P1 REFRESH THEORY

SYLLABUS

TRADITIONAL COSTING

C H A P T E R 1

PURPOSE OF COSTING

• Inventory valuation

The cost per unit can be used to value inventory in the statement of financial

position.

• To record costs

The costs associated with the product need to be recorded in the income

statement.

• To price products

The business may use the cost per unit to assist in pricing the product or

service.

• Decision making

The business may use the cost information to make important decisions.

FIXED COSTS • Defined as ‘a cost which is incurred for an accounting period that,

within certain output or turnover limits, tends to be unaffected by

fluctuations in the levels of activity (output or turnover)’.

• This is also regarded as „period cost‟ since it is incurred according to

the time elapsed, rather than according to the level of activity.

• Examples – rent, rates, insurance, executive salaries

• If the activity level gets beyond the critical point, then fixed cost will

be increased. The cost behavior pattern is known as a stepped fixed

cost.

VARIABLE COSTS • Defined as a ‘cost that varies with a measure of activity’.

• Examples – direct material, direct labour, variable overheads

• These costs do approximate to a linear function.

• However, there are curvilinear variable costs which does not

approximate to a linear function.

• If there is economies of scale, each successive unit adds less variable

cost than the previous unit. Example – discounts in purchasing direct

material in bulk

• If there is diseconomies of scale, each successive unit adds more

variable cost than the previous unit. Example – direct labour where

employees are paid an accelerating bonus for achieving higher levels of

output.

SEMI-VARIABLE COSTS

• Defined as ‘a cost containing both fixed and variable components and

thus partly affected by a change in the level of activity.’

• Also referred as semi-fixed, hybrid, or mixed cost.

• Example – Electricity

ABSORPTION COSTING

Total Cost

Production costs

Direct (Prime) costs

E.g. materials & labour

Indirect costs

E.g. factory rent, supervisor's salary,

electricity, depreciation Non-production costs

E.g. selling & distribution costs (advertising, delivery)

& administrative costs (cleaners, postage)

In absorption costing, only production costs are applicable for deriving the cost

per unit.

ABSORPTION COSTING – COST CARD

$

Direct material per unit X

Direct labour per unit X

Production overhead per unit (Note 1)

X

Full production cost per unit X

Note 1 – All production overhead should be absorbed into units of production,

using an overhead absorption rate on a suitable basis, e.g. units produced, labour

hours or machine hours etc.

𝑂𝑣𝑒𝑟𝑕𝑒𝑎𝑑 𝐴𝑏𝑠𝑜𝑟𝑝𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒 = 𝑇𝑜𝑡𝑎𝑙 𝑂𝑣𝑒𝑟𝑕𝑒𝑎𝑑 𝐶𝑜𝑠𝑡 (𝐴𝑙𝑙𝑜𝑐𝑎𝑡𝑒𝑑 𝑎𝑛𝑑 𝐴𝑝𝑝𝑜𝑟𝑡𝑖𝑜𝑛𝑒𝑑)

𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑣𝑜𝑙𝑢𝑚𝑒

REVIEW OF OVERHEAD ABSORPTION PROCEDURE

Steps to follow:

• Overhead allocation

Indirect production costs are allocated to cost centers' or cost codes.

• Overhead apportionment

The overhead costs that have been allocate to cost centers' and cost codes other than direct production departments must next be apportioned to direct production departments.

• Overhead absorption

An absorption rate is calculated for each production department.

OVER-OR-UNDER ABSORPTION

• Since predetermined absorption rates are used to absorb overhead to

the units produced, this can lead to over-or-under absorption of the

overhead when compared to the actual overhead incurred.

Over-or under-absorption can be calculated as follows;

Budgeted overhead rate per unit X actual units − Actual overheads

ADVANTAGES & DISADVANTAGES OF ABSORPTION COSTING • Advantages

– A large proportion of fixed costs can be attributed to the measurement

of product cost.

– Absorption costing follows the matching concept (accruals concept)

– It is necessary to include fixed production overhead in inventory values

for financial statements.

– Analysis of over-or under-absorbed overhead may be useful for

identifying inefficient utilization of production resources.

– There is an argument that all costs are variable in the long term.

ADVANTAGES & DISADVANTAGES OF ABSORPTION COSTING • Disadvantages

– The apportionment and absorption of overhead costs is arbitrary. E.g.

factory rental cost can be apportioned to production departments on

the basis of floor area, labour hours or machine hours depending on the

production process is labour oriented, machine oriented and utilisation

of space.

– Profits vary with changes in production volume.

Profit can be manipulated by changing inventory levels. Therefore managers can

inflate the profits by overproducing units and increasing closing inventory.

MARGINAL COSTING

• This method charges products or services with variable costs alone.

The fixed costs are treated as period costs and written off in total

against the contribution of the period.

• Marginal cost is the extra cost arising as a result of producing one or

more unit, or the cost saved as a result of producing one less unit. It

comprises;

– Direct material

– Direct labour

– Variable overheads

ADVANTAGES & DISADVANTAGES OF MARGINAL COSTING • Advantages

– Costing method is simple.

– Marginal costing reflects the behaviour of costs in relation to activity.

Marginal costing is more relevant and appropriate for short-run decision

making than absorption costing.

– Marginal costing avoids the disadvantages of absorption costing. (refer

Slide 12)

ADVANTAGES & DISADVANTAGES OF MARGINAL COSTING • Disadvantages

– Marginal costing is not suitable for measuring product costs and

profitability over the longer term. Because the marginal cost of

production and sales will be a small proportion if the fixed costs are high

relative to the variable costs and it provides insufficient and inadequate

information about costs and product profitability.

– Treatment of direct labour can be argued as unrealistic since mostly the

employees are paid fixed salaries nowadays.

ABSORPTION COSTING PROFIT STATEMENT $ $

Sales X

Less: Cost of Sales

Opening stock X

+Production costs X

𝑿

Less: Closing stock (𝑿)

(𝑿)

𝑿

(Under)/over absorption ±X

Gross Profit 𝑿

Less: Selling, distribution & admin costs

Variable X

Fixed 𝑿

(𝑿)

Net Profit/(loss) 𝑿

MARGINAL COSTING PROFIT STATEMENT

$ $

Sales X

Less: Variable Cost of Sales

Opening stock X

+Variable Production costs X

𝑿

Less: Closing stock (𝑿)

(𝑿)

𝐗

Less: Variable Selling, distribution &

admin costs

(X)

Contribution 𝑿

Less: Fixed costs

Selling X

Selling, distribution & admin costs 𝑿

(𝑿)

Net Profit/(loss) 𝑿

RECONCILING THE PROFITS $

Absorption costing profit X

(Increase)/decrease in stock X fixed overheads per unit (X)/X

Marginal costing profit 𝑿

If stocks increase, absorption costing profits will be higher than marginal costing

profits. This is because, some of the fixed overheads will be carried forward in

stock instead of being written off the sales for the period.

