Managerial, Absorption and ABC Costing _MBA

Teaching Slides in Mgmt Acc

1. Cost Behaviour

2. Objective of the Chapter: Cost Behaviour Understand the cost behaviour Distinguish between fixed, variable, semi-variable and step fixed costs Use the High and Low method and scatter graphs to analyse semi-variable costs Y = a+ bx Identify Direct and Indirect Costs Methods of determining the cost of production Discuss the differences between absorption and marginal costing Reporting the cost and determining the profit statement Prepare profit statement under both approaches and explain the differences

3. Cost and its Classification Cost: “ Different cost for different purpose ” Relates to specific objects i.e., Product, Service, Department… Anything that we need/want to know the cost of. Decision: Product/ Service: Are they profitable ? Servicing a particular client: Contract, Renegotiation ? Classification: Many ways managers can classify cost ( e.g., T-Shirt Manufacturer ) Direct v/s Indirect: Cost that CAN and CANNOT directly traced back to cost object i.e. Direct: Fabrics, Wages, Sales commission (traced directly) Indirect (Overhead): Electricity, Rent, Maintenance (Problem to direct trace) Product v/s Period: Manufacturing v/s Non- Manufacturing ( Important effect in FS ) Product: Direct materials, Direct Labor, Indirect mfg. costs i.e., Electricity, Rent, Indirect labor / Maintenance Period: Sales Salaries, General Administration cost Variable v/s Fixed (Based on how cost behave in response to activity level) Variable: Change with respect to the level of activity i.e., Direct materials, Commission, Electricity Fixed: No change with respect to the level of activity i.e., Rent, Insurance, Salary

4. Cost and its Classification: Example

5. Cost Behaviour Cost Behaviour is a concept that helps us to understand the relationship between costs and volume of production (activity) . Managers need to have an understanding of how costs change in relation to various factors in order for them to know how much to charge for their products and to decide the optimum level of production . Relationship between total costs and activity level: Based on behavior, costs are categorized as either fixed, variable, mixed/ semi variable and step cost. Fixed costs are constant regardless of activity level, variable costs change proportionately with output and mixed costs are a combination of both.

6. Cost Behaviour Essential for: Budgeting Cost control Evaluating divisional performance Resource planning- demand levels, sales mix, scarce resources, purchasing decisions etc. Pricing–cost base, cost plus, discretionary pricing etc. Predict future cost based on expected activity

7. Cost Behaviour and their types

8. Cost Behaviour and their types: Example

9. Cost Behaviour: Specific attention Fixed cost v/s Variable cost with increased in activity level:

10. Cost Behaviour: Specific attention Fixed cost with increased in activity level:

11. Cost Behaviour: Analyze semi variable cost In order to forecast the level of a Semi- Variable Cost for a given volume of production it is necessary to identify the fixed and variable elements. How? Based on past data: cost and activity level Three tools for estimating cost Scatter plot High Low method Regression Example in excel

12. Cost of Production: Absorption v/s Marginal

13. Cost of Production: Issue of fixed cost Marginal and absorption costing are two different approaches to dealing with fixed production overheads and whether or not they are included in valuing inventory. Argument: Fixed production overhead should be included in per unit calculation Fixed production overhead already exists, hence no need to include it in production. It’s a period cost. Why prepare both? Regulatory requirement (assign all cost) v/s Objective decision making

14. Marginal v/s Absorption Absorption costing applies all production costs to all units produced. Marginal costing applies only those costs to inventory that were incurred when each individual unit was produced, This results in the following differences between the two methods: Cost application . variable cost is applied to inventory under marginal costing, while fixed overhead costs are also applied under absorption costing. Profitability . The profitability of each individual sale will appear to be higher under marginal costing, while profitability will appear to be lower under absorption costing. Measurement . contribution margin (which excludes applied overhead) vs the gross margin (which includes applied overhead)

15. Marginal Costing The marginal cost of an item is its variable cost . The marginal production cost of an item is the sum of its direct materials cost, direct labor cost, direct expenses cost (if any) and variable production overhead cost. So as the volume of production and sales increases total variable costs rise proportionately. Fixed costs , in contrast are cost that remain unchanged in a time period, regardless of the volume of production and sale. Marginal production cost is the part of the cost of one unit of production service which would be avoided if that unit were not produced, or which would increase if one extra unit were produced.

16. Marginal Costing From such argument the following definition of  marginal costing  as used in management accounting is developed: Marginal costing  is the accounting system in which variable costs are charged to cost units and fixed costs of the period are written off in full against the aggregate  contribution . ( Contribution Margin is the amount contributed by sales towards fixed expenses and profit ) Note that variable costs are those which change as output changes - these are treated under  marginal costing  as costs of the product . Fixed costs, in this system, are treated as costs of the period . Marginal costing  is also the principal  costing  technique used in decision making. The key reason for this is that the marginal costing  approach allows management's attention to be focused on the changes which result from the decision under consideration.

17. Marginal Costing: Accounting

18. Absorption Costing Absorption costing is a method of cost accounting which considers the total cost incurred in producing a product or service. Full (absorption) cost = Direct costs + Share of overheads In order to find the share of overheads (i.e., overhead cost per unit ) we have to find the overhead absorption rate (OAR). There are 2 main ways in which to spread overheads across cost units - OAR (overhead absorption rate) = Budgeted overhead/ Budgeted volume of activity Cost driver rate–derived from activities that creates the overhead (ABC- activity based costing)

19. Overhead absorption rate: Proposal and Problem

20. Overhead absorption rate: Proposal and Problem What’s the problem?

21. Overhead absorption rate: Proposal and Problem What’s the problem? Same Overhead for both types. Overhead for Delux > Basic

22. Overhead absorption rate: Solution

23. Overhead absorption rate: Solution

24. Overhead absorption rate: Important Aspects << Very Important: Management choices (Pool and Bases) that affetc the calculation.

25. Absorption Costing: Accounting

26. Absorption and Marginal Costing: Example I <<Question Answer >>

27. Absorption and Marginal Costing: Example II

28. Absorption and Marginal Costing: Example II

29. Absorption v/s Marginal Costing

30. Absorption v/s Marginal Costing: Reconciliation

31. Activity Based Costing: ABC (Optional)

32. Overhead absorption rate: Traditional Method << Very Important: Management choices (Pool and Bases) that affetc the calculation.

33. Traditional Methods: Advantages Advantages of management choices that affetc the calculation: Pool and Bases

34. Traditional Methods: Issue << Assumption of management choices that affetc the calculation: Pool and Bases Problem due to automation: Use of DL as a bases ( assumption I ) poses a problem because of technology >>

35. Solution: ABC

36. Solution: ABC Change in pool and base: Focus on activity cost and use of such actvity.

37. Solution: ABC Example

38. Solution: ABC Example

39. Questions ?