Strategic Cost Management MBA PDF

Strategic cost management MBA Calicut University Module 1 Contents: Cost concept Classification of cost- Element Wise Classification of cost- Functions Classification based on cost behavior...

Strategic cost management MBA Calicut University Module 1 Contents: Cost concept Classification of cost- Element Wise Classification of cost- Functions Classification based on cost behavior techniques for separation of costs 001-0001-0001-03-10-00000008-01-01 Cost concept Definition of Cost Concept: The term ‘cost’ is most widely used as the ‘money cost’ of production which relates to the money expenditure of a firm on: ) Wages and salaries paid to the labour. (ii) Payment incurred on machinery and equipment. (iii) Payment for materials, power, light, fuel, transportation etc. (iv) Payments for rent and insurance. Payments to Government by way of taxes. Money costs therefore relate to money outlays by a firm or factors of a production which enable the firm to produce and sell a product. It should be remembered that every producer is interested in money costs. Besides money cost there are other costs that are equally important to take decisions on various matters. Scope of Cost Concept: It is advisable to plan before-hand the scope of activities of the firm On the basis of further experience the plan may be revised from time to time in deciding about the scope. The following points should be taken into consideration in this regard: (1) What techniques have to be followed in production? What parts have to be manufactured in the factory itself end for what parts should depend on other firm? (2) Should all the processes involved in the production be carried in the factory or some have to depend upon contracts? (3) Has the firm to produce the raw-materials itself or should it depend upon other firms? (4) How far the firm should specialise in production or should it depend upon other firms? (5) Should all the connected goods with the main product be manufactured by the firm itself and the business scope be expanded? (6) Should the marketing of the product be organised by the firm itself or should it depend upon other agencies for marketing? (7) Should the after-sale services to the consumers be undertaken by the firm itself or should firm enter into some agreement with other firm for this important responsibility. The firm has to take decision on the above question and other allied problems finally setting up the unit, keeping in view that the unit cost in producing and distributing on the product or service should be the lowest and the changes of maximum profits are the brightest. Size of Cost Concept: The success and efficiency of the firm also depends on its suitable size. The size of the firm should be optimum as to ensure maximum profitability. The optimum size of the firm is that point which results in the lowest production cost and maximum efficiency. At this optimum point of output all the technical managerial marketing factors are well balanced. It should be noted that optimum size of the firm is not fixed but goes on altering with the improved techniques of production and managerial experience. 001-0001-0001-03-10-00000008-01-02 Classification of cost- Element Wise Element Wise Classification Of Costs / Overhead We come across three classes, if indirect expenses are classified element wise: Indirect Materials; (ii) Indirect labour & (iii) Indirect expenses. The following are some examples: Indirect materials: Factory: Stores which are consumable; Canteen food stuff; materials for first aid; materials for fire extinguishing etc. Administration: Cost of stationery; expenses incurred in connection with canteen food stuff; cost incurred for the purpose of cleaning of materials etc.  Selling & Distribution: Expenses incurred with respect of packing of materials; stationery expenses; fuel & lubricating oil charges incurred in respect of delivery van etc. Indirect Labour: Factory: Expenses incurred for payment of salary to the works manager, supervisor, foreman etc.; wages incurred for the purpose of payment made to the indirect workers, stores staff, maintenance & repairs staff etc.; wages incurred for payment to the personnel of the time office & pay-roll department etc. Administration: Expenses incurred for the purpose of payment of salary for all the administrative function’s employees, starting from the managing director to sweeper; remuneration paid to the directors etc. Selling & Distribution: Expenses incurred for the payment of salary of the staff of the sales office & for the salary of the distribution men. Indirect Expenses: Factory: Expenses for the purpose of repairs & maintenance; payment of rent, rates & taxes; charges in respect of insurance; depreciation; expenses incurred with respect to stores, other than salaries paid to the repair staff, maintenance staff & stores staff etc. Administration: All expenses incurred in connection with general administration other than the cost of the materials used & expenses regarding salary. Examples are depreciation; printing charges; rent, rates & taxes payment; cost of postage etc. Selling & Distribution: Expenses relating to advertisement & exhibition; cost incurred in respect of market research; payment of rent for godown ; insurance charges; depreciation etc. (c) Behavior wise (or Behavioral) classification: The main consideration for behavior wise classification is how each element of overhead behaves, when there is a change in the volume of production etc. Fixed overhead are constituted of expenses which irrespective of the level of output remain fixed; variable overhead are constituted of expenses which, with the change in the level of output, changes proportionately & semi-variable overhead or semi-fixed overhead are those expenses which, with the change in level of output, changes but not proportionately. For the purpose of marginal costing, for the preparation of flexible budget or standards & also for the purpose of controlling overhead costs, behavioral classification is of fundamental importance. Some of the examples of fixed, variable & semi-variable (or semi-fixed) overhead costs are the following: Fixed Overhead:  Expenses incurred with respect of rent, rates etc; cost incurred for insurance; stationery cost; expenses incurred for the payment of salary to the management staff; expenses incurred for postage etc. Variable Overhead: Indirect material & labour; expenses incurred for the payment of commission to the salesmen; packing expenses; cost of power, etc. Semi-variable or semi-fixed overhead: Depreciation; charges for repairs & maintenance; salary paid to the supervisors etc. These charges are neither totally variable charges nor they are totally fixed charges. Only up to a certain production level, they remain fixed; but beyond that level these items increase, even though the proportion may vary. Thus, semi-variable overhead includes fixed elements & variable elements. However for the purpose of having only two classes- fixed overhead & variable overhead, segregation of semi-variable needs to be done. For segregation of semi-variable overheads into fixed overhead & variable overhead, different methods can be used, like analytical method, simultaneous method, least square method, level of activity method, high & low method etc. Let us assume the semi-variable overhead costs corresponding to the output be as below: Semi-variable overhead costs ($) Output (units) 16000 6000 18000 7000 The variable & fixed elements present in semi-variable overhead can be found by simultaneous equation method as below: Let the fixed overhead cost be x & the variable overhead cost per unit be y. Now, x + 6000y = $ 16000…………….. (i) x + 7000y = $ 18000…………… (ii) Deducting (i) from (ii), 1000y = $ 2000 Therefore, y = $ 2 Substituting the value of y in equation (i) we get, x +6000*2 = $ 16000 Therefore, x = $ 4000 Thus, the variable element is $ 2 per unit & the fixed element amount is $ 4000 (d) Control wise Classification: Overhead costs can either be controlled or uncontrolled. This is known as controllable cost when proper influence of management can control this. The same becomes uncontrollable when this cannot be controlled even by the exercise of proper management. Online Live Tutor Behavior wise (or Behavioral) classification: We have the best tutors in Economics in the industry. Our tutors can break down a complex Behavior wise (or Behavioral) classification problem into its sub parts and explain to you in detail how each step is performed. This approach of breaking down a problem has been appreciated by majority of our students for learning Behavior wise (or Behavioral) classification concepts. You will get one-to-one personalized attention through our online tutoring which will make learning fun and easy. Our tutors are highly qualified and hold advanced degrees. Please do send us a request for Behavior wise (or Behavioral) classification tutoring and experience the quality yourself. 001-0001-0001-03-10-00000008-01-03 Classification of cost- Functions Classification of Costs based on Functions / Activities Costs can be classified based on functions or activities in an organization. All the costs of a business can be classified into production costs, administration costs, finance costs, selling costs, distribution costs, research and development costs. These are just the major functions or activities in a business but there can be more detailed classification. CLASSIFICATION OF COSTS PRODUCTION COSTS All the costs relating to the production of goods or services, whether direct or indirect, are included in the production cost. We can classify production costs into direct and indirect production costs. Example of Direct Production Costs (also known as direct manufacturing costs) Direct Raw Material Direct Labor Other Direct Expenses such job work charges relating to particular product, etc. Examples of Indirect Production Costs (also known as Production or Manufacturing Overheads) Salaries of Supervisors, Production Heads, Technical and Planning Staff etc Quality control costs Other labor-related expenses Store expenses etc ADMINISTRATION COSTS These costs are incurred in connection with the general management of the business. These are normally indirect costs and are also known as administrative overheads. Example of such costs can be following: Salaries of staff in general management Office related expenses such as rent, rates, taxes, telephone, stationery etc. Charges levied by bank Audit and legal fees Office related depreciation etc. SELLING COSTS Selling costs include all kinds of expenses incurred for achieving sales of the products and services. These are also considered indirect expenses are known as selling overheads. Examples of such costs are as follows: Salaries of selling staff Commission, conveyance, discount etc Product market research Royalty etc DISTRIBUTION COSTS Distribution costs include all kinds of expenses are incurred for distributing the products from its point of production to its customers. Examples of distribution costs are as follows: Transportation costs Warehouse rents Commission to Distribution channel etc RESEARCH AND DEVELOPMENT COSTS Costs under these heads are the costs comprising of development costs of new products, improvement related expenses etc. 001-0001-0001-03-10-00000008-01-04 Classification based on cost behavior Types of Costs by Behavior Cost behavior refers to the way different types of production costs change when there is a change in level of production. There are three main types of costs according to their behavior: Fixed Costs: Fixed costs are those which do not change with the level of activity within the relevant range. These costs will incur even if no units are produced. For example rent expense, straight-line depreciation expense, etc. Fixed cost per unit decreases with increase in production. Following example explains this fact: Total $30,000 $30,000 $30,000 Fixed Cost ÷ Units 5,000 10,000 15,000 Produced Fixed $6.00 $3.00 $2.00 Cost per Unit Variable Costs: Variable costs change in direct proportion to the level of production. This means that total variable cost increase when more units are produced and decreases when less units are produced. Although variable in total, these costs are constant per unit. For example Mixed Costs: Mixed costs or semi-variable costs have properties of both fixed and variable costs due to presence of both variable and fixed components in them. An example of mixed cost is telephone expense because it usually consists of a fixed component such as line rent and fixed subscription charges as well as variable cost charged per minute cost. Another example of mixed cost is delivery cost which has a fixed component of depreciation cost of trucks and a variable component of fuel expense. Since mixed cost figures are not useful in their raw form, therefore they are split into their fixed and variable components by using cost behavior analysis techniques such as High-Low Method, Scatter Diagram Method and Regression Analysis. Total $10,000 $20,000 $30,000 Variable Cost ÷ Units 5,000 10,000 15,000 Produced Variable $2.00 $2.00 $2.00 Cost per Unit 001-0001-0001-03-10-00000008-01-05 techniques for seperation of costs Separation of Cost into Fixed Cost and Variable Cost Article shared by : The following methods are used in separation of such costs into fixed cost and variable cost. They are: 1. Industrial Engineering Method 2. Account Inspection Method 3. Scatter Graph Method 4. High and Low Method. 