Strategic Cost Management

Reference Books

Cost Management : Ravi M. Kishore Cost Management – A Strategic

Emphasis: Bolcher, Chen/Lin Cost Management : Jawahar Lal Cost Accounting: Khan & Jain

COST MANAGEMENT INFORMATION

Cost management information is required for major management functions:

Strategic management Planning and decision making Management and Operational

Control Preparation of Financial statements

A Manager Quoted in Cost Accounting Desk Reference by Dudick, Best and Kraus

“When I first took over as General Manager, I Asked the cost accountant for some cost information. What I received was several computer output reports containing unanalyzed raw data. There as no question about the accuracy of the numbers, but what surprised me was how unfamiliar this individual was with the manufacturing process for making the products. He had difficulty in associating the figures contained in the reports with the factory operations behind the figures”

STRATEGIC MANAGEMET

A strategy is a set of goals and specific action plan which if

achieved will provide the desired competitive advantage.

Strategic Management involves identification and

implementation of these goals and action plan.

Strategic Cost Management SCM is the development of cost

management information to facilitate the principal management function, strategic management

COST

Amount of expenditure actual or notional relating to cost object.

Fixed Cost Variable cost

COST FOR DECISION MAKING

OPPORTUNITY COST- An opportunity cost is the benefit given up or sacrificed when one alternative is chosen over another. They are not recorded in the accounting system as they are not based on the past payment or commitments to pay in future.

SUNK COST:

A cost that has already been incurred. It is a past or committed cost which is gone for forever. It’s a historical cost.

RELEVANT COST: Cost which differs between alternatives. Cost which may also be defined as the costs which are affected and changed by the decision.

DIFFRENTIAL COST: It is the difference in total cost between any two alternatives. It is the only difference in amount of two cost.

SHUT DOWN COST:

Cost which have to be incurred under all situations in the case of stopping manufacture of a product or closing down a department or a division.

CONTROLLABLE &NON CONTROLLABLE COST: A cost which can be influenced by the action of a specified member of an undertaking

(Controllable cost) A cost which cannot be influenced by the action of a specified member of an undertaking ( Non controllable)

MARGINAL COSTING

According to Institute of Cost &Management Accountants London Marginal Cost represents “the amount of any given volume of output by which aggregate costs are changed if the volume of output is increased by one unit”

For example:

Cost of production of 1000 units =Rs.200,000

Cost of production for 1001 units=Rs.200,150

difference= Rs. 150 (Marginal Cost)

Decipher this one:

7 I of I Hint There are also seven books in the

set.

Answer 7 Incarnations of Immortality

Every now and then you cut my headYet I don't complain but obey instead

I am a way for your thoughts and feelings to be spreadDespite the fact that I am totally dead

A double edged weapon that is easily leadSo don't always believe me: use your head

Answer The pencil.

Cut my head: by sharpeningObey instead: write whatever you wantWay for your thoughts and feelings to be spread: by expressing them through writing

Can you decipher this phrase?

ch poorri

Hint Think Robin Hood.

Answer Take from the rich and give to the

poor.

What phrase is shown below?

The Hamburgler Horse RustlersBonnie & Clyde Honor Ali BabaThe Great Train Robbers Billy the Kid

Answer Honour amongst thieves

MARGINAL COSTING

According to Institute of Cost &Management Accountants London Marginal Cost represents “the amount of any given volume of output by which aggregate costs are changed if the volume of output is increased by one unit”

ASSUMPTIONS:

Elements of Cost: Production, Administration and Selling Expenses are divided into fixed and variable cost

Variable cost fluctuates directly in proportion to changes in volume of output.

Selling price remains constantFixed cost remains constantVolume of production Influences costVolume cost are regarded as cost of the

products.

Break Even Analysis/Cost Volume Profit Analysis According to Herman C. Heiser “ The

most important single factor in profit planning of Average business is the relationship between volume of business, cost & profit”

CVP Analysis

Two aspects: Broad Aspect: Study of Relationship

between CVP Narrow Aspect: Technique of

determining level of operations where Total Revenue=Total Expense

MAJOR CONCEPTS FOR BREAK EVEN ANALYSIS CONTRIBUTION: Contribution is the

excess of selling price over variable cost is the amount contributed towards fixed expenses and profit.

Contribution= Sales-variable cost Example: Selling Price: Rs.20 per unit

Variable Cost : Rs 15 per unit Contribution Rs. 5 per Unit

For Example: Fixed Expenses : Rs 50,000 Total units Sold : 8000 units Total Contribution : 8000*5= 40,000(in

contin)( not sufficient to meet Fixed Expenses)

If increase total output by 10,000 units, total contribution 50,000 ( No profit No loss)

Any output beyond 10,000 Units will give profits ( total output increased by 15000 units, total contribution 75,000)

Contribution = sales – variable cost Contribution = fixed cost +/- profit (loss) Contribution per unit= selling price – variable cost per

unit We can derive marginal costing equation: Sales-variable cost= contribution Sales- variable cost= fixed cost +/- profit In case three factors known fourth factor can be

known: Example: sales: 2,40,000/- Profit : 50,000/- Direct material : 80,000/- Direct labor : 50,000/- Variable overheads : 20,000 Variable cost: 1,50,000 Sales – Variable Cost = Fixed Cost +/- Profit 2,40,000-1,50,000 -50,000 = 40,000 Fixed Cost = 40,000

Profit/ Volume Ratio (contribution Ratio)

P/V ratio = Contribution/ sales = sales- variable cost / sales

= Fixed Cost +/- Profit (loss) / sales = Change in profit or contribution /

change in sales This can be shown in the form of percentage by multiplying by100.Example: selling price = 15/-

Variable cost = 10/-

P/V ratio = 15-10/15 = 1/3*100 = 33 1/3%

It establishes relationship between contribution and sales:

High P/V ratio reflects high profitLow P/V ration reflects low profitRatio can be increased by increasing

contribution: Increasing selling price per unitReducing variable cost per unitSwitching the production to more

profitable products.

