Chapter 2: Cost And Costing

Question 1

To manage any size business, what just you understand?

Answer 1

How costs respond to changes in sales volume and the effect of costs and revenue on profits.

Question 2

What is a prerequisite to understanding cost-volume-profit (CVP) relationships?

Answer 2

Knowledge of how costs behave.

Question 3

Management cost concepts.

Answer 3

Management needs information. One very important type of information is related to costs. Eg. Questions such as the following should be asked:

1. What costs are involved in the sale of products and services?
2. If sales volume is decreased, will costs decrease?
3. How can costs best be controlled?

Question 4

To answer the prior questions, what does management need?

Answer 4

Reliable and relevant cost information.

Question 5

What is a cost?

Answer 5

A cost is a resource forgone.

In the “production” of services our costs will mainly be:
. Cash laid
. Labour applied to a service (especially in profession services
. The use of equipment or infrastructure (eg. Hotels or transportation) or
. The purchase and sale of goods bought for resale.

Question 6

What are the three classifications of costs that we can identify?

Answer 6

. Direct and indirect costs; labour, material and overhead
. Product and period costs
. Cost behaviour, that is, fixed and variable costs

Question 7

What are labour and material costs?

Answer 7

Labour costs apply to services where they major component of service delivery is the time spent by an employee carrying out an activity to satisfy a customer.

Materials costs apply in wholesale and retail businesses. For the sale of goods at wholesale and retail levels, cost are incurred to purchase goods for resale. This results in an increase in inventory and a subsequent reduction in inventory when the goods are sold.

Both are considered direct costs.

Question 8

What are direct costs?

Answer 8

They are losses which are traceable to a particular product or service.

Question 9

What are indirect costs?

Answer 9

In addition to direct costs, all business also incurs substantial overhead costs - termed as indirect costs in management accounting, because, although necessary for the production of goods and services, THESE COSTS CANNOT EASILY BE TRACED TO A PARTICULAR SALE.

Question 10

What are examples of indirect costs?

Answer 10

. The rent of an office or shop premises 
. Managerial salaries 
. Advertising 
. Utilities 
. Depreciation on equipment

Question 11

In manufacturing business, why is the distinction between direct and indirect costs more complex?

Answer 11

Because raw materials are converted into finished goods.

Question 12

What are product costs?

Answer 12

These are the costs that are a necessary and integral part of a product or service. Product costs are recorded as inventory when goods are purchased.

Under matching principle, these costs do not become expenses until the inventory is sold. The expense is cost of sales.

Each of the cost components (materials, labour and overhead) are product costs.

Question 13

What are period costs?

Answer 13

Costs that are matched with the income of a specific time period rather than included as part of the cost of a saleable product.

Period costs include financing, selling and administrative expenses. They are deducted from income in the period in which they are incurred.

Question 14

What is cost behaviour analysis?

Answer 14

Cost behaviour analysis is the study of how specific costs respond to changes in the level of business activity.

. As you might expect, some costs change, and others remain the same.
. On the other hand, Gold Coast Hospital’s employee costs to run the emergency room on any given night are relatively constant regardless of the number of patients serviced.

Question 15

How is the starting point in cost behaviour analysis measured?

Answer 15

The starting point in cost behaviour analysis is measuring the key business activities.

Activity levels may be expressed in terms of sales dollars (in a retail company), kilometres driven (in a trucking company), room occupancy (in a hotel) or dance classes taught (by a dance studio).

For an activity level to be useful in cost behaviour analysis, changes in the level or volume of activity should be correlated with changes in costs. The activity level selected is referred to as the activity (or volume) index.

Question 16

What the activity index identify?

Answer 16

The activity index identifies the activity that causes changes in the behaviour of costs. With an appropriate activity index, it is possible to classify the behaviour of costs in response to changes in activity levels into three categories: variable, fixed or mixed.

Question 17

What are variable costs?

Answer 17

Variable costs are costs that vary in total directly and proportionately with changes in the activity level.

Examples of variable costs include cost of sales, sales commissions and freight-out for a wholesaler; and fuel in airline and trucking companies. A variable cost may also be defined as a cost that remains the same per unit at every level of activity.

Do not mix up variable costs per unit and total variable costs.

Question 18

What are fixed costs?

Answer 18

Fixed costs are costs that remain the same in total regardless of changes in the activity level.

Examples include insurance, rent, supervisory salaries and depreciation on buildings and equipment.

Because total fixed costs remain constant as activity changes, it follows that fixed costs per unit vary inversely with activity: as volume increases, unit cost declines, and vice versa.

Question 19

What is relevant range?

Answer 19

A.K.A. The normal/practical range.

The range over which a company expects to operate during a year is called the relevant range of the activity index.

