An introduction into costing, variance analysis and cash budget

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1. Variable Cost

Variable cost is an expense that will change with the increases and decreases of quantity ofproduction output. As the production volume rise, the cost of production will increase on the other hand, as the Production fall as so as to the cost of production. There are a few type of variable cost such as direct material costs, direct labor hours, direct machine hours and so on. For example, a company packaging cost of one of its products is their variable costs. As the company sales more of their product, the costs of packaging will increase. On the other hand, when the quantity products sold is little, the packaging cost of the product will consequently decrease in amount. (Anon,2014)

On a graph, variable costs would look like:

fixed costs

Figure 1.1 Variable cost

Graph taken from: (opentuition.com, 2014)

Figure 1.1 shows that the cost increases as the activity of production increases.

The formula uses for calculating variable cost are:

For example: Let's assume Y Company has received an order of 5,000 widgets of their product, for a totalsalesprice of RM5,000. In order to determine thegross profitthatmaybe generated by completing the order, the variable costs per widget must first be determined.

Let's assume:

Annual Widgets Produced: 100,000 Raw Materials Costs: RM10,000 Direct Labor Costs: RM50,000

From the information given, we can determine that each widget costs 10 cents (RM10,000 / 100,000 widgets) in raw materialsand 50 cents (RM50,000 / 100,000 widgets) in direct labor costs. By using the formula as shown above, we can calculate the total variable cost of Y Company on the following order:

Total Variable Cost = Total Quantity of OutputxVariableCost per Unitof Output

RM3,000 = 5,000 x (RM0.10 + RM0.50)

In conclusion, a RM2,000 gross profit (RM5,000 - RM3,000) can be earn by Y company from the order. Formula and example taken from: (InvestingAnswers, 2001)

2. Fixed Cost

Fixed cost is a cost that will not be affected by the increase or decrease in the quantity of goods or services produced (Anon, 2014). It is because fixed costis the cost that doesn’t related with the production and need to be paid regardless of the quantity of the product sold. Regardless of how much the product or services sold, the fixed costs still have to be pay. An example of fixed cost is the overhead; overhead may include the rent for the space of which the company occupies such as the office space or maybe the weekly payroll of the employee. Beside overhead, fixed expense may also come in the form of depreciation. Depreciation are the depreciation of the machinery and the depreciation of motor vehicle. These are just a few examples of expenses that need to be pay no matter what the sales volumes are. (Peavler, 2014)

On a graph, fixed costs would appear as:

variable costs

Figure 2.1 Fixed cost

Graph taken from: (opentuition.com, 2014)

Figure 2.1 shows that the cost will always be constant as the activity of production go on. The cost will still need to be pay regardless of the sales.

How it works is:

For example: Let's assume that it costs Company X RM1,000,000 to produce 1,000,000 widgets peryear (RM1 per widget). This RM1,000,000 cost includes RM500,000 of cost such as administrative, insurance, and marketing expenses, in which case are generally a fixed costs. If Company X decides to produce 2,000,000 widgets next year, the total production costs may only rise to RM1,500,000 (RM0.75 per widget) this is because the fixed cost can spread over more units. Although Company X's total costs increase from RM1,000,000 to RM1,500,000, the company can becomes more profitable because each widget becomes less expensive to produce as the quantity increases as the fixed cost remain unchange. (InvestingAnswers, 2001)

3. Semi-Variable Cost

Semi-variable cost is a cost that is consists of a combination of the fixed and variable costs. The costs of production are fixed for a set level of production. After the level of production is exceeded, it becomes a variable cost.The other name of semi-variable cost is semi-fixed cost also know as mixed cost. (Anon, 2014).

On a graph, fixed costs would appear as:

semi variable fixed costs

Figure 3.1 Semi-variable cost

Graph taken from: (opentuition.com, 2014)

Figure 3.1 shows that the cost is separated into two parts. The first part, the fixed element shows that the costs remain constant throughout the activity level, it’s the fixed cost. On the other hand, the variable element show that the cost increases as the activity level increases. Together, it is called the semi-variable costs or mixed costs. A way to understand this cost is to usea cell phonebill as an example to show the semi-variable cost. In the cell phone bill, customers need to pay afixed ratefor their monthly plan, but thebill amount mayincreasewith the additional text messages orlong distance calls. Therefore, thisbill would be consist of a semi-variable expense.

Formula of semi-variable cost

For example: Let assume that the company expects to produce 800 units and company has to pay afixed costof RM25,000 and a variable manufacturing cost is RM3.00 per unit. The total mixed cost would be calculated as follows:

The total mixed cost = Totalfixed cost + (Variable cost per unit x The level of activity)

The total mixed cost = RM25,000 + (RM3.00 × 800 units)

= RM27,400

Formula and example taken from: (Accounting4management, 2014)

The High and Low Point Method: Part 1 by using the high and low point method, the variable and fixed cost can be isolated. The high and low method is a two step process, in which its’ first estimates variable cost by dividing achange in costwith the change in activity. An analysis of the company activity is needed when calculating, as this method required its’ lowest and highest points. The lowest and highest point is called “first point” and “second point,” respectively. The formula uses for doing this method is: variable costs = (Y2-Y1)/(X2-X1), in which case the y variables is the cost at the alternate points of activity, and the x variables equal those points of activity themselves.

The High and Low Point Method: Part 2 After the calculation of the part 1 of the high and low method, by subtracting the variable elements from the total documented costs thefixed costcan be determined. For instance, if a company spends a total amount of RM10,000 and calculates a variable cost of RM5,000, it is concluded that thefixed costwould amount to RM5,000. This formula provides a simplified method for estimation. Although it’s not perceived as the most accurate calculation of fixed and variable rates because of it only analyzes the companies at their opposite extremes. It is believe that every company employs some version of semi-variable costs. Even for a business whose input and output displays an inordinate level of regularity might pay their employees a variable commission on top of a fixed salary. Usual, maintenance for machinery and the cost ofequipmentreplacement is also constitute of variable expenses, in which case would be added to thefixed costof keeping thosemachinesrunning, thus making up the semi-variable total. (variablecost.net, 2014)

4. Marginal & Absorption Costing

Marginal costing is used to calculate the change in total cost that comes from producing one additional item. To determine at what point an organization can achieve economies of scale, marginal costing is used. The calculation is mostly used among manufacturers as a means of achieve an optimum production level. (Anon, 2014)

In contrast, Absorption costing is a management accounting cost method of expensing all costs related to manufacturing of a specific product. The use of total direct costs and overhead costs is involved in the absorption costing method, as it is related to the manufacturing of a product as the cost base. Besides that the Generally AcceptedAccounting Principles(GAAP), also accept absorption costing. (readyratios, 2011)

The difference between marginal costing and absorption costing

There are some difference between the marginal costing and absorption costing. The first differences is that in marginal costing, only the variablecost is considered for product costing and inventory valuation, on the other hand both the fixed cost andvariablecost are taken into consideration for productcostingandinventory valuation in absorption costing. Besides that, the fixed cost overhead treatment is different in the marginal costing compare to absorption costing.The fixed cost is considered as a period cost in marginal costing and the profitability of different product is judged by profit-volume ratio. In the absorption costing method, the fixed cost is charged in the costof production. This mean that each of the product is to bear a reasonable share of fixed cost and profitability of product is consequently influenced by subjective apportionment of fixed cost.

For the marginal costing method, the total contribution and contribution data from each product is used to highlight the production cost. On the other hand, in the absorption method presentation of cost is on conventional pattern. Net profit of each product is determined after deducting fixed overheads. Lastly, in the marginal costing method the difference in the magnitude of opening stock and closing stock will not affect the unit costof production. But, in the absorption method the difference in the magnitude of opening stock and closing stock affects the unit costof productionbecause of the impact of related fixed overheads. (Anon, 2012)

5. Limiting Factor

Limiting factor is something that can limits the manufacturing or sale of a particular product. The other name of limiting factor is shortfall or shortage. Nearly all firms will suffer from some kind of limiting factors. For examples limited machine hours, limited labor-hours and shortage of materials and skilled labor. These are a few of the limiting factor that can be found in a business. (Barron's Educational Series, 2007)

Example 1

Sausage makes two products, the Mash and the Sauce. Unit variable costs are as follows.

Mash

Sauce

RM

RM

Direct materials

1

3

Direct labor (RM3 per hour)

6

3

Variable overhead

1

1

8

7

The sales price per unit is RM$14 per Mash and RM11 per Sauce. During July the available direct labor is limited to 8,000 hours. Sales demand in July is expected to be as follows.

Mash

3,000 units

Sauce

5,000 units

Required:

Determine the production budget that will maximize profit, assuming that fixed costs per month are RM20,000 and that there is no opening inventory of finished goods or work in progress.

Solution:

1. Determine the limiting factor

Mash

Sauces

Total

Labour hours per unit

2 hrs

1 hr

Sales demand

3,000 units

5,000 units

Labour hours needed

6,000 hrs

5,000 hrs

11,000 hrs

Labour hours available

8,000 hrs

Shortfall

3,000 hrs

Labour is the limiting factor on production.

2. Identify the contribution earned by each product per unit of scarce resource, that is, per labour hour worked.

Mash

Sauce

RM

RM

Sales price

14

11

Variable cost

8

7

Unit contribution

6

4

Labor hour per unit

2 hrs

1 hr

Contribution per labor hour (= per unit of limiting factor)

RM3

RM4

Ranking

2

1

3. Determine the budgeted production and sales.

Product

Units

Hours needed

Contribution per unit

Total

RM

RM

Sauces

5,000

5,000

4

20,000

Mashes (Bal.)

1,500

3,000

6

9,000

8,000

29,000

Less: fixed costs

20,000

Profit

9,000

Example taken from: (Anon,2007)

6. Break Even Analysis

Break even analysis is an analysis used to determine the point at which the revenue received is equals to the receiving the revenue. Break-even analysis is uses to calculate the margin of safety, this mean that the amounts of revenues exceed the break-even point. This is the amount that revenues can fall while still staying above the break-even point. (Anon, 2014)

The formula of break even analysis

For example: If you have RM5,000 of product sales, this will not cover RM5,000 in the monthly overhead expenses. The expenditure of selling RM5,000 in retail goods could easily be RM3,000 at the wholesale price, so the RM5,000 in sales revenue only provides RM2,000 in gross profit. When revenue equals all business costs means that the breakeven point is reached. In order to calculate the breakeven point, you first need toidentify the fixed and variable costs. Fixed costs are the expense that does not change as the sales volume, such as the monthly rent and salaries of the employee. The variable costs rise and fall directly with sales volume, such as purchasing inventory, shipping, and manufacturing of the product.

Formula and example taken from: (sba.gov, 2014)

7. Variance Analysis

Variance analysis is uses to explaining the difference between actual costs and the standard costs allowed for the good output. For instance, the materials costs are divided into the materials price variance and the materials usage variance. Variance analysis is used to help the management to understand the present cost and help to manage the future cost of the product or services. The difference between the actual sales and the budgeted sales can be explained by using the variance analysis. Examples include sales price variance, sales quantity variance and sales mix variance. The difference in the quantities of sales can be the reason for the company’s profits and losses. (Averkamp, 2003)

Variance analysisis mostly used when doing business accounting. One of the most commonly uses of it is in the purchasing of manufacturing materials. The following formula is uses to calculate the variance analysis:

This analysis is also used with the overhead and labor spending and efficiency. (Anon, 2014)

8. Cash Budget

Cash budget is the estimation of the cash flow for a businesses or individual in a particular period of time. To assess whether the entity has sufficient cash flow to fulfill their regular operations or whether too much cash is being left in unproductive capacities cash budgets is used. (Anon, 2014)

In the following example, the uses of cash budget is illustrates. Company A maintains a minimum cash balance of $5,000. In case of a insufficiency, loan is obtained at 8% annual interest rate on the first day of the period.

Company A

Cash Budget

For the Year Ending December 30, 2014

Quarter

1

2

3

4

Year

Beginning Cash Balance

RM5,200

RM5,000

RM5,000

RM11,740

RM5,200

Add: Budgeted Cash Receipts:

37,150

54,190

53,730

62,300

207,370

Total Cash Available for Use

RM42,350

RM59,190

RM58,730

RM74,040

RM212,570

Less: Cash Disbursements

Direct Material

14,960

16,550

16,810

19,410

67,730

Direct Labor

8,830

9,610

9,750

11,900

40,090

Factory Overhead

10,020

10,400

11,000

11,780

43,200

Selling and Admin. Expenses

7,640

8,360

8,500

9,610

34,110

Equipment Purchases

6,000

14,000

20,000

Total Disbursements

RM41,450

RM50,920

RM46,060

RM66,700

RM205,130

Cash Surplus/(Deficit)

RM900

RM8,270

RM12,670

RM7,340

RM7,440

Financing:

Borrowing

4,100

4,000

Repayments

−3,188

−912

−4,000

Interest

−82

−18

−100

Net Cash from Financing

RM4,100

−RM3,270

−RM930

−100

Budgeted Ending Cash Balance

RM5,000

RM5,000

RM11,740

RM7,340

RM7,340

Example taken from: (Jan, 2014) 9. List of references

Anon. (2014). Microeconomics, Operating Cost, [Internet]. Investopedia.com. Available from: <http://www.investopedia.com/terms/v/variablecost.asp> [22 March 2014]

Opentuition. (2014). Cost classification, [Internet]. opentuition.com. Available from: <http://opentuition.com/fia/ma1/cost-classification/ > [23 March 2014]

InvestingAnswers. (2001). Variable Costs, [Internet]. Investinganswers.com. Available from: <http://www.investinganswers.com/financial-dictionary/economics/variable-costs-804> [22 March 2014]

Anon. (2014). Microeconomics, Operating Cost. [Internet]. Investopedia.com. Available from: <http://www.investopedia.com/terms/f/fixedcost.asp> [22 March 2014]

InvestingAnswers. (2001). Fixed Costs, [Internet]. Investinganswers.com. Available from: <http://www.investinganswers.com/financial-dictionary/economics/fixed-costs-2948> [22 March 2014]

Rosemary Peavler. (2014). Fixed and Variable Costs, [Internet]. bizfinance.about.com. Available from: <http://bizfinance.about.com/od/pricingyourproduct/qt/Fixed_Variable_Costs.htm> [22 March 2014]

Anon. (2014). AccountingFundamental Analysis,Microeconomics, [Internet]. Investopedia.com. Available from: < http://www.investopedia.com/terms/s/semivariablecost.asp> [23 March 2014]

Accounting4management. (2014). Mixed Cost or Semi-variable Cost, [Internet]. Accounting4management.com. Available from: <http://www.accounting4management.com/mixed_costs.htm> [23 March 2014]

Variablecost.net. (2014). Calculating and Separating Semi-Variable Costs, [Internet] Variablecost.net. Available from: <http://www.variablecost.net/Semi-Variable-Costs.html> [23March 2014]

Anon. (2014). Marginal Cost Of Production, [Internet]. investopedia.com. Available from: <http://www.investopedia.com/terms/m/marginalcostofproduction.asp> [23 March 2014]

Barron's Educational Series. (2007). Dictionary of Accounting Terms, [Internet]. allbusiness.com. Available from:< http://www.allbusiness.com/glossaries/constraining-limiting-factor/4949815-1.html> [23 March 2014]

Anon. (2014). Financial Theory,Operating Cost,Value Investing. [Internet]. Investopedia.com. Available from: <http://www.investopedia.com/terms/b/breakevenanalysis.asp> [22 March 2014]

sba.gov. (2014). Breakeven Analysis, [Internet]. sba.gov. Available From: <http://www.sba.gov/content/breakeven-analysis> [23 March 2014]

Harold Averkamp. (2003). What is variance analysis?, [Internet]. accountingcoach.com. Available from: <http://www.accountingcoach.com/blog/variance-analysis-standard-cost> [24 March 2014]

Anon. (2014). UsingVariance Analysisto Track Business Performance, [Internet]. varianceanalysis.org. Available from: <http://www.varianceanalysis.org/> [24 March 2014]

Anon. (2014). Budgeting, [Internet]. Investopedia.com. Available from: <http://www.investopedia.com/terms/c/cashbudget.asp> [24 March 2014]

Irfanullah Jan. (2014). Cash Budget, [Internet]. accountingexplained.com. Available from: <http://accountingexplained.com/managerial/master-budget/cash-budget> [24 March 2014]

Readyratios. (2011). Absorption Costing, [Internet]. readyratios.com. Available from: <http://www.readyratios.com/reference/accounting/absorption_costing.html> [24 March 2014]

Anon. (2012). Difference between absorption costing and marginal costing, [Internet]. mohanmekap.com. Available from: <http://www.mohanmekap.com/2012/02/difference-between-absorption-costing.html> [24 March 2014]

Anon. (2007). Chapter 5 Limiting Factors and Throughput Accounting, [Internet]. googleusercontent.com. Available from: <http://hkiaatevening.yolasite.com/resources/PBEP2Notes/Ch5-LimitingFactors.doc> [24 March 2014]

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