1. Industrial Engineering Method: This method is used to collect cost information that is not available in an organization’s records and is particularly relevant when an organization is just beginning a new activity. Every productive process involves employing a particular mix of materials, labour and capital equipment in order to yield physical output. When the relationship between the input and output is established by an engineer or technical expert e.g., 2 kgs. of materials + 3 hours of labour = 1 unit of output. The material and labour costs can be estimated by imputing material prices and wage rates to physical input needs. It is important to note that these costs are estimates because of possible uncertainty with regard to wastage in material usage and changes in labour efficiency in production process. The engineering method is particularly useful when applied to material and labour costs which represent a large proportion of the total output cost. If the relationship between material and labour inputs and outputs remain static over time, then these cost estimates can be used in the future without significant adjustment. When costing new products, the engineering method is the only approach that can be used due to lack of historic data. However, there are three main disadvantages of the engineering method: (1) It is expensive as work measurement involves detailed analysis of the physical movements required in each task, in order to produce one unit of output. (2) There are other costs incurred in the production process e.g., machine maintenance and supervision which cannot be associated with specific units of output, but may be direct costs of the department. The engineering method cannot be applied to these costs, whose equations will have to be derived from an analysis of past data or from subjective evaluation. (3) Different mixes of materials and skills may be used to produce the same unit of output, leading to several conflicting cost estimates. Although the engineering method is usually associated with production, work study techniques are applied to other areas, such as selling and administrative functions of the organization. 2. Account Inspection Method: This method is a fast and inexpensive way of estimating costs as it simply involves examining each account and subjectively classifying the account’s total cost into either fixed or variable elements. This requires that the Management Accountant inspect each item of expenditure within the ledgers at a given level of output to determine whether a cost is fixed, variable or semi-variable. Limitations: This technique has the following limitations: (a) It depends heavily on the initial decision to classify an account as fixed or variable. (b) It fails to recognize that semi-variable costs exist. (c) It relies on a single observation of the account to determine the cost equation rather than using an average based on several observations of each account. (d) It assumes that transactions have been correctly charged to one account or another. The account inspection method should be used only when a crude approximation of cost behaviour is sufficient for making decisions. 3. Scatter Graph Method: In this method, it involves plotting several observed levels of cost and their associated levels of activity on a scatter-graph and then applying statistical analysis to fit the best line through these points. Illustration: The point at which the line of best fit touches the ordinate indicates fixed component of the cost i.e., Rs. 9,500 in this case. The slope of the line indicates the degree of variability of costs. The scatter-graph as shown in figure 2.4 can be drawn with the help of the above data: The line of best fit is relatively simple to apply and it does attempt to use all the information in the relevant range of production to arrive at the estimated cost function. However, it remains rather crude and does not adequately handle data points which are far away from the main body of points (called out liners). Another problem with this method is that each accountant using the same cost data to estimate the cost of equation may draw different total cost lines by eye, to describe the relationship between cost and activity. Despite the short-coming, the method may be sufficient for the small company that does not possess the expertise to use complicated statistical technique. 4. High and Low Method: Under this method, the highest and lowest volumes of output and the relevant cost figures are taken into consideration. The difference of cost between volumes, i.e., incremental cost for incremental output will be arrived at. The incremental cost will be further divided by the incremental output. This will give the variable cost per unit. Total variable cost for any level of output can be determined easily. Now, the total cost of the volume of output less the total variable cost at that level of output gives the fixed cost which will remain for all levels of activity. Cost sheet Cost Sheet: Meaning, Advantages and Preparation Article shared by : After reading this article you will learn about:- 1. Meaning of Cost Sheet 2. Advantages of Cost Sheet 3. Items Required for Preparation.  Meaning of Cost Sheet: Cost sheet is a document which provides for the assembly of the estimated detailed cost in respect of a cost centre or a cost unit. It is a detailed statement of the elements of cost arranged in a logical order under different heads. It is prepared to show the detailed cost of the total output for a certain period. It is only a memorandum statement and does not form part of the double entry system. Additional columns can be provided to indicate cost per unit at different stages of production or to enable comparison to be made of the current costs with that of historical costs. Advantages of Cost Sheet: The main advantages of a cost sheet are: (i) It indicates the break-up of the total cost by elements, i.e. material, labour, overheads, etc. (ii) It discloses the total cost and cost per unit of the units produced. (iii) It facilitates comparison. (iv) It helps the management in fixing selling prices. ADVERTISEMENTS: (v) It acts as a guide to the management and helps in formulating production policy. (vi) It enables to keep control over cost of production. (vii) It helps the management in submitting quotations or preparing estimates for tenders. (viii) It is a simple and useful medium of communication of costs to various levels of management.  Items Required for Preparation of the Cost Sheet: i. Stock of Raw Materials: While preparing a cost sheet, it is necessary to determine the cost of raw material consumed. If the opening stock of raw materials, purchase of raw materials during the period and closing stock of raw material at the end of the period are given, then the cost of raw materials consumed is calculated as follows:  ii. Stock of Work-in-Progress: ADVERTISEMENTS: Work-in-progress refers to the semi-finished goods on which some work has been done but which are not yet complete at the end of the period. As such these goods are not yet available for state. The stock of work-in-progress may be valued at prime cost or factory/work cost basis, but generally, it is valued on the basis of work cost. The adjustment for the stock of work-in-progress valued at works cost should be made as follows: iii. Stock of Finished Goods:  Stock of finished goods refers to the stock of products on which all factory work has been completed. Thus, it is valued at the cost of completed production. If opening and closing stocks of finished goods are given, then the following adjustment should be made while calculating cost of goods sold: iv. Carriage Inward or Carriage on Raw Materials Purchased: Carriage inward which is incurred on bringing the raw material purchased should be added while calculating the cost of raw materials consumed as below: v. Scrap of Materials: Scrap is discarded material having some value which is usually either disposed off without further treatment or is introduced into the production process in the place of raw materials. If the value of scrap is negligible, then it is credited to profit and loss account as an income. The cost of production bears the cost of scrap because total cost is not reduced by the amount of scrap. However, in case the value of scrap is significant, then it is deducted from the cost of material consumed or factory overhead/cost depending upon the stage of scrap. If the scrap materials occur in raw condition stage, then the net amount realised from the sale of scrap should be deducted from the cost of materials used. But, if the scrap is obtained in the course of manufacturing process, then the net amount realised from the sale of scrap should be deducted from the factory overhead or factory cost. vi. Items Excluded from Costs:  The items of expenses, losses or incomes which are related to capital assets, appropriation of profits, amortization of fictitious or intangible assets, abnormal gains and losses or items of purely financial nature do not form part of the costs and these are excluded from cost accounts. The examples of such items include— loss on sale of building or machinery, interest on capital, discount on issue or redemption of shares or debentures, expenses relating to previous period, cash discounts, bad debts, damages payable, penalties and fines, interest or dividend received on investments, transfer fees received, profit on sale of fixed assets, appropriation of profits such as income-tax, dividend paid, transfer of profits to reserves or funds, donations and charities, excess provision for depreciation on fixed assets, amortization of fictitious or intangible assets such as goodwill written off, preliminary expenses written off, patents, trademarks and copyrights written off, capital issue expenses, underwriting commission, loss on issue of shares and debentures written off, etc. Thus, it should be noted that such items-are not taken into consideration (excluded) while preparing a cost sheet. Illustration 