For example: Sales: 100,000/- Profit: 10,000/- Variable Cost =70% Calculate PV ratio, Fixed Cost, Sales volume to

earn profit of 40,000/- 70% *100,000 = 70,000 P/V Ratio= 100,000-70,000 / 100,000 *100 =

30% Contribution = Fixed Cost +/- Profit (loss) 30,000 = Fixed Cost + 10,000 Fixed Cost = 20,000 Sales volume required to earn given profit :

FC + Profit / pv ratio 20,000+40,000 /30% = 60,000 /30% =

200,000

BREAK EVEN POINT It is defined as that point of sales volume at which

total revenue is equal to total cost. (No profit No loss)

Sales revenue at B.E.P. = fixed cost + variable Cost Algebraic form Break even point in units = Fixed Cost / Contribution

per unit Break Even point in terms of money value = Total sales= TFC = TVC S= F+ VC S-VC =FC Dividing by S-VC S-VC / S-VC = FC / S-VC 1= FC / S-VC (multiplying by S) S= (FC / S-VC )*S

break Even point as percentage of estimated capacity:

Fixed Cost / total contribution For Example: Output : 3000 units Selling price per unit : Rs.

30/- Variable cost per unit : Rs.

20/- Total fixed cost : Rs 20,000/- Calculate B.E.P. in units and Sales value B.E.P. (units) 20,000/ 30-20 = 2000 units Sales = FC*S / S-VC = 20,000* 90,000

/ 90,000-60,000 = 60,000

Margin Of Safety: Excess of actual sales over break even sales is known as Margin of

safety. MOS : Total sales – Sales at B.E.P. Angle of Incidence

Angle between sales line and total cost line formed at B.E.P. where sales line

and total cost line intersect each other. AOI indicates the profit earning capacity

of business. AOI and MOS indicate the soundness of

business.

MANGERIAL DECISION PRICING DECISION:

◦ Under normal conditions prices are based on total cost of sales so as to cover both fixed and variable cost and to certain extent profit.

◦ Other circumstances like stiff competition, exploring new markets etc. Products are sold at price below total cost.

◦ During depression prices can be reduced to an extent which covers the variable cost and contribute something towards fixed cost.

◦ Accepting bulk order and exploring foreign markets is generally made to utilize the idle capacity. The order from the local merchants should not be accepted at a below normal price it affects the relationship of the concern with the other customers. In case of foreign markets goods may be sold at prices below normal price.

Operate or shutdown cost: Differential cost analysis is used when the business is confronted with the possibility of temporary shutdown.. This type of analysis has to determine whether in the short run a firm is better off operating than not operating.

For Example: an analysis of a possible temporary shutdown ,assume that company operating below 50% of its capacity expects that the volume of sales will drop below the present level of 10,000 units per month. Management is concerned that further drop in sales volume will create a loss and has under consideration, a recommendation that operation be suspended until better market condition prevail and also a better selling price available. The present operating statement:

Sales revenue (10,000 units @30/-) 300,000

Less variable cost@20 per unit

200,000 Fixed cost

100,000 (fixed cost at shut down is 40,000/-) Net Income :

0

Make or Buy decision: the clear distinction must be made between fixed cost and variable cost. The variable cost must be compared with the purchase price of the product available in the market. If variable cost is less than the purchase price it’s preferred to make the product and if the variable price is more than the purchase rice its preferred to buy the product.

For Example:: A machine manufactures 10,000 units of a part at a total cost of Rs21 of which Rs 18 is variable. This part is readily available in market at Rs 19 per unit. If the part is purchased from the market then the machine can either be utilized to manufacture a component in same quantity contributing Rs2 per component or it can be hired out at Rs21000

Key or Limiting Factor: Factor which puts limit on production and profits of business generally it is sales. Production can be limited due to shortage of material, labor, and plant capacity.

Example: If there is a limited material which is used on two products X and Y. 3 units used for X and 5units of Y. Contribution per unit is 12 for X and 15 for Y. X gives contribution (12/3) 4 per unit and Y gives contribution(15/5) 3 per unit. X makes more contribution per unit.

Selection of suitable product or sales mix: Best product mix which yield maximum contribution should be retained and production should be increased. This can be done by comparing the PV ratio and break even point of various alternatives.

Effect of changes in sales price: Change in sales price effect the profitability of the concern.

Example: Sales:60,000 per unit Variable Cost : 30,000 per unit Fixed Cost: 15,000 Calculate: a) pv ratio, BEP, MOS b) effect of 10% increase in sales c) 10% decrease in sales price. a) PV Ratio: 50% BEP: Fixed Cost / PV Ratio = 30,000 MOS: present sales- Sales at BEP=30,000 b) Sales= 60,000+10% = 66,000 PV Ratio = 54.55% BEP = 27,500 MOS = 38500 Sales= 60,000-10% = 54,000 PV Ratio: 44.4% BEP = 33,750 MOS = 20,250

Alternative Methods of Production : Employing machine 1 or Machine 2, if to choose among them marginal costing technique can be applied highest contribution can be adopted keeping in view limiting factor.

Determine the optimum level of activity. To determine this activity contribution at different levels of activity can be found.