MGT705 (Lec 1-22)

MGT 705 - Advanced Cost and Management Accounting
Lecture 1

Introduction to Management Accounting
Definition: process of identifying, measuring and communicating economic information to permit informed judgments and decisions. Provide information to decision makers to make good decisions.
Users of Accounting Information Managers decision making and control S are olders value and income from investments !mployees a"ility to pay salaries and avoid redundancies #reditors a"ility to meet financial o"ligations $overnment statistical information, ta%es &t ers potential investors' researc Users (sers can "e divided into ) categories: *nternal users +it in t e organi,ation !%ternal users i.e. s are olders, creditors Management accounting is for internal users -inancial accounting information is for e%ternal users
Decision1making process
1 *dentify o"jectives Searc alternative courses of action $at er data a"out alternatives Select appropriate alternative c o n t r o l P l a n n i n g
*mplement decision #ompare actual and planned outcomes 2espond to divergence from plans
Identifying objectives !conomic t eory : firms seek to ma%imi,e profits .too simplistic/ -irm is a coalition of various groups: s are olders, employees, customers, suppliers 0roadly1 firms seek to ma%imi,e future cas flo+s Search for Alternatives
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Possi"le courses of action to ac ieve o"jective !ssential to identify potential opportunities and treats. i.e. Developing ne+ products in e%isting markets Developing ne+ products for ne+ markets Developing ne+ markets for e%isting products Searc for alternatives involves ac4uiring information concerning future opportunities
Gather data 5 en potential areas of activity are identified, management s ould assess: Potential gro+t rate 6"ility to esta"lis ade4uate market s are #as flo+ for eac alternative activity (ncontrolla"le factors: !conomic "oom ' recession *nflation Strengt of competition Select appropriate alternative *n practice decision making involves c oosing "et+een competing alternatives and selecting t e one t at "est meets t e organi,ations o"jectives. 6ssuming o"jective to "e to ma%imi,e future net cas flo+s, alternative selected +ill "e "ased on comparison of t e different cas flo+s. Implementation of ecisions 7 e "udget is t e financial plan for implementing management decisions. !%pressed in terms of cas inflo+s and outflo+s, sales revenues and e%penses. 7 e master "udget consists of a "udgeted profit and loss account, "alance s eet and a cas flo+ statement. !omparing actual vs plan 7 e managerial function of control consists of measurement, reporting and su"se4uent correction of performance to ensure firms o"jectives are ac ieved. Performance reports of actual costs and revenues in comparison +it "udget, s ould "e prepared at regular intervals. 7 ese reports ig lig t activities t at do not conform to plan "esponding to divergence !ffective control re4uires t at corrective action is taken for diverging activities. 7 is may re4uire modification in plan if t e plan ."udget/ is inappropriate and not attaina"le
e! management a""roac#es
8ey success factors: cost, 4uality, time, innovation #ustomer satisfaction is top priority
#ontinuous improvement
7otal value c ain analysis
!mployee empo+erment
!ost efficiency and #uality 8eeping costs lo+ and "eing cost efficient provides an organi,ation +it a strong competitive advantage. 6ccuracy and relia"ility in costing systems as gained importance. #ompanies are focusing on 7otal 9uality Management .79M/ in response to customer demands for ig 4uality. 7 e goal of 79M is customer satisfaction. !ontinuous improvement #ontinuous improvement is a process t at focuses on delivery of products or services of consistently ig 4uality in a timely fas ion. *t is c eaper to produce items correctly t e first time rat er t an to +aste resources making su"1standard items t at ad to "e detected, re+orked, scrapped or returned "y customers. !ycle time #ycle time is a measure t at management accounting systems ave "egun to focus on, it is t e lengt of time from start to completion of a product or service. #ycle time is minimi,ed "y reducing time spent on transfer of product during production, +ait time, inspection time, re1+orking time and olding period of inventory. 7 ese are referred to as non1value added activities, as against processing time + ic adds value to t e product. $enchmar%ing 0enc marking is a tec ni4ue t at is increasingly "eing adopted as a mec anism ac ieving continuous improvement.
*t is a process of measuring a firm;s product, service or activity against t e ot er "est performing organi,ations. 0enc marking involves a focus on latest developments and "est practices t at can "e incorporated in various "usiness operations.
&mployee empo'erment *n t eir 4uest for continuous improvement managers ave found t ey ave to rely increasingly on t e people closest to t e operating processes and customers, to develop ne+ approac es to improve performance. 7 is as lead to employees "eing provided +it relevant information to ena"le t em to make continuous improvements in processes.
7 e value c ain
7 e value c ain is t e linked set of value creating activities all t e +ay from t e "asic ra+ material suppliers to t e ultimate end1use product delivered to customers.
7 e value c ain can also "e vie+ed from t e customer;s perspective, +it eac link "eing seen as t e customer of t e previous link. *f eac link in t e value c ain is designed to meet t e needs of its customer, t en end customer satisfaction s ould ensue.
Impact of I()( * &"+ &ne advanced *7 application t at as considera"le impact on "usiness information systems is !nterprise 2esource Planning .!2P/ system . !2P comprises a set of integrated soft+are application modules t at aim to control all information flo+s +it in a company. 6 major feature of !2P systems is t at all data are entered only once, typically + ere t e data originates.
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Lecture ,
Introduction to Management Accounting
!ost )erms and !oncepts !ost reflects a monetary measure of resources sacrificed ' foregone to ac ieve a specific o"jective i.e. ac4uiring of goods and services. 6ccounting systems measure costs + ic are used for profit measurement, inventory valuation, decision making, performance measurement and controlling "usiness activities. !ost -bjects 6 cost o"ject is any activity for + ic a separate measurement of cost is desired. !%amples of cost o"ject include: cost of a product, cost of rendering a service and cost of operating a particular department. 6 costing system +ill typically: 6ccumulate costs "y classifying t em into certain categories suc as la"or, materials and over eads. 7 en assign t ese costs to cost o"jects. Some cost terms Direct and *ndirect costs Product and Period costs #ost "e avior in relation to volume of activity 2elevant and *rrelevant costs 6voida"le and (navoida"le costs Sunk costs &pportunity costs *ncremental and Marginal costs.
Direct and *ndirect #osts

*n manufacturing organi,ations one cost o"ject is usually t e product. #ategories of costs are:
Direct material % Direct la"or % !onversion Prime cost % !ost Production over ead % Production cost % Direct cost can "e specifically and e%clusively identified +it a particular cost o"ject. *ndirect costs are classified as production over ead.
+roduct and +eriod !osts Product costs are t ose t at are identified +it t e goods "eing produced for resale. 7 ese include direct material, direct la"or and production over eads. Period costs are treated as e%pense in t e period in + ic t ey are incurred. 7 ey are not included in inventory valuation. >on1manufacturing over eads e.g. admin, sales ? distri"ution, are regarded as period costs. &.ample -ancy -ans #ompany of $ujran+ala produces 3@@,@@@ identical units of product during Aanuary. #osts for Aanuary are : Manufacturing costs: Direct la"or <@@,@@@ Direct material )@@,@@@ Manufacturing over ead )@@,@@@ B@@,@@@ >on1manufacturing costs :@@,@@@ *n Aanuary t e company sold =@,@@@ units for 2s C=@,@@@ and remaining =@,@@@ +ere unsold. Profit and loss account +ill "e:
2s
2s D
Sales .=@,@@@ units/ Direct la"or Direct materials Production &ver eads Production cost .product costs/ Eess closing stock .=@,@@@ units/ #ost of goods sold $ross Profit Eess >on production costs .period costs/ >et profit
C=@,@@@ <@@,@@@ )@@,@@@ )@@,@@@ B@@,@@@ <@@,@@@ <@@,@@@ :=@,@@@ :@@,@@@ =@,@@@
7reatment of product and period costs
Production cost
Product code
unsold
*ncluded in inventory
Sold
>on production cost

Period code
*ncluded as e%pense in t e period
!ost in relation to volume Decisions + ic re4uire information on o+ cost +ill vary in relation to volume are: Folume of production for t e ne%t year 2educe selling price to sell more units Sales staff s ould "e paid salary, commission, "ot # ange in costs and revenues of ospital, if one more patient is admitted for seven days # ange in costs and revenues of otel, if a room and meals are provided for ) for a C days stay.
Faria"le, -i%ed and Semi1Faria"le #osts

Faria"le costs vary in direct proportion to volume of activity i.e. if volume is dou"led, t e cost +ill also dou"le. 7otal varia"le cost is linear and varia"le cost per unit is constant.
Faria"le cost D@@@ <@@@ )@@@ )@@ <@@ D@@ B@@ #ost variation +ill remain true for a range of activity level 6ctivity 7otal Faria"le #ost !%amples of varia"le costs include direct material, direct la"or, energy cost to operate a mac ine
/i.ed !osts -i%ed costs remain constant over a +ide range of activity. !%amples of fi%ed costs include depreciation of factory "uilding, supervisor salary, leasing c arges. 5 ile total fi%ed cost remains constant, fi%ed cost per unit decrease proportionally. Step fi%ed costs: "eyond a certain range of activity fi%ed costs +ill c ange. Senior managers may "e added, ne+ mac inery may "e ac4uired. Semi*variable costs 7 ese costs include a fi%ed component and a varia"le component. !%amples include payment to sales staff of salary as +ell as commission, line rent paid on telep one toget er +it c arges for calls made. "elevant and Irrelevant costs #osts can "e relevant or irrelevant in respect of a particular decision or project. 6ll costs + ic c ange in response to a decision +ill "e regarded as relevant to t e decision. !.g. use of car vs pu"lic transport, road ta% and insurance paid on car is irrelevant. Petrol cost of car +ill depend on t e alternative c osen. *n t e s ort1term all costs and revenues are not relevant for decisions "eing made. Avoidable and Unavoidable !osts0 6voida"le costs are t ose t at may "e saved + en a given alternative is not adopted. (navoida"le costs cannot "e saved. Gence only avoida"le costs are relevant in decision1making. Decision rule is to accept t e alternatives t at generate revenue in e%cess of avoida"le costs.
Sun% !osts 7 ese are costs of resources already ac4uired and +ill "e unaffected "y t e c oice "et+een various alternatives. !%ample: Mac ine purc ased < yrs ago 2s 3@@,@@@ !%pected life .scrap value is >il/ = years 5DF under st. line met od 2s )@,@@@ 7 e 5DF +ill ave to "e +ritten off no matter + at future action is c osen. *f mac ine is scrapped and ne+ one purc ased, )@,@@@ +ill "e +ritten off. *f mac ine is used in production, )@,@@@ +ill still "e +ritten off. 7 is is classified as sunk cost. Sun% costs( Sunk costs are irrelevant for decision making, "ut t ey are distinguis ed from irrelevant costs "ecause not all irrelevant costs are sunk costs. !.g. a comparison of t+o alternative production met ods may result in identical direct material e%penditure for "ot alternatives, so direct material cost +ould "e irrelevant, "ut t e material cost is not sunk since it +ill "e incurred in t e future. -pportunity cost &pportunity cost is t e cost t at measures t e alternative sacrificed or lost + en one course of action is adopted. &pportunity cost applies only to use of scarce resources. 5 en resources are not scarce t ere is no sacrifice in t e use of t ese resources. 5 en no alternative use of resources e%ists, t e opportunity cost is ,ero. &.ample0 Sun% and -pportunity !osts Mr. Aa angir as taken out a lease on a s op for a do+n payment of 2s =@@@. 6dditionally t e rent under t e lease amounts to 2s =@@@ per annum. *f t e lease is cancelled, t e initial payment of 2s =@@@ is forfeited. Mr. Aa angir plans to use t e s op for t e sale of clot ing, and as estimated operations for t e ne%t 3) mont s as follo+s: Sales 3@@,@@@ #ost of goods sold 5ages ? related costs 2ent incl. do+n payment Geat, lig t, insurance 6udit, legal e%penses >et Profit "efore ta% =@,@@@ 3),@@@ 3@,@@@ 3:,@@@ ),@@@ BC,@@@ 3:@@@ Mr. Aa angir can su"let t e s op to a friend for 2s ==@ per mont , if e does not use it imself. Sun% and -pportunity !ost e.ample 7 e do+n payment of 2s =@@@ represents a sunk cost. 7 e lost profit from su"letting of 2s 3D@@ calculated as : *ncome .2s ==@% 3)/ DD@@ Eess annual rent =@@@ 3D@@ *t is an e%ample of opportunity cost. >ote only rental is included in opportunity cost calculation. 2s =@@@ sunk cost is e%cluded.
"elevant information for shop 7 e relevant information for running t e s op is: >et sales 3@@,@@@ #osts .BC@@@1 =@@@ sunk cost/ B),@@@ 3B,@@@ Eess opportunity cost .su"let/ 3,D@@ Profit 3D,<@@ Incremental and Marginal costs *ncremental .differential/ costs and revenues represent t e difference in cost under eac alternative "eing considered. -or e%ample, t e incremental cost of increasing output from 3@@@ to 33@@ units per +eek is t e additional cost of producing e%tra 3@@ units per +eek. Marginal cost'revenue represents t e additional cost ' revenue of one e%tra unit of output.
11111111111111111111111111111111111111111111111111111111 Lecture 1 !ost 2olume +rofit Analysis
!ost 2olume +rofit model 3!2+4 7 is is a systematic met od of e%amining t e relations ip "et+een c anges in activity .output/ and c anges in sales revenue, e%penses and profit. *t is a useful tool for decision making in setting selling prices and output levels. 7 is model also elps to identify t e output level at + ic neit er profit nor loss +ill occur i.e. "reak1even point.
7 e 0asic Model
7 e analysis is "ased on relations ip "et+een volume, sales revenue and costs in t e s ort1run, + ere certain factors suc as plant capacities cannot "e e%panded.
Falue Profit area 0reak1even Point Eoss area Sales revenue
7otal #ost
-i%ed cost
&utput
3@
&.ample 5 !ity &nterprise #ity enterprises operate in t e entertainment industry and one of its activities is to promote cricket matc es t roug out t e country. 7 e company is e%amining t e via"ility of a cricket matc in Sialkot: !stimated fi%ed costs 2s D@,@@@ .includes amounts paid to cricketers, ire of ground and advertising cost/. Faria"le costs .pre1packed lunc "o%/ 2s 3@ per ticket sold. Proposed selling price 2s )@ per ticket Management ave re4uested t e follo+ing information: 7 e num"er of tickets t at must "e sold to "reak1even Go+ many tickets must "e sold to earn a target profit of 2s :@,@@@ 5 at profit +ould result if B@@@ tickets +ere sold 5 at selling price must "e c arged to give a profit of 2s :@,@@@ on sale of B@@@ tickets Go+ many additional tickets must "e sold to cover e%tra cost of television advertising of 2s B@@@.
$rea%*even point in units #ontri"ution Margin approac : Contribution = Sales Revenue -variable expenses. 6s varia"le cost per unit and selling price per unit are assumed to "e constant, t e contri"ution margin per unit is also assumed to "e constant. Sales price per ticket 2s )@ Faria"le cost per ticket 2s 3@ #ontri"ution margin per ticket 2s 3@ $rea%*even 7 e "reak1even point +ill occur + en fi%ed costs +ill "e covered "y contri"ution i.e. -i%ed #ost I #ontri"ution 0reak1even point in units can "e calculated as: 0'!.units/I-i%ed cost'contri"ution per unit i.e. D@@@@'3@ I D@@@ tickets. 7ickets re4uired for profit of 2s :@@@@ Gere t e contri"ution margin must e4ual t e fi%ed costs as +ell as t e desired profit, ence: 7ickets re4uired for :@@@@ profit I fi%ed cost J :@@@@ ' contri"ution per ticket ID@@@@J:@@@@ ' 3@ I H@@@ tickets Profit from sale of B@@@ tickets #ontri"ution margin on B@@@ tickets: B@@@ % 2s 3@ I B@@@@ -i%ed costs I D@@@@ Profit I )@@@@ Profit 2s :@@@@ from B@@@ tickets #ontri"ution re4uired for profit of 2s :@@@@: fi%ed cost J profit: D@@@@J:@@@@ I 2s H@@@@ *f num"er of tickets sold is B@@@, contri"ution per ticket s ould "e: H@@@@'B@@@I33.)= !%isting contri"ution I 2s 3@ 6dditional contri"ution I 2s 3.)= >e+ selling price is 2s )@J3.)= I 2s )3.)= 7elevision advertising cost
33
6dditional tickets t at must "e sold to meet television advertising costs of 2s B@@@: 1 fi%ed costs +ill no+ increase "y 2s B@@@ 1 e%tra tickets re4uired to cover fi%ed cost at t e contri"ution margin rate of 2s 3@ I B@@@'3@ I B@@ tickets
#ontri"ution Margin 2atio 6lso kno+n as t e profit volume ratio, it is : #ontri"ution ' Sales revenue *t represents t e proportion of sales availa"le to cover fi%ed costs and provide for profit. *n t e a"ove e%ample t e contri"ution margin is 2s 3@ and selling price is 2s )@, ence t e contri"ution margin ratio is @.= *f sales revenue I contri"ution +ill "e deduct fi%ed costs profit I )@@@@@, 3@@@@@ .)@@@@@ % .=/ .D@@@@/ <@@@@
#ontri"ution Margin.#M/ 2atio 7 us a profit of 2s <@@@@ +ill "e o"tained from total sales revenue of 2s )@@@@@ i.e. Profit I .sales revenue % #M ratio/ -i%ed #ost Profit J -i%ed #ost I sales revenue % #M ratio 7 erefore at 0reak1even point.+ ere profitI@/ Sales revenue I -i%ed #ost ' #M ratio "elevant "ange *t is vital to remem"er t at t e formulae met od can only "e used for decisions +it in t e relevant range of output. &utside t is range t e unit selling price and varia"le cost are no longer deemed to "e constant. *n our e%ample of #ity !nterprises, let us assume caterers c arges +ill "e ig er if ticket sales are "elo+ <@@@, "ut lo+er if sales e%ceed 3)@@@. Faria"le cost of 2s 3@ relates only to a sales volume range of <@@@ to 3)@@@ tickets. 6lso t e ire c arges for t e ground may "e reduced for ticket sales of less t an <@@@, and increased for ticket sales of more t an 3)@@@. 7 is implies t at t e relevant range is sales volume of <@@@ to 3)@@@, and outside t is range t e results of our analysis do not apply. Margin of Safety 7 e margin of safety indicates "y o+ muc sales may decrease "efore a loss occurs. (sing t e a"ove e%ample + ere unit selling price is 2s )@, varia"le cost is 2s 3@ and fi%ed costs are 2s D@@@@, +e noted t e "reak1even point +as D@@@ tickets of 2s 3)@@@@ sales revenue. *f sales are e%pected to "e B@@@ tickets or 2s 3D@@@@, t e margin of safety +ill "e )@@@ tickets or 2s <@@@@. Margin of safety can "e e%pressed as a percentage: K margin of safety I e%pected sales "reakeven sales !%pected sales I 3D@@@@13)@@@@ I )=K 3D@@@@
+rofit 5 2olume Graph 7 e "reak1even and contri"ution c arts do not ig lig t t e profit or loss at different volume levels. 3) Virtual University of Pakistan
7 e profit volume grap is a more convenient met od of s o+ing t e impact of c anges in volume on profit. 7 e ori,ontal a%is represents t e various levels of sales volume, and t e profits and losses are recorded on t e vertical a%is.
Profit Folume $rap L

5 en units are ,ero, loss I fi%ed costs D@@@@ 6t "reak1even .,ero profit/ sales volume is D@@@ tickets. 7 e profit line is dra+n "et+een t ese t+o points. 2elevant range
+rofit 0reak1even point )@@@@ <@@@@ D@@@@ Loss )@@@ <@@@ D@@@ 3)@@@
/or each additional tic%et sold beyond 97778 a surplus of "s 17 is obtained
&utput
If 17777 tic%ets are sold8 profit 'ill be "s 67777
11111111111111111111111111111111111111111111111111111111 Lecture 6 3cont4

