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Overview Overview Cost classification

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Overview Overview Cost classification Powered By Docstoc
					                                                                                                             2/11/2010




                                                                     Overview
                                               • MAF very broad
                                                  – Lots of topics but few core topics
                                                  – Need to understand – very NB
                                                       • Can’t brute force MAF
                                                  – Theory forms a big part
                                                       • Ability to think in light of what you understand
             TOE408W                           • No new knowledge
                                               • Questions non-specific
       Applied Management                         – Practice practice practice
            Accounting                            – Expect to have to think about what is required
                                                  – Expect to be thrown
                                               • Lectures
             The nature of costs                  –   Overview of core knowledge
                                                  –   Guide you through work
                                                  –   Simple level
            Tutorial letter 102/2010:             –   Lots of presumed knowledge
                   Part 1 of 2                 • Workshops
                                                  – Use to practice and engage lecturers
                                               • Textbook
                                                  – Either Drury or Vigario
                                           1
                                                  – Don’t get lost in the detail                              2




               Overview                                    Cost classification
• Topics for today                             • Overview
                                                  – Classified according to response to change
  – Cost classifications                            in activity
  – Cost estimations                                   • Not name – often name misleads
                                                  – Relevant range NB
  – Cost Systems                                       • Costs always variable at some point
  – Absorption costing                                     – Decisions always need a time frame
                                                       • Cost functions / relationships change
  – Variable costing                                       – Quality of materials available etc
                                                           – Design tweaks, permanent learning curves
• Next lecture’s related topics                        • Economies / Inefficiencies of scale
  – CVP – variable costing                        – Understanding costs very important
                                                       • Creating models / expectations
  – Cost allocation – ABC and absorption               • Projecting cash flows
    costing                                            • Making decisions
                                                  – Broad categories
                                                       • Categories help to simplify understanding
                                                           – Risk of oversimplification
                                                       • Cost vs benefit
                                                           – Is it worth paying to minimise the risk of incorrect
                                                             information
                                           3                                                                  4




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              Cost classification                                                 Cost classification
• Cost object                                                           • Direct costs (Prime costs)
    – Anything for which cost data is desired                              – Costs that can be easily associated with a
         • vague                                                             cost object – eg product
    – Level at which decision / analysis will be                           – Always variable
      made                                                                 – Always production / manufacturing if cost
                                                                             object is product
    – Used to understand scope of costs
         •   Product sold (car)                                         • Indirect costs
         •   Process (the car painting process)                            – Costs that cannot be easily associated with
         •   Activity (sheet metal pressing)                                 a cost object – e.g. product
         •   Department (the production dept)                              – Can be variable, fixed or mixed
         •   Service (support helpdesk)                                       • e.g. Electricity to run factory (variable, mixed)
                                                                              • e.g. Rent to lease factory (fixed)
         •   Customer
                                                                              • e.g. Maintenance of machinery (mixed)
    – 90% Cost object is product
                                                                           – Can be production / manufacturing costs or
    – ABC uses multiple cost objects                                         selling, admin and general costs
                                                                              • Selling, admin and general are always period
                                                                 5                                                           6
                                                                                costs – never linked to products




              Cost classification                                                 Cost classification
• Fixed cost                                                            • Semi – fixed
    – Constant cost irrespective of changes in                             – Costs increase with increased production
      activity within relevant range                                         but only at intervals
    – Relevant range – maximum capacity                                    – Step costs or batch costs
    – E.g. Lease expense - Bottling plant                                  – Fixed costs when seen outside relevant
         • Capacity is ltd (100 000 litres p.m.)                             range are actually semi - fixed
         • Cost is fixed until capacity breached                           – E.g. Machine setup costs – loading
         • Lease second plant                                                bottles
                             Fixed Cost
                                                                              • R2000 per setup at each 1 000 bottles
                     200
                                                                              • Between intervals costs are constant
                     150
              Cost




                     100
                                                     Cost
                     50

                      0
                              Activity →

          Relevant range                                         7                                                              8
Note: the steps should not have a slope (too time consuming on excel)




