1. Marek Botek, MSc, PhD Course „Enterpise Economics“ UCT, Department of Economics and Management

2.  Costs – brief repetition  Introduction to calculations  Calculation Formula  Absorbing calculations ◦ Division calculations with equivalence numbers ◦ Surcharge calculation  Summary 2

3. Situation is:  fixed costs 600 000 CZK,  variable costs 10 CZK/piece,  planning production 30 000 pieces, Costs per 1 piece is? 30 CZK/piece 3

4. Up until now we were talking about production costs as a whole. Now we are going to talk about costs in relation to individual products. The set of methods and calculation processes, whose goal is to set costs needed for cost unit, is called calculation / costing. The choice of cost unit depends on the type of production- it can be 1product, 1kwH, 1 ton of gas, 1 liter of milk, 1hour of service, etc. The calculation performed by a dealer based on real results is called final calculation. It can be also preliminary calculation, if the dealer use estimated data. The calculation can be prepared for total amount of production (total calculation) or for the unit (unit calculation). 4

5. In the previous lectures you talked about the division of costs from different aspects. For the purposes of traditional calculations we divide costs to direct, which are directly related to a specific cost unit, and to indirect, which are related to several processes and don’t have a direct relationship to a cost unit. Direct cost is for example flour consumption in the making of pies, or depreciation of a single-purpose machine. An example of an indirect cost can be the salary of a payroll clerk. 5

6. 6 Example 7.1 A pie producer sold its products (500 pies) to a dealer for 10 CZK a piece. The dealer bought 100 cellophane wraps for 1 CZK a piece, he wrapped the pies (5 at once) and sold for 60CZK per one package. When he sold everything he made the following calculation: purchase price of pies5,000 purchase price of wraps100 unit production costs10.20 selling price6,000 income per unit12 profit per unit1.80 total profit900

7. The simpliest calculation is division calculation, when we make only one type of product,the costs of cost unit will be the same for all products and will be equal to where j=1,2,…n products This simple calculation method assumes that during the production process, no supply of finished or unfinished products occurs. In the case where the production is divided into several manufacturing steps and the following manufacturing steps take over the actions of the previous steps in their existing costs or in their price, we use two-stage division calculation. 7

8.  In the first manufacturing step we make 1,000 pieces of the product. In the second manufacturing step we only work with 800 pieces of the product, which are going to be sold later. Profit margin is 20%. What is our offering price? 8 production costs of the first step15,000 production size 1,000 unit costs15 profit margin 20%3 price of the unfinished product18 production costs of the second step4,000 production size800 unit costs5 profit margin 20%1 total price of the finished product24 (18+5+1)

9. However, most of the companies don’t make only one product. The basic principle used for the allocation of indirect costs to cost units is the causality principle. It is based on the idea that every product should only bear the costs it actually induces. We use it when we try to find a specific relationship between the indirect cost and the particular cost unit (allocation base). Several requirements should be met: - it should represent the relationship of causal dependency of the indirect costs to the chosen base; - the ratio between the base and the indirect costs should be stable so the calculations can be compared in longer time periods; - the value for the allocation base should be easily and reliably discoverable; - the value should be sufficiently large so that a small mistake in the size of the allocation base does not cause a big deviation in the calculation. 9

10. In every company, the structure of costs for the calculation of the processes is different and is realized in so called individual calculation formula. But the basic should be same: 1. Direct materials 2. Direct wages 3. Other direct costs 4. Manufacturing overhead Own costs of production (items 1-4) 5. Administrative and supply overhead Own costs of performance (items 1-5) 6. Sales overhead Total own costs of performance (items 1-6) 7. Profit (loss) Price of the performance 10

11. Direct material includes all of the resources, basic material and other material, whose consumption can be detected and added to particular cost units according to the technological norms. In the direct wages item we usually exhibit the basic wages and social costs, supplementary and additional wages and bonuses. Wages of laborers maintaining the equipment and other jobs of a general character (janitors) are not included in direct wages. Manufacturing overhead includes cost items related to the management of the production process and to the operators of production, who can’t be detected directly in the cost unit. 11

12. Administrative overhead represents costs for the management and administration of the corporate character. An example can be depreciation, service and maintenance of administrative buildings. The selling (sales) overhead includes costs of storing, manipulating, and dispatching of finished products, transportation and other overhead costs related to the realization of the products, work of the services, which cannot be set to the cost unit. 12

13. The general calculation formula is not an ideal managerial tool for several reasons: - it synthetizes cost items having a different relationship to the calculated activities and are assigned to them according to different principles - it does not consider the importance of the individual cost items when dealing with different decisional problems, mainly when deciding about the production optimization - it represents a static display of the relationship between the costs and the cost unit, therefore it cannot depict the change in costs caused by the change in the size of production. 13