$rea%*even analysis e.ample 5 &astern !ompany 7 e summari,ed profit and loss statement for t e !astern #ompany for t e last year is as follo+s: Sales .=@,@@@ units/ Direct materials Direct 5ages -i%ed Production over eads Faria"le Production over eads 6dministration over eads Selling and distri"ution over eads Profit ' .Eoss/ &astern !ompany
!ost 2olume +rofit Analysis
3@@@ :=@ )@@ )@@ =@ 3B@ 3)@ 33@@ .3@@/
3:
6t a recent 0oard meeting t e directors discussed t e results and t e # airman asked for suggestions to improve t e situation. Mou are re4uired to evaluate t e follo+ing proposals and comment "riefly on eac . 6/Pay salesmen a commission of 3@K of sales and t is +ill increase sales to "reak1even point 0/ 2educe selling price "y 3@K + ic , it is estimated +ill increase sales volume "y :@K #/ *ncrease direct +ages from 2s < to 2s = per our as a part of productivity'pay deal. *t is oped t at t is +ould increase production and sales "y )@K, "ut t e advertising cost +ould increase "y 2s =@@@@. D/ *ncrease sales "y advertising of 2s :@@,@@@ +it an increased selling price of )@K, setting profit margin at 3@K.
&astern !ompany * solution 5orkings: Sales 3@@@ Faria"le costs D@@ #ontri"ution <@@ -i%ed costs =@@ Profit ' .Eoss/ .3@@/ (nit selling price I 2s )@ .2s 3M'=@,@@@/ (nit varia"le cost I 2s 3) .2s D@@@@@'=@,@@@/ (nit contri"ution I 2s B !astern #ompany .6/ sales commission 3@K, sales increase to 0'! 3@K sales commission I 2s ) per unit #ontri"ution per unit no+: 2s D per unit 0reak1even point : =@@,@@@'D I B:,::: units 7 is re4uires an increase of DCK on previous 7 e directors +ill need to consider + et er t is is realisticN
sales
of
=@,@@@
units.
.0/ 2educe selling price "y 3@K, increase sales volume "y :@K 3@K reduction in selling price I 2s ) per unit. 2evised contri"ution per unit *f sales volume increased "y :@K #ontri"ution .D=@@@ % D/ Eess: fi%ed costs Profit'.Eoss/ I 2s D I =@@@@%3:@K I D=@@@ I :H@@@@ I =@@@@@ .33@@@@/
!stimated loss is +orse t an last year, proposal not recommended.
.#/ *ncrease direct +ages, production and sales +ill go up )@K, 6dv 2s =@@@@ 5ages increase from 2s < to 2s = per r )=K Direct +ages cost +ill increase from )@@@@@ to )=@@@@, and output increases "y )@K. Income Statement Sales . D@,@@@ units/
3.)@@,@@@ 3<
Direct materials and varia"le over eads .D@,@@@ units/ Direct +ages #ontri"ution Eess: -i%ed costs .advertising 2s =@,@@@/ Profit ' .Eoss/
<B@,@@@ )=@,@@@ C:@,@@@ <C@,@@@ .==@,@@@/ .B@,@@@/
7 is represents an improvement of 2s )@,@@@ over last year loss of 2s 3@@,@@@ o+ever it does not make t e #ompany profita"le. .D/ *ncrease advertising "y :@@,@@@ selling price "y )@K, profit margin 3@K 2evised selling price .)@ % 3)@K/ I )< Eet O I revised sales volume, sales .varia"le cost J fi%ed cost/ I profit )<O .3)O J B@@,@@@/ I .3.)<O/ H.DO I B@@@@@ P O I B:,::: units 7 e proposal results in profit, "ut +ould re4uire an increase in sales volume of DCK. 6dditionally, t e risk of increase in fi%ed cost "y 2s :@@,@@@ must "e considered.
Separation of semi*variable costs Semi varia"le costs include "ot a fi%ed and a varia"le component. !.g. t e cost of maintenance is a semi varia"le cost consisting of planned maintenance + ic is undertaken + atever t e level of activity, and a varia"le element + ic is directly related to t e level of activity. 7 e ig 1lo+ met od to separate fi%ed and varia"le costs consists of e%amining past costs and related activity. :igh*lo' method Selecting t e ig est and t e lo+est activity levels and comparing t e c anges in costs + ic result from t e t+o levels. Folume Semi varia"le costs =@@@ ))@@@ Eo+est activity Gig est activity 3@@@@ :)@@@ *f varia"le costs per unit are constant, and fi%ed costs remain unc anged, t e increase in costs +ill "e due entirely to an increase in varia"le costs. Gig 1lo+ met od L Faria"le cost per unit can "e calculated as : Difference in cost I 3@@@@ I 2s ) per unit Difference in activity =@@@ 7 e fi%ed cost can no+ "e calculated for any level of activity: 6t =@@@, 7otal cost I 2s ))@@@ varia"le cost .=@@@ % )/ I 2s 3@@@@ 0alance is fi%ed cost 3)@@@ &.ample Aamal Sons operate a single retail outlet selling direct to t e pu"lic. Profit statements for 6ugust and Septem"er are: Aug Sep Sales B@@@@ H@@@@ #ost of sales =@@@@ ==@@@ 3= Virtual University of Pakistan
$ross profit Eess: Selling and Dist. 6dmin >et Profit
:@@@@ B@@@ 3=@@@ C@@@
:=@@@ H@@@ 3=@@@ 33@@@
Aamal SonsL a/ (se t e ig 1lo+ points tec ni4ue to identify t e "e avior of: i/ cost of sales ii/ selling and distri"ution costs iii/ 6dministration costs Aug Diff Sales B@@@@ #ost of sales =@@@@ Selling ? Dist B@@@ 6dministration 3=@@@
Sep H@@@@ ==@@@ H@@@ 3=@@@
3@@@@ =@@@ 3@@@ nil
*ncrease in sales of 3@@@@ results in increase in cost of sales =@@@ and selling and distri"ution costs of 3@@@. Gence varia"le costs are: cost of sales =@K of sales, selling and dist. 1 3@K of sales -i%ed cost can "e derived using 6ugust data: 7otal.Far. cost -i% cost ."al/ #ost of sales =@,@@@ <@,@@@ 3@,@@@ Selling ? dist B,@@@ B,@@@ nil 6dministration 3=,@@@ nil 3=,@@@ )=,@@@ 7otal cost I )=,@@@ .fi%ed/ J D@K Sales .var. cost/ "/ Dra+ a contri"ution "reakeven c art and identify t e mont ly "reakeven sales value and area of contri"ution. 7 e follo+ing items are plotted on t e grap : Faria"le #ost 7otal #ost Qero sales nil )=@@@ -i% B@@@@ sales <B@@@.D@K/ C:@@@ H@@@@ sales =<@@@.D@K/ CH@@@ =@@@@ sales :@@@@.D@K/ ==@@@ 3@@@@@ sales D@@@@ B=@@@
3D
#ontri"ution "reak1even grap

0'! pt I
value 0reak1even point .D)=@@/
-i%ed costs .)=@@@/ I D)=@@ contri"ution to sales ratio ..</

A Sales 7otal cost $ Faria"le cost
)=@@@
6rea of contri"utionI 6rea 6@0 Mont ly sales
c4 6ssuming margin of safetyI :@K of "reak1even value, calculate Aamal Sons annual profit. 6ctual sales I 3.: % "reak1even sales .D)=@@/ I B3)=@ #ontri"ution .<@K of sales/ I :)=@@ -i%ed costs I )=@@@ Mont ly profit I C=@@ 6nnual profit .C=@@%3)/ I H@@@@ ;amal Sons 5 ne' outlet Aamal sons is no+ considering opening anot er retail outlet selling t e same products. 7 ey plan to use t e same profit margins in "ot outlets and as estimated t at t e specific fi%ed costs of t e second outlet +ill "e 3@@@@@ per annum. Aamal sons also e%pects t at 3@K of its annual sales from t e e%isting outlet +ould transfer to t is second outlet. #alculate t e annual value of sales re4uired from t e ne+ outlet to ac ieve t e same profit as "efore. #ontri"ution from single outlet I :H@,@@@ .:),=@@ % 3)/ #ontri"ution to cover lost sales .3@K/ I :H,@@@ Specific fi%ed costs I 3@@,@@@ 7otal contri"ution re4uired =)H,@@@ 2e4uired sales I =)H,@@@'@.< I 3,:)),=@@
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3C
Lecture <

Multi*+roduct $rea%*even Analysis
Most firms produce and sell a num"er of products or services. 5e s all consider o+ +e can adopt t e analysis "ased on a single product to a multi1product setting. !%ample: 7 e Super 5aves #ompany sells t+o types of +as ing mac ines a delu%e model and a standard model. 7 e follo+ing information is "ased on t e sales forecast for t e period: elu.e 3)@@ "s 777s :@@ 3=@ 3=@ Standard D@@ "s 777 )@@ 33@ H@ 3)@,@@@ DD,@@@ =<,@@@ )C,@@@ )C,@@@ )otal "s 777s
Sales volume (nit selling price Faria"le cost per unit (nit contri"ution
7otal sales revenue :D@,@@@ Eess: total varia"le cost 3B@,@@@ #ontri"ution to direct and #ommon fi%ed costs 3B@,@@@ Eess: Direct avoida"le fi%ed costs H@,@@@ #ontri"ution to common fi%ed costs H@,@@@ Eess: #ommon fi%ed costs &perating profit
<B@,@@@ )<D,@@@ ):<,@@@ 33C,@@@ 33C,@@@ :H,@@@ CB,@@@
Super =aves !ompany *n t e a"ove e%ample t e #ompany sells ) products so t ere are ) unit contri"ution margins. *f all fi%ed costs are directly attri"uta"le to products i.e. t ere are no common fi%ed costs, +e simply apply t e analysis as follo+s: Delu%e 0'! pt IDirect fi%ed cost H@,@@@ ID@@ units (nit contri"ution 3=@ Standard 0'! Pt I )C@@@ I H@ :@@ units Go+ever, as t ere are common fi%ed costs also, selling D@@ delu%e and :@@ standard mac ines +ill not cover t e common fi%ed costs and t e "reak1even for t e firm as a + ole +ill not "e ac ieved. 7 e common fi%ed costs cannot "e specifically identified +it t e product, and any allocation +ill "e inappropriate and ar"itrary.
Multi product $>&

7 e solution to t e pro"lem is to convert t e sales volume measure of t e individual product into standard "atc es of products "ased on a planned sales mi%. *n t e e%ample, t e Super 5aves #ompany plans to sell 3)@@ delu%e and D@@ standard mac ines giving a sales mi% ratio of ):3. 5e t erefore define our standard "atc of products as comprising ) delu%e and 3 standard mac ine, giving a contri"ution of :H@ per "atc . ) delu%e mac ines contri"ution of 3=@ eac I:@@ 3 standard mac ine contri"ution I H@ :H@ 7 e "reak1even point in standard "atc es can "e calculated "y t e same met od as "efore: $>& number of batches I 7otal fi%ed costs #ontri"ution margin per "atc
3B
I 33C@@@J:H@@@ :H@ I 3=D@@@ I :H@ <@@ "atc es 7 us B@@ delu%e mac ines and <@@ standard mac ines must "e sold to "reak1even. 7 e follo+ing profit statement verifies t is: elu.e Standard (nits sold B@@ <@@ 2s @@@s 2s @@@s (nit contri"ution margin 3=@ H@ #ontri"ution to direct and #ommon fi%ed costs 3)@,@@@ :D,@@@ Eess: Direct fi%ed costs H@,@@@ )C,@@@ #ontri"ution to common fi%ed costs :@,@@@ H,@@@ Eess: #ommon fi%ed costs Profit
)otal 2s @@@s 3=D,@@@ 33C,@@@ :H,@@@ :H,@@@ nil
Note: #ontri"ution as "een defined as sales less varia"le cost. 5 ere fi%ed costs are divided into direct and common .indirect/ fi%ed costs, it is possi"le to identify ) separate contri"ution categories. 7 e first is contri"ution to direct and common fi%ed costs, "eing e4ual to sales less varia"le cost. 7 e second is after deduction of direct fi%ed cost and is descri"ed as contri"ution to common or indirect fi%ed cost. Multi*product brea%*even Eet us assume t at t e actual sales volume of 3)@@ units consisted of D@@ units of eac type of mac ine. 7 e sales mi% is 3:3 compared to t e planned sales mi% of ):3. 7 e contri"ution to direct and common fi%ed costs +ill "e: Delu%e .3=@%D@@/ I H@,@@@ Standard .H@%D@@/ I =<,@@@ 3<<@@@ Eess : Direct and common fi%ed cost I3=D@@@ .3)@@@/ Eoss Multi1productL Gence t e "reak1even point +ill vary depending on t e sales mi%. 7 e sales mi% c anged from ):3 to 3:3, and contri"ution per "atc c anged from :H@ to )<@.3%3=@/J.3%H@/ 7 e revised "reak1even point +ill "e : 3=D@@@')<@ I D=@ units "ased on sales mi% of 3:3. Multi products*e.ample ?eno Ltd Qeno Etd produces ) products and t e follo+ing "udget applies for t e year )@3): +roduct @ +roduct A 2s 2s Selling price D 3) Faria"le #ost ) < #ontri"ution Margin < B -i%ed #osts 3@@,@@@ )@@,@@@ (nits sold C@,@@@ :@,@@@ 2e4uired: #alculate t e "reak1even points of eac of t e products, and t e #ompany as a + ole, comment on your findings. 0reak1even point I -i%ed #ost #ontri"ution per unit +roduct @ : 3@@,@@@'< I )=,@@@
+roduct A : )@@,@@@'B I )=,@@@ 3H
#ompany as + ole : :@@,@@@'=.)@R I =C,DH) R6verage contri"ution per unit: S.C@,@@@%</J.:@,@@@%B/T'3@@,@@@ I =.)@ Gence t e sum of t e "reak1even points is less t an t e "reak1even for t e #ompany as + ole. *t +ould "e incorrect to simply add t e 0'! of t e products to arrive at t e 0'! for t e #ompany, "ecause t e sales mi% +ill "e different from t e plan. Summing up +ould assume =@:=@ sales mi% + ereas t e planned sales mi% is C@::@ $rea%*even analysis assumptions 6ll ot er varia"les remain constant. 6 single product or constant sales mi%. 7otal costs and revenues are linear functions of output. Profits are calculated on varia"le costing "asis. 7 e analysis applies to relevant range of output only. #osts can "e accurately divided into t eir fi%ed and varia"le elements. 7 e analysis applies only to a s ort term ori,on. +roblem0 Indus Ltd *ndus Etd is a company engaged solely in t e manufacture of s+eaters, + ic are "oug t mainly for sporting activities. Present sales are direct to retailers, "ut in recent years t ere as "een a steady decline in output "ecause of increased foreign competition. *n t e last trading year .)@O3/ t e accounting report indicated t at t e company produced t e lo+est profit for ten years. 7 e forecast for )@O) indicates t at t e present deterioration in profits is likely to continue. 7 e company considers t at a profit of 2s B@,@@@ s ould "e ac ieved to provide an ade4uate return on capital. 7 e managing director as asked t at a revie+ "e made of t e present pricing and marketing policies. 7 e marketing director as completed t is revie+, and passes t e proposals on to you for evaluation and recommendation, toget er +it t e profit and loss for t e year ending Decem"er :3, )@O3. Indus Ltd 5 +rofit and Loss Account y>e 11 ecember ,7@1 Sales revenue 3,@@@,@@@ .3@@, @@@ s+eaters U 2s 3@/ -actory cost of goods sold: Direct materials 3@@,@@@ Direct la"or :=@,@@@ Faria"le factory over eads D@,@@@ -i%ed factory over eads ))@,@@@ C:@,@@@ 6dministration over ead 3<@,@@@ Selling and Distri"ution over ead: Sales commission.)K of sales/ )@,@@@ Delivery cost =@,@@@ .varia"le per unit sold/ -i%ed cost <@,@@@ 33@,@@@ HB@,@@@ Profit )@,@@@ Indus Ltd*Information for M *nformation to "e su"mitted to MD includes t e follo+ing t ree proposals: i/ 7o proceed on t e "asis t at t e demand for s+eaters is suc t at 3@K reduction in selling price +ould increase demand "y <@K. ii/ 7o proceed on t e "asis t at a 3@K price reduction, toget er +it a national advertising campaign costing 2s :@,@@@ may increase sales to t e ma%imum capacity of 3D@,@@@ s+eaters. )@
iii/7o proceed +it an en4uiry from a mail order company of purc asing =@,@@@ units annually if t e selling price is rig t. 7 e mail order company +ould transport t e s+eaters from *ndus Etd to its o+n +are ouse and no sales commission +ould "e paid on t ese sales "y *ndus Etd. Go+ever, if an accepta"le price can "e negotiated, *ndus Etd +ould "e e%pected to contri"ute 2s D@,@@@ per annum to+ards t e cost of producing a mail order catalogue. *t +ould also "e necessary for *ndus Etd to provide special additional packaging at a cost of 2s .=@ per s+eater. 7 e marketing director considers t at in )@O) sales from t e e%isting "usiness +ould remain unc anged at 3@@,@@@ units, "ased on a selling price of 2s 3@ if t e mail order contract is undertaken. "e#uired0 a/ 7 e calculation of "reak1even sales value "ased on )@O3 accounts. "/ 6 financial evaluation of proposal .i/ and a calculation of t e num"er of units *ndus Etd +ould "e re4uired to sell at 2s H eac to earn a target profit of 2s B@,@@@. c/ 6 financial evaluation of proposal .ii/. d/ 6 calculation of t e minimum price t at +ould ave to "e 4uoted to t e mail order company, first, to make sure t at *ndus Etd at least "reak1even on t e mail order contract, secondly, to ensure t at same overall profit is earned as proposal .i/ and t irdly, to ensure t at t e overall target profit is earned. Indus Ltd 5 brea% even sales value 0'! sales I -i%ed costs ' contri"ution margin #ontri"ution I sales varia"le cost #ontri"ution margin I contri"ution ' sales -i%ed costs: -i%ed factory over eads ))@,@@@ 6dministration over eads 3<@,@@@ Selling ? distri"ution <@,@@@ *ndus Etd .a/ "reak even sales value... Faria"le cost: Direct material 3@@,@@@ Direct la"or :=@,@@@ Faria"le over eads D@,@@@ Sales commission )@,@@@ Delivery costs =@,@@@ #ontri"ution I 3,@@@,@@@ =B@,@@@ I <)@,@@@ #ontri"ution margin I<)@@@@'3@@@@@@ I @.<) 0'! sales I -i%ed costs ' contri"ution margin I <@@,@@@ '@ .<) I H=),:B@
<@@,@@@
=B@,@@@
."/ -inancial evaluation of proposal .i/ Proposal: 3@K reduction in selling price +ill increase demand "y <@K. 2evised selling price H.@@ Eess: varia"le costs Direct materials 3.@@ Direct la"or :.=@ Faria"le over ead @.D@ Delivery e%penses @.=@ Sales commission .)K of price/ @.3B =.CB #ontri"ution per unit :.)) Proposal .i/L
)3
>um"er of units sold .<@K increase/ 3<@,@@@ 7otal contri"ution .:.))%3<@@@@/ <=@,B@@ -i%ed costs <@@,@@@ Profit from proposal .i/ =@,B@@ Part ."/ (nits re4uired for profit of 2s B@,@@@ at selling price of 2s H per unit: Desired contri"ution: <B@,@@@ #ontri"ution per unit: 2s :.)) 2e4uired units: <B@,@@@ ' :.)) I 3<H,@DB .c/-inancial evaluation of proposal .ii/ Proposal .ii/: Price reduction 3@K, advertising 2s :@,@@@ and sales 3D@,@@@ units. 6t selling price 2sH, unit contri"ution I 2s :.)) 7otal contri"ution of 3D@@@@ units I2s =3=,)@@ -i%ed costs .increase "y 2s :@,@@@/ I 2s<:@,@@@ Profit 2s B=,)@@ .d/ Proposal .iii/ Proposal: mail order =@,@@@ units, no transport cost, no sales commission. -i%ed costs increase "y 2s D@,@@@ for catalogue and packaging costs increase "y 2s@.=@ Faria"le cost: Direct material 3.@@ Direct la"or :.=@ Faria"le over ead @.D@ Delivery e%pense nil Sales commission nil 6dditional packaging @.=@ =.D@ 0reak1even contri"ution per unit: D@,@@@.fi%ed cost/ ' =@,@@@ units I 2s 3.)@ 7 erefore re4uired selling price is: Faria"le cost 2s =.D@ #ontri"ution 2s 3.)@ Selling price 2s D.B@ Part ii/ earn profit of 2s =@,B@@: #ontri"ution re4uired I D@,@@@ J=@,B@@ I33@B@@ i.e. #ontri"ution per unit I 33@B@@'=@@@@ I 2s ).)) Faria"le cost: =.D@, 2e4uired price: 2s C.B) Part iii/ earn profit of 2s B@,@@@ #ontri"ution re4uired I 3<@,@@@ i.e. 2s ).B@ 2e4uired selling price I ).B@J=.D@ I 2s B.<@
***************************************************************** Lecture 9

