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Module 1 - Review of Part 1
Module 1 - Review of Part 1
LEARNING OUTCOMES:
The following specific learning objectives are expected to be realized at the end of the session:
1. Recall the topics on management advisory services part 1
KEY POINTS
CORE CONTENT
Introduction:
This module covers the discussion of
a. Cost behavior
b. CVP analysis
c. Relevant cost
d. Absorption costing
e. Variable costing
f. Master budget
IN-TEXT ACTIVITY
What is Cost Behavior Analysis?
Cost behavior analysis refers to management’s attempt to understand how operating costs change in relation to a change
in an organization’s level of activity. These costs may include direct materials, direct labor, and overhead costs that are
incurred from developing a product. Management typically performs cost behavior analysis through mathematical cost
functions.
Cost functions are descriptions of how a cost (e.g., material, labor, or overhead) changes with changes in the level of
activity relating to that cost. For example, total variable costs will change in relation to increased activity, while fixed costs
will remain the same. Cost functions may come in various forms.
Fixed Costs
Fixed costs are those which do not change with the level of activity within the relevant range. These costs will be incurred
even if no units are produced. For example rent expense, straight-line depreciation expense, etc.
Cost behavior refers to the relationship between total costs and activity level. Based on behavior, costs are categorized as
either fixed, variable or mixed. Fixed costs are constant regardless of activity level, variable costs change proportionately
with output and mixed costs are a combination of both.
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. Average variable cost i.e. variable cost per unit is
constant .
The cost-volume-profit analysis makes several assumptions, including that the sales price, fixed costs, and variable cost
per unit are constant.
Profit may be added to the fixed costs to perform CVP analysis on a desired outcome. For example, if the previous
company desired an accounting profit of $50,000, the total sales revenue is found by dividing $150,000 (the sum of fixed
costs and desired profit) by the contribution margin of 40%. This example yields a required sales revenue of $375,000.
Absorption vs. variable costing will only be a factor for companies that expense costs of goods sold (COGS) on their
income statement. Absorption vs. variable costing is not optional for public companies because they are required to use
absorption costing due to their GAAP accounting obligations.
Before looking at absorption versus variable costing, it will be important to understand the difference between direct and
indirect costs on the income statement. Direct costs are usually associated with COGS, which affects a company’s gross
profit and gross profit margin. Indirect costs are associated with the operating expenses of a company and will heavily
influence operating profit and the operating profit margin.
Some of the direct costs associated with manufacturing a product include wages for workers physically manufacturing a
product, the raw materials used in producing a product, and direct, overhead costs involved in manufacturing a product.
Absorption costing involves allocating all of the direct costs associated with manufacturing a product to COGS. This
includes any variable costs directly associated with manufacturing, such as:
Cost of raw materials
Hourly cost of labor
Salaries of manufacturing workers
Variable costs of electricity used to run a plant in manufacturing mode
Using the absorption costing method will increase COGS and thus decrease gross profit per unit produced. This means
companies will have a higher breakeven price on production per unit. It also means that customers will pay a slightly
higher retail price. Furthermore, it means that companies will likely show a lower gross profit margin.
The impact of absorption costing will depend on the business. For example, a company has to pay its manufacturing
property mortgage payments every month regardless of whether it produces 1,000 products or no products at all. A
company may see an increase in gross profit after paying off a mortgage or finishing the depreciation schedule on a piece
of manufacturing equipment. These are considerations cost accountants must closely manage when using absorption
costing.
The absorption costing method is typically the standard for most companies with COGS. It is required for compliance with
GAAP. Most auditors and financial stakeholders will also require it for external reporting. Depending on the type of
business structure, small businesses may also be required to use absorption costing for their tax reporting.
Variable Costing
Some private companies may choose to use the variable costing method. With variable costing, all of the variable, direct
costs are included in COGS. The fixed, direct costs are allocated to operating expenses rather than COGS. The types of
fixed, direct costs remain the same in both absorption and variable costing:
A mortgage payment on a building used for manufacturing
Insurance on a manufacturing property
Depreciation on a manufacturing machine
Variable costing will result in a lower breakeven price per unit using COGS. This can make it somewhat more difficult to
determine the ideal pricing for a product. With variable costing, gross profit will be slightly higher, resulting in a slightly
higher gross profit margin compared to absorption costing.
