Managing Finance and Budgets

1
Managing Finance and Budgets

• Lecture 5

2
Session 5 - Costing Pricing (1)

• LEARNING OUTCOMES
• Understand the different ways of classifying
  costs and be able to classify a wide variety of
  costs typically found in SMEs, VCOs and large
  organisations in order to critically analyse a
  situation and use the data to inform
  decision-making
• Understand and choose relevant cost analysis
  techniques to analyse situations typically found
  in SMEs, VCOs and large organisations

3
Contents of the Lecture

• A Concepts and Definitions of Costing
• B Break-Even Analysis
• C Full (Absorption)Costing

4
A Concepts and Definitions
5
Key Concepts

• What is Cost Analysis?
• Objectives of Cost Analysis
• Cost definitions
• Cost behaviour
• Break-even analysis
• Full (absorption) costing

6
What is Cost Analysis?

• Cost
• is defined as the amount of resources,
  sacrificed in order to achieve an objective.
• is usually measured in monetary terms.
• Cost Analysis
• is the classification and scrutiny of the
  different components which make up the cost of
  achieving the objective.
• In resale will involve such elements as original
  price (historic cost), and staff wages (outlay
  costs).
• In manufacturing it will involve such elements as
  labour, raw materials, (direct costs) salaries,
  phone bill (indirect costs).

7
Objectives of Cost Analysis

• Cost Analysis is used for
• Decision-making - e.g. pricing, whether to go
  ahead with a particular project etc
• Planning - setting targets for production,
  distribution etc
• Controlling (production, sales etc.)
• Evaluation of activities (in financial terms)
• Motivation (providing feedback)

8
Cost definitions

• Historic cost - actual cost paid for an item or
  activity
• Opportunity cost - cost of not doing something
• Outlay cost - cost incurred to achieve an
  objective
• Sunk cost - cost incurred before the decision
  point is reached
• Committed costs - costs which will be incurred
  regardless of the decision
• Disposal cost - disposal may result in a cash
  gain, but a book loss (if the value is less
  than the book value)
• It is essential to include relevant costs and
  exclude irrelevant costs when making decisions

9
Activity One

• A garage has an old car standing around which it
  bought several months ago for 3,000. The car
  needs a replacement engine before it can be sold.
  It is possible to buy a reconditioned engine for
  300. It would take a mechanic (who paid is 8
  per hour) 7 hours to fit the engine. At present
  the garage is short of work, but the owners are
  reluctant to lay off any mechanics or even to cut
  down their basic working week because skilled
  labour is difficult to find and an upturn in
  repair work is expected soon. Without the engine
  the car could be sold for an estimated 3,500.
  Identify the following
• Historic cost of the car
• Outlay cost if the car is to be repaired
• Opportunity cost of the car and sunk cost of
  the car
• Relevant costs to consider in deciding whether
  or not to repair the car
• What is the minimum price to sell the car for to
  justify carrying out the work?
• How would the minimum price change if the garage
  were busy at the moment, and the mechanics time
  could be charged to other customers at 12 per
  hour.

10
Activity One Solution (1)

• Historic cost 3,000
• What we paid for the car originally
• Outlay cost (to repair) 300
• NB We disregard labour costs of 8 x 7 56
  because the mechanics are already paid, but not
  employed.
• Opportunity cost 3,500
• What we think we can sell the car for now
• Sunk cost 3,000
• What we have currently spent on the car to date
• Relevant costs to consider
• Opportunity Costs Outlay Costs 3500 300
  3800
• 3,800 is the minimum price that the garage will
  sell the car for
• in order to justify carrying out the work.

11
Activity One Solution (2)

• If the garage were busy, with the mechanics
  time charged at 12 per hour.
• Historic cost 3,000
• What we paid for the car originally
• Outlay costs (to repair) Engine 300
• Labour Costs 12 x 7 84
  384
• Relevant costs to consider
• Opportunity Costs Outlay Costs 3500 384
  3884
• 3,884 is the minimum price that the garage will
  sell the car for
• in order to justify carrying out the work.