Measuring "elevant !osts and "evenues
2elevant costs and revenues for decision making are only t ose t at +ill "e affected "y t e decision. #osts and revenues independent of t e decision, and not affected "y it, are o"viously not relevant and need not "e considered + en making t at decision.
Bualitative factors
))
Many times it is difficult to 4uantify in monetary terms all t e important elements of a decision, t ese are referred to as 4ualitative factors. 6 decline in employee morale t at results from redundancies is an e%ample of a 4ualitative factor + ic can affect future output. &ut side suppliers may not deliver on time, resulting in loss of customer good+ill and a decline in future sales. Gence 4ualitative factors s ould also "e taken into account in t e decision making process.
&.ample 5 )he /aisalabad*-ne !ompany 7 e -aisala"ad1&ne #ompany is a manufacturer of clot ing t at sells its output directly to clot ing retailers. &ne of its departments manufactures s+eaters. 7 e department as a capacity of =@,@@@ s+eaters per mont . 0ecause of t e li4uidation of one of its major customers, t e #ompany as e%cess capacity. -or t e ne%t 4uarter, mont ly production and sales volume is e%pected to "e :=@@@ s+eaters at a selling price of 2s <@ per s+eater. !%pected costs and revenues for t e ne%t mont at :=@@@ s+eaters are as follo+s: "s( +er Unit Direct la"or <)@,@@@ 3) Direct materials )B@,@@@ B Faria"le manufacturing over eads C@,@@@ ) Manufacturing non1varia"le &ver eads )B@,@@@ B Marketing ? distri"ution cost 3@=,@@@ : 7otal costs 3,3==,@@@ :: Sales 3,<@@,@@@ <@ Profit )<=,@@@ C 7 e -aisala"ad #ompany is e%pecting an increase in demand and considers t at t e e%cess capacity is temporary. 6not er company as offered to "uy for its staff :@@@ s+eaters eac mont for t e ne%t t ree mont s at a price of 2s )@ per s+eater. 7 e company +ill collect t e s+eaters from -aisala"ad ≠s factory t us no distri"ution cost +ill "e incurred. >o su"se4uent sales to t is customer are anticipated. 7 e company +ould re4uire its logo inserted on t e s+eater + ic +ill cost 2s 3 per s+eater. S ould t e -aisala"ad company accept t is offer. o not accept Direct la"or <)@,@@@ Direct materials )B@,@@@ Faria"le manufacturing over eads C@,@@@ Manufacturing non1varia"le over eads )B@,@@@ *nserting #ompany logo :,@@@ Marketing and distri"ution cost 3@=,@@@ 7otal cost 3,3==,@@@ Sales 3,<@@,@@@ Profit per mont )<=,@@@ accept <)@,@@@ :@<,@@@ CD,@@@ )B@,@@@ :,@@@ 3@=,@@@ 3,3BB,@@@ 3,<D@,@@@ )C),@@@ ifference )<,@@@ D,@@@
::,@@@ D@,@@@ )C,@@@
):
Important factors -our important factors must "e considered "efore recommending acceptance of order: 14 *t is assumed t at future selling price +ill not "e affected "y selling some of t e product "elo+ market price. &t er+ise loss of future profits may "e greater t an s ort1term profits. ,4 >o "etter opportunities are likely to arise during t e period. 14 #ompany as no alternative use of resources t at yield contri"ution more t an 2s )C@@@ p.m. 64 -i%ed costs are unavoida"le for t e period under consideration
&valuation in the longer*term

*n t e previous e%ample +e focused on t e s ort1term, so direct la"or and fi%ed costs +ere considered irrelevant, as t ey +ere unlikely to c ange in t e s ort1term. Go+ever in t e long1term it may "e possi"le to reduce capacity and spending on fi%ed costs and direct la"or. *n our e%ample of -aisala"ad1&ne #ompany, t e follo+ing factors +ill apply in t e long1 term: Direct la"or cost could "e reduced as t is la"or could "e made redundant +it no redundancy costs involved. #apacity could "e reduced "y cancellation of rental contracts of some mac inery. #ost savings could "e made in some supervisory and support staff costs. *f capacity is reduced, it may "e possi"le to rent out part of t e facility. 7 erefore in t e longer1term decisions, some of t e costs t at +ere fi%ed in t e s ort1term could "e c anged and no longer remain fi%ed.
+roduct mi. decisions 5 'hen capacity constraint e.ists

*n t e s ort term, sales demand may "e in e%cess of current productive capacity. &utput may "e restricted "y a s ortage of skilled la"or, materials, e4uipment or space. 7 e resources responsi"le for limiting t e output s ould "e identifiedP t ese are kno+n as limiting factors. 5 ere limiting factors apply, profit is ma%imi,ed + en t e contri"ution to profit from t e limiting factor is ma%imum.
&.ample 5 ayan Autos Dayan autos supplies component parts to firms operating in t e automo"ile industry. *nformation on t ree components is as follo+s: #ontri"ution per unit .2s/ Mac ine ours per unit !stimated sales .units/ Mac ine rs for : mont s @ 3) D )@@@ 3)@@@ A 3@ ) )@@@ <@@@ ? D 3 )@@@ )@@@
Due to "reak1do+n capacity is limited to 3)@@@ rs for t ree mont s. Mou are asked to advice on product mi% for t e t ree mont period. Mou may t ink top priority s ould "e given to product O as it as t e ig est contri"ution per unit, "ut t is assumption +ould "e incorrect. #omponent O re4uires D mac ine ours per unit, + ereas M and Q re4uire ) and 3 ours respectively. 7 e optimum production plan is determined "y calculating t e contri"ution per limiting factor for eac component.
&.ample 5capacity constraint (

)<
#ontri"ution per unit Mac ine ours re4uired #ontri"ution per mac ine our 2anking 7 e company can no+ allocate t e 3)@@@ mac
@ A ? 3) 3@ D D ) 3 ) = D : ) 3 ine ours according to t e a"ove rankings.
Priority +ould "e to produce ma%imum component Q. Sales are projected at )@@@ units so )@@@ ours +ill "e used, leaving 3@,@@@ ours unused. Second c oice +ould "e to produce ma%imum product M. Sales of )@@@ units +ill result in use of <@@@ ours, leaving a "alance of D@@@ ours 7 is +ill ena"le 3@@@ units of component O to "e produced. 7 e allocation can "e summari,ed as: Production rs used "al )@@@ units of Q )@@@ 3@@@@ )@@@ units of M <@@@ D@@@ 3@@@ units of O D@@@ nil 7 is production program results in t e follo+ing total contri"ution: )@@@ units of Q at 2s D per unit 3),@@@ )@@@ units of M at 2s 3@ per unit )@,@@@ 3@@@ units of Q at 2s 3) per unit 3),@@@ 7otal contri"ution <<,@@@ *t is necessary to consider 4ualitative factors "efore t e production program is determined. #ustomer good+ill nay "e lost if company is una"le to supply all t ree products to its major customers. 7 is may cause a reduction in future sales. Difficulties arise + ere more t an one resource is scarce. !.g. it could not "e applied if la"or ours +ere also limited, and "ased on contri"ution per la"or our, a different ranking resulted. *n t ese situations linear programming is used for decision making. 7 is +ill "e covered later in t e course. *n t e longer term, additional resources s ould "e ac4uired if t e additional contri"ution can justify incurring t e cost. Buestion * Limiting factors and optimal production program 6 farmer is planning is production for t e ne%t season, e as asked you to recommend t e optimal mi% of vegeta"le production for t e coming year. Ge as given you t e follo+ing data relating to t e current year: Potatoes 7urnips Peas #arrots 6rea occupied .acres/ )= )@ :@ )= Mield per acre .tons/ 3@ B H 3) Selling price per ton .2s/ 3@@ 3)= 3=@ 3:= Faria"le cost per acre .2s/ -ertili,ers :@ )= <= <@ Seeds 3= )@ :@ )= Pesticides )= 3= )@ )= Direct 5ages <@@ <=@ =@@ =C@ -i%ed over eads per annum 2s =<@@@ 7 e land t at is "eing used for production of carrots and peas can "e used for eit er crop, "ut not for potatoes or turnips. 7 e land t at is "eing used for potatoes and turnips can "e used for eit er crop "ut not for carrots or peas. *n order to provide an ade4uate market service, t e gardener must provide eac year at least <@ tons eac of potatoes and turnips and :D tons eac of carrots and peas. Mou are re4uired to present a statement to s o+ : .i/ 7 e profit for t e current year )= Virtual University of Pakistan
.ii/ 7 e profit for t e production mi% t at you +ould recommend. Solution 1 Eimiting factors and optimal production program Preliminary calculations: Faria"le costs are 4uoted per acre, "ut selling prices are 4uoted per ton. 7 erefore it is calculate t e planned sales revenue per acre: +otatoes )urnips +eas !arrots Mield per acre in tons 3@ B H 3) Selling price per ton 3@@ 3)= 3=@ 3:= Sales revenue per acre 3@@@ 3@@@ 3:=@ 3D)@ Faria"le cost per acre <C@ =3@ =H= DD@ #ontri"ution per acre =:@ <H@ C== HD@ Profit statement for t e current year: 6cres )= )@ :@ )= #ontri"ution per acre =:@ <H@ C== HD@ 7otal contri"ution 3:)=@ HB@@ ))D=@ )<@@@ &verall contri"ution Eess: -i%ed cost Profit +rofit statement for the recommended mi.0 6rea 6 .<= acres/ 6rea 0 .== acres/ +otatoes )urnips +eas !arrots #ontri"ution per acre =:@ <H@ C== HD@ 2anking 3 ) ) 3 Minimum sales re4uirements .acres/ = < 6cres allocated <@ =3 2ecommended mi% <@ = < =3 #ontri"ution )3,)@@ )<=@ :@)@ <BHD@ 7otal contri"ution C=,D:@ Eess: -i%ed costs =<,@@@ Profit )3,D:@
necessary to
DHC@@ =<@@@ 3=C@@
>otes 7 e minimum sales re4uirement for turnips is <@ tons, and t is +ill re4uire allocation of = acres. 7 e minimum sales re4uirement for peas is :D tons, re4uiring allocation of < acres.
Lecture C
"eplacement of e#uipment 5e +ill e%amine one aspect of asset replacement at t is stage, t at is t e treatment of "ook values, and apply relevant cost principles .i.e. past or sunk costs are irrelevant for decision making/. &.ample * ayan Autos Dayan autos purc ased a mac ine t ree years ago for 2s 3B@,@@@. Depreciation, using t e straig t line "asis, assuming a life of si% years +it no salvage value, as "een recorded eac year in t e financial accounts. 7 e present +ritten do+n value of t e e4uipment is 2s H@,@@@ and it as a remaining life of t ree years. Management is considering replacing t is +it a ne+ mac ine t at +ill reduce varia"le operating costs. 7 e ne+ mac ine +ill cost 2s C@,@@@ and +ill ave an e%pected life of : years +it no scrap value. )D
7 e varia"le operating costs are 2s : per unit for t e old mac ine, and 2s ) per unit for t e ne+ mac ine. *t is e%pected t at "ot mac ines +ill "e operated at )@,@@@ units per annum. Sales revenues of "ot mac ines +ill ence "e identical. #urrent disposal value of t e old mac ine is 2s <@, @@@ and +ill "e ,ero in t ree years time. 7otal costs over a period of : years for eac alternative are as follo+s: "etain "eplace difference +resent mach machine 3relevant cost4 Faria"le operating cost )@,@@@ units U 2s : for : yrs 3B@,@@@ )@,@@@ units U 2s ) for : yrs 3)@,@@@ .D@,@@@/ &ld mac ine "ook value: : yr depreciation c arge Eump sum +rite1off H@,@@@ H@,@@@ nil &ld mac ine disposal value .<@,@@@/ .<@,@@@/ Purc ase of ne+ mac ine C@.@@@ C@,@@@ )C@,@@@ )<@,@@@ :@,@@@ *t can "e seen t at t e H@,@@@ "ook value of t e old mac ine is irrelevant to t e decision as it +ill "e +ritten off in "ot cases. 7 e disposal value of t e old mac ine toget er +it cost and "enefit of t e ne+ mac ine need to "e considered. 7 ese are all items +it a cas flo+ impact. 7 e decision t erefore considers all items t at ave a cas flo+ impact. 7 e a"ove analysis s o+s t ere is a cas flo+ advantage of 2s :@,@@@ over : years, in replacing t e old mac ine +it t e ne+ one. 7 is advantage arises due to reduction in varia"le operating cost. Managers can sometimes take incorrect decisions as t ey may vie+ t e old asset in isolation as follo+: 0ook value H@,@@@ Sale proceeds <@,@@@ Eoss on sale =@,@@@ Go+ever t e decision s ould "e vie+ed toget er +it t e advantage o"tained from t e purc ase of t e ne+ mac ine and t e cost and "enefit of replacement e%amined over t ree years. Depreciation and profit or loss on sale of replaced assets is irrelevant for replacement decisions Special pricing * e.ample 6 company + ic produces a range of products and a"sor"s production over eads using a rate of )@@K on direct +ages, is faced +it a decision1making pro"lem. 7 e a"sorption rate +as calculated from t e follo+ing "udgeted figures: Faria"le production costs D<,@@@ -i%ed production costs HD,@@@ Direct la"or costs B@,@@@ +roblem 1 7 e normal selling price of product % is 2s )) and production cost of one unit is: 2a+ material B Direct la"or < Production over ead B )@ 7 ere is a possi"ility of supplying a special order for )@@@ units of product O at a price of 2s 3D eac . >ormal "udgeted sales +ill not "e affected, and #ompany as spare capacity for t e additional units. Solution 1
)C
Production over ead a"sorption rate I D<,@@@.Faria"le/ J HD,@@@ .fi%ed/ B@,@@@.direct la"or/ I )@@K of direct la"or Faria"le over ead rate I D<,@@@ varia"le I B@K of direct la"or B@,@@@ direct la"or +er unit ,777 units 6dditional revenue 3D.@@ :),@@@ 6dditional costs: 2a+ material B.@@ Direct la"or <.@@ varia"le over ead .B@K of direct la"or/ :.)@ 3=.)@ :@,<@@ #ontri"ution @.B@ 3,D@@ 7 e order s ould "e accepted "ecause it provides a positive contri"ution to fi%ed costs. *t is assumed t at direct la"or is a varia"le cost.
-utsourcing
&utsourcing is t e process of o"taining goods and services from outside suppliers instead of producing t e same goods or providing t e same services +it in t e organi,ation. Many organi,ations outsource some of t eir activities suc as maintenance of certain mac inery, cleaning, p otocopying and packaging.
&.ample * Ma%e or buy decision 6 company + ic produces a range of products and a"sor"s production over eads using a rate of )@@K on direct +ages, is faced +it a decision1making pro"lem. 7 e a"sorption rate +as calculated from t e follo+ing "udgeted figures: Faria"le production costs D<,@@@ -i%ed production costs HD,@@@ Direct la"or costs B@,@@@ +roblem , 7 e cost of making component 9, + ic forms part of product M, is stated "elo+: "s 2a+ materials < Direct la"or B Production over ead 3D )B #omponent 9 could "e "oug t from an outside supplier for 2s )@. S ould t e company continue making component 9V Solution , 2elevant manufacturing costs of t e component are: 2s 2a+ material <.@@ Direct la"or B.@@ Faria"le over ead .B@K%B/ D.<@ 3B.<@ 7 e additional costs of manufacturing are lo+er t an t e cost of purc ase, ence company s ould continue to manufacture component. !ase A &ne of t e divisions of Dayan 6utos is currently negotiating +it anot er supplier regarding outsourcing component 6 + ic it manufactures. 7 e division currently manufactures 3@,@@@ units per annum of t e component. 7 e cost currently assigned to t e component are as follo+s:
)B
Direct materials Direct la"or Faria"le manufacturing over eads -i%ed manufacturing over eads S are of non1manufacturing over eads 7otal costs
)otal 3)@,@@@ 3@@,@@@ 3@,@@@ B@,@@@ =@,@@@ :D@,@@@
unit cost 3) 3@ 3 B = :D
7 e a"ove costs are e%pected to remain unc anged in t e foreseea"le future *f Dayan 6utos continues to manufacture t e component. 7 e supplier as offered to supply 3@,@@@ components per annum at a price of 2s :@ per unit guaranteed for a minimum of t ree years. *f component 6 is outsourced, t e current direct la"or +ill "e made redundant at no additional cost. Direct materials and varia"le over ead are avoida"le if component 6 is outsourced. -i%ed manufacturing over eads +ould "e reduced "y 2s 3@,@@@ per annum, "ut non1 manufacturing costs +ould remain unc anged. S ould t e division of Dayan 6utos make or "uy t e componentV 6t first it appears t at t e component s ould "e outsourced since t e purc ase price of 2s :@ is less t an t e unit cost of manufacturing of 2s :D. Go+ever, t e unit cost includes some costs t at +ould remain unc anged + et er or not t e components are outsourced. 7 ese costs are t erefore not relevant to t e decision.
.2s per annum/ Make 3@@@@ 0uy 3@@@@ Difference Direct materials 3)@,@@@ 1 3)@,@@@ Direct la"or 3@@,@@@ 1 3@@,@@@ Faria"le manufacturing over ead 3@,@@@ 1 3@,@@@ -i%ed manufacturing over ead B@,@@@ C@,@@@ 3@,@@@ >on1manufacturing over ead =@,@@@ =@,@@@ 1 &utside purc ase cost WWWWWWW :@@,@@@ .:@@,@@@/ 7otal cost per annum :D@,@@@ <)@,@@@ .D@,@@@/ WWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWW 7 is is easier to interpret if restated as follo+s: .2s per annum/ 2elevant cost 2elevant cost of making of outsourcing Direct materials 3)@,@@@ Direct la"or 3@@,@@@ Faria"le over eads 3@,@@@ -i%ed over eads 3@,@@@ &utsourcing cost WWWWWWW :@@,@@@ )<@,@@@ :@@,@@@
!ase $ >o+ assume t at t e e%tra capacity t at +ill "e made availa"le from outsourcing component 6, can "e used to manufacture and sell 3@,@@@ units of part 0 at a price of 2s :< per unit. 6ll t e la"or force re4uired to manufacture component 6 +ill "e used to make part 0. 7 e varia"le over eads, fi%ed over eads and non1manufacturing over eads +ill "e t e same as for 6. )H Virtual University of Pakistan
Material re4uired for part 0 +ould cost 2s 3: per unit. S ould Dayan autos outsource component 6V 7 e management of Dayan 6utos no+ ave t ree alternatives: 3. Make component 6 , do not make part 0 ). &utsource component 6, do not make part 0 :. &utsource component 6, make and sell part 0. *t is assumed t ere is insufficient capacity to make "ot 6 and 0. .3/Make 6 >ot 0 3)@,@@@ 3@@,@@@ 3@,@@@ B@,@@@ =@,@@@ WWWWWWW :D@,@@@ .)/ 0uy 6 >o 0 .:/0uy 6 Make 0 3:@,@@@ 3@@,@@@ 3@,@@@ B@,@@@ =@,@@@ :@@,@@@ .:<@,@@@/ ::@,@@@
Direct materials Direct la"or Faria"le over eads -i%ed over eads >on1manufacturing over eads &utsourcing cost 2evenue from sale of part 0
C@,@@@ =@,@@@ :@@,@@@ WWWWWWW <)@,@@@
>ote e%cept for non1manufacturing costs, all ot er costs vary "et+een t e alternatives, and are t erefore relevant to t e decision. >on1manufacturing costs are irrelevant to t e decision and may "e ignored. #omparison of t e t ree alternatives indicates t at "uying component 6 and using t e e%tra capacity to make part 0 is t e prefera"le alternative. 7 e incremental costs of outsourcing are 2s D@,@@@ more t an making component 0, "ut t e e%tra capacity released ena"les Dayan 6utos to o"tain a profit contri"ution of 2s H@,@@@. .sales 2s :<@,@@@ less incremental costs of 2s )=@,@@@/. &verall outcome is a "enefit of 2s :@,@@@. *ncremental .relevant/ cost of making part 0 are as follo+s: 2s Direct materials 3:@,@@@ Direct la"or 3@@,@@@ Faria"le over eads 3@,@@@ -i%ed over eads 3@,@@@ )=@,@@@
*********************************************** Lecture D iscontinuation ecisions

