FIDM 2019-20 - L2 Complete

BM01AFM
Financial Information &

Decision Making
Lecture 2
RSM – 2019-20
Recap • Overhead allocation • Cost Allocation of Supporting Departments • Joint costs • Absorption costing
Turmoil in the oil markets….
RSM – 2019-20 2
Why is cost „behavior“ important?
RSM – 2019-20 3

Variable cost per
barrel: ~$25
What happens to shale production when oil price is between $25 and $65, assuming
fixed costs like exploration licenses, machines etc. have already been incurred?
RSM – 2019-20 4
RSM – 2019-20 5
Fixed Costs and Startups
Who of you is thinking about founding
a startup after graduation?
RSM – 2019-20 6
Fixed Costs and Startups
“Don’t buy what you can rent,
don’t rent what you can borrow,
don’t borrow what you can steal!”
RSM – 2019-20 7
Introduction to cost management • Cost terms • Regression • CVP Analysis
Break-Even Analysis Framework
“Contribution margin
per unit”
“Contribution margin ratio”

RSM – 2019-20 8
Breakeven point extended: Profit Planning
• The breakeven point formula can be adjusted to become a profit

planning tool.
‒ Instead of setting π to 0, as in the BE formula, we set it to the desired profit
with π ≠ 0:
FC + Profit
Q=
P - VC
RSM – 2019-20 9
Break-Even Analysis Practice
*2016 data, in thousands
Revenue* 7,000,132
Assumed variable production 4,453,776
costs
Depreciation* 947,099
R&D expenses* 834,408
SG&A expenses* 1,432,189
(assume 50% variable)
Simplified assumed loss -667,340
Estimated sales volume 76.230
(assume one car type only)
How many units would Tesla have to sell to earn a profit of 1,000,000,000?
CM Tesla: 1,830,262,000; CM/u = 24009
FC = 2,497,602,000
Units to be sold: (2,497,602,000+1,000,000,000)/24009 = 145,679 units
RSM – 2019-20 10
Sensitivity Analysis
• CVP analysis allows to answer a variety of “what-if” scenarios.
• What happens to break even point
‒ (1) if R&D spending is slashed by 50%?
‒ (2) if prices increase by 10%?
• (3) What happens to profit if prices increase by 10% and volume reduces
by 5%?
Revenue 7,000,132
Assumed variable production 4,453,776
costs
Depreciation 947,099
R&D expenses 834,408
SG&A expenses 1,432,189
(assume 50% variable)
Simplified assumed loss -667,340
Estimated sales volume 76.230
(assume one car type only)
RSM – 2019-20 11
Solution
(1) R&D spending reduced to 50%:
FC after decrease: 947,099,000 + (834,408,000 * 0.5) + (1,432,189,000 * 0.5)

= 2,080,397,500 / 24,009 (CM/u) = 86,651 units
(2) 10% price increase scenario:
Price before increase: 7,000,132,000 / 76,230 = $91,829

Price after increase: 91,829 * 1.1 = $101,012
Revenue after increase: $101,012 * 76,230 = 7,700,137,137
CM: 7,700,137,137 - 4,453,776,000 – (1,432,189,000 * 0.5)
= 2,530,274,000; CM/u=33,193
FC = 2,497,602,000
BEP Tesla: 2,497,602,000/33,193 = 75,245 units
RSM – 2019-20 12
Solution
(3) 10% price increase and demand reduction of 5% scenario:
Price after increase: $91,829 * 1.1 = $101,012 (see scenario before)

VC/u before (constant):(4,453,776,000 + (1,432,189,000 * 0,5)) / 76,230 = $67,819
Volume after reduction: 76.230 * 0.95 = 72,419
FC: 2,497,602,000
Profit: (($101,012 - $67,819) * 72,419) – 2,497,602,000 = $-93,798,133
RSM – 2019-20 13
CVP and Income Taxes
• After-tax profit can be calculated as follows:
Net Profit = Operating Profit * (1 – tax rate)
Operating profit can be substituted by net profit in the CVP analysis by the
following formula:
Operating Profit = Net profit / (1 – tax rate)
RSM – 2019-20 14
Multiple products and sales-mix in CVP
• The formulae presented to this point have assumed a single product is

produced and sold.
• A more realistic scenario involves multiple products sold, in different
volumes, with different costs.
• The same formulae are used, but instead use average contribution
margins for bundles of products.
RSM – 2019-20 •15