If stocks decrease, marginal costing profits will be higher than absorption costing

profits. Because, the fixed overhead which had been carried forward in stock with

absorption costing is now being released to be charged against the sales of the

period.

Profit difference in the long term will be the same whichever method is used.

Because all costs will be eventually be charged against sales. It is merely the timing

of sales that causes the profit differences from period to period.

RECONCILIATION OF PROFITS BETWEEN PERIODS

• Marginal costing reconciliation

• Absorption costing reconciliation

$

Profit for period 1 X

Increase/(decrease) in sales X contribution per unit X/(X)

Profit for period 2 𝑿

$

Profit for period 1 X

Increase/(decrease) in sales X profit per unit X/(X)

(Over-)/under-absorption in period 1 (X)/X

Over-/(under)-absorption in period 2 X/(X)

Profit for period 2 𝑿

PRICING STRATEGIES BASED ON COST

• Full cost plus pricing

Selling price = Full cost per unit X (1 + mark up %)

• Marginal cost plus pricing

Selling price = Marginal cost per unit X (1 + mark up %)

Usually the mark up decided for marginal costing plus pricing is higher than

the full cost plus pricing because the selling price needs to cover both fixed

costs and profit in marginal cost plus pricing.

ADVANTAGES & DISADVANTAGES OF PRICING STRATEGIES BASED ON COST

Full cost plus pricing

Advantages Disadvantages

Required profits will be made if budgeted sales volumes are

achieved.

Problems associated with the selection of suitable basis on

which to charge fixed costs. This can lead over/under pricing

of the products.

A useful method in contract costing where proportion of

fixed costs is relatively low compared to variable costs

If prices are set on the basis of normal volume and actual

volume turns out to be considerably lower, overhead will

not be fully recovered from sales.

Pricing method is cheap and quick given that company

knows its cost structure.

The mark up can be very arbitrary and may not properly

account for factors such as competition levels.

Useful in justifying selling prices to customers.

Marginal cost plus pricing

Advantages Disadvantages

It is accurate just as full cost plus pricing. Like any other costing method, it ignores other factors such

as competition, customer attitudes etc.

Knowledge of marginal cost gives the management the

option of pricing below total cost when times are bad, in

order to fill capacity.

The mark up becomes even more arbitrary than that used in

full cost plus as now it must also include a subjective

element which allows for the selling price to cover fixed

costs.

It is particularly useful in pricing specific one-off contracts

because it recognizes relevant costs and opportunity costs

as well as sunk costs.

It also recognizes the existence of scarce or limiting

resources. Marginal costing can be used to maximize the

total contribution based on the limiting factor.

ACTIVIT Y -BASED COSTING

C H A P T E R 2

INTRODUCTION • Defined as an approach to the costing and monitoring of activities which

involves tracing resource consumption and costing final outputs.

Resources are assigned to activities, and activities to cost objects based

on consumption estimates. The latter utilise cost drivers to attach activity

costs to output.

• Activity based costing has been developed to solve the problems that

traditional costing methods create in the modern environments.

• Traditional methods of costing produce standard cost cards that less

useful due to inaccurate product costs.

• This method is an alternative approach to product costing and it is a

form of absorption costing.

PROBLEMS WITH TRADITIONAL COSTING Absorption costing Marginal costing

Overhead costs not being small compared

to machine hours or labour hours leading

to inaccuracies in the charging of overheads

to product costs.

Variable costs might be small in relation to

fixed costs.

Method is not valid in complex

manufacturing environment, where

production is based on smaller customized

batches of products, indirect costs are high

in relation to direct costs and a high

proportion of overhead activities are not

related to production volume.

„fixed‟ costs might be fixed in relation to

production volume, but they might vary

with other activities that are not volume-

related or even production-related.

Not well suited to the costing of many

services.

COST POOLS AND COST DRIVERS

• Cost pool is an activity that consumes resources and for which

overhead costs are identified and allocated. For each cost pool, there

should be a cost driver.

• A cost driver is a unit of activity that consumes resources. An

alternative definition of a cost driver is a factor influencing the level of

cost.

IDENTIFYING ACTIVITIES (OR TRANSACTIONS)

• Logistical transaction

These are activities or transactions concerned with moving materials or

people, and with tracking the progress of materials or work through the

system.

• Balancing transactions

These are concerned with ensuring that the resources required for an

operation are available.

• Quality transactions

These are concerned with ensuring that output or service levels meet quality

requirements and customer expectations.

• Change transactions

These are activities required to respond to changes in customer demand, a

change in design specifications, a scheduling change, a change in production or

delivery methods, and so on.

IDENTIFYING COST DRIVERS

• A chosen cost driver should be relevant to the consumption of the

resources

• Easy to measure

• Types of cost drivers

– Transaction drivers

The cost of an activity is affected by the number of times a particular action is

undertaken.

– Duration drivers

The cost of an activity is affected by the length of time.

– Intensity drivers

In this case, efforts would be directed at determining what resources were

used in making of a product or service.

CALCULATING THE FULL PRODUCTION COST PER UNIT USING ABC 1) Group production overhead into activities, according to how they

are driven.

2) Identify cost drivers for each activity. i.e. what causes these activity

costs to be incurred.

3) Calculate a cost driver rate for each activity.

4) Absorb the activity costs into the product.

5) Calculate the full production cost and/ or the profit or loss.

WHEN IS ABC RELEVANT?

• Indirect costs are high relative to direct costs

• Products or services are complex

• Products or services are tailored to customer specifications

• Some products or services are sold in large numbers but other are

sold in small numbers.

ADVANTAGES AND DISADVANTAGES OF ABC Advantages Disadvantages

It provides a more accurate cost per unit. As

a result, pricing, sales, strategy, performance

management and decision making should be

improved.

