ACT4131 Management Accounting III

1. Topic 2 Cost Behaviour and Allocation ACT4131 Management Accounting III

2. Cost behaviour 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

3. Variable and Fixed Costs • Variable costs (or expenses) are variable because they vary proportionately with volume of activity, such as sales. • Fixed costs = in total do not vary with activity (within the relevant range).

4. Flexible Costs • Arises from use of flexible resources • Examples: raw materials, electrical power consumed • The actual level of quantities of products determine the quantity of flexible resources used. • Capacity of flexible resources can be adjusted to match with actual use

5. Committed Costs • Reflect the cost of capacity that is locked in place BEFORE any production takes place • Committed costs arise from a decision to acquire a capacity to perform work • Affected by the planned level of activities for acquiring or contracting resources BEFORE actual work is done (e.g. personnel costs, depreciation & maintenance of buildings)

6. Committed Costs • Committed costs reflect amount of capacity acquired rather than used • thus, unaffected by use of the committed resources • costs would still be incurred even with no production • thus, are not variable or do not vary in proportion to production quantity

7. Operating Leverage • The extent to which a business uses fixed costs (compared to variable costs) in its operations is referred to as "operating leverage." • The greater the use of operating leverage (fixed costs, often associated with fixed assets), the larger the increase in profits as sales rise and the larger the increase in loss as sales fall.

8. Changing Cost Structures • The increase in fixed costs results from: • The shift toward greater automation, which requires more production engineering, scheduling, and machine setup activities • The emphasis on better customer service • The increase in support activities required by a proliferation of multiple products • Further, both variable and fixed costs associated with design, product development, distribution, selling, marketing, and administrative activities have increased

9. Changing Cost Structures • Today, direct labouris only a small portion of manufacturing costs • The cost of direct materials remains important, representing 40% to 60% of the costs in many plants • The big change has been the vastly increased share of total costs from capacity-related costs

10. Changing Cost Structures • Changing cost structures have caused cost systems allocating indirect costs using volume measures to become increasingly inaccurate in computing product costs • Many costing systems take costs that did not vary proportionally with volume, accumulate them, and then allocate them using a measure of volume • These systems often underallocate costs to cost objects (e.g., product lines) produced in low volumes

11. Opportunity Costs • A measure of the value that is lost or sacrificed when the choice of one course of action requires giving up an alternative course of action. • Not associated with cash outlays. • Not measured in accounting records. • If an alternative requires any resources that would otherwise be used for some income producing purpose, there is an opportunity cost measured by income that would have been earned had the resources been devoted to the other purpose.

12. 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.

13. Sunk Cost • A cost that has already been incurred and therefore cannot be changed by any decision currently being considered. • Example: all historical costs. • Not a differential cost.

14. Throughput Accounting Throughput accounting also pays particular attention to the concept of 'bottleneck' (referred to as constraint in the Theory of Constraints) in the manufacturing or servicing processes. The system's constraint dictates its performance therefore, if we want to increase the system's performance we have to identify and explore the system's constraint.

15. Theory of Constraints • The Theory of Constraints (TOC) is a philosophy of management and improvement originally developed by Eliyahu M. Goldratt • At any point in time, there is most often only one aspect of the system that is limiting its ability to achieve more of its goal.

16. Constraint Management • With constraint in the production process, the management has to decide which products are more important as there is not enough capacity to sell everything the market wants. • Constraint must be identified and the whole system must be managed to attain any significant improvement. • Sell products with highest throughputs and, at the same time, sell the products that use less time on the constraint.

17. Throughput per constraint unit • Need a measurement that maximises the company's throughput. • To decide which one most contributes to the company's bottom line, divide the product's throughput by the time it uses on the constraint • Compute product's Throughput per time of the constraint. (or T/CU, throughput per constraint unit)

18. Capacity Related Terminologies • Capacity • Available time for production • Bottleneck Work Center (BNWC) • Capacity is less than demand placed on resource • Nonbottleneck • Capacity is greater than demand placed on resource

19. Theory of Constraints • Constraint must be kept operating at its full capacity • If not, the entire process slows further • Focus is on maximizing throughput • Sales – totally variable costs • All other costs treated as fixed operational expenses • Cannot vary much in the short-run

20. Theory of Constraints • Based on the concepts of drum, buffer and ropes • Drum • Output of the constraint is the drumbeat • Sets the tempo for other operations • Tells upstream operations what to produce • Tells downstream operations what to expect

21. Theory of Constraints • Buffer • Stockpile of work in process in front of constraint • Precaution to keep constraint running if upstream operations are interrupted • Rope • Sequence of processes prior to and including the constraint • Want to “pull” the rope at the maximum speed • Speed of the constraint

22. Internal Process constraints Machine time, etc. Policy constraints No overtime, etc. External Material constraints Insufficient materials Market constraints Insufficient demand Steps in the TOC Process • Identify the system constraints • How is a constraint identified?

23. Steps in the TOC Process • Decide how to exploit the constraint • Produce the most profitable product mix • Want it working at 100% • How much of a buffer? • Holding costs • Including risk, quality costs • Stock-out costs

24. Steps in the TOC Process • Alleviate the constraint • Determine how to increase its capacity • Repeat the process • Always a new constraint

25. 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

26. 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

27. 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

28. 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

29. 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