NB What we could charge for their labour, rather
than what it costs us.
12
Cost behaviour

• Variable Costs
• vary in (more or less) direct proportion to the
  volume of activity
• Fixed Costs
• stay (more or less) the same regardless of the
  volume of activity
• may vary in the longer term, but not directly in
  relation to activity
• Semi-fixed (or semi-variable) Costs
• have a fixed and a variable element to them -
  e.g. telephone, electricity

13
Activity Two

• Identify a range of Fixed and a range of
  Variable Costs for each of the following types of
  organisation
• Manufacturing company
• Hotel
• Supermarket

14
Activity Two Solution
Fixed Costs Variable Costs
Manufacturing Rent/Rates Cleaning Raw Materials Transport
Hotel Rates/Mortgage Cleaning Food, Laundry
Supermarket Rates/Lease Admin Salaries Goods, Some wages
15
B Break-Even Analysis
16
Break-even analysis

• This Analysis identifies
• The Fixed and Variable Costs in producing the
  item.
• The level of sales activity needed to cover an
  organisations fixed costs.

17
Break-even analysis An example

• A manufacturing company has Fixed Costs of
  5,000, and variable costs of 100 per unit. Each
  unit is sold for 250. How many units need to be
  sold to break even?
• UNITS SOLD SALES VALUE FIXED COSTS
  VARIABLE COSTS PROFIT/LOSS
• 10 2,500 5,000 1,000 3,500-
• 20 5,000 5,000 2,000 2,000-
• 30 7,500 5,000 3,000 500-
• 40 10,000 5,000 4,000 1,000
• 50 12,500 5,000 5,000 2,500

18
Break-even analysis An example
The Total Cost is just the sum of the Fixed cost
and the Variable Cost
19
Break-even analysis An example
The Break-Even Point is where the Total Costs
Line intersects the Sales Line.
At this point Profit/ Loss ZERO (about 35
items sold)
20
Break-Even Analysis Calculation

• The Break-even point can be calculated as
  follows
• Sales (No. of items) to break even
• Fixed Costs
  .
• Sales per unit - Variable costs per
  unit
• In the example, our break-even point was
  5,000
• 
  250-100
• 33.33 items

21
Break-Even Analysis Some Terms

• Contribution
• Sales Revenue per Unit Variable costs per
  unit.
• This is the denominator of the Break Even
  calculation
• In our example
• Contribution 250 100 150 per unit

22
Break-Even Analysis Calculation Some Terms

• Margin of safety extent to which planned
  output or volume is above the break-even point)
• This can be calculated by
• Margin of Safety
• (Planned Sales Break-Even Sales)
  Contribution
• For example,
• if we planned to have sales of 45 items, our
  margin of safety would be
• (45 - 33.33) (150) 1750.50

23
Break-Even Analysis Calculation Some Terms

• Operating Gearing
• This is the relationship between fixed costs and
  contribution (i.e. how many units have to be sold
  to pay Fixed Costs

In our example, 20 units needed to be sold just
to recoup the fixed cost.
24
Activity Three

• Company A Company B
• FIXED COSTS 10,000 54,000
• UNIT SALES PRICE 20 20
• VARIABLE COSTS PER UNIT 10
  2
• PLANNED SALES 2000 units
  5000 units
• Calculate the following for each Company
• Contribution per Unit
• Break-even point and Margin of safety
• Profit at planned sales, twice planned sales
  and
• 1/2 x planned sales
• Which company has the higher operating gearing
  and what effect does this have?

25
Activity Three Company A Solution

• Company A
• FIXED COSTS 10,000
• UNIT SALES PRICE 20
• VARIABLE COSTS PER UNIT 10
  
• PLANNED SALES 2000 units
• Contribution per Unit 20 -10 10
• Break-even point 10000/10 1000
• Margin of safety (2000 1000) x 10 10,000
• Profit at planned sales 10,000
• twice planned sales 30,000
• 1/2 x planned sales NIL

26
Activity Three Company B Solution

• Company B
• FIXED COSTS 54,000
• UNIT SALES PRICE 20
• VARIABLE COSTS PER UNIT 2
  
• PLANNED SALES 5000 units
• Contribution per Unit 20 -2 18
• Break-even point 54000/18 3000
• Margin of safety (5000 3000) x 10 20,000
• Profit at planned sales 20,000
• twice planned sales 110,000
• 1/2 x planned sales 9,000 Loss

27
Activity Three Operational Gearing

• Company A Company B
• FIXED COSTS 10,000 54,000
• UNIT SALES PRICE 20 20
• VARIABLE COSTS PER UNIT 10
  2
• PLANNED SALES 2000 units
  5000 units
• Ratio of Fixed Cost to 1001 18,0001
• Variable Cost
• B has Higher Operational Gearing.
• If output is higher than expected, (e.g. double)
  then profits can rise dramatically.
• For B profits are 5.5 times that expected
• For A, profits are 3 times that expected,
• If output is lower than expected, (e.g. half)
  profits can turn into become serious losses.
• For A, profit is NIL, but for B the loss is
  9,000

