COST BEHAVIOR AND COST-

COST BEHAVIOR AND COST- VOLUME-PROFIT ANALYSIS

C^OURSE – C^OST M^ANAGEMENT S^TRATEGIES COURSE COORDINATOR – DR. KAVITA WADHWA

GENERAL COST CLASSIFICATION

Basis of cost classification:

I. Degree of traceability to a cost object i.e. product or job II. Management function

III. Timing of charges against sales revenue

IV. Cost Behavior in relation to changes in output, activity V. Relationship with accounting period

VI. Decision making and planning

I. ON THE BASIS OF DEGREE OF TRACEABILITY

Some costs such as costs of materials are easier to assign to a cost object than others such as costs of supervision.

a. Direct cost of a cost object: The cost which can be traced to the cost object in an economically feasible (cost-effective way). Example: cost of steel and tires for making car.

b. Indirect cost of a cost object: Related to cost object but tracing is not easy. Example: salaries of plant administrators.

• Note: the cost tracing is the basis.

DIRECT COST OF A COST OBJECT

1. Direct Material:

 Cost of the materials which becomes a major part of the finished product.

 Raw materials that are integral part of the finished product and are conveniently and economically traceable to specific units of product.

• Examples: Crude oil to produce petrol or diesel, raw cotton in textile, steel in automobile making.

 Materials specifically purchased for a particular job, order, process or product.

 Materials passing from one process to another process.

 Primary packing materials, wrapping, and cardboard boxes.

• Note: Import duties, dock charges, transport cost of materials, storing of material cost, and cost of purchasing and receiving materials are added to their invoiced price.

CONTD…DIRECT COST OF A COST OBJECT

2. Direct Labor:

 Labor of those workers who are engaged in the production process. Can be easily (i.e.

physically and conveniently) traced to individual units of product.

 Some times called as touch labor.

 Example: labor cost of assembly line workers, carpenters, bricklayers, and machine operators.

• Note: Direct labors are expended directly upon the materials comprised finished product.

CONTD…DIRECT COST OF A COST OBJECT

3. Direct Expenses:

 Expenses that can be allocated conveniently to a unit of cost other than direct material and direct labor.

 Carriage on materials, royalty paid on the basis of quantity of goods produced.

 Special necessary expenses can be identified with cost units and are charged directly to the product as part of the prime cost. Also called as chargeable expenses.

Examples of direct expenses

 Cost of hiring special machinery or plant.

 Cost of special moulds, designs and patterns

 Experimental costs and expenditure on model and pilot schemes

 Fees paid to architects, surveyors and other consultants

 License fees

CONTD….INDIRECT COST OF A COST OBJECT

Indirect Cost: Those costs which cannot be identifiable with or traced to a single product because they are common to several products.

• Example: Indirect material (lubricants), salary of factory supervisors (indirect labor), rent.

• Note: The term cost allocation is used to describe the assignment of indirect costs to a particular cost object.

1. Indirect Material:

 Materials which are used for maintenance and repair of machinery, running of service department, spare and components, packing materials.

 They don’t normally form a part of the finished product.

CONTD… INDIRECT COST OF A COST OBJECT

2. Indirect Labor:

 Wages which can not be traced to different jobs or products. Indirect wages are part of factory expenses.

 Example: wages paid to watch and ward staff, repair gangs, supervisor, general helpers, cleaners, employees engaged in maintenance work.

3. Indirect Expenses:

 Rent, insurance-fire and liability

 Taxes

 Depreciation

 Maintenance and repair

 Power, light, steam and heat

CONTD… INDIRECT COST OF A COST OBJECT

Implication:

 Indirect costs are often referred as Overheads

 Costs may also indirect with respect to particular company segments or divisions.

• “The salary of the plant manager of plant A is a direct cost of plant A. But if the multiple products are produced in plant A, the managers salary is indirect to specific products.”

CONTD… INDIRECT COST OF A COST OBJECT

TYPES OF OVERHEADS 1. Factory Overheads

 Also called as manufacturing overheads/expenses

 Cost of indirect materials, indirect labor, and indirect expenses incurred at factory.

2. Administrative Overheads

 Office salaries, rent, executive salaries

 Depreciation of equipment, Telephone,

 Travel

 Property taxes

 Auditing expenses

 Stationery, and printing, postage and other administrative expenses.

