No. of rocking chairs made and sold) + $ 400,000.00.
Note [ $ 80 = Total of V.C for[wood $25 + labor $30 + supplies $5 + Selling and shipping $ 20]
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Cost - Volume Profit Analysis (CVP)

What is CVP ?

CVP is a model used to determine how profit will be affected by changes in costs, selling price or business activity (i.e. volume of sales). CVP analysis is a key factor in: Pricing products Determining marketing strategies Assessing viability of a product/event CVP assumes that all costs can be divided into two types; Fixed Variable
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The Profit Equation

Operating Profit = Total Revenue Total Cost
Total Revenue Outputs = Selling price per unit X Units of

Total Cost = [Variable Cost per unit X Units of Outputs] + Fixed Cost

Developing and Using the CVP Equation

Contribution Margin Revenue - Variable Costs = Contribution Margin The contribution margin per Unit is the contribution

that each unit makes to covering fixed costs and providing a profit = Selling price Variable Cost The contribution margin Ratio is the ration of contribution margin per unit to selling price per unit.

The Break-Even Point

The Break-Even Point is the volume level where profits equal zero.
To find the break-even point in units, we use the target volume in units equation and set the profit to zero. To find the break-even point in sales dollars, we use the target volume in sales dollars equation and set the profit to zero.
Sales revenue Variable expenses Fixed expenses = Profit
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The Break-Even Point

Sales $ 250,000 Less: variable expenses 150,000 Contribution margin 100,000 Less: fixed expenses 100,000 Net income $ -

Chart of The Break-Even Point

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Contribution-Margin Approach
Consider the following information developed by the accountant at Retag Company

Total Sales (500 Bag) $ 250,000 Less: variable expenses 150,000 Contribution margin $ 100,000 Less: fixed expenses 80,000 Net income $ 20,000

Per Unit $ 500 300 $ 200

Percent 100% 60% 40%

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Finding Target Profit/ Volumes

How many Bag must Retag Co. sell to earn an annual profit of $100,000

Target Volume (units)

Fixed costs + Target profit Contribution margin per unit

$80,000 + $100,000 $200

= 900 Bags
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Other Useful Cost Definitions

Mixed Costs :

Its a cost that contains both a fixed component and a variable component. Mixed cost is also known as semi-variable cost or semi-fixed cost. Example: Your Mobile Bill , its contains both fixed amount [subscription Monthly] and calls value for your calls.
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Other Useful Cost Definitions

Step Variable Costs

Step-variable costs are costs that stay fixed over a range of activity and then change after this range is overcome. In other words, these costs change in increments.
Example: is the salary of an accountant worker in the Fin. Dept. Each Accountant worker is capable of reviewing a certain number of tasks every day. Once the transactions process exceeds that volume level, another accountant worker must be hired.
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Other Useful Cost Definitions

Incremental Costs: is the extra cost associated

with manufacturing one additional unit of production. Example : suppose youre deciding whether to travel to Amman, for vacation. Some incremental costs of making the trip include the following: Bus tickets , Hotels , gifts and Extra Expenses You have to pay these incremental costs if you go to Amman but not if you stay at home.
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Other Useful Cost Definitions

Sunk costs are those which;

Have already been incurred. Do not affect any future cost and cant be changed by any current or future action. Sunk costs do not meet the definition of relevant information. Example : inventory costs or R&D expenses, because it has already happened. Sunk costs are independent of any event that may occur in the future. 16

Other Useful Cost Definitions

Relevant Cost : is a cost that will change as

a result of some decision. Relevant costs in accounting refer to those costs that can influence a decision. These are costs that are to be incurred by a firm or a company in the future and impact cash flow. They are also referred to as differential costs.
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Other Useful Cost Definitions

Opportunity Cost: The Potential benefit that is

forgone as a result of choosing one alternative over another. Example. Let's say you have $15,000 and your choice is to either buy shares of Company XYZ or leave the money in a Deposit that earns only 5% per year. If the Company XYZ stock returns 10%, you've benefited from your decision because the alternative would have been less profitable. However, if Company XYZ returns 2% when you could have had 5% from the CD, then your opportunity cost is (5% 2% = 3%).
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Other Useful Cost Definitions

Avoidable Cost: A cost that can be avoided by

undertaking some actions. Avoidable cost refers to variable costs that can be avoided, unlike most fixed costs. For example, a manufacturer with many product lines can drop one of the lines, thereby eliminating associated expenses such as labor and materials. Corporations looking for methods to reduce or eliminate expenses often analyze avoidable costs associated with weakness or non-profitable product lines. 19

Relevant Costs
Steps in the Decision-Making Process (the Five Ds)

Define the problem Develop alternatives Decide which alternative is best Do what is indicated Determine if the decision was a good one (feedback)
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Relevant Information

Information is relevant if is concerned to a decision problemit will directly affect, or be affected by, the decision Information must also be accurate Information must also be timely

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Cost considerations for review

Sunk costs: have already been incurred and can

not be changed by any current or future decision. Therefore no longer relevant. Differential costs: difference between the costs of two (or more) decision alternatives Incremental costs: additional cost differential of one alternative Opportunity costs: potential benefit that must be given up when an alternative is selected
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Make or Buy (Outsourcing)

Involves a choice between producing a product/service in-house or outsourcing it. Decision criteria is the similar to special orders:

Allocate relevant costs to each alternative Compare for cost savings (or not)

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Make or Buy (Outsourcing) Example

Green land considers cost of making desserts vs. outsourcing: initial costs of making appear higher because of FC allocation, but when considering relevant costs:
Make Costs to outsource desserts @ $0.21 each V.C of producing desserts in-house Allocated FC: supervisory depreciation of equipment Total costs under each alternative Potential loss from outsourcing $140,000 $40,000 $70,000 $250,000 Buy $210,000 $30,000 * $70,000 ** $310,000 -$60,000

* could cut two supervisors if outsourcing, others are sunk cost ** sunk cost--no change under either alternative
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Manufacturing Costs
On financial statements, each product must include the costs of the following:
Direct material : directly traceable to the products such as the wood that used in manufacture Tables. Direct labor : directly traceable to the products such as carpenter salary in case making tables. Manufacturing overhead : Indirect factoryrelated costs such as glue. 25

Add or Drop (Service / Product / Segment)

This is identical to segment reportingmust consider the segment margin each product or service or department/division/segment contributes to the firm. Againdont assume all fixed costs will be eliminatedsome are sunk. Consider only incremental / relevant costs.

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Add or Drop example

DROP: Replace a product or a product line with another that contributes more to indirect fixed costs. Add a product or a product line that contributes (significantly) to indirect fixed costs. Drop a product or a product line that does not contribute to indirect fixed costs.

ADD:

REPLACE:

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Add or Drop example

Identify which of the following products should be retained.

A B $10,000 6,000 $ 4,000 3,000 C $12,000 8,000 $ 4,000 5,000

Product

Sales revenue. . . . . . . . . $15,000 Variable costs. . . . . . . . . . 8,000 Contribution margin . . . . $ 7,000 Direct fixed costs . . . . . . . 5,000 Contribution to indirect fixed costs. . . . .$ 2,000

$ 1,000

$(1,000)

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Add or Drop example

Products A and B are contributing to indirect fixed costs and should be retained unless a more profitable product is available.
Product C should be dropped because it does not cover its own costs.

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The End Thank you.

We made it!

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