Chapter 8: Relevant costs for decision making
• What is meant by cost?, Relevant costs, sunk costs and committed costs (pp.291-298)
Chapter 9: Cost-Volume-Profit Analysis
• Cost behavior, fixed cost, variable cost, semi-fixed cost, finding the break-even point (pp. 310-320)

Accounting chapter 8

Relevant costs for decision making

What is meant by “cost”?

Cost: represent the amount of resources, usually measured on monetary terms, sacrificed to achieve a particular business objective. Measuring cost is straightforward process, it is the amount paid for the item of goods being supplied or service being provided. Cost can be classified into two categories:-

1-Relevant cost: A cost that is relevant to a particular decision. Such as opportunity cost and outlay cost must satisfy the following criteria:

-It must relate to the objectives of the business, and must have an effect on the wealth of the business.

-It must be future cost

-It must vary with the decision

  • Opportunity cost: Do not involve any out-of-packet expenditure; hence they are rarely taken into account in the routine accounting process. However, they are normally calculated where they are relevant to a particular management decision. It can be defined as the value in monetary terms of being deprived of the next best opportunity in order to pursue the particular objective.
  • Outlay cost: Is the amount of money that will have to be spent to achieve that objective.

2-Irrelevant cost: Any other costs that do not meet the criteria’s of the relevant costs would be irrelevant. It is a cost that is not relevant to a particular decision.

  • Historic cost (past costs):The cost of retaining the item is not the same as the purchase price, its only academic interest and it can’t use to make a decision, and can never be relevant to future decision, it’s an irrelevant cost. It used in preparing financial statement such as the statement of financial position, and the income statement. It does involve out-of-packet expenditure and are recorded.
  • Sunk cost: Which is simply another way of referring to past cost (historic costs), so the terms sunk cost and past cost can be used interchangeably.
  • Committed cost: Arises where an irrevocable(نهائي) decision has been made to incur the cost, because for example, business has entered into binding contract. A committed cost can never be a relevant cost for decision-making purposes, to be relevant a cost must be capable of varying according to the decision made. If the business is committed by a legally binding contract to a cost, that cost cannot vary with the decision.
  • The past cost are irrelative costs but that does not mean that what happened in the past is irrelevant, the fact that the business has an asset which could be deployed in the future is relevant but how much it cost to acquire this asset is irrelevant, Another reason is that the past experience may provide us with a valuable guide in making future decision.
  • Go back Figure 8.1 and activities 8.2/8.3/8.4/8.5 / 8.6 pp 305-306.

Accounting chapter 9

Cost-volume-profit analysis

Cost Behavior

  • Costs may be classified according to whether they:

-Remain constant (fixed) when changes occur to the volume of activity.

-Vary according to volume of activity.

Fixed cost

  • They are costs that stay the same when changes occur to the volume of activity. Like rent cost.
  • They are likely to be affected by inflation.
  • Fixed cost elements are always time based, they vary with the length of time concerned.
  • Stepped fixed costs; is the increase in fixed costs that occurs in specific levels of output. figure 9.2 p322

Variable cost

  • They are costs that vary according to the volume of activity. Like raw materials costs.
  • Figure 9.3 p323. At zero volume of activity, the variable cost is zero it then increases in straight line as activity increases. This straight line implies that this type of cost will be the same per unit of activity.

Semi-fixed (semi-variable) cost

  • They costs that have an element of both fixed and variable costs like electricity cost.

Analyzing semi-fixed (semi- variable) costs

  • It is a technique used to determine the variable rate by taking the difference in the highest and lowest total cost figures. Divided by, the difference in the highest level of activity and the lowest level.
  • The weakness in this method that it relies on only two points in a range of information
  • Example9.1 p324 and figure 9.4.
  • ((Variable cost per unit= Difference between the highest cost and the lowest cost divided by the difference in the highest level of activity and the lowest level.))
  • Fixed cost= highest/lowest cost – (variable cost X highest/lowest activity level)
  • Extra example;
  • Suppose you have two levels of activities and costs as follows:
    lowest volume of activity 1,000,000 Lowest cost $80,000
    highest volume of activity2, 000,000 Highest cost $150,000

Variable cost per unit=
(150000-80000)/ (2000000-1000000) =0.07

To find the fixed cost=
multiply the rate by the highest or lowest level of activity.