CONTD… INDIRECT COST OF A COST OBJECT

TYPES OF OVERHEADS

3. Selling and Distribution Overheads:

 Advertising, sales promotion, samples

 Salesmen salaries, travel

 Depreciation of sales equipment

 Rent of sales branches/stores

 Telephone, telegraph, supplies at sales department

 Stationery, printing, freight and carriage out

 Sales accounting.

II. ON THE BASIS OF MANAGEMENT FUNCTION

a. Manufacturing cost: Direct material costs, Direct manufacturing labor cost, Direct manufacturing other expenses, Indirect manufacturing costs.

b. Non-manufacturing cost: Administrative costs, Marketing, selling and distribution costs.

• Note: Indirect manufacturing costs: all mfg costs that are related to cost object but cannot be traced to the cost object in an economical feasible way, i.e. plant maintenance, plant rent, plant insurance, compensation of plant manager. Also called as mfg overhead or factory overhead costs.

CONTD…II. ON THE BASIS OF MANAGEMENT FUNCTION

BY ELEMENT AND FUNCTION

III. ON THE BASIS OF TIMING OF CHARGES AGAINST SALES

a. PRODUCT COST b. PERIOD COST

(Already Discussed)

IV. ON THE BASIS OF COST BEHAVIOR IN RELATION TO CHANGES IN OUTPUT, ACTIVITY

 Costing systems record the cost of resources acquired, such as materials, labor, and equipment, and track how these resources are used to produce and sell products or services.

 Consider three basic types of cost behavior patterns:

a. Fixed cost b. Variable cost

c. Mixed cost (Semi variable or semi fixed cost)

CONTD…IV. ON THE BASIS OF COST BEHAVIOR….

a. FIXED COST

 Does not change in total for a given time period despite change in volume, output or Activity.

 Depends mainly on effluxion of time and do not vary directly with volume or rate of output.

 Examples: rent, property tax, supervising salary, depreciation on office facilities, advertising, insurance.

 By nature total fixed cost is constant and are expressed in terms of time i.e. per day, per month, per year and not per unit.

• Note: when considering fixed costs, always focus on total costs.

IMPLICATION

 Management policy decides the nature of the cost as fixed or variable. Example: if depreciation on machinery is charged with reference to total number of hours for which the machine is expected to function.

 Note: Costs are defined as variable or fixed with respect to specific activity and for given time

CONTD…IV. ON THE BASIS OF COST BEHAVIOR….

b. VARIABLE COST

 VC is one whose total amount changes in proportion to the activity level. However, variable cost per unit remain fixed.

 Tends to follow (in the short term) the level of activity.

 Example: Direct material, direct labor paid on piece rate basis, set up labor cost, sales representative’s commission.

• Note: When considering how variable costs behave always focus on total cost.

Example: BMW

• BMW buys a steering wheel at Rs. 600 for each of its BMW X5 vehicles. The total cost of steering wheels should be Rs.600 times the number of vehicles produced.

• BMW incurs a total cost of Rs. 2 crore per year for supervisors who work exclusively on the X5 line.

These costs are unchanged in total over a designated range of the number of vehicles produced during

CONTD…IV. ON THE BASIS OF COST BEHAVIOR….

CONTD…IV. ON THE BASIS OF COST BEHAVIOR….

c. MIXED COST (SEMI VARIABLE OR SEMI FIXED COST)

 SVC is the one whose total amount varies with the change in activity level but not in direct proportion.

 Example: salesmen are entitled for a fixed salary plus a commission for every rupee sales.

Telephone costs-may have a fixed monthly payment and a charge per phone-minute used.

 The amount of a fixed cost item remains constant for a particular range of activity level and for a specified period, which are known as relevant range and relevant period respectively.

V. ON THE BASIS OF RELATIONSHIP WITH ACCOUNTING PERIOD

a. CAPITAL EXPENDITURE b. REVENUE EXPENDITURE

CAPITAL AND REVENUE EXPENDITURE:

• A capital expenditure provides benefit for future periods and is classified as an asset.

• A revenue expenditure is assumed to benefit the current period and is classified as an expense and hence matched with revenue for the current period.

• A capital expenditure will flow into the cost stream as an expense when the asset is used up or written off.

V. ON THE BASIS OF DECISION MAKING AND PLANNING

A. Opportunity cost B. Differential cost C. Sunk cost

D. Relevant cost E. Shutdown cost

V. ON THE BASIS OF DECISION MAKING AND PLANNING

a. Opportunity cost

• The potential benefit that is given up or sacrificed when one alternative is selected over another.

