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Business Management Techniques

Assignment 2

Select and Apply Costing Systems and Techniques

Business Management Techniques

Manage Work Activities to Achieve Organisational Objectives

By Steve Goddard

By Steve Goddard – April 2009

Business Management Techniques

Assignment 2

Select and Apply Costing Systems and Techniques

By Steve Goddard

Acknowledgements

David Sullivan – Supplier of lecture resources.

Mike Tooley & Lloyd Dingle – For there book on higher national engineering.

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Table of Contents

Section Description Page- Executive Summary 61 Task 1 72 Task 2 13- References 16

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Executive Summary

This report is written as two parts the first part of my findings identifies and describes the appropriate costing systems and techniques for a new product in a specific market so that an estimated selling price can be decided.

Seeing as the product is entering an “untapped market” the market uptake is unknown. Therefore I have been asked to assess the resources needed to manage an unknown market. I will do this by measuring and evaluating the impact of changing activity levels on engineering business performance.

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Task 1 – Identify and describe appropriate costing systems and techniques for specific engineering business functions

Costing Systems

Job Costing

Job costing is the process of tracking the expenses incurred on a job against the revenue produced by that job.

Job costing is an important tool for those who are pairing a relatively high pound volume per customer with a

relatively low number of customers. For example, building contractors, subcontractors, architects and consultants

often use job costing, whereas a hardware store or convenience store would not use job costing.

Job costing using accounting software enables you to track a number of factors and analyze the results to aid

decision making. A Job costing report helps you ensure that all costs involved in a job have been properly

invoiced to the customer. An Estimates vs. Actuals report compares quoted costs to actual costs, and quoted

revenues to actual revenues so that you can analyze any variances between your quote and the actual result.

You can then use the results of your analysis to create more accurate quotes when you bid on future jobs.

Using job costing will allow you to identify the most and least profitable areas of your business, so that you can

focus on the profitable elements, and try to make the less profitable aspects of your business more efficient. It will

help you to quote new jobs more accurately, and assist you in managing jobs in progress.

Components of job costing

There are numerous aspects to job costing, and you may use many, some or none of them. If you want to use

job costing, you need to:

1. Track the costs involved in the job

2. Make sure all of the costs are invoiced to the customer

3. Produce reports showing details of costs and revenues by job

The fundamental components of job costing are:

← Quotes – also known as estimates, bids, or proposals

← Fixed fee jobs

← Time and materials jobs

← Revenues

← Items

← Direct costs

← Standard costs

Job Costing ExampleItem Quantity Price/unit Cost (£) Charge (£)Hire of machinery 1 days £55/day 55.00 60.501" Chipboard 4m x 3m £2/sq m 24.00 26.401/2" Chipboard 25sq m £1.60/sq m 40.00 44.002" x 2" Timber 8m £1/m 8.00 8.80Wood Screws 50 £0.03/ea 1.50 1.65Glue 2 £1.50/ea 3.00 3.30Felt 10sq m £2/sq m 20.00 22.00Labour 8 hours £18/hour 144.00 144.00

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£310.65

Contract Costing

Contract costing is very similar to job costing but is used for larger jobs. As contract costing is used for larger

more complicated jobs that often last for longer durations there are more costs to be accounted for. For example

the cost of money due to inflation, interest to be paid on borrowed money. Overheads can often include

accountancy and legal fees, general admin costs, bank charges etc. Sub costs that have already been incurred

cannot be charged for.

Process Costing

Process costing is a type of costing system that is used for uniform, or homogeneous, products. Process costing

averages the costs over all units to come to the per unit cost. This is in contrast to other types of costing systems,

such as job-order costing that is used for products that are in differentiated batches. Unlike job-order costing,

process costing is tracked using a work-in-process account for each department, rather than through subsidiary

ledgers.

Process Costing Procedures

Process costing systems follow specific procedures, and while exact procedures may vary by company or by

industry, they will generally follow these steps:

While other types of costing start with a sales order, a sales order is not needed for process costing as it

is a continuous process

The work-in-process accounts are divided by department and are named as such – for example: Work-in-

process – Department Name

The first department in the process makes the first entry into the work-in-process account, generally for

the direct raw materials

As the products move from department to department, entries are made to each work-in-process

department account

Direct labour costs are recorded by period

Actual overhead costs are recorded; no contra-account is needed because there is no over- or under-

applied overhead due to the actual cost being applied

Indirect costs are applied to the overhead account in actual amounts

Normal spoilage is recorded as a cost to the work-in-process account; abnormal spoilage is removed from

the work-in-process account and applied to a separate account so it can be addressed by management.

When Is Process Costing Appropriate?