14. If the calculation formula includes all costs that are related to the production of that particular product, it is used for absorption calculation. - division calculation with equivalence numbers - surcharge calculation. If the indirect costs of individual products are not divided with efficient accuracy, then some products carry particular costs of other products. This phenomen is called calculating compensation. 14

15. This method is mainly used in productions, where more types of the same product are being produced; they are not homogenous but they are in a certain fixed cost relation. These types of products usually have some similarity in the cost structure, for example the same basic material is being processed, but the working time or the use of production factors differs. The individual products don’t always consume the calculated costs with the same intensity. For example distillation column. 15

16. This method is mainly used in productions, where more types of the same product are being produced; they are not homogenous but they are in a certain fixed cost relation. These types of products usually have some similarity in the cost structure, for example the same basic material is being processed, but the working time or the use of production factors differs. The individual products don’t always consume the calculated costs with the same intensity. For example distillation column. 16

17. 17

18. In practice we often get into situations where the production plan for the whole year is not known ahead of time. Products that will be added to the production plan, their quantities, and sometimes even the production process are set during the year. In these cases we use the surcharge calculation for the division of overhead costs. This method allows calculating of the costs even when we don’t know the exact size of the production of individual products. The starting point is to select an allocation base (AB) for the planned period, whose size can be determined with efficient accuracy- for example direct wages, planned working time fund, usable time fund of the production equipment, etc. 18

19. 19

20. These approaches respect the fact that not every product causes fixed costs and that not every product brings profits. These categories are not bounded to individual products in non-absorption calculations, but they are bounded to a certain time period.  Calculation of variable costs  Gros margin calculation 20

21. In this type of calculations, the only thing we are interested in are variable costs. The amount with which the j th product contributes to the covering of the fixed costs and profit is called contribution margin. We don’t determine the profit of one product, but the profit produced by the whole production assortment of the company. 21 ABCTotal Revenues (R)1 5002 0001 0004 500 Variable costs (C V )250450200900 Contribution margin1 2501 5508003 600 Fixed costs (C F ) 3 100 Profit (P) 500

22. 22 It is often difficult to find out the variable costs because of the character of the internal accounting, and therefore it seems easier to find out the direct costs. The advantages of non-absorption calculations are especially obvious in situations when the share of fixed costs in the total costs crosses a certain line and classical calculation methods are used for the division of indirect costs become insufficient, because a significant part of the costs is only estimated.

23. Dynamic calculation is done by using alternative calculations for different quantities produced. The limitation of dynamic calculations is in both the ability to find out the costs in a necessary breakdown and in the expression of production Q in situations, when more products are produced. 23

24. Traditional calculation methods are not able to consider changes in the structure of costs, which are happening lately. Therefore, we are now going to talk about calculation approaches that are trying to eliminate these disadvantages.  Cost calculation based on elementary processes  Target costing 24

25. Calculation methods known as activity based costing assigns overhead costs to individual activities rather than to cost unit. Costs of activities are assigned to business processes (products or services), which require that particular activity. The purpose of this method is to express the relationship between the costs and the cause of these costs in the best possible way. It is important to first identify relevant activities (marketing, maintenance, administration, etc.) and divide them into cost centers. In the next phase, it is important to set the main units of their costs and to define the relationships between activities and costs. Then it is important to set the cost bases, which characterize the individual activities from the aspect of their relationship to the cost center. 25

26. It forces the company to analyze the linkage between individual business units and it turns the attention to auxiliary and service processes and activities. The method requires a lot of time to prepare and process the input information and it requires a lot of experience about the operation of a business. The difference between the traditional calculation methods and the ABC method is shown in the following scheme: 26

27. In the modern day, when the business process management is conditional to market and customer orientation, it is suitable to use costs allowed by the market, rather than the company expenses. It started in the 60’s in Japan. The method is based in the price of a product, which the market is willing to accept. From this value we then subtract the target (calculated) profit and we get the value of allowable costs, which can be related to the production of that certain product. 27

28. This type of production is especially used in the chemical industry. All costs that are created by the joint production are common to all joint products and they can’t be allocated to a cost unit.  Calculation using the subtraction method  Calculation using index numbers 28

29. 29

30. The important question, whose solution significantly influences the calculation’s result, is the valuation of the secondary products. This method is popular for its simplicity, but there are some problem related to its use. The first one is already mentioned complication with the valuation of secondary products. The second one is the fact that the valuation of secondary products in the planning period is considered to be constant and any change in costs is illogically only obvious in the costs of the primary products. 30

31. This type of calculation is used when joint products can’t be divided to primary and secondary products. A typical example of this kind of joint production is the production of gasoline using oil distillation. With this calculation method we need to set an apposite characteristic and by using a known calculation method we divide costs among the joint products using the index numbers. The principle is very similar to division calculation with equvalence number. 31