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The role of various cost concepts in decision making process
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Super Admin

 
By Super Admin
Published on 30 August 2006
 
In this assignment, at first define various types of costs (manufacturing costs, non-manufacturing costs, fixed costs, variable cost, absorption costing, variable costing, opportunity costs, sunk costs, product costs, period costs, differential costs, standard costs, direct cost & indirect cost, mixed cost) then show how they are playing role in different situation.

The role of various cost concepts in decision–making process

April 08, 2002

Rakibur Rahman Khan
Course instructor
School of Business,
Independent University,
Baridhara, Dhaka.

Dear Sir,

It is my immense pleasure to submit my class project on various costs concept, as you asked me to prepare and submit as a requirement of Accounting-202 program. The name of my project is " The role of various cost concepts in decision–making process "

I have tried my best to compile the pertinent information as comprehensively as possible. And if you need any further information, I will be obliged to assist you.


Thanking you,
Md.Sakil Siddique
ID: 0010005

 

Decision making is central to the management of an enterprise. The manager of a profit making business has to decide on the manner of implementation of the objectives of the business, at least one of which may well relate to allocating resources so as to maximize profit. All organizations, whether in the private or the public sector, take decisions, which have financial implications. Decisions will be about resources, which may be people, products, services, or long term and short term investment. Decisions will also be about activities, including whether and how to undertake them. Where the owners are different persons from the manager (for example, shareholders of a company as separate persons from the directors), the managers may face a decision where there is a potential conflict between their own interests and those of the owners. In such a situation cost considerations may be evaluated in the wider context of the responsibility of the managers to act in the best interests of the owners.

The name of my project is " The role of various cost concepts in decision–making process " In this assignment I am trying to define the cost first then show how they are playing role in different situation. The costs that I discuss about are as follows:

Manufacturing costs
Non-manufacturing costs
Fixed costs
Variable cost
Absorption costing
Variable costing
Opportunity costs
Sunk costs
Product costs
Period costs
Differential costs
Standard costs
Direct cost & Indirect cost
Mixed cost.


Manufacturing costs, non-manufacturing costs & their role in decision-making

Manufacturing costs:

Most manufacturing companies divide manufacturing cost into three broad categories. Direct material, Direct labor and Manufacturing overhead.

Direct material: Direct materials are those materials that become an integral part of the finished product and that can be physically and conveniently traced to it. For example: Panasonic use electric motor in it’s CD Players to make the CD spin.

Direct labor: The term direct labor is reserved for those labor costs that can be easily traced to individual product. Direct labor is sometime called touch labor, since direct labor workers typically touch the product while it is being made. For example the labor cost of machine operator.

Manufacturing overhead: Manufacturing overhead the third element of manufacturing cost, includes all cost of manufacturing except direct material and direct labor. So, we can say that all costs associated with operating the factory are included in the manufacturing overhead category. Such as indirect material, indirect labor, maintenance and repairs on production equipment etc.

Role in decision-making

Manufacturing cost is used to determine the inventory valuation on the balance sheet and cost of goods sold on the income statement of external financial reports.
Assume that Tongi national company produce fan. The total manufacturing cost of one unit is 850 taka, where

Direct material:   400 tk
Direct labor:        150 tk
MOH:                  300 tk
Total                    850 tk

Now from this manufacturing cost the company can decide that how much they want to make profit and set a selling price based on that. Suppose they want to make 20% profit on manufacturing cost then their selling price will be 1020 tk.

But after setting selling price they see that one of their competitor sales their product at 950 tk. In this situation the company can justify the manufacturing cost that where the wrong is going on. If their material price is high then they can buy the raw material from other supplier at low cost to reduce the access cost. If their labor cost is high, then they can hire labor from other at low cost or can cut the number of employee to reduce the cost. By taking this corrective action the company can maintain the manufacturing cost to stay in the market.

Non-manufacturing costs:

Generally non-manufacturing costs are sub-classified into two categories, (1) Selling costs, (2) Administrative costs

Selling costs: Selling cost include all costs necessary to secure customer orders and get the finished product on service into the hand of the customer. This cost is also known as marketing cost. Example: Advertising, Shipping, Sales travel etc.