ABS will be of limited benefit if the overhead

costs are primarily volume related or if the

overhead is a small proportion of the overall

cost.

It provides a much better insight into what

drives overhead costs.

It is impossible to allocate all overhead costs

to specific activities.

ABC recognizes the overhead costs are not

all related to production and sales volume.

The choice of both activities and cost drivers

might be inappropriate.

In many businesses, overhead costs are a

significant proportion of total costs, and

management needs to understand the drivers

of overhead costs in order to manage the

business properly.

ABC can be more complex to explain to the

stakeholders of the costing exercise.

It can be applied to derive realistic costs in a

complex business environment.

The benefits obtained from ABC might not

justify the costs.

ABC can be applied to all overhead costs, not

just production overheads.

ABC can be used just as easily in service

costing as in product costing.

IMPLICATIONS OF SWITCHING TO ABC

More realistic pricing Pricing decisions will be improved because the price will be

based on more accurate cost data.

Sales strategy can be more

soundly based

Target customers that appeared unprofitable using absorption

costing but may profitable under ABC

Stop targeting customers or market segments that are now

shown to offer low or negative sales margins.

Improved decision making Research, production and sales effort can be directed towards

those products and services which ABC has identified as

offering the highest sale margins.

Improved performance

management

Performance management should be enhanced due to the

focus on selling the most profitable products and through the

control of cost drivers.

ABC can be used as the basis of budgeting and longer term

forward planning of overhead costs. The more realistic

budgeted overhead cost should improve the system of

performance management.

OTHER COSTING TECHNIQUES

C H A P T E R 3

JOINT PRODUCT COSTING • Some products may be produced at the same time in the same

process before being separated for sale or further individual

processing. These products are known as joint products and the

separation point is known as split-off point.

• Joint costs are the total of the raw materials, labour, and overhead

costs incurred up to the initial split-off point.

DEFINITIONS IN JOINT PRODUCT COSTING

• Joint cost

A joint cost is the cost of a process that results in more than one main

product.

• Common cost

A common cost is a cost relating to more than one product or service.

• Joint products

Joint products are 2 or more products produced by the same process and

separated in processing, each having a sufficiently high saleable value to merit

recognition as a main product.

• By-product

A by-product is output of some value produced incidentally in manufacturing

something else (main product)

Accounting for joint products

Physical measurement Joint costs can be apportioned to units of output of each joint

product. Alternatively, a technical estimate of relative usage by

each product may be made by the organization.

Market value Joint costs can be apportioned on the basis of the market value

of each joint product at the point of separation. The effect is to

make each product appear to be equally profitable.

Net realisable value Where certain products are processed after the point of

separation, further processing costs may be deducted from the

market values before joint costs are apportioned.

Accounting for by products

The proceeds from the sale of the by-product may be treated as pure profit, or the proceeds

from the sale, less any handling and selling expenses, may be used to reduce the cost of the

main products.

If a by-product needs further processing to improve its marketability, the cost will be

deducted in arriving at net revenue. Note that recorded profits will be affected by the

method adopted if stocks of the main product are maintained.

ACCOUNTING FOR JOINT PRODUCTS AND

BY PRODUCTS

JOINT COSTS IN DECISION MAKING

• To carry out the whole process or not.

The decision is based on the total revenues and costs of the process.

• Whether or not to further process products.

This decision is based on the incremental revenues and costs of

further processing. Revenue and cost at the split-off point are

irrelevant to the decision as they will not change.

THROUGHPUT ACCOUNTING • In throughput accounting is very similar to marginal costing but it is used

to make longer term decisions about capacity/production equipment.

𝑡𝑕𝑟𝑜𝑢𝑔𝑕𝑝𝑢𝑡 𝑎𝑐𝑐𝑜𝑢𝑛𝑡𝑖𝑛𝑔 = 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 − 𝑡𝑜𝑡𝑎𝑙𝑙𝑦 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡𝑠

• The aim of throughput accounting is to maximize this measure of

throughput contribution.

• Throughput accounting is based on 3 concepts.

– Throughput

– Investment

– Operating expenses

CONCEPTS IN THROUGHPUT ACCOUNTING - THROUGHPUT

• The only cost that is deemed to relate to volume output is the direct

material cost. All other costs (including all labour costs) are deemed to

be fixed. Therefore;

𝑡𝑕𝑟𝑜𝑢𝑔𝑕𝑝𝑢𝑡 𝑐𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 = 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 − 𝑑𝑖𝑟𝑒𝑐𝑡 𝑚𝑎𝑡𝑒𝑟𝑖𝑎𝑙 𝑐𝑜𝑠𝑡𝑠

• Conversion costs

Conversion costs are the addition of direct labour, factory rent, equipment

depreciation, inspection costs (which are regarded as fixed costs) etc. to

differentiate direct material costs from other costs.

CONCEPTS IN THROUGHPUT ACCOUNTING - INVESTMENT

• This is defined as all the money the business invests to buy the things

that it intends to sell and all the money tied up in assets so that the

business can make me throughput.

• Investment consists of;

Unused raw materials

Work-in-progress

Unsold finished goods

CONCEPTS IN THROUGHPUT ACCOUNTING – OPERATING EXPENSES

• Defined as all the money a business spends to produce the throughput

(i.e. to turn the inventory into throughput). It is not correct to think of

operating expenses as fixed costs.

PROFIT REPORTING

$

Revenue 750,000

Raw material cost (totally variable cost) 200,000

Throughput contribution 550,000

Operating expenses 400,000

Net profit 150,000

An example with illustrative figures included.

MAXIMISING THROUGHPUT

• If the business has more capacity then there is customer demand, it

should produce to meet the demand in full.

• If the business has a constraint (bottleneck) that prevents it from

meeting customer demand in full, it should make the most profitable use

that it can of the constraining resource. This means giving priority

to those products earning the highest throughput for each unit

of the constraining resource that it requires.

• The aim is to identify bottlenecks and remove them, or, if this

is not possible, ensure that they are fully utilized at all times.

MULTI-PRODUCT DECISION MAKING • Steps

1. Identify the bottleneck constraint

2. Calculate the throughput contribution per unit for

each product

3. Calculate the throughput contribution per unit of the

bottleneck resource for each product

4. Rank the products in order of the throughput

contribution per unit of the bottleneck resource.