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                 Cost classification                                             Cost classification
• Semi – fixed                                                          • Variable
                                                                          – Increasing cost with changes in activity
                            Semi Fixed Cost
               200                                                        – Theoretically perfectly linear
               150
                                                                             • Cant buy too much of anything without
                                                                               effecting price
        Cost




               100
                                                            Cost
                                                                          – Relevant range
                50
                                                                             • Plays a small role, but not as NB as fixed
                 0
                               Activity →                                      costs
                                                                             • Efficiencies / inefficiencies of scale
                                                                                 – Can be considered semi – variable costs
Relevant range                                                            – E.g. Raw materials – plastic for bottles
                                                                             • R2 per bottle for 50 or 10000
Note: the steps should not have a slope (too time consuming on excel)
                                                                          – Labour – fixed or variable
                                                                             • Relative to the decision and the time
                                                                               horizon
                                                                   9                                                         10




                 Cost classification                                             Cost classification
• Variable                                                              • Semi – variable
                                                                          – Two types
                             Variable Cost
                                                                          – Efficiencies of scale
                       10
                                                                             • Total costs that increase at a decreasing rate
                                                                             • Decreasing incremental costs
                Cost




                        5
                                                     Cost                    • Learning curve costs
                                                                             • Marginal or incremental cost always less
                        0                                                      than last unit
                               Activity →
                                                                             • E.g. Bulk buying raw materials
                                                                          – or inefficiencies of scale
                                                                             • Costs that increase at an increasing rate
                                                                             • Increasing incremental costs
                                                                             • Supply constrained costs
                                                                                 – The more you need the more you must pay
                                                                             • E.g. Wastage or buying pressure
                                                                          – Often confused with mixed costs
                                                                             • Literature is ambiguous
                                                                   11                                                        12




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            Cost classification                                Cost classification
• Semi - variable                                      • Mixed
                   Efficiencies                          – These costs include a fixed and a variable
           10                                              portion.
                                    Actual                  • Differ to semi-variable costs
    Cost




           5                        Cost                         – constant underlying fixed component
                                    Perfectly                    – Not increasing or decreasing rate per unit
                                    variable
           0                                                • Split into fixed and variable portion
                 Activity →
                                                            • E.g. Shopping centre rentals
                                                                 – Cost is made up of minimum rental and
                  Inefficiencies                                   percentage of sales
           10                                                    – R200 per m2 plus 2% revenue
                                                                 – Need to split in order to use info to make
                                    Actual                         decisions
    Cost




           5                        Cost
                                                                 – Use High – Low to split - later
                                    Perfectly
                                                                 – Very Very NB!!
                                    variable
           0
                 Activity →


                                                  13                                                            14




            Cost classification                                Cost classification
• Mixed                                                • Summary
                                                         – Direct costs (all variable)
                  Mixed Costs
                                                            • Direct labour
           10
                                                            • Direct material
                                   Fixed                    • Direct production overheads
    Cost




           5                       component
                                   Variable
                                                         – Indirect product costs
                                   component                • Variable production overheads
           0
                 Activity →                                      – Allocated / absorbed or expensed
                                                                     » Plant electricity
      • Logically you can see on the graph the              • Fixed production overheads
        natural split                                            – Allocated / absorbed or expensed
      • In essence these are two costs with the                      » Machinery leasing
        same name                                                    » Production salaries
                                                         – Indirect selling, general and admin costs
                                                            • Variable SG & A costs
                                                            • Fixed SG & A costs
                                                  15
                                                            • Never allocated / absorbed always expensed
                                                                                                     16




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              Cost estimation                                                Cost estimation
• Determining how costs will change with                          • Methods
  changes in output or other activity                               – Engineering methods
  – i.e. The cost function – mathematical
                                                                       • Engineers analyse the technical relationship
    relationship
                                                                         between inputs and outputs
  – NB principle in man acc as many tools
                                                                       • Eg. Chemical production – Haber process
    depend on this process
      •   Scenario and sensitivity analysis                            • N2 + 3H2 = 2NH3
      •   Budgeting                                                    • Known chemical relationship.
      •   Standard costing                                             • Known price of inputs therefore cost
      •   Bidding and decision making                                    function known
• Objectives                                                        – Inspection of accounts
  – Identify and describe different methods                            • Basic observation
  – Calculate, understand and interpret                                • Accountant and manager decide
      • Scatter graph                                                      – Logical guestimate of the function
      • Hi – Lo                                                            – Based on cost totals in TB
      • Learning curves
  – Understand cost function
      • multiple regression                                  17                                                           18