Different Cost Classifications for Different Purposes

• Different cost classifications for different purposes
Direct Variable
Costs Costs
Costs
Fixed Indirect
Costs Costs
‒ Fixed vs variable: Financial planning
‒ Direct vs indirect: Estimating product/service costs
‒ Any non-diagonal combination is possible
RSM – 2019-20 16
Introduction to Cost Allocation
• Multi-product firms have to estimate the costs of each product

‒ Total cost of a product = ∑(direct costs, indirect costs)
• Direct costs are easily traced to products, e.g.,

‒ assembly line labor traced using employee time sheets
‒ components and material traced using bill of material
• Indirect costs are difficult to trace to products, e.g.,

‒ costs of corporate support functions (HR, Finance, Marketing, …)
‒ production overhead (maintenance, setting up machines, depreciation, …)
• Cost allocation is the process of assigning indirect costs to products

‒ Indirect costs are allocated to products using cost drivers
‒ Cost centers  Cost drivers  Products
RSM – 2019-20 17
The Importance of Cost Allocation
• Product portfolio decisions

‒ Allocate indirect costs to products to estimate product profitability
• Performance evaluation of business unit (BU) managers

‒ Allocate support function costs to BUs to estimate BU performance
• Execute cost reduction programs

‒ Deloitte (2016): 88% of firms pursue cost reduction over next 24 months
‒ Identifying activities causing indirect costs vital for successful cost reduction
Source: Deloitte’s fourth biennial cost survey

RSM – 2019-20 18
$938 million in revenue

$150 million production costs
• Guess how much profit the movie made?
Net profit: -$167 million
• What happened?
RSM – 2019-20 19
RSM – 2019-20 20
$938 million in revenue

$150 million production costs
• Guess how much profit the movie made?
Net profit: -$167 million
• What happened?
Welcome to Hollywood! WB allocated dubious costs it would pay to itself, such
as distribution, advertising and interest to the movie
• Why?
Screenwriter and actors often have a contract clause that they receive bonus
based on the movie’s profit!
RSM – 2019-20 21
Cost Allocation: What is the problem?
• A home appliance manufacturer produces two products:

Washing machine Dishwasher
• Direct costs are assembly labor and material

• Indirect costs
‒ Machine depreciation and maintenance
‒ Labor costs for setting up machines
‒ Labor costs involved in scheduling production and purchasing material
‒ Packing and shipping
‒ Engineering
RSM – 2019-20 22
Cost Allocation: How Does It Work?

Total indirect costs (aka overhead costs): $800,000
Depreciation, Setting-up Scheduling & Packing and Engineering
maintenance machines purchasing shipping $100,000
$330,000 $40,000 $180,000 $150,000
We need to take three decisions:

1. At which detail level do we want to accumulate production costs?
2. How do we apply overhead costs to products? Which cost driver(s) do we use?
3. How do we measure costs? At actual, normal or standard rates?
RSM – 2019-20 23
1. At which detail level do we want to accumulate production costs?
Job-costing – Cost object is a unit or multiple units (batch) of a distinct

product, service or project called job. Traces costs to jobs.
• Different jobs with different amount of resource consumption
• Appropriate when most costs can be readily identified with a specific job
• E.g. construction, advertising, consulting or auditing engagement
Process-costing – for mass production of identical or similar products.