• It is the income foregone by selecting another alternative.

• It is the cost of opportunity lost.

• Example: It is assumed that the manufacturer can sell a semi-finished product to a customer for Rs.50,000. He decides however, to keep it and finish it. The opportunity cost is Rs.50,000.

• Note: The general rule is that the opportunity cost should not exceed the value of the option selected.

b. Differential Cost:

• Costs and revenues that differ among alternatives.

• Example: You have a job paying Rs.55000 per month in your hometown. You have a job offer in a neighboring city that pays Rs.70,000 per month. The commuting cost to the city is Rs.5000 per month.

• Differential revenue is: 70,000 – 55,000 = 15000

• Differential cost is: Rs.5000

V. ON THE BASIS OF DECISION MAKING AND PLANNING

c. Sunk Cost:

• Sunk costs have already been incurred and cannot be changed now or in the future. They should be ignored when making decisions.

• It is a past or committed cost, cost gone forever.

• Any historical cost is a sunk cost

Example: A restaurateur is considering expanding his restaurant into a chain. They spend

$10,000 on market research, and using that research determine that opening a new location in a specific area isn't likely to be profitable. They don't move forward with the expansion, and that

$10,000 is a sunk cost.

Implication:

1. Suppose that your car which have been bought for $10,000, could be sold now for $5,000. What is the sunk cost?

V. ON THE BASIS OF DECISION MAKING AND PLANNING

d. Relevant Cost

1. Relevant costs are future costs i.e. those costs which are expected to be incurred in future.

2. Costs which are affected and changed by a decision. Irrelevant costs are those costs which remain the same and not affected by the decision, whatever alternative is chosen. Hence irrelevant but not forgotten.

3. Relevant costs are only incremental (additional) or avoidable costs. Incremental costs refer to an increase in cost between two alternatives.

• Case: A business firm purchased a plant for Rs.1,00,000 and has now a book value of Rs.10,000. The plant has become obsolete and cannot be sold in its present condition. However, the plant can be sold for Rs.15,000 if some modification is done on it which will cost Rs. 6000.

• Implication:

 Rs. 6000 (modification cost) and Rs.15000 (sales value) both are relevant. Generates incremental cost, reflect future, and future revenues. Incremental benefit, Rs.15000 - 6000 = Rs. 9000.

 Rs. 100,000 has already been incurred and being a sunk cost is not relevant for decision i.e. whether modification should be done or not. Similarly the book value of Rs. 10,000 has to be written off whatever

V. ON THE BASIS OF DECISION MAKING AND PLANNING

e. SHUTDOWN COST

1. Shutdown costs are those costs which have to be incurred under all situations in case of stopping manufacture of a product or closing down a department or division.

2. Shut down costs thus refer to minimum fixed costs which are incurred in the event of closure of a department, division etc.

IMPLICATION:

Shut down costs are always fixed costs, because, if the manufacturing of a product is stopped variable costs will not be incurred.

Example:

a) Rent, watchman’s salary, property taxes. Such fixed costs are unavoidable.

b) Some fixed costs can be avoidable: Supervisor’s salary, Factory manager salary, Lighting.

SOME OTHER COSTS

 Sticky Cost: Some types of costs that are generally considered to be 100 percent variable are in actuality less than 100 percent variable on the downside. They fall less with decreases in volume or activity than they rise with increases in volume or activity. Costs are sticky primarily managers tend to increase resources more readily when volume increase that they reduce them when volume decrease.

 Step- Function Cost: Some items of cost vary in steps. These costs are incurred when resources are used in discrete chunks such as when one supervisor is added for every additional 10 nonsupervisory employees.

IMPORTANT FACTS ON COST

 Expenses excluded from Cost

The total cost of a product should include only those items of expenses which form part of cost of production and which are charged against profit. Items of expenses which do not form a part of costs are as follows:

 Income tax

 Dividend to shareholders

 Commission to partners and managing agents

 Cash discount given

 Exceptional items such as bad debts

 Interest paid on loan

COST VOLUME PROFIT ANALYSIS

MARGINAL COSTING

 Cost of an article:

 Variable Expenses : which are incurred per unit of output

 Fixed or constant Expenses:-factory, office, selling and distribution- which are incurred for period.

• Note: If from the cost per unit the record of fixed or constant expenses were excluded and if therefore only variable expenses are recorded the system would be known as marginal costing.