2: The following extract of costing information related to commodity X for the half year ended 30th June, 2011: Advertising, discount allowed and selling cost 75 paise per ton sold. 25,600 tonnes of commodity was produced during the period. You are required to ascertain: (a) The value of raw materials used (b) Cost of output for the period (c) Cost of turnover for the period (d) Net profit for the period (e) Net profit per tonne of the commodity sold. Solution:  Illustration 3: The directors of a manufacturing business require a statement showing the production results of the business for the month of March, 2011. The cost accounts reveal the following information: You are required to construct the statement so as to show: (a) The value of materials consumed; (b) The total cost of production; (c) The cost of goods sold; (d) The gross profit on goods sold and (e) The net profit for the month. Solution: module2 Contents: Marginal costing Features of marginal costing Formula used in Marginal costing Marginal costing and Absorption costing Application of marginal costing in decision making Cost-Volume-Profit Relationship & Break Even Analysis 001-0001-0001-03-10-00000008-02-01 Marginal costing The increase or decrease in the total cost of a production run for making one additional unit of an item. It is computed in situations where the breakeven point has been reached: the fixed costs have already been absorbed by the already produced items and only the direct (variable) costs have to be accounted for. Marginal costs are variable costs consisting of labor and material costs, plus an estimated portion of fixed costs (such as administration overheads and selling expenses). In companies where average costs are fairly constant, marginal cost is usually equal to average cost. However, in industries that require heavy capital investment (automobile plants, airlines, mines) and have high average costs, it is comparatively very low. The concept of marginal cost is critically important in resource allocation because, for optimum results, management must concentrate its resources where the excess of marginal revenue over the marginal cost is maximum. Also called choice cost, differential cost, or incremental cost. Meaning of Marginal Costing: According to the Institute of Cost and Management Accountants, London, “Marginal Costing is the ascertainment, by differentiating between fixed costs and variable costs, of marginal cost and of the effect of profit of changes in the volume or type of output.” An understanding of the concept of marginal cost requires a thorough understanding of the various classes of costs and their relation with the change in the level of activity. Under marginal costing, costs are mainly classified into fixed costs and variable costs. The essential feature of marginal costing is that the product or marginal costs i.e., those costs that are dependent on the volume of activity are separated from the period or fixed costs i.e., costs that remain unchanged with a change in the volume of activity. Variability with the volume of output is the main criterion for the classification of costs into product and period categories. Even semi-variable costs have to be bifurcated into their fixed and variable components based on the variability criterion. Advantages of Marginal Costing: The important advantages of Marginal Costing are: (a) Marginal costing is easy to understand. It can be combined with standard costing and budgetary control and thereby makes the control mechanism more effective. (b) Eliminating of fixed overheads from the cost of production prevents the effect of varying charges per unit, and also prevents the carrying forward of a portion of the fixed overheads of the current period to the subsequent period. As such, costs and profits are not vitiated and cost comparisons become more meaningful. (c) The problem of over or under absorption of overheads is avoided. (d) A clear – cut division of costs into fixed and variable elements makes the flexible budgetary control system easy and effective and thereby facilitates greater practical cost control. (e) It helps profit planning through break-even charts and profit graphs. Comparative profitability can easily be assessed and brought to the notice of the management for decision-making. (f) It is an effective tool for determining efficient sales or production policies, or for taking pricing and tendering decisions, particularly when the business is at low ebb. Managerial Uses of Marginal Costing: The following may be listed as specific managerial uses: (a) Cost Ascertainment: Marginal costing technique facilitates not only the recording of costs but their reporting also. The classification of costs into fixed and variable components makes the job of cost ascertainment easier. The main problem in this regard is only the segregation of the semi-variable cost into fixed and variable elements. However, this may be overcome by adopting any of the methods in this regard. (b) Cost Control: Marginal cost statements can be understood easily by the management than those presented under absorption costing. Bifurcation of costs into fixed and variable enables management to exercise control over production cost and thereby affect efficiency. In fact, while variable costs are controllable at the lower levels of management, fixed costs can be controlled at the top level. Under this technique, management can study the behaviour of costs at varying conditions of output and sales and thereby exercise better control over costs. (c) Decision-Making: Modern management is faced with a number of decision-making problems every day. Profitability is the main criterion for selecting the best course of action. Marginal costing through ‘contribution’ assists management in solving problems. Some of the decision-making problems that can be solved by marginal costing are: (a) Profit planning (b) Pricing of products (c) Make or buy decisions (d) Product mix etc. Limitations of Marginal Costing: Despite its superiority over absorption costing, the marginal costing technique has its own limitations. (a) Segregation of all costs into fixed and variable costs is very difficult. In practice, a major technical difficulty arises in drawing a sharp line of demarcation between fixed and variable costs. The distinction between them hold good only in the short run. In the long run, however, all costs are variable. (b) In marginal costing, greater importance is attached to the sales function thereby relegating the production function largely to a secondary position. But, the real efficiency of a business is to be assessed only by considering the selling and production functions together. (c) The elimination of fixed costs from the valuation of inventories is illogical since costs are also incurred in the manufacture of goods. Further, it results in the understatement of the value of stock, which is neither the cost nor the market price. (d) Pricing decision cannot be based on contribution alone. Sometimes, the contribution will be unrealistic when increased production and sales are effected, either through extensive use of existing machinery or by replacing manual labour by machines. Another possibility is that there is danger of too many sales being affected at marginal cost, resulting in denial to the business of inadequate profits. (e) Although the problem of over or under absorption of fixed overheads can be overcome to a certain extent, the same problems still persists with regard to variable overheads. (f) The application of the technique is limited in the case of industries in which, according to the nature of business, large stocks have to be carried by way of work-in-progress (e.g. contracting firms). 001-0001-0001-03-10-00000008-02-02 Features of marginal costing Features of Marginal costing: - It is a method of recoding costs and reporting profits. - It involves ascertaining marginal costs which is the difference of fixed cost and variable cost. - The operating costs are differentiated into fixed costs and variable costs. Semi variable costs are also divided in the individual components of fixed cost and variable cost. - Fixed costs which remain constant regardless of the volume of production do not find place in the product cost determination and inventory valuation. - Fixed costs are treated as period charge and are written off to the profit and loss account in the period incurred. - Only variable costs are taken into consideration while computing the product cost. - Prices of products are based on variable cost only. - Marginal contribution decides the profitability of the products. Features of Marginal Costing: The main features of marginal costing are as follows: (a) All costs are categorized into fixed and variable costs. Variable cost per unit is same at any level of activity. Fixed costs remain constant in total regardless of changes in volume. (b) Fixed costs are considered period costs and are not included in product cost, only variable costs are considered as product costs. (c) Stock of work-in-progress and finished goods are valued at marginal cost of production. (d) In marginal process costing, products are transferred from one process to another are valued at marginal costs only. (e) Prices are determined with reference to marginal cost and contribution margin. (f) Profitability of departments, products etc. is determined with reference to their contribution margin. (g) In accounting, marginal cost, the overhead control account in the cost ledger represents only the variable overhead. Fixed costs are taken as expenses in the profit and loss account and thus excluded from costs. (h) Presentation of data is oriented to highlight the total contribution and contribution from each product. (i) The difference in the magnitude of opening stock and closing stock does not affect the unit cost of production since all the product costs are variable costs. Marginal cost is the variable costs incurred when producing additional units of a goods or services. It is calculated when a breakeven point has been reached – fixed costs are incorporated in the finished product and only the direct variable costs have yet to be accounted for. The usual variable costs included are labor and materials, plus the estimated increases in fixed costs (if any), such as: administration, overhead, and selling expenses. The marginal cost formula can be used in financial modeling to optimize the generation of cash flow. Below we will break down the various components of the marginal cost formula. Marginal cost is the variable costs incurred when producing additional units of a goods or services. It is calculated when a breakeven point has been reached – fixed costs are incorporated in the finished product and only the direct variable costs have yet to be accounted for. The usual variable costs included are labor and materials, plus the estimated increases in fixed costs (if any), such as: administration, overhead, and selling expenses. The marginal cost formula can be used in financial modeling to optimize the generation of cash flow. Below we will break down the various components of the marginal cost formula. 