Costing Overview

Understanding cost behavior: Fixed Cost, Variable Cost

It is important to understand such cost behavior because it will enable us to make important
business decisions (Covered in future chapters of the course)

Fixed Cost: It does not change within installed capacity or relevant range. E.g. Depreciation,
Rent, Lease payments, Fixed Salaries etc.

Variable Cost: Varies in direct proportion with output. E.g. Direct Material, Direct Labor

One of the most primary analysis that any business owner or company does is to calculate the
Break Even Point (BEP) for sales.

BEP is the sales level at which total cost = total sales and profit = 0

We need to understand cost behavior to be able to calculate BEP. More specifically, we need
to bifurcate costs into fixed and variable components to be able to apply the BEP formulas.

Single Product Break Even Point

BEP units = Total Fixed Costs / Contribution Margin (CM) per unit

Contribution Margin (CM) per unit = Selling Price per unit – Variable Cost per unit

Contribution Margin contributes towards recovering the Fixed Costs till you reach BEP and
after reaching BEP it contributes towards profits.
Multi-Product Break Even Point

BEP mix = Total FC / Contribution Margin per mix

BEP Units = BEP mix x Units per mix

Direct Costs are those costs that are directly associated with a product, service, or department
and can be can be observed being directly utilized in the manufacturing of a product or
provision of a service E.g. Direct (Raw) Material and Direct Labor.

Indirect Costs (Overhead Costs) are those costs that cannot be observed being directly
utilized in the manufacturing of a product or provision of a service however they are as
important as the direct costs to successfully run a business E.g. Utilities, Maintenance,
Supervision, Quality Control, Record Keeping and Administration etc.

It is easy to allocate Direct Costs to individual components of a business such as products,

orders, divisions etc. as you can directly observe such costs being applied to a process

Since Indirect Costs are often shared by various individual components of a business, and
cannot be directly observed being applied to a process, it is more difficult to allocate them
accurately to products, orders, divisions etc. In this chapter we will discuss two methods of
allocating Indirect Costs to individual products, orders, divisions etc.: Traditional Method
and Activity Based Costing

Overhead (OH) / Indirect Cost Allocation (Traditional Method)

1. Identify companywide total Indirect (OH) Costs
2. Identify companywide Allocation Basis
3. Calculate OH Allocation Rate = Total OH / Total Allocation Basis
4. Allocate OH = OH Allocation Rate x Allocation Basis Consumed by Individual
Components

Overhead (OH) / Indirect Cost Allocation (Activity Based Costing)

1. Identify Individual Overhead costs
2. Identify Total Drivers for each OH Cost
3. Calculate Activity Rate (AR) = Total OH Cost/Total Driver
4. Allocate OH = AR x Driver Used by individual product/division/order etc.

Symptoms of Cost Misallocation:

1. You introduce products with higher profit margins in your product mix yet overall profit of
the company goes down.
2. Your products struggle to compete in the market in terms of prices. Customers are always
asking for discounts.
3. Your products are hyper competitive in the market. You can produce and sell as much as
you can yet you do not achieve desired profit levels.