Cost estimation is a term used to describe the measurement of historical cost so as to be able to predict future costs for management decision making. That is, historical information is analyzed to provide estimates on which to base future operational To do cost estimation, it is important for the Accountants to be able to ascertain the activity level as well as cost drivers which exert main influence on the company activity. A cost driver is any factor whose change causes a change in the total cost of the operations of an activity. Some examples of cost drivers are: (a) direct labour hours
(b) machine hours
(c) Units of output and
(d) Number of production runs
In some cases, there are mixed costs. That is, such costs have both fixed and variable elements that would need to be segregated.
METHOD OF SEGREGATING MIXED COSTS INTO FIXED COST AND VARIABLE COSTS Mixed costs can be separated into their fixed and variable elements, using a number of methods which include: (i) The accounts classification method
(ii) The high-low method
(iii) The scatter graph
(iv) The linear regression analysis
(v) The multiple regression analysis
Account Classification Method
This is a subjective way of segregating the mixed cost into fixed and variable element. It is usually based on the personal experience of the accountant. This method requires that the the accountant inspect each item of expenditure within the accounts for some output level, and then classify each item of expenses as a wholly fixed, variable or semi- variable cost.
KAI uses an inappropriate volume- based cost allocation method that causes inefficient resource allocation, disincentive among employees and weaker financial performance. To improve the existing method, Senior Management should consider reviewing the current situation to identify the problems, followed by adopting an alternative cost allocation method. The current revenue-based cost allocation ...
This represents an objective way of segregating the mixed cost into fixed and variable elements. It involves the following procedure- (i) Identify the highest and least activity levels among the observed data.
(ii) Ascertin the difference between the two activity levels (iii) Identify the corresponding cost to both the highest and lowest activity levels.
(iv) Determine the difference between the two corresponding cost. (iv) Divide the difference in cost by the difference in activity level in order to determine variable cost per unit or the level of variability, (vi) Use the variable cost per unit to determine total variable cost. ADVANTAGES
(i) It is capable of providing consistent result from different user (ii) It eliminates subjectivity
(iii) High and low method is simple to calculate.
(i) The method relied solely on the two extreme values, that is highest and lowest. (ii) The fina1 result of the method may not represent the actual cost position of the Company
By this method of cost estimation, historical costs from previous periods are plotted and from the resulting diagram, a ‘line of best fit’ can be drawn by visual estimation
Linear Regression Analysis
This is a statistical method of estimating fixed and variable costs using historical data from previous accounting periods.
Multiple Regression Analysis
Multiple regression recognizes several different factors as affecting levels of activity. For example, total cost may be affected by volume of output, time of the year, size of batch, labour turnover, age of machinery etc. The multiple regression model enable the accountant to estimate the amounts by which the above variables affect total cost.
(a) Separate the cost, into the fixed element and the variable cost per machine hour, using the high-low method (b) Estimate the total costs likely in week 9 if the expected level of machine hours is 7,200.
... the breakeven analysis. Breakeven point brings the relationship in the organization between its price, fixed costs, variable costs and the volume of ... level that is variable costs at the unit level, cost of control at the batch level, cost of product movement at the product level and depreciation cost ... of titanium for the organization to start realizing profits. The one for carbon lite is 915 while ...
COST VOLUME PROFIT ANALYSIS (CVP ANALYSIS)
The Cost volume profit analysis (CVP analysis) is one of the most powerful tools that managers use to help them understand the interrelationship between cost, volume, and profit in an organization. The main focus is on interactions among the following five elements: (a) Prices of products
(b) Volume or level of activity
(c) Per unit variable cost
(d) Total fixed cost
(e) Mix of product sold
The decision areas in which the application of CVP analysis can be useful include: (a) What products to manufacture or sell
(b) What pricing policy to follow
(c) What marketing strategy to employ and
(d) What type of productive facilities to acquire.
Assumptions in CVP Analysis
The CVP analysis relies on a number of simple assumptions.
(a) Only one product is sold. However, multiple products can be accommodated. (b) Beginning inventory is assumed equal to zero, and production is assumed equal to sales (c ) The analysis is confined to the relevant range. In other words, fixed costs remain unchanged in total and variable costs remain unchanged per unit, over the range of quantity under consideration. The Basic Profit Equation
Cost-Volume-Profit analysis (CVP) relates the firm’s cost structure to sales volume and profitability. A formula that facilitates CVP analysis can be easily derived as follows: Profit = Sales – Expenses
Profit = Sales – (Variable Costs + Fixed Costs)
Profit + Fixed Costs = Sales – Variable Costs
Profit + Fixed Costs = Units Sold x (Unit Sales Price – Unit Variable Cost)
Therefore, the Basic Profit Equation is abbreviated as:
P + FC = Q x (SP – VC) The Basic Profit Equation is used to solve one equation in one unknown, where the unknown can be any of the elements of the equation. For example, given an understanding of the firm’s cost structure and an estimate of sales volume for the coming period, the equation predicts profits for the period. As another example, given the firm’s cost structure, the equation indicates the required sales volume Q to achieve a targeted level of profits P. If targeted profits are zero, the equation simplifies to:
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Q = FC ÷ Unit Contribution Margin
In this case, Q indicates the required sales volume to break even, and the exercise is called breakeven analysis.