Periodic profita"ility analysis provides attention1directing information t at ig lig ts t ose unprofita"le activities + ic re4uires a more detailed appraisal to ascertain + et er or not t ey s ould "e discontinued. 5e +ill see o+ t e principle of relevant costs can "e applied to discontinuation decisions.
&.ample 5 )he ollar !ompany 7 e dollar company is a + olesaler + ic sells its products t roug out 6sia. 7 e company ead4uarters are in Singapore and as a regional structure +it eac region consisting of :1= territories. !ac region as its o+n regional office and a +are ouse + ic distri"utes t e goods directly to t e customers.
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!ac territory as an office + ere marketing staff are located. 7 e 5est 6sia region consists of t ree sales territories +it offices located in 8arac i, #olom"o and Dacca. 7 e "udgeted results for t e ne%t 4uarter are as follo+s: .2s @@@s/ 8arac i #olom"o Dacca 7otal #ost of goods sold B@@ B=@ 3@@@ )D=@ Salespersons salaries 3D@ )@@ )<@ D@@ Sales office rent D@ H@ 3)@ )C@ Depn of sales office e4uipment )@ :@ <@ H@ 6pportionment of +are ouse rent )< )< )< C) Depn of +are ouse e4uipment )@ 3D )) =B 2egion and Gead4uarter costs #ause and effect allocations 3)@ 3=) 3BD <=B 6r"itrary apportionments :D@ <@@ :<@ 33@@ 7otal costs assigned to eac location 3=D< 3CD) 3HC) =)HB 2eported profit ' .loss/ ):D ):B .)C)/ )@) Sales 3B@@ )@@@ 3C@@ ==@@ 6ssuming t e a"ove results are typical of future performance, s ould Dacca territory "e discontinuedV &.ample 5 )he ollar !ompany *t is apparent t at t e 5est 6sia region is profita"le, "ut t e analysis suggests t at t e Dacca sales territory is unprofita"le. 6 more detailed study is re4uired to ascertain + et er it s ould "e discontinued. 7 is study indicates: Discontinuing Dacca territory +ill eliminate cost of goods sold, salespersons salaries, sales office rent and 2egional Gead4uarter e%penses arising from t e cause and effect allocation. it +ill ave no effect on depreciation of sales office e4uipment, +are ouse rent, depreciation of +are ouse e4uipment, and ar"itrary cost allocation of G9 e%penses. "elevant cost computation 7otal costs and revenues 2s @@@s 8eep Dacca Discontinue Difference #ost of goods sold )D=@ 3D=@ 3@@@ Salespersons salaries D@@ :D@ )<@ Sales office rent )C@ 3=@ 3)@ Depn sales office e4uipment H@ H@ 6pportionment of +are ouse rent C) C) Depn of +are ouse e4uipment =B =B 2egional and Gead4uarter costs #ause and effect allocations <=B )C) 3BD 6r"itrary apportionment 33@@ 33@@ WWWW 7otal costs to "e assigned =)HB :C=) 3=<D 2eported profit )@) <B 3=< Sales ==@@ :B@@ 3C@@ etermining the relevant cost of direct materials 7 e company +ill continue to incur some costs even if t e Dacca territory is closed, t ese costs are t erefore irrelevant to t e decision. 7 is s o+s t at profits +ill decline "y 2s 3=<,@@@ if t e Dacca territory is closed. :3
5e ave assumed + en considering various decisions t at any materials re4uired +ould not "e taken from e%isting stock "ut +ould "e purc ased at a later date, so t e estimated purc ase price +ould "e t e relevant material cost. 5 ere materials are taken from e%isting stock, t e original purc ase price represents a past or sunk cost and is t erefore irrelevant for decision1making. #onsider t e situation + ere t e materials ave no furt er use apart from t e particular activity. *f t e materials ave some reali,a"le value, t eir use +ill result in loss of t is sales revenue. 7 is +ill represent an opportunity cost and must "e assigned to t e activity. *f t e materials ave no reali,a"le value, t e relevant cost of materials +ill "e ,ero. *f t e materials are to "e replaced, t en using t em for a particular activity +ill necessitate t eir replacement. 7 erefore t e future replacement cost represents t e relevant cost of t e materials.
etermining relevant cost of direct labor 5 ere t e company as temporary spare capacity and la"or force is to "e maintained for t e s ort1term, t e direct la"or cost incurred +ill remain t e same for all alternative decisions. 7 e direct la"or cost +ill t erefore "e irrelevant for s ort1term decision making purposes. 5 ere casual la"or is used and + ere +orkers can "e ired on a daily "asis, a company may adjust t e employment of la"or to e%actly t e amount re4uired. Ea"or cost +ill increase if company accepts additional +ork, and +ill decrease if production is reduced. *n t is situation la"or cost +ill "e a relevant cost for decision1making purposes. *n a situation of full capacity, t e only +ay t at la"or resources could "e o"tained for a specific order +ould "e to reduce e%isting production. 7 is +ould result in lost contri"ution, and must "e taken into account in t e relevant cost for t e specific order. 7 e relevant la"or cost is t erefore t e ourly rate plus an opportunity cost consisting of t e contri"ution lost "y accepting t e order. !%ample 6 division of Dayan 6utos as received an en4uiry from one of its major customers for a special order for a component t at +ill re4uire 3@@@ skilled la"or ours and t at +ill incur ot er varia"le costs of 2s B@@@. Skilled la"or is currently in s ort supply, and if t e company accepts t e order it +ill "e necessary to reduce production of component P. Details of cost per unit and selling price of component P are as follo+: &.ample 5 direct labor "s "s Selling price BB Eess: direct la"or <@ < rs U 2s 3@ ' r &t er varia"le costs 3) =) #ontri"ution :D 5 at is t e minimum selling price t e company s ould accept for t e special orderV *n t is e%ample t e relevant la"or cost is 2s 3H per our, consisting of ourly +age rate of 2s 3@ plus t e lost contri"ution of 2s H per our from component P. .t e contri"ution of component P is 2s :D and re4uires < direct la"or ours. Gence relevant cost for special order are: Faria"le cost .e%cl direct la"or/ B@@@ Direct la"or .3@@@ rsU 2s 3H/ 3H@@@ )C@@@ 7 e acceptance of t e special order means t at production of component P must "e reduced "y )=@ units .3@@@'</. 5e can no+ compare t e special order +it component P: !omponent Special + order Sales .)=@ units UBB/ ))@@@ )C@@@ Direct la"or .)=@U<@p.u/ 3@@@@ 3@@@@ :) Virtual University of Pakistan
Faria"le cost .)=@U3)p.u/ :@@@ B@@@ #ontri"ution H@@@ H@@@ 7 e contri"ution to profits +ill "e unc anged if t e selling price of t e special order is e4uivalent to t e relevant cost of t e order. Misconceptions about relevant costs 6ll fi%ed costs are irrelevant only correct +it in a s ort1term time ori,on. !.g salaries +ere relevant for discontinuation decision. Faria"le costs are al+ays relevant t+o alternative production met ods t at re4uire identical direct materials, and t en direct materials cost is irrelevant. 2elevant costs are incremental or differential costs. Mou s ould focus on t e impact decisions +ill ave on future costs and revenues for t e company as a + ole, not parts +it in t e #o. a'ood Ltd 5 alternative use of obsolete material Da+ood Etd is a company t at as in stock some materials of type O7 t at cost 2s C=@@@ "ut are no+ o"solete and ave a scrap value of only 2s )3@@@. &t er t an selling for scrap, an alternative use is: converting t e o"solete materials into a speciali,ed product, + ic +ould re4uire t e follo+ing additional +ork and materials: Material 6 D@@ units Material 0 3@@@ units Direct la"or: =@@@ rs skilled, =@@@ rs semi1skilled and =@@@ rs ig ly skilled, total 3=@@@ ours. !%tra selling and delivery e%penses 2s )C@@@ !%tra advertising 2s 3B@@@ H@@ units +ould "e produced and sold for 2s <@@ per unit. a'ood Ltd 5 alternative use of obsolete material Material 6 is already in stock and is +idely used +it in t e firm. Go+ever any material used in t is alternative +ill ave to "e replaced immediately. Material 0 is also in stock, "ut it is unlikely t at any additional supplies can "e o"tained for some time. Material 0 is normally used in production of product Q, + ic sells at 2s :H@ per unit and incurs total varia"le cost .e%cl material 0/ of 2s )3@ per unit. !ac unit of Q uses < units of 0. Details of materials 6 and 0 are: a'ood Ltd 5 alternative use of obsolete material A $ 6c4uisition cost per unit 3@@ 3@ >et reali,a"le value per unit B= 3B 2eplacement cost per unit H@ 1 5age rates and over ead recovery rates of Da+ood Etd are: Faria"le over ead 2s 3 per direct la"or r -i%ed over ead 2s : per direct la"or r (nskilled la"or 2s D per direct la"or r Semi1skilled la"or 2s B per direct la"or r Gig ly skilled la"or 2s 3@ per direct la"or r 7 e unskilled la"or is employed on a casual "asis and sufficient la"or can "e ac4uired to e%actly meet production re4uirements Semi1skilled la"or is part of permanent force and company as temporary e%cess supply at present Gig ly skilled la"or is in s ort supply, t is is presently engaged in meeting demand for product E, + ic re4uires < ours per unit. 7 e contri"ution from sale of one unit of product E is 2s )<.
::
2e4uired: advise + et er stock of material O7 s ould "e sold or converted into speciali,ed product. Solution0 #onversion versus immediate sale: 2s 2s Sales revenue .H@@ units at 2s <@@ per unit/ :D@,@@@ Eess: relevant costs: Material O7 opportunity cost )3,@@@ Material 6 .D@@ units at 2s H@/ =<,@@@ Material 0 .3@@@ units at 2s <=/ <=,@@@ Direct la"or unskilled .=@@@ rs U 2s D/ :@,@@@ semi1skilled nil ig ly skilled .=@@@ rs U 2s 3D/ B@,@@@ Faria"le over eads .3=@@@ rs U 2s 3/ 3=,@@@ 6dvertising 3B,@@@ -i%ed over eads nil WWWWWW )H@,@@@ !%cess of relevant revenues C@,@@@ Eotes0 Material 6 replacement cost 2s H@P Product Q relevant revenue less relevant cost is 2s 3B@ .selling price :H@ less varia"le cost .)3@/ per unit, Q uses < units of material 0 i.e Material 0 opportunity cost is <= per unit P Eost contri"ution of product E is 2s )< or 2s D per r, so relevant cost of ig ly skilled +orkers +ill "e 2s 3D per our.
*********************************************** Lecture F
&.ample 5 acceptance of special order 7 e production manager of your organi,ation as approac ed you for some costing advice on project Oen, a one1off project from overseas t at e intends to tender for. 7 e costs associated +it t e project are as follo+s: Material 6 <@@@ Material 0 B@@@ Direct la"or D@@@ Supervision )@@@ &ver eads 3)@@@ :)@@@ Mou ascertain t e follo+ing information : i/ Material 6 is in stock and t e a"ove +as t e cost. 7 ere is no+ no ot er use for Material 6, ot er t an t e a"ove project, +it in t e factory it +ould cost 2s 3C=@ to dispose of. Material 0 +ould ave to "e ordered at t e cost s o+n a"ove. ii/ Direct la"or costs of 2s D@@@ relate to +orkers t at +ill "e transferred to t is project from anot er project. !%tra la"or +ill need to "e recruited to t e ot er project at a cost of 2s C@@@. iii/Supervision costs ave "een c arged to t e project on t e "asis of ::.::K of la"or costs and +ill "e carried out "y e%isting staff +it in t eir normal duties. iv/ over eads ave "een c arged to t e project at t e rate of )@@K on direct la"or. v/ 7 e company is currently operating at a point a"ove "reak1even. vi/ 7 e project +ill need utili,ation of mac inery t at +ill ave no ot er use to t e company after t e project as finis ed. 7 e mac inery +ill ave to "e purc ased at a cost of 2s 3@,@@@ and t en disposed of for 2s =)=@ at t e end of t e project.
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7 e production manager tells you t at t e overseas customer is prepared to pay up to a ma%imum of 2s :@,@@@ for t e project and a competitor is prepared to accept t e order at t at price. Ge also informs you t at t e minimum e can c arge is 2s <@,@@@ as t e a"ove costs s o+ 2s :),@@@ and t is does not take into consideration t e cost of t e mac ine and t e profit to "e taken on t e project. "e#uired0 a/ #ost of t e project for t e production manager, clearly stating o+ you ave arrived at your figures. "/ 6dvise t e production manager stating + et er t e organi,ation s ould go a ead +it t e tender for t e project, and t e price "earing in mind t at t e competitor is prepared to undertake t e project for 2s :@,@@@. c/ state four non1monetary factors t at s ould "e taken into account "efore tendering for t is project. Solution 5 acceptance of special order 3a4 2elevant costs of t e project: 2s Material 6 .3C=@/ Material 0 B@@@ Direct la"or C@@@ >et cost of mac inery <C=@ 2elevant cost 3B@@@ #ontract price :@@@@ #ontri"ution 3)@@@ Eotes0 Disposal costs of 2s 3C=@ are saved if material 6 is used in t e project. 6ctual cost of material 0 represents t e incremental cost. Ea"or costs are represented "y t e additional cas 1flo+s of t is contract. 7 e net cost of purc asing t e mac inery represents t e additional cas 1flo+s associated +it t is contract. Supervision and over eads +ill continue even if t e contract is not accepted, ence t ese are irrelevant. 3b4 7 e costs given do not represent incremental cas 1flo+s arising from undertaking t e contract. - 6s t e company is operating at an activity level in e%cess of "reak1even point, and sales revenue in e%cess of 2s 3B,@@@ .incremental cost/ +ill provide additional contri"ution and increase profits. - 6ssuming t at t e company as spare capacity, and t at a competitor is prepared to accept t e order at 2s :@,@@@ a tender price slig tly "elo+ 2s :@@@@ +ould "e appropriate. 3c4 non1monetary factors: - i/ is t ere sufficient spare capacity to undertake t e project. - ii/ is t e overseas customer credit1+ort y. - iii/ Does t e +orkforce ave t e necessary skills to undertake t e project. - iv/ is t e contract likely to result in repeat "usiness +it t e customer. -
&.ample 5 deletion of a product 0lue 7ur"an Etd makes t ree products and is revie+ing t e profita"ility of its product line. Mou are given t e follo+ing "udgeted data a"out t e firm for t e coming year 3all 777s4 A $ ! Sales .units/ 3@@ 3)@ B@ := Virtual University of Pakistan
3=@@ 3<<@ BB@ =@@ <B@ )<@ <@@ :)@ 3D@ D=@ D@@ :D@ 3==@ 3<@@ CD@ Profit ' loss .=@/ <@ 3)@ 7 e company is concerned a"out t e loss on product 6. *t is considering ceasing t e production of it, and s+itc ing t e spare capacity of 3@@, @@@ units to product #.
2evenue #osts: material la"or &ver ead
Mou are told: .i/ all production is sold .ii/ )=K of la"or cost for eac product is fi%ed. .iii/ -i%ed administration over eads of 2s H@@,@@@ ave "een apportioned to eac product on t e "asis of units sold and are included in t e over ead cost a"ove. 6ll ot er over eads are varia"le in nature. .iv/ #easing production of product 6 +ould eliminate t e fi%ed la"or c arge associated +it it and one1si%t of t e fi%ed administration over ead apportioned to product 6. .v/ *ncreasing t e production of product # +ould mean t at t e fi%ed la"or cost associated +it product # +ould dou"le, t e varia"le la"or cost +ould rise "y )@K and its selling price +ould ave to "e decreased "y 2s 3.=@ in order to ac ieve t e increased sales. "e#uired0 .a/ prepare marginal cost statement for a unit of eac product on t e "asis of .i/ t e original "udget .ii/ if product 6 is deleted ."/Prepare a statement s o+ing t e total contri"ution and profit for eac product group on t e "asis of .i/ t e original "udget *f product 6 is deleted .c/6dvise + et er product 6 s ould "e deleted. Solution 5 deletion of a product 3a4 3i4 6 0 # Selling price 3= 3) 33 Eess varia"le cost: Materials = < : Ea"or : ) 3.= Faria"le over eads :.= ) 3.= #ontri"ution :.= < = -i%ed over eads are apportioned to t e products on t e "asis of sales volume and t e remaining over eads are varia"le +it output. 3ii4 0 # Selling price 3) H.= Eess varia"le costs: Materials < : Ea"or ) 3.B Faria"le over eads ) 3.= #ontri"ution < :.) 7 e price of # as "een reduced "y 2s 3.=@ and varia"le la"or cost as increased "y )@K. b4 3i4 3all @@@s/ 6 0 # 7otal 7otal contri"ution :=@ <B@ <@@ 3):@ Eess fi%ed costs: Ea"or 3@@ B@ <@ ))@ 6dministration :@@ :D@ )<@ H@@ :D Virtual University of Pakistan
3b4 3ii4 c4
Profit
.=@/
<@
3)@
33@
.@@@s/ 0 # 7otal 7otal contri"ution <B@ =CD 3@=D Eess fi%ed costs: Ea"our B@ B@ 3D@ -i%ed administration B=@ Profit <DW -i%ed over ead cost apportioned to product 6 of :@@ +ill decline "y one1si%t , ence fi%ed admin over eads decline from H@@ to B=@.
*f product 6 is eliminated t e majority of t e fi%ed cost allocated to it +ill continue and "e "orne "y t e remaining products. Product 6 generates a contri"ution of 2s :=@,@@@ to+ards fi%ed costs, "ut t e capacity released +ill provide additional contri"ution from product # of 2s 3CD,@@@ .=CD <@@/. 7 is +ill result in net loss in contri"ution of 2s 3C<,@@@. .:=@ 3CD/ Go+ever, fi%ed cost saving of 2s 33@,@@@ can "e o"tained if product 6 is a"andoned as follo+s: 6dministration apportioned to 6 =@,@@@ -i%ed la"or cost for 6 3@@,@@@ Eess: additional fi%ed cost for # .<@,@@@/ 33@,@@@ 7 erefore t ere +ill "e a net loss in contri"ution of 2s D<,@@@ .3C< 33@/ and profits +ill decline from 2s 33@,@@@ to 2s <D,@@@. +roduct A should not be eliminated even though a loss is reported.
*********************************************** Lecture 17
Activity based costing * A$! 7 e measurement of indirect relevant cost for decision making using 6ctivity 0ased #osting tec ni4ues +ill "e e%amined. 6n 60# system assigns over eads to eac major activity .rat er t an departments/. 5it 60# systems, many activity "ased cost1centers .called activity cost pools/ are esta"lis ed, + ereas +it traditional systems over eads are pooled "y departments and descri"ed as cost centers. 6ctivities can "e many different tasks and may include: sc eduling production, setting1up mac ines, moving materials, purc asing materials, inspecting items, and processing supplier records. Production process activities include mac ining of products and assem"ling products. (sually production process activity cost centers are identical to cost centers used "y traditional systems. &verall 60# systems +ill ave a greater num"er of cost centers. 7 e second stage of t e allocation process allocates costs from cost centers .pools/ to products or ot er cost o"jects. *nstead of using t e term Xover ead allocation rates, or "ases;, t e term cost drivers is used in 60# systems. Direct la"or ours and mac ine ours are used as allocation "ases in traditional systems.
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#ost drivers include num"er of production runs for production sc eduling and num"er of purc ase orders for purc asing activity. 7raditional systems allocate service department costs to production centers, and t us included in t e production center over ead rates. *n contrast 60# systems esta"lis separate cost driver rates for service departments, and assign t e service activities directly to cost o"jects, +it out any reallocation to production centers. 0y using greater num"er of cost centers and different types of cost drivers, and assigning activity costs to cost o"jects on t e "asis of cost driver usage, 60# systems can more accurately measure t e resources consumed "y cost o"jects.
&.ample0 General &nterprises * )raditional system 7 e annual over ead costs for $eneral !nterprises + ic as t ree production centers .t+o mac ine centers and one assem"ly center/ and t+o service centers .materials procurement and general factory support/ are as follo+s: *ndirect +ages and supervision 2s Mac ine center O 3,@@@,@@@ M 3,@@@,@@@ 6ssem"ly 3,=@@,@@@ Materials procurement 3,3@@,@@@ $eneral factory support 3,<B@,@@@ D,@B@,@@@ *ndirect materials Mac ine center O M 6ssem"ly Materials procurement $eneral factory support Eig ting and eating Property ta%es =@@,@@@ B@=,@@@ 3@=,@@@ @ 3@,@@@
3,<)@,@@@
=@@,@@@ 3,@@@,@@@ 3=@,@@@ 3,=@@,@@@ )=@,@@@ B@@,@@@
*nsurance of mac inery Depreciation of mac inery *nsurance of "uildings Salaries of +orks management
<,)@@,@@@ 33,C@@,@@@
&.ample0 General &nterprises * )raditional system &.pense 3All "s 777s4 )otal Mach @ *ndirect +ages D@B@ 3@@@ *ndirect materials 3<)@ =@@ Eig ting and eating =@@ 3@@ Property ta%es 3@@@ )@@ *nsurance of mac inery 3=@ B@
Mach A Assmbly Mat proc Gen sup 3@@@ 3=@@ 33@@ 3<B@ B@= 3@= 1 3@ =@ 3=@ 3=@ =@ 3@@ :@@ :@@ 3@@ =@ 3@ = = :B
Depreciation of mac inery *nsurance of "uilding Salaries of +orks mangt
3=@@ )=@ B@@ 33C@@
B@@ =@ )<@ )HC@ Mac M )DH@ BB@ <=@ :B@@ )@@@ :.B@
=@@ )= 3D@ )DH@
3@@ C= )<@ )<B@
=@ C= B@ 3CD@ Mat proc 3CD@ .3B@@/
=@ )= B@WWW 3B@@ $en sup 3B@@
7otal Mac O 33C@@ )HC@ 2eallocation of service center costs: Mat proc .value of mat issued/ Gen factory sup .direct la"or rs/ 33C@@ <:@@ Mac ine and dir la"or rs &ver ead rate ).3=
6ssm"ly )<B@ ))@ H@@ )@@@ .3CD@/
DD@ <=@ :D@@ 3@@@ 3.B@
5e s all compute t e manufacturing cost of t+o products. Product 6 is a lo+ sale volume product +it direct costs of 2s 3@@. *t is manufactured in "atc es of 3@@ units and eac unit re4uires = ours in Mac ine center 6, 3@ ours in mac ine center 0 and 3@ ours in t e assem"ly center. Product 0 is a ig sales volume product and is manufactured in "atc es of )@@ units. !ac unit re4uires 3@ ours in Mac ine center 6, )@ ours in Mac ine center 0 and )@ ours in t e assem"ly center. Direct costs of 2s )@@ ave "een assigned to Product 0. #alculations of t e manufacturing costs assigned to t e products are as follo+s: +roduct A Direct costs .3@@ units % 2s 3@@/ &ver ead allocation: Mac ine center 6 .3@@ units % = mac rs % 2s ).3=/ Mac ine center 0 .3@@ units % 3@ mac rs % 2s :.B@/ 6ssem"ly .3@@ units % 3@ dir la" rs % 3.B@/ 7otal cost #ost per unit .3DDC= ' 3@@/ I 2s 3DD.C= +roduct $ Direct costs .)@@ units % 2s )@@/ &ver ead allocation Mac ine center 6 .)@@ units % 3@ mac rs % ).3=/ Mac ine center 0 .)@@ units % )@ mac rs % :.B@/ 6ssem"ly .)@@ units % )@ dir la" rs % 3.B@/ 7otal cost #ost per unit .DD,C@@ ' )@@/ I 2s :::.=@ Illustration of cost assignment 'ith an A$! system Activity Production activities: mac ining: activity center 6
"s 3@,@@@ 3,@C= :,B@@ 3,B@@ 3D,DC=
<@,@@@ <,:@@ 3=,)@@ C,)@@ DD,C@@
Activity cost ),HC@,@@@
cost driver
Buantity
cost driver rate 3.<B= :H
mac ine rs
),@@@,@@@
mac ining: activity center 0 assem"ling Material procurement : purc asing components receiving components dis"urse materials $eneral support activities: production sc eduling set1up mac ines 4uality inspection 7otal cost of manufacturing 6ctivities
Activity !ost driver "ate
),DH@,@@@ ),<B@,@@@ HD@,@@@ D@@,@@@ )@@,@@@ 3,@@@,@@@ D@@,@@@ )@@,@@@ WWWWWWWWW 33,C@@,@@@
mac ine rs dir la"or rs purc ase orders material receipts production runs production runs set1up ours item inspections
3,@@@,@@@ ),@@@,@@@ 3@,@@@ =,@@@ ),@@@ ),@@@ 3),@@@ 3,@@@
).DH 3.)< HD 3)@ 3@@ =@@ =@ )@@
Buantity or 177 of A
Buantity for ,77 of $
!ost to A
!ost to $
Mac ining 6 Mac ining 0 6ssem"ly Purc asing components 2eceiving components Dis"urse materials Production sc eduling Set1up mac ines 9uality inspection 7otal over ead cost (nits produced &ver ead cost per unit Direct costs per unit 7otal cost per unit
3.<B= ).DH 3.)< HD 3)@ 3@@ =@@ =@ )@@
=@@ rs 3@@@ rs 3@@@ rs 3 3 = = =@ rs 3
)@@@ rs <@@@ rs <@@@ rs 3 3 3 3 3@ rs 3 3@,=BH 3@@ 3@@ )@@ )@D
C<: ),HC@ ),DH@ 3@,CD@ 3,)<@ <,HD@ HD HD 3)@ 3)@ =@@ 3@@ ),=@@ =@@ ),=@@ =@@ )@@ )@@ )@,)@D )@@ 3@D 3@3 :@3
3"s4 )raditional A$! Product 6 3DC )@D Product 0 ::< :@3 #ompared +it 60# t e traditional system under1costs product 6 and over1costs product 0. 6llocating cost on t e "asis of mac ine ours or direct la"or ours, t e traditional system incorrectly assumes t ese are t e cause of costs of t e support activities. Product 0 consumes t+ice as many mac ine rs and direct la"or rs as product 6, t erefore t e traditional system allocates t+ice t e amount of support costs to 0.
*********************************************** Lecture 11
!ost assignment 'ith an A$! system 60# systems create separate cost centers for eac major support activity and allocates costs to products using cost drivers t at are t e significant determinants of t e cost of t e activity.
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7 e 60# system recogni,es t at + ere a "atc of t+o products consume t e same 4uantity of purc asing, receiving and inspection activities, it allocates t e same cost to "ot products.
2olume based and non*volume based cost drivers 7 ese cost drivers are appropriate for measuring consumption of e%penses suc as mac ine energy costs, depreciation related to mac ine usage and indirect la"or employed in production centers. Folume "ased cost drivers are appropriate in t e a"ove circumstances, as activities are performed eac time a unit of product is produced. >o+ consider t+o activities: setting up a mac ine and re1engineering products. Set up resources are consumed eac time a mac ine is c anged from one product to anot er. *t costs t e same to set up a mac ine for 3@ or =@@@ units. 60# systems rely on a greater num"er and variety of second stage cost drivers. 7 ey use "ot volume "ased and non1volume "ased cost drivers. 7raditional systems use only volume "ased cost drivers. Folume "ased cost drivers assume t at a product;s consumption of over ead resources is directly related to units produced. 7ypical volume "ased cost drivers used "y traditional systems are: units of output, direct la"or ours and mac ine ours. 7 e num"er of set1ups rat er t an units produced is a more appropriate measure of consumption of set1up activity. Similarly product re1engineering costs may depend upon t e num"er of different engineering +orks orders and not t e num"er of units produced. -or "ot t ese activities, non volume "ased cost drivers suc as num"er of set ups and engineering orders are needed for t e accurate assignment of costs of t ese activities. (sing only volume "ased cost drivers to assign non1volume related over ead costs can result in reporting of distorted product costs. 7 e e%tent of distortion depends on + at proportion of total over ead costs t e non1volume "ased over eads represent and t e level of product diversity. *f non1volume related over ead costs are only a small proportion of t e total over ead costs, t e distortion of product cost +ill not "e significant. *n t ese circumstances traditional systems are likely to "e accepta"le.
+roduct diversity Product diversity applies + en products consume different over ead activities in dissimilar proportions. Differences in product si,e, product comple%ity, si,e of "atc es and set1up times cause product diversity. *f all products consume over ead resources in similar proportions, product diversity +ill "e lo+ and products +ill consume non1volume related activities in t e same proportion as volume related activities, product cost distortion +ill not occur +it traditional product costing systems. 7+o conditions t erefore +ill lead to product cost distortion in traditional costing systems: non1volume related over eads are a large proportion of total over eads, and product diversity applies. &.ample 5 $oric !ompany 7 e 0oric #ompany as only one over ead cost center. *t currently operates a traditional costing system using direct la"or ours to allocate over ead to products. 7 e company produces several products, t+o + ic are t e GF and t e EF. GF is made in ig volumes + ereas EF is made in lo+ volumes.
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GF is produced in large production "atc es, and consumes :@K of direct la"or ours. EF as irregular and lo+ demand, is produced in small "atc es and consumes only =K of direct la"or ours. Detailed investigation indicates t at t e num"er of "atc es processed causes t e demand for over ead resources. 7 e traditional system is t erefore replaced +it an 60# system using t e num"er of "atc es processed as t e cost driver. Mou ascertain t at eac product accounts for 3=K of "atc es processed during t e period and over eads assigned to t e cost center amount to 2s 3 million. 7 e direct costs and sales revenues assigned to t e products are as follo+s: :2 L2 Direct costs :3@,@@@ <@,@@@ Sales revenue D@@,@@@ 3=@,@@@ S o+ t e product profita"ility analysis for products GF and EF using t e traditional and 60# systems. 7 e reported product costs and profits for t e t+o products are as follo+s: 7raditional system 60# system .all @@@s/ GF EF GF EF Direct costs :3@ <@ :3@ <@ &ver eads allocated R :@@ .:@K/ =@.=K/ 3=@ .3=K/ 3=@.3=K/ 2eported profits'losses .3@/ D@ 3<@ .<@/ Sales revenue D@@ 3=@ D@@ 3=@ R6llocation of 2s 3 million over eads using direct la"or ours as allocation "ase for traditional system and num"er of "atc ed processed as cost driver for 60# system.
GF is ig volume product t at consumes :@K of direct la"or ours, + ereas EF t e lo+ volume product consumes only =K. 7 e traditional system t at uses direct la"or ours as t e allocation "ase allocated si% times more over ead to product GF. Go+ever, 60# recogni,es t at over eads are caused "y ot er factors. *n t is e%ample t ey are caused "y num"er of "atc es processed, and 60# uses t is as t e cost driver. 0ot products re4uire 3=K of total num"er of "atc es so t ey are allocated an e4ual num"er of over eads. *t is apparent t at t e traditional system "ased on direct la"or ours +ill over1cost ig volume products. Si% times more over eads +ere assigned to GF as t e consumption ratio for GF is .: and EF is .@= 5 en num"er of "atc es processed is used as t e cost driver, t e consumption ratio is .3= for "ot and an e4ual amount of over ead is assigned. Distorted product costs are reported +it t e traditional system t at uses volume "ased cost driver, "ecause t+o conditions specified a"ove apply: >on1volume over eads are a large proportion of total over eads. . 3@@K in our e%ample/ Product diversity e%ists as consumption ratios for t e t+o identified cost drivers are significantly different.
esigning A$! systems -our steps are involved: identifying major activities t at take place in an organi,ation
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assigning costs to cost pools'cost centers for eac activity Determining t e cost driver for eac major activity 6ssigning t e cost of activities to products, "ased on t e product;s demand for activities
Identifying activities 6ctivities are composed of units of +ork or tasks. !.g. purc ase of materials, t is activity consists of many different tasks suc as receiving a purc ase re4uest, identifying suppliers, preparing purc ase orders, mailing purc ase orders and performing follo+1ups. 6ctivities are identified "y carrying out an activity analysis. Starting point is to e%amine t e p ysical plan of t e +orkplace, and t e payroll listing .to ensure all relevant personnel ave "een taken into account/. 7 is as to "e supplemented "y series of intervie+s, or aving staff complete a time s eet for a specific period, e%plaining o+ t eir time is spent. Many detailed tasks are likely to "e identified, "ut after furt er intervie+s, t e main activities +ill emerge. !.g. Purc asing: *f decomposed into its constituent tasks may involve collection of vast amount of data and "e too costly. 6lternatively it may "e merged +it receiving, storage and issuing activities. 7 is is too ig a level of aggregation "ecause a single cost driver is unlikely to provide a satisfactory determinant of cost. >um"er of purc ase orders may give a good e%planation of purc ase costs, "ut inappropriate for costs relating to receiving and issuing. Gence it is prefera"le to "reak it into t ree activities, and esta"lis separate cost driver for eac . 7 e final c oice of activities must "e a matter of judgment "ut it is likely to "e influenced "y factors suc as total cost of activity center .must "e significant to justify separate treatment/, and t e a"ility of a single cost driver to provide a satisfactory determinant of cost of activity. 5 ere t is is not possi"le, furt er decomposition of t e activity +ill "e necessary. 7 us all activities t at ave t e same cost driver can "e merged to form a single activity. Go+ever, if t ere are significant differences in consumption ratios, activities s ould not "e aggregated
Step , 5 Assigning costs to activity cost centers 6fter t e activities ave "een identified t e cost of resources consumed over a specified period must "e assigned to eac activity. Many of t e resources +ill "e directly attri"uta"le to specific activity centers ot ers .e.g. lig ting, eating/ may "e indirect and jointly s ared "y several activities. 7 ese s ould "e assigned on t e "asis of cause1and1effect cost drivers to provide a reasona"le estimate. 6r"itrary allocations s ould not "e used. 7 e greater t e amount of costs apportioned to activity centers, t e more ar"itrary and less relia"le +ill "e t e product cost information generated "y t e 60# system. Step 1 5 Selecting cost drivers for assigning activity costs to cost objects( *n order to assign activity center costs to a product a cost driver must "e selected for eac activity. 7 ere are t ree types of activity cost drivers: transaction drivers, duration drivers and intensity drivers. )ransaction drivers suc as num"er of purc ase orders, num"er of customer orders, num"er of inspections and num"er of set1ups, all count t e num"er of times an activity is performed. <:
7ransaction drivers are t e least accurate "ecause t ey assume t e same amount of resources are consumed eac time t e activity is performed. uration drivers represent t e amount of time re4uired to perform t e activity. !%amples of duration drivers include set1up ours and inspection ours. *f one product re4uires a long set1up time and anot er re4uires a s ort set1up time, t en using set1up ours as a cost driver +ill more accurately measure resource consumption t an t e transaction driver .num"er of set1ups/, + ic assumes e4ual amount of resources are consumed "y "ot products. (sing num"er of set1ups +ould result in cost of t e product re4uiring long set1up ours "eing under1stated. Intensity drivers involve direct c arging "ased on t e actual activity resources committed to t e product. -or e%ample if activities re4uire unskilled and skilled personnel, a duration driver +ould esta"lis an average ourly rate to "e assigned to t e products. 5 ereas an intensity driver +ould record t e actual or estimated time for eac type of personnel, and assign t e specific resources directly to t e products. Sometimes a +eig ted average approac can "e used. !.g. + ere purc asing is an activity cost center, overseas orders may "e +eig ted 3.= times relative to a ome order.
Step 6 5 Assigning cost of activities to products 7 e final stage involves applying t e cost driver rates to products. 7 e cost driver must "e measura"le in a +ay t at ena"les it to "e identified +it t e individual product. 7 us if set1up ours are selected as t e cost driver, t ere must "e a mec anism for measuring t e set1up ours consumed "y eac product. 7 e ease and cost of o"taining data on cost driver consumption "y products is t erefore a factor t at must "e considered during t e t ird stage. 7 is is + en an appropriate cost driver is "eing selected.
*********************************************** Lecture 1,
Activity hierarchies Manufacturing activities can "e classified along a cost ierarc y dimension consisting of: 3. unit1level activitiesP ). "atc 1level activitiesP :. product1sustaining activitiesP <. facility1sustaining activities. (nit1level activities .also kno+n as volume1related activities/ are performed eac time a unit of product or service is produced. !%penses in t is category include direct la"or, direct materials, energy costs and e%penses t at are consumed in proportion to mac ine processing time .suc as maintenance/. (nit1level activities consume resources in proportion to t e num"er of units produced. $atch*related activities 0atc 1related activities suc as setting up a mac ine, or processing a purc ase order are performed eac time a "atc of goods is produced. 7 e cost of "atc related activities varies +it t e num"er of "atc es made, "ut is fi%ed .same/ for all units in t e "atc . -or e%ample, set1up resources are consumed + en a mac ine is c anged from one product to anot er. 6s more "atc es are produced, more set1up resources are consumed. *t +ould cost t e same to set1up a mac ine for 3@ or =@@@ items.
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7 us demand for set1up resources is independent of t e num"er of units produced after set1 up. Similarly purc ase resources are consumed eac time a purc ase order is processed, "ut t e resource consumed is independent of t e num"er of items on t e purc ase order. &t er e%amples of "atc 1related costs include t e resources devoted to production sc eduling, sample inspection and materials movement. 7raditional costing systems treat "atc 1related e%penses as fi%ed costs. 60# systems assume t at "atc 1related e%penses vary +it t e num"er of "atc es processed.
+roduct*sustaining activities 7 ese are performed to ena"le continued production and sale of an individual product. !%amples include maintaining and updating product specifications and tec nical support provided to individual products. &t er e%amples are t e resources to prepare and implement c anges to design and test routines and to perform product en ancements. 7 e costs of product sustaining activities are incurred irrespective of t e num"er of units produced, or "atc es processed. 7 eir e%penses +ill tend to increase as t e num"er of products produced is increased. /acility*sustaining activities 7 ese are performed to support t e facility;s general manufacturing process and include general administrative staff, plant management and property costs. 7 ey are incurred to support t e organi,ation as a + ole and are common and joint to all t e products manufactured in t e plant. 7 ere +ould ave to "e an e%pansion or contraction in t e si,e of t e plant, for facility1 sustaining costs to c ange. 60# advocates t at t ese costs s ould not "e assigned to products since t ey are unavoida"le and irrelevant for most decisions. *nstead t ey are regarded as common costs to all products and deducted as lump sum from total of operating margin. !omparison of traditional product costing 'ith A$! * e.ample Details of four products and relevant information for a company, are given "elo+ for one period. +roduct A $ ! &utput in units 3)@ 3@@ B@ 3)@ #ost per unit: 2s 2s 2s 2s Direct material <@ =@ :@ D@ Direct la"or )B )3 3< )3 Mac ine rs p.u. < : ) : 7 e four products are similar and usually produced in production runs of )@ units and sold in "atc es of 3@ units. 7 e production over eads are currently a"sor"ed using a mac ine our rate, and t e total of t e production over eads for t e period as "een analysed as follo+s: Mac ine dept. costs .rent, depreciation, supervision/ 3@<:@ Set1up costs =)=@ Stores receiving :D@@ *nspection ' 4uality control )3@@ Materials andling and despatc <D)@ Mou ave ascertained t at t e cost drivers to "e used are s o+n "elo+ for t e over eads listed: #ost #ost Driver Set up costs num"er of production runs Stores receiving re4uisitions raised <= Virtual University of Pakistan
*nspection ' 9#
num"er of production run Materials andling and despatc orders e%ecuted
7 e num"er of re4uisitions raised on t e stores is )@ for eac product, and t e num"er of orders e%ecuted is <), eac order "eing for a "atc of 3@ units of a product Mou are re4uired: .a/ to calculate t e total costs for eac product if all over ead costs are a"sor"ed on a mac ine our "asis. ."/ to calculate t e total cost for eac product using activity1"ased costing .c/ to calculate and list t e unit product costs from your figures in .a/ and ."/ a"ove, to s o+ t e differences and to comment "riefly on any conclusions + ic may "e dra+n + ic could ave pricing and profit implications. Solution .a/ &ver eads a"sor"ed on mac ine r "asis 7otal mac ine ours I .3)@%</J.3@@%:/J.B@%)/J.3)@%:/I3:@@ ours Mac ine r over ead rate I 3@<:@J=)=@J:D@@J)3@@J<D)@ 3:@@ rs I 2s )@ per mac ine r +roduct Direct material Direct la"or &ver eads U)@per m'c r (nit of output 7otal cost A <@ )B B@ 3<B 3)@ 3CCD@ $ ! =@ :@ D@ )3 3< )3 D@ <@ D@ 3:3 B< 3<3 3@@ B@ 3)@ 3:3@@ DC)@ 3DH)@
."/ (sing activity1"ased costing: !ost "s !ost driver vol !ost p(u Mac ine dept 3@<:@ m'c rs 3:@@ B.@) Set up costs =)=@ prod run )3 )=@ Stores receiving :D@@ re4uisition B@ <= *nspection ' 9# )3@@ prod run )3 3@@ Mat andling <D)@ orders e%e <) 33@ >ote: )@ re4n for eac prod .)@%</ I B@ re4uisitions Production runs I total units .<)@/ ' )@ units per run I )3 prod runs #ost for eac product is computed "y multiplying t e cost driver rate per unit "y t e 4uantity of t e cost driver consumed "y eac product. 6 0 # D Prime costs B3D@ C3@@ :=)@ HC)@ Set ups .)=@ ea/ 3=@@ 3)=@ 3@@@ 3=@@ Stores .<= ea/ H@@ H@@ H@@ H@@ *nspect .3@@ ea/ D@@ =@@ <@@ D@@ Gandling .33@/ 3:)@ 33@@ BB@ 3:)@ Mac ineR.B.@)' r/ :B=3 )<@C 3)B< )BBB 7otal costs 3D::3 3:)=C CHB< 3DH)B 6 3<B 3:D 0 3:3 3:: # B< 3@@ D 3<3 3<3 <D
.c/ #ost per unit #osts from .a/ #osts from ."/
Difference 3) .)/ .3D/ 1W Product 6 cost is over1stated +it t e traditional system. Products 0 and # are under1stated and similar costs are reported for product D. *t is claimed t at 60# more accurately measures t e resources consumed "y t e products. 5 ere cost1plus pricing is used, t e transfer to an 60# system +ill result in different product prices. *f activity "ased costs are used in stock valuations, t en stock valuations as +ell as reported profits +ill differ.
*********************************************** Lecture 11
Activity*based costing profitability analysis 7 e approac of activity "ased profita"ility analysis is to categori,e costs according to t eir ierarc ical levels. Gierarc ies identify t e lo+est level to + ic cost can meaningfully "e assigned +it out relying on ar"itrary allocations. 7 e lo+est ierarc ical level may "e t e product or customer, and ignoring t e "usiness unit level, t e ig est levels are product lines and distri"ution c annels. Eet us focus on t e product as t e cost o"ject. 6 unit level contri"ution margin is calculated for eac individual product. 7 is is derived "y deducting t e cost of unit level activities from sale revenue. -rom t is unit level contri"ution, e%penses related to "atc level activities are deducted. >e%t t e cost of product sustaining activities are deducted .7 us t e t ree different contri"ution levels are reported at t e individual product level. Differentiating contri"utions at t ese levels provides a "etter understanding of t e implications of product mi% and discontinuation decisions in terms of cost and profit "e avior. 7 ere are t+o furt er levels +it in t e product ierarc y, t ese are t e product "rand level and product line level. 5 ere products are marketed "y "rands, all e%penditure relating to a "rand, suc as management and "rand marketing, is for t e "enefit of all products +it in t e "rand and not for any specific individual product. *t s ould t us "e attri"uted to t e "rand and not t e individual product. Similarly marketing, researc and development and distri"ution e%penses mig t "e incurred for t e "enefit of t e + ole product line and not for any specific "rand. 7 erefore t ese product line sustaining e%penses s ould "e attri"uted to t e product line. -inally t e profit for t e organi,ational unit as a + ole can "e determined "y deducting facility sustaining e%penses from t e sum of t e product line contri"utions. 7 e aim of 60# ierarc ical profita"ility analysis is to assign all organi,ational e%penses to a particular ierarc ical or organi,ational level + ere cause1and1effect cost assignments can "e esta"lis ed so t at ar"itrary allocations are non1e%istent. 7 e ierarc ical approac elps to identify t e impact on resource consumption "y adding or dropping items at eac level of t e ierarc y. -or e%ample if a product +it in a particular "rand is dropped, t en all unit, "atc and product1sustaining activities uni4uely associated +it t at product +ill "e affected "ut t e ig er level "rand and product level activities +ill "e unaffected.
"esource consumption models