• Does not accumulate costs per unit/job, instead direct material, direct
labor and overhead costs are accumulated at the departmental level and
then averaged to products
‒ Computer processors, chemicals, textiles, orange juice etc.
Main difference is the extent of averaging used to compute the unit costs
RSM – 2019-20 24
2. How do we apply overhead costs to products?
Volume based approach:

• Use volume based cost-drivers to allocate overhead
• We have seen volume based cost-drivers when discussing variable costs,
such as production or sales volume
What problem arises when you have multiple products but allocate costs
based on volume based cost-driver, e.g. production volume?
RSM – 2019-20 25
Different products, services or projects require different amounts of overhead
Production volume as a cost-driver charges each screw the same amount of

overhead, e.g. for packing and shipping
RSM – 2019-20 26
In a multi product firm, volume is better measured in terms of a common

input factor
• Often direct labor hours or machine hours
• Overhead should be proportional to direct labor hours/machine hours
needed to manufacture that unit
‒ For example maintenance, setting-up machines, packing and shipping
We also need to decide whether we use actual or predetermined

(budgeted) overhead rates.
RSM – 2019-20 27
Actual costs: Jan: $75,000 Feb: $65,000 … Nov: $85,000 Dec: $45,000
Actual DLH: Jan: 1,000 Feb: 1,300 … Nov: 1,200 Dec: 500
Exceptionally cold month. Machine breakdown. Worker strike.

Unusually high heating costs. High repair costs. Low productivity.
Actual OHR: Jan:$75/DLH Feb:$50/DLH … Nov:$71/DLH Dec:$90/DLH
Shorter periods distort cost rates more due to

fluctuations in nominator and denominator.
Total actual overhead costs for year: $880,000

Total actual direct labor hours for year: 16,000
Actual OHR: $55/DLH
Longer periods have bigger time lags before actual rate is known
which makes them less useful for control purposes.
RSM – 2019-20 28
• Budgeted overhead rates are estimated at the beginning of the accounting

period by estimating cost driver quantities and overhead costs.
Estimated total overhead costs for year: $800,000
Estimated total direct labor hours for year: 12,800
Budgeted OHR: $62.50/DLH
• As work is done in the factory, overhead is allocated to the product(s) and

entered into the work-in-process account.
Later we will see a more sophisticated method of applying overhead costs:

By using activity-based cost drivers
RSM – 2019-20 29
3. How do we measure costs?
Actual Costing - Allocates

Uses actual costs for all product costs, i.e. direct material, direct labor and
manufacturing overhead
Actual costs = Actual direct cost rates * actual usage for the job
Overhead costs = Actual overhead rate * actual usage for the job
Normal Costing - Allocates

Uses actual costs for direct material and direct labor, but predetermined costs for
manufacturing overhead
Actual costs = Actual direct cost rates * actual usage for the job
Overhead costs = Budgeted overhead rate * actual usage for the job
Attention: Service firms usually use budgeted rates of direct labor costs and have no
(significant) direct material costs.
Standard Costing - Allocates

Quantify what products “should” cost for performance evaluation purposes
Uses standard costs for direct material, direct labor, and manufacturing overhead
 Lecture on variance analysis
RSM – 2019-20 30
Accounting for Overhead
Using a predetermined overhead rate means that actual costs will rarely
equal budgeted costs
• If allocated overhead < actual overhead, then overhead is underallocated
• If allocated overhead > actual overhead, then overhead is overallocated
Difference has to be accounted for
• Proration approach—the difference is allocated between cost of goods sold,
work-in-process, and finished goods based on their relative sizes
• Write-off approach—the difference is simply written off to cost of goods sold
(recommended by IAS2)
Balance sheet Income statement
RSM – 2019-20 31
End of period adjustment
Already allocated: $1,000,000

Underallocated amount: $100,000
Work-In-Process Finished Goods Cost of Goods

Inventory Inventory Sold
Allocated: $200,000 Allocated: $300,000 Allocated: $500,000

20% of $1,000,000 30% of $1,000,000 50% of $1,000,000
20% of $100,000 30% of $100,000 50% of $100,000

Proration: + $20,000 + $30,000 + $50,000
100% of $100,000
Write-off: + $100,000
Which method would you prefer if you wanted to minimize your tax
payments in the current period?
RSM – 2019-20 32
What about overhead from supporting departments?
We now allocated direct costs and manufacturing overhead

• But how do we allocate the overhead costs from supporting
departments?
RSM – 2019-20 33
Allocating Costs of Supporting Departments to Operating Departments
• By allocating them to production departments

‒ Production department—directly adds value to a product or service
‒ Supporting (service) department—provides the services that assist the
production departments in the company
• Three methods, increasing in complexity