              Cost estimation                                                Cost estimation
• Methods                                                         • Methods
  – Graphical / Scattergraph method                                 – High – Low method
      • Plot historic data points on chart                             • Introduced under mixed costs
            – i.e. Different observations of cost and activity         • Very NB – always found somewhere
            – More observations is better
                                                                       • Basic if identified
      • Fit a straightline                                                 – Look for two activity levels and two costs
            – Visual approximation “guess at best fit”
                                                                       • If costs are constant at each activity level
            – Determine the linear cost function of the line
                                                                               » Fixed cost
                » Y = mx + c or Y = a + bx
                                                                       • If costs change at each activity level
      • Unlikely to be asked as very subjective...
                                                                           – Divide cost by activity at each level
          500                                                              – If same number
                        Cost     Linear (Cost)                                  » Variable cost
          400
                                                                           – If different number
   Cost   300
                                                                                » Mixed cost
          200
                                                                                » Use high – low and split
          100
                                                                       • Costs are usually either fixed, mixed or
             0
                                                                         variable
                 0   Output →       5                   10   19            – Fixed costs do increase over periods         20




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              Cost estimation                                                     Regression
• Methods                                                          • Overview
  – High – Low method (cont...)                                      – Methodology the same as scattergraph
     • High – Low calculation                                        – No visual approximation – Maths
          –   Based on changes between two observations
          –   Usually the highest and the lowest activity level
                                                                     – ‘Least squares method’
          –   (∆ in cost)/(∆ in activity) = VC per activity             • Minimise the total difference between the
          –   Total cost – (VC x activity) = Fixed cost                   line (function) and the dots (observations)
          –   Classify, interpret, use accordingly                      • Assumes the history represents the future
     • Lecture example                                                  • ‘squares’ the difference is squared before
                                                                          being totalled and minimise
                                                                           – Square a negative = positive
                                                                           – Gives equal weight to differences above the line
                                                                             (positive) and below the line (negative)

                                                                   • Simple regression
                                                                     – One cost driver (independent variable)
                                                                     – i.e. Unit cost = R4 x (no of units)
                                                              21                                                         22




                      Regression                                             Learning curves
                      Simple regression
                                                                   • Overview
                           Cost          Linear (Cost)
          500                                                        – Non linear function
          400          y = 31.851x + 87.506                             • Standardised function
   Cost
          300                                                           • Not necessarily reality
          200                                                           • Easy way of approximating reality if costs
                                                                          behave this way.
          100
                                                                           – Labour become familiar with tasks
              0                                                            – Processes are streamlined over time
                  0                  5                   10
                       Output →                                      – Learning curve rate
                                                                        • i.e. 80%
• Multiple regression
                                                                        • Every time production doubles average costs
  – Many cost drivers                                                     are 80% of what the were.
  – i.e. Unit cost = R4 x (no of units) + R2 x                          • An average saving of 20%
    (labour hours) + R5 x (machine hours)


                                                              23                                                         24




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            Learning curves                                                      Learning curves
                     Average time per unit
         1200                                                        • 3 Types of questions
         1000
          800                                                             • What is the average time/unit to produce x
          600                                    Average                    units
          400                                    time                     • What is the total time/unit to produce x
          200
            0                                                               units
                 1    4       7       10 13 16                            • What is the incremental time to produce the
                                                                            last x units
                          Total time per unit                        • Formula
         20000
                                                                       – See formula sheet / illustrative example
         15000
         10000                                    Total Time
          5000                                    No learning