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Possi"ly t e most important t eoretical advance in 60# systems +as one + ic emp asi,ed t at 60# systems are models of resource consumption. 60# systems measure t e cost of using resources and not t e cost of supplying resources. 7 is ig lig ted t e critical role played "y unused capacity. 7o ave a good conceptual grasp of 60# it is essential t at you understand t e contents of t is section. (se t e follo+ing e4uation to formali,e t e relations ip "et+een activity resources supplied and activity resources used for eac activity: Cost of resources = Cost of resources + Cost of unused supplied used capacity 7 e left and side of t e a"ove e4uation indicates t e amount of e%penditure on an activity depends on t e cost of resources supplied rat er t an t e cost of resources used. &.ample0 7 e follo+ing information relates to t e purc asing activity of #essna #ompany for t e ne%t year: 3. 2esources supplied:3@ full time staff for 2s :@,@@@ per year .*ncluding employment costs/ I 2s :@@,@@@ annual activity cost. #ost driver I num"er of purc ase orders processed. 9uantity of cost driver supplied per year: .eac mem"er of staff can process 3=@@ orders per year./ I 3=@@@ purc ase orders. !stimated cost driver rate: 2s )@ per P.&. .:@@@@@ ' 3=@@@/ .)/ 2esources used !stimated num"er of purc ase orders to "e processed during t e year I 3:@@@ !stimated cost of resources used assigned to parts and materials I 2s )D@,@@@ .3:@@@%)@/ .:/ #ost of unused capacity 2esources supplied .3=@@@/ 2esources used .3:@@@/ at 2s )@ per order I 2s <@,@@@ .)@@@%)@/ Periodic financial accounting profit statements measure t e e%pense incurred to make t e resources availa"le .i.e t e cost of resources supplied/. 5 ereas 60# systems measure t e cost of resources used "y t e individual products. !ssna #ompany e%pects to process 3:@@@ purc ase orders, t e 60# system +ill t erefore assign 2s )D@,@@@ .3:@@@ @rders at 2s )@ per order/ to t e parts and material ordered during t e year. 7 is represents t e cost of resources used. 7 e predicted cost of unused capacity +ill "e 2s <@,@@@ .)@@@ orders at 2s )@ per order/.
"esource consumption models (nused capacity arises "ecause t e supply of some resources as to "e ac4uired in discrete amount in advance of its usage. Supply cannot "e continually adjusted in t e s ort1run to matc e%actly t e usage of resources. 7ypical e%penses in t is category include t e ac4uisition of e4uipment and t e employment of non1piece+ork employees. 7 ey are categori,ed as fi%ed costs. Some resources e.g material, casual la"or, energy can "e continually adjusted to meet e%actly t eir usage. 7 ese are categori,ed as varia"le costs. 7 e pro"lem of adjusting t e supply of resources to matc t eir usage applies only to fi%ed costs. 6ctivity "ased systems +ill measure t e cost of using t ese resources, even t oug t e cost of supplying t em +ill not vary +it t e s ort run usage. Managers make decisions .e.g on c anges in output volume, mi% and process c anges/ and suc decisions result in c anges in activity resource usage.
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5 ere suc decisions result in a decline in demand for activity resources, t en t e first term on t e rig t and side on t e e4uation a"ove .cost of resources used/ +ill decline. Go+ever, t e cost of unused capacity .t e second term on t e rig t and side of t e e4uation/ +ill increase to offset e%actly t e lo+er resource usage cost. 7o translate t e "enefits of reduced activity demand into cas flo+ savings, management action is re4uired. 7 ey must permanently remove t e unused capacity "y reducing spending on t e supply of resources. Demands for activity resources can also increase "ecause of decisions to introduce ne+ products or e%pand output. Suc decisions can lead to situations + ere activity resource usage e%ceeds t e supply of resources. *n t e s ort term t e e%cess demand mig t "e a"sor"ed "y people +orking longer ours or faster. !ventually o+ever, additional spending +ill "e re4uired to increase t e supply of activity resources.
Selecting the cost driver denominator level *n t e a"ove e%ample of #essna #ompany, t ere are t+o potential denominator levels t at can "e used to esta"lis t e cost driver rates. 7 ese are t e capacity supplied and t e "udgeted activity level. *f practical capacity is used t e cost driver rate +ill "e :@@,@@@ ' 3=@@@ I 2s )@ per purc ase order. 5 ereas if t e "udgeted activity level is used, t e cost driver rate +ill "e :@@,@@@ ' 3:@@@ I 2s ):.@B Support activity costs are caused "y t e level of capacity made availa"le, rat er t an t e "udgeted activity level. 7 erefore t e correct denominator is practical capacity. (sing "udgeted activity +ould mean t at t e cost of unused capacity is idden in t e cost driver rate and c arged to products. 0udgeted capacity usage can lead to ig er cost driver rates, and +ill result in an increase in reported product costs. 7 ere is a danger t at "id prices +ill "e increased + en demand is depressed, at a time + en a firm s ould "e considering lo+ering prices. Practical capacity oug t to "e used for measuring uman resources. -or p ysical resources it is recommended t at a modified practical capacity i.e normal capacity . : year outlook/ s ould "e used.
*********************************************** Lecture 16 +ricing decisions and profitability analysis