Within the relevant range, a straight line relationship generally exists for both variable and fixed costs.

although the straight-line relationship may not be completely realistic, the linear assumption produces useful data when the level of activity remains within the relevant range.

For most companies, operating at almost zero or at 100% capacity is the exception rather than the rule. Instead, companies often operate over a some- what narrower range, such as 40–80% of capacity

Question 20

More on relevant range (variable costs).

Answer 20

In most business situations, a straight-line relationship does not exist for variable costs throughout the entire range of possible activity.
. Abnormally low levels of activity (often impossible to be cost efficient)
- Small-scale operations may not allow the company to obtain quantity discounts for goods bought or to use specialised labour.
. Abnormally high levels of activity (labour costs may increase sharply because of overtime pay)
- Also at high activity levels, the cost of purchasing goods may jump significantly because of supplier capacity being limited.

As a result, in the real world, the relationship between the behaviour of a variable cost and changes in the activity level is often curvilinear.

Question 21

More on relevant range (fixed costs).

Answer 21

Total fixed costs also do not have a straight-line relationship over the entire range of activity.

. Some fixed costs will not change. But it is possible for management to change other fixed costs.
. For example, in the Scene Setter the dance studio’s rent was originally variable and then became fixed at a certain amount.
. It then increased to a new fixed amount when the size of the studio increased beyond a certain point.

Question 22

What are mixed costs?

Answer 22

Mixed costs are costs that contain both a variable element and a fixed element. Sometimes called semivariable costs, mixed costs change in total but not proportionately with changes in the activity level.

The rental of a car is a good example of a mixed cost. Assume that local rental terms for a standard car, including insurance, are $50 per day plus $1.25 per kilometre. The per diem charge is a fixed cost with respect to kilometres driven, whereas the mileage charge is a variable cost.

In this case, the fixed cost element is the cost of having the service available. The variable cost element is the cost of actually using the service. Another example of a mixed cost is utility costs (electricity, telephone and so on), where there is a flat service fee plus a usage charge.

Question 23

Importance of identifying variable and fixed costs.

Answer 23

Why is it important to segregate costs into variable and fixed elements? The answer may become apparent if we look at the following business decisions.

1. If Qantas is to make a profit when it reduces all domestic fares by 30%, what reduction in costs or increase in passengers will be required? Answer: To make a profit when it cuts domestic fares by 30%, Qantas will have to increase the number of passengers or cut its variable costs for those flights. Its fixed costs will not change.
2. What happens if Kellogg’s increases its advertising expenses but cannot increase prices because of competitive pressure? Answer: Sales volume must be increased to cover three items:
   (1) the increase in advertising,
   (2) the variable cost of the increased sales volume and
   (3) the desired additional profit.

Question 24

What is cost-volume-profit analysis?

Answer 24

Cost–volume–profit (CVP) analysis is the study of the effects of changes in costs and volume on a company’s profits.

CVP analysis is important in profit planning. It also is a critical factor in such management decisions as setting selling prices, determining product mix and maximising use of production facilities.

Question 25

What are the components of a CVP Analysis?

Answer 25

. Volume or level of activity
. Unit selling price
. Variable cost per unit
. Total fixed costs
. Sales mix

Question 26

What assumptions underlie each CVP analysis?

Answer 26

1. The behaviour of both costs and revenue is linear throughout the relevant range of the activity index.
2. All costs can be classified with reasonable accuracy as either variable or fixed.
3. Changes in activity are the only factors that affect costs.
4. All units produced are sold.
5. When more than one type of product is sold, the sales mix will remain constant. That is, the percentage that each product represents of total sales will stay the same.

Sales mix complicates CVP analysis because different products will have different cost relationships (In this chapter we assume a single product -Sales mix issues are addressed in advanced accounting courses).

When these five assumptions are not valid, the results of CVP analysis may be inaccurate.

Question 27

What is a contribution margin statement?

Answer 27

Because CVP is so important for decision making, management often wants this information reported in a contribution margin statement format for internal use.

The contribution margin statement classifies costs as variable and fixed and calculates a contribution margin.

Contribution margin (CM) is the amount of revenue remaining after deducting variable costs. It is often stated both as a total amount and on a per unit basis.

Question 28

What does a contribution margin statement look like?

Answer 28

Sales (unit selling price x amount of products sold) 
(Less) Variable costs 
(=) Contribution margin 
(Less) Fixed costs 
(=) Profit

There can be two columns on the right, one for total and for per unit.
A traditional statement of profit or loss and a contribution margin statement both report the same bottom-line profit. However, a traditional statement of profit or loss does not classify costs as variable and fixed, and therefore a contribution margin would not be reported. In addition, both a total and a per unit amount are often shown on a contribution margin statement to facilitate CVP analysis.

Question 29

What is contribution margin per unit?

