What we do in this course is to teach us how to use the language of accounting to get what you want. The essence is that it does not matter what you do, as long as you understand the language of accounting. We are going to do management accounting. It is way more free than financial accounting.
Today is all about discussing costs and cost behavior. With regards to cost behavior, we want to answer the question whether to expand production or not, and to identify the financial risk to the organisation of the cost structure.
Costs can be either product cost or period costs. Period costs are called expenses, they are expensed. This means every time you incur those costs, you put them on your income statement (for example, a salary). Product costs are costs related to assets (when it is not sold, it is an asset and when it gets sold it will show up on the income statement). This means that when you incur these costs, you get something back for it (COGS). You transfer the cash into the product. Period costs do not relate directly to the product.
The components of product cost are the materials, labor (the people that actually work on the product, so not the manager or CEO) and overhead costs (those costs associated to the product, that are difficult to allocate to an individual product) that go into the product.
Inventories on the balance sheets are finished products that have not been sold yet (for Ericsson, these are the radio-base stations that they built and have been finished, but are still for sale). The cost of sales (income statement) is the costs of making the product. Selling and administrative expenses are period costs (even if net sales is zero and no radio base stations were sold, costs will still be there).
So, product costs are in some sort of way a pile of money that you can transform into a product.
We talk about direct costs as costs that are easily traceable to a product (like direct material or labor). We talk about indirect or overhead costs as cots that cannot be traced easily to a product. For that reason, we assign it to the product.
There are all sorts of different costs. Examples of indirect costs are depreciation, the supervisor’s salary or utilities.
Manufacturing product cost summary:
- Direct materials: Raw material costs that can easily be traced to products
- Direct labor: factory wages that can easily be traced to products
- Manufacturing overhead: other factory costs such as indirect materials and labor, utilities, rent, security and depreciation.
Another way of looking at costs is defining them as fixed and variable costs. Fixed costs are the costs that are independent of the volume, so it stays the same (e.g. a band will be paid 48000 for a concert no matter how many people show up). If you have a lot of fixed costs you have a great incentive to do more and more and more because then the fixed costs per unit will decrease (economies of scale). The reason for this is that fixed costs do not change. As the activity increases, the fixed cost decreases.
As for variable costs, for every additional unit there are additional costs. So the more products you make the more variable costs you will have (e.g. a band will receive 16€ for every ticket sold). So the total variable costs increase as the number of units increase.
Operating leverage is a measure of how much money you have left after having paid all your costs. In a situation where there are a lot of fixed costs, you need to earn revenues. Therefore, when all costs are fixed, every additional sales dollar contributes one dollar to gross profit. So once you pay them off, every additional revenue more than these costs is profit. In a situation where you have variable costs, no matter how great we increase our activity level, for each additional unit we still have to pay off an addition in costs.
Shifting the cost structure from fixed to variable not only reduces risk but also the potential for profit. In an all fixed company, the net income will be the highest, and in an all variable company the lowest. Yet, the decrease in income is also greater in the all fixed company.
The contribution margin is the revenue minus variable costs. It represents the income you have left to pay off your fixed costs, after paying variable costs.
Contribution margin < fixed costs = loss
Contribution margin > fixed costs = profit
Operating leverage = contribution margin / net income
You break-even when the contribution margin equals fixed costs. You also break-even when your sales equal variable costs and fixed costs.
There are three ways of calculating the BEP:
This is the recognition that at one point all the sales equal all costs. Therefore, the formula would then look like:
(selling price per unit X number of units sold) = (variable cost per unit X number of units sold) + fixed cost. OR total revenue = total variable costs + total fixed costs. If you get the question, how many units do we need to sell before we get to the BEP, you need to play with the formula, you transform it and then calculate the amount of units. Therefore one should keep in mind that you can approach this equation method in different ways.
Contribution margin per unit method: in this case, the formula looks like this:
Break-even volume in units = fixed costs/contribution margin per unit
Contribution margin ratio method: In this case, the formula looks like this:
Contribution margin ratio = contribution margin / sales, OR
Break-even volume in dollars = fixed costs / contribution margin ratio. Once again, keep in mind that every type of question can (or has to) be approached in a different way.