Process costing is appropriate when products are homogeneous (or identical). Where job-order and other types of costing seek to find the cost per unit for batches of differentiated products, process costing seeks to find the average cost of all units over a period of time. Therefore, process costing is only appropriate when all units are the same. For example, a manufacturing company that produces only one homogeneous product may elect to use process costing

Process Costing Example

Process 1 Direct materials £6,000.00Direct Labour £4,250.00Production Overheads £3,950.00

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  Total cost of process 1 £14,200.00

Process 2 Direct materials £1,000.00Direct Labour £4,400.00Production Overheads £5,700.00

  Total cost of process 2 £11,100.00

Total cost of production   £25,300.00

Fixed Costs

Fixed costs are those business costs that are not directly related to the level of production or output. In other words, even if the business has a zero output or high output, the level of fixed costs will remain broadly the same. In the long term fixed costs can alter - perhaps as a result of investment in production capacity (e.g. adding a new factory unit) or through the growth in overheads required to support a larger, more complex business.

Examples of fixed costs:- Rent and rates- Depreciation- Research and development- Marketing costs (non- revenue related)- Administration costs

Variable Costs

Variable costs are those costs which vary directly with the level of output. They represent payment output-related inputs such as raw materials, direct labour, fuel and revenue-related costs such as commission.

A distinction is often made between "Direct" variable costs and "Indirect" variable costs.

Direct variable costs are those which can be directly attributable to the production of a particular product or service and allocated to a particular cost centre. Raw materials and the wages those working on the production line are good examples.

Indirect variable costs cannot be directly attributable to production but they do vary with output. These include depreciation (where it is calculated related to output - e.g. machine hours), maintenance and certain labour costs.

Semi-Variable Costs

Whilst the distinction between fixed and variable costs is a convenient way of categorising business costs, in reality there are some costs which are fixed in nature but which increase when output reaches certain levels. These are largely related to the overall "scale" and/or complexity of the business. For example, when a business has relatively low levels of output or sales, it may not require costs associated with functions such as human resource management or a fully-resourced finance department. However, as the scale of the business grows (e.g. output, number people employed, number and complexity of transactions) then more resources are required. If production rises suddenly then some short-term increase in warehousing and/or transport may be required. In these circumstances, we say that part of the cost is variable and part fixed.

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Costing Techniques

Absorption Costing/ Full Costing

Absorption Costing is a costing technique where all normal costs whether it is variable or fixed costs are charged

to cost units produced. Unlike marginal costing which take the fixed cost as period cost.

Advantages

It recognizes the importance of fixed costs in production; This method is accepted by Inland Revenue as stock is not undervalued; This method is always used to prepare financial accounts; When production remains constant but sales fluctuate absorption costing will show less fluctuation in net

profit and

Unlike marginal costing where fixed costs are agreed to change into variable cost, it is cost into the stock value

hence distorting stock valuation.

Disadvantages

As absorption costing emphasized on total cost namely both variable and fixed, it is not so useful for management to use to make decision, planning and control;

As the manager’s emphasis is on total cost, the cost volume profit relationship is ignored. The manager needs to use his intuition to make the decision.

Marginal (Variable) Costing

Marginal Costing is a costing technique where only variable cost or direct cost will be charged to the cost unit produced.

Marginal costing also shows the effect on profit of changes in volume/type of output by differentiating between fixed and variable costs.

Marginal costing involves ascertaining marginal costs. Since marginal costs are direct cost, this costing technique is also known as direct costing;

In marginal costing, fixed costs are never charged to production. They are treated as period charge and is written off to the profit and loss account in the period incurred;

Once marginal cost is ascertained contribution can be computed. Contribution is the excess of revenue over marginal costs.

The marginal cost statement is the basic document/format to capture the marginal costs.

Features

It is a method of recording costs and reporting profits; All operating costs are differentiated into fixed and variable costs; Variable cost charged to product and treated as a product cost whilst Fixed cost treated as period cost and written off to the profit and loss account

Advantages

It is simple to understand re: variable versus fixed cost concept; A useful short term survival costing technique particularly in very competitive environment or recessions

where orders are accepted as long as it covers the marginal cost of the business and the excess over the marginal cost contributes toward fixed costs so that losses are kept to a minimum;

Its shows the relationship between cost, price and volume; Under or over absorption do not arise in marginal costing; Stock valuations are not distorted with present years fixed costs; Its provide better information hence is a useful managerial decision making tool;

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It concentrates on the controllable aspects of business by separating fixed and variable costs The effect of production and sales policies is more clearly seen and understood.

