Management Accounting 1st March 2011 Cost Behaviour Management Accounting 1st March 2011

Basic Cost Revision Direct or Variable Costs are generally the materials and direct labour which go into making a Cost Object (Product or Service) Indirect or Fixed Costs are generally the Overheads which are Allocated to the Cost Object Together these make up the Total Cost of the Cost Object

Ctd Selling Price is the Total Cost plus a Contribution or Revenue from the Cost Object Revenue is often expressed as a Sales Margin or a percentage (%) of the Total Costs Plus Total Costs

Common Abbreviations Variable (Direct) Cost = VC Fixed (Indirect) Cost = FC Units of Production = U Total Costs = TC Revenue = R Sales Margin = M (Expressed as a %) Selling Price = SP Total Profit = TP

Some Relationships TC = VC + FC (Total Costs = Direct + Indirect Costs) R = (TC x M%) + TC (Revenue = Total Costs x Margin as a percentage) + Total Cost SP = TC + M (Selling Price = Total Costs + Margin)

Assumptions of Cost Behaviour We assume that Variable Costs are Linear to Units Produced, as production increases so to does Variable Cost We Assume that Fixed Costs do not change with production, so as units produced increases Fixed cost remain even

True? Sometimes this is true, but only in very simple cases Fixed and Variable Costs are usually more complex There are a number of reasons for this Economies or Dis-economies of scale Step Effects Mixed Costs

Variable Costs Most costs are variable, they change in relation to something else In our simple model the Variable Costs share a Linear Relationship with Units Produced, as units produced increase so too do Variable Costs In more complicated analysis Variable Costs change in relation to the Activity Base

Activity Base The Activity Base is whatever causes the costs to vary In the simple model the Units Produced are the Activity Base The Activity Base can be anything Common Activity Base’s can be: Batches of Production Changes to Direct Labour But there are many more, and often they are unique to the organisation

Example There is a good example of this in your Text (pg 175)

Example A good example of this is the Variable Cost of offering some Services We are an Electrical Repair Company Our Allocation base is Number of Repair Jobs Completed per day We pay our Repairman a daily wage of $10 Our Repairman completes 5 Jobs per day

Ctd Our Allocation Base is therefore not the number of Jobs completed but how many Repairmen we need to employ to service the demand We can understand this cost by plotting a Graph of $ cost and Jobs completed assuming that each Repairman completes 5 Jobs per day

Repairman Step Variable Cost

Linearity Assumptions Economics states that cost behave in a curvilinear way Accountants assume Linear Relationships (or as we have seen Step Variability) Who is right? Its the Economists

Why Curvilinear? There are economies and diseconomies of scale. For instance: Price per unit of raw material will often fall as larger numbers of units are orders Prices are subject to discounts for minimum orders As Volume increases more problems can occur in production or larger units of labour are required than in a strict linear relationship

Fixed Costs In the modern manufacturing environment there is a Trend to Fixed Costs The Manufacturing Environment has become dominated by Technology The Price of operating and maintaining highly technical equipment is very high This has meant that Overheads such as maintenance and depreciation of machinery has become the major cost, rather than Labour or Direct Materials

Committed Fixed Costs Types of Committed Fixed Costs Investment in Facilities, Machinery and Depreciation Salaries of Managers and Costs of Sales Committed Fixed Costs generally Remain relatively constant Stay stable over fairly long periods of time

Discretionary Fixed Costs Types of Discretionary Fixed Costs Advertising Research and Development Company Relations Discretionary Fixed Costs will generally Have a short term planning horizon Be relatively unique

Fixed Costs and the Relevant Range Fixed costs are subject to the same relevant range idea as Variable costs Fixed Costs tend to step in line with production Therefore we need to understand how relevant the range is to our cost assumptions

The Relevant Range

Cost Analysis So we need to ‘diagnose’ the costs involved and discover the ‘relevant range’ that applies to our production levels We can do this by plotting graphs of Dependant Variables and Independent Variables

Dependant Variables Dependant Variables are plotted on the Y axis Dependant Variables are always the cost

Independent Variables Independent Variables are plotted on the X Axis Independent Variables are the Activity Base

Identifying the Relevant Range The Relevant Range can be identified by plotting a scatter graph and applying linearity where it is seen You run a hotel, it has enough room for a maximum of 60 Guests, and you have the following cost information

Hotel Stays (People) Cost $ 10 80 15 20 25 30 35 88 40 96.8 45 106.48 50 117.128 55 128.8408 60 141.7249

Seminar Exercises

Cost Analysis 1) You Have the following information: Direct Materials $4 per unit Direct Labour $3 per unit Indirect Costs $3 per unit Total Units Produced 20 Sales Margin 25% Provide the following information Total Indirect Costs Total Costs per unit Selling Price Revenue

Answers Total Indirect Costs $60 (20 x 3) Total Cost per unit $10 (4+3+3) Selling Price =$12.50 (10 x 25% + TC) Revenue = $12.50 x 20 units = $250

Cost Behaviour Produce a Table of the costs including columns for Units, Fixed, Variable, Total Costs and Revenue

Units Variable Fixed Total Revenue 1 7 60 67 12.5 2 14 74 25 3 21 81 37.5 4 28 88 50 5 35 95 62.5 6 42 102 75 49 109 87.5 8 56 116 100 9 63 123 112.5 10 70 130 125 11 77 137 137.5 12 84 144 150 13 91 151 162.5 98 158 175 15 105 165 187.5 16 112 172 200 17 119 179 212.5 18 126 186 225 19 133 193 237.5 20 140 250

Plotting Graphs Plot a Graph to contain all of the information that you have produced

Relevant Ranges Plot a Graph for the following information and show where the relevant range is Predicted Costs Actual Costs 1 0.5 2 3 2.2 4 5 6 7 8 10 9 12.5 15.625

Review Questions What is Cost Behaviour? What is Linearity? Is Linearity true? What can cause Curvilinear Cost Behaviour? What is the Relevant Range? How can we identify the Relevant Range