Let’s multiply it by the highest level of activity (0.07*2000000) =140000

And deduct the amount from the highest cost (150000-140000) =10000

So the fixed cost is 10000

Finding the break-even point

If we know the fix cost for period and the variable cost per unit so we can produce this graph

  • The bottom shows the fixed cost area, added to this is the variable cost, the wedge-shaped portion at the top.
  • The total cost covers the range of Volume of activity.
  • The total cost can be measured by the vertical distance between the graph horizontal axis and the relevant point of total cost.
  • The total cost at zero activity is the amount of the fixed cost
  • AS the volume of activity increase from zero, the fixed cost is added by the relevant variable cost to give the total cost.
  • If we take the total cost in first figure up and we put it up on it, a line representing total revenue over the range of volume of activity we obtain the (break-even chart) that is in the second figure.
  • In the second figure at zero volume of activity there is zero sales revenue.
  • The profit (loss) which is the deference between total sales revenue and total cost, for a particular volume of activity is the vertical distance between the total sales revenue and the total cost at the volume of activity.
  • Where there is no vertical distance between these two the volume of activity is at break-even point (BEP): total sales revenue equal total cost.
  • At this point there is neither loss nor profit. Where the volume of activity is below BEP total cost exceeds total sales revenue loss is occurred, versa the profit.

Pleeeese look to activities start from 9.1 until 9.7 and examples 9.1and 9.2

Lowest quarterly activity / Highest quarterly activity
Volume of activity / 130,000 Units / 200,000 Units
Total water cost / 60,000 K.D. / 110,000 K.D.

Requirement:
Calculate the total water cost according to the High-Low Method.

(1)Define the “Break-Even Analysis”, and illustrate its chart.

(2)Asiana Company makes toys. The fixed cost of operating is 650 K.D. monthly. Each toy requires material that cost 3 K.D. and takes one hour to make. The company pays the toy makers 12 K.D. per hour. The toy makers are all on contracts such that if they do not work for any reason, they are not paid. The toys are sold to a retailer for 20 K.D. each.

Requirement:

Calculate the BEP for toy making for the business.

(3)JoizoIndustries makes batteries. The fixed cost of operating is 400 K.D. monthly. Each battery requires material that cost 7 K.D. and takes one hour to make. The company pays the battery makers 15 K.D. per hour. The battery makers are all on contracts such that if they work or not for any reason, they are paid. The batteries are sold to anagent for 25 K.D. each.

Requirement:

Calculate the BEP for battery making for the business.

Chapter 12: Budgeting
• How budgets link with strategic plans and objectives (pp.445-446)
• How budgets link to one another (pp.450-453)
• How budgets help managers (pp.453-455)

Accounting chapter 12

Budgeting

How budgets link with strategic plans and objectives

  • The developments of plans for the future of the business involve five key steps;

1-Establish mission and objectives

-The purpose of the business is set out in the mission statement which attempts to capture the essence of the business.

-The strategic objectives set out how the mission statement can be achieved.

2-Undertake a position analysis

-Involving an assessment of where the business is currently placed in relation to where it wants to be, as set out in its mission and strategic objectives.

3-Identify and assess the strategic options

-The business must explore the various ways in which it might move from where it is now to where it wants to be.

4-Select strategic options and formulate plans

-By selecting best action or strategies and formulating a long-term strategic plan. This strategic plan is then broken down into a series of short-term plans. These plans are the budget.

-Budget: is a business plan for the short term (one year) and is expressed in financial terms. Its role is to convert the strategic plans into actionable blueprints for immediate future.

-Budget will define precise targets concerning such things as

  • Cash receipts and payments
  • Sales volumes and revenues: broken down into amounts and prices for each of the products or services provided by the business
  • Detailed inventories requirements
  • Detailed labor requirements
  • Specific production requirements

5-Perform, review and control.

-The business pursues by compeering the actual outcome with the budget, managers can see if things are going according to the plan or not.

  • The relationship between the mission, strategic objectives, strategic plans and budgets are as follows;

-The mission: Sets the overall direction which lasts for long-term.