5. Allocate resources using the ranking

THROUGHPUT ACCOUNTING MEASURES

1. 𝑟𝑒𝑡𝑢𝑟𝑛 𝑝𝑒𝑟 𝑓𝑎𝑐𝑡𝑜𝑟𝑦 𝑕𝑜𝑢𝑟 = 𝑡𝑕𝑟𝑜𝑢𝑔𝑕𝑝𝑢𝑡 𝑐𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛

𝑝𝑟𝑜𝑑𝑢𝑐𝑡′𝑠 𝑡𝑖𝑚𝑒 𝑜𝑛 𝑡𝑕𝑒 𝑏𝑜𝑡𝑡𝑙𝑒𝑛𝑒𝑐𝑘 𝑟𝑒𝑠𝑜𝑢𝑟𝑐𝑒

Return per factory hour shows the value added by the organization

and managers are encouraged to maximize by increasing the

throughput or reducing the time taken in the process.

2. 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑓𝑎𝑐𝑡𝑜𝑟𝑦 𝑕𝑜𝑢𝑟 =𝑡𝑜𝑡𝑎𝑙 𝑓𝑎𝑐𝑡𝑜𝑟𝑦 𝑐𝑜𝑠𝑡

𝑡𝑜𝑡𝑎𝑙 𝑡𝑖𝑚𝑒 𝑜𝑛 𝑡𝑕𝑒 𝑏𝑜𝑡𝑡𝑙𝑒𝑛𝑒𝑐𝑘 𝑟𝑒𝑠𝑜𝑢𝑟𝑐𝑒

The cost per factory hour shows the Joint product costingcost of

operating the factory in terms of overheads, labour costs etc.

THROUGHPUT ACCOUNTING MEASURES

3. 𝑡𝑕𝑟𝑜𝑢𝑔𝑕𝑝𝑢𝑡 𝑎𝑐𝑐𝑜𝑢𝑛𝑡𝑖𝑛𝑔 𝑟𝑎𝑡𝑖𝑜 =𝑟𝑒𝑡𝑢𝑟𝑛 𝑝𝑒𝑟 𝑓𝑎𝑐𝑡𝑜𝑟𝑦 𝑕𝑜𝑢𝑟

𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑓𝑎𝑐𝑡𝑜𝑟𝑦 𝑕𝑜𝑢𝑟

Throughput accounting ratio measures the return from a product

against the cost of running the factory. Throughput accounting ratio

being 1 or greater indicates the production is worthwhile. But that

does not mean that ratio less than 1 is not worthwhile. Because the

return per factory hour and throughput accounting ratio are for

individual products whereas the cost per factory hour is for the whole

company. Therefore throughput accounting ratio may not reveal the

full story.

CRITICISMS OF THROUGHPUT ACCOUNTING

• Concentrates in the short term when a business has a fixed

supply of resources ad operating expenses are largely fixed.

• It is more difficult to apply throughput accounting concepts

to the longer term. When all costs are variable, and vary

with the volume of production and sales or another cost

driver.

• Activity based costing might be more appropriate for

measuring and controlling performance in the long run even

though throughput accounting is suitable for measuring

profit and performance in the short term.

ENVIRONMENTAL MANAGEMENT ACCOUNTING

• Importance

– All organisations are faced with increasing legal and

regulatory requirements relating to environmental

management.

– All organisations need to meet customers‟ needs and

concerns relating to the environment.

– All organisations need to demonstrate effective

environmental management to maintain a good public

image.

– All organisations need to manage the risk and potential

impact of environmental disasters.

– All organisations can make cost savings by improved use

of resources such as water and fuel.

CONTRIBUTION OF ENVIRONMENTAL MANAGEMENT ACCOUNTING - EMA

Identifying and estimating the costs of environmental related activities.

Identifying and separately monitoring the usage and cost of resources such as water, electricity and fuel and to enable costs to be reduced.

Ensuring environmental considerations form a part of capital investments decisions

Assessing the likelihood and impact of environment risks

Including environment-related indicators as part of routing performance monitoring

Benchmarking activities against environmental best practice

EMA & EFFECT ON FINANCIAL PERFORMANCE

Environmental prevention costs

• Evaluating and selecting pollution control equipment

• Selecting and evaluating suppliers

• Training staff

• Designing processes and products

• Creating environmental policies

• Environmentally driven research and development

• Site and feasibility studies

• Investment in protective equipment

• Community relations and outreach programmes

Environmental appraisal costs

• Monitoring, testing and inspection costs

• Site survey costs

• Improved systems and checks in order to prevent fines/penalties

• Permit costs

• Citification costs

• Developing performance measures

• Monitoring supplier performance

Environmental internal failure costs

• The cost of recycling or disposing of waste or harmful materials

• Product take back costs (such as bear costs of customers returning used batteries, cartridges etc.)

• Clean up costs

• Legal costs, insurance and fines

• Site decontamination

• Back-end costs such as decommissioning costs on project completion

• Off-set costs (example – paper manufacturing companies plant trees in order to off-set the damage they may be creating to existing forestry)

Environmental external failure costs

• Adverse impact on the organization’s reputation

• Adverse impact on natural resources such as rivers, forests and rock formations

• Carbon emissions and the adverse impact these have on the global climate

• Medical costs for employees and local communities

Identifying and accounting for environmental costs

(with examples)

INPUT/OUTPUT ANALYSIS • Al alternative technique which can be used to identify and

allocate environment costs.

• This technique records material flows with the idea that „what

comes in must go out – or be stored‟.

• Purchased input is regarded as 100% and is balanced against

the outputs.

• Example

Input Output

Product 60%

Scrap for recycling 20%

Disposed of as waste 15%

Not accounted for 5%

100% 100%

THE MODERN MANUFACTURING ENVIRONMENT &

THE IMPORTANCE OF QUALIT Y

C H A P T E R 4

CHARACTERISTICS OF THE MODERN MANUFACTURING ENVIRONMENT

• Wide variety of modern practices and techniques based on computer systems. Used to improve product design, test products.

Greater use of advanced manufacturing systems

(ATM)

• Companies operate in a world economy

• Customers, competitors come from all over the world

• Products are made from components all over the world

• Firms have to be world class to compete

Global environment

• Clearly an important factor to the customer. Beneficial for a firm during a price war.

Cost reduction

• As competition increases, customers are demanding ever-improving levels of service in cost.