6ccounting information is often an important input to pricing decisions. Market leaders or organi,ations t at sell ig ly customi,ed products, ave some discretion in setting selling prices. Pricing decisions +ill "e influenced "y t e cost of t e product. *n ot er organi,ations prices are set "y market and supply forces, nevert eless cost information is re4uired for determining profita"ility of different products, and t e target product mi%.
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!sta"lis ing optimum selling price

7 e economic model s o+s t at firms +ill set selling prices + ere profits are ma%imi,ed. Precise 4uantification in practice is very difficultP management produces estimates of sales demand at various selling prices.
Price P3 P) 93 9) 6 demand curve
9uantity &stablishing optimum selling price

!stimate of profits at different output levels: +rice Units sold )otal "evenue <@ 3@ <@@ :B 33 <3B :D 3) <:) 16 3: <<) :) 3< <<B :@ 3= <=@ )B 3D <<B )otal !ost :D@ :D< :C@ :CB :BB <@@ <3< +rofit <@ =< D) 96 D@ =@ :<
7o determine optimum selling price, it is necessary to estimate t e total cost for eac price level. Profits are ma%imi,ed at a selling price of :<.
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$rap ical presentation

price 72
Profits
7 #
&ptimal Folume
9uantity
)he role of cost information in pricing decisions Small firms operating in an industry + ere prices are set "y dominant market leaders, +ill ave little influence over t e price of t eir products. 7 ey are descri"ed as price1takers. 7 e market leaders and ig ly customi,ed producers are descri"ed as price1setters. #ost information is vital to price1takers as +ell as price1setters.
7 ere are several assumptions + ic form t e "asis of t e economic t eory, ence it is difficult to apply in practice
+rice setting firm in short*run &nly incremental costs of undertaking a special order s ould "e taken into account. *n service companies e.g. otels, t e incremental cost of accepting one1off special "usiness are likely to "e minimal. 7 ey may consist of meals, laundering and "at room facilities. *n most cases incremental costs are likely to "e confined to unit level activities. 0ids s ould "e made at prices t at e%ceed incremental costs. #ost data is likely to "e t e dominant factor.
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Special order in the short*run 0ids for one1time orders "ased on covering incremental costs s ould meet t e follo+ing conditions: Sufficient capacity is availa"le for all resources re4uired. *f some resources are fully utili,ed, opportunity cost of t e scarce resources must "e covered "y t e "id price. 0id price +ill not affect future selling price. &rder +ill utili,e unused capacity in s ort period only, and released for more profita"le opportunity +rice setting firm in the long*run *n t e long1run firms can adjust t e supply of virtually all t eir activity resources. 7 ree approac es are relevant: Pricing customi,ed products Pricing non1customi,ed products 7arget costing for non1customi,ed products. !ustomiGed products: product s ould "e priced to cover all resources "eing used. 7 is +ill re4uire a costing system t at accurately measures resources consumed "y eac product. -or price1setters t ere are stronger grounds for 60#.
+roduct pricing using A$! 5 !holistan !ompany 7 e # olistan company as received a re4uest for a price 4uotation from one of its regular customers for an order of =@@ units as follo+s: Direct la"or per unit produced Direct material per unit produced Mac ine our per unit produced >um"er of component and material purc ases >um"er of production runs prior to assem"ly 6verage set up time per production run >um"er of deliveries >um"er of customer visits !ngineering design and support #ustomer support +roduct pricing using A$! 5 !holistan !ompany Details of activities re4uired for t e order: Activity Direct la"or processing and assem"ly Mac ine processing Purc asing and receiving materials Sc eduling production Setting1up mac ines Packaging and delivering orders *nvoicing and accounts administration Marketing and order negotiation #ustomer support incl. after sales !ngineering design and support
) ours 2s )) 3 our D < : ours 3 ) =@ ours =@
!ost driver rate 2s 3@ per la"or r 2s :@ per mac ine r 2s 3@@ per purc ase order 2s )=@ per production run 2s 3)@ per r 2s <@@ per delivery 2s 3)@ per customer order 2s :@@ per customer visit 2s =@ per customer service r 2s B@ per engineering r =)
!stimate of cost of resources re4uired to fulfill t e order. (nitlevel e%penses Direct materials .=@@%))/ 33@@@ Direct la"or .=@@%)%3@/ 3@@@@ Mac ining .=@@%3 r % 2s :@/ 3=@@@ :D@@@ 0atc 1level e%penses Purc asing and receiving material .D%3@@/ D@@ Sc eduling production .< runs % )=@/ 3@@@ Setting1up mac ines .< runs % : rs % 3)@/ 3<<@ Packaging and delivery .3 % <@@/ <@@ :<<@ Product sustaining e%penses !ngineering design and support .=@ rs % B@/ <@@@ #ustomer sustaining e%penses Marketing and order negotiation .)visits % :@@/ D@@ #ustomer support .=@ rs % =@/ )=@@ :3@@ 7otal cost of resources <D=<@ 7 e full cost .e%cluding facility sustaining cost/ of t e order is 2s <D,=<@. -acility sustaining costs are incurred to support t e organi,ation as a + ole and not for individual products. 7o determine a proposed selling price an appropriate percentage mark1up is added to t e estimated cost. Mark1up s ould "e sufficient to cover facility sustaining cost and a profit contri"ution. 6ssume # olistan #o. adds )@K, it +ould give a price of 2s ==B<B. .6dd H:@B/. 7 is is cost1plus pricing.
+roduct pricing using A$! #onsider a purc ase order of :@@@ units instead of =@@ units, + ere t e "atc level e%penses remain unc anged. #ost of resources used +ill "e: (nit level e%penses .D % :D@@@/ )3D@@@ 0atc level e%penses :<<@ Product sustaining e%penses <@@@ #ustomer sustaining e%penses W:3@@ 7otal cost of resources ))D=<@ #ost per unit for =@@ unit order .<D=<@'=@@/ I 2s H:.@B #ost per unit for :@@@ unit order.))D=<@':@@@/ I 2s C=.=3
*********************************************** Lecture 1< +ricing non*customiGed products

6 market leader must make pricing decisions for large and unkno+n volumes, of a product t at is sold to t ousands of customers. 6n estimate of sales volume is re4uired to determine t e unit cost. Gence t+o unkno+ns, sale price and sales volume. *t is recommended t at cost1plus selling prices are estimated for a range of potential sales volumes.
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Eon*customiGed products 5 !ase A 7 e 6lipur #ompany is launc ing a ne+ productP sales volume +ill "e dependent on selling price. 7 e "est estimate is t at demand is likely to range "et+een 3@@,@@@ and )@@,@@@ units provided t e selling price is "elo+ 2s 3@@. 7 e company as produced t e follo+ing cost estimates and selling prices re4uired to generate a target profit contri"ution of 2s )million from t e product. 7 e 6lipur #ompany as produced estimates of total cost for a range of output levels. 7 e information indicates sales volume and accompanying selling prices t at are re4uired to generate t e target profit. 7 e unit cost calculation indicates t e "reakeven selling price. Management must asses t e price +it ig est pro"a"ility of generating t e specified sales volume. Sales volume .@@@s/ 3@@ 3)@ 3<@ 3D@ 3B@ )@@ 7otal cost .@@@s/ 3@@@@ 3@B@@ 33)@@ 33D@@ 3)D@@ 3:@@@ 2e4uired profit .@@@s/ )@@@ )@@@ )@@@ )@@@ )@@@ )@@@ 2e4uired sales .@@@s/ 3)@@@ 3)B@@ 3:)@@ 3:D@@ 3<D@@ 3=@@@ 2e4uired selling price 3)@ 3@C H< B= B3 C= (nit cost 3@@ H@ B@ C: C@ D= Eon*customiGed products 5 !ase $ Same cost sc edule applies, "ut t e ) million minimum contri"ution does not apply. !stimate of sales demand at different selling prices ave "een made, "ased on market researc . Potential selling price 3@@ H@ B@ C@ D@ !stimated sales volume at Potential prices 3)@ 3<@ 3B@ 3H@ )@@ !stimated sales revenue 3)@@@ 3)D@@ 3<<@@ 3::@@ 3)@@@ !stimated total cost 3@B@@ 33)@@ 3)D@@ 3)B@@ 3:@@@ !stimated profit 3)@@ 3<@@ 3B@@ =@@ .3@@@/ Profits are ma%imi,ed at selling price of 2s B@. 6not er pricing policy could "e to sell at t e lo+er price of 2s C@ to ensure a larger market s are is o"tained in future.
)arget !osting
*n target costing t e starting point is t e determination of t e target selling price. >e%t a standard or desired profit is deducted to get to a target cost for t e product. 7 e aim is to ensure t at future cost +ill not "e ig er t an t e target cost. 7 e stages involved in target costing can "e summari,ed as follo+s: Stage 3: determine t e target price + ic customers +ill "e prepared to pay for t e product. Stage ): deduct a target profit margin from t e target price to determine t e target cost. Stage :: estimate actual cost of t e product. Stage <: if estimated cost e%ceeds t e target cost, investigate +ays of driving do+n t e actual cost to t e target cost. 7 e major attraction of target costing is t at marketing factors and customer researc provide t e "asis for determining selling price. 5 ereas costs tend to "e t e dominant factor in cost1plus pricing. -urt er attraction is t at t e approac re4uires t e colla"oration of product designers, production engineers, marketing and finance staff. 7arget costing is most suited for setting prices for non1customi,ed and ig sales volume products.
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Short*term product mi. decisions Price taking firms +ill "e faced +it opportunities of taking on s ort1term "usiness at a market determined selling price. *n suc situations accept s ort1term "usiness + ere incremental sales revenue e%ceeds s ort run incremental costs. Go+ever, as mentioned earlier in t e course, suc "usiness is accepta"le under certain conditions. 7 ese are: Sufficient capacity is availa"le for all resources re4uired. *f some resources are fully utili,ed, opportunity cost of t e scarce resource must "e covered in t e selling price. 7 e company +ill not commit itself to repeat long1term "usiness t at is priced to cover only s ort1term incremental costs. &rder +ill utili,e unused capacity only for a s ort period, and capacity +ill "e released for use on more profita"le opportunities. >ote, in t e longer term capacity constraints can "e removed. Long*run product mi. decisions *n t e longer1term a firm can adjust t e supply of resources committed to a product. 7 erefore sales revenue from t e product s ould e%ceed t e cost of all resources committed to it. Gence t ere is a need to undertake periodic profita"ility analysis to distinguis "et+een profita"le and non1profita"le products. 6ctivity "ased profita"ility analysis s ould "e used to evaluate eac product;s long1run profita"ility. (nder t is, products are t e cost o"jects in four different ierarc ical levels. (nit, "rand, product line and + ole "usiness. Most decisions are likely to "e made at t e individual product level. 0efore discontinuing, ot er alternatives and considerations are taken into account. Sometimes it is important to maintain a full product line for marketing reasons. &t er options considered "efore discontinuing products include re1engineering or re1 designing t e products to reduce t eir resource consumption. 5 ere products are discontinued, overall profita"ility +ill improve only if managers eliminate spending on supply of activity resources no longer re4uired.
!ost*plus pricing
#ompanies use different cost "ases and mark1ups to determine t eir selling price. #ost 2s m1up K Price Direct varia"le cost )@@ )=@ =@@ Direct non1varia"le cost 3@@ 7otal direct costs :@@ C@ =3@ *ndirect costs WB@W 7otal cost .e%cl. ig er level/ :B@ <@ =:) Gig er level sustaining cost D@W 7otal cost <<@ )@ =)B
&stablishing target mar%*up H Mark1ups are related to demand. -irms are a"le to command a ig er mark1up for a product t at as ig demand. Mark1ups are likely to decrease + en competition is intense. Eu%ury goods +it lo+ sales turnover may attract ig profit margins, + ereas non1lu%ury goods +it ig sales turnover may not. 6not er approac to c oose a mark1up is to earn a target rate of return on capital investment.
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-or e%ample if t e cost per unit of a product is 2s 3@@ and annual volume is 3@,@@@ units. Product re4uires investment of 2s 3 million and t e target rate of return is 3=K, t e target mark1up +ill "e: 3=K % 3,@@@,@@@ I 2s 3= per unit 3@,@@@ units 7arget price +ill "e 3@@ J 3= I 33= 7 e major pro"lem +it t is approac is t at it is difficult to determine t e capital invested to support a product. 6ssets are normally used for many different products. Management s ould use t is information toget er +it t eir kno+ledge of t e market and intended pricing strategies, "efore t e final price is set.
Limitations of cost plus pricing 7 e main criticism against cost1plus pricing is t at it ignores demand for t e product. *t is assumed t at prices s ould solely depend on costs. -or e%ample a cost1plus formula may suggest 2s )@ for a product + ere t e demand is 3@@,@@@ units. 5 ereas at a price of 2s )= t e demand may "e B@,@@@ units. 6ssuming t at varia"le cost for eac unit sold is 2s 3=, t e total contri"ution +ill "e 2s =@@,@@@ at price of 2s )@, and 2s B@@,@@@ at t e price of 2s )=. 7 us t e cost1plus pricing formula mig t lead to incorrect decisions. #ost1plus can give rise to a loss if t e volume is insufficient and contri"ution does not cover fi%ed costs.
*********************************************** Lecture 19 +ricing policies