-The strategic objectives: Sets out how the mission can be achieved.

-The strategic plans: It identifies how each objective will be pursued (followed).

-The budget: Sets out the short-term plans and targets necessary to fulfill the strategic objectives.

How budgets links to one another

  • A business will prepare more than one budget for a particular period. Each budget prepared will relate to a specified aspect of the business.
  • The ideal situation is that there should be a separate operating budget for each person who is managerial position.
  • The contents of all the individual operating budgets will be summarized in master budgets consisting of a budgeted income statement and statement of financial position.
  • The cash budget is considered to be a third master budget.

There will be horizontal relationship between budgets and vertical ones as well.

Breaking down the sales budget into a number of subsidiary budgets is a common approach.

The interlinking of individual operating budgets as follows according to figure down

  • The sales budget is the first to be prepared.
  • The finished inventories requirement tends to be set by the level of sales. It would be dictated by the policy of the business on the level of the finished products inventories that it chooses to hold.
  • The requirement for finished inventories will determine the required production level, which will dictate the requirement of the individual production departments of sections.
  • The demands of manufacturing conjunction (اقتران)with the business policy in how long it holds raw material before enter production, define raw materials inventories budget.
  • The purchases budget will be dictated by the materials inventories budget, which will in conjunction with the policy of the business on taking credit from suppliers, dictate the trade payables budget and receivable budget.
  • From the sales budget cash will affected by overhead budgets and direct labour costs and by capital expenditure.
  • The following illustrate the vertical relationship between a business’s sales budget:
  • Business has four geographical sales regions, each one the responsibility of a separate manager located in the region concerned.
  • Each regional manager is responsible to the overall sales manager of the business
  • The overall sales budget is the sum of the budgets for the four sales regions.
  • Sales are often managed on a geographical basis, and so their budgets reflect this, they may be managed on some other basis.
  • Very large business may even have separate product-type managers for each geographical region.
  • Each of these managers would have a separate budget which would combine to form the overall sales budget for the business as a whole.
  • All the operating budgets must mesh (انسجم) with the master budgets. That is, the budget income statement and statement of financial position.

How budgets help managers

  • Budgets are generally regarded as having 5 areas of usefulness:

1-promote forward thinking and possible identification of short term problems

-Identifying the potential problem early gives managers time for calm and rational consideration of the best way of overcoming it.(activity12.4)

2-Budgets can be used to help coordinate between the various sections of the business

-It is important that the activities of the various departments and sections of the business are linked so that the activities of one are complementary to those of another.

3-Budgets can motivate managers to better performance

-Managers and staff will be better motivated by being able to relate their particular role in the business to its overall objectives. Since budgets are directly derived from strategic objectives.

4-Budget can provide the basis for a system of control

-Control is concerned with ensuring that events conform to plans.

-If senior management want to control the performance of more junior staff, its need some yardstick (مقياس) that is (planned performance) to measure and assess performance.

-If there is information available concerning the actual performance for a period, then a basis of control will have been established. This will enable the use of management by exception, where senior managers can spend more time dealing with those staff and activities that have failed to achieve the budget.

-It also allows junior managers to exercise self-control. By knowing what is expected of themselves and what they have actually achieved.

5-Budget can provide a system of authorization for managers to spend up to a particular limit

-Some activities like staff development are allocated a fixed amount of funds this provides the authority to spend.

  • The 5 identified uses of budgets can conflict with one another occasionally.
  • Some business set budget targets at a more difficult level than the managers are expected to achieve in an attempt to motivate managers to strive and reach these targets. For control purpose, however the budget becomes less meaningful as a benchmark against which to compare actual performance.
  • Conflict between different uses mean that managers must decide which particular uses of budget should be given priority.
  • The relationship between the mission , strategic objectives , strategic plans , and budgets are follows :
  • The mission sets the overall direction which lasts for long tern
  • The strategic objectives sets out how the mission can be achieved
  • The strategic plan it identifies how each objectives will be pursued
  • The budget sets out the short term plans and targets necessary to fulfill the strategic objectives
  • Define the “Master Budgets”, and explain how budgets link to one another. Support your answer with example.

(1)Explain how budgets help managers? Or

Budgets are generally regarded as having 5 areas of usefulness