Customer focus

• Mass production techniques are redundant and flexible manufacturing systems are more important.

Flexibility

• Employees are empowered more than ever.

• Management accounting systems are moving from providing information to managers to monitor employees to providing information to employees to empower them to focus on continuous improvement.

Employee participation

• Companies need to be continually developing new products in order to survive. Shorter product life

cycle

• The world class manufacturing approach to quality is quiet different from the traditional approach because the primary emphasis is placed on the resolution of the problems that cause poor quality, rather than merely detecting it.

Quality

TOTAL QUALITY MANAGEMENT • It has 3 important features.

BASIC PRINCIPLES OF TQM

TQM considers that costs of prevention is less than the costs of correction. One of the main aims is to achieve zero defects and zero rejects and to ensure that all customer needs or expectations are satisfied.

„Get it right, first time‟

Since zero rejects and zero defects are unobtainable, companies are seeking to improve the present level of rejects and defects. Therefore a costing technique is called „kaizen‟ approach is used reflect continuous efforts to reduce product costs, improve product quality, and/or improve production process after manufacturing activities have begun.

Continuous improvement

Quality is examined from a customer perspective and the system is aimed at meeting customer needs and expectations.

Customer focus

OTHER PRINCIPLES OF TQM

Most senior directors and managers are totally committed in achieving highest quality standards. So the rest of the organization follows the same path.

Commitment to quality

Throughout and beyond all organisations, whether they are manufacturing concerns, retail stores, universities or hostels, there is a series of quality chains which should not be broken at any point to maintain the quality.

Quality chains

A quality circle is a team of 4 to 12 people usually coming from the same area who voluntarily meet on a regular basis to identify, investigate, analyse and solve work-related problems. The team presents its solutions to the management and is then involved in implementing and monitoring the effectiveness of the solutions.

Quality circles

COSTS OF QUALITY

Costs of quality

Conformance costs

Prevention costs Appraisal costs

Non conformance costs

Internal failure costs

Externa failure costs

COSTS OF QUALITY

Conformance costs Non conformance costs

Prevention costs

Cost of any action taken to prevent

or reduce defect and failures

Internal failure

Costs arising from inadequate

quality where the problem is

discovered before the transfer of

ownership from supplier to

purchaser.

Appraisal costs

Cost incurred in testing, inspection

External failure

Costs arising from inadequate

quality discovered after transfer of

ownership from supplier to

customer.

COSTS OF QUALITY

It is generally accepted that an increased investment in prevention and appraisal

is likely to result in a significant reduction in failure costs. As a result of the

trade-off, there may be an optimum operating level in which the combined costs

are at minimum. In short, an investment in „prevention‟ inevitably results in saving

on total quality costs.

SUCCESSFUL IMPLEMENTATION OF TQM

An organization should undertake to achieve each of the following to ensure

TQM is successful.

• Total commitment throughout the organization

• Get close to their customers to fully understand their needs and

expectations

• Plan to do all jobs right first time

• Agree expected performance standards with each employee and customer

• Implement a company-wide improvement process

• Continually measure performance levels achieved

• Measure the cost of quality mismanagement and the level of firefighting

• Demand continuous improvement in everything you and your employees

do

• Recognise achievements

• Make quality a way of life

FINANCIAL & NON-FINANCIAL MEASURES - TQM

Under TQM financial measures focus more on quality and will include reports

such as;

– Cost of downtimes

– Cost of job reworks

– Lost revenue from customer returns

– Training costs as a percentage of revenue

Non financial measures are used to assess the impact of quality improvement

programmes further and the impact of quality of costs.

– Number of defect at inspection as percentage of the number of units produced.

– Number from reworked units expressed as percentage of total sales value

– Number of defective units delivered to customers as percentage of total units

delivered

– Number of customer complaints

– Number of defectives supplied by suppliers

– Time taken to respond customer requests.

JUST-IN-TIME (JIT)

JIT is method of inventory control based on 2 principles.

1. Goods and services should be produced only when they are

needed.

2. Products or services must be delivered to the customer at the

time the customer wants them. (just-in-time)

• Therefore JIT considers inventory as a burden hence targeting for zero

inventory.

• Since this is not possible, purchasing systems are placed to eliminate

administrative costs and to ensure that receipt and usage of materials, to

the maximum extent possible, coincide.

• JIT responds to customer demand, so that regarded as a pull through

system which is in contrast with push system where inventories build up

when there is no immediate demand.

EXAMPLES OF WASTE

Overproduction Overproducing builds up inventory which go against JIT

Waiting time Evidence of hold up in the flow of production through the system.

E.g. set up time

Unnecessary movement Moving items or people around a production area does not add

value.

Waste in the process These caused by design defects, unfinished goods, reworks, due to

poor maintenance.

Inventory Building inventory does not add value to the business

Complexity in work

process Complexity adds unnecessary actions which do not add value

Defective goods Significant cause of waste in many operations

Inspection time This is wasteful because it does not add value. This can be

eliminated by making the process free from errors and defects.

Waste is defined as any activity that does not add value.

PREREQUISITES FOR JIT

Operational requirements for the successful implementation of JIT

production are as follows.

High quality

Without high quality, there will be disruptions in

production, reducing throughput. Production must be

reliable and not subject to hold-ups.

Speed

Throughput in the operation must be fast, so that

customer orders can be met by production. Without fast

throughput, it will be necessary hold some inventory to

meet customer orders.

Flexibility

The production system must be able to respond

immediately to customer orders. Production must

therefore be flexible, and in small batch sizes. Ideal batch

size is 1.

Lower costs Fewer errors, less waste, greater reliability and flexibility

and faster throughput should all help to reduce costs.

Benefits Problems

Less cash tied up in inventory

Relies on predictable demand,

flexible supplier and a flexible

workforce

Less storage space needed There will be initial set-up costs

Better quality For businesses with a wide

geographical spread

More flexible production

There is no fallback position if

disruptions occur in the supply

chain

Fewer bottlenecks It may be harder to switch

suppliers

Better co-ordination

More reliable and supportive

suppliers

BENEFITS AND PROBLEMS IN JIT

BREAK-EVEN ANALYSIS

C H A P T E R 5

COST-VOLUME-PROFIT ANALYSIS (CVP ANALYSIS)

• Defined as „study of the effects of future profit of changes in foxed

cost, variable cost, selling price, quantity and mix.’