#ost information is one of t e many varia"les t at must "e considered in t e pricing decision. -inal price +ill depend upon t e pricing policy of t e company. 6 price skimming or a price penetration policy mig t "e selected. +rice s%imming policy is an attempt to e%ploit t ose sections of t e market t at are relatively insensitive to price c anges. -or e%ample ig initial prices may "e c arged to take advantage of t e novelty appeal of a ne+ product + en demand is initially inelastic. 6 skimming policy offers a safeguard against une%pected future increases in costs, or large fall in demand after t e novelty appeal as declined. &nce t e market "ecomes saturated, t e price can "e reduced to attract t at part of t e market t at as not yet "een e%ploited. 6 skimming pricing policy s ould not "e adopted + en a num"er of close su"stitutes are already "eing marketed. 6 penetration pricing policy is "ased on t e concept of c arging lo+ prices initially +it t e intention of gaining rapid acceptance of t e product. Suc a policy is appropriate + en close su"stitutes are availa"le or + en markets are easy to enter.
+roduct life*cycle
Many products ave a product life cycle consisting of four stages: *ntroductory product is launc ed, minimal a+areness and acceptance. $ro+t sales "egin to e%pand "ecause of introductory promotions Maturity sales taper off as ne+ customers are e% austed. Decline sales diminis as t e product is replaced +it ne+ and "etter versions.
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*n t e introductory stage it may "e appropriate to keep a slig tly ig er or lo+er price compared to t e price found "y normal analysis to create a more favora"le demand in future years. Eimited production capacity may rule out lo+ prices. 6 ig er initial price may "e set and reduced progressively. *f t ere is no production constraint, a lo+er price may "e preferred. 7 is may result in ig er sales volume and a slo+ competitive reaction. 6t t e maturity stage a firm s ould adopt a selling price t at +ill ma%imi,e s ort1term profits. :amdard Ltd Gamdard as recently spent some time on researc ing and developing a ne+ product for + ic t ey are trying to esta"lis a suita"le price. Previously t ey ave used cost plus )@K to set t e selling price. 7 e standard cost per unit as "een esta"lis ed as follo+s: Direct materials Material 3 3@ .< kg at 2s ).=@ ' kg/ Material ) C .3 kg at 2s C/ Direct la"or 3: .) rs at 2s D.=@ per r/ -i%ed over ead C .) rs at 2s :.=@ per r/ :C "e#uired0 .a/ (sing standard costs, calculate t+o different cost plus prices using t+o different "ases and e%plain an advantage and disadvantage of eac met od. ."/ $ive t+o ot er possi"le pricing strategies t at could "e adopted and descri"e t e impact of eac one on t e price of t e product. Solution0 .a/ Faria"le cost plus )@K I :@ % 3.)@ I 2s :D 7otal cost plus )@K I :C % 3.)@ I 2s <<.<@ 6dvantages of varia"le cost include t at it avoids ar"itrary allocations, identifies s ort1term relevant costs, simplicity. 7 e disadvantages are t at it represents only a partial cost is s ort1term oriented and ignores price demand relations ips. 6dvantages of total cost include t at it attempts to include all costs, reduces t e possi"ility t at fi%ed costs +ill not "e covered. Disadvantages are t at some ar"itrary apportionments are likely and price'demand relations ip is ignored. 3b4 +ricing strategies Price skimming is likely to lead to ig er initial price. Price penetration policy is likely to lead to lo+er initial prices. !ustomer profitability analysis *n t e past management accounting reports ave tended to focus on analy,ing profits "y products. *ncreasing attention is no+ "eing given to analy,ing profits "y customers. #ustomer profita"ility analysis provides important information t at can "e used to determine + ic classes of customers needs to "e emp asi,ed or de1emp asi,ed. #ase 6 company found t at customer related selling costs represent :<K of t e total costs. 7 ese costs +ere allocated on t e "asis of sales value. 6n activity "ased costing system +as introduced t at soug t to e%plain t e resources consumed "y different customers. 6 detailed study identified t+o cost drivers: >um"er of orders placed: eac order ad a large fi%ed cost t at did not vary +it t e num"er of items purc ased. =C Virtual University of Pakistan
>on1standard production items: t ese items +ere more costly to produce t an standard items. 7 e company estimated t e cost per order, and t e cost of andling standard and non1 standard items. 6 customer profita"ility analysis +as performed "ased on t e sales for t e previous year. 7 is analysis revealed t at only <@K of its customers +ere profita"le and a furt er 3@K lost 3)@K of total profits. i.e 3@K incurred losses e4ual to 3)@K of t e profits. 7+o of t e most unprofita"le customers turned out to "e among t e top t ree in total sales volume. 7 ese t+o companies made small orders of non1standard items.
&.ample 5 )he aisy !ompany 7 e Daisy #ompany as recently adopted customer profita"ility analysis "y a revie+ of t e past 3) mont s. Details of activities and t e cost driver rates for customer related e%penses are as follo+s: Activity !ost driver rate Sales order processing 2s :@@ per sales Sales visits 2s )@@ per sales visit >ormal delivery cost 2s 3 per delivery km Special deliveries 2s =@@ per special deliver #redit collection costs3@K p.a. on avg. pay1time Details relating to four of t e customers: #ustomer 6 0 # D >um"er of sales orders )@@ 3@@ =@ :@ >um"er of sales visits )@ 3@ = = 8m per delivery :@@ )@@ 3@@ =@ >um"er of deliveries 3@@ =@ )= )= 7otal delivery 8m :@@@@ 3@@@@ )=@@ 3)=@ Special deliveries )@ = @ @ 6verage collection period .days/ H@ :@ 3@ 3@ 6nnual sales 3m 3m .=m )m 6nnual operating profit contri"ution H@@@@ 3)@@@@ C@@@@ )@@@@@ 7 e profita"ility analysis in respect of t e four customers is as follo+s: !ustomer attributable costs A $ A ? Sales order processing D@@@@ :@@@@ 3=@@@ H@@@ Sales visits <@@@ )@@@ 3@@@ 3@@@ >ormal deliveries :@@@@ 3@@@@ )=@@ 3)=@ Special .urgent/ deliveries 3@@@@ )=@@ @ @ #redit collection )<D=B B))@ 3:C@ =<B@ 3)BD=B =)C)@ 3HBC@ 3DC:@ &perating profit contri"ution H@@@@ 3)@@@@ C@@@@ )@@@@@ #ontri"ution to sustaining e%penses .:BD=B/ DC)B@ =@3:@ 3B:)C@ *t can "e seen t at 6 and 0 are ig cost to serve and M and Q are lo+ cost to serve customers. #ustomer 6 provides positive operating profit contri"ution, "ut is unprofita"le + en customer attri"uta"le costs are taken into account. 7 is is "ecause customer 6 re4uires more sales orders, sales visits and normal and urgent deliveries t an t e ot er customers. *n addition t e customer is slo+ to pay and as ig er delivery costs. =B
#ustomer 6 can "e made profita"le if it can "e persuaded to place smaller num"er of large 4uantity orders, avoid special deliveries and reduce credit period. &t er+ise selling price s ould "e increased or discounts reduced, to cover t e e%tra resources consumed.
&.ample 5 'ith limiting factor 6 manufacturer as t ree products 6, 0 and #. #urrently sales, cost and selling price details and processing time re4uirements are as follo+s: 6 0 # 6nnual sales D@@@ D@@@ C=@ Selling price )@ :3 :H (nit cost 3B )< :@ Processing time p.u. . rs/ 3 3 ) 7 e firm is +orking at full capacity .3:=@@ rs per year/. -i%ed manufacturing over eads are a"sor"ed into unit costs "y a c arge of )@@K of varia"le cost. 6ssuming t at .i/ processing time can "e s+itc ed from one product line to anot er, .ii/ demand at current price is: 6 0 # 33@@@ B@@@ )@@@ and selling prices are not to "e altered. "e#uired0 #alculate t e "est production programme for t e ne%t operating period and to indicate t e increase in t e net profit t at t is s ould yield. *dentify t e opportunity cost of a processing our. Solution -i%ed manufacturing over ead costs are a"sor"ed into t e unit costs "y a c arge of )@@K of varia"le cost. 7 erefore unit varia"le cost is one t ird of total unit cost. #ontri"ution per processing our 6 0 # Selling price )@ :3 :H Faria"le cost D B 3@ #ontri"ution 3< ): )H #ontri"ution per processing r 3< ): 3<.= 2anking : 3 ) &ptimal programme: &utput Gours #ontri"ution Product 0 B@@@ B@@@ 3B<@@@ Product # )@@@ <@@@ =B@@@ Product 6 3=@@ 3=@@ )3@@@ W 3:=@@ )D:@@@ !%isting programme: &utput Gours #ontri"ution Product 6 D@@@ D@@@ B<@@@ Product 0 D@@@ D@@@ 3:B@@@ Product # C=@ 3=@@ )3C=@W )<:C=@ #ontri"ution and profits +ill increase "y 2s 3H)=@ if t e optimal production programme is implemented. 6n additional our of processing +ould "e used to increase product 6 "y one unit, t us increasing contri"ution "y 2s 3<. 7 erefore t e opportunity cost of one processing our is 2s 3<.
*********************************************** Lecture 1C
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Information for +lanning and !ontrol 5 )he $udget +rocess