Answer 29

Contribution margin per unit indicates the amount of money remaining, after a product is sold, to cover fixed costs and contribute to profit.

It is calculated like this:
Unit selling price - unit variable costs = contribution margin per units

Question 30

What is contribution margin ratio?

Answer 30

Some managers prefer to use a contribution margin ratio in CVP analysis.

Contribution margin per unit / the unit selling price = contribution margin ratio

The percentage indicates the cents of each sales dollar available to apply to fixed costs and to contribute to profit.

This expression of contribution margin is very helpful in determining the effect of changes in sales on profit. By using the contribution margin ratio, managers can quickly determine increases in profit from any change in sales.

Question 31

What is the break-even analysis?

Answer 31

A key relationship in CVP analysis is the level of activity at which total revenue equals total costs (both fixed and variable).

This level of activity is called the break-even point. At this volume of sales, the company will realise no profit and will suffer no loss. The process of finding the break-even point is called break-even analysis.

The break-even point can be:
1. Calculated from a mathematical equation (don’t worry about this).
2. Calculated by using contribution margin.
3. Derived from a cost–volume–profit (CVP) graph.

The break-even point can be expressed either in sales units or sales dollars.

Question 32

Why is knowledge of the break-even point important?

Answer 32

Knowledge of the break-even point is useful to management when it decides whether to introduce new product lines, change sales prices on established products, or enter new market areas.

Question 33

Break-even analysis (contribution margin technique).

Answer 33

We know that contribution margin equals total revenue less variable costs. It follows that at the break-even point, contribution margin must equal total fixed costs.

On the basis of this relationship, we can calculate the break-even point using either the contribution margin per unit or the contribution margin ratio.

When the contribution margin per unit is used:
Fixed costs ➗ contribution margin per unit = break-even point in units

When the contribution margin ratio is used:
Fixed costs ➗ contribution margin ratio = break-even point in dollars

Question 34

Break-even analysis (graphic presentation).

Answer 34

An effective way to find the break-even point is to prepare a break-even graph. Because this graph also shows costs, volume and profits, it is referred to as a cost–volume–profit (CVP) graph.

Sales volume is recorded along the horizontal axis. This axis should extend to the maximum level of expected sales.

Both total revenue (sales) and total costs (fixed plus variable) are recorded on the vertical axis.

The CVP graph also shows both the profit and loss areas. Thus, the amount of profit or loss at each level of sales can be derived from the total sales and total cost lines.

Question 35

What are the steps for making a CVP graph?

Answer 35

1. Plot the total-revenue line, starting at the zero activity level. For every product sold, total revenue increases by according to the selling price. The revenue line is assumed to be linear throughout the full range of activity.
2. Plot the total fixed cost using a horizontal line. The fixed cost is the same at every level of activity.
3. Plot the total cost line. This starts at the fixed-cost line at zero activity. It increases by the variable cost at each level of activity. On the graph, the amount of variable cost can be derived from the difference between the total cost and fixed cost lines at each level of activity.
4. Determine the break-even point from the intersection of the total cost line and the total revenue line. The break-even point in dollars is found by drawing a horizontal line from the break-even point to the vertical axis. The break-even point in units is found by drawing a vertical line from the break-even point to the horizontal axis. At this sales level, the company will cover costs but make no profit.

Question 36

Why is a CVP graph useful?

Answer 36

A CVP graph is useful because the effects of a change in any element in the CVP analysis can be quickly seen.

For example, a 10% increase in selling price will change the location of the total revenue line.

Likewise, the effects on total costs of wage increases can be quickly observed.

Question 37

What is target profit?

Answer 37

This is when management sets a profit objective for individual product lines. It indicates the sales necessary to achieve a specified level of profit.

The sales necessary to achieve target profit can be determined from each of the approaches used to determine break-even sales.

Question 38

What is the contribution margin technique for target profit?

Answer 38

As in the case of break-even sales, the sales required to meet a target profit can be calculated in either units or dollars. The formula using the contribution margin per unit is as follows:

(Fixed costs + target profit) ➗ contribution margin per unit = required sales in units

The formula using the contribution margin ratio is as follows:

(Fixed costs + target profit) ➗ contribution margin ratio = required sales in dollars

Question 39

What is overhead allocation?

Answer 39

Overhead allocation is the process of spreading indirect costs (i.e. those overheads that cannot be traced directly to products/services) equitably over the volume of production.

Question 40

How are overhead costs usually allocated?

Answer 40

Direct costs (variable costs) + indirect costs (fixed costs) = total costs

Direct costs:
. Variable costs - costs of goods bought for resale labour (eg. Professional services)
. Directly traceable to product/service cost

Indirect costs:
. Fixed costs - Eg. Management salaries, rent, depreciation, etc.
. Allocated to product/service cost

Question 41

Overhead allocation problem.

