4a Costing and Financial Decision Making

4a Costing and Financial Decision Making - COSTING &...

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COSTING & FINANCIAL DECISION-MAKING January 2009 © Professor K E O’Neill
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Expected Outcomes understand costing terminology be able to distinguish between absorption and marginal (contribution) costing understand and calculate contribution, break-even points and margin of safety be able to analyse a range of modules to determine how much each contributes to the fixed costs and profits be able to build up the cost of a product or service from the elements of cost and pricing decisions - 2 -
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1 Introduction to Costing Why do we need detailed cost information? to price future contracts to prepare budgets to indicate trends to aid decision-making to value stocks to help achieve profit objectives Are small cost savings worth the effort? Imagine product which sells for $10/kg Cost/kg Materials $3.00 Labour $4.00 Overheads $2.60 Total cost/kg $9.60 Profit/kg $0.40 Suppose we reduce each item of costs by 5% Materials $2.85 Down 5% Labour $3.80 Down 5% Overheads $2.47 Down 5% Total cost/kg $9.12/kg Down 5% Profit/kg $0.88/kg Up 120% We are in business to make a profit – the benefit of even small cost reductions is therefore apparent. A 5% reduction is perhaps ambitious, but even a 1% reduction would have increased profits by 24%. What if we allow costs to rise through weak management? In the previous example if the original costs had risen by 5% the position would be Materials $3.15 Labour $4.20 Overheads $2.73 Total cost/kg $10.08 Loss $0.08 k/g The need for effective control of costs is obvious. Situations can require information in great detail, on a frequent basis, doing everything we can to achieve small reductions in cost and trying to avoid small increased. - 3 -
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i. Costing Terminology (i) The elements of cost are: Materials (part of product) Labour (wage and salary costs) Expense (the rest!) (ii) Costs can be direct or indirect ie direct materials indirect materials + direct labour + indirect labour + direct expenses + indirect expenses = DIRECT COSTS = OVERHEADS (iii) Costs can be variable or fixed ie variable materials fixed materials + variable labour + fixed labour + direct expenses + fixed expenses = MARGINAL/VARIABLE = FIXED COSTS COSTS (v) So there can be fixed and variable overheads! - 4 -
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DIFFERENCES BETWEEN ABSORPTION AND MARGINAL COSTING In introducing the two approaches, the key message is that they differ in the way they treat “fixed costs” or as they are more often called (incorrectly) “overheads”. As long as we are aware that we are dealing with fixed costs (as opposed to variable costs) when we allude to overheads we can stick with the usage of the word in some of the examples which follow. Businesses exist to produce profits for the owners – without profit the business will not
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This note was uploaded on 10/13/2009 for the course MGT 3150 taught by Professor Ken during the Spring '09 term at Al Akhawayn University.

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4a Costing and Financial Decision Making - COSTING &...

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