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Cost and Management Accounting

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Cost & Management Accounting (MGT-402)
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LESSON # 42
DECISION MAKING
Companies are often faced with the problem of whether to close down temporarily a part of the
plant during periods of low demand.
How long operations should be continued?
As long as products contribute fixed expenses, a company seems to be better off than if the plant
were shut down.
Size of fund
The fund required to continue production is the difference between the following:
(a) Fixed costs at normal operations,
(b) Fixed costs when plant is shut down.
Arguments against shut-down
(a) If the company continues operation, expenses that would be incurred with the closing down
of the plant will be saved; e.g. an increase in factory security.
(b) Continued operation means saving (he expenses that will otherwise be incurred if the plant is
reopened again at a later stage.
(c) A shut-down for a short period of fine will not eliminate all costs. Rent, rates, depreciation
and insurance will have to be incurred during the shutdown period.
(d) If the factory is shut down, this will affect not only morale but also its market standing if it
cannot meet consumer demand.
Illustration
Lanka Manufacturing Company is considering temporarily closing down a division due to an
unexpected fall in demand. On the basis of the following information you are required by the
board of directors to prepare a statement in such a way as to show clearly whether or not it is
advisable to close down the division temporarily.
Production capacity
50%
70%
90%
100%
Units
50,000
70,000
90,000
100,000
Prime cost
Rs. 210,000
Rs. 294,000
Rs. 378,000
Rs. 420,000
Production overhead
200,000
240,000
290,000
300,000
Other overhead
90,000
102,000
114,000
120,000
The division is operating at 60 percent capacity with a turnover of Rs. 515,000. If it is decided to
close the division temporarily, it is estimated that:
(a)
expenses that would be incurred with the closing down of the division would
amount to Rs. 60,000
(b)
present fixed costs would be reduced by Rs. 54,000 per annum;
(c)
plant maintenance during shut-down would be Rs 10,000 per annum;
(d)
On reopening, the cost of overhauling plant, training and engagement of new
personnel would be Rs. 30,000
It is expected that in about twelve month's time it may be possible to work at 80 percent
capacity.
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Cost & Management Accounting (MGT-402)
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Differential Costing for Short-Term Decision Making
The role of fixed costs
If the decrease or increase in the level of activity affects fixed costs then these costs should be
considered differential costs. It is generally accepted that if the plant has excess capacity then new
or additional volume may be accepted if the selling price ii greater than variable costs. In such a
situation, fixed costs arc not relevant if they remain fixed at an increased level of output. But if
they are incurred because of the increased level of activity then they are certainly variable. Once
incurred, if they arc committed fixed costs, they become a permanent feature and the company
may find (hat it has capacity far in excess of requirements.
The following illustration has been prepared so as to place particular emphasis on the role of fixed
costs.
Illustration
Sena of London operates at 100 percent of normal capacity. At this volume it produces 50,000
units of a product.
Income statement
Sales (50,000 units at Rs. 10 each)
Rs. 500,000
Prime cost (Rs. 5 per unit)
Rs. 250,000
Rs. 250,000
Variable production overhead (Rs. 1 per unit)
Rs. 50,000
Rs. 200,000
Fixed production overhead
Rs. 100,000
Factory profit
Rs. 100,000
The marketing director reports that an overseas customer has offered to pay Rs. 7.50 per unit for
an additional 20,000 units. To produce the additional order fixed costs would increase by Rs.
25,000. Would you advise the company to accept the order?
Differential cost statement-method 1
Present business
With
Difference
additional
business
Sales
Rs. 500,000
Rs. 650,000
Rs. 150,000
Prime cost
250,000
350,000
100,000
Variable production overhead
50,000
70,000
20,000
Fixed production overhead
100,000
125,000
25,000
Factory profit
Rs. 100,000
Rs. 105,000
Rs. 5,000
Differential cost statement ­ method 2
Present
Additional
Total
Sales
Rs. 500,000
Rs. 150,000
Rs. 650,000
Prime cost
250,000
100,000
350,000
Variable production overhead
50,000
20,000
70,000
Fixed production overhead
100,000
25,000
125,000
Factory profit
100,000
5,000
105,000
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Cost & Management Accounting (MGT-402)
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Traditional statement for additional business
Sales (20,000 units at Rs. 7.50)
Rs. 150,000
Prime cost (20,000 at Rs. 5)
100,000
Variable production overhead (20,000 at Rs. 1)
20,000
Joint fixed production overhead (using a
predetermined rate of absorption:
Rs. 100,000/50,000 = Rs. 2 (20,000 at Rs. 2)
40,000
Separable fixed costs
25,000
Loss on additional business
(Rs. 35,000)
The traditional cost statement for additional business would cause management to reject the offer.