001-0001-0001-03-10-00000008-02-03 Formula used in Marginal costing What is the Formula for Marginal Cost? Here is the marginal cost formula: Marginal Cost = (Change in Costs) / (Change in Quantity) What is Change in Costs? At each level of production and during each time period, costs of production may increase or decrease, especially when the need arises to produce more or less volume of output. If manufacturing additional units requires hiring one or two workers and increases the purchase cost of raw materials, then a change in the overall production cost will result. To determine the change in costs, simply deduct the production costs incurred at during the first output run from the production costs in the next batch when output has increased. What is Change in Quantity? Since it’s inevitable that the volume of output will increase or decrease with each level of production. Thus, the quantities involved are significant enough to evaluate the changes made. An increase or decrease in the volume of goods produced translates to costs; therefore, it is important to know the difference. To determine the changes in quantity, the number of goods made in the first production run is deducted from the volume of output made in the following production run. Calculating Contribution and Marginal Costing Article shared by : Contribution is the difference between sales and variable cost or marginal cost of sales. It may also be defined as the excess of selling price over variable cost per unit. Contribution is also known as Contribution Margin or Gross Margin. Contribution being the excess of sales over variable cost is the amount that is contributed towards fixed expenses and profit. If the selling price of a product is Rs. 20/- per unit and its variable cost is Rs. 15/- per unit, contribution per unit is Rs. 5/- (i.e. Rs. 20-15). Further, let us say that the fixed expenses are 50,000 and the total number of units sold is 8,000. This means that the total contribution is 8000 × 5 or Rs. 40,000 which is not sufficient even to meet the fixed expenses and the result is a loss of Rs. 10,000 (50,000 – 40,000). In case, the output is 10,000 units, then total contribution of Rs. 50,000 equals the fixed cost, and no amount is left for profit. The profit can be earned only when the amount of contribution exceeds the fixed costs. Hence, any output beyond 10,000 units, will give some profit e.g., at a level of output of 15,000 units, the total contribution is 15,000 × 5 = Rs. 75,000 while the fixed costs remain Rs. 50,000, thus making a profit of Rs. 25,000. Contribution can be represented as: Contribution = Sales – Variable (Marginal) Cost or Contribution (per unit) = Selling Price – Variable (or marginal) cost per unit or Contribution = Fixed Costs + Profit (—Loss) Advantages of Contribution: The concept of contribution is a valuable aid to management in making managerial decisions. A few benefits resulting from the concept of contribution margin are given below: i. It helps the management in the fixation of selling prices. ii. It assists in determining the break-even point. iii. It helps management in the selection of a suitable product mix for profit maximisation. iv. It helps in choosing from among alternative methods of production; the method which gives highest contribution per limiting factor is adopted. v. It helps the management in deciding whether to purchase or manufacture a product or a component. vi. It helps in taking a decision as regards to adding a new product in the market. Marginal Cost Equation: For the sake of convenience, a marginal cost equation can be derived as follows: Sales – Variable cost = Contribution or, Sales = Variable cost + Contribution or, Sales = Variable cost + Fixed Cost ± Profit/Loss or, Sales – Variable cost = Fixed cost ± Profit/Loss or, S – V = F ± P where ‘S’ stands for Sales ‘V’ stands for Variable cost ‘F’ stands for fixed cost ‘P’ stands for Profit/Loss The marginal cost equation is very useful in the sense that if any three factors out of the four are known, the fourth can easily be found out. Illustration 1: Determine the amount of variable cost from the following particulars: Solution: The marginal cost equation is: Sales – Variable cost = Fixed Cost ± Profit/Loss or 1,50,000 – V.C.= 30,000 + 40,000 or Variable cost = 1,50,000 – 70,000 = Rs. 80,000. Illustration 2: From the following information find out the amount of profit earned during the year using the marginal costing technique: Solution: S–V=F+P Sales = rs. 75,000 × 15 = Rs. 11,25,000 Variable Cost = 75,000 × 10 = Rs. 7, 50,000 Fixed Cost = Rs. 2, 50,000 Profit (P) = ? 11,25,000 – 7,50,000 = 2,50,000 + P 3,75,000 = 2,50,000 + P P = 3,75,000 – 2,50,000 Profit = Rs. 1,25,000 Problem-2 (Variable and absorption costing unit product costs and income statements) Posted in: Variable and absorption costing (problems) ZKB company manufactures a unique device that is used by internet users to boost Wi-Fi signals. The following data relates to the first month of operation: Beginning inventory: 0 units Units produced: 40,000 units Units sold: 35,000 units Selling price: $120 per unit Marketing and administrative expenses: Variable marketing and administrative expenses per unit: $4 Fixed marketing and administrative expenses per month: $1,120,000 Manufacturing costs: Direct materials cost per unit: $30 Direct labor cost per unit: $14  Variable manufacturing overhead cost per unit: $4 Fixed manufacturing overhead cost per month: $1,280,000 Management is anxious to see the success as well as profitability of newly designed unique booster. Required: 1. Calculate unit product cost and prepare income statement under variable costing system and absorption costing system. 2. Prepare income statement under two costing system. 3. Prepare a schedule to reconcile the net operating income under variable and absorption costing system. Solution: (1) Calculation of unit product cost: $1,280,000/40,000 units (2) Income statements: a. Absorption costing: b. Variable costing: (3) Reconciliation schedule: 001-0001-0001-03-10-00000008-02-04 Marginal costing and Absorption costing The difference between marginal costing & absorption costing is as below: Under marginal costing: for product costing & inventory valuation, only variable cost is considered whereas, under absorption costing; for product costing & inventory valuation, both fixed cost & variable cost are considered. Under marginal costing, there is a different treatment of fixed overhead. Fixed cost is considered as period cost & by Profit/Volume ratio (P/V ratio), profitability of different products is judged. On the other hand, under absorption costing system, the fixed cost is charged to cost of production. A reasonable share of fixed cost is to be borne by each product & thereby subjective apportionment of fixed overheads influences the profitability of product. Under marginal costing, the presentation of data is so oriented that total contribution & contribution from each product gets highlighted. Under absorption costing, the presentation of cost data is on conventional pattern. After deducting fixed overhead, the net profit of each product is determined. Under marginal costing, the unit cost of production does not get affected by the difference in the magnitude of opening stock & closing stock. Whereas, under absorption costing, due to the impact of the related fixed overheads, the unit cost of production get affected by the difference in the magnitude of opening stock & closing stock. Effects of opening & closing stock on profit: When income statements under absorption costing & marginal costing are compared, the under mentioned points should be considered: The results under both the methods will be same in situations where sales & production coincide i.e., there is neither opening stock nor closing stock. Profit under absorption costing will be more than the profit under marginal costing, when closing stock is more than the opening stock. The reason behind this is that, under absorption costing, a portion of fixed overhead, instead of being charged to the current period, is charged to the closing stock & carried over to the next period. Profit shown under absorption costing will be lower than the profit shown under marginal costing, when closing stock is less than the opening stock. The reason behind this is that, under absorption costing, to the current period, a portion of fixed cost related to previous year is charged. Reconciliation of results of absorption costing & marginal costing: When comparison of the results of absorption costing & marginal costing is undertaken, the adjustments for under- absorbed & / or over absorbed overheads becomes necessary. Under absorption costing, on the basis of normal level of activity, the fixed overhead rate is predetermined. A situation of under-absorption &/or over-absorption arises when there is a difference between actual level of activity & normal level of activity. (i) Under-absorbed fixed overhead = Excess of normal level of activity over actual level of activity * Fixed overhead rate per unit. If there is under-absorption, the profit under absorption costing, before comparison with profit as per marginal costing, should be reduced with under-absorbed fixed overheads. Alternatively, by adding the under-absorbed fixed overhead to the cost of production, the same objective can be achieved. (ii) Over absorbed Fixed overhead = Excess of actual level of activity over normal level of activity * Fixed overhead rate per unit. If there is over absorption, then before the comparison of profit as per absorption costing with the profit as per marginal costing, with over-absorbed fixed overheads, the profit under absorption costing should be increased. Alternatively, by reducing the over-absorbed fixed overhead from the cost of production, the same objective can be achieved. Problem 1: For a particular product, the following cost data is given: Per unit ($) Selling Price 20 Variable cost 12 Fixed cost 4 Normal production 52000 units For the four consecutive periods, the following additional data are given: Period 1 Period 2 Period 3 Period 4 Total Units Units Units Units Units Opening stock - - 12000 4000 - Production 52000 60000 48000 60000 220000 Sales 52000 48000 56000 64000 220000 Closing stock - 12000 4000 - - Prepare a statement showing the profit for different periods under both marginal costing method & absorption costing method. Solution: Under Marginal Costing Particulars Period 1($) Period 2 ($) Period 3($) Period 4($) Total ($) Sales – (i) 1040000 960000 1120000 1280000 4400000 Opening stock - - 144000 48000 - Production 624000 720000 576000 720000 2640000 Total 624000 720000 720000 768000 2640000 Less: Closing stock -___ 144000 48000 - -____ Cost of goods Sold (ii) 624000 576000 672000 768000 2640000 Contribution (i) –(ii) 416000 384000 448000 512000 1760000 Less: Fixed Cost 52000 units @ 4 208000 208000 208000 208000 832000 Profit 208000 176000 240000 304000 928000 Under Absorption Costing Particulars Period 1 Period 2 Period 3 Period 4 Total ($) ($) ($) ($) ($) Sales – (i) 1040000 960000 1120000 1280000 4400000 Opening stock @ $ 16 per unit - - 192000 64000 Cost of Production $ 16 per unit 832000 960000 768000 960000 3520000 Total 832000 960000 960000 1024000 3520000 Less: Closing stock @ $ 16 per unit - 192000 64000 - -__ Cost of goods sold (Actual) 832000 768000 896000 1024000 3520000 Less: Over-absorbed - 32000 32000 64000 Overheads (Notes 1) (Notes 3)________ 832000 736000 896000 992000 3456000 Add: Under-absorbed 16000 16000 Overheads (Notes 2)____________________ Cost of Sales after adjusting under/over absorbed overheads - (ii) 832000 736000 912000 992000 3472000 Profit [(i) – (ii) 208000 224000 208000 288000 928000 Notes: The following adjustments should be carried out for the purpose of comparison of results of absorption costing & marginal costing: The normal capacity is 52000 units. Actual production during the period is 60000 units. That means there is over-absorption of fixed overhead amounting $ 32000 [(60000 units – 52000 units) * $4]. Actual production is 4 8000 units which are less than normal production by 4000 units. That means there is under-absorption of fixed overhead amounting $ 16000 [(52000 units – 48000 units) * $4]. Actual production is 60000 units which are more than normal production by 8000 units. That means there is over-absorption of fixed