1. Direct method
2. Step-down method
3. Reciprocal method
• After allocation, department-specific overhead rate can be calculated

according to cost driver (MHs, LHs etc.)
RSM – 2019-20 34
Data Used in Support Department Allocation Example
Support departments Production departments

Information Human Clothing Shoes
Technology Resources
EUR 1,000 EUR 2,000 EUR 20,000 EUR 10,000
Department IT helpdesk hours HR service hours

used used
Information Technology - 2
Human Resources 10 -
Clothing 50 5
Shoes 40 3
Methods differ in the extent to which they account for services provided
among the different service departments.
RSM – 2019-20 35
Direct Method
• Allocates support costs only to production departments.

• Does not allocate support-department costs to other support departments.
Information Technology: Human Resources:

$1,000 $2,000
Clothing Shoes
RSM – 2019-20 36
Direct Method

IT HR Clothing Shoes
Costs before support EUR 1,000 EUR 2,000 EUR 20,000 EUR 10,000
cost allocations
HR service hours used 2 - 5 3

Percentage of HR costs = 5/8 = 3/8
= 62.5% = 37.5%
Allocation of HR costs 2,000 x 0.625 2,000 x 0.375
= EUR 1,250 = EUR 750
IT helpdesk hours used - 10 50 40
Percentage of IT costs = 50/90 = 40/90

= 55.55% = 44.44%
Allocation of IT costs 1,000 x 0.5555 1,000 x 0.4444 =
= EUR 556 EUR 444
Total costs EUR 21806 EUR 11194
RSM – 2019-20 37
Step-Down Method
• Allocates in a sequential manner and partially recognizes provision of

mutual services
• Usually begin with the supporting department that gives highest
percentage of services to other supporting departments
Human Resources: Information

$2,000 Technology: $1,000
Clothing Shoes
RSM – 2019-20 38
Step-Down Method

cost allocations

Percentage of HR costs = 2/10 = 5/10 = 3/10
= 20% = 50% = 30%
Allocation of HR costs 2,000 x 0.2 = 2,000 x 0.5 2,000 x 0.3
EUR 400 = EUR 1,000 = EUR 600
IT helpdesk hours used - 10 50 40
Percentage of IT costs = 50/90 = 40/90

= 55.55% = 44.44%
Allocation of IT costs 1,400 x 0.5555 1,400 x 0.4444
= EUR 778 = EUR 622
Total costs EUR 21778 EUR 11222
RSM – 2019-20 39
Reciprocal Method
• Allocates costs by fully recognizing the mutual services provided among

all support departments.
• Solve linear equation system with 2 equations and 2 unknowns.
Human Resources: Information

$2,000 Technology: $1,000
Clothing Shoes
RSM – 2019-20 40
Reciprocal Method
cost allocations

Percentage of HR costs = 2/10 = 5/10 = 3/10
= 20% = 50% = 30%
Number of IT hours used - 10 50 40
Percentage of IT costs =10/100 = 50/100 = 40/100

= 10% = 50% = 40%
RSM – 2019-20 41
Solution
(1) IT = 1,000 + 0.2 * HR ; (2) HR = 2,000 + 0.1 * IT

HR = 2,000 + 0.1 * (1,000 + 0.2 * HR) = 2,000 + 100 + 0.02 HR  HR = 2142
IT = 1,000 + 0.2 * 2142 = 1,429
Clothing = 20,000 + 0.5 * 2142 + 0.5 * 1429 = EUR 21,786
Shoes = 10,000 + 0.3 * 2142 + 0.4 * 1429 = EUR 11,214
RSM – 2019-20 42
Joint costs
• Joint costs are incurred to produce two or more outputs from the same
input
‒ only in disassembly processes, such as refining and food processing
• Split-off point: The point in the disassembly processing at which all joint
costs have been incurred
• After the split-off point, products become separately identifiable.
• Physical unit method

