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Costing for Decision-making

# Costing for Decision-making

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10/25/2012

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# Costing For Decision-Making Cost defined as total expense . 1.

Relevance Opportunity cost It is the sacrifice of a return or benefit from a rejected alternative or net advantages of an alternative foregone. Sunk Cost It is historical cost that has already been incurred and will not be changed by a decision. Historical & Replacement Cost

2.Controllability 3.Variability Fixed costs Variable costs

OUTPUT 1 2 3 4 5 6 7 8 9 10

TFC 30 30 30 30 30 30 30 30 30 30

AFC 30 15 10 7.5 6 5 4.3 3.75 3.3 3

Costs which tend to remain unaffected by variations in volume or level or activity are Fixed costs. Variable costs UNITS 1 2 3 4 5 6 7 8 9 10 TVC AVC 12 24 36 48 60 72 84 96 108 120 12 12 TVC AVC 21 32 42 50 60 72 89 114 150 200 21 16 14 12.5 12 12 12.77 14.25 16.7 20

MARGINAL COST UNIT 1 2 3 4 5 6 7 8 9 10 TFC 30 30 30 30 30 30 30 30 30 30 TVC 21 32 42 50 60 72 89 114 150 200 TC 51 62 72 80 90 102 119 144 180 230 MC 11 10 8 10 12 17 25 36 50

The additional or incremental cost of producing one more unit of output than the existing level is know as the marginal cost.

FIXED COSTS & COST PER UNIT Unit produced (a). 1000 (b) 2000 © 3000 VC. Rs. 5/unit FC. Rs. 4000 Units 0 1,000 2,000 3,000 FC 4,000 4,000 4,000 4,000 VC TC 4,000 Cost/unit 9 7 6.33

5,000 9,000 10,000 14,000 15,000 19,000

MARGINAL COSTING Marginal costing is a costing technique the considers only the costs that very directly with volume -direct material direct later and variable factory overheads and ignores fixed costs in additional out fort devises . Thus the technique of marginal costing 1.Differentiation between fixed and variable costs. 2.Ascertainment of marginal costs . 3.Finding out effect on profit due to change in volume or type of out fort. ABSORPTION COSTING or full cost method according to this, the cost of product is determined after subside ring both fixed and variable cost. The variable costs such as those of direct materials direct labor etc are directly changed to products while the fixed costs a apportioned on a suitable basis over different products manufactured during a period. The all costs are identified with the manufactured products.

Contribution : The difference between marginal cost of the various products many factored and their respective selling price is the contribution which each product make towards fixed or period costs and profits .It represents the excess of sales over variable cost that is the amount to meet fixed cost and profit expectation of a firm. It can be calculated as : Contribution = Sales ± Variable cost OR Contribution per unit = Selling price =VC per unit Contribution = FC + profit/loss OR S-V-F = P/L

Profit/volume ratio (P/V ratio)

P/V Ratio =

Contribution Sales

= Sales ± VC Sales = 1V S VC = S ( 1- P/V ratio )

Or

S -V S

From the above example , VC can be comported as under : VC = 1-0.4=0.6 I.e , 60 % of sales = Rs. 120,000 Or PV ratio = s-v s = s- v = s ( P/V ratio )

Or V= ( s- s x P/V ratio ) or = s ( 1- P/V ratio ) P/V ratio = Fixed cost + profit Sales Ex.compete I. PV ratio ii. FC = F+P s iii. Sales to earn a

Profit of Rs. 5000 from the following : Sales : Profit : VC : Rs. 50,000 5,000 80 %

i.Sales = Rs. 50,000 VC = 80 % = Rs. 40,000 ii. PV ratio = s-v s X 100 = 50,000 ± 40,000 50,000 X 100 = 20 %

iii. Contribution = FC + P , 10,000 = FC + 5000 = Rs. 5000 This ratio can also be known by comparing the change in contribution to change in sales change in profit to change in sales. Any increase in contribution would mean increase in profit only because fixed costs are constant at all levels of out fort thus. change in contribution P/V ratio = change in sales change in profit change in sales This ratio would remain constant at different levels of out fort since VC as a proportion to sales remain constant at various levels. Or

