L04 & L05 Cost Concepts and Behaviour PDF

BAF1013 Finance & Accounting for Decision Making __________________________________________________________________________________ Lectures 4 & 5: Cost Concepts & Behaviour Learning Objectives At the end of the lecture, you should be able to: 1. Explain cost concepts and measurement...

BAF1013 Finance & Accounting for Decision Making __________________________________________________________________________________ Lectures 4 & 5: Cost Concepts & Behaviour Learning Objectives At the end of the lecture, you should be able to: 1. Explain cost concepts and measurements that are widely used in management accounting. 2. Describe the flow of costs in a business. 3. Explain how costs respond to changes in activity levels. 4. Explain the differences between direct and indirect costs, controllable and uncontrollable costs. 1. Definition of Costs In management accounting, a cost refers to the monetary value associated with the resources consumed in producing goods or services, i.e., the value spent by a business to produce goods or services. All businesses incur costs to operate, regardless of size or industry. No matter the business type, expenses will always be involved in creating products or delivering services. For example, if a restaurant buys ingredients, pays rent, and employs staff, all these expenses are classified as costs. Similarly, a car manufacturing company incurs costs for raw materials (like steel), factory rent, and worker wages. A cost object is any item for which costs are measured and assigned. An example is a product, sales territory, department, or some activity such as research and development. 1.1 Role of Costs in Decision-Making Costs are not just financial figures recorded in accounting books—they are critical tools for managers in planning, control, and decision-making. Planning Managers need to forecast costs in order to effectively plan for the future. By predicting how much money will be required, they can allocate resources efficiently and avoid unexpected financial shortfalls. Control Monitoring costs is essential to ensure the business stays within its budget and identifies inefficient areas. Regular tracking allows managers to compare actual expenses with 1 BAF1013 Finance & Accounting for Decision Making __________________________________________________________________________________ the planned budget, making it easier to take corrective actions when necessary. Decision-making Managers analyze costs to make informed decisions about whether to produce a product or service in-house or outsource it, launch a new product, or discontinue an existing service. Cost analysis helps them determine the most efficient and profitable course of action. Example: Consider a café: The café must understand the cost of coffee beans, milk, staff salaries, rent, utilities, and equipment to accurately price a cup of coffee. If they underprice their coffee without accounting for all costs, they may not cover their expenses, reducing profitability. 1.2 Types of Costs Manufacturing Business Example: Manufacturing Costs These are costs incurred directly in the process of producing goods. They are essential to the transformation of raw materials into finished products. Manufacturing costs are usually classified into three main categories: Direct Material Cost Definition These are the costs of raw materials that are an integral part of the finished product and can be easily traced to each unit of product. Examples o Steel for automobile manufacturing, fabric for clothing, flour for a bakery Direct Labour Cost Definition These are the wages paid to workers who are directly involved in the production process and whose efforts can be directly traced to specific products. Examples o Wages paid to assembly line workers in a car factory or machine operators in a textile plant 2 BAF1013 Finance & Accounting for Decision Making __________________________________________________________________________________ Factory Overhead Definition Factory overhead includes all the indirect costs of manufacturing that cannot be traced directly to specific units of production. These are costs incurred in the factory that are not direct materials or direct labour. Examples o Indirect materials: Materials like lubricants, cleaning supplies, and small tools used in the production process. o Indirect labour: Salaries for factory supervisors. o Other overhead costs: Depreciation of machinery, factory rent, utilities (electricity, water), repair and maintenance costs, and insurance on factory buildings. These costs are essential for determining the total production cost per item and setting a price that covers costs and generates a profit. Non-Manufacturing Costs Non-manufacturing costs are the expenses associated with the business operations that are unrelated to production. These costs are typically classified into two main categories: Selling & Distribution