The break-even analysis represents the position where total cost will equate the total revenue. The concept of break-even analysis relies heavily on the application of the behavioural classification of cost. Breakeven analysis helps us understand a number of issues which include: (a) The number of units that an organization should produce and sell in order to equate the total cost of production
(b) The total turn-over required by an organization in order to equate the total cost of production or what is the break-even point in sale value.
(c) The turn-over required by organization for the purpose of achieving a pre- determined level of profit
(d) Under a pre-determined amount of profit, how many units must an organization produce and sell in order to achieve the desired profit target.
Assumption of Break-Even Analysis
(i) A state of no uncertainly
(ii) Variable cost remain constant
(iii) All cost can be accurately divided into fixed and variable elements (iv ) There are no stock level changes or that stocks are valued at marginal cost only
(v ) A relevant range is defined to which the analysis applies only (vi) Profit are calculated on a variable costing basis
(vii) The only factor affecting revenue and cost is activity level (viii) A mono-product situation is assumed sales mix.
(ix) Fixed costs will remain constant within the relevant range (x) Method of production, level of technology and efficiency remaining unchanged. (xi) Linear relationship between costs and revenue is assumed.
(i) Breakeven Point
Paul owns a service station in Ketu. He is considering leasing a machine that will allow him to offer customers satisfactory services. The machine costs N6,000 per month to lease. The variable cost per service (i.e., per car serviced) is N10. The amount that Paul can charge each customer is set by the Union and is currently N40.
How many services would Paul have to perform monthly to break even from this part of his business?
The increasing complexity of today’s business environment makes it virtually impossible for most firms to be controlled centrally. Decentralisation is a necessary response to this increasing complexity and involves the delegation of decision-making responsibility by senior management to sub-ordinates. The structure is such that decision making is dispersed to various units within the organisation, ...
Q = FC ÷ Unit Contribution Margin
Q = N6,000 ÷ (N40 –N10) = 200 services
Note: Unit contribution is Revenue less variable cost.
(ii) Targeted profits, solving for volume
Refer to the information in the previous question. How many services would Paul have to perform monthly to generate a profit of N3,000 from this part of his business?
P + FC = Q x (SP – VC)
N3,000 + N6,000 = Q x (N40 — N10)
N9000 =Q x N30
Q = 9000/300
(iii) Targeted profits, solving for sales price
Nosa runs a store in Lagos. Her daily fixed costs are N20. Her variable costs are N2 per glass of ice-cold, refreshing cream. Nosa sells an average of 100 glasses per day. What price would she have to charge per glass, in order to generate profits of N200 per day?
P + FC = Q x (SP – VC)
N200 + N20 = 100 x (SP — N2)
SP = 220 +2
N4.20 per glass
(iv) Contribution margin
Refer to the previous question. What price would Nosa have to charge per glass, in order to generate a total contribution margin of N200 per day?
Total CM = Q x (SP – VC) N200 = 100 x (SP — N2.00)
200 + 2
SP = N4.00 per glass
(v) Refer to the information about Nosa, but now assume that Nosa wants to charge N3 per glass of ice-cream, and at this price, she can sell 110 glasses of ice-cream daily. Applying target costing, what would the variable cost per glass have to be, in order to generate profits of N200 per day? P + FC = Q x (SP – VC)
N200 + N20 = 110 x (N3 – VC)
Abu Ltd manufactures a single product which has a variable cost of sale of N8 per unit and a sales price of N12 per unit. Budgeted fixed costs are N24,000. What volume of sales would be required to : (a) Break even
(b) Earn a profit of at least of N6000?
EXAMINATION TYPE QUESTION
The following information were extracted from the books of Henry Ltd for he year 2008. Units Produced 55,000 units
Direct materials 935,000
The cost-volume-profit analysis is a business tool which companies utilize in order to analyze the effects of changes on costs and volume in its profits. It has five major components namely, volume or level of activity, unit selling prices, variable cost per unit, total fixed cost, and sales mix. The volume of level of activity refers to the quantity of the product which is sold. Unit selling ...
Direct labour 1,567,500
Variable Production overhead 539,000
Fixed Production overhead 695,000
Selling and Admin costs ( Fixed) 354,800
1.The relevant range for fixed costs is 10,000 units to 85,000 units 2. It is expected that in the coming year, 2009:
(a) variable and fixed costs are expected to behave in the same way as indicated above but inflation in expected to increase costs in general by 20% (b) the selling price will be raised by N10 per unit
(c )ignore income tax
Prepare a report for the management showing:
(i) The number of units to be sold to breakeven for both 2008 and 2009 (ii) The number of units to be sold in 2009 to earn the same amount of profit as in 2008 (iii) How many units the company would be required to sell in order to earn a profit of N415,800