Disadvantages

Marginal cost has its limitation since it makes use of historical data while decisions by management relates to future events;

It ignores fixed costs to products as if they are not important to production; It fails to recognize that in the long run, fixed costs may become variable; Its oversimplified costs into fixed and variable as if it is so simply to demarcate them; It’s not a good costing technique in the long run for pricing decision as it ignores fixed cost. In the long

run, management must consider the total costs not only the variable portion;

Difficulty to classify properly variable and fixed cost perfectly, hence stock valuation can be distorted if fixed cost

is classified as variable.

Activity Based Costing

Activity based costing (ABC) assigns manufacturing overhead costs to products in a more logical manner than the

traditional approach of simply allocating costs on the basis of machine hours. Activity based costing first assigns

costs to the activities that are the real cause of the overhead. It then assigns the cost of those activities only to the

products that are actually demanding the activities.

Let's discuss activity based costing by looking at two products manufactured by the same company. Product 124

is a low volume item which requires certain activities such as special engineering, additional testing, and many

machine setups because it is ordered in small quantities. A similar product, Product 366, is a high volume product

—running continuously—and requires little attention and no special activities. If this company used traditional

costing, it might allocate or "spread" all of its overhead to products based on the number of machine hours. This

will result in little overhead cost allocated to Product 124, because it did not have many machine hours. However,

it did demand lots of engineering, testing, and setup activities. In contrast, Product 366 will be allocated an

enormous amount of overhead (due to all those machine hours), but it demanded little overhead activity. The

result will be a miscalculation of each product's true cost of manufacturing overhead. Activity based costing will

overcome this shortcoming by assigning overhead on more than the one activity, running the machine.

Activity based costing recognizes that the special engineering, special testing, machine setups, and others are

activities that cause costs—they cause the company to consume resources. Under ABC, the company will

calculate the cost of the resources used in each of these activities. Next, the cost of each of these activities will be

assigned only to the products that demanded the activities. In our example, Product 124 will be assigned some of

the company's costs of special engineering, special testing, and machine setup. Other products that use any of

these activities will also be assigned some of their costs. Product 366 will not be assigned any cost of special

engineering or special testing, and it will be assigned only a small amount of machine setup.

Activity based costing has grown in importance in recent decades because (1) manufacturing overhead costs

have increased significantly, (2) the manufacturing overhead costs no longer correlate with the productive

machine hours or direct labor hours, (3) the diversity of products and the diversity in customers' demands have

grown, and (4) some products are produced in large batches, while others are produced in small batches.

Standard Costing

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Standard costs are usually associated with a manufacturing company's costs of direct material, direct labor, and

manufacturing overhead.

Rather than assigning the actual costs of direct material, direct labor, and manufacturing overhead to a product,

many manufacturers assign the expected or standard cost. This means that a manufacturer's inventories and cost

of goods sold will begin with amounts reflecting the standard costs, not the actual costs, of a product.

Manufacturers, of course, still have to pay the actual costs. As a result there are almost always differences

between the actual costs and the standard costs, and those differences are known as variances.

Standard costing and the related variances is a valuable management tool. If a variance arises, management

becomes aware that manufacturing costs have differed from the standard (planned, expected) costs.

If actual costs are greater than standard costs the variance is unfavorable. An unfavorable variance tells

management that if everything else stays constant the company's actual profit will be less than planned.

If actual costs are less than standard costs the variance is favorable. A favorable variance tells

management that if everything else stays constant the actual profit will likely exceed the planned profit.

The sooner that the accounting system reports a variance, the sooner that management can direct its

attention to the difference from the planned amounts.

Additional Costing and Budget Techniques

Cost and Profit Centers

For any business it is important to have an understanding of how much it costs to run various parts of the

company, for example a department or a machine in that department. Without this specific knowledge the

business might find itself subsidising loss making departments or machines without knowing it. In other words the

loss made by a particular cost unit is compensated for by the profits of other units.

Knowing which parts of the organisation are profitable and which run at a loss makes it possible to cut out loss

making units.

Cost centres are part of the organisation structure of the business. Costs are related to the department or section

of the organisation that incurs them.

A cost centre is a location, function or items of equipment in respect of which costs may be ascertained and

related to cost units for control purposes.

A printing firm has printing presses costing £1m each. It may be decided that each machine is to be a cost centre.

A television company consists of a number of departments including: make-up, programming, advertising, and

public relations. It is decided that each of these departments will be a cost centre.

Cost Units

As well as using cost centres another important way of costing is to determine the cost per unit of production or

sales. For example, in a printing firm producing books, each book can be counted as a cost unit.

