How cost assists management in decision making

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A Public Limited Company which is listed at the London Stock Exchange needs to expense to run the various types of activity within the company for producing product or providing service. In that case it is very important to know about the cost which will assist management in the decision making process.

Outcome 1:

Cost:

Cost is an expense to run the business for the company. A Company serves products or services to run the business and that's why business involved to expense costs to produce products or services. The types of cost could be as following Figure 1:

Direct Cost:

According to the Brammer and Penning (2001) "Costs that are directly attributable to the units of output. They can be divided into direct materials, direct labour and direct expenses." Direct cost related to the production of the company. It is specific and related to the cost unit as well. Direct costs have been shown by giving an example as following Figure 2:

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To make Product X, Direct costs of the Company would be:

Particulars (£)

Direct Materials 10

Direct Labour 6

Direct Expenses 9

Prime cost = 25

The addition of direct costs called as prime cost.

Indirect Cost:

It is not directly related to the production of the company. Indirect cost can also be shared cost. According to the Horngren et al (2002) "Indirect cost are costs that are related to the particular cost object but cannot be traced to it in an economically feasible (cost-effective) way." Indirect costs are allocated to the cost object using a cost allocation method.

Indirect costs have been shown by giving an example as following Figure 3:

To make Product X, Indirect costs of the Company would be:

Particulars (£)

Indirect Materials 6

Indirect Labour 4

Indirect Expenses 5

Overheads = 15

The addition of indirect costs called as Overhead.

The Behaviour of Costs:

Cost is involved to achieve the business objective of the company. According to the Atrill, P and McLane, E (2008) "The cost incurred by a business may be classified in various ways and one important way is according to how they behave in relation to change in the volume of activity." The type of cost behaviour has been described as following Figure 4:

Variable Cost:

It is depends to the number of production. If the number of production is increase then the total cost will be increase and if the number of production is reduce then total cost will also be decrease but the per unit production cost will be the same. Figure 5 is showing the variable cost:

Here, horizontal line shows that the total number of unit production and vertical line shows the total cost of production. Here, when the total 5 number of unit produced then the total cost of production is £ 10. So it shows that per unit cost is £2. Again the total number of unit increased by 10 then the total cost of production is £20. Here is also total cost has increased but per unit cost has been remain same.

Example of Variable cost:

Variable cost can be raw materials, labours etc. The increment of this cost is depends on the production. When production is increase then the cost of raw materials, labours is increase and the same way it is reverse when the production is decrease.

Fixed Cost:

Fixed cost is a cost which is not change according to the production. It always remains constant although the production of the company is increase or decrease. Figure 6 is showing the fixed cost:

Here, horizontal line shows that the total number of unit production and vertical line shows the total cost of production. It is showing here, when 5 units has been produced then the fixed cost was £10000 and when number of production has been increased from 5 to 10 that time also fixed cost £10000. That means the fixed cost is never change and by the variation of the production, fixed cost is not change.

Example of Fixed Cost:

The fixed cost of products or services can be Building, depreciation, Rent & rates, salaries etc. This cost will not change if the production is increase or decrease.

Semi variable Cost:

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It is a mixed cost with variable and fixed cost. The sum of total variable cost and fixed cost is semi variable cost. If the company does not produce something then also cost will involve which is fixed cost. Figure 7 is showing the semi variable cost:

Here, horizontal line shows that the total number of unit production and vertical line shows the total cost of production. When the total unit of production is 10000 then the total cost of production is £70000. Here fixed cost is showing £50000, then total variable cost will be (70000- 50000) = £20000. That means it can be say Fixed cost + Variable cost = Semi variable cost.

Example of Semi- variable cost:

Phone bill or utility bill can be semi- variable cost. To use the connection, some specific amount have to pay for the service that is connection fee which will remain same in every month and on depending of uses have to pay with the connection fee which can be vary on the uses.

Stepped Cost:

It is a type of cost which will be fix for a certain period or range. When the range exceeded and goes up to next stage then the cost will be involve for the previous range plus new range. Figure 7 is showing the Stepped cost:

Here, horizontal line shows that the total number of unit production and vertical line shows the total cost of production. In Stepped cost, company produce 20 unit which cost is £40, if the production increased up to 35 then the cost will be increase (Relevant Range A+B) 40 +45 = 85. If again the production is increased up to 40 then in that case the cost will be ( Relevant Range A+B+C) £(40+45+50)= £135.

Example of Stepped Cost:

Stepped cost can be water price or gas prices which are natural resources and those are not abundant.

Outcome 2:

For any business it is very important to reduce cost and increase the value of business. To maintain the quality of business and at the same time to keep the reduce cost, business need to analysis some various techniques and will find out which technique are fit for the business.

There are some techniques which have been showing in Figure 8:

Total Quality Management (TQM):

This technique comes from Japanese organization TOYOTA which has been provided a significant role in global business success. To prevent the costs than the correction of costs are the fundamental principal of Total Quality Management.