Ex . Sales VC FC P/V ratio

Rs. 200,000 120,000 40,000 200 000 ± 120, 000 200 000 = .4

The ratio is useful for the determination of the desired level of out fort or profit and for the calculation of VC for any volume of Sales.the VC can be expressed as under : Ex . Assuming that the cost structure and selling price prices remain the same in period . i, and , ii. Find out the P/V ratio : Period 1 11 Sales Rs. 140 000 160 000 Total loss Rs. 125,000 140 000

Solution : period 1 11 PV Ratio

profit ³

Rs. 15000 20,000 X 100

= change in profit change in sales = 5000 20,000 X 100 = 25 %

Contribution Project Data

Capacity Output FC VC SP A (20,000 units ) Sales VC Cont . FC NP

: 25,000 units : 20,000 units : Rs. 200,000 : Rs. 5/unit : Rs. 15/unit

Rs. 300,000 100,000 200,000 200,000 x

B (24000 units) Sales VC Cont 360,000 120,000 240,000 FC/unit at 200,000 out fort Rs. 200,000 20,000 FC NP 200,000 40,000 at 24000 out fort = Rs. 200,000 24000 = Rs. 83

Pricing Decisions Say a full plane Load & Jaipur would fee Rs. 30,000 (seats 50) Per seat Total cost VC FC Profit Total Offer Rs. 250 per seat x 50 = Rs. 12500 is the offer acceptable ? Rs. 600 (two way fare ) Rs. 27,000 Rs. 9000 Rs.18,000 Rs. 3000 Rs. 30,000

Closing A Line Sales VC Cont FC NP 50 25 25 21 4 A 10 5 4 +1 B 20 12 8 +4 C 20 8 9 -1

Closure / Discontinuance Total Debit X Sales Marginal cost FC TC Profit/loss 1425 4900 +150 125 1500 -250 1000 2500 -500 300 900 +900 5050 3475 1250 1375 Y 20000 1500 Z 1800 600

Should µ Y¶ be Closed ? Marginal Cost Statement Total Sales Marginal Cost CONTBN FC Profit 1575 1425 150 -125 500 1200 5050 3475 X 1250 1375 Y 2000 1500 Z 1800 600

Marginal Costing- Selecting A Product A machine costing Rs. 60,000 (FC) co. manufacture tables or backs- while is more profitable ? Products Table Rs. SP/unit VC Cont/unit FC Sale / units Total CONTBN FC Profit 200 80,000 60,000 20,000 800 400 400 Rs. 60,000 300 75,000 60,000 15,000 Rs. Rack 1000 750 250

Contribution Analysis :A company presently sells 10,000 units at a price of Rs. 10 per unit. The cost of producing one unit is Rs. 8 ( Rs. 5 , VC & Rs. 3 FC ). The co. receives an order for 1000 units @ Rs. 7 per unit . Assuming the co. has capacity the producing should the order be accepted ? Comparative Cost Statement Sales (units) Present 10,000 Sales revenue (Rs.) VC Contribution (Rs) FC (Rs.) Profit (Rs.) 100,000 50,000 50,000 30,000 20,000 New offer 1,000 7,000 5,000 2000 2000 Total 11,000 107000 55,000 52,000 30,000 22,000

Since FC does not change , contribution increase by Rs. 2000 and results in extra profit of Rs. 2 the offer should be accepted.

