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AMA - Dev in Business Env > Decision Making - CVP - Chapter 2 > Flashcards

Decision Making - CVP - Chapter 2 Flashcards

1
Q

Concepts of Opportunity Costs & Relevant Costs

A

Opportunity cost
- Measure of benefit == of opportunity foregone == when various alternatives are considered
- Cost of sacrifice by alternative action
(funds in business vs invest in bank)

Relevant cost

  • Expected future cost which differ for alternative course
  • not necessary all VC relevant and all FC irrelevant
  • FC/VC that differ for alternative are relevant costs
  • attention is drawn to cost elements relevant for decisio
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2
Q

What is meant by incremental revenue

A
  • Additional revenue
  • arising from production OR sale
  • of group of additional units
  • incremental cost and incremental rev used for diff analy
  • Incremental cost is - ADDED cost due to change in
    • level of activity
    • nature of activity
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3
Q

Distinguish between marginal cost and differential cost

A

Marginal cost

  • inc/dec in TOTAL cost with small change in output
  • Variable cost = marginal cost

Differential cost

  • Change (inc/dec) in TOTAL cost (var + fix) due to
    • change in level of activity
    • change in technology
    • change in production process/method
  • Cost of one unit of product/service that would be avoided if the unit is not produced / service not provided

Main point of distinguishment

  • change in FC when production volum inc/dec by a unit
  • in Diff cost var + fix cost (both) change due to change in level of activity
  • in marg cost - only var cost change due to change in level of activity
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4
Q

Applications of Incremental costs techniques in making managerial decisions

A

Incremental cost technique :

  • Technique used in preparation of adhoc info
  • In this only cost & income differences between ALTERNATIVE courses of action are considered

Prerequisites for making decision using ICT

  • compare incremental cost with incremental rev
  • If incr Rev > incr Cost - ok and decision favour proposal

Application of ICT

  • Introduction of new product
  • Discontinuing product / segment
  • To process further or not
  • Accept addl order from special cust at lower price
  • Opening new territory / branch
  • Optimize investment plan
  • Make / Buy decision
  • Submit tender
  • Lease / Buy
  • Equipment replacement
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5
Q

Sunk cost is irrelevant in decision making but irrelevant cost are not sunk costs

A

Sunk cost

  • cost created by decision in the past
  • Cannot be changed by decision in future
  • Eg - WDV of assets previously purchased = SC
  • not relevant for Decision Making - since they r PAST cos

All irrelevant cost sunk cost
eg :
- compare 2 alternative methods of production
- result = identical material cost for both alternatives
- so both alternatives same material cost
- But Direct Material cost is FUTURE cost to be incurred
- it is still irrelevant BUT NOT SUNK COST

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6
Q

Formulas

A

contribution margin ration
= Contribution / Sales
= Contrbution per unit / SP per unit
= Change in Contribution / Change in Sales

BEP
= Point where no P/L
At BEP = contribution = Fixed Cost
BE Sales = FC / PV Ratio

Margin of Safety
= Sales - BEP
= Contribution / PV Ratio - FC / PV Ratio
= Profit / PV Ratio

Profit
= Sales x PV Ratio - Fixed Cost
= MoS x PV Ratio

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7
Q

Concept of Relevance of cost with examples

A

Relevant cost

  • cost pertinent to decision
  • cost influenced by decision
  • cost not affected by decision are not relevant

Examples Relevant

  • All variable cost = relevant cost
  • Fixed cost that vary with decision = relevant cost
  • Incremental cost = relevant cost

Examples Non Relevant

  • All Fixed cost - Generally not relevant
  • VC that DO NOT vary with decision are not relevant
  • Book value of asset
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8
Q

Commited or Discretionary Fixed cost
Annual inc Sal/Wag of admin staff 5 % as per agreemtn

New Advt for existing product recommended by mktg
dept for achieving sales qty budgeted at beginning of yr

Rent paid for factory premises for past 6 months and rents payable for next six months. Production is going on in factory

Research cost on product that has reached maturity stage in life cycle and research cost needed to introduce cheaper substitute in market for facing competition.