Expenses Definition These are the costs incurred in marketing, promoting, and distributing the product to customers Examples o Sales staff salaries, advertising costs, commissions to salespeople, shipping or freight costs, and travel expenses for the sales team Administrative Expenses Definition These are the costs incurred in the general management and operation of the business. They are not directly linked to production or sales but are necessary for the overall functioning of the company Examples o Salaries of administrative personnel (e.g., human resources, accounting, and management staff), office rent, utilities, office supplies, and legal or audit fees 3 BAF1013 Finance & Accounting for Decision Making __________________________________________________________________________________ Comparison Between Manufacturing and Non-Manufacturing Costs: Manufacturing Non-Manufacturing Nature Related to production in Related to selling, the plant/factory. distribution, and administration. Key Categories Direct materials, direct Selling, distribution, labour, overhead administrative Examples Raw materials, wages for Advertising costs, factory workers, factory administrative salaries, maintenance shipping costs Service Business Example: In service industries, the main focus is on costs associated with people and the delivery of services, since they often do not involve physical products or inventories like manufacturing businesses do. One key expense is the cost of human resources, such as employee salaries and benefits, which are essential for the performance of service. For example, in a consulting firm, the most significant portion of expenses typically comes from paying consultants who provide expert advice and solutions to clients. These salaries must be carefully monitored, representing a major part of the firm's total costs. Besides wages, the firm may incur other costs such as office rent, utilities, software licenses, and travel expenses for consultants when working on client projects. 4 BAF1013 Finance & Accounting for Decision Making __________________________________________________________________________________ Economic Cost Concepts: Opportunity Cost Definition Opportunity cost refers to the potential benefits or income an individual or organization misses out on when choosing an alternative. It represents the value of the next best alternative that is foregone. Examples o If a company decides to invest $100,000 in new machinery instead of expanding its marketing efforts, the opportunity cost is the potential increase in sales that could have been generated through more effective marketing. Sunk Cost Definition A cost incurred in the past that future actions cannot change. Such costs are not relevant to decision-making. Examples o The cost of an existing equipment Differential Cost Definition Differential cost, or incremental cost, is the difference in total cost between two alternatives. It represents the additional cost (or cost saving) incurred when choosing one option over another. Differential costs are relevant in decision-making because they highlight the financial impact of selecting a specific action. Examples o If a company decides whether to produce 1,000 or 1,500 units of a product and producing 1,500 units would cost an additional $10,000, then the differential cost is $10,000. o If a business is considering upgrading equipment, and the new equipment will increase production costs by $5,000 per month compared to current equipment, this $5,000 is the differential upgrade cost. 5 BAF1013 Finance & Accounting for Decision Making __________________________________________________________________________________ 2. Flow of costs in a business 2.1 Cost Flow Overview Manufacturing Business: Costs in a business move through different stages, particularly in a manufacturing setting. These costs are typically categorized as: Production Costs: Direct materials Raw materials that are easily traceable to the final product (e.g., fabric in T-shirt manufacturing) Direct labour The wages of employees directly involved in production (e.g., sewing machine operators) Overhead Indirect costs necessary for production but not directly traceable to individual products (e.g., factory utilities, equipment maintenance) Inventory Costs: These are the costs that move through the different stages of production, eventually becoming the cost of goods sold (COGS) when products are sold. Key Point: This process has four main stages: raw Materials Inventory, Work in Progress (WIP), Finished Goods Inventory, and Cost of Goods Sold (COGS). Service Business: Service Costs: Accumulate based on the time and resources used to deliver a service. Example: A consulting firm accumulates labour hours as employees work on client projects, and these costs are recorded when billed. Key Difference: In manufacturing, costs are linked to inventory, while in services, costs are mostly tied to