HND in Business

Unit 5: Management Accounting

Lesson 4

Microeconomic techniques:
What is meant by cost? Different costs and cost analysis.
Cost-volume profit, flexible budgeting and cost variances.

By Shan Wikoon
 According to the official terminology of CIMA (2005), it
defined Costing as the technique and process of
ascertaining cost. These costing techniques comprise
principles and rules to ascertain cost of products or
services.

Cost is the amount of resource used in exchange for goods

or services. The resources used can be money or moneys
worth, which is usually expressed in monetary units
Cost accounting is an accounting process that measures
and analyzes the costs associated with products,
production and projects so that correct amounts are
reported on financial statements.

Cost accounting aids in decision-making processes by

allowing a company to evaluate its costs. Some types of
costs in cost accounting are direct, indirect, fixed, variable
and operating costs.
 Cost ConceptCosts are different from expenses.

Costs are resources sacrificed to achieve an objective.

Expenses are the costs charged against revenue in a particular

accounting period.

Hence, cost is an economic concept, while expense is a term

that falls within the domain of accounting.
Let's say your company is in the catering business and will cater its biggest event
this evening. In the morning your company purchased about 125% of the paper
goods that you believe will be used at the event. (You purchased the additional
25% for future events and also to ensure you don't run out of these items at this
evening's event.)

The paper goods that were purchased had a cost of 500, and only 400 of the
paper items were used at today's event. The remaining 100 were put in your
company's storeroom for use at the events to be catered in the next few weeks.

In this example, the cost of 500 consisted of a 400 expense and a 100 asset.
Cost Classification And Cost Behaviour
Variable costs and fixed
costs.
 Variable costs
Variable costs are corporate expenses
that vary in direct proportion to the
quantity of output. Variable costs are a
direct function of production volume,
rising whenever production expands and
falling whenever it contracts.

The formula for calculating total variable

cost is:

Total Variable Cost =

Total Quantity of Output x Variable Cost Per Unit of
Output
What are examples of variable costs?
Direct materials. The most purely variable cost of all, these are the raw materials that go into a
product.
Piece rate labor. This is the amount paid to workers for every unit completed (note: direct labor is
frequently not a variable cost, since a minimum number of people are needed to staff the production
area; this makes it a fixed cost).
Production supplies. Things like machinery oil are consumed based on the amount of machinery
usage, so these costs vary with production volume.
Billable staff wages. If a company bills out the time of its employees, and those employees are only
paid if they work billable hours, then this is a variable cost. However, if they are paid salaries (where
they are paid no matter how many hours they work), then this is a fixed cost.
Commissions. Salespeople are paid a commission only if they sell products or services, so this is
clearly a variable cost.
Credit card fees. Fees are only charged to a business if it accepts credit card purchases from
customers. Only the credit card fees that are a percentage of sales (i.e., not the monthly fixed fee)
should be considered variable.
Freight out. A business incurs a shipping cost only when it sells and ships out a product. Thus,
freight out can be considered a variable cost.
 Variable Costs
Variable costs remain constant per unit
but change in total as volume changes.

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Variable Costs

2016 Pearson Education, Ltd.


HOW to calculate variable costs:
Let's assume XYZ Company has received an
order for 5,000 widgets for a total sales price of
$5,000 and wants to determine the gross profit
that will be generated by completing the order.
First, the variable costs per widget must be
determined.
Let's assume the following:
Annual Widgets Produced: 100,000
Raw Materials Costs: $10,000
Direct Labor Costs: $50,000
Each widget costs 10 cents ($10,000 /
100,000 widgets) in raw materials
Each widget costs 50 cents ($50,000 /
100,000 widgets) in direct labor costs
variable cost per unit is : $0.10 + $0.50 =
$0.60
total variable cost on the order is:
5,000 x ($0.10 + $0.50) = $3,000
Gross profit = total sales price - total
variable cost
Gross profit = $5,000 - $3,000
= 2,000
 Fixed Costs
Fixed costs are costs that do not change
when the quantity of output changes. Unlike
variable costs, which change with the amount
of output, fixed costs are not zero when
production is zero.
Fixed costs can create economies of scale,
which are reductions in per-unit costs through
an increase in production volume. This idea is
also referred to as diminishing marginal cost.
Some examples of fixed costs include rent,
insurance premiums, or loan payments.
For example, let's assume it costs Company
XYZ $1,000,000 to produce 1,000,000
widgets per year ($1 per widget).
This $1,000,000 cost includes $500,000 of
administrative, insurance, and marketing
expenses, which are generally fixed.
If Company XYZ decides to produce
2,000,000 widgets next year, its total
production costs may only rise to
$1,500,000 ($0.75 per widget) because it
can spread its fixed costs over more units.
Although Company XYZ's total costs
increase from $1,000,000 to $1,500,000,
each widget becomes less expensive to
produce and therefore more profitable.
Fixed Costs