Keep in mind, companies using the cash method may not need to recognize some of their expenses as immediately with
variable costing since they are not tied to revenue recognition, which can be an advantage.
The operating budget shows the income-generating activities of the firm, including revenues and expenses. The result is a
budgeted income statement.
The financial budget shows the inflows and outflows of cash and other elements of the firm's financial position. The
inflows and outflows of cash come from the cash budget. As such, the result of the financial budget is the budgeted
balance sheet.
Sales Budget
The first schedule to develop is the sales budget, which is based on the sales forecast. The sales budget is not usually the
same as the sales forecast but is adjusted based on managerial judgment and other data.
Production Schedule
The second schedule for budget planning is the production schedule. The company must determine the number of sales
the company expects to make in the next year. Then, it must budget how many sales in units it needs to make to meet the
sales budget and meet-ending inventory requirements. Most companies have an ending inventory they want to meet
every month or quarter so that they don't stock out.
Administrative Budget
The selling and administrative expense budget deal with non-manufacturing costs such as freight or supplies.
Cash Budget
The cash budget states cash inflows and outflows, expected borrowing, and expected investments, usually on a monthly
basis. Any item that is not in cash, such as depreciation, is ignored by the cash budget.
Capital Expenditures
The budget for capital expenditures contains budgetary figures for the large, expensive fixed assets for the business firm.
With standard costing, the general ledger accounts for inventories and the cost of goods sold contain the standard costs
of the inputs that should have been used to make the actual good output. Differences between the actual costs and the
standard costs will appear as variances, which can be investigated.
If the company spends more for the direct materials, direct labor, and/or manufacturing overhead than should have been
spent, the company will not meet its projected net income. In other words, analysis of variances will direct management's
attention to the production inefficiencies or higher input costs. In turn, management can take action to correct the
problems, seek higher selling prices, etc.
Since the company's external financial statements must reflect the historical cost principle, the standard costs in the
inventories and the cost of goods sold will need to be adjusted for the variances. Since most of the goods manufactured
will have been sold, most of the variances will end up as part of the cost of goods sold.
There are two basic types of variances from a standard that can arise, which are the rate variance and the volume
variance. Here is more information about both types of variances:
Rate variance. A rate variance (which is also known as a price variance) is the difference between the actual price paid
for something and the expected price, multiplied by the actual quantity purchased. The “rate” variance designation is most
commonly applied to the labor rate variance, which involves the actual cost of direct labor in comparison to the standard
cost of direct labor. The rate variance uses a different designation when applied to the purchase of materials, and may be
called the purchase price variance or the material price variance.
Volume variance. A volume variance is the difference between the actual quantity sold or consumed and the budgeted
amount, multiplied by the standard price or cost per unit. If the variance relates to the sale of goods, it is called the sales
volume variance. If it relates to the use of direct materials, it is called the material yield variance. If the variance relates to
the use of direct labor, it is called the labor efficiency variance. Finally, if the variance relates to the application of
overhead, it is called the overhead efficiency variance.
Thus, variances are based on either changes in cost from the expected amount, or changes in the quantity from the
expected amount. The most common variances that a cost accountant elects to report on are subdivided within the rate
and volume variance categories for direct materials, direct labor, and overhead. It is also possible to report these
variances for revenue.
It is not always considered practical or even necessary to calculate and report on variances, unless the resulting
information can be used by management to improve the operations or lower the costs of a business. When a variance is
considered to have a practical application, the cost accountant should research the reason for the variance in detail and
present the results to the responsible manager, perhaps also with a suggested course of action.
SESSION SUMMARY
Cost-volume-price analysis is a way to find out how changes in variable and fixed costs affect a firm's profit.
Companies can use the formula result to see how many units they need to sell to break even (cover all costs) or
reach a certain minimum profit margin.
Relevant costs are only the costs that will be affected by the specific management decision being considered.
The opposite of a relevant cost is a sunk cost.
Management uses relevant costs in decision making, such as whether to close a business unit, whether to make or
buy parts or labor, and whether to accept a customer's last minute or special orders.
SELF-ASSESSMENT
Assignment : Computation
Quiz : Problem solving
REFERENCES
Refer to the references listed in the syllabus of the subject.