• Based on each product’s pro rata share of total quantity produced
• Market-based methods
• Sales value at split-off
• Net realizable value
• Gross profit (look up yourself)
RSM – 2019-20 43
Physical-measurement method
Split-off point
A 10,000 kg,
Price: $20/kg
$18,000
= $200,000 total
Joint
costs
B 5,000 kg,
Price: $5/kg
= $25,000 total
RSM – 2019-20 44
Physical-measurement method
Uses a common physical measure such as pounds, feet, cans, and so on

to determine each product’s share of the total joint costs.
A B
Production (kg) 10,000 5,000
Weighting 10/15 5/15
Joint costs allocated ($) 12,000 6,000
Joint prod. cost per kg 1.2 1.2
RSM – 2019-20 45
Sales-value at split-off method:
• Can be used only when sales values are available for intermediate
product at split-off point
• Allocate joint costs to products using their proportional sales value at the
split-off point
A B
Sales value at split off ($) 200.000 25.000
Weighting 200/225 25/225
Joint costs allocated ($) 16.000 2.000
Joint prod. cost per kg 1,6 0,4
RSM – 2019-20 46
NRV method
• Not all products can be sold at split-off point

• Some products require further processing that comes with additional
costs
• Uses final sales value less additional individual processing costs to
allocate costs at the split-off point
RSM – 2019-20 51
NRV method
A 10,000 kg,
Split-off point (can’t be sold)
C 10.000 kg,
$3/kg Price: $24/kg
= $30,000 total = $240,000 total
$18.000
Joint costs
B 5,000 kg,
Price: $5/kg
= $25,000 total
RSM – 2019-20 48
NRV method
• Not all products can be sold at split-off point

• Some products require further processing that comes with additional
costs
• Uses final sales value less additional individual processing costs to
allocate costs at the split-off point
C B
• Sales ($) 240.000 25.000
• Separable costs ($) 30.000 0
• NRV at split-off ($) 210.000 25.000
• Weighting 210/235 25/235
• Joint costs allocated ($) 16.085 1.915
• Joint prod. cost per kg ($) 1,608 0,383
49 RSM – 2019-20 53
Joint costing and decision-making
Problem:
• Should each joint product be processed further or sold as it is at the
split-off point?
Solution:
• The joint costs are sunk costs at the split-off point!
• Key question: do the incremental benefits of further processing exceed
the incremental costs?
RSM – 2019-20 50
A 10.000 kg,
Price: $20/kg
Split-off point
C 10.000 kg,
$3/kg* Price: $24/kg
$18.000
* Separable costs
Joint costs
$2/kg*
D 4.000 kg,
B 5.000 kg, Price: $7/kg
Price: $5/kg
RSM – 2019-20 51
Decision making
• First: process further or not?
• Criterion: extra revenues vs. extra costs
Product C
• extra cost $30.000 (10.000kg x $3)
• extra revenues $40.000 (10.000kg x ($24-$20))
• Produce!
Product D
• extra costs $10.000 (5.000kg x $2)
• extra revenues $3.000 ((4.000kg x $7) – (5.000kg x $5))
• Do not produce!
RSM – 2019-20 52
Overproduction in the Automotive Industry
RSM – 2019-20 53
Many car producers have built up plenty of excess capacity over the last
couple of years. As a consequence, hey have increased production
beyond growth in demand.
Why?
• For external reporting firms are required to assign all excess capacity
costs, i.e. fixed manufacturing costs, to either
‒ COGS (sold products) or
‒ Inventory (unsold products)
Work-In-Process Finished Goods Cost of Goods

Inventory Inventory Sold
• Managers have incentives to maximize GAAP profit
RSM – 2019-20 54

When production volume increases but demand does not
More cars end up in inventory, so with absorption costing:
‒ A smaller portion of fixed manufacturing costs goes to COGS
‒ A larger portion of fixed manufacturing costs goes to Inventory
Production Sales Total Fixed Fixed Manufacturing Fixed Manufacturing

Volume Volume Manufacturing Costs Costs in COGS Costs in Inventory
100,000 90,000 $750m $675m $ 75m
125,000 90,000 $750m $540m $210m
• Portion of fixed manufacturing costs assigned to COGS

