Cost Types and Calculations

• These notes summarize the main points of each week's lecture.
• The notes are not an exhaustive coverage of your syllabus.

Week 1: Costs

• Variable costs vary in direct proportion to the activity level.
• Fixed costs remain constant over a range of activity levels in the short to medium term.
• Semi-variable costs have both fixed and variable elements.
• The HiLo method is used to get the variable cost per unit (VCpu) and the fixed costs (FC) for semi-variable costs.
• VCpu is calculated as the change in costs divided by the change in activity level.
• Total cost (TC) is calculated as FC + (VCpu x Activity Level).
• Stepped costs remain constant within a given range of activity, but then increase with a step at certain levels.
• Unit costs include direct materials, direct labor, direct variable overheads, marginal or variable cost, fixed production overheads per unit and total production cost.
• Marginal or variable cost is abbreviated as MC.
• Total production cost is also known as absorption cost (AC).
• Profit = Revenue - Variable Costs - Fixed Costs.
• Profit is a necessary calculation for any business and of interest to all stakeholders.
• Contribution = Revenue - Variable Costs.
• Contribution is used internally within a business for decision-making purposes.

Week 2: 3A's:

• The 3A's refer to calculating the Fixed Manufacturing Overheads per unit.
• First, allocate costs to their specific department
• Then, apportion overheads to departments using a fair basis for each department.
• Next, determine what basis should be used to divide each fixed overhead between the departments
• Reapportion service department overheads to production departments using a suitable base depending on the information given.
• Finally, absorb the total production departments’ overheads into the products.
• Calculate the FOAR (Fixed Overhead Absorption Rate) based on the activity level, usually direct labor hours or machine hours.
• Break-even point (BEP) occurs where Total Costs = Revenue, no profit or loss.
• The break-even point calculation uses the whole life of the project, accounts for the time value of money, and shows the gain to shareholders.
• FOAR per hour = Budgeted Fixed Production Overhead / Budgeted Total Hours.
• FOAR per unit = FOAR per hour x hours per unit.

Week 3: Under/Over Absorption

• The FOAR is based on budgeted overheads and activity levels, therefore they may not give the correct Fixed Production Overhead figure in accounts.
• Absorbed Overhead = FOAR per hour x Actual Hours.
• This is the amount of overhead that has been actually absorbed into our Statement of Profit or Loss, based on the FOAR and the actual labor or machine hours used in the time period.
• Under/(Over) Absorbed Overhead = (Absorbed Overhead - Actual Overhead)
• Under-absorbed overhead gets deducted in the Statement of Profit or Loss Account.
• Over-absorbed overhead gets added into the Statement of Profit or Loss Account.

Selling Prices

• When a selling price is set as a mark-up, the profit is stated as a percentage of the cost.
• When a selling price is set as a margin, the profit is stated as a percentage of the selling price.

Week 4: P/L Accounts

• Absorption cost includes an estimate of Fixed Production Overhead per unit.
• Marginal cost only contains the Variable Production costs.
• When drawing up a Statement of Profit or Loss using both methods, different unit costs will be accounted for.
• Common P/L accounts include Sales Revenue, Cost of Sales, Opening inventory, Production, Closing inventory, Cost of sales, Actual Fixed Production Overheads*, Gross Profit, Selling, Dist and Admin.
• Difference = (Closing Inventory units – Opening inventory units) x FOAR per unit

Week 5: Breakeven Analysis

• Breakeven Analysis is the minimum level of activity required, i.e. the activity level needed to make no profit at all, so to breakeven.
• Breakeven point (BEP) in units = Fixed Costs / Contribution per unit.
• This is the number of units to produce and sell to make no profit at all, it only covers the costs.
• Volume to earn a target profit = (Fixed Costs + Target Profit) / Contribution per unit.
• This is the number of units to produce and sell to earn a certain Target Profit.
• Margin of safety (units) = Activity Level – BEP.
• This is the number of units above the BEP, which also represents the number of units that make a profit.
• Margin of safety (%) = (Activity Level – BEP) / Activity Level x 100%.
• Operating Gearing is a measure of Business Risk, represented by the comparison of Fixed Costs and other costs.
• Operating Gearing can be measured as Fixed Costs / Variable Costs, or Fixed Costs / Total Costs
• It can also be measured as % Change in Profit / % Change in Revenue, or Fixed Costs / Contribution or Fixed Costs / Profit.
• Businesses in the same industry tend to have the same level of Fixed Costs in comparison with other costs.
• If there are high fixed costs, and revenue falls, those fixed costs still have to be paid in the short to medium term and so make it risky.
• If the revenue increases, extra profits will be made as fixed costs are already covered.

Week 6: Relevant Costing

• Relevant Costing is a technique used purely for Decision Making.
• Analyze the future incremental cash flows of the project, this will give the minimum cost, and so therefore the minimum acceptable price to be accepted.
• Focus on FUTURE costs, not past or sunk costs.
• INCREMENTAL - cash flows that will change if project is taken on, e.g. not allocated/absorbed fixed overheads.
• CASH FLOWS - e.g. not depreciation.
• Can also be used to decide whether or not to discontinue a product, an outlet, or a department.
• Use relevant costing to work out the actual cash flows that would change if the discontinuance occurred.

Weeks 7 & 8: Investment Appraisal

• One method is Net Present Value (NPV).
• If NPV is positive, accept the project, if NPV is negative, reject the project.
• Another method is IRR is the discount rate at which NPV is zero.
• If the cost of capital < IRR, accept the project as it gives a positive NPV.
• Another method is ARR = Average Annual Profits x 100% / Initial Investment.
• If ARR > the target return, accept the project.
• Another method is PAYBACK.
• If the payback < target, accept the project.

Weeks 9 & 10: Budgeting

• Incremental Budgeting - last year's budget +/- %.
• Zero-Based Budgeting (ZBB) - start from scratch.
• Imposed Budgeting - budget is prepared by senior management.
• Participative Budgeting - budget is prepared by junior management.
• There are also Cash Budgeting, Fixed Budget and Flexed Budget.
• A flexed budget creates an easy comparison to actual results, therefore variances will be more useful and informative.