The purpose of a costing exercise is to determine the cost of a cost unit, therefore all costs should be allocated to

cost units whenever possible. Only when costs cannot be attributed to a specific product are they to be charged to

a cost centre - for example, take two costs incurred in a workshop of a garage, the wages of a mechanic working

on customers' cars and the cost of electricity used for powering workshop tools and lighting. The wages of the

mechanic can be identified with cost units provided a record is kept of how time has been spent, e.g. by each

repair or service job, but it is not practical to record the electricity attributable to specific jobs. This cost should be

allocated to the cost of running the workshop (i.e. it is a cost centre cost).

If we can break up an organisation into cost centres to see how much machines, departments, or other

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components cost to operate we can also divide the organisation into profit centres.

In a profit centre we will need to look at the costs associated with running that centre and the revenues to

calculate the profit. For example, an organisation like the BBC can be split into profit centres and each can be set

profit targets to work towards. Dividing an organisation into profit centres makes it possible to identify the parts of

the organisation that generate the profits and the parts that do not.

Discounted Cash Flow

A valuation method used to estimate the attractiveness of an investment opportunity. Discounted cash flow (DCF)

analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of

capital) to arrive at a present value, which is used to evaluate the potential for investment. If the value arrived

at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one.  

Calculated as:

Task 2 - Measure and evaluate the impact of changing activity levels on engineering business performance

Break Even Analysis

Break-even analysis is a technique widely used by production management and management accountants. It is based on categorising production costs between those which are "variable" (costs that change when the production output changes) and those that are "fixed" (costs not directly related to the volume of production).

Total variable and fixed costs are compared with sales revenue in order to determine the level of sales volume, sales value or production at which the business makes neither a profit nor a loss (the "break-even point").

The Break-Even Chart

In its simplest form, the break-even chart is a graphical representation of costs at various levels of activity shown on the same chart as the variation of income (or sales, revenue) with the same variation in activity. The point at which neither profit nor loss is made is known as the "break-even point" and is represented on the chart below by the intersection of the two lines:

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In the diagram above, the line OA represents the variation of income at varying levels of production activity ("output"). OB represents the total fixed costs in the business. As output increases, variable costs are incurred, meaning that total costs (fixed + variable) also increase. At low levels of output, Costs are greater than Income. At the point of intersection, P, costs are exactly equal to income, and hence neither profit nor loss is made.

The formula: To conduct breakeven analysis, take the fixed costs, divided by the price, minus the variable costs.

As an equation, this is defined as:

Breakeven Point = Fixed Costs/(Unit Selling Price - Variable Costs)

This calculation will show how many units of a product need to sell to break even. Once you’ve reached that point,

you’ve recovered all costs associated with producing your product (both variable and fixed).

Above the breakeven point, every additional unit sold increases profit by the amount of the unit contribution

margin, which is defined as the amount each unit contributes to covering fixed costs and increasing profits. As an

equation, this is defined as:

Unit Contribution Margin = Sales Price - Variable Costs

Here is how to work out the breakeven point, using the example of a firm manufacturing compact discs. You can

assume the firm has the following costs:

Fixed costs: £10,000

Variable costs: £ 2.00 per unit

You first construct a chart with output (units) on the horizontal (x) axis, and costs and revenue on the vertical (y)

axis. On to this, you plot a horizontal fixed costs line (it is horizontal because fixed costs don't changewith output).

Then you plot a variable cost line from this point, which will, in effect, be the total costs line. This is because the

fixed cost added to the variable cost gives the total cost. To do this, you multiply:

Variable cost per unit × number of units

In this example of the CD manufacturing firm, you can assume that the variable cost per unit is £2 and there are 2

000 units = £4,000

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Once you have done this, you are ready to plot the total revenue line. To do this, you multiply:

Sales price × number of units (output)

If the sales price is £6.00 and 2.000 items were to be manufactured, the calculation is:

£6.00 × 2,000 = £12,000 total revenue

Where the total revenue line crosses the total costs line is the breakeven point (ie costs and revenue are the

same). Everything below this point is produced at a loss, and everything above it is produced at a profit.

Fixed costs: £10,000, Variable costs: £2 per unit, Sales price: £6 per unit

If you read downwards, it tells you how many units you need to produce and sell at this price to breakeven: 2,500

CDs

If you read across, it tells you how much money you must spend before you recover your outlay: £15,000

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References

Books

Tooley & Dingle HNC Engineering

Internet Pages

http://www.businesslink.gov.uk/bdotg/action/detail?

r.l1=1073858790&r.l3=1074416511&r.lc=en&type=RESOURCES&itemId=1074416965&r.l2=1073858944&r.s

=sc

http://www.equiworld.net/internet.htm

http://en.wikipedia.org/wiki/New_product_development

http://blog.livemygoals.com/EntrepreneursChampion/archive/2008/05/18/ideas-pt-3-how-to-decide-if-an-

idea-is.aspx

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