Administrative costs: It includes all executive, organizational and clerical costs associated with the general management of an organization rather than with manufacturing and selling. Example: Secretarial, compensation, public relation and other this types of costs

Role in decision-making

Non-manufacturing cost is playing a great role in decision-making. In income statement we deduct non-manufacturing cost or operating cost from gross margin to get net profit. Suppose we expect “X” amount of money as net profit. But if the net income falls below than our expectation, then we must reduce operating cost to gain more profit. We can give one example to clear this idea. Suppose our net income is less than our expectation. Now we have to reduce price. We can take advertising cost as a sample. In case of advertising our first motive is to identify our target consumer then we have to select the advertising media. Suppose we make one types of product and our target consumers are fishermen. In this case we must use radio as an advertising media rather than television and it will cost less. By this way we can save non-manufacturing cost. In this purpose we can also reduce the cost of shipping, sales travel, compensation, public relation cost, sales salary etc. to increase net profit. 


Fixed costs, variable costs & their role in decision-making

Fixed costs:

A fixed cost is a cost that remains constant in total, regardless of changes in the level of activity. As the activity level rises and falls, the fixed cost remains constant in total amount unless influenced by some outside force, Such as price changes. There are two types of fixed cost.

(1) Committed fixed cost: Committed fixed costs relate to the investment in facilities, equipment and the basic organizational structure of a firm. Example: Rent.

(2) Discretionary fixed cost: Discretionary fixed cost usually arise from annual decisions by management to spend in certain fixed cost areas. Example: Advertising.

Role in decision-making

Usually fixed cost is used to determine break-even point. The formula for break-even point is = fixed cost  Cm per unit.
Suppose our fixed cost       = $ 20,000
                     Selling price  = $ 250
                     Variable cost = $ 150
Then break-even unit = {20,000  (250 – 150)}
                                   = 200 unit
In the break-even point there is no profit as well as no loss at all. We have calculated break-even point to determine the sales level and using this method we can also calculate the number of unit to gain our expected profit.
Reduction of fixed cost is also very important to increase net income. If we reduce fixed cost per unit then it will contribute to net income. Suppose our production is not running in our full capacity level then we can increase production in order to reduce our fixed cost per unit. For example:
Capacity:         400 Units
Production:     300 Units
Fixed cost:      $20,000
Variable cost:  $150
Selling price:   $250

      Current income statement
Sales          =             $75,000
(300 250)
(-) V. cost           =             $45,000
(300150)                        
Cm                                     $30,000
(-) F. cost           =              $20,000
Net income                        $10,000
                                        
Here we see that in the current situation we have a net income of $10,000. Now we get an offer from outside to deliver 100 extra units at $200. In this case our proposed net income as follows:

      Proposed income statement
Sales   =                   $95,000
(300 250) + (100200)
(-) V. cost           =            $60,000
(400150)                        
Cm                                    $35,000
(-) F. cost           =             $20,000
Net income                       $15,000
 
In this case we will accept the proposal because our proposed net income is greater than the current net income. Though the proposed selling price is less than current one but we can generate more income because in this case fixed cost goes down from (20,000  300) = $66.67 to (20,000  400) = $50.00, So here we see that how fixed cost plays effective role in decision-making.


Variable cost:

A variable cost is a cost that varies in total, in direct proportion to changes in the level of activity. The activity can be expressed in many ways, such as units produced, units sold, miles driven, lines of print and so forth. A good example of variable cost is direct material. It is important to note that when we speak of a cost as being variable, we mean the total cost rises and falls as the activity level rises and falls. There are two types of variable cost.

(1) True variable cost: Direct material is a true variable cost because the amount used during a period will vary in direct proportion to the level of production activity.

(2) Step-variable cost: A cost that is obtained only in large chunks and that increases or decreases only in response to fairly wide changes in the activity level is known as step-variable cost. Maintenance cost is an example of step-variable cost.