28
Break-even analysis

• Assumes simplicity!
• Uses linear relationships between sales prices,
  costs and volume
• Does not allow for stepped fixed costs
• Focuses on one product line

29
Marginal costing

• One response to this is use Marginal Analysis
• This dispenses with fixed costs, as these are
  static, unchangeable and not totally relevant,
  choosing to focus on the direct costs of
  producing additional sales.
• As we may be selling a number of different items,
  this avoids unrealistic and arbitrary
  apportionment of the indirect costs
• Allows us to identify the true costs of
  additional sales (or the MINIMUM price for which
  an item should be sold)
• (see M A for further details)

30
C Full Costing
31
Full (absorption) costing

• An analysis of the FULL cost of achieving a
  particular objective
• Used for pricing purposes, and to measure costs
  (e.g. valuing stock or assets)
• Widely used though focuses on past costs rather
  than future or outlay costs

32
Full costing - Example

• RUSTIC BREWERIES
• COST of producing 10,000 pints of bitter in 1
  month
• Ingredients 1,000
• Labour 2,000
• Fuel 500
• Rental of brewery 425
• Depreciation 75
• Other Overheads 6,000
• Total cost 10,000 1 per pint
• Complications Justification of depreciation,
  Stock
• Work-in-progress, Other products

33
Job costing

• Producing an analysis of the FULL cost of a
  particular output by assigning all DIRECT costs
  plus an appropriate share of INDIRECT costs
• DIRECT costs are those costs which can be
  directly identified with units of output
• INDIRECT costs cannot be directly attributed to
  units of output
• DIRECT COSTS can be VARIABLE or FIXED
• INDIRECT COSTS can be VARIABLE or FIXED

34
Job costing - Allocating Indirect Costs

• Range of methods used to allocate indirect costs
  e.g.
• As a of total quantity of units produced
• Labour cost as of Total Labour (Direct Labour
  Hours)
• Product weight, Machine Time
• Segmentation - using different methods for
  different oheads
• By department - dependent on amount of time spent
  in each department (e.g. finishing, handling,)
• No method is correct though DLH tends to be
  most popular

35
Activity Four

• Calculate the COST of producing 5,000 pints of
  bitter and 2,300 pints of lager in 1 month using
  the Direct Costs the three methods of
  allocating overheads shown below.
• DIRECT COSTS Bitter Lager
• Ingredients 10p per pint 25p per pint
• Labour 20p per pint 10p per pint
• Fuel 5p per pint 10p per pint
• Brewery/Depreciation 500 Overheads 5,000
• Method 1 Allocate overheads according to pints
  produced
• Method 2 Allocate overheads according to of
  labour cost
• Method 3 Allocate overheads according to overall
  direct cost of production

36
Activity Four Solution Method 1
37
Activity Four Solution Method 2
38
Activity Four Solution Method 3
39
Activity Five

• The full cost of pursuing an objective is
  effectively the long-run break-even selling
  price.
• What does this mean?

40
Activity Five - Solution

• The full cost of pursuing an objective is
  effectively the long-run break-even selling
  price.
• If the analysis has been performed correctly,
  then selling the item for its full cost, should
  do just that, precisely recover the cost of
  producing it.
• This is just another way of saying we would
  neither make a profit or a loss, but just break
  even

41
Activity Six

• You work in the costing department of a budget
  airline. What items need to be taken into account
  when trying to calculate the unit cost of
  transporting a passenger from one destination to
  another?

42
Activity Six - Solution

• What items need to be taken into account when
  trying to calculate the unit cost of transporting
  a passenger?
• This is not an exhaustive list
• Airport Service/Tax Charges
• Air Traffic Control Charges
• Maintenance Replacement (Labour Parts)
• Cleaning
• Depreciation of Aircraft
• Fuel other running costs
• Food costs
• Baggage handling costs
• Staff salaries (cabin and ground)
• Admin Costs (booking, travel agent commission
  etc.)

43
Seminar Five - Activities

• Preparation read Chapters 8, 9 and 10
• Describe key concepts
• Objectives of cost analysis
• Cost definitions
• Cost behaviour Break-even analysis
• Full (absorption) costing
• Exercises 10.4 (page 337) and 10.8 (page 340)