7 e various activities +it in a company s ould "e coordinated "y t e preparation of plans of actions for future periods. 7 ese detailed plans are usually referred to as "udgets. &ur o"jective is to focus on t e planning process +it in a "usiness organi,ation and to consider t e role of "udgeting. Planning is t e design of a desired future and of effective +ays of "ringing it a"out. 6 distinction is normally made "et+een s ort1term planning and long1term planning kno+n as corporate planning or strategic planning.
Stages in the +lanning +rocess Stage 1 5 !sta"lis ing &"jectives: #omprises t e mission of t e organi,ation, corporate o"jectives and unit o"jectives. 7 e mission descri"es in very general terms t e "road purpose and reason for t e organi,ation, t e nature of "usiness and t e customers it seeks to serve. #orporate o"jectives relate to t e organi,ation as a + ole. 7 ey are normally measura"le and are e%pressed in financial terms suc as desired profits or sales levels, return on capital employed, rates of gro+t or market s are. !sta"lis ing o"jectives #orporate o"jectives are formulated "y t e 0oard of Directors and anded do+n to senior managers. &verall o"jectives are "roken do+n into su"sidiary o"jectives relating to areas suc as project range, market segmentation, customer service etc. (nit o"jectives relate to specific o"jectives of individual units +it in a company. Stage , 5 *dentify Potential Strategies 7 e ne%t stage is to identify a range of possi"le course of action t at mig t ena"le t e company;s o"jectives to "e ac ieved. 7 e identification of strategies s ould take into account t e follo+ing: $eneric strategy to "e pursued Eo+est cost producer or a uni4ue product, serviceP focus on particular segment 6lternative directions to develop. Market penetration or ne+ market developmentP product development or diversification Stage 1 5 !valuation of strategic options Suita"ility e%ploits company strengt s and environmental opportunities, avoid +eakness -easi"ility can t e strategy "e fundedV 6nd necessary market position ac ievedV #an t e company cope +it competitive reactions, 6ccepta"ility 1 +ill it "e sufficiently profita"le, is t e level of risk accepta"le. Stage 6 5 Select course of action 6fter selection of t e strategic options, long1term plans s ould "e created to implement t e strategies. 6 long1term plan is a statement of preliminary targets and activities re4uired "y an organi,ation to ac ieve its strategic plan, toget er +it a "road estimate of t e resources re4uired in eac year. 6s it concerns t e future, plans tend to "e general in nature, imprecise and su"ject to c ange. Stage < 5 *mplementation of long1term plans Eong1term plans represent t e "road direction t at top management intend to follo+. 7 e "udget is developed in t e conte%t of ongoing "usiness and is ruled "y previous decisions already taken.
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*nitial estimates are revie+ed in t e lig t of more recent information. 7 is revie+ process may result in decisions "eing taken on possi"le activity adjustments +it in t e current "udget period. 0udgeting must "e considered as an integrated part of t e long term planning process.
Stages 9 I C Monitor actual outcomes ? respond to divergences 7 e final stages are to compare t e actual and planned outcomes, and to respond to any divergences from plan.
*********************************************** Lecture 1D
)he multiple functions of budgets Planning annual operations managers must produce detailed plans for t e implementation of t e long1range plans. !ncourages managers to anticipate pro"lems "efore t ey arise. #oordinating t e activities of various parts of t e organi,ation t e "udget serves as t e ve icle t roug + ic t e actions of t e different parts of t e organi,ation can "e "roug t toget er and reconciled into a common plan. #ommunicating plans to t e various responsi"ility center managers everyone in t e organi,ation s ould ave a clear understanding of t e part t ey are e%pected to play in ac ieving t e annual "udget. Motivating managers to strive to ac ieve t e organi,ational goals "udget is a useful device to influence managerial "e avior. 6 "udget is a standard t at managers may "e motivated to ac ieve. Eike a c allenge. #ontrolling activities a "udget assists managers in managing and controlling t e activities for + ic t ey are responsi"le. 0y comparing +it actual results, managers can ascertain + ic costs do not conform to plan and re4uire attention. 7 is process ena"les management "y e%ception. !valuating t e performance of managers success is measured in meeting t e "udget, "onuses may "e a+arded on ac ieving of targets. !onflicting roles of budgets 6s a single "udget is used to serve several purposes, t ere is a danger t at t ey may conflict +it eac ot er. Demanding "udgets t at may not "e ac ieved may "e appropriate to motivate ma%imum performance, "ut t ey are unsuita"le for planning purpose. 7 ere is also a conflict "et+een planning and performance evaluation roles. 0udgets are set in advance on anticipated circumstances. Performance s ould "e "ased on an adjusted "udget to reflect actual operating circumstances. )he $udget +eriod 7 e conventional approac is t at once a year t e manager of eac "udget center prepares a detailed "udget for one year.7 e preparation of "udgets on an annual "asis as "een strongly critici,ed on t at grounds t at it ties t e company to a t+elve mont commitment. 7 is can "e risky as t e "udget is "ased on uncertain forecast. 6n alternative approac is for t e "udget to "e "roken do+n "y mont s for t e first t ree mont s, and "y 4uarters for t e remaining nine mont s. 7 e 4uarterly "udgets are developed into mont ly "udgets as t e year proceeds. *n )nd 4tr mont ly "udgets for t e :rd 4tr is prepared, and so on. 6 ne+ "udget for a fift 4uarter +ill also "e prepared. 7 is process is kno+n as continuous or rolling "udget.7 is ensures t at a t+elve mont "udget is al+ays availa"le "y adding a
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4uarter as t e 4uarter just ended is dropped. 2olling "udgets ensure t at planning is not somet ing t at takes place once a year. Planning is a continuous process and managers are encouraged to constantly look a ead and revie+ future plans.
A detailed illustration 5 )he &nterprise !ompany 7 e enterprise company manufactures t+o products, kno+n as t e alp a and "eta. 6lp a is produced in dept 3 and "eta in dept ). 7 e follo+ing information is availa"le for )@O@ Standard material and la"or costs: Material O C.)@ per unit Material M 3D.@@ per unit Direct la"or 3).@@ per unit &ver ead is recovered on a direct la"or our "asis. 7 e standard material and la"or usage for eac product is as follo+s: Model 6lp a Model 0eta Material O 3@ units B units Material M = units H units Direct la"or our 3@ ours 3= ours )he balance sheet for the previous year end ,7@7 'as as follo's0 2s 2s -i%ed 6ssets Eand 3C@@@@ 0uildings and e4uipment 3)H)@@@ Eess depreciation )==@@@ 3@:C@@@ #urrent 6ssets Stocks, finis ed goods HH@CD ra+ materials 3BH)@@ De"tors )BH@@@ #as :<@@@W D33)CD Eess: #urrent lia"ilities #reditors .)<BB@@/ :D)<CDW >et 6ssets 3=DH<CD 2epresented "y IIIIIIII 3)@@@@@ ordinary s ares 3)@@@@@ 2eserves :DH<CD 3=DH<CD IIIIIIII -ther relevant data is as follo's for the year ,7@7 -inis ed products Alpha $eta -orecast sales .units/ B=@@ 3D@@ Selling price per unit 2s<@@ 2s=D@ !nding inventory re4uired .units/ 3BC@ H@ 0eginning inventory .units/ 3C@ B= Direct material Material O Material M 0eginning inventory .units/ B=@@ B@@@ !nding inventory re4uired .units/ 3@)@@ 3C@@ Dept 3 Dept ) 0udgeted varia"le over eads rates .per direct la"or r/ 2s 2s
D)
*ndirect materials *ndirect la"or Po+er .varia"le portion/ Maintenance .varia"le portion/ dept 3 2s 0udgeted -i%ed over eads Depreciation Supervision Po+er .fi%ed portion/ Maintenance .fi%ed portion/ 3@@@@@ 3@@@@@ <@@@@ <=D@@
3.)@ 3.)@ @.D@ @.)@ dept ) 2s B@@@@ <@@@@ )@@@ :3HD <@@@ C<@@@ )B@@@ D@@@@ ))@@@ B@@@@ B@@@WW )CD@@@
@.B@ 3.)@ @.<@ @.<@
!stimated non1manufacturing over eads: Stationery etc. .admin/ Salaries sales office #ommissions #ar e%penses .sales/ 6dvertising Miscellaneous .office/
$udgeted cash flo's are as follo's0 .6ll 2s @@@s/ 2eceipts from customers Payments: Materials Payments for +ages &t er costs and e%penses
93 3@@@ <@@ <@@ 3)@
9) 3)@@ <B@ <<@ 3@@
9: 33)@ <<@ <B@ C)
9< HB= =<B D<D 3<
Mou are re#uired to prepare a master "udget for t e year )@O@ and t e follo+ing "udgets: 3. ). :. <. =. D. C. B. Sales "udget Production "udget Direct materials usage "udget Direct materials purc ase "udget Direct la"or "udget -actory over ead "udget Selling and administration "udget #as "udget
*********************************************** Lecture 1F
Sales budget
7 e sales "udget s o+s t e 4uantities of eac product t at t e company plans to sell and t e intended selling price. *t provides t e prediction of total revenue from + ic cas receipts from customers +ill "e estimated.
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*t also provides t e "asic data for constructing "udgets for production costs, selling and distri"ution and administrative e%penses. 7 e sales "udget is t erefore t e foundation for all ot er "udgets. *f sales "udget is not accurate, ot er "udgets +ill "e unrelia"le. 6ssume market analysis s o+ t is result: Product (nits sold Price 2evenue 6lp a B=@@ <@@ :<@@,@@@ 0eta 3D@@ =D@ BHD,@@@ <)HD@@@ 7 is +ill "e supported "y detailed "udgets s o+ing territories, mont ly details "y product. etailed monthly budget for 6 territories Month >ort Sout !ast 5est 7otal units value units value units value units value units value Aanuary 6lp a 0eta WWWW WWWWW WWWW WWWWW WWWWW WWWW WWW WWWWW WWWWW WWWWWW 7otal -e" Mar 6pr May Aun Aul 6ug Sep &ct >ov Dec 7otal 6lp a :@@@ 3)@@ )=@@ 3@@@ 3@@@ <@@ )@@@ B@@ B=@@ :<@@ 0eta =@@ )B@ D@@ ::D )@@ 33) :@@ 3DB 3D@@ BHD Annual +roduction budget ept 1 ept , Alpha $eta (nits to "e sold B=@@ 3D@@ Planned closing stock 3BC@ H@ 7otal units re4uired 3@:C@ 3DH@ Eess planned opening stock 3C@ B= (nits to "e produced 3@)@@ 3D@= 7 e total production for eac dept s ould also "e analy,ed on a mont ly "asis. irect materials usage budget 7 e supervisors of depts 3 and ) +ill prepare estimates of t e materials re4uired to meet t e production "udget. Department 3 (nits price total 3@)@@@ C.)@ C:<<@@ =3@@@ 3D B3D@@@ 3==@<@@ Department ) units price total 3)B<@ C.)@ H)<<B 3<<<= 3D ):33)@ :):=DB
Material O Material M
=or%ing Material O 1 3@)@@ units at 3@ units per unit of alp a I 3@)@@@ 1 3D@= units at B units per unit of "eta I 3)B<@
D<
Material M 1 3@)@@ units at = units per unit of alp a I =3@@@ 1 3D@= units at H units per unit of "eta I 3<<<=. irect materials purchase budget 7 e o"jective is to purc ase materials at t e rig t time and at t e planned purc ase price. *t is necessary to take into account t e planned ra+ material stock levels. Material @ Material A 9uantity necessary for production 33<B<@ D=<<= Planned closing stock 3@)@@ 3C@@ 3)= @<@ DC3<= Eess: planned opening stock B=@@ B@@@ 7otal units to "e purc ased 33D=<@ =H3<= Planned unit purc ase price C.)@ 3D 7otal purc ases B:H@BB H<D:)@ -or detailed planning and control it +ill "e necessary to analy,e t e annual "udget on a mont ly "asis. /actory overhead budget 6nticipated activity 3@)@@@ direct la"or rs .dept 3 3@)@@ O 3@ rs/ )< @C= direct la"or rs .dept ) 3D@= O 3= rs/ Faria"le over ead rate #ontrolla"le over eads: Dept 1 Dept , *ndirect material 3.)@ .B@ *ndirect la"or 3.)@ 3.)@ Po+er .varia"le portion/ @.D@ @.<@ Maintenance .var portion/@.)@ @.<@ >on1controlla"le over eads: Depreciation Supervision Po+er .fi%ed portion/ Maintenance .fi%ed portion/ 7otal over ead Departmental over ead rate &ver eads Dept 1 3))<@@ 3))<@@ D3)@@ )@<@@ 3@@@@@ 3@@@@@ <@@@@ <=D@@ D3)@@@ D.@@ Dept , 3H)D@ )BBH@ HD:@ HD:@ B@@@@ <@@@@ )@@@ :3HD 3H)D@D B.@@
Selling and Administration budget *n practice separate "udgets +ould "e prepared for selling and for administration Selling: Salaries #ommission #ar e%penses 6dvertising 6dministration: Stationery Salaries Miscellaneous C<@@@ D@@@@ ))@@@ B@@@@ <@@@ )B@@@ B@@@
):D@@@
<@@@@ )CD@@@
D=
Master budget 5 en all t e "udgets ave "een prepared, t e "udgeted profit and loss account and "alance s eet provide t e overall picture of t e planned performance for t e "udget period.
$udgeted profit and loss account for the year ending ,7@7 Sales .sc edule 3/ <)HD@@@ &pening stock of ra+ material 3BH)@@ Purc ases .sc edule </ 3CB=<@B Eess closing stock of ra+ material .3@@D<@/ #ost of ra+ material consumed 3BC:HDB Direct la"or 3=3)H@@ -actory over ead .sc edule D/ B@<D@D 7otal manufacturing cost <3H3<C< 6dd opening stock of finis ed goods HH@CD Eess closing stock of finis ed goods .DD=HB</ #ost of sales :D)<=DD $ross profit DC3<:< Selling and administration e%penses )CD@@@ 0udgeted operating profit for t e year :H=<:<
Inventory valuation 6lp a units 2s Direct materials O M Direct la"or -actory &ver eads: Dept 3 Dept )
0eta (nits 2s B H 3= 3= =C.B@ 3<<.@@ 3B@.@@ 3)@.@@ DD
3@ = 3@ 3@
C).@@ B@.@@ 3)@.@@ D@.@@ WWWWWW
::).@@ #losing stock: 6lp a 3BC@ units U ::) I D)@B<@ 0eta H@ units U =@3.D@ I <=3<< DD=HB<
=@3.D@
*********************************************** Lecture ,7
$udgeted $alance Sheet -i%ed assets: Eand 0uildings and !4uipment Eess depreciation #urrent assets: 2a+ material stock -inis ed goods stock De"tors #as #urrent Eia"ilities: #reditors 2epresented "y 3)@@@@ ord s ares 2s 3@ eac 3)@@@@@ 2eserves :DH<CD Profit and Eoss account :H=<:< 3C@@@@ 3)H)@@@ <:=@@@ 3@@D<@ DD=HB< )B@@@@ 3HH3C@ 3)<=CH< :@CBB< H:CH3@ 3HD<H3@ IIIIIII 3HD<H3@ IIIIIIII B=C@@@ 3@)C@@@
=or%ings depn: )==@@@J3B@@@@ .sc D/ I <:=@@@ De"tors: )BH@@@ .o'"al/J<)HD@@@.sales/ <:@=@@@ .cas recd/ I )B@@@@ #as closing "al per "udget #reditors: )<BB@@.o'"al/ J 3CB=<@B .purc ases/ J 3<3DD@ indirect materials 3BCDHB< .cas paid/ I :@C BB<
!ash $udgets
#as "udgets elp a firm to identify cas "alances t at are surplus to its re4uirements, t ese can "e invested in t e s ort term. 7 ey also identify cas deficiencies + ic need to arranged to meet t e re4uirements. 7 e overall aim s ould "e to attain ma%imum cas availa"ility and earn ma%imum return on idle funds. B1 B, B1 B6 )otal &pening "alance :<@@@ 33<@@@ )H<@@@ <)3HB< :<@@@ 2eceipts from de"tors 3@@@@@@ 3)@@@@@ 33)@@@@ HB=@@@ <:@=@@@ 3@:<@@@ 3:3<@@@ 3<3<@@@ 3<@DHB< <::H@@@ Payments: Purc ase of material <@@@@@ <B@@@@ <<@@@@ =<CHB< 3BDCHB< Payment of +ages <@@@@@ <<@@@@ <B@@@@ D<D3BB 3HDD3BB &t er costs and e%penses 3)@@@@ 3@@@@@ C)@3D 3:D<) :@=D=B H)@@@@ 3@)@@@@ HH)@3D 3)@CB3< <3:HB:@ #losing "alance 33<@@@ )H<@@@ <)3HB< 3HH3C@ 3HH3C@
DC
/inal "evie' 7 e "udgeted profit and loss account, "alance s eet and cas flo+ +ill "e su"mitted to t e "udget committee for revie+. -inancial ratios suc as return on capital employed, +orking capital, li4uidity and gearing ratios +ill "e revie+ed. *n t e e%ample 2&#! is )@K "ut t e +orking capital ratio is <:3, so management s ould consider +ays of reducing investment in +orking capital, "efore finally approving t e "udget. Activity based budgeting -or t ose indirect costs and support activities + ere consumption of resources does not vary +it output of products, conventional "udgets merely serve as aut ori,ation for certain levels of spending for eac item of e%pense. Performance reporting normally implies little more t an c ecking + et er t e "udget as "een e%ceeded. 5it conventional "udgeting indirect costs and support activities are prepared on an incremental "asis. 7 is means current "udgeted allo+ance for e%isting activities is taken as t e starting point. 7 e "ase is t en adjusted for c anges + ic are e%pected to occur. 7 is is called incremental "udgeting. Incremental approach to budgeting *n incremental "udgeting t e e%pense may "e "ased on t e previous "udgeted allo+ance plus an increase to cover ig er prices. 7 e major disadvantage of t e incremental approac is t at t e majority of e%penditure associated +it t e "ase activity remains unc anged. Past inefficiencies and +aste is perpetuated. 7o manage costs more effectively, organi,ations t at ave implemented 6ctivity 0ased #osting ave also adopted activity "ased "udgeting .600/ Activity based budgeting 7 e aim of 600 is to aut ori,e supply of only t ose resources t at are needed to perform re4uired activities to meet t e production volume. *n 600 cost o"jects are t e starting point. 7 eir "udgeted output determines t e necessary activities, + ic are t en used to estimate t e resources re4uired. Stages in A$$ 600 involves t e follo+ing stages: !stimate t e production and sales volume "y individual products and customers. !stimate t e demand for organi,ational activities Determine t e resources re4uired to perform t e organi,ational activities. !stimate for eac resource, t e 4uantity re4uired to meet demand. 7ake action to adjust t e capacity of resources to matc projected supply. 7 e first stage is identical to conventional "udgeting. >e%t 600 e%tends conventional "udgeting to support activities suc as ordering, receiving, sc eduling production and processing customer orders. !stimates of 4uantities of activity cost drivers must "e derived for eac activity. !.g. num"er of Pos, num"er of receipts, num"er of set1ups and num"er of customer orders processed 7 ird stage is to estimate t e resources re4uired for performing 4uantity of activity drivers demanded. !.g if orders processing is estimated at =@@@ and eac order takes :@ minutes processing time, t en )=@@ la"or ours of customer order processing must "e supplied. 7 e final stage is to compare t e 4uantity of resource re4uired +it t e resources currently committed. 5 ere necessary, additional spending must "e aut ori,ed in t e "udget to ac4uire additional resources. DB Virtual University of Pakistan
6lternatively, if t e demand for resources is less, t e "udget process s ould result in action to reduce resources no longer needed.
$udgeting in non*profit organiGations 0udgeting in non1profit organi,ations normally "egins +it managers of various activities calculating t e costs of maintaining ongoing activities. 7 en costs of furt er development of services are added. 7 e availa"le resources s ould "e sufficient to cover total costs of suc services. &ne difficulty encountered is t at precise o"jectives are not defined in a 4uantifia"le +ay. 6ctual accomplis ments are difficult to measure. *n most situations output cannot "e measured in monetary terms. *n profit oriented organi,ations output can "e measured in sales revenue terms. 7 e effect is t at "udgets in non1profit organi,ations tend to "e concerned mainly +it input of resources. 7 ere is not t e same emp asis on + at is intended to "e ac ieved for a given input of resources.
Line item budgets 6 line item "udget is + ere t e e%penditures are e%pressed in considera"le detail, "ut t e activities "eing undertaken are given little attention. Eine item "udget s o+s t e nature of t e spending "ut not t e purpose. #ompliance +it t ese "udgets provides no assurance t at resources are used +isely, effectively or efficiently in financing various activities.
*********************************************** Lecture ,1
&.ample 5 preparation of cash budget 7 e management of 8ader 0u% Etd as "een informed t at t e union of direct +orkers intends to call a strike. 7 e accountant as "een asked to advise management on t e effect t e strike +ill ave on cas flo+. 7 e follo+ing "udget data +as made availa"le: 5eek 3 +eek ) 5eek : Sales <@@ units =@@ units <@@ units Production D@@ units <@@ units nil 7 e strike +ill commence "eginning of +eek t ree, and +ill continue for at least < +eeks. Sales at <@@ units per +eek +ill continue during t e strike period until stocks of finis ed goods are e% austed. Jader $u. Ltd Production +ill stop at t e end of +eek ). 7 e current stock of finis ed goods is D@@ units Selling price of t e product is 2s D@ and manufacturing cost is made up as follo+s: Direct material 3= Direct +ages C Faria"le over eads B -i%ed over eads 3B 7otal <B Direct +ages are regarded as varia"le cost. 7 e company operates full1a"sorption costing and t e fi%ed over ead a"sorption rate is "ased on "udgeted fi%ed over eads of 2s H@@@ per +eek.
DH
*ncluded in t e fi%ed over eads is 2s C@@ for depreciation of e4uipment. During t e period of t e strike direct +ages and varia"le over eads +ould not "e incurred and t e cas e%pended on fi%ed over eads +ould "e reduced "y 2s 3=@@ per +eek. 7 e current stock of ra+ material are +ort 2s C=@@, it is intended t at t ese stocks s ould increase to 2s 33@@@ "y t e end of +eek 3 and t en remain at t is level during t e period of t e strike. 6ll direct materials are paid for 3 +eek after t ey ave "een received. Direct +ages are paid one +eek in arrear. 6ll relevant over eads are paid immediately as t e e%pense is incurred. 6ll sales are on credit, C@K of sales value is received in cas at t e end of t e first +eek, and "alance at t e end of t e second +eek. 7 e current amount outstanding to suppliers is 2s B@@@ and direct +age accruals amount to 2s :)@@. 0ot of t ese +ill "e paid in +eek 3. 7 e current "alance o+ing from de"tors is 2s :3)@@ of + ic 2s )<@@@ +ill "e received during +eek 3, and t e remaining during +eek ). 7 e current "alance of cas in and and at "ank is 2s 3@@@.
"e#uired 0 3a4 .i/ prepare a cas "udget for +eeks 3 to D s o+ing t e "alance of cas at t e end of eac +eek toget er +it a suita"le analysis of receipts and payments during eac +eek. .ii/ comment upon any matters arising from t e cas "udget + ic you consider s ould "e "roug t to t e management;s attention. 3b4 e%plain + y reported profit figure for a period does not normally represent e amount of cas generated in t at period. Solution * Jader $u. Ltd #as 0udget for +eek 3 D 2eceipts from de"tors Payments : 7o material suppliers 7o direct +orkers -or varia"le over eads -or fi%ed over eads 7otal payments >et movement 1:@@ &pening "al .+k 3 given/ #losing "alance =or%ings 0 De"tors (nits sold Sales #as received .C@K/ .:@K/ given 7otal receipts 5eek 3 5eek ) 5eek : 5eek < )<@@@ )<@@@ )B)@@ )=B@@ B@@@ 3)=@@ :)@@ <)@@ <B@@ :)@@ B:@@ B:@@ )<:@@ )B)@@ 1<)@@ 3)D@@ 3@@@ C@@ C@@ 1:=@@ +eek 3 +eek) <@@ =@@ )<@@@ :@@@@ 3DB@@ )3@@@ D@@@ )B@@ 1 DB@@ 3=D@@ 3H@@@ 1:=@@ H3@@ 1 1 1 DB@@ DB@@ 3:@@@ H3@@ )B3@@ 5eek = 5eek D 3HB@@ =<@@ 1 1 1 DB@@ DB@@ 1 )B3@@ <33@@ 1 1 1 DB@@ DB@@ 3<@@ <33@@ :HC@@
+eek : +eek < +eek = +eek D <@@ :@@ 1 1 )<@@@ 3B@@@ 1 1 3DB@@ 3)D@@ 1 C)@@ H@@@ C)@@ =<@@
)<@@@ C)@@ )<@@@ )<@@@ )B)@@ )=B@@ 3HB@@ =<@@
Sales in +eek I opening stock .D@@ units/ J production in +eeks 3 and ) .3@@@ units/ less sales in +eeks 3 to : .3:@@ units/ I :@@ units
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#reditors Materials consumed U 2s 3= *ncrease in stocks Materials purc ased Payment to suppliers .given/
5eek 3
+eek )
+eek : +eek< +eek = +eek D 1 1 1
H@@@ D@@@ 1 :=@@ 3)=@@ D@@@ B@@@ 3)=@@ D@@@
5ages 5ages consumes U 2s C <)@@ )B@@ 1 1 1 1 5ages paid :)@@ <)@@ )B@@ 1 1 1 .given/ Faria"le over ead payments I "udgeted production O "udgeted cost per unit. -i%ed over ead payments for +eeks 31) I fi%ed over eads .H@@@/ less depn .C@@/ -i%ed over eads for +eeks :1D I B:@@ .normal/ less 3=@@ per +eek. 3ii4 !omments for Management -inance +ill "e re4uired to meet t e cas deficit in +eek ), "ut lo+ering of "udgeted material stocks at end of +eek 3 +ould reduce t e "orro+ing at end of +eek ). Surplus cas after +eek ) s ould "e invested on s ort1term "asis. 6fter +eek D t ere +ill "e no cas receipts, only outflo+s of 2s DB@@ per +eek. 7 e closing "alance of 2s :HC@@ at t e end of +eek D +ill "e sufficient for a furt er = to D+eeks .:HC@@'DB@@/ 3b4 +rofits and cash*flo's 6ccording to t e matc ing concept, revenues and e%penses may not "e attri"uted to t e same period as t e related cas flo+s. Some items of e%pense do not affect cas flo+ e.g. depreciation.
********************************************** Lecture ,,
?ero*based budgeting Qero1"ased "udgeting .also kno+n as priority "ased "udgeting/ emerged to overcome t e limitations of incremental "udgets. 7 is approac re4uires t at all activities are justified and prioriti,ed "efore a decision is taken to allocate resources. Qero1"ased "udgeting also focuses on programs and activities instead of line items of traditional "udgeting. Q00 +orks on t e premise t at eac year;s "udget s ould "e compiled as if t e programs +ere "eing launc ed for t e first time. 6ll funds are allocated on t e "asis of cost1"enefit or similar analysis. *t 4uestions long standing assumptions and serves as a tool for systematically e%amining any unproductive projects. *t is "est suited for discretionary costs suc as advertising, researc and development and training. Q00 involves t e follo+ing t ree stages: 6 description of eac organi,ational activity !valuation and ranking of decisions in order of priority 6llocation of resources "ased on order of priority upto t e spending cut1off level. $enefits of ?$$
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0enefits of Q00 over traditional met ods are "eing claimed as follo+s: Q00 avoids t e deficiencies of incremental "udgeting and represents a move to+ards t e allocation of resources on need "asis. 7 e level of funding is not taken for granted. Q00 takes a 4uestioning attitude rat er t an one t at assumes current practices represent value for money. Q00 focuses attention on output in relation to value for money.
?$$ 5 lac% of success 7 e main reason for its lack of success +ould appear to "e t at its too costly and time1 consuming. 7 e process of identifying decisions and determining t eir purpose, cost and "enefits is e%tremely time1consuming. -re4uently t ere is insufficient information availa"le to evaluate and rank decisions. &rgani,ations tend to appro%imate t e principles of Q00 rat er t an applying t e full scale approac . !.g. applied to some areas of t e organi,ation selectively. )ransfer pricing -inancial means for evaluating divisional performance !sta"lis ed transfer price is a cost to t e receiving division and revenue to t e supplying division 7ransfer price +ill affect profita"ility of "ot divisions 7ransfer pricing can also apply to cost centers i.e. support ' service centers, sometimes t ere is no need for a profit element to "e included. +urpose of transfer pricing 7o provide information t at motivates divisional managers to make good economic decisions. 7o provide information useful for evaluating managerial performance, and economic performance of divisions and cost centers. 7o intentionally move profits "et+een divisions or locations. 7o encourage divisional autonomy. Information for good economic decisions $oods transferred from one division to anot er are kno+n as intermediate products, + ere as t ose sold to t e outside +orld are kno+n as final products. 7ransfer prices are used to determine t e values of intermediate products. *t can also "e used for decisions on + et er t e product s ould "e sold or processed furt er. 7 is is done on incremental cost "asis. Managers must take care not to treat transfer price as incremental cost. -or e%ample assume t e incremental cost of a intermediate product is 2s 3@@ and additional cost of furt er processing is 2s D@. 7 e incremental cost of t e final product +ill t erefore "e 2s 3D@. 6lso assume t ere is temporary e%cess capacity, and t at t e market price of t e final product is 2s )@@. 7 e correct decision +ould "e to convert intermediate product to final product. *f t e transfer price +as "ased on full cost plus profit margin and set at 2s 3=@, t e incremental cost of t e final product +ould "e 2s )3@ .3=@ J D@/. 7 e manager +ould decide not to purc ase t e intermediate product for furt er processing, as t e incremental cost is more t an t e selling price . 7 is +ould "e an incorrect decision. 7 e pro"lem +ould "e overcome if transfer price is set at t e incremental cost + ic is 2s 3@@ in t is e%ample. C) Virtual University of Pakistan
&valuating divisional performance 7 e price at + ic goods are transferred from one division to anot er, +ill influence t e division;s reported profits. 6n unsound transfer price +ill result in a misleading performance measure. 7 e divisional manager may feel t e transfer price is affecting is performance unfairly. 7 is may ave negative motivational conse4uences. !onflict of objectives >o single transfer price +ill perfectly serve all four specified purposes. 7 ey often conflict and managers are forced to make trade1offs. 7 e decision1making and t e performance evaluation may conflict +it eac ot er. !.g. sometimes in t e s ort1term, t e transfer price for optimal economic decision is t e marginal cost. Fery often t is +ill e4ual varia"le cost. 7 e supplying division +ill fail to recover its fi%ed over eads and may report a loss. -urt er, as s o+n, transfer price satisfactory for divisional performance .2s 3=@/ leads to incorrect decisions from a company +ide perspective.
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MGT 705 - Advanced Cost and Management Accounting

Introduction to Management Accounting

MGT 705 - Advanced Cost and Management Accounting

Virtual University of Pakistan

MGT 705 - Advanced Cost and Management Accounting

7otal value c ain analysis

MGT 705 - Advanced Cost and Management Accounting

Virtual University of Pakistan

MGT 705 - Advanced Cost and Management Accounting

Introduction to Management Accounting

Virtual University of Pakistan

MGT 705 - Advanced Cost and Management Accounting

Direct and *ndirect #osts

MGT 705 - Advanced Cost and Management Accounting

7reatment of product and period costs

>on production cost

*ncluded as e%pense in t e period

Virtual University of Pakistan

MGT 705 - Advanced Cost and Management Accounting

Faria"le, -i%ed and Semi1Faria"le #osts

Virtual University of Pakistan

MGT 705 - Advanced Cost and Management Accounting

MGT 705 - Advanced Cost and Management Accounting

11111111111111111111111111111111111111111111111111111111 Lecture 1 !ost 2olume +rofit Analysis

MGT 705 - Advanced Cost and Management Accounting

MGT 705 - Advanced Cost and Management Accounting

MGT 705 - Advanced Cost and Management Accounting

Profit Folume $rap L

If 17777 tic%ets are sold8 profit 'ill be "s 67777

11111111111111111111111111111111111111111111111111111111 Lecture 6 3cont4

!ost 2olume +rofit Analysis

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MGT 705 - Advanced Cost and Management Accounting

!stimated loss is +orse t an last year, proposal not recommended.

MGT 705 - Advanced Cost and Management Accounting

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MGT 705 - Advanced Cost and Management Accounting

$ross profit Eess: Selling and Dist. 6dmin >et Profit

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Sep H@@@@ ==@@@ H@@@ 3=@@@

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Virtual University of Pakistan

MGT 705 - Advanced Cost and Management Accounting

#ontri"ution "reak1even grap

-i%ed costs .)=@@@/ I D)=@@ contri"ution to sales ratio ..</

6rea of contri"utionI 6rea 6@0 Mont ly sales

MGT 705 - Advanced Cost and Management Accounting

Multi*+roduct $rea%*even Analysis

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Multi product $>&

MGT 705 - Advanced Cost and Management Accounting

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MGT 705 - Advanced Cost and Management Accounting

Virtual University of Pakistan

MGT 705 - Advanced Cost and Management Accounting

MGT 705 - Advanced Cost and Management Accounting

Measuring "elevant !osts and "evenues

Multi+roduct $rea%even Analysis