overhead amounting $ 32000 [(60000 units – 52000 units) * $4]. There is difference of profits under both the methods. The reasons of such difference are: Period 1: During this period, since no opening or closing stock is there, there is no difference in profit figures under both the methods. Period 2: During this period, profit under Absorption costing is more than that of Marginal costing by $ 48000. This is due to the fact that fixed cost of 12000 units @ $ 4 is being carried forward for the next year. Period 3: During this period, profit under Absorption costing is less than that of Marginal costing by $ 32000. This is due to the fact that by 8000 units opening stock is more than that of closing stock. As a result, to the cost of production of current year, a portion of last year’s fixed overhead is being charged. Period 4: During this period, profit under Absorption costing is less than that of Marginal costing by $ 16000. This is due to the fact that to the cost of production of current years, the fixed overhead relating to opening stock is being charged. Presentation of data: The difference of presenting the data under marginal costing & absorption costing is summarized in the under mentioned table: Marginal Costing Absorption Costing Sales XXX Sales XXX Less: Variable Cost Less: Manufacturing cost of Manufacturing XXX goods sold (including Administration XXX fixed manufacturing Selling XXX XXX overheads) XXX Contribution XXX XXX Less: Fixed cost Less: Administration & Manufacturing XXX Selling Expenses XXX Administration XXX Profit XXX Selling XXX XXX Profit XXX Note: Profits figure under the two methods will be different, if there are opening & closing inventories. Online Live Tutor Reconciliation of results of absorption costing & marginal costing: We have the best tutors in Economics in the industry. Our tutors can break down a complex Reconciliation of results of absorption costing & marginal costing problem into its sub parts and explain to you in detail how each step is performed. This approach of breaking down a problem has been appreciated by majority of our students for learning Reconciliation of results of absorption costing & marginal costing concepts. You will get one-to-one personalized attention through our online tutoring which will make learning fun and easy. Our tutors are highly qualified and hold advanced degrees. Please do send us a request for Reconciliation of results of absorption costing & marginal costing tutoring and experience the quality yourself. 001-0001-0001-03-10-00000008-02-05 Application of marginal costing in decision making Application of Marginal Costing in Managerial Decision Making Marginal costing is very helpful in managerial decision making. Management's production and cost and sales decisions may be easily affected from marginal costing. That is the reason, it is the part of cost control method of costing accounting. Before explaining the application of marginal costing in managerial decision making, we are providing little introduction to those who are new for understanding this important concept. Marginal cost is change in total cost due to increase or decrease one unit or output. It is technique to show the effect on net profit if we classified total cost in variable cost and fixed cost. The ascertainment of marginal costs and of the effect on profit of changes in volume or type of output by differentiating between fixed costs and variable costs. In marginal costing, marginal cost is always equal to variable cost or cost of goods sold. We must know following formulae a) Contribution ( Per unit) = Sale per unit - Variable Cost per unit b) Total profit or loss = Total Contribution - Total Fixed Costs or Contribution = Fixed Cost + Profit or Profit = Contribution - Fixed Cost c) Profit Volume Ratio = Contribution/ Sale X 100 ( It means if we sell Rs. 100 product, what will be our contribution margin, more contribution margin means more profit) d ) Break Even Point is a point where Total sale = Total Cost e) Break Even Point ( In unit ) = Total Fixed expenses / Contribution f) Break Even Point ( In Sales Value ) = Break even point (in units) X Selling price per unit g) Break Even Point at earning of specific net profit margin = Total Contribution / Contribution per unit or = fixed cost + profit / selling price - variable cost per unit Application of Marginal Costing in Managerial Decisions By effective use of marginal costing formulae, we can apply marginal costing for managerial decisions with following ways : 1st Application : Managerial Decision Relating to Determination of Optimum Selling Price To determine the optimum selling price of any product or service is big challenge for a manager of any company because company wants to profit of each unit of any product or service. In marginal costing technique, fixed cost will not be changed at any level of production. Only variable cost is changed for getting optimum selling price where company can achieve expected profit. Example : Suppose a company wants to earn 15% net profit margin on 20,000 unit sold. What price will company fix? Following other information is give suppose fixed cost which fixed = Rs. 180,000 suppose variable cost = Rs. 25 This decision can be easily taken with marginal costing's formula. Above, I have written 7 formula. Now we use 7th formula of out of them. Break even units at desired profit = fixed cost + profit / selling price - variable cost per unit or No. of units expected to sell = Fixed cost + desired profit / contribution per unit 20000 = 180000 + 15% X ( 20000X S.P) / selling price - 25 20000 X ( S.P. - 25) = 180000+ 15% X( 20000 X S.P) 20000 S.P. - 500,000 = 180000 + 3000 S.P 20000 S.P - 3000 S.P = 180000 +500000 17000 S.P = 680000 S.P = 680000/17000 = 40 or Expected Selling price = Rs. 40 2nd Application : To Check the Effect of Reducing of Current Price on profit We all know, this is the time of competition, customer has become king. He wants product at minimum price. One example, we can see free video on YouTube. Instead of buying costly CDs and DVD, customers of entertainment industry see free films and movies on YouTube. But on the other side, company wants to maintain his current profit. At that time, manager will be in tension because it is not possible to maintain profit even after reducing price. But if manager learns marginal costing techniques and uses it effective way, they can check the effect of reducing of current price on net profit, after this, he can decide to reduce production or increase production. It is the law of economics, variable cost will reduce by reducing units of production in same proportion but when we increase production, fixed cost will fastly decreases due to constant nature. Example : Sale of a product amount to 1000 units per annum at Rs. 500 per unit. Fixed overheads are Rs. 100000 per annum and variable cost Rs. 300 per unit. There is a proposal to reduce the price by 20% due to survive in competition. How many units must be sold to maintain total profit after reducing the price by 20%? First of all we check the effect of reducing of current price on profit Our Gross profit ratio or P/V Ratio without reducing price = Gross profit or Contribution / Sale per unit X 100 = Sale per unit - variable cost per unit / sale per unit X 100 = 500 - 300/500 X 100 = 40% Break Even Point ( in units where profit is zero ) = Fixed cost / Contribution per unit = 100000/ 200 = 500 units After reducing 20% of sale price , our gross profit or P/V ratio will be = 500- 300 / 500 - 500 X 20% X 100 = 25% It means our Gross profit will reduce 15% ( 40% - 25%) if we reduce our sale prices 20%. Break Even Point ( in units where profit is zero ) = Fixed cost / Contribution per unit = 100000/ 100 = 1000 units Now No. of Units Sold at Break Even point at desired profit :- For this we have to know present profit Present Gross profit or contribution = 40% gross margin on sale X( total no. of sale units X sale per unit) = = 40% X ( 1000 units X Rs. 500 per unit ) = 2,00,000 Present Net Profit = Contribution or gross profit - Fixed cost = 200,000 - 1,00,000 = 1,00,000 Now, number of units required to maintain same net profit = Fixed cost + Net profit / New contribution after reduction of sale prices = 1,00,000 + 1,00,000 / Rs. 100 = 200,000 / 100 = 2000 units Now, manager has to take decision to produce more 1000 units if he wants to earn same gross margin 40% instead of 25% 3rd Application : Choose of Good Product Mix It may be possible that company is producing more than one product, at that time company has to calculate each product's contribution margin or gross profit margin. After this, manager see which product is giving high contribution margin. Company manager will give preference to that product whose contribution will high. One more decision can be taken by manger. He can check contribution by producing different quantity of different products. If he see any quantity of products is producing maximum contribution, it will be equilibrium point. Production of units at that quantity will be benefited to company. 4th Application : Calculation of Margin of Safety Marginal costing can be utilized for calculating margin of safety. Margin of safety is difference between actual sale and sale at break even point. According to marginal costing rules, production will follow sales. Suppose current sale is Rs. 4,00,000 and BEP is Rs. 3,00,000, margin of safety is Rs.100000. We can calculate it with following formula = Profit/ P/V ratio If company's sale is less than margin of safety, then manager can take step to reduce both fixed and variable cost or increase prices. 5th Application : Decision Regarding to Sell goods at Different Prices to Different Customers Sometime, company has to give special discount to special customers. These customers may be govt, foreign companies or wholesaler. At that time manager has to take decision at what limit, we can give discount to special customers. Marginal costing may help in this decision. 001-0001-0001-03-10-00000008-02-06 Cost-Volume-Profit Relationship & Break Even Analysis Cost-Volume-Profit Relationship & Break Even Analysis Break-even analysis, a subset of cost-volume-profit (CVP) analysis, is used by management to help understand the relationships between cost, sales volume and profit. This techniques focuses on how selling prices, sales volume, variable costs, fixed costs and the mix of product sold affects profit. Understanding some of the basic tenets of CVP analysis can help you analyze these factors in your business and make better business decisions. Break Even CVP analysis is most often used to determine a company's break-even point. This is the level of sales where the company will not incur a loss, yet not make a profit. To calculate the break-even point, you must first calculate the contribution margin. The contribution margin is a company's sales less its variable expenses. Then, divide the company's fixed costs by the contribution margin. This will give you the company's break-even point in total dollars of sales. If you want to calculate the break-even point in units sold, replace the contribution margin in the denominator with the contribution margin per unit. The contribution margin per unit is calculated as the sales price less the variable cost per unit. Margin of Safety The margin of safety is volume of sales that the company is selling above the break-even point. Like the break-even point, the margin of safety can be expressed either in units or sales dollars. However, the margin of safety is most often expressed as a percentage of sales. The first step in calculating the margin of safety is to calculate the break-even point in sales dollars. Once the break-even point is calculated, this figure is subtracted from the actual sales in