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Cost is something of value, usually an amount of money, which is given up in exchange for something else, like goods or services. Cost can be defined as the amount of assets, measured in financial terms to attain a specific objective.
In other words cost is the essential spending which must be made for a business to run.
It should be kept in mind that all expenses are costs, but all costs are not expenses.
Types of Costs
There are two types of costs, namely:
Direct Cost is one which can be recognized by a specific product/profitable service. Direct cost comprises of direct materials used in the product, direct wages paid to the workers and direct expenses incurred on the product. Direct costs are same as variable costs. Prime costs are good example of direct cost.
Prime costs are those costs which are of huge importance for making and manufacturing any product. The sum of direct material and direct labor is also called prime cost.
Prime Cost = Direct Material + Direct Labor
Indirect Cost is one which cannot be identified with any one specific product, but it needs to be shared over a number of products. Examples can be that of salaries, consumable materials etc. Indirect costs are similar to fixed costs. Indirect cost includes overheads as well.
Relationship between direct cost and indirect cost can be shown by the figure below:
Indirect Cost (overheads)
Direct cost of the unit
Full cost of the unit
Cost can be classified into different categories based on their material, labor and expenses. For example materials may be broken down into raw materials, maintenance material etc. We can classify them as production costs, selling costs, distribution costs and administration costs.
Production Costs are costs that originate from receipt of the assets till completion of the product. Selling Costs are costs that relates to creating demand for products and securing orders. Distribution Costs are costs that go from production department to delivery to the customer. Administration Costs are costs that related with managing the company. (Terence, 1999)
Cost behavior is the way by which costs are affected by changes in the level of volume. The phenomenon of cost behavior can be understood by different types of costs, where costs may be classified according to whether they:
Remain constant (fixed).
Vary according to the volume (units of outputs).
Fixed Costs are costs which don't change for a certain period of time and don't change with production. Examples are salaries, tax, rent etc. Fixed cost is likely to be affected by inflation. They are also called indirect costs. Fixed costs are also sometimes called overhead costs.
0 volume (units)
The graphs shows that as the volume of output increases, the fixed cost stays exactly the same.
Variable Costs are costs that change directly with production of a unit. Output and variable costs are directly proportional to each other. Whenever output/production increases, variable costs also increase. These are also known as direct costs. More labor and material is required to generate more output, the cost/price of labor and material changes as it is in direct proportion to the volume of production/output. Example can be that of raw material.
The graphs shows that at zero point, there is no variable cost but as the volume increases so does the variable cost increases.
Semi Variable Costs are costs which have indirect and variable elements. Example can be that of a person who works for the organization, he might have a fixed/permanent salary but at the same time he may earn profit/commission on sales. Semi variable costs are also called mixed costs.
0 volume (units)
The graphs shows the semi variable cost phenomenon.
Total costs can be calculated by summing up indirect/fixed, semi-variable and variable costs all together. The level of activity at which total cost equals total sales revenue is called breakeven point.
Stepped Cost are costs in which fixed cost increases to a high level in step with the significant changes in activity or usage. It is variable over a large range or volume (Peter and Eddie, 2009)
Step cost is of two types:
Step up cost.
Step down cost.
Examples of steeped up cost can be that of bills and that of steeped down can be discounts.
Utility expenditure remains fixed/constant up to a possible degree of volume. When the level increases to certain point, the utility expenditure instantly rises. The utility expenditure graph rises when the activity level reaches another point, the cost remains constant as it is shown in the graph below.
Cost (£) Cost (£)
0 volume 0 volume
In step down case the value rises up to a certain degree/level of volume, a rate is offered when it reaches a higher activity level increases and then remains constant up to a particular volume of level.
Outcome # 2
Total Quality Management
Total Quality Management is a value analysis tool used by management to improve performance of a business. In other words total quality management is a process that can improve company's competence, value and efficiency.
Quality is about satisfying needs of a customer.
Idea behind total quality management arose in early 1960's, this idea was first carried in Japan by Toyota Motor Company and from there it spread all over the world. People started realizing the fact that excellence could not be guaranteed by few number of quality professionals, but it requires the participation of the entire company, in which everyone needs to play a part, this includes managers, employees and people related from all departments. (Jill and Roger, 2003)
Total Quality Management includes several principles, which are to be followed in order to maintain their quality. These are defining good quality in terms of customers and their requirements. It emphasizes on prevention rather than detection of errors/ defects. It focuses on process rather than output.
Advantages of Total Quality Management
There are many advantages of TQM few of them are listed below:
It improves business reputation, means that the errors and bugs are marked and sorted more rapidly/faster and there is no/null defect in the product.
Quality Control inspectors operate at all time to ensure that the level is maintained all the time.
Morale of employees is very high as the employees are motivated and dedicated to work more and with full concentration because they are involved in decision making, they work in groups/teams and they have extra responsibility on their shoulders.
Disadvantages of Total Quality Management
There are few areas where TQM lacks its control and hence its disadvantages might not be huge ones but are listed below:
Change may not be liked by employees as they may resist change. Job security may be another factor as they may feel less safe about their future and in that way may not be able to work with full dedication.
Early costs such as training of employees. This may take time and hence income/profit may not be earned immediately.
Cost of Quality
Cost of QualityÂ is a measurement tool used for assessing the waste or losses from some defined process (e.g. machine, production line, company, etc.) (Peter and Eddie, 2009)
Quality assurance is done to make sure before proceeding that everything is under control and in fine state. Workers must know what they are doing and make sure they do every work in a fine way. There are many advantages of cost of quality but the disadvantages cannot be neglected. These are that there are slow rates of improvement. There is very low or no profitability. Changes in one department/area tend to have terrible effects in other areas/department.
Cost of Quality can be divided into four categories, namely:
Internal Failure Cost.
External Failure Cost.
Prevention and appraisal costs arise in order to prevent faulty items reaching customers. Internal and External failure costs arise because problems are found (in products) in spite of efforts to stop them. These costs are recognized as poor quality costs.
The best way to deal with quality costs is that we must first see that there is no fault/effect in the item. In case of prevention cost machine must be of good quality. Labor is qualified and of good quality (skilled). Labors are kept happy in order to take good advantage of their skills. Parts which are defective or which needs repairing should be fixed in the production process. Before the items are ready to be delivered to the customer it should be seen that they are not faulty/defective, such type of costs which arise to identify this process are called appraisal costs. Appraisal cost deals with the fact that the material to be used must be of a good/high quality. Higher the quality of machine higher the performance.
Internal failure cost deals with repairs and repairing works. For instance if any machine or material is out of shape or order it has to be repaired. Labors don't work when the machines get out of order, but still they get paid which puts an extra burden on the company. Quality controllers are required to keep a check and balance on the whole scenario.
When a defective item/product is delivered to the customer external failure cost arises. By External failure cost we mean guarantees and warranties. Sometime customers get unhappy can be a factor in company's decline. Customers fail u (company). If they don't like a particular service or product they can try something else from another company, so looking after your customers is a priority for the company to gain success.
Balance Score Card
Balanced scorecard monitors, measures and provides information to company so that they can plan and implement new ideas and strategies to achieve their goals. Organizations can make improvements as well. (Jill and Roger, 1999)
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It was first described by Kaplan and Norton. According to them it was assumed as a performance measuring formation that gave additional plan for non financial actions to basic financial terms which gave managers a view to see company's progress and report. Balance score card takes into consideration the financial and non financial aspects of the business. Balance scorecard has four perspectives. Namely:
Innovation and learning.
Financial perspective looks at the profits, ROCE and earnings per share. Innovation and learning perspective means doing new things, introducing new methods at a less price. Company knows what is it doing and where it stands after a certain period of time. By internal perspective we mean that a company looks at its workers, employees, management and shareholders. Do they have right salaries, are they well paid, are all the workers happy. External perspectives relates to customer satisfaction and customers happiness. Because company's success depends upon customers support and loyalty.
Total Quality Management and Balance Score Card goes hand to hand with each other.
It is a creative method by which we can raise the worth of a product or a tool. It is also known as functional analysis.
Four aspects should be considered while dealing with value analysis, namely:
Improving product quality.
Customer Employee relations.
By following these four aspects and implementing value analysis company can achieve reduced material use and costs. Reduced distribution costs and wastes/losses. Profit margins are improved. There is an increase in customer satisfaction. There is an increase in employees morale and he works more efficiently ever before. Value analysis should be part of a constant improvement effort.
Value Analysis can achieve four objectives, these are discussed here. It focuses on those parts which are mostly important for customers that attract customers and are of worth to them. Costs are reduced by removing the functions that do not provide compensation to fulfill customer's needs. Exchange Values and Esteem values are all part of it.
Outcome # 3
Budget is a plan for both incoming and outgoing of money, personal, purchase items, sales items, which manager believes that determining the future course of action will assist in achieving company goals. In financial terms it's a planning for a company. (Brammer and Penning, 2001)
The simple method of preparing and planning a budget includes ideas about businesses costs (direct & indirect) and after that deciding about how to allocate these resources to different departments so, that company may achieve its goals. There is usually a separate budget for each key area. Budgets are prepared for twelve months or for just few months.
Benefits of preparing a Budget
Budget helps in synchronizing the different aspects of the business. It motivates employees, hence increases the level of performance. It helps in providing control over the business/system.
Criticisms of preparing a Budget
Budget is basically a waste of time and resources. Budget cannot deal with rapid changes. Budget encourages a top down management style. It's too much time consuming. It emphasizes more on short term economic targets instead of planning about long term valuable ideas..
Preparing a Budget
A well organized budget has many advantages. Company needs to carry out different procedures in order to succeed. Company must plan their spending. Know about their Required Profit. Each budget must link (co-ordinate) with others. Steps involved in preparation of budget are shown in figure below.
Objectives of Budget
While preparing budget company can look forward to meet certain objectives and fulfill them. There can be many of them, few are listed below like plan, control, motivation etc.
Objectives of Budget
Company needs to calculate its costs and revenues before starting the task. Control over the employees and management is very important. There is a proper check and balance system and consultants are hired to check the progress of work. Staff and management members are motivated and there level of performance increases which helps the company to achieve its goals. Performance evaluation is done time to time, to monitor the quality of work the employees are doing and maintain good quality of services and products. Coordination is improved , in a sense that repetition is stopped. Communication between the staff and management increases. Everyone is ready to participate for the betterment of the company.
Types of budget
There are four types of budgets, namely:
Zero based budget.
Activity based budget.
Zero Based Budget
Activity Based Budget
Incremental Budget takes the last year as a foundation and adds/deducts a percentage to arrive at the budget for the current year. It is used for stable environment. It's the easiest budget. This type of budget is outdated. It takes less resources and less time but it doesn't works in a competitive environment. It may not be achievable or it may change. E.g: Councils. Zero Base Budget is concerned with the phenomenon that all spending/expenditures needs to be justified. It is a best type of budget in a competitive environment. The more we sell the more we get profit. E.g: Tesco, British Airways. This sort of budget encourages managers to adopt to a more questioning approach to their areas of responsibilities. One needs quite a long period of time to prepare it. Activity Base Budget is a method of budgeting that develops budgets based on activities and cost drivers. It is a very common like Zero base budget. Both these budgets go hand to hand. We need to have a good data base for Activity Based budget. It increases value of a business and decreases/reduces cost of business. It is good for a competitive environment. It is a value analysis budget. It is useful to keep control of costs. E.g: It is used in hospitals. Rolling Budget is a budget in which a budget made at the beginning of an accounting period is continuously amended to reflect variances that arise due to changing situations. It should be prepared very accurately. It is also good for incremental budget. It is used by small organizations. There are too many costs. It is a realistic budget but is very accurate.
Budget Committee consists of a group of people that creates and maintains a budget. In an organization, this committee usually consists of the top management. Budget committee reviews and approves different departmental budgets that are submitted by the various department heads/managers.
A budget committee is usually responsible for overall policy matters of budget program and for coordinating/communicating the preparation of the budget itself. This committee usually consists of the president, vice president and the controller. They are monitoring different functions such as sales, purchasing, production etc. If there is any problem between different departments or segments of the company they are also resolved by budget committee. Budget committee also has a final say to budgets preparation, it receives reports and checks the progress of the company in achieving budgeted goals.
The budget process consists of activities that include the development, realization, and assessment of a plan for the provision of services and capital assets. (Terence, 2003)
Several important features describe a good budget process. It incorporates a long-term perspective. Establishes linkages to broad goals. Focuses budget decisions on results and outcomes. Involves and promotes efficient communication with stakeholders, and provides incentives to government management and employees. Focuses budget decisions on results.
A period for which a budget is prepared and during which it is intended to apply. Budget periods are twelve months in length, but they may vary as they can be less than a year and vice versa.
Before creating a budget company must decide what period of time it wants to plan for. The most common budget periods are monthly and annual.
Outcome # 4
Responsibility center is part of a company that has a complete control over costs, revenues and savings. Managers are responsible for all the proceedings that go on in their department.
It is a place, site, department in an organization in relation to which cost can be accumulated.
Managers need to motivate there staff members. Communication level needs to be good. It's a huge responsibility which needs to be taken and fulfilled well. Manager of the department will be accountable for any decrease/increase in costs. As shown in above table the department has used more resources and the cost exceeds the given budget. Manager cannot be sacked as there can be genuine reasons for this increase. May be time wasn't managed that well. Employees may have done over time and hence had more salaries in return could be a factor. Manager needs to sort out this problem. Staff needs to be motivated, they should be fully committed to their department. Monitoring system should work properly. Better monitoring of investment returns.
It is a place, site, location, department in an organization in relation to which revenue can be accumulated. Revenue can be collected. No costs.
It is a place, site, location or a department in relation to which cost and revenue can be measured.
Here in this table company had a profit. Costs depends on material and labor. The costs were cut down and the company made profit. In other words manager might have bargained with the suppliers to achieve company's goals. Labor worked on their allocated time and were paid on time. No extra expenses took place. Loss of overall central control of the company. Profit centre could be working towards different or non-company agendas are few disadvantages.
Investment centers form part of large organizations, where the manager is made responsible for the local decisions. It is also called a division center and includes cost and profit centers. E.g: Tesco, Sainsbury etc.
These are the costs that managers can easily increase or decrease. Advertising or developing new products, training costs can be an example of it. These costs should not form part of responsibility accounting.
The difference between the actual figures and the budgeted figures in called variance. Variances may be favorable or adverse according to whether they result in an increase to, or decrease from, the budgeted profit.
If the actual costs are lower than the budgeted costs, there will be a favorable variance, and this will result in a higher final profit. If the actual costs are higher than the budgeted costs, there will be an adverse variance, which will result in lower profit. (Brammer and Penning, 2001). Variance analysis may result in cost reductions and control of costs is improved. At the same time it may be difficult to set standards in a new organization. Variance analysis is too much time consuming. Performance evaluation is difficult. Variance can be overcome by using Balanced Scorecard. Improving accounting systems. Applying standard cost accounting. Using Direct Costing. Through segmentation.