• Marginal cost- Cost of producing one extra unit of product or Total variable cost attributable to one unit. In this context one unit may be a single article, a batch of articles, an order, a stage of production capacity, a process or a department.

 Cost Structure:

• Greater the automation in manufacturing process, higher is the proportion of fixed assets and vice versa.

• This cost structure has a significant effect on the way profits fluctuate in response to change in sales volume

 Greater the proportion of fixed costs, greater is the change in profit for a given change in sales volume

ASSUMPTIONS

 Selling price per unit, sales mix, unit variable cost and total fixed costs constant through out the entire relevant range

 Efficiency and productivity of process and workers remain constant

 Revenue and total cost are linear function of quantity

 Total cost can be accurately split into fixed and variable components

 No change in finished goods inventory. Units produced = Units sold

MARGINAL COSTING

 Margin - difference between selling price and variable cost - Contribution OR Contribution Margin

 Equation Approach

 Under marginal costing the term profit is not given much importance but contribution is given more weightage.

 Contribution is the useful guide towards profitability in business. Hence it is the basis for business decisions i.e. choosing a profitable product mix, optimal use of resources, make or buy decision, profit

CVP RELATIONSHIPS AND INCOME STATEMENT (EXAMPLE)

BREAK EVEN POINT (BEP)

 The quantity of output where there would be neither loss nor profit.

 BEP in unit = Fixed Cost / Contribution-margin per unit

 BEP in value = FC / Contribution - margin ratio

= FC / (Unit contribution/unit selling price) or = BEP in unit * SP

 The above approach of measuring BEP is known as Contribution-margin approach

CVP GRAPH (EXAMPLE)

CONTRIBUTION - SALES RATIO (C-S RATIO)

 It is a ratio of marginal contribution and sales.

 C/S ratio (normally a percentage) is the rate at which contribution or profit increases with sales volume.

 C/S ratio is constant for a single unit of product or a number of units. It remains constant over substantial changes of volume.

Interpretation of C-S Ratio

 A high C/S ratio indicates that a slight increase in volume (without increase in fixed cost) would give higher profit.

 C/S also indicate that the profitability can be improved if the management concentrate on the manufacture of products having high C/S ratio.

 This ratio is not affected by any change in fixed overhead, although the change in fixed cost will

FACTORS AFFECTING BEP

 Change in Fixed cost (If FC ↑ then BEP↑ and vice versa)

 Change in variable cost (If VC per unit ↑then BEP↑ and vice versa)

 Change in selling price per unit (If SP per unit ↑ then BEP ↓ and vice versa)

 Change in production quantity beyond present capacity limit.

(if production exceeds capacity the fixed cost will increase, which ultimately affect the BEP)

SALES TO ACHIEVE THE TARGET PROFIT

MARGIN OF SAFETY (MOS)

 Any sales in excess of break even volume.

 MoS = Actual sales - Break even sales

 MoS (in %) = ((Actual sales-Break even sales)/Sales)*100

 MoS ratio = (Actual sales-Break even sales)/Sales

 MoS (amount) = Profit/(PV ratio or CS ratio) and MoS (units) = Profit/contribution per unit Interpretation of MOS:

 Once break even sales amount is achieved contribution from additional sales (MoS) generates profit only.

 Improvement of MoS:

 Lowering fixed cost

 Lowering VC

 Increasing sales volume if there is capacity

 Increasing selling price if market permits

EXAMPLE (MOS)

DEGREE OF OPERATING LEVERAGE (DOL)

 DOL arises due to Operating Fixed Costs in the cost structure

 DOL measures the extent to which a firm’s operating income change for a given % change in sales, ceteris paribus

 DOL = [% change in profit / % change in sales] or

= Contribution

Operating Income = Contribution (Contribution – FC)

= (OI + FC) OI

= 1+ FC

OI >=1

 If FC = 0, DOL = 1; As FC increases, |DOL| increases

 A negative DOL indicates Sales<BEP

DEGREE OF OPERATING LEVERAGE

 Higher the DOL, higher the change in OI, for a given % change in sales

 DOL is affected by the extent to which a firm uses FC in its cost structure.

- High % FC =>Low % VC => High DOL => Higher the ability to increase OI from an increase in sales revenue

- After the BEP has been reached, a larger contribution – margin ratio (due to lower VC) will add to the bottom line in a high FC structure, when compared against a structure that is high in VC

- The risk is also greater because if the BEP is not reached, losses will be larger in a high operating leverage situation

MOS% AND DOL

T ^{HANK YOU}