PM 521 Project Cost Accounting and Finance

American University of Ras Al Khaimah

School of EngineeringDr. Ahmed Al sharif

Week 2:Project Cost Accounting

and Finance

Cost ClassificationCost-Volume-Profit Analysis

What Does Cost Mean?• There is no single definition of cost

• Costs are developed and used for some specific purpose

• The way the cost is to be used will define the way it should be computed

• Management accountants have used different systems, or classifications, to develop cost information

Methods of costing• It refers to the techniques and processes employed in the ascertainment of costs

•Choice of the method depends upon the type and nature of manufacturing activity

•Types: Broadly,• Job costing or job order costing• Process CostingOther methods are variations of one of these methods.

Methods of costing - Types• Job Order Costing – Applies where work is undertaken to customers special requirements.

•Contract Costing or Terminal Costing: It is same as Job order costing; however, job is small and contract is big contract. Contract is of long duration and may continue for more than a financial year.

•Batch costing: Cost of a batch or group of identical products is ascertained; each batch of products is a cost unit for which costs are ascertained.

Methods of costing – Types…..• Process Costing – Applies to a context where there is