Chapter 2: Cost And Costing Flashcards
(52 cards)
To manage any size business, what just you understand?
How costs respond to changes in sales volume and the effect of costs and revenue on profits.
What is a prerequisite to understanding cost-volume-profit (CVP) relationships?
Knowledge of how costs behave.
Management cost concepts.
Management needs information. One very important type of information is related to costs. Eg. Questions such as the following should be asked:
- What costs are involved in the sale of products and services?
- If sales volume is decreased, will costs decrease?
- How can costs best be controlled?
To answer the prior questions, what does management need?
Reliable and relevant cost information.
What is a cost?
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.
What are the three classifications of costs that we can identify?
. Direct and indirect costs; labour, material and overhead
. Product and period costs
. Cost behaviour, that is, fixed and variable costs
What are labour and material costs?
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.
What are direct costs?
They are losses which are traceable to a particular product or service.
What are indirect costs?
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.
What are examples of indirect costs?
. The rent of an office or shop premises . Managerial salaries . Advertising . Utilities . Depreciation on equipment
In manufacturing business, why is the distinction between direct and indirect costs more complex?
Because raw materials are converted into finished goods.
What are product costs?
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.
What are period costs?
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.
What is cost behaviour analysis?
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.
How is the starting point in cost behaviour analysis measured?
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.
What the activity index identify?
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.
What are variable costs?
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.
What are fixed costs?
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.
What is relevant range?
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
More on relevant range (variable costs).
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.
More on relevant range (fixed costs).
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.
What are mixed costs?
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.
Importance of identifying variable and fixed costs.
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.
- 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.
- 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.
What is cost-volume-profit analysis?
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.
