Business Planning and Finance (4. Costing methods and tools (Cost…
Business Planning and Finance
4. Costing methods and tools
Cost-volume-profit (CVP) analysis tools
Sales mix analysis
: the proportion of individual product-type sales volumes that make up the total sales volume.
Target income volume analysis
: translate sales targets into production requirements.
• Target income sales volume = (fixed costs + target income) / unit CM
Break-even (BE) analysis
• B/E point (units) = fixed costs / unit CM
• B/E point (dollar) = fixed costs / CM ratio
Contribution margin (CM) = sales – variable costs
• Unit CM = unit selling price – unit variable cost
• CM ratio = CM / sales
Standard costs and variance analysis
Step 5: re-measure variances
Step 4: implement the changes
Step 3: determine changes that will produce improvement
Step 2: measure and analyse the variance.
• Materials variances
are measured by quantity used and price.
• Labour variances
are measured by rate of use and efficiency.
• Overhead variances
are measured by spending and by efficiency.
Step 1: define standards costs.
: the targeted costs of an operation, process, or product including direct material, direct labour, and overhead charges.
• Materials, based on cost at the time of purchase
• Labour at the point of production
• Variable manufacturing overhead.
Activity-based cost accounting
the costs of
that are required to produce a product or service.
Activity-based management (ABM)
: costs based on activities performed and then use cost drivers to allocate these costs to products or other bases.
Steps in activity-based costing:
Identify cost drivers;
Assign an overhead rate for each driver;
Estimate the number of occurrences for each driver;
Repeat for all drivers associated with the product.
Job-order, process, and operation costing
when products produced have both common and distinguishing characteristics.
when product is continuously mass-produced and has little variation, such as oiland chemical refineries or textile production.
(costs are collected by time period and average over all the units produced during the period)
Steps in determining process costs:
Determine how much has been produced in the period and in what stage of production;
Sum equivalent amounts;
Total costs and allocate them by work unit.
process cost (unit)
= (material + labour + overhead costs) / equivalent amounts
when products are produced in lots or batched or as an order manufactured to a customer’s specification.
(costs are assigned to specific jobs)
Job costing = direct cost + (required hours * overhead rate)
Overhead rate = budgeted annual overhead / budgeted annual activity units
Ps: budgeted annual activity represents the organization’s capacity in number of hours.
the costs that could vary depending on the level of production – materials and labour, set up costs, or utilities.
Total unit cost = unit direct cost +
unit variable overhead
the cost-per-unit calculation the all variable direct costs plus
a shared of fixed overhead costs for the period
Total unit cost = unit direct cost +
unit fixed overhead
United share of fixed overhead = (direct costs * fixed overhead rate) / product volume
Costs of quality
(purpose: assessing value gained or lost through quality practices)
Differential, sunk, and opportunity costs
(purpose: analysing investment alternatives)
Direct/ indirect cost
(product pricing and performance control)
) costs that are not directly incurred by a particular job or operation.
: variable costs that can be directly attributed to a particular job or attention.
Variable/ fixed cost
(purpose: analysing cost behaviour under different conditions)
: an expenditure that does not vary with the production volume, including rent, property tax, salary.
: an opening cost that varies directly with a change of one unit in the production volume.
Product and period costs
(purpose: external reporting)
: accrued at the time the purchase is made. (not included in COGS, but includes selling and administrative expenses)
: recognized or accrued in the same reporting period in which it’s sold.
Manufacturing/ non-manufacturing costs
(purpose: external reporting)
: cost associated with individuals and activities involved in managing the operation as a whole, including accounting, HR, clerical support.
Marketing or selling costs
: advertising, shipping, sales compensation and expense, warehousing.
Manufacturing or factory overhead
: everything but direct material and labour, including maintenance and repair, utilities and property costs.
: contributes to the entire shop floor production, but not to any specific product, including delivering inventory to multiple work stations or cleaning the shop.
: the work that goes into creating a unit.
: a relatively small part of a product, including small pieces of hardware and item difficult to quantify, such as solder or glue.
: everything that becomes part of finished product, whether it is raw material or a component.
Types of budgets
: comprise many separate budgets with specialized purposes.
: the investment of resources (either cash on hand or financial debt) to improve an organization’s long-term competitive.
Profitability index = present value of investment / initial value
Internal rate of return (IRR) (= hurdle rate)
PV factor = initial investment / annual cash flows
Net present value (NPV)
Accounting rate of return = (annual cash flow – straight-line depreciation) / (0.5 * initial investment)
Payback period = cost of investment / annual cash savings
ROI = (gain from investment – cost of investment) / cost of investment
Residual income = operating income – (minimum required rate of return * operating assets)
Pro forma balance sheet
Pro forma income statement
Selling and administrative expense
Steps in preparing a master budget
Prepare a sales forecast;
Determine expected production volume;
Estimate manufacturing costs and operating expense;
Determine cash flow and other financial effects;
Create pro forma financial statement.
2. Financial statement analysis
Market value ratio
: the attractiveness of an organization’s stock to its investors.
Total factor productivity
: the weighted productivity ratios of different production inputs
Cash conversion cycle
: the length of time from the purchase of raw materials to the collection of accounts receivable from customers for the sale of product or service.
Cash-to-cash cycle time
: how long cash is tied up in inventory before it is sold and payment is collected from customers.
cash-to-cash cycle time = day’s inventory outstanding + day’s sales outstanding – day’s payable outstanding
day’s inventory outstanding = inventory / cost of sales
day’s sales outstanding = accounts receivable / net credit sales
day’s payable outstanding = accounts payable / costs of sales
Price/earnings (P/E) ratio
: investor confidence as evidenced by the value of the stock.
P/E ratio = market price per share / earnings per share
Earnings per share (EPS) = (net income – preferred dividends)/ holders of common stock
: an organization’s solvency: its ability to satisfy its long-term debt.
time-interest-earned ratio = earnings before interest and taxes (EBIT) / interest expense
debt ratio = total liabilities / total assets
: the efficiency with which the organization has used its assets to produce value.
Average collection period
: the amount of time on average that it takes the organization to receive payment.
Accounts receivable ratio
: the organization’s ability to collect payment from its customer.
accounts receivable ratio = average accounts receivable / net credit sales
Inventory turnover ratio
: the amount of time an organization holds inventory before the inventory generates income.
inventory turnover ratio = average inventory level / annual cost of sales
: an organization’s ability to liquidate or satisfy its short-term debt, such as wages, account payable, or interest payments on loans.
Quick asset ratio = (current assets – inventory) / current liabilities
Current ratio = current assets / current liabilities
each item in the statement is described as a percentage of the largest item in the statement.
an analysis of the variance of each item in a statement from the previous year. (found in
Several important data
trends are important;
size is relative;
performance must be considered in context;
significance is relative.
1. Financial statements
Uses of financial statements
Statement of cash flows/ funds flow statement
a financial statement showing the flow of cash and its timing into and out of an organization or report.
a financial statement showing the resources owned, the debt owned, and the owner’s share of a company at a given point in time.
Assets = liabilities + equity
a financial statement showing the net income for a business over a given period of time.
Income = revenues – expenses
General components of financial statements
: the stage in strategic planning where goals become projected revenue, against which the organization must allocate its financial resources.
Generally accepted accounting practices (GAAP)
International Financial Reporting Standards (IFRS)