Role in decision-making

Variable cost plays a great role in decision-making we know that if we increase our production then our variable cost will also increase. So we have to concentrate on reduction of total cost and in this case we must consider fixed cost also. If we increase our production within our capacity, our unit cost of production will decrease. Because as production increase variable cost will also increase but fixed cost per unit will decrease.

Suppose,
Variable cost =  $1                                                                                                                                                                                                                                                                                                                                                                                                             
          Fixed cost     = $10
          Capacity        = 20 unit

    Production        Variable cost          Fixed cost           Total cost
         unit                   per unit                per unit                per unit

           5                          1                           2                          3
          10                         1                           1                          2
          15                         1                          .56                       1.56

Here we see that as production increases total cost per unit decrease because fixed cost per unit continuously decreases. So, in case of reducing total cost we must increase the production level. And as we know variable cost is constant so we must try to reduce the total cost from other sector to generate more profit. Thus variable cost has a significant impact on selling price.   

Variable cost is also used to calculate cm per unit, cm ratio, margin of safety, degree of operating leverage and other this types of important things.


Absorption costing, Variable costing and their role in decision making

Absorption costing:

A costing method that includes all manufacturing costs, direct materials, direct labor and both variable and fixed overhead as part of the cost of a finished unit of production.
For example in this method the unit cost is as follows:

Unit cost           
Direct material:           03
Direct labor:               02
Variable MOH:          03
Fixed MOH:               02                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
Total                   $ 10 per unit
Here fixed and variable MOH both are considered.

Role in decision-making

Absorption costing is the generally accepted method for preparing mandatory external financial reports and income tax returns. Absorption costing treats fixed manufacturing overhead as a product cost. If fixed costs are treated as period costs and there is a low level of sales activity in a period then a low profit or a loss will be recorded. If there is a high level of sales activity there will be relatively high profit. Absorption costing creates a smoothing of these fluctuations by carrying the fixed costs forward until the goods are sold. Many firms use the Absorption approach exclusively because of its focus on full costing of units of product.

Variable costing:

In variable costing, only variable costs of production are allocated to products and the unsold stock is valued at variable cost of production. Fixed production costs are treated as a cost of the period in which they are incurred.
For example in this method the unit cost is as follows:

Unit cost           
Direct material:          03
Direct labor:               02
Variable MOH:          03
Total                   $ 08 per unit

Here fixed MOH is not considered.

Role in decision-making

Variable costing is used internally for planning purposes. Under Variable costing, only those production costs that vary with output are treated as product cost. This includes direct material, direct labor and variable overhead. Fixed manufacture overhead is treated as a period cost and charged off against revenue as it is incurred, the same as selling and administrative expenses. Under Variable costing, the profit for a period is not affected by changes in inventory. This cost is particularly important for company having cash flow problems. One thing is very important that when Variable costing is in use profits move in the same direction as sales. We can also take the data for CVP analysis directly from a contribution margin format income statement that are not available on a conventional income statement based on absorption costing. The Variable costing approaches are often indispensable in profit planning and decision-making.


Opportunity costs, Sunk costs & its role in decision making

Opportunity costs:

Opportunity cost is the potential benefit that is given up when one alternative is selected over another. For example: Suppose I worked in a company and it gives me 20,000 taka per month. But suddenly I leave that job and get admitted in North-South University for M.B.A. Then my salary 20,000 taka is my opportunity cost which I sacrificed for further education.

Role in decision-making

Opportunity cost is a very important item, which is playing an effective role in decision-making. By considering opportunity cost we can determine the real cost of production. We can give an example to clear this idea.

Let,
Direct material        : $3 (Avoidable)
Direct Labor           : $2 (Avoidable)
Supervisor salary    : $1 (Avoidable)
Factory rent            : $1 (Unavoidable)
Depreciation           : $2 (Unavoidable)
Allocated general
       Expense            : $3 (Unavoidable)
Total cost per unit   : $12

Avoidable cost        : (3+2+1) = $6
Unavoidable cost     : (1+2+3) = $6

Here we see that if we make the material the cost of per unit will be $12. Now we get an offer from outside at $8 per unit. If we want to buy we have to consider some other things because there are some unavoidable cost that we can’t ignore. It will add to the buying cost. Now we see that if we buy it will costs (8+6) =  $14 per unit. So we can easily determine that we will go for making not buying. In this case we have to consider opportunity cost. Suppose the room, where we will make our production, the rent of that room is $20,000 and we get an offer for 5,000 unit.