• 100,000 cars: (90,000 / 100,000) * $750m = $675m
• 125,000 cars: (90,000 / 125,000) * $750m = $540m
• Portion of fixed manufacturing costs assigned to Inventory
• 100,000 cars: (10,000 / 100,000) * $750m = $ 75m
• 125,000 cars: (35,000 / 125,000) * $750m = $210m
RSM – 2019-20 55
Absorption vs. Variable costing
Variable (Direct) Costing

• Inventoriable costs include material, labor, and variable overhead only.
• Does not include fixed overhead.
• Usually more useful for decision making
• Not GAAP compliant.
Absorption (Full) Costing

• Inventoriable costs include material, labor, and all manufacturing overhead.
• Includes fixed overhead.
• GAAP compliant and required for external reporting.
RSM – 2019-20 56
Fixed Manufacturing Overhead
RSM – 2019-20 57
• Difference in the treatment of fixed manufacturing overhead.

‒ Absorption costing allocates all manufacturing costs (i.e. full costs) to
product costs
‒ Variable costing excludes fixed costs from product costs and expenses them
in the year that the costs are incurred
Dysfunctional effect under AC:

• Managers can defer recognition of fixed manufacturing costs by building
ending inventory
• Incentive to over-produce
RSM – 2019-20 62
• In 2003, Chrysler CEO Dieter Zetsche promised that overproduction

would never happen again but it got even worse in 2005 and 2006
• Similar problems at Ford and GM
• Overproduction of semiconductors also
a big problem (e.g., Intel in 2002)
RSM – 2019-20 59
Any questions?
• See you next week!
RSM – 2019-20 60

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BM01AFM

Financial Information &

Turmoil in the oil markets….

Why is cost „behavior“ important?

Why is cost „behavior“ important?

Why is cost „behavior“ important?

Fixed Costs and Startups

Who of you is thinking about founding

a startup after graduation?

Fixed Costs and Startups

“Don’t buy what you can rent,

don’t rent what you can borrow,

don’t borrow what you can steal!”

Break-Even Analysis Framework

“Contribution margin ratio”

Breakeven point extended: Profit Planning

• The breakeven point formula can be adjusted to become a profit

Break-Even Analysis Practice

*2016 data, in thousands

(1) R&D spending reduced to 50%:

FC after decrease: 947,099,000 + (834,408,000 * 0.5) + (1,432,189,000 * 0.5)

(2) 10% price increase scenario:

Price before increase: 7,000,132,000 / 76,230 = $91,829

(3) 10% price increase and demand reduction of 5% scenario:

Price after increase: $91,829 * 1.1 = $101,012 (see scenario before)

Profit: (($101,012 - $67,819) * 72,419) – 2,497,602,000 = $-93,798,133

CVP and Income Taxes

• After-tax profit can be calculated as follows:

Net Profit = Operating Profit * (1 – tax rate)

Operating Profit = Net profit / (1 – tax rate)

Multiple products and sales-mix in CVP

• The formulae presented to this point have assumed a single product is

RSM – 2019-20 •15

Different Cost Classifications for Different Purposes

‒ Fixed vs variable: Financial planning

‒ Direct vs indirect: Estimating product/service costs

‒ Any non-diagonal combination is possible

Introduction to Cost Allocation

• Multi-product firms have to estimate the costs of each product

• Direct costs are easily traced to products, e.g.,

• Indirect costs are difficult to trace to products, e.g.,

• Cost allocation is the process of assigning indirect costs to products

The Importance of Cost Allocation

• Product portfolio decisions

• Performance evaluation of business unit (BU) managers

• Execute cost reduction programs

Source: Deloitte’s fourth biennial cost survey

The Importance of Cost Allocation

$938 million in revenue

Net profit: -$167 million

The Importance of Cost Allocation

$938 million in revenue

Net profit: -$167 million

Cost Allocation: What is the problem?

• A home appliance manufacturer produces two products:

• Direct costs are assembly labor and material

Cost Allocation: How Does It Work?

We need to take three decisions:

1. At which detail level do we want to accumulate production costs?

Job-costing – Cost object is a unit or multiple units (batch) of a distinct

Process-costing – for mass production of identical or similar products.

2. How do we apply overhead costs to products?