Understanding Cost Behavior

1. Understanding Cost Behavior Topic 2 Management Accounting III

2. What Does Cost Mean? • There is no single definition of cost • Costs are developed and used for some specific purpose • The way the cost is to be used will define the way it should be computed • Management accountants have used different systems, or classifications, to develop cost information

3. Expenditures, Costs & Expenses • Expenditure – company purchases raw materials for RM100 • Cost – company reports RM100 of raw materials on balance sheet • Expense – company records RM100 expense on income statement when it sells the product that uses the raw material

4. Product Costs • Organizations incur product costs to produce the volume and mix of products made during the period • Manufacturing costs • Materials costs, labor costs, and the cost of equipment, machinery and buildings • Allocated between ending inventory and cost of goods sold

5. Types of Production Activities • Unit related • Batch related • Product sustaining • Customer sustaining • Business sustaining

6. Internal Use of Cost Information • Costs are used for planning and evaluation. • The objective is to determine all the components, both manufacturing and nonmanufacturing, of the costs associated with a cost object

7. Cost Object • Management accounting concept • A cost object is something for which we want to compute a cost: • A product • A product line • An organizational unit

8. Cost Structure Flexible resources are resources whose costs are proportional to the amount of the resources used • Wood used to make furniture in a factory • Electrical power to operate machinery • Fuel used to deliver the furniture to customers Variable costs – proportional to the amount of resource used

9. Cost Structure • Committed /Capacity-related resources are acquired in advance of the work being done • Capacity-related costs depend upon how much of the resource is acquired, not used • Fixed costs

10. Illustration

11. Deriving The Total Cost Function • Total cost = head office costs + Business Type I + Business Type II + Business Type III • Total Cost = RM200,000 +RM600 per service + RM25 per unit Committed/capacity related Cost: -decision in all business by head office -Depreciation expenses from all segments -Other expenses associated with the segments Flexible cost: -Variable component in the total cost functions -Estimate how total cost varies in proportion to activities (no. of service /no. of units)

12. Cost of Resources Used • Equation of cost functions can be apportioned into: • Costs related to providing business Type I • Costs related to providing business Type II • Costs related to providing business Type III • Costs related to providing business Type I & II • Costs related to providing business Type I & III • Costs related to providing business Type II & III • Costs related to providing business Type I, II & III

13. Cost of Unused Capacity • Examples of committed capacity: (1) Building / factories (2) Leased from outsiders and long term (3) Scheduling requirement purposes • Resources Supplied = Resources used + Unused Capacity • Unused/idle capacity will be treated as period cost

14. CVP Analysis • Decision makers often like to combine information about flexible and capacity-related costs with revenue information to project profits for different levels of volume • Cost-volume-profit (CVP) analysis is based on the following assumptions: • All organization costs are either purely flexible or capacity related • Units made equal units sold • Revenue per unit does not change as volume changes

15. CVP Analysis for Multiple Products • Many combinations of sales levels to break even • Using a spreadsheet by varying the sales levels of the multiple products and finding combinations that result in total profits being zero • Develop the weighted average product based on the estimated sales mix

16. Weighted Average Product • Compute each product’s share of total sales • Multiply each product’s revenue per unit by its proportion of total sales to get a weight • Add the weights for all the products to get the total weighted revenue • Apply the same technique to compute the weighted variable cost • Subtract the weighted variable cost from the weighted revenue to get the weighted contribution margin per unit of “product”

17. Example

19. Multi-Product Example • Given that the total capacity-related costs at Lynn’s Landscaping is RM300,000, use the formula for breakeven to compute the breakeven level of sales for this composite product. Contribution margin = RM 53.06 • Break-even quantity = 300,000/53.06 = 5,653.50

20. Multi-Product Example (3 of 4) • To translate this average product break-even quantity to individual products, simply reverse the process of computing the average: • Lawn Mowing = 5653.50 x 4600/6200 = 4194.529 • Layout Design = 5653.50 x 350/6200 = 319.14892 • Other Maintenance = 5653.50 x 1250/6200 1139.818

22. Opportunity Cost • An opportunity cost is the sacrifice you make when you use a resource for one purpose instead of another • Opportunity costs are implicit costs that do not appear anywhere in the accounting records • Machine time used to make one product cannot be used to make another, so a product that has a higher contribution margin per unit may not be more profitable if it takes longer to make.

23. Theory of Constraints • The Theory of Constraints (TOC) describes methods to maximize operating income when faced with some bottleneck and some non bottleneck operations • TOC focuses on a short-run time horizon and assumes that operating costs are fixed costs

24. Product 1 Product 2 Demand per month 1,000 600 Price per unit $ 900 $ 1,500 Material cost per unit $ 400 $ 800 Hours required per unit Test components 0.25 0.40 Assemble components 1.00 1.50 Install electronics 0.50 0.50 Final inspection and test 1.25 1.00 Package and ship 0.10 0.10 Identify the constraint Hours available Slack per month hours Product 1 Product 2 Total Test components 250 240 490 640 150 Assemble components 1000 900 1900 2240 340 Install electronics 500 300 800 800 0 Final inspection and test 1250 600 1850 1760 (90) Package and ship 100 60 160 160 0 Steps in the TOC Process

25. Steps in the TOC Process Identify the best use of the constraint Price per unit $900 $1,500 Material cost per unit $400 $800 Throughput per unit $500 $700 Constraint time per unit 1.25 1.00 Throughput per hour $400 $700 Identify the most profitable product mix Total demand 1,000 600 Units produced in best mix 928 600 Unmet demand 72 - Throughput generated Units produced 928 600 Throughput per unit $ 500 $ 700 Total throughput $ 464,000 $ 420,000 $ 884,000

26. Evaluation of TOC • Advantages • Improves capacity decisions in the short-run • Avoids build up of inventory • Aids in process understanding • Avoids local optimization • Improves communication between departments

27. Evaluation of TOC • Disadvantages • Negative impact on non-constrained areas • Diverts attention from other areas that may be the next constraint • Temptation to reduce capacity

28. Evaluation of TOC • Ignores long-run considerations • Introduction of new products • Continuous improvement in non-constrained areas • May lead organization away from strategy • Not a substitute for other accounting methods