Philosophy of TQM:

According to the CIMA Text Book, "The philosophy of TQM is based on the idea of a series of quality chains which may be broken at any point by one person or service not meeting the requirements of the customer. The key to TQM is for everyone in the organisation to have well-defined customers - an extension of the word, beyond the customers of the company, to anyone to whom an individual provides a service."

Aims of TQM:

Analysing the principal and the philosophy of TQM, it describes that to ensure or control the quality of the products and services first time so that the cost can be reduce at the same time increase the value of goods and services than the other competitors and can keep high customer satisfaction.

Cost of Quality:

It's maintained the acceptable quality and prevent from the cost of poor quality. It assures the high quality of the business and also assures there is no default anywhere in the business.

TQM techniques work on four cost of quality which has been categorized below Figure 9:

Prevention Costs:

It is linked with the team who are involved to prevent defects and other quality problem. This team prevent all defects of the qualities from occurring in the first place by controlling suppliers, products and process improvements. So at the end organization do not face any quality difficulties and they don't need to expend more time and money to find out defects. Example: Planning, preparation and training are prevention costs.

Appraisal Costs:

Before delivering goods, it is evaluate, check default of goods and test the quality. Example: Appraisal costs can be trial of production, tests.

Internal Failure Costs:

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Internal failure cost involve when any default found in an organization. It is depends on appraisal activities. Example: Internal failure cost can be modification, re-test and re-design, overtime.

External Failure Costs:

This external failure costs arise after delivering goods and services to the customers. When the customer is actually not satisfied about products or services then it is involved. It is involved lost future business. Example: This cost can be refund, warranty, loss of customer goodwill.

Balance Score Card (BSC):

Balance Score Card (BSC) is another technique to reduce cost and improve the value of the business. The Balance Score Card technique was invented by Robert Kaplan and David Norton which has been published in 1996.

This technique measures the performance of finance, customers, business process, innovation and learning in the business to increase the value of business and reduce cost. It is a strategic approach which is work from four perspectives which has been showing in Figure 10:

Above the four perspectives of Balance Score Card is inter-related to each other which has been analysed below:

Financial Perspective:

It measures the profit, return on capital employed (ROCE), earning per share (EPS) and then move towards to improve the area where they are deficient.

Internal Perspective:

This perspective measures the internal process of business. On the other way it can depicts, by this perspective management informed about the internal process is running good or not and then can take precaution steps.

Innovation & Learning Perspective:

It measures of employee's training & learning opportunity, about job satisfaction, percentage of expertise in the business so that the quality of the product or service can be improve and cost is reduce.

External Perspective:

This perspective measures the customer satisfaction, delivery performance, percentage of the customer in the market, customer retention.

Value Analysis:

It is also another technique apply to reduce the cost of the business and increase the value.

This value analysis method analyse the value of each steps in the organisation to reduce cost and increase value.

This analysis based on four aspects which has been depicts below Figure 11:

Cost Value:

It is depend on the cost of production and selling finished goods. This aspect tries to reduce unit cost and keep improving value of the product.

Exchange Value:

This aspect measures the value of the product in the market. On the other sense it can be delineate that the satisfaction of the customer for the product.

Use Value:

This aspect measures the performance of the product which is related to the exchange value and esteem value.

Esteem Value:

It measures the desire of the customer for the product.

Hence, after analysed above all various types of techniques to reduce costs and increase value within a business more or less similar. Though more or less similar, organisations use any one of the technique according to their mission, vision, objectives and structure of the organization.

Outcome 3:

Budget is a future reflection of the company objective, mission and goal. According to Lucey, T (1996), "A budget is a quantitative expression of a plan of action prepared in advance of the period to which it relates." Budget is prepared for to estimate the situation of future activities in the company.

Objective of the budget:

Generally, from the above definition of budget it could assume that to success the mission and goal of the company are the objective of the budget. In every step, company need to control and know how much cost is involved in particular production. By estimating budget, company know the cost and can fulfil their goal to control cost.

Budget committee and their role:

A team within the company who are accountable for illustrate budget which meet all requirements of the company, make certain they meet the terms and then give in to the head of the company. The role of the committee is to present all the requirements in the budget to gain the company goal.

Types of Budget:

There are various types of budget and company can adopt according to their structure. The types of budget are showing in following Figure 12:

Incremental Budget:

Incremental budget is prepared by following previous year budget with increase or decrease amount added or erased for the new budget period. It is a traditional budget method which can be use in stable environment of company. This method is very easy to create budget and also easy to understand. On the other hand it is very simple budget which doesn't use in the unstable environment of the company.

Example of incremental budget:

The next year budget has added increase amount by following current year budget.Zero Based Budgeting:

It is another method of budget which starts nil at the commencement of the year and justify all of expenditure. This budget is based on merit. In this budget 'value for money' approach must be followed. (Lucey, T 1996).