                                           Make                                    Buy
Unit cost                               $12                                      $14
For 5,000 unit                    $60,000                               $70,000
(+) Opportunity cost          $20,000                                   ------
Total cost                           $80,000                              $70,000


Here we see that if we go for making it will cost more and if we buy raw material from outside we can generate $10,000 as a profit. So, in this case we will definitely go for buy not make.

Sunk costs:

A sunk cost is a cost that has already been incurred and that cannot be changed by any decision made now or in the future. So, they should be ignored when making decision. Example: Suppose we buy a machine costs 50,000 taka to produce one kind of goods. But now there is no longer demand of that product. So we buy another new machine costs 70,000 taka. Now there is no use of old machine and we have already incurred that cost. So, here 50,000 taka is sunk cost, which was paid for purchasing of old machine.

Role in decision-making

Sunk cost does not play any role in decision-making. On the other hand it plays a great role in decision -making. Usually we deduct the sunk cost from both keep old machine & purchase of new machine. By this way we can show the proper fixed cost. Suppose our sunk cost is $50,000 but the salvage value of that machine is $20,000. Now if we don’t consider the sunk cost then it will show us $20,000 income and if we consider sunk cost, ultimately it will show us 30,000 losses. Thus sunk cost plays an effective role to show proper income. Sunk cost is also playing a great role in another criteria. If we don’t deduct the sunk cost from fixed cost then our fixed cost will be greater and our unit cost will increase also. In this case we cannot compete with our competitors. So we must deduct sunk cost from our account.


Product costs, period costs & role in decision making

Product costs:

Product costs include all the costs that are involved in acquiring or making a product. In the case of manufacturing goods these costs consist of direct material, direct labor and manufacturing overhead. Product costs are initially assigned to inventories. So, they are known as inventoriable costs.

Role in decision-making

If an organization want to minimize their inventory cost they can fallow just in time process. In this process the cost of inventory is less than the normal process. So, the product cost is minimized and it will help to generate more profit.

If an organization follows normal process for manufacturing goods, then they must reserve material for future and it will cost a lot. Such as rent for place, guard salary, maintenance cost. And it will reduce net income. So, they must follow just in time process to increase the net income.

Period costs:

Period costs are all the costs that are not incurred in product costs. These costs are expensed on the income statement in the period in which they are incurred, using the usual rules of accrual accounting. Period costs are not included as part of the cost of either purchase or manufactured goods. Example: Sales commission, Office rent.

Role in decision-making

Depending on period cost we can also take some corrective action. Normally sales commission, office rent and other these types of cost are included in period cost. Suppose our net income is lower than our expectation then we can increase our net income by reducing period cost. Let’s take office rent. If our office rent is high then we can reduce the rent by shifting office place. However for many decision-making purposes the period costs are seen as being non-controllable in the short-term, so that attention may focus on product cost.


Differential costs, standard costs and role in decision-making

Differential costs:

A difference in costs between any two alternatives is known as differential cost. A differential cost is also known as incremental cost. Technically an incremental cost should refer only to an increase in cost from one alternative to another. Decreases in cost should be referred to as decremental costs. So here we see that differential cost is broader term consist of both incremental cost & decremental cost.  

Role in decision-making

Differential cost can be either fixed or variable. To illustrate assume that Keya cosmetics ltd. is thinking about changing it’s marketing method from distribution through retailer to distribution by door-to-door direct sale. Present cost and revenues are compared to projected costs and revenues in the following table:


                                     Retailer                Direct sale             Differential cost
                                  Distribution            Distribution                and revenue
Revenue                      $500,000                  $600,000                       $100,000
Deduct                      =======================================
Cost of good sold         $150,000                 $200,000                   $50,000
Advertising                  $50,000                    $25,000                     $(25,000)
Commission                   - 0 -                        $20,000                     $20,000
Depreciation                $25,000                    $50,000                     $25,000
Other expenses            $20,000                    $20,000                         -- 0 -- 
Total                            $245,000                   $315,000                   $70,000
Net income                  $255,000                   $285,000                   $30,000
                                  ======================================
According to the analysis the differential revenue is $100,000 and the differential cost is $70,000 leaving a positive differential net income $30,000 under the proposed marketing plan.
From the given table the company can easily decide that which marketing plan they should follow. As we see in the above analysis the net income under door-to-door is $30,000 higher than the previous one. And they can get it simply focusing on differential cost, revenue and net income. By this way differential cost helps in decision-making.

Standard costs:

Standard costs are target costs, which should be attained under specified operating conditions. They are expressed as a cost per unit. For example: Hospitals have standard cost (for food, laundry and other items) for each occupied bed per day, as well as standard time allowance for certain routine activities, such as laboratory test.                                                 

Role in decision-making

Standard cost is used to integrate costs in the planning and pricing and pricing structure of a business.  Once the Standard cost has been decided, the actual cost may be compared with the standard. If it equals the standard then the actual outcome has matched expectations. If the actual cost is different from the standard cost allowed, then there will be variance to be investigated, whether it is favourable or unfavourable. When the actual cost is less than the standard cost then it is called favourable and when the actual cost is greater than the standard cost then it is called unfavourable. In case of favourable term management will accept the proposal and in case of unfavourable term, they will reject it.
Direct cost & Indirect cost


Direct cost, indirect cost, mixed cost and role in decision-making

Direct cost:

A direct cost is a cost that cannot be easily and conveniently traced to the particular cost object under consideration. The concept of direct cost extends beyond just direct material and direct labor. Example: Suppose woodland company is assigning costs to it’s various regional and national sales offices. Then the salary of the sales manager in its Bombay office would be a direct cost of that office.

Indirect cost:

An indirect cost is a cost that cannot be easily and conveniently traced to the particular cost object under consideration. For example: Igloo company makes varieties ice-cream. The factory manager’s salary would be an indirect cost of a particular variety such as igloo chocbar.

Role in decision-making

Direct cost includes direct material, direct labor; on the other hand indirect cost includes indirect material and indirect labor. They are playing a great role in decision-making, but not individually. They have a significant impact on manufacturing cost, because these costs are included in manufacturing cost. So ultimately they are playing role in setting selling price.

Mixed cost:

A mixed cost is one that contains both variable and fixed cost elements. Mixed costs are also known as semi-variable cost. Mixed cost is calculated by following equation.

Y = a  bx
Here Y = Total cost
a = fixed cost
b = Variable cost
x = Total unit.

The fixed portion of a mixed cost represents the basic, minimum cost of just having a service ready and available for use. The variable portion represents the cost incurred for actual consumption of the service. The account analysis and the engineering approach is used to estimate the fixed and variable portion of a mixed cost.

For example: The cost of providing X-ray services to the to patients at the P>G hospital is a mixed cost. There are substantial fixed costs for equipment depreciation and for salaries for radiologists and technicians but there are also variable costs for X-ray film, power and supplies.

Role in decision-making

Mixed costs also have some role in decision-making because this cost is a combined form of fixed and variable cost. As we know fixed costs are constant but variable cost differs with the production level. So, by reducing the variable cost we can decrease total unit cost and it will help to increase net income.


Conclusion and sources

Conclusion

If any organization wants to run a manufacturing company successfully then the management needs to take proper decision on time. . Most decisions will at some stage involve consideration of financial matters, particularly cost. Decisions may also have an impact on the working conditions and employment prospects of employees of the organization, so that cost considerations may, in the final analysis, be weighed against social issues. If the management can control the cost then the company will generate more profit, on the other way they will suffer loss. So, by going through this project we can easily understand how different types of cost play role in decision-making and we can apply these terms in practical life.

 

Sources:
                      1. Managerial Accounting
                               Ray H. Garrison
                               Eric W. Noreen

                      2. Introduction to Management Accounting
                               Professor Pauline Weetman
                               Paul Gordon

                      3. Class lecture