time or resources used. 6 BAF1013 Finance & Accounting for Decision Making __________________________________________________________________________________ 2.2 Cost Flow Diagram The movement of costs through the production process: Raw Materials Inventory Put into production: Raw materials + direct labours + overhead Work in Progress (WIP) Production is complete. Finished Goods Inventory Goods are sold. Cost of Goods Sold (COGS) 2.3 Stages in Cost Flow Stage 1: Raw Materials Inventory Definition The value of all raw materials on hand that will be used in the production process. Explanation These are initially recorded as an asset on the balance sheet. Example: A T-shirt manufacturer buys rolls of fabric, which are stored in the raw materials inventory until they are needed for production. 7 BAF1013 Finance & Accounting for Decision Making __________________________________________________________________________________ Stage 2: Work in Progress (WIP) Definition The costs of partially completed products. This includes direct materials, direct labour, and overhead. Explanation As raw materials are used in production, they move from the inventory into WIP. Direct labour costs and manufacturing overhead are added to these raw materials. Example: Once the fabric is cut and sewn, it moves into WIP. The labour costs for workers sewing the T-shirts and overhead expenses, such as utility expenses for running the sewing machines, are added to WIP. Stage 3: Finished Goods Inventory Definition The value of fully completed products that are ready for sale but have not yet been sold. Explanation When production is finished, the accumulated costs in WIP are transferred to finished goods. These costs remain in inventory until the product is sold. Example: Completed T-shirts are now in finished goods inventory, ready to be shipped to customers. 8 BAF1013 Finance & Accounting for Decision Making __________________________________________________________________________________ Stage 4: Cost of Goods Sold (COGS) Definition The total cost of producing the goods that have been sold during a period. Explanation Once the product is sold, the related costs are transferred from finished goods inventory to COGS, which appears as an expense on the income statement. Example: When the T-shirts are sold, the cost of production (i.e. fabric, labour, and overhead used to produce them) is transferred to COGS. 3. Response of costs to changes in activity levels Fixed Costs Definition Fixed costs are expenses that remain constant regardless of the level of activity. They do not fluctuate with changes in output. Examples o Rent: The bakery pays the same monthly rent whether it makes 100 loaves or 500. o Insurance premiums: Fixed amounts paid regularly to cover liabilities and protect assets and employees. o Salaries for permanent staff: Salaried employees still receive the same pay even if business activity slows. 9 BAF1013 Finance & Accounting for Decision Making __________________________________________________________________________________ Variable Costs Definition Variable costs change directly in proportion to changes in activity levels. Examples o Raw materials: Costs increase as more raw materials (flour, sugar) are used to bake more loaves of bread. o Wages for temporary staff: Costs for temporary workers will increase during busy seasons and decrease when production slows. o Packaging: More packaging is needed as production increases. Mixed Costs Definition Mixed costs contain both fixed and variable components. They remain fixed up to a certain activity level and then increase as activity increases further. Examples o Electricity: There may be a fixed charge for electricity plus a variable charge depending on how much energy is used. o Maintenance costs: Monthly maintenance may be required (fixed), but additional maintenance may be needed if equipment is used more frequently (variable). Lecture exercise: Café Bliss – A Small Café Business Scenario: Café Bliss is a neighbourhood café that has been operating for a year and serves various coffee, pastries, and sandwiches. The owner, Jane, wants to analyse her costs to improve profitability. Café Bliss pays a monthly rent of $2,000 for the café’s space. Jane also pays a salary of $3,000 to the café manager, who works full-time. For every cup of coffee sold, Café Bliss uses coffee beans, milk, sugar, and cups — the cost of making a cup of coffee averages $1.50. Additionally, Jane hires part-time staff during busy hours, paying them $10/hour, depending on the café’s needs. Café Bliss has an electricity bill consisting of a fixed monthly fee of $100 and an additional $0.05 per kilowatt-hour (kWh) based on actual usage. For example, if Café Bliss uses 1,000 kWh in a month. Required: Categorize the above costs as fixed, variable, or mixed. 