dollars. This figure is the margin of safety in dollars. To convert this to a percentage, simply divide the margin of safety in dollars by the actual sales and multiple by 100. Target Profit While knowing the break-even point is important, most businesses hope to do better than break even. Often small-business owners will aspire to a target level of profit. CVP analysis allows owners to calculate the level of sales require to achieve this goal. To calculate target profit in sales dollars, add the target profit to the company's total fixed costs and then divide by the contribution margin. This will tell you the level of sales that you need to achieve to meet your profit goal. If you are interested in calculating the target profit in units, then instead of dividing by the contribution margin, just divide by the contribution margin per unit. Contribution Margin Analysis While the contribution margin is used as an intermediate calculation in many CVP analyses, this metric can provide information by itself. The contribution margin ratio, contribution margin divided by sales, tells management how much of every dollar is going to contribute to covering fixed expense up until the break-even point is reached. After the break-even point is reached, the contribution margin ratio tells management how much each dollar contributes to the company's profit. Cost-Volume-Profit Relationship  Sales are good. As a business owner, you know that while the top line is important, the bottom line is what determines if you can keep the doors open month after month. When you consider new costs like an advertising campaign, or changes in costs like sales discounts, analyzing the relationship between cost, volume and profit helps you set targets you need to hit to break even and generate a profit. Cost Sales incur certain costs. Before you can sell a product or service, you must acquire it. Sales staff might earn a commission off the sale. These expenses, along with other expenses that vary directly with volume, are called variable expenses. Determining the variable expense of each product line is a preliminary step in conducting cost-volume-profit analysis. Subtracting the variable expense from the sales price provides the contribution margin. Contribution margin is the amount generated from the sale available to cover fixed expenses and, hopefully, profit. Volume Volume impacts your bottom line only by amplifying the impact of your products contribution margins. If you sold 100,000 units in a month, that alone doesn’t provide enough information to say that volume is either good or bad. When you sell products at a profit, meaning your contribution margin is greater than 0, then it could be good. On the other hand, if that product sells at a loss, meaning your contribution margin is less than 0, it is likely bad. Example You sell speakers at a price of $200 and you know each sale costs $195. As a result, each speaker contributes $5 and a sales volume of 100,000 speakers provides $500,000 of revenue to cover fixed expenses and profit. While the speakers have a relatively low contribution margin compared to their sales price, each speaker contributes a positive amount and you sell a large volume of speakers. Your sales manager believes adding a three percent commission would increase sales volume by 20 percent; however, despite selling 20,000 more speakers you would lose $120,000 from the sale of speakers if you paid that three percent commission. Profit Cost and volume alone can’t show whether your operations are profitable. You may bring in $500,000 a month in contribution, but if you have fixed expenses totaling $600,000 then your business is bleeding $100,000 a month. Fixed expenses include costs like rent, salaries and insurance, which don’t vary with work volume. When determining profit, you must first apply contribution to covering fixed expenses before counting revenue as profit. For example, you could not say that you had a profit of $500,000 simply because you didn’t pay your fixed expenses for the month. Break Even Analysis  Break even analysis is a special application of cost-volume-profit analysis. You look for the volume or sales dollar figure at which contribution is enough to pay fixed expenses and leave nothing left for profit. When you know the contribution margin, divide the fixed expenses by the contribution margin to calculate the necessary volume to break even. Divide by the ratio of contribution margin to sales revenue if you want the break even point in sales dollars. Cost Volume Profit Analysis Updated February 06, 2001 Cost volume profit analysis (also called break-even analysis) is an extremely useful tool for managers because of its simplicity and because of its focus on essential business factors. This material will cover the development of the break-even chart, the use of profit graphs (with illustrations of how cost and price changes impact profits), and a discussion of how you can develop a spreadsheet to generate profit graphs and compute break-even points. Finally, the last section looks at how managers can use CVP to evaluate things like price changes and changes in marketing promotion expenditures. Development of a Break-Even Graph The following graphs illustrate how one builds a break-even chart. This company has annual fixed costs of $40, a unit selling price of $10, and a unit variable cost of $6. Since it earns $4 from each unit that it sells for $10, the company has a margin percentage of 40% of sales.First, one draws the fixed cost line on a graph. A flat line at the $40 level represents fixed costs. Cost-volume-profit (CVP) analysis is used to determine how changes in costs and volume affect a company's operating income and net income. In performing this analysis, there are several assumptions made, including: Sales price per unit is constant. Variable costs per unit are constant. Total fixed costs are constant. Everything produced is sold. Costs are only affected because activity changes. If a company sells more than one product, they are sold in the same mix. CVP analysis requires that all the company's costs, including manufacturing, selling, and administrative costs, be identified as variable or fixed.  Contribution margin and contribution margin ratio Key calculations when using CVP analysis are the contribution margin and the contribution margin ratio. The contribution margin represents the amount of income or profit the company made before deducting its fixed costs. Said another way, it is the amount of sales dollars available to cover (or contribute to) fixed costs. When calculated as a ratio, it is the percent of sales dollars available to cover fixed costs. Once fixed costs are covered, the next dollar of sales results in the company having income. The contribution margin is sales revenue minus all variable costs. It may be calculated using dollars or on a per unit basis. If The Three M's, Inc., has sales of $750,000 and total variable costs of $450,000, its contribution margin is $300,000. Assuming the company sold 250,000 units during the year, the per unit sales price is $3 and the total variable cost per unit is $1.80. The contribution margin per unit is $1.20. The contribution margin ratio is 40%. It can be calculated using either the contribution margin in dollars or the contribution margin per unit. To calculate the contribution margin ratio, the contribution margin is divided by the sales or revenues amount. Break-even point The break‐even point represents the level of sales where net income equals zero. In other words, the point where sales revenue equals total variable costs plus total fixed costs, and contribution margin equals fixed costs. Using the previous information and given that the company has fixed costs of $300,000, the break‐even income statement shows zero net income. This income statement format is known as the contribution margin income statement and is used for internal reporting only. The $1.80 per unit or $450,000 of variable costs represent all variable costs including costs classified as manufacturing costs, selling expenses, and administrative expenses. Similarly, the fixed costs represent total manufacturing, selling, and administrative fixed costs. Break‐even point in dollars. The break‐even point in sales dollars of $750,000 is calculated by dividing total fixed costs of $300,000 by the contribution margin ratio of 40%. Another way to calculate break‐even sales dollars is to use the mathematical equation. In this equation, the variable costs are stated as a percent of sales. If a unit has a $3.00 selling price and variable costs of $1.80, variable costs as a percent of sales is 60% ($1.80 ÷ $3.00). Using fixed costs of $300,000, the break‐even equation is shown below  Break‐even point in units. The break‐even point in units of 250,000 is calculated by dividing fixed costs of $300,000 by contribution margin per unit of $1.20. The break‐even point in units may also be calculated using the mathematical equation where “X” equals break‐even units module3 Contents: Costing in service sector Service cost units Service cost analysis Operating cost statement Operating cost- transport,Hotel Process costing Joint product and By product Equivalent production 001-0001-0001-03-10-00000008-03-01 Costing in service sector Service sector companies provide services to their customers that are intangible. Service sector costing is a method of ascertaining costs of providing or operating a service. This method of costing is applied by those undertakings which provide services like schools, hotels, hospitals, canteens, transportation etc rather than production of commodities. Service sector costing has emerged as a separate method of costing due to the shortcomings in traditional costing methods to apply to this sector. Shortcomings of traditional costing method for this sector are: 1. No cost of goods sold; 2. No profit centre; 3. No break even analysis; 4. No pricing  formulations; 5. Unlike inventories, no storage of services; 6. More emphasis on responsibility accounting. Question Explain the main characteristics of Service sector costing. Answer Main characteristics of service sector are: 1. Activities are labour intensive: The activities of service sector generally are labour intensive. The direct material cost is either small or non-existent. 2. Cost-unit is usually difficult to define: The selection of cost units usually, for service sector is difficult to ascertain as compared to the selection of cost unit for manufacturing sector. 3. Product costs in service sector: Costs are classified as product or period costs in manufacturing sector for various reasons. It is difficult to apply such classification to service sector since it is not possible to identify inventories that are intangible. Question Give an appropriate cost unit for each of the following service sectors: 1. Hotel 2. School 3. Hospital 4. Accounting firm 5. Transport 6. Staff Canteen 7. Machine maintenance 8. Computer Department Answer Respective Cost Units are: 1. Hotel - Bed nights available or occupied 2. School - Student hours or no. of full time students 3. Hospital - Patient- day / Room-day 4. Accounting firm - Client hours 5. Transport - Passenger-Kms, or Quintal km or tonne-km 6. Staff Canteen - No. of meals provided or no. of staff 7. Machine maintenance - Maintenance hours to user departments 8. Computer Department - Computer time to user departments. Question Discuss with examples, the basic costing methods to assign costs to services. Answer Generally the following methods are adopted to assign costs to services: 1. Job costing method: The cost of a particular service is obtained by assigning costs to a distinct identifiable service. e.g. Job Costing method is used in service sectors – like Accounting Firm, Advertisement campaign. Indirect costs may be allotted / apportioned on the basis of Activity Based Costing or such other suitable methods. 