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Fixed Costs

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Fixed Costs

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 Mixed Costs
Mixed costs have both fixed and variable
components.

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Mixed Costs

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How Do Costs Behave When There Is a Change in Volume?

Some costs change as the volume of sales

increases or decreases. Other costs are
not affected by changes in volume.

Different types of costs are:

Variable costs
Fixed costs
Mixed costs
2016 Pearson Education, Ltd.
Cost Classifications for Predicting Cost
Behaviour
How a cost will react to changes in
the level of business activity.

Total variable costs change

when activity changes.
Total fixed costs remain
unchanged when activity
changes.
Cost Classifications for Predicting Cost
Behavior
Cost
Behavior:

Fixed,
Variable,
Mixed, and
Step Costs
 Cost-volume-profit
Cost-volume-profit (CVP) analysis is used to determine how changes in costs
and volume affect a company's operating income and net income. In performing
this analysis, there are several assumptions made, including:
Sales price per unit is constant.
Variable costs per unit are constant.
Total fixed costs are constant.
Everything produced is sold.
Costs are only affected because activity changes.
If a company sells more than one product, they are sold in the same mix.

https://www.cliffsnotes.com/study-guides/accounting/accounting-principles-ii/cost-volume-profit-relationsh
ips/cost-volume-profit-analysis
 Cost - volume - profit
24 500 10

24 1000 50

35 500 5

68 500 1
Cost-volume profit
 one watch sell 10
Selling watches with
one watch cost 3 Only variable cost
fixed cost 0 No fixed cost

amount cost per unit sales income Profit

1 3 10 7
2 6 20 14
3 9 30 21
4 12 40 28
5 15 50 35
6 18 60 42
7 21 70 49
8 24 80 56
9 27 90 63
10 30 100 70
11 33 110 77
12 36 120 84
13 39 130 91
14 42 140 98
15 45 150 105
 one watch sell 10
Selling watches with
one watch cost 3 variable cost + fixed cost
fixed cost 100

variable fixed cost sales

amount cost fixed cost per unit total cost income Profit
1 3 100 100 103 10 -93
2 6 100 50 56 20 -36
3 9 100 33 42 30 -12
4 12 100 25 37 40 3
5 15 100 20 35 50 15
6 18 100 17 35 60 25
7 21 100 14 35 70 35
8 24 100 13 37 80 44
9 27 100 11 38 90 52
10 30 100 10 40 100 60
11 33 100 9 42 110 68
12 36 100 8 44 120 76
13 39 100 8 47 130 83
14 42 100 7 49 140 91
15 45 100 7 52 150 98
 flexible budgeting and cost variances
What is a flexible budget?
A flexible budget is a budget that shows
differing levels of revenue and expense,
based on the amount of sales activity that
actually occurs. Typically, actual revenues
or actual units sold are inserted into a
flexible budget model, and budgeted
expense levels are automatically generated
by the model, based on formulas that are
set at a percentage of sales.
 flexible budgeting and cost variances
Cost variance?
A flexible budget variance is any difference
between the results generated by a flexible budget
model and actual results. If actual revenues are
inserted into a flexible budget model, this means
that any variance will arise between budgeted and
actual expenses, not revenues.

If the number of actual units sold is inserted into a

flexible budget model, there can then be variances
between the standard revenue per unit and the
actual revenue per unit, as well as between the
actual and budgeted expense levels.
 flexible budgeting and cost variances

http://www.accountingtools.com/flexible-budget
 End.

About the tutor...

Shan is an experienced HND tutor and assessor who works in London, UK. He has a Degree of Master
of Laws in Law of International Trade - University of Wales, a - Diploma in Business Administration, a
Degree of Bachelor of Law and a Diploma in Computing.

If your institution is in London and seeking reliable tutors, please contact Shan on
shanwikoon@gmail.com