• Contribution concept is used in the analysis.

• Important aspects of CVP analysis

– Contribution to sales (C/S) ratio

– Breakeven point

– Margin of safety

• 𝑐𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 = 𝑠𝑎𝑙𝑒𝑠 𝑣𝑎𝑙𝑢𝑒 − 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡

• Variable costs are sometimes referred to as marginal costs.

CONTRIBUTION SALES RATIO

•𝐶

𝑆 𝑟𝑎𝑡𝑖𝑜 =

𝑐𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡

𝑠𝑒𝑙𝑙𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 or

𝑡𝑜𝑡𝑎𝑙 𝑐𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛

𝑡𝑜𝑡𝑎𝑙 𝑠𝑎𝑙𝑒𝑠 𝑟𝑒𝑣𝑒𝑛𝑢𝑒

• C/S ratio of a product is the proportion of the selling price

that contributes to fixed overheads and profits. It is

comparable to the gross profit margin.

BREAKEVEN POINT

• Breakeven point will occur when;

– Total sales revenue = total costs, i.e. profit = 0

Or

– Total contribution = fixed costs, i.e. profit = 0

• Breakeven point can be calculated in number of units sold.

– 𝑏𝑟𝑒𝑎𝑘𝑒𝑣𝑒𝑛 𝑝𝑜𝑖𝑛𝑡 =𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠

𝑐𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡

• Breakeven point can be calculated in terms of revenue.

– 𝑏𝑟𝑒𝑎𝑘𝑒𝑣𝑒𝑛 𝑝𝑜𝑖𝑛𝑡 =𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠

𝐶

𝑆 𝑟𝑎𝑡𝑖𝑜

MARGIN OF SAFETY

• Margin of safety is the amount by which anticipated sales (in

units) can fall below budget before a business makes a loss. It

can be calculated in terms of number of units or as a

percentage of budgeted sales.

• Margin of safety calculation;

– Margin of safety = budgeted sales – breakeven point sales

– 𝑎𝑠 𝑎 % 𝑜𝑓 𝑏𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑠𝑎𝑙𝑒𝑠 =𝑏𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑠𝑎𝑙𝑒𝑠−𝑏𝑟𝑒𝑎𝑘𝑒𝑣𝑒𝑛 𝑠𝑎𝑙𝑒𝑠

𝑏𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑠𝑎𝑙𝑒𝑠

– Therefore;

• Expected profit = margin of safety (in units) X

contribution per unit

BREAKEVEN CHARTS

Interpretation of this breakeven chart will be in the next slide.

INTERPRETATION OF THE BREAKEVEN CHART

• Fixed costs are $20,000 – this is the point at which the total

cost line cuts the vertical axis.

• The breakeven point occurs at 1,000 units – this is the point

at which the line for total cost line crosses the line for total

revenue.

• At the breakeven point, costs and revenues total $50,000

each – this can be found by reading across to the vertical axis

at this point.

• We can see by reading along the horizontal axis that the

margin of safety is 700 units.

• Budgeted sales are 1,700 units – this is determined by adding

the margin of safety to the breakeven point.

STEPS IN DRAWING A BREAKEVEN CHART

1. Draw the axes to the extent where the maximum

monetary values and number of units take place. Use

appropriate scales to spread the graph well in the paper.

2. Draw the fixed cost line and label it.

3. Draw the total cost line and label it.

4. Draw the revenue line and label it.

5. Marked any required information on the chart and read off

solutions as required.

CONTRIBUTION BREAKEVEN CHART

• This type of chart is used to read contribution at any level of

activity since it is not able to read contribution in the conventional

chart.

• Profit and margin of safety can also be read in this chart and this

chart is useful when variable costs need more attention.

THE PROFIT VOLUME CHART

• Another form of breakeven chart in which the profit/loss is depicted

by a single line at each level of activity. This is useful when the user

wants to read the profit or loss at any level of activity.

• This can be easily drawn by plotting 2 points. One point is when

activity level is zero when the company incurs only fixed cost (here

it is $20,000) and the other point is calculated breakeven point

(1000 units)

MULTI PRODUCT BREAK-EVEN ANALYSIS

• Where an organization produces and sells more than one

product, a weighted average C/S ratio is calculated by using

the formula;

– 𝑤𝑒𝑖𝑔𝑕𝑡𝑒𝑑 𝑎𝑣𝑒𝑟𝑎𝑔𝑒𝐶

𝑆𝑟𝑎𝑡𝑖𝑜 =

𝑡𝑜𝑡𝑎𝑙 𝑐𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛

𝑡𝑜𝑡𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒

• Breakeven point is sales revenue can be calculated as;

– 𝑏𝑟𝑒𝑎𝑘𝑒𝑣𝑒𝑛 𝑝𝑜𝑖𝑛𝑡 =𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠

𝑤𝑒𝑖𝑔𝑕𝑡𝑒𝑑 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝐶

𝑆 𝑟𝑎𝑡𝑖𝑜

MULTI PRODUCT BREAK-EVEN ANALYSIS

• Breakeven analysis gets complex when multiple products are

sold due to different selling prices, variable costs and

contribution margins.

• In order to cope with this, CVP analysis assumes that pre-

determined sales mix will remain constant for all

volumes of activity.

• This allows for the calculation of a weighted average

contribution margin or a weighted average

contribution sales ratio which can be used in breakeven

analysis.

ESTABLISHING A TARGET PROFIT FOR MULTIPLE PRODUCTS

• This approach is the same as in single product situations, but

the weighted average contribution to sales ratio is now used

so that;

𝑟𝑒𝑣𝑒𝑛𝑢𝑒 𝑟𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑡𝑜 𝑔𝑒𝑛𝑒𝑟𝑎𝑡𝑒 𝑎 𝑡𝑎𝑟𝑔𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 =𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠 + 𝑟𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑝𝑟𝑜𝑓𝑖𝑡

𝑤𝑒𝑖𝑔𝑕𝑡𝑒𝑑 𝑎𝑣𝑒𝑟𝑎𝑔𝑒𝐶𝑆 𝑟𝑎𝑡𝑖𝑜

THE MULTI-PRODUCT PROFIT VOLUME GRAPH

In multi-product environment, 2 lines must be shown on the profit-volume

graph. One straight line, where a constant mix between the products is

assumed; and one bow shaped line, where it is assumed that the company

sells its most profitable product first and then its next most profitable

product and so on.