Answer 41

Allocating overhead is rarely important for wholesale/retail businesses. In most cases in these businesses the majority of the costs incurred at the level of the individual store are direct costs, with overhead incurred in central storage and distribution facilities and in the head office where most purchasing, finance and administration takes place.

In other businesses, the overhead allocation problem is a significant issue, as most businesses produce a range of products/services for customers.

The allocation problem can lead to overheads being arbitrarily allocated across different products/services, which can lead to misleading information about product/service profitability.

Question 42

What is the most common form of overhead allocation employed?

Answer 42

The most common form of overhead allocation employed by professional services (such as accounting) firms has been to allocate overhead costs to products/services in proportion to direct labour.

Eg. A professional services firm that charges hours worked to clients would include in the hourly rate charged not only the labour cost but also an appropriate overhead burden. However, this method may not accurately reflect the resources consumed in producing the service.

That is, processes may be resource intensive in terms of space, equipment, people or working capital. Some processes may be labour intensive while others depend more on technology, such as in a bank. The cost of labour, due to specialisation and market forces, may also vary between different processes. Further, the extent to which processes consume the overheads of the businesses can be quite different.

Question 43

What are the two methods of overhead allocation?

Answer 43

. The absorption method and

. Activity-based costing.

Question 44

Explain the following overhead allocation method: absorption method.

Answer 44

A predetermined overhead rate is based on the relationship between estimated annual overhead costs and expected annual operating activity.

This relationship is expressed in terms of a common activity base. The activity may be stated in terms of direct labour hours or any other measure that will provide an equitable basis for applying overhead costs.

Using a predetermined overhead rate enables a cost to be determined immediately.

The formula for predetermined overhead rate is:
Estimated annual overhead costs ➗ expected annual operating activity = predetermined overhead rate

(The percentage at the end of this equation refers to the overhead rate or the cents of overhead per dollar of activity/sale).

Question 45

What does the use of a predetermined overhead rate do for a company?

Answer 45

The use of a predetermined overhead rate enables the company to determine the approximate total cost of each job when the job is completed for each client.

Question 46

Explain the following overhead allocation method: activity-based costing.

Answer 46

Activity-based costing (ABC) focuses on the activities performed in producing a product or service. In addition to direct costs, ABC rejects the simplistic allocation of overhead using a single activity base such as direct labour.

Instead, ABC recognises that to have accurate and meaningful cost data, more than one basis of allocating activity costs to products is needed.

In selecting the allocation basis, ABC seeks to identify the cost drivers that measure the activities performed on the product. A cost driver may be any factor or activity that has a direct cause–effect relationship with the resources consumed.

Question 47

What are some examples of activities and possible cost drivers?

Answer 47

Activity:
. Ordering goods
. Supervision
. Computer processing

Cost driver:
. Number of orders
. Number of employees
. Processing hours/number of documents

Question 48

How would an activity-based costing table be set out?

Answer 48

Activity: Cost driver: Overhead: No. of drivers: Cost per driver:
AS no. of clients 60,000 500 clients $1200 per client

AS = administrative support
Full table on page 59

Question 49

Comparing costs.

Answer 49

The different assumptions used to solve the overhead allocation problem result in varying allocations and therefore varying total costs.

The absorption method is based on average overheads of X% of direct costs and a total cost of $Y. The activity-based costing method identifies activities that consume resources (not only the consultant time, but also management, computer processing and administrative support).

Identifying cost drivers for these activities and allocating overheads on this basis leads to a total cost of $Z.

Neither method is correct or incorrect, merely based on different assumptions. However, the ABC method is generally considered to be more accurate.

Question 50

Summarise the steps in ABC.

Answer 50

1. Identify the major activities that pertain to the business.
2. Accumulate overhead costs by activities.
3. Identify the cost driver(s) that accurately measure(s) each activity.
4. Assign overhead costs for each activity using the cost driver rates.

Question 51

What are the benefits of Activity-Based Costing (ABC)?

Answer 51

A primary benefit of ABC is more accurate costing. In addition, ABC offers the following other benefits:

1. Control over overhead costs is enhanced. Many overhead costs are incurred directly by activities. Thus, managers become more aware of their responsibility to control the activities that generate the costs.
2. Better management decisions can be made. More accurate costing should contribute to setting selling prices that will achieve desired profitability levels. The cost data also should be helpful in deciding whether to discontinue or expand a product or service.

Question 52

What are the limitations of Activity-Based Costing (ABC)?

Answer 52

The principal disadvantages of ABC generally focus on two factors.

First, the expense of obtaining the cost data required by the system is relatively high.

Second, ABC requires data that are not normally generated within a company’s financial accounting system, and an accounting system that supports a business process view and enables costs of activities to be collected.