Remember: when you want to calculate how to achieve an X amount of profit, you can still use the break even formulas in order to do so. A possible formula might then look like this:
Sales – total variable cost – total fixed cost = profit OR
Sales volume in units = (fixed costs + desired profit) / contribution margin per unit
When your job is dependent on these things, you want to know how close are we actually to this BEP? Then, it is very helpful to use the margin of safety, which basically says how far away (relatively) is the BEP, from the sales that I expect to make. If the two are very close together, only something small needs to happen in order to turn a profit into loss, and the other way around. It can be calculated as follows:
Margin of safety = (budgeted sales – break-even sales) / budgeted sales
When a company sells multiple products, one can still calculate the BEP. Yet, the first step is then to determine the weighted average contribution margin per unit, in order to compute the BEP. In this case, the formula can be formulated as follows:
Break-even sales = fixed cost / weighted average per unit cont. margin.
Once again, this type of formula can also be used to calculate how many products to sell when you want an X amount of profit. Then, the formula would look like this:
sales volume in units = (fixed cost + desired profit) / weighted average cont. margin per unit
When one is interested in profit, it is (always) better to sell more of a product that has the highest contribution margin, because it leaves more space for making profit.
A cost object is any type of activity, product or service to which accountants would like to trace costs. Cost accumulation starts with figuring out the cost objects and cost drivers. A cost driver is any type of factor that may cause/drive an activity’s costs, e.g. units produced, machine hours, labor hours or miles driven. We want to allocate these direct costs to cost objects (the thing we want to know the cost of).
Costs that one can trace to departments in a cost-effective manner are called direct costs. Costs that one cannot trace to departments in a cost-effective manner are called indirect costs.
There are two steps that have to be taken in order to allocate indirect costs:
Allocation rate = total cost / cost driver activity
Allocated cost = allocation rate X weight of the cost driver activity
An increase in the volume of manufacturing/production is likely to cause variable overhead costs to increase. In that case, volume measures serve as great cost drivers for the allocation of variable overhead (units produced, labor hours, materials used). ‘
You can ask yourself: What volume measure should I use? Keep in mind that judgement an reasoning are necessary (there is no best).
Activity-based costing allocates overhead costs based on different activities. Therefore in the profit statement of a company producing multiple products it becomes possible to see what product has higher costs. It shows which product is most/least profitable. ABC allows you to be more efficient/better aware of indirect costs, not necessarily profit, but it helps you to make better decisions.
In the past, very often cost systems were based on labor intensive manufacturing processes. This meant that a single company-wide overhead rate would be used based on labor hours, because these generated most costs. Very often this type of cost system leads to unreasonable situations, where one product ends up paying (most) costs for the other.
The essence of ABC is do not take a single driver anymore, but take different activities. The more activities in an organisation a product consumes, the more it needs to pay. Depending on whether you allocate costs based on volume or activity, one product might have to pay more overhead (because it produces more), while it does not necessarily cost more to produce this amount of products.
In the traditional two-stage cost allocation process, overhead costs are allocated to departments and then to products. In the ABC-allocation process, overhead costs are allocated to activity centers and then to products. Still, even though it might be a ‘’better’’ way of allocating costs, it does not always work out for firms because it is just so complicated. This is because every time something in the production process is improved or adjusted, calculations regarding the ABC allocations have to be done all over again, which costs a lot of time and might cause confusions.
There are four types of production activities, and overhead costs that are associated with each category are pooled together and allocated to products according to how those products benefit from the activities:
Unit-level activities, which can be avoided by eliminating one unit of product
Batch-level activities, which can be avoided when a batch of work is eliminated
Product-level activities, which can be avoided if a product line is eliminated
Facility-level activities, of which some costs can possibly be avoided if a business segment is eliminated
Traditional costing might result in undercosting one product line and overcosting the other.
There are two primary characteristics which distinguish relevant from useless information:
Relevant information differs among the alternatives under consideration
Relevant information is future oriented
Some costs are simply not relevant, e.g. sunk costs. This is a cost that has been incurred in the past, and will be there no matter what you do, because they have already been paid for. It simply cannot change, making it irrelevant for making current decisions.
An opportunity cost is not a real cost, it is more a kind of revenue that you will not be getting. An opportunity cost is the benefit that you would have gotten if you choose for another alternative. It is the sacrifice that is incurred in order to obtain an alternative opportunity.