THE MULTI-PRODUCT PROFIT VOLUME GRAPH

The diagram illustrates 2 potential break even points.

• The lower line indicates the break even point if the

products are sold in the standard product mix.

• The upper line indicates the breakeven point if the

products are sold in order of the C/S ratio ranking.

STEPS IN DRAWING MULTI-PRODUCT PROFIT VOLUME GRAPH 1. Calculate the C/S ratio of each product being sold, and rank the products

in order of profitability.

2. Draw the graph by , showing cumulative sales revenue on the x axis and the profit/loss on the y axis in the order of profitability ranking. (So you will get the steepest slope first for the most profitable product, then the next steepest slope for the next profitable product and so on creating a bow shaped line.)

3. After bow shaped line is drawn, then match the end points of the bow shaped line. You get the lower line of the graph.

• This chart shows 2 different break even points depending on the way of sales are made. i.e. a lower (more favourable) break even point is achieved when sales are made according to the profitability ranking whereas a higher (less favourable) break even point is achieved when sales are made according to the constant sales mix.

ADVANTAGES AND DISADVANTAGES OF CVP ANALYSIS

Advantages Disadvantages

Provides a target volume

• Indicates a lowest amount of activity

necessary to prevent losses

Profits can be affected by other factors

besides volume

Some factors are;

• Unit price of input

• Efficiency

• Changes in production

technology

• Wars

• Strikes

• Legislation

Helps the understanding of costs and

revenues and the relationship between

them

• Aids decision making and can be

extended to show how changes in

fixed costs – variable costs

relationships or in revenues will

affect profit levels and break even

points.

A small change in the assumptions could

have a large change in the impact.

UNDERLYING ASSUMPTIONS IN CVP ANALYSIS

• A behaviour of total cost ad total revenue has been reliably

determined and is linear over the relevant range.

• All costs can be divided into fixed and variable elements.

• Total fixed cost remain constant over the relevant volume

range of the CVP analysis.

• Total variable costs are directly proportional to volume over

the relevant range.

• Selling prices are to be unchanged.

• Prices of the factors of production are to be unchanged (e.g.

material, prices, wage rates)

• Efficiency and productivity are to be unchanged.

UNDERLYING ASSUMPTIONS IN CVP ANALYSIS

• The analysis either covers a single product or assumes that a given

sales mix will be maintained as total volume changes.

• Revenues and costs are being compared on a single acitivity

basis(e.g. units produced and sold or sales value of production)

• Perhaps the most basic assumption of all is that the volume is the

only relevant factor affecting cost. Of course, other factors also

affect costs and sales. Ordinary CVP analysis is a crude

oversimplification when these factors are unjustifiably ignored.

• The volume of production equals the volume of sales, or change in

beginning and ending inventory levels are insignificant in amount.

• In multi-product systems;

– Sales mix remains constant is unrealistic. (theories such as

economic demand and supply, complementary product theories

are ignored.)

– Having 2 break even points is confusing.

RELEVANT COSTS AND DECISION

MAKING

C H A P T E R 6

CHARACTERISTICS OF RELEVANT COSTS

CIMA defines „relevant costs’ and „relevant revenues‟ as

the „costs and revenues appropriate to a specific management

decision; they are represented by future cash flows whose magnitude

will vary depending upon the outcome of the management decision

made’.

CHARACTERISTICS OF RELEVANT COSTS

Relevant costs and revenues have the following features.

1. They are future costs and revenues – as it is not possible

to change what happened in the past, then relevant costs

and revenues must be future costs and revenues.

2. They are incremental or differential – relevant costs

are incremental costs and it is the increase in costs and

revenues that occurs as a direct result of a decision taken

that is relevant. Common costs can be ignored for the

purpose of decision making.

3. They are cash flows – relevant costs do not include non-

monetary items such as depreciation.

DISTINCTION BETWEEN RELEVANT AND NON -RELEVANT COSTS

Sunk costs

(non-relevant)

A sunk cost has already been incurred and therefore will not be

relevant to the investment decision. Sunk cost is defined as „a cost

that has been irreversibly incurred or committed and cannot therefore

be considered relevant to a decision. Sunk cost may also be termed as

‘irrecoverable cost‟.

Committed costs

(non-relevant)

Expenditure that will be incurred in the future, but as a result of

decisions taken in the past that cannot now be changed. These are

known as committed costs and are not treated as relevant costs

for decision making.

Opportinity costs

(relevant)

As in all decision making, opportunity costs are relevant, and

should be included in decisions.

Fixed costs

(relevant/non-relevant)

Should be treated as a whole and only where relevant. This means

that fixed overheads that

“abosorbed”/”charged”/”allocated”/”apportioned” to a project

should be ignored. Only extra/incremental changes in fixed

overheads should be included in decisions.

Depreciation

(non-relevant)

Depreciation is not a cash flow, and so should never be included in

decisions. Because these costs are merely the book entries that

are designed to spread the original cost of an aseet over its useful

life.

OPPORTUNITY COST

• Opportunity cost is an important concept in decision making.

It represents the best alternative that is forgone in

taking the decision. It is simply referred as the cost of the

next best alternative.

• It is defined as ‘the value of thebenefit sacrificed when one course

of action is chosen, in preference to an alternative. The opportunity

cost is represented by the forgone potential benefit from the best

rejected course of action.’

OPPORTUNITY COST

Example:

Chris is deciding whether or not to take a skiing holiday this

year. The travel agent is quoting an all-inclusive holiday cost of

$675 for a week. Chris will lose the chance to earn $200 for a

part-time job during the week that the holiday would be taken.

Relevant cost if taking the holiday is $875. this is made up of

out-of-pocket cost of $675, plus the $200 opportunity cost, that

is the part-time wages forgone.

AVOIDABLE COSTS, DIFFERENTIAL AND INCREMENTAL COSTS

• There are 2 other types of relevant cost that you will need to

know about.

1. Avoidable costs

Defined as ‘the specific costs of an activity or sector of a business

which would be avoided if that activity or sector did not exist’.

e.g. if a company is considering shutting down a department,

then the avoidable costs are those that would be saved as a

result of the shut down. Such costs can be rental cost for space,

labour costs. But head office costs apportioned to the

department would not be avoidable since other operations have

to be administered by head office. Therefore head office cost will

not be relevant.