            0
                 1        4       7   10 13 16




                                                                25                                                     26




            Costing systems                                                      Costing systems
• What is a costing system                                           • Understand history
  – Accounting system to monitor costs                                 – Information often limited to
  – Methodology                                                           •   Actual materials used
  – Not economic reality                                                  •   Total costs
     • All systems approximate or estimate reality                        •   Labour hours
                                                                          •   Machine hours
  – Cost vs benefit
     •      info =                cost (ABC costing)
                                                                       – No computers and computer models
     •      info =                cost (VC and ABS costing)               • No real time costing
                                                                               – Therefore use estimates / standards
                                                                          • No accurate forecasting
                                                                       – Costs recorded at period end
                                                                          • Problem with timely decision making
                                                                          • Budgets and standards necessary
                                                                       – Modern computer cost systems
                                                                          • track exact costs and model cost functions
                                                                27          very accurately.                         28




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     Variable vs Absorption                                         Variable vs Absorption
             costing                                                        costing
• Absorption (full costing)                                    • Variable (Marginal or Direct)
                                                                     • Only direct product costs are allocated
     • All production costs allocated to inventory                   • Indirect production costs expensed as period
        –   Direct labour                                              costs
        –   Direct material                                          • Selling, general and admin costs are considered
        –   Direct manufacturing overhead                              period costs.
                                                                     • Better suited
        –   Indirect manufacturing overhead (allocated)
                                                                         – Planning, control and decision making
     • Selling, general and admin costs are                                   » Highlights costs which vary in the short term
                                                                                and are therefore manageable
       considered period costs.
                                                                                   • Relevant costing decision making
     • Allows for matching of product expenses                                » Clearly shows how profits will change with
       with product income.                                                     volume
                                                                                   • Cost volume profit analysis (next lecture)
        – Through expenses staying in inventory                               » Profits are not influenced by inventory levels
     • Logic – all production costs even if hard to                                • Less manipulation
                                                                         – In the long run businesses must cover fixed costs
       allocate should still form part of the cost of
                                                                              » But decisions are often made case by case
       the product                                                            » E.g. Airlines seats, stadium seats, any
                                                                                unutilised capacity.
  – Problems                                                             – Variable cost lecture example 1 and 2
        – Bad signals for product pricing                            • Problems
        – Decisions to discontinue etc                                   – Understates true cost of production
        – Inventory levels effect profit                                 – Ongoing variable cost decisions can lead to losses
                                                          29                                                                     30




     Variable vs Absorption                                         Variable vs Absorption
             costing                                                        costing
• Financial reporting purposes                                 • Types
                                                                  – Fully integrated
  – IAS 2 inventories                                                • Overhead costs are allocated based on a
     • Costs to include                                                predetermined overhead rate.
        – Direct costs (labour, raw materials)                       • Results in over or under absorption (variance)
                                                                         – Expensed / recovered as a period cost at period end
        – Systematic allocation of production overheads                  – Normally separate line adjusting COS
          (variable and non variable)
                                                                  – Closing stock valued at actual absorption cost
     • Normal capacity                                               • Overhead costs are allocated only at year end based
        – Average expected production over a number of                 on actual costs.
          periods                                                    • Process driven by the valuation of closing stock.
        – Includes planned maintenance                               • No over or under absorption (variance) as actual cost
        – Actual can be used if similar to normal                      has been used.
        – Actual is used if exceeds normal                           • Closing inventory is valued based on this rate
        – Not maximum                                             – Don’t worry about complexity
                                                                     • Principle is as follows
     • Result is absorption costing                                      –   Determine costs to be absorbed
        – An accumulation and allocation of costs incurred               –   Determine method of absorbing (units etc)
     • Unallocated costs                                                 –   Determine normal capacity if choice
                                                                         –   Calculate allocation rate per unit
        – i.e. Under absorbed costs                                      –   Determine full cost per unit
        – expensed as period costs                                       –   Determine closing stock
                                                          31                                                                     32
                                                                         –   COS = o/s + all prod expenses - c/s




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    Variable vs Absorption
            costing

• Reconciling Absorption profit to
  Variable profit
  – Only difference is the inventory effect
  – Fixed overheads in inventory
     • opening inventory
        – decreases absorption profit relative to variable
          profit
     • closing inventory
        – Increases absorption profit relative to variable
          profit
     • Rand amount is the fixed overhead
       absorption rate per unit.
  – Always use the change in inventory units
    x the overhead absorption rate to
    reconcile.
• lecture example 3
                                                        33




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