2. Process Costing method: Cost of a service is obtained by assigning costs to masses of similar unit and then computing cost / unit on an average basis. e.g. Retail banking, postal delivery, credit card etc. 3. Hybrid method: Combination of both (1) & (2) above. The main cost components in service sector are labour hours and service overheads. Question “Customer profile is important in charging cost.” Explain this statement in the light of customer costing in service sector. OR How will you apply customer costing in service sector? Explain with suitable example. Answer The customer costing is a new approach to management. The central theme of this approach is customer satisfaction. In some service industries, such as public relations, the specific output of industry may be difficult to identify and even more difficult to quantify. Further there are multiple customers, identifying support activities i.e. common costs with particular customer may be more problematic. In such cases it is important to cost customer. An ABC analysis of customers’ profitability provides valuable information to  help management in pricing customer. For instance in banking sector, the activities for customers will include the following types: 1. Stopping a cheque 2. Withdrawal of cash 3. Updating of pass book 4. Issue of duplicate pass book 5. Returning a cheque because of insufficient funds 6. Clearing of a customer cheque. Different customers or categories of customers use different amount of these activities and so customer profiles can be built up and customer can be charged according to the cost to serve them. 001-0001-0001-03-10-00000008-03-02 Service cost units A unit cost is the total expenditure incurred by a company to produce, store and sell one unit of a particular product or service. Unit costs include all fixed costs, or overhead costs, and all variable costs, or direct material costs and direct labor costs, involved in production. Determining the unit cost is a quick way to check if companies are efficient in producing their products. Service cost The expense associated with having another person perform a valuable task for which specialized expertise may be required. When the service cost to a business of employing independent contractors to perform necessary tasks reaches a certain critical level, it may become more economical to hire full time employees to do the work. Service costing is the technique of finding the total operating cost and cost per services of services organization i.e. transportation, hospital, hotel, school and college, cinema hall and power house, library, drinking water etc. Service costing is applicable for those understanding or services cost center under any enterprise, which provides generated services. These types of services may be needed for internal as well external purposes. Services generated for internal purpose means ancillary services provides by sections and department to the production department under a manufacturing concern as canteen, builder house, electronic generation department services etc. the services generated for external purposed are directly related to the public utility services provides to the public. As transport services, inutility services, distribution services, etc.  The method of operating costs used for the costing of services can be distinguished from the costing of manufactured products. Operating cost is the cost of providing services. Operating costing is the term applied to describe the system used the system used to find the cost of performing the services According to institute of cost and management accountants (ICMA), London,"operating costing applied where standardized services are provides by a undertaking or by the service cost center within undertaking." According to wheldon, "operating services is a until costing as applied to the costing of services." Thus, services costs are the cost of providing and operating services in a particular sector. In short, it is considered generally by inducting services instead of producing goods. It is the method of costing which provides information how to calculate operating cost. 001-0001-0001-03-10-00000008-03-03 Service cost analysis The Benefits Of Service Cost Analysis If you were to ask a typical organisation what its overall cost of IT is, you’ll usually get an answer with a reasonable level of confidence behind it. However, when it comes to questions regarding the cost to deliver individual services e.g. email, CRM, ERP etc. the response is typically quite different. To some, services “cost what they cost” and regardless, each business-critical service has to be delivered, no matter what. This point of view is understandable, however in an environment of increasingly squeezed budgets – having to deliver more with less, knowing the exact cost structure of a service is arguably a fundamental piece of information to have access to. If the overall cost of a service is understood and you can drill down to the cost of infrastructure, software and support elements, then a picture of where specific savings can be made begins to become clearer. For example by uncovering an area of overlapping support capabilities where there is inherently wasted cash. To justify the exercise, a better place to start from could be derived from Simon Sinek’s book “Start with Why”. In his book and associated TED talk, Sinek suggests organisations (and individuals) focus initially on why they are doing what they are doing, rather than the what and how. Why Service Cost Analysis? Linking IT service costs and overall product profitability – i.e. where to focus investment. Identify which services to invest more in, which ones to retire Overlaps and inefficiencies (reduce costs, carbon footprint etc.) Gives insight into cost profile (Capex vs. Opex) and identify strategies and roadmaps for moving to a different strategic model Service interdependencies (risk and cost) As for lowering an organisations carbon footprint; this is becoming a more and more pressing matter and something which undoubtedly cannot be ignored moving forwards. A solid understanding of an organisations cost base for delivering a service to the business will inherently expose areas of overlap. These areas of overlap area immediately areas where the carbon footprint can be lowered – whether than be through workforce management (less staff = less travel for example), or the decommissioning of kit and the subsequent decrease in power, cooling and heating required. When it comes to strategic decision making, this is not something that can be done without having all the relevant data to hand. Having performed a service cost analysis, senior management are able to actually make well informed decisions on how to adapt and plan for IT spend, which in turn allows them to more confidently and accurately report to shareholders on company performance – A large CAPEX spend could have very unwanted effects on quarterly financials – it’s a very different story though if there is an element of forecasting said expenditure. Moreover, by understanding the cost profile of a service, and subsequently the operating expense ratio, management can make a truly informed decision on the profitability and efficiency of the service. And finally, let us not forget that it is has always been the case (and probably always will be), that the larger and more complex the organisation, the more valuable this exercise will be, because no doubt there will be an element of “the right hand doesn’t know what the left hand is doing” type syndrome occurring; And in a world where growth is always one of the golden mantras for any business, this will never change. 8 steps to an accurate cost-of-service analysis Getting a firm handle on costs is a challenge for any public works manager, but particularly for solid waste leaders in this era of lean-and-mean local government. Elected officials tend to target solid waste because of perceived high labor, equipment, and capital costs, even though many communities allocate collection-and-disposal revenues to other municipal operations. That makes full cost accounting difficult and adds to agency overhead. As a result, many haven’t raised rates despite sharp hikes in fuel, maintenance, insurance, and employee health benefit expenses. Finally, the lack of reliable benchmarking data makes it difficult to rate agency performance. Competition from the private sector remains intense, and politicians seeking ways to keep taxes and service costs low often make the threat of privatization. Given the current climate, a cost-of-service or rate study is more important than ever to focus attention on critical financial and management issues. The analysis will demonstrate how much revenue from tipping fees, collection fees, and/or assessments a solid waste agency/department needs to provide those services. Eight basic steps ground the review in basic accounting and financial principles while ensuring that input from key stakeholders is obtained and addressed. Think of the process as a pyramid with data-gathering forming the base and the remaining seven steps building on the results. The situation at hand Charlotte County was one of the first Florida communities to implement a special assessment to fund solid waste operations. The program has gone beyond disposal to include collection and recycling in the customer’s property tax assessment. On average, the county’s 108-acre landfill takes in 170,000 tons per year from about 84,000 residential units and 300 business customers. The county’s remaining three-year term of its existing contract with its franchise hauler requires the Solid Waste Division to assess residential units within unincorporated areas and a few beach communities outside the district assessments for trash and recycling collection and disposal at the landfill. County leaders were concerned that they might have to dip into reserve funds to cover shortfalls in tipping fee revenues or collection assessments due to the continuing declines in waste tonnage and residential building caused by the Great Recession. Here’s how the county allocates the $148.04 annual solid waste assessment: Franchise curbside collection: $109.80 Landfill operations (recycling, diversion, an illegal dumping task force, and household hazardous waste programs): $32.80 Administration (tax collection and mailing notices): $5.44 The Solid Waste Division has six cost centers: administration capital improvements two customer drop-off centers illegal dumping prevention landfill cost-of-service analysis, cost of service studyA type of research and reporting used to determine the actual costs of providing service to individual customers, groups of customers, or an entire customer base. In the energy industry, cost-of-service analyses are performed at all stages of the supply chain from generation right through to billing. Utilities use these studies to determine what they require in the way of operating capital and what rates they can afford to set for some or all services. The act of performing a cost-of-service analysis does not necessarily mean that the utility intends to offer cost-of-service pricing. These types of studies are performed by businesses in all service industries as part of standard operating procedure. 