Legal consultancy fees payable for patent rights on a new product patenting rights have been applied for

A 
committed
discretionary
committed
discretionary - research cost for substitutes
committed
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9
Q

Limitations of using marginal costing technique

A

Marginal costing Definition :\

  • It is the ascertainment of Marginal cost
  • It is the effect on prft of changes in volume / output type
  • By Differentiating Fixed & Variable cost

Limitations :
- Difficult to classify exactly into fixed and variable
- contribution is not guide unless linked to key factor
- Sales staff may mistake MC = TC hence low sales price
- OH of fixed nature cannot be excluded
- Assumption regarding cost behavior not realistic
(eg : FC remain static throughout )

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10
Q

Briefly discuss on curvilinear CVP analysis

A

In CVP analysis the general assumption is that
- Total sales line & Total VC line have linear relationship
- Actually not linear due to 2 reasons
1) After reaching saturation point sale hav downwrd trend
2) Avg Unit VC declines initially
meaning
- Since output inc - bulk discount - matl & Div of labor
- More higher level outpu - bottleneck / breakdown
so VC tend to increase

so contribution will not increase in linear propotion
so total cost line will not be straight but curvilinear

RESULT = 2 BREAKEVEN POINTS

OPTIMUM PROFIT - earned where distance between sales and total cost is greatest

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11
Q

use of absorption costing method for valuation of finished goods inventory provides incentive for over production

A

With absorption costing
- production fixed oh are charged to products
- they are included in product cost
Net effect
- charge to PnL is reduced if Closing stock > Opening stk
- so inflated profit

So if stock levels fluctuate so absorption costing distort profit

In Marginal cost FC are charged off to PNL and do not distort profit

Impact of absorption costing

  1. If Sales = Production
    MC profit & Absorption costing profit same
  2. If Production > Sales
    Absorption costing profit > MC Profit
  3. If Sales > Production
    Absorption costing profit
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12
Q

Angle of incidence and significance to management

A
  • Angle between total cost line & total sales line
  • if angle large - firm making profits at high rate/vice vers
  • High AoI and High MoS - sound business condition
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13
Q

Discretionary cost concept with examples

A

Discretionary cost can be explained with its features

  1. Arise from Periodic decisions regarding max outlay to incurred
  2. They are not tied to clear cause / effect between input and output

Examples

  • Advertising
  • Public relations
  • Executive training
  • Teaching
  • Research
  • Healthcare
  • Mgt consulting services

Main feature -
- managers are not confident that correct amount are being spent

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14
Q

How control exercised over discretionary cost

A
  • Points/Parameters may be established
  • These points need to be devised individually
  • For R&D function to control discretionary cost - data should be there to submit report to management
  • For Advt/Sales promotion - can be controlled by pre-setting targets
  • Employee benefits - by meeting employees and explaining FC will be by company and VC by employee
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15
Q

use of opportunity cost for

  • decision making
  • cost control
A

Decsion making

  • OC apply to use of scarce resources
  • if no scarce resources - no sacrifice from use of resoruc
  • if a certain course of action requires use of scare resource then must include lost profit foregone by using scarce resources
  • if resource no alternative use - only additional cashflow from course of action included in decision making as relevant cost

Cost control
- Conentional variance analysis will report adverse usage variance / adverse sales volume variance
- but Failure to achieve budgeted optimum output may be due to inefficient use of scarce resources
- The FOREGONE contribution should be charged to manager responsible for controlling scares resoruces
and not sales manager
- failure to achieve bud sales is due to failure to use scarce resources properly
- so if resource is scarce USAGE variance should reflect ACQUISITION cost + bud Contribution per unit of scarce resource
- If LOST sales are made good later, Opp cost consists of lost interest arsing from delay in receiving the net cashflows and NOT foregone contribution

