December 8, 2011

Traditional Cost Objectives and Their Utility - Review Notes


Cost Object: Cost object is anything for which a separate measurement of cost is desired.

Product cost and department cost are two main cost objects or cost objectives. But as a concept cost object can be anything for which a measurement of cost is desired.

Managers can ask the cost accounting department for cost information that is required for their decision models. Ordering cost, inventory carrying cost, shortage cost etc. are cost information for decision making in inventory area. Inventory managers or materials managers are justified in asking for these pieces of cost information from the cost accounting department.

Similarly, production management decisions, equipment replacement decisions require cost information for decision making.

There is a possibility that cost accountants do not understand the concepts, that operating managers are using for cost information. But cost accounting texts do use many of these concepts. So basically a coordination is required between the operating department and the cost accounting department to arrive at proper cost information.

A cost system accumulates costs and the assigns them to various cost objects. Information regarding cost objects requires that there is a cost accumulation system designed for providing the required cost information is in place. Activity based costing system can give much more information compared to traditional cost accumulation systems. But operating departments have to provide more information also in Activity based costing system when they are preparing their expense vouchers or material issue slips and similar other documents.

A List of Cost Objectives in Different Disciplines of Management

Materials Management (Inventory Control)

Ordering Cost
Inventory Carrying Cost
Shortage Cost

Production Management

Set Up cost
Cost of Quality

Maintenance Management

Breakdown cost

Human Resources Management

Cost Absenteeism
Cost of Ignorance

Cost-Volume-Profit Analysis

Cost-Volume-Profit analysis examines the behavior of total revenues, total costs, and profit as changes occur in the output level, selling price, variable costs per unit, or fixed costs. Therefore, the analysis is useful in taking decisions that involve change in these variables or setting these variables.

The standard model of CVP analysis is based on these assumptions.

1. At this stage of decision making, revenues and costs changes only because of change in output sold.
2. Total cost related to the product under consideration can be broken down into fixed cost and variable cost.
3. In the range where decision making is involved, the relation between total revenue and total cost is linear (straight line).
4. The unit selling price, variable cost, and fixed cost are constant within the range of decision making.
5. This analysis is used with single product focus (Change in the volume of this product has no effect on other product costs)
6. As it is a short period decision, time value of money is not considered in the analysis.

In the chapter, Horngren et al. defined Operating income from the product as total revenue from operations (manufacture and sale of the product) minus operating costs that include manufacturing, selling and distribution.

Contribution margin: The difference between total revenues and total variable costs is called contribution margin.

Contribution margin per unit is the difference between the selling price and the variable cost of the unit.

Breakeven point: Breakeven point is that quantity of sales where total revenues equal total costs. Managers are interested to know this figure as they have to plan and make efforts to keep sales well above this level of sales and should not allow sales to fall below this level except under extraordinary circumstances.

Equation of method of calculating breakeven point
Revenue - variable cost - fixed cost = 0 (Total renue = Total cost)
(USP * SQ) - (UVC * SQ) - FC = 0

Where USP = Unit selling price, SQ = Sales in quantity, UVC = Unit variable cost, FC = Fixed cost)

Above equation can be rewritten as

As UVP - UVC is called Contribution margin per unit or Unit contribution margin (UCM)
Break even point = FC/UCM

Target Operating
What should be the sales target to get a prespecified operating income.
As the equation is
Revenue - Variable cost - Fixed cost = Operating income
(USP * SQ) - (UVC * SQ) - FC = OI

Where USP = Unit selling price, SQ = Sales in quantity, UVC = Unit variable cost, FC = Fixed cost, OI = Operating income)
if a target is specified for OI, the targt sales quantity can be calculated.

Refer for More Detailed Explanation
Horngren et al. Cost Accounting, 13th Edition, Pearson Education
Cost Accounting - Horngren et al., Book Information and Review

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1 comment:

  1. Cost of ignorance - I have to find where I wrote about it in detail.