AVOIDABLE COSTS, DIFFERENTIAL AND INCREMENTAL COSTS

2. Differential/incremental costs

Defnied as ‘the difference in total cost between alternatives.

This is calculated to assist in decision making.’

e.g. if the relevant cost of contract X is $5,700 and the relevant

cost of contract Y is $6,200, we would say that the differential or

incremental cost is $500, that is the extra cost of contract Y is

$500.

INCREMENTAL REVENUE

Just as incremental costs are the differences in cost between

alternatives, so incremental revenues are the differences in

revenues between the alternatives. Matching the incremental

costs againsts the incremental revenues will produce a figure

for the incremental gain or loss between the alternatives.

THE RELEVANT COST OF VARIABLE COSTS AND OVERHEADS

1. Relevant cost of materials

Are the material

already in stock?

Will they be

replaced?

Will it be used

for other

purposes?

Net realisable

value

Cost of

purchase

Replacement

cost

Opportunity

cost f alternative

use

No

Yes

No

No

Yes

Yes

THE RELEVANT COST OF VARIABLE COSTS AND OVERHEADS

2. Relevant cost of labour

Is there spare

capacity?

Can additional

labour be hired?

Contribution

forgone PLUS

direct labour

cost

Nil

Direct labour

cost

Yes

No

No

Yes

THE RELEVANT COST OF VARIABLE COSTS AND OVERHEADS

3. Relevant cost of overheads

Relevant cost of overheads

Only those overheads that vary

as a direct result of a decision

taken are relevant overheads

RELEVANT COST OF NON-CURRENT ASSETS

• If plant and machinery is to be replaced at the end of its

useful life, then the relevant cost is the current replacement

cost.

• If plant and machinery is not to be replaced, then the relevant

cost is the higher of the sale proceeds (if sold) and the net

cash inflows arising from the use of the asset (if not sold).

DECISION MAKING BASED ON RELEVANT COSTING PRINCIPLES

• The types of decisions you may be asked to deal with

include and which are explored in the following sections are;

– Limiting factor decisions

– Make or buy decisions

– Shutdown decisions including deleting a segment or

temporary closure

– Accept or reject an order decisions

– Minimum pricing decisions

– Joint product and further processing decisions

In all of these decisions it will be important to remember that

only relevant costs should be used in the calculations.

LIMITING FACTOR DECISIONS

A limiting factor refers to a resources which prevents a

company from achieving the output and sale that it would like

to achieve.

• Single limiting factor

If there is a just one limiting factor then the rule is to

maximise the contribution per unit of scarce

resource.

Given that fixed costs are unaffected by the short term

production decision, the problem is best solved as follows;

1. Identify the bottleneck constraint (also known as the

limiting factor, key budget factor or principal budget

factor)

2. Calculate the contribution per unit for each product

LIMITING FACTOR DECISIONS

3. Calculate the contribution per unit of the bottleneck

resource for each product

4. Rank the products in order of the contribution per unit

of the bottleneck resource

5. Allocate resources using this ranking and answer the

question.

• This method is appropriate when there is only one limiting

factor. For multiple scarce resources, linear programming will

be used.

MAKE OR BUY DECISIONS

• This is an extension to the limiting factor problem. If it is

possible to buy-in the product and therefore avoid the use of

limiting factor, then the products need to be ranked

differently.

• Products should be ranked (from highest to lowest) based on

the saving made (the difference between the buy-in cost

and the incremental cost of internal production) per usage

of the scarce resource.

• If the internally manufactured components cost the direct

material, wages costs and variable factory overhead all of

which are greater than the buy-in cost, then the decision

would be to purchase components externally.

Accept or reject decisions

– This might occur where a customer has placed a one-off

order for a product or a service.

– The selling price ill already be known and if it is greater

than the relevant costs, the order should be accepted.

Shut down decisions

– This type of decision may involve deleting (or shutting

down) a segement of the business. A product line, a

service etc.

– The focus for shut down decisions should be whether the

costs and revenues are avoidable.

– Businesses need to therefore determine the forgone

revenues from the closure and the incremental cost

savings from closure.

MINIMUM PRICING DECISIONS

• The minimum pricing decision is a useful method in situation

where there is a lot of intense competition, surplus

production capacity, clearance of old stocks, getting special

orders and/or improving market share of the product.

• The minimum price should be set at the incremental costs of

manufacturing, plus opportunity costs (if any).

– E.g. a company has prepapred a summary of relevant costs

for a special order. Here the minimum price should be

$650.

MINIMUM PRICING DECISIONS

• Minimum price is a start for the pricing decision for a product

in these instances. Management can price a higher selling price

than the minimum price to improve company‟s profits.

Material P $120

Material Q $(280)

Labour -

Variable overhead $600

Rent forgone $210

Total relevant cost $650

JOINT PRODUCTS AND FURTHER PROCESSING DECISIONS

With many joint products, it is possible to sell the product at

the split-off point or to send it through a further process

which will enhance its value. There 2 rules to follow when

ascertaining whether the further processing is worthwhile.

1. Only the incremental costs and revenues of the further

process are relevant.

2. The joint process costs are irrelevant – they are already

„sunk‟ at the point of separation.

JOINT PRODUCTS AND FURTHER PROCESSING DECISIONS

• The main decisions involving joint products are;

– To carry out the whole process or not (here the common

costs in total are relevant since it is decision about carrying

out a whole process)

– Whether or not to further process products (here the

revenues and costs at split-off point are irrelevant to the

decision)

QUALITATIVE FACTORS IN DECISION MAKING

• In some decision-making situations, qualitative aspects are

more important than immediate financial benefit from a

decision. They will vary with different business circumstances

and are those factors relevant to a decision that are difficult

or impossible to measure in terms of money.

• Qualitative factors are defined as ‘factors that are relevant to a

decision but are not expressed numerically’.

• For an organisation faced with a decision qualitative factors

may include;

– The state of economy, and its levels of inflation

– The availability of cash

– Effect of a decision on employee morale, schedules and

other internal elements

QUALITATIVE FACTORS IN DECISION MAKING

– Effects of a decision on relationships with and

commitments to different stakeholders, such as;

• Shareholders

• Managers

• Environment

• Local community

• Suppliers

– Effect of a decision on long-term future profitability

– Effect of a decision on a company‟s public image and the

reaction of customers

– The likely reaction of customers