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16
Q

Important factors to be considered in marginal costing decisions

A
  • Whether product makes contribution
  • If alternative selected - Addl fixed cost if any
  • Continutity of demand after expression and impact on Selling Price
  • Non cost factors - eg need to keep labour force intact , government attitude etc
17
Q

Cost is not the only criteria for deciding in favor of shut down

A

Non Cost factors

  • Interest of workers if workers are discharged. Difficult to get skilled workers later
  • during competition may be difficult to re-establish market of the product
  • plant may become obsolete/depreciate faster or get rusted. so heavy capex on reopening
18
Q

How CVP analysis can help managers cope with uncertainty

A

Sensitivity analysis focus on :
- how results will change if orgininal estimates change
- how results will change if underlying assumption chang
CVP analysis give answer to manager for foll question
- what will be profit if sales mix change from original pred
- what will be profit if FC inc by 10% and VC dec by 5%

Spreadsheet/models help managers decide
thus can study various combinations of price/ produc mix
etc and react quickly and not wait for formal reports from accountants

19
Q

State the non cost factors to be considered in make/buy decisions

A
  1. use of RELEASED CAPACITY as a result of buying
  2. Source of supply should be reliable and meet uninterrupted supply
  3. Assurance of QUALITY
  4. Resonably certain to meet DELIVERY DATES
  5. Discourage if Tech know how secretive (Rentokil)
  6. Buying out should not create INDUSTRIAL RELATIONS problem due to workforce layoff
  7. Should not affect relationship with suppliers
  8. Ensure more than one supplier to reduce risk
  9. If no Tech expert internally better outside
20
Q

Factors involved in decision for expansion of capcity

A
  • Additional OH involved to be considered
  • Possible decrease in SP due to Inc production capacity
  • Whether enough demand to absorb production
21
Q

Roles of cost in product mix decisions

A
  • Normally all cost in cost acct is used for Decision makin
  • Cost which plays major role in product mix decision is
    RELEVENT COST
  • Cost to be relevant should meet following criteria
    • The cost should be expected as future costs
    • The cost differs among alternative course of action
      Decision about product mix is taken should be done keeping end result as profit max in mind
      Variable cost are RELEVANT in product mix so CONTRIBUTION plays major role in decision making

Other factors to be considered :

  • available production capacity
  • Limiting factor
  • Contribution per limiting factor
  • Market demand for products
  • Opportunity costs
22
Q

State relative economics of of make vs buy decision in management control

A

Generally to make a decision on make vs buy comparison is made between
suppliers price and the marginal cost of making + opp cost
Since M Vs B is strategic short/long term thinking on cost aspects to be done

When will a company buy instead of making

  • cost less to buy than manufacture
  • Return on investment for manufacture is not good
  • No skilled manpower
  • If internally manufacture - then labour problem
  • No Managerial manpower to take charge of addl labour
  • if seasonal demand and so risk of inventories
  • If Transport and infra availabled
  • If making process is confidential/patented
  • Risk of tech obsolecesnse for component
23
Q

Use of Absorption costing in decision making process leads to anamolies

A
  • In absorption costing FOH are assigned to products using OH absorption rates on budgeted output
  • so profit will decline if sales increases
  • if stock fluctuate significantly - profits distorted since stok fluctuatin will affect FOH allocated
  • If profits taken monthly quarterly then SEASONAL
    fluctuation will cause serious changes in profits
  • Internal reports are generated for managerial performance ..so managers may adjust inventory level to influence profits
  • When sales less stock increases - part of FOH in value of closing stock is reduced from FC allocated to production
  • so if sales reduced inventory will increase and absorption costing will show higher profit
  • if sales increased compared to production inventory will be reduced and absorption costing will reduce profits
24
Q

Major areas of decision making in which differential costing is used

A

DC used for all short medium long term Decision making
- when 2 level of activities are considered
- while choosing between competing alternatives
Eg ;
- Capex decision
- Make/Buy decisions
- Production planning
- Sales mix decision
- Production decision
- Change in level or nature of activity

AMA - Dev in Business Env (5 decks)

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