10 BAF1013 Finance & Accounting for Decision Making __________________________________________________________________________________ Solution: Rent and the manager’s salary are both fixed costs. They remain the same every month, regardless of the café’s performance or the number of customers it serves. Fixed Costs: Rent: $2,000/month Manager’s salary: $3,000/month The cost of coffee ingredients and part-time staff wages are variable because they change with the café’s level of production and sales. The more coffee sold, the more ingredients are required, and the more part-time staff may be needed during peak hours. Variable Costs: Cost per cup of coffee: $1.50 Part-time staff wages: $10/hour The electricity bill is a mixed cost because it includes a fixed portion ($100) and a variable portion that depends on the café’s energy usage. The cost increases as the café uses more electricity during busy months. Mixed Costs: Fixed charge for electricity: $100 Variable usage charge: $0.05 per kWh If 1,000 kWh is used: Total electricity bill = $100 (fixed) + (1,000 kWh × $0.05) = $150 11 BAF1013 Finance & Accounting for Decision Making __________________________________________________________________________________ Summary Table of Costs for Café Bliss Cost Type Example from Café Bliss Cost Behaviour Fixed Costs Rent ($2,000), Manager’s salary ($3,000) Stays constant regardless of activity Variable Coffee ingredients ($1.50 per cup), Part- Changes with production and Costs time wages ($10/hour) sales levels Mixed Electricity bill ($100 base + $0.05 per Fixed component + variable Costs kWh) usage component By categorizing costs as fixed, variable, and mixed, Jane can better understand her café’s cost structure. This knowledge will help her make informed decisions about setting prices, managing staffing levels, and planning for peak seasons or slow periods. 4.1 Direct vs indirect costs Direct costs Definition Direct costs are expenses that can be directly traced to the production of a specific product or service. Because they are directly linked to the creation of goods, direct costs are typically easy to identify and allocate. Examples o Raw materials: The ingredients used in manufacturing, such as steel for a car manufacturer or flour for a bakery. o Direct labour: Wages paid to workers who are directly involved in producing the product. For example, in a shoe factory, the wages of workers assembling the shoes are direct labour costs. Indirect costs Definition Indirect costs are expenses that are not directly traceable to a specific product or service but are necessary for the overall operation of the business. These costs are shared across various products or services. Examples o Utilities: The cost of electricity or water, which cannot be directly linked to the production of any single product. o Factory security: Salaries for security personnel are necessary to keep the factory safe but are not tied to the production of a specific item. 12 BAF1013 Finance & Accounting for Decision Making __________________________________________________________________________________ 4.2 Controllable vs uncontrollable costs Controllable costs Definition Controllable costs can be influenced or managed by decisions made within the business. Example o Materials selection: Purchasing higher-quality materials for a product versus a cheaper option. Management can decide whether to buy premium or low-cost materials based on the desired quality or budget. o Advertising and promotions: Management can choose the amount spent on marketing campaigns. Uncontrollable costs Definition Uncontrollable costs are those that cannot be influenced or altered by management's actions in the short term. External factors, such as government policies or contractual obligations typically dictate these costs. Example o Tax rate: Corporate taxes imposed by the government cannot be changed by a company’s management. Lecture exercise: Scenario: Imagine you are the owner of a clothing manufacturing company. Categorize the following costs as direct or indirect and controllable or uncontrollable: 1. The cost of fabric used to make shirts. 2. Electricity used to power the factory. 3. Wages of the sewing machine operators. 4. Rent for the factory space. 5. The decision to use higher-quality zippers for jackets. 13 BAF1013 Finance & Accounting for Decision Making __________________________________________________________________________________ Solutions: 1. Direct, Controllable (Fabric is a direct cost, and the decision to use a specific fabric can be controlled). 2. Indirect, Uncontrollable (Electricity is an indirect cost, and the price per kWh is typically uncontrollable). 3. Direct, Controllable (Wages of workers directly making products are direct and can be controlled by management decisions). 4. Indirect, Uncontrollable (Rent is an indirect cost and uncontrollable in the short term if it’s based on a contract). 5. Direct, Controllable (The quality of zippers directly impacts the cost of goods and is a controllable decision). ~ End ~ 14