Management may also not accept the offer because as computed under the traditional method
absorption costing the price offered per unit is less than the total cost per unit and also because it
is less than the current selling price of Rs. 10 per unit:
Price offered per unit
Rs. 7.50
Cost per unit
Rs.
Prime cost
5.00
Variable production overhead
1.00
Joint fixed costs
2.00
Separable fixed costs (Rs. 25,000/20,000)
1.25
Loss per unit
Rs. (1.75)
In the differential cost statements (methods 1 and 2) the additional business has been charged with
differential cost only. It should be noted that the reason for the differential profit is that the regular
sales were not affected by the acceptance of additional business. If the acceptance of additional
business caused the price to be reduced to Rs. 7.50 per unit on all sales then the result would be a
loss of Rs. 20,000 for the company:
Revised income statement ­ all sales at 7.50
Sales (70,000 units at Rs. 7.50)
Rs. 525,000
Variable costs (70,000 at Rs. 6)
420,000
Joint fixed production costs
100,000
Separable fixed production costs
25,000
Loss
Rs. (20,000)
The role of variable costs
In differential cost studies, if the plant is not operating at practical capacity owing to lack of orders,
variable costs usually represent the differential cost whether they are incremental or avoidable. The
term refers to those costs that will change. It is often assumed that the variable cost per unit will
remain constant regardless of the level of activity.
One may question the validity of the above assumption. What if the variable cost per unit does not
remain constant at various levels of activity? An increased level of activity may cause the variable
cost per unit to change for a variety of reasons.
Examples are:
(a)
At a higher level of output material cost per unit may be reduced by bulk buying at
lower prices;
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Cost & Management Accounting (MGT-402)
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(b)
Direct labour cost per unit may increase as a result of overtime working if there is a
labour shortage;
(c)
Greater spoilage and waste with increase production.
Illustration that follows puts particular emphasis on the role of variable costs:
The following are assumed:
Sena of London produces 40,000 units operating at 50 per cent capacity.
Production fixed costs
Rs. 20,000
Other fixed costs
Rs. 40,000
Variable cost per unit:
Direct material
Rs. 3.00
Direct labour
2.00
Variable overhead
1.00
Rs. 6.00
Selling price per unit: Rs. 10
An overseas customers offer to buy increased quantities during the forthcoming year at the
following prices:
10,000 units at Rs. 9
20,000 units at Rs. 8
30,000 units at Rs. 7
40,000 units at Rs. 6
If the offer is accepted then the variable cost per unit is expected to change as follows:
First 10,000 units
Would cause a drop in the material cost per unit due to
large scale purchases
Next 10,000 units
A further reduction in the material cost per unit but an
increase in direct wages
Next 10,000 units
Would involve some overtime and so variable overhead
per unit would increase.
Next 10,000 units
A further reduction in material cost per unit, and increase
labour cost per unit and variable cost per unit.
Summary of expected changes
Units
1st 10,000
2nd
3rd 10,000
4th 10,000
10,000
Material per unit
(5%)
(5%)
-
(5%)
Labour per unit
-
5% +
-
5% +
Variable overhead per unit
-
-
5% +
5% +
Variable cost per unit at various levels of activity
Normal  Additional
Additional
Additional
Additional
(Rs.)