001-0001-0001-03-10-00000008-03-04 Operating cost statement What is an 'Operating Cost' Operating costs are expenses associated with the maintenance and administration of a business on a day-to-day basis. The operating cost is a component of operating income and is usually reflected on a company’s income statement. While operating costs generally do not include capital outlays, they can include many components of operating a business including: Accounting and legal fees Bank charges Sales and marketing costs Travel expenses Entertainment costs Non-capitalized research and development expenses Office supply costs Rent Repair and maintenance costs Utility expenses Salary and wage expenses The formula for operating cost can be expressed in the following way: Operating Cost = Cost of Goods Sold + Operating Expenses Operating Expense on the Income Statement section of the income statement focuses on the operating expenses that arise during the ordinary course of running a business. Operating expenses include everything from employee salaries to the toilet paper in the office restrooms; research and development to electricity bills; copy paper to corporate phone lines and high-speed Internet. The general rule of thumb: If an expense doesn't qualify as a cost of goods sold, meaning it isn't directly related to producing or manufacturing a good or service, it goes under the operating expense section of the income statement. There are several categories, the biggest of which is known as Selling, General, and Administrative Expense, but we'll get to that later in this article. Whether you are a new investor trying to study a company's annual report and 10K, a business owner examining your operations, or an entrepreneur considering buying or starting a new undertaking, understanding the role of operating expenses is vital to your success. This includes developing a firm grasp on the company's business model and how that plays into its competitive strengths. For example, some businesses have a high-touch, top-shelf customer service model that relies upon making the customer experience extraordinary. This means never having the phone ring more than twice before it's answered, proactively solving problems or making suggestions, befriending clients on a more personal level, as well as doing whatever is necessary to bring a smile to the client's face. This typically results in higher operating expenses on the income statement but, in exchange, you often get much higher customer retention rates and pricing power. Other businesses focus on a bare-bones, do-it-yourself, rock-bottom cost model that results in operating expenses being a mere fraction of those found at competitors when measured as a percentage of revenue. Both can be the pathway to success, just as you can build a fortune running a luxury hotel such as a Ritz Carlton or by operating a Super 8, which is more modest in its accommodation. One of the largest banks in America is famous for purposely running operating expenses about 10% to 15% higher than competitors because its executives and shareholders believe that shorter lines combined with a face-to- face presence in the community results in "stickier" deposits; that people will want to use them rather than the folks online or across the street. The results speak for themselves because this particular financial institution is the envy of the commercial banking sector and funds most of its balance sheet at a cost of a few dozen basis points. In general, you want to work with managements that strive to keep operating expense as low as possible within the business model they are following, without going so low they begin to damage the underlying business by effectively putting the company into liquidation. Again, it's important to understand the business model in order to gauge whether or not its operating expenses are too low or too high. To go back to the bank I just used as an illustration, the former CEO famously wouldn't buy the employees at headquarters a Christmas tree, telling them it wasn't the stockholders' job to pay for their decorations. On the other hand, the branch offices were always well-maintained, well-lit, and well-staffed. It's about prioritizing expenditures that lead to higher returns on equity. Statement of Operations The statement of operations is one of the three primary financial statements used to assess a company’s performance and financial position (the two others being the balance sheet and the cash flow statement). The statement of operations summarizes a company's revenues and expenses over the entire reporting period. The statement of operations is also known as a profit and loss (P&L) statement, statement of earnings, income statement, or statement of income. The basic equation on which an statement of operations is based is Revenues – Expenses = Net Income. HOW IT WORKS (EXAMPLE): All companies need to generate revenue to stay in business. They use revenues to pay expenses, interest payments on debt, and taxes owed to the government. After these costs of doing business are paid, the amount left over is called net income. Net income is theoretically available to shareholders, though instead of paying out dividends, the firm’s management often chooses to retain earnings for future investment in the business. Statements of operations are all organized the same way, regardless of industry. The basic outline is shown in the following example: Statement of Operations for Company XYZ, Inc. for the year ended December 31, 2008 Total Revenue $100,000 Cost of Goods Sold ($ 20,000) Gross Profit $ 80,000 Operating Expenses Salaries $10,000 Rent $10,000 Utilities $ 5,000 Depreciation $ 5,000 Total Operating Expenses ($ 30,000) Operating Profit (EBIT) $ 50,000 Interest Expense ($ 10,000) Income before taxes (EBT) $ 40,000 Taxes ($ 10,000) Net Income $ 30,000 Number of Shares Outstanding 30,000 Earnings Per Share (EPS) $1.00 001-0001-0001-03-10-00000008-03-05 Operating cost- transport,Hotel Operating cost- transport 1. Transport Costs and RatesTransport systems face requirements to increase their capacity and to reduce the costs of movements. All users (e.g. individuals, corporations, institutions, governments, etc.) have to negotiate or bid for the transfer of goods, people, information and capital because supplies, distribution systems, tariffs, salaries, locations, marketing techniques as well as fuel costs are changing constantly. There are also costs involved in gathering information, negotiating, and enforcing contracts and transactions, which are often referred as the cost of doing business. Trade also involves transactions costs that all agents attempt to reduce since transaction costs account for a growing share of the resources consumed by the economy.Frequently, corporations and individuals must take decisions about how to route passengers or freight through the transport system. This choice has been considerably expanded in the context of the production of lighter and high value consuming goods, such as electronics, and less bulky production techniques. It is not uncommon for transport costs to account for 10% of the total cost of a product. This share also roughly applies to personal mobility where households spend about 10% of their income for transportation, including the automobile which has a complex cost structure. Thus, the choice of a transportation mode to route people and freight between origins and destinations becomes important and depends on a number of factors such as the nature of the goods, the available infrastructures, origins and destinations, technology, and particularly their respective distances. Jointly, they define transportation costs.Transport costs are a monetary measure of what the transport provider must pay to produce transportation services. They come as fixed (infrastructure) and variable (operating) costs, depending on a variety of conditions related to geography, infrastructure, administrative barriers, energy, and on how passengers and freight are carried. Three major components, related to transactions, shipments and the friction of distance, impact on transport costs.Transport costs have significant impacts on the structure of economic activities as well as on international trade. Empirical evidence underlines that raising transport costs by 10% reduces trade volumes by more than 20% and that the general quality of transport infrastructure can account for half of the variation in transport costs. In a competitive environment where transportation is a service that can be bided on, transport costs are influenced by the respectiverates of transport companies, the portion of the transport costs charged to users.Rates are the price of transportation services paid by their users. They are the negotiated monetary cost of moving a passenger or a unit of freight between a specific origin and destination. Rates are often visible to the consumers since transport providers must provide this information to secure transactions. They may not necessarily express the real transport costs.The difference between costs and rates either results in a loss or a profit from the service provider. Considering the components of transport costs previously discussed, rate setting is a complex undertaking subject to constant change. For public transit, rates are often fixed and the result of a political decision where a share of the total costs is subsidized by the society. The goal is to provide an affordable mobility to the largest possible segment of the population even if this implies a recurring deficit (public transit systems rarely make any profit). It is thus common for public transit systems to have rates that are lower than costs and targeted at subsidizing the mobility of social groups such as students, the elderly or people on welfare.For freight transportation and many forms of passenger transportation (e.g. air transportation) rates are subject to a competitive pressure. This means that the rate will be adjusted according to the demand and the supply. They either reflect costs directly involved with shipping (cost-of-service) or are determined by the value of the commodity (value-of-service). Since many actors involved  in freight transportation are private rates tend to vary, often significantly, but profitability is paramount. Operating cost- Hotel Through the recent economic recovery, the hospitality industry has fared well. Hotels emerged from the recession in a position to excel, and looking at the numbers, it appears they have done just that. For a hotelier to succeed in the rising economy, they must carefully manage their operating costs. High expenses and wasteful practices deplete profit margins and affect any property’s livelihood. Forbes reported awhile back that net profit margins approached 5% in 2012, a huge improvement from the negative 1% 5-year margin in years previous. Hotels have many unavoidable costs such as labor, utilities, property operation costs, customer acquisition costs, etc. The first step in reducing operating costs and increasing profit margins is tracking and managing your costs. Large hotels and chains already meticulously track their costs, but it is equally as important for independent hotels and hostels to do the same. That said, tracking operating expenses can be time-consuming and difficult if done manually. We suggest using a property management system with reporting functionality to do the manual work for you, such as myfrontdesk (shameless plug). According to a recent tnooz article, one out of four US hoteliers still use a pen and paper to manage their properties. With a property management system, a hotelier is better able to predict future needs based on future bookings and trends over time. HotelExecutive.com stresses the importance of having an automated revenue management system. These systems save time and create accurate reports. Hotel managers with automated systems can focus on the hotel’s performance instead of working with big data to pull insights. Understanding hotel performance is imperative to identifying and controlling the largest cost contributors. The Largest Cost Contributors Labor