Managerial Application Marginal costing is a useful tool to deal with situations of demands and supply cost of production competition and short terms decision making as pricing : Ex M/S Electro Toys submits the following information Selling Price per unit VC per unit FC Output Rs. 5.00 2.00 Rs. 75,000 75,000

The co. is expected to reduce the selling price in order to meet the competition. Calculate the level of output to maintain present level of profit if the proposed reduction in price 10% and 20 %

Marginal Cost Statement Present Price Rs. Sales Less VC Contribution Less FC Profit Contribution / unit 375,000 150,000 225,000 75,000 150,000 Rs. 3.00 10% 3375,00 150,000 1875,00 75,000 112,500 2.50 20% 300,000 150,000 150,000 75,000 75,000 2.00 Price Reduction

Profit to be maintained (Desired Profit )

Rs. 150,000

Contribution to be earned = Profit Regd + FC = 150 000+75000=Rs. 225,000 No. of units to the sold at different levels of price reduction : 10 % reduction = Rs. 225000 2.50 20 % reduction = 225000 2 = 112,500 unit = 90000 unit

Scarce Resource Decisions Management is after faced with a problem when certain factors are scarce and hence must give priority to the most profitable products to maximize profits . The profitability of various alternatives under the condition of scarce resources can be made with the help of following ratio. Ex. M/AS PQR manufactures three rubber products using the same rubber compound . The supplies of the compound cut their supplies by 25%. Advise the co. on the priorities of the product when material is a limiting factor.

Cost Per Unit Direct material Direct ways Variable over heads Fixed over heads Total cost Selling Price/ Unit Units produced

A ( Rs.) 200 50 100 300 650 1100 4000

B (Rs.) 75 200 400 125 800 900 1500

The priorities of the product can be fixed on the basis of contribution cost ratio.

Particulars SP Less VC Direct material Direct wages Variable heads Marginal cost Contribution

A Rs. 1100

B Rs. 900

200 50 100 350 750 375 %

75 200 400 675 225 300 5

Canton/ material cost ratio Production Priority A& B

Sales Mix Decision A diversified co. with its large product line can use marginal costing technique to decide about appropriate sales mix. Particulars Direct material Direct wages Variable heads Fixed over heads Selling Price Alfa/ unit Rs. 25 15 15 Rs. 15000 pa Rs.75 Rs.125 Beta / unit Rs. 30 20 20

From the information given above advise the management about the profitable sales mix from the given alternatives: a.300 units of Alfa & 200 unit Beta b.600 units of Alfa c.800 units of Beta d.100 units of Alfa and 300 units of Beta. Marginal Cost Statement Particulars Selling Price/ unit Less VC Direct material Direct wages Marginal cost Contribution 25 15 55 20 30 20 70 55 Alfa 75 Beta 125

Statement of Sales Mix Particulars a. 300 units of Alfa and 200 unit of Beta (300x20)+(200x55) Less off-fixed Profit b. 600 units of Alfa 12,000 6000 11000 17000 -15000 2000 12,000 -15000 -3000 Alfa Beta Total

Contribution (600x20) Less off-fixed Profit

c. 800 units of Beta Contribution (800x55) Less : OH- fixed Profit d. 100 units of Alfa & 300 units of Beta Alfa (1100x20) Beta (300x55) Less : OH ± Fixed Profit 2000 16500 18,500 -15000 35000 44000 44000 -15000 29000

As the sales mix of 800 units of Beta giving maximum profit, it is recommended . Marginal Costing Desirable i.To continue production so as not to lose the market to rival firms. ii.To avoid the situation of incurring the advertisement and selling expenses again. iii.To avoid the cost of closing the unit and opening it again. iv. To introduce a new product. v. Labor costs- recruitment, training etc. vi.To drive out a weak competitor. v.To explore a foreign market ± Dumping or getting import quota

Marginal Costing Assumptions & Limitations 1.That the FC remain unchanged. 2.That there is a constant relation between sales and VC at all levels of activity. 3.That VC remains constant per unit. 4.That all expenses can be classified into FC & VC . 5.That FC are non_ controllable. 6.The relative profitability of different products/departments is determined on the basis of contributions made available by each product or department .

Outsource Or Integrate Maker ± Videocon, from glass shells of TV picture tube the co. tries to integrate all operations to achieve volumes . Telco ± Does its own forging , foundry operations, small parts machining, research design, manufacturing of body panels engines and transmission systems. Arvind Mills . The co. has forward- integrated to manufacture garments from yarn and fabric. Its rationale : the opportunity for value ± addition and high ± markup in the commodities textiles business is falling off. Asian Paints : Being the market leader , the co. does not relay on an external supply-chain since a disruption will affect market- shares . Hindustan Motors : Since 1966, fabricating everything from nuts & bolts to seat-covers from body panels to light, from transmission systems to engines- result, run ± away costs.

Reliance ± The classic case of vertical integration set up its own 10,000 ton (Pa) PY plant. It pwfressively integrated Bach wards with the claim receding to the starting point : oil refining so as to ensure that at no stage the value ± claim was starved of raw material . It has also got the benefit of economies of scale. Outsourcing : Bo dreg outsourcers all its distribution to retailers even wholesalers- from the ware ± housing to bill collection. Malrindra Ford : Focusing on its come function, outsourcing 40 % of its component, ware housing as well as distribution. Indo Ram : Yarn production is outsourcing marketing distribution and warehousing. Jenson & Nicholson : Inverting in marketing & distribution but outsourcing all its chemicals and raw- materials. Nike & Reebok have refused to branch and from product design and marketing into manufacturing remaining lean organization.

Maruti : Outsource transmissions body trims engine components ± all vendors located close-by not only to save costs on time and transportation but also to exercise quality control.

Make Or Buy A firm that requires 10,000 units of a component can purchase them from a supplier for Rs. 90000. If the same component is manufactured internally, it would cost ( per unit ) Direct material Direct labors Variable overhead Fixed over head : : : : 3.00 3.50 1.50 2.00 10.00 per unit

Total Rs.

Assuming the firm has spare capacity, should it make the component or buy it ? The relevant cost for making in hones are Rs. 8 per unit . Hence MAKE

Make or buy A TV manufacturing co. is considering what to buy a particular component ± CM2 or to manufacture it. The component is available in the market at the rate of Rs. 10 each . The cost elements of manufacturing the component ± cm2 per unit are : VC : Rs. 5

Machine hour required per unit : 3 hours. The machine on which the component- CM2 Is processed is also used for another produced PP with its cost structure as : SP per unit VC per unit Rs. 100 60

Contribution per unit Rs. 40

No. of hours regd. On that machine Per unit Contribution per hour 20 hours 40/20 = Rs. 2

Should the co. Buy or manufacture ? In this situation , machinery is the limiting factor .( It cannot therefore be assumed that spare capacity is available for manufacturing). In such cases the relevant costs are the marginal cost plus lost contribution. Since the machinery is fully utilized for manufacturing PP, the component ± CM2 would affect PP production and so the cost of CM2 would be VC Rs. 5

Machinery cost (3 hours ) Rs. 6 Total Rs. 11

Decision Rule : When VC + contribution lost > Price Buy. In the present case Rs. 5+6> Rs. 10 Buy. The decision essentially depends on the opportunity cost. Contribution Analysis :A company presently sells 10,000 units at a price of Rs. 10 per unit. The cost of producing one unit is Rs. 8 ( Rs.5, VC & Rs. 3 FC ). The co. receives an order for 1000 units @ Rs. 7 per unit. Assuming the co. has capacity to producing should the order be accepted ?

Comparative cost statement Sales (units) Present 10,000 Sales revenue(Rs) VC Contribution(Rs) FC (Rs) Profit (Rs) 100,000 50,000 50,000 30,000 20,000 New offer 1,000 7,000 5,000 2,000 2000 Total 11,000 107000 55,000 52,000 30,000 22,000

Since FC does not change contribution increase by Rs. 2000 and results in extra profit of Rs. 200 the offer should be accepted.

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