10,000
20,000
30,000
40,000
Direct material
3.00
2.85
2.7075
2.7075
2.572
Direct labour
2.00
2.00
2.1000
2.1000
2.205
Direct expenses  1.00
1.00
1.0000
1.0500
1.1025
Variable
cost 6.00
5.85
5.8075
5.8575
5.8795
per unit
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Cost & Management Accounting (MGT-402)
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Differential cost statement
Normal
Additional
Additional
Additional
Additional
40,000
10,000
20,000
30,000
40,000
Sales value per Rs. 10
Rs. 9.00
Rs. 8.00
Rs. 7.00
Rs. 6.00
unit
Variable cost per 6
5.85
5.8075
5.8575
5.8795
unit
Contribution per Rs. 4
Rs. 3.15
Rs. 2.1925
Rs. 1.1425
Rs. 0.1205
unit
Fund
160,000
31,500
43,850
34,275
4,820
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Table of Contents:
  1. COST CLASSIFICATION AND COST BEHAVIOR INTRODUCTION:COST CLASSIFICATION,
  2. IMPORTANT TERMINOLOGIES:Cost Center, Profit Centre, Differential Cost or Incremental cost
  3. FINANCIAL STATEMENTS:Inventory, Direct Material Consumed, Total Factory Cost
  4. FINANCIAL STATEMENTS:Adjustment in the Entire Production, Adjustment in the Income Statement
  5. PROBLEMS IN PREPARATION OF FINANCIAL STATEMENTS:Gross Profit Margin Rate, Net Profit Ratio
  6. MORE ABOUT PREPARATION OF FINANCIAL STATEMENTS:Conversion Cost
  7. MATERIAL:Inventory, Perpetual Inventory System, Weighted Average Method (W.Avg)
  8. CONTROL OVER MATERIAL:Order Level, Maximum Stock Level, Danger Level
  9. ECONOMIC ORDERING QUANTITY:EOQ Graph, PROBLEMS
  10. ACCOUNTING FOR LOSSES:Spoiled output, Accounting treatment, Inventory Turnover Ratio
  11. LABOR:Direct Labor Cost, Mechanical Methods, MAKING PAYMENTS TO EMPLOYEES
  12. PAYROLL AND INCENTIVES:Systems of Wages, Premium Plans
  13. PIECE RATE BASE PREMIUM PLANS:Suitability of Piece Rate System, GROUP BONUS SYSTEMS
  14. LABOR TURNOVER AND LABOR EFFICIENCY RATIOS & FACTORY OVERHEAD COST
  15. ALLOCATION AND APPORTIONMENT OF FOH COST
  16. FACTORY OVERHEAD COST:Marketing, Research and development
  17. FACTORY OVERHEAD COST:Spending Variance, Capacity/Volume Variance
  18. JOB ORDER COSTING SYSTEM:Direct Materials, Direct Labor, Factory Overhead
  19. PROCESS COSTING SYSTEM:Data Collection, Cost of Completed Output
  20. PROCESS COSTING SYSTEM:Cost of Production Report, Quantity Schedule
  21. PROCESS COSTING SYSTEM:Normal Loss at the End of Process
  22. PROCESS COSTING SYSTEM:PRACTICE QUESTION
  23. PROCESS COSTING SYSTEM:Partially-processed units, Equivalent units
  24. PROCESS COSTING SYSTEM:Weighted average method, Cost of Production Report
  25. COSTING/VALUATION OF JOINT AND BY PRODUCTS:Accounting for joint products
  26. COSTING/VALUATION OF JOINT AND BY PRODUCTS:Problems of common costs
  27. MARGINAL AND ABSORPTION COSTING:Contribution Margin, Marginal cost per unit
  28. MARGINAL AND ABSORPTION COSTING:Contribution and profit
  29. COST VOLUME PROFIT ANALYSIS:Contribution Margin Approach & CVP Analysis
  30. COST VOLUME PROFIT ANALYSIS:Target Contribution Margin
  31. BREAK EVEN ANALYSIS MARGIN OF SAFETY:Margin of Safety (MOS), Using Budget profit
  32. BREAKEVEN ANALYSIS CHARTS AND GRAPHS:Usefulness of charts
  33. WHAT IS A BUDGET?:Budgetary control, Making a Forecast, Preparing budgets
  34. Production & Sales Budget:Rolling budget, Sales budget
  35. Production & Sales Budget:Illustration 1, Production budget
  36. FLEXIBLE BUDGET:Capacity and volume, Theoretical Capacity
  37. FLEXIBLE BUDGET:ANALYSIS OF COST BEHAVIOR, Fixed Expenses
  38. TYPES OF BUDGET:Format of Cash Budget,
  39. Complex Cash Budget & Flexible Budget:Comparing actual with original budget
  40. FLEXIBLE & ZERO BASE BUDGETING:Efficiency Ratio, Performance budgeting
  41. DECISION MAKING IN MANAGEMENT ACCOUNTING:Spare capacity costs, Sunk cost
  42. DECISION MAKING:Size of fund, Income statement
  43. DECISION MAKING:Avoidable Costs, Non-Relevant Variable Costs, Absorbed Overhead
  44. DECISION MAKING CHOICE OF PRODUCT (PRODUCT MIX) DECISIONS
  45. DECISION MAKING CHOICE OF PRODUCT (PRODUCT MIX) DECISIONS:MAKE OR BUY DECISIONS