It builds questioning system to make the budget and that's why it is easy to identify which is not efficient or not cost effective. For the questioning system it can properly carried out the most cost effective operation of the company and then the goal of the company could be achieved. On the contrary it is a very lengthy process and need to do lot of paper work to make final decision. It can only use in unstable environment of the business.

Example of Zero based Budgeting:

To make a Zero based budget will have to go through some procedures or levels which has been discussed as following:

Level one: First will have to write down all the sources of income and then all the list of expenses.

Level two: classify all expenses types and to make allocate fixed and semi-fixed expenses. And will have to make allocate all variable expense then will have to calculate the difference between income and expenditure.

Finally: Adjust income and expenditure.

Activity Based Budgeting:

This budget is more common with Zero based budgeting. It is prepare by measuring each and every single thing of the business so that if the budget maker or management is not good then activity based budget will not be appropriate. This budget is called also as value analysis budget. This budget is easy to understand and more effectible if it is made accurately. But this is also lengthy process to make budget which is waste of time and in stable environment of the business it cannot use.

In a purchase department there are two main activities, one is suppliers and another one is purchase orders. There 200 suppliers and 1000 purchase orders have been forecast based on the activity expected for the period. Here per unit cost for suppliers is (34000/200) = £170 and per unit cost for purchase order is (35000/1000) = £35.

Rolling Budget:

It is another method of budget which rolls ahead every month. This budget can regularly amend for the situation of the business. This budget can use according to the circumstances of the business. But this budget doesn't use in stable environment.

Here above, the budget for direct material and direct labour has been changed or rolling in every month.

Behavioural Aspects in Budget Setting:

In the time of budget setting different types of behaviour affect to set a budget. Depending on the behavioural aspect, budget might be or might not be successful. Behavioural aspect of setting budget has been depicts in following

Imposition:

Budget is being prepare from the top level management and it implement to low level. There is no participation from the lower level where it is being implemented. In that case, it is very quicker to setting a budget for the company that is time oriented. But there might not be any reflection of the present situation which is facing lower level. Perhaps budget difficulty can be arising and also it can be unsuccessful.

Participation:

It comes from the lower level where total participation of the organisation is being involved. By sharing different perception, knowledge is increase. It can also motivate employees to fill the target of the budget. When employees participate to set a budget then the target can be achievable by delegation of authority. Because employee can believe that they are a part of the organisation. For the participation, internal communication is being made so that budget can be goal congruent. On the other hand, it is time consuming. To set a budget is takes long time so that it is also cost affected.

Outcome 4:

There are various parts of the business are involved to evaluate the performance of the organisation against budget. Here, in the following by analysing the Responsibility accounting and variance analysis; the performance of the organisation has been evaluated.

Responsibility Accounting:

Responsibility accounting is a method to evaluate the performance of plan by budget and its consequence. According to Brammer and Penning (2001), "Responsibility accounting is used to describe a way of looking at an organisation in terms of areas of responsibility, which could be departments, activities or function." To evaluate the performance of responsibility accounting in the organisation it has four parts which is showing in following Figure 14:

Cost Centre:

Cost centre in responsibility accounting, where the manager are responsible for cost only. Example: In a chain hotel, the maintenance department will be the cost centre where the maintenance manager is responsible for cost. So when he will make budget then he will emphasis on cost to better performance. If manager could reduce actual cost from the budgeted cost then it shows the better performance of the cost centre or if it is reverse then it shows the lower performance.

Revenue Centre:

In revenue centre manager will responsible for only revenue. Example: In a chain hotel, sales department is the revenue centre. And the manager of sales department is only responsible for revenue. So, during the preparing budget manager will concentrate on revenue and if he could gain more revenue from the budgeted revenue then it shows the good performance of the revenue centre.

Profit Centre:

In profit centre, manager accountable for cost and revenue. Example: In a chain hotel, the hotel manager is in charge for cost and profit. Here in budget, the hotel managers will emphasis on both cost and revenue to keep performance better.

Investment centre:

There manager are responsible for cost, revenue and also investment. Example: The regional manager of chain hotel might be responsible for investment, revenue and cost. So if the regional manager planning for new hotel then he would be responsible for cost, revenue and investment. So during preparing budget he would more emphasis on investment, cost and revenue to show better performance in the organisation.

Variance Analysis:

Variance analysis depicts the difference between the real and expected result. So the performance of the organisation can easily evaluate using variance analysis.

Variance analysis has been showing in following Figure 15:

In variance Analysis, if actual result is improved than expected result then performance of the company is in favourable or if the actual result is worse than expected result then the performance of the company is in adverse

Hence, there are various parts in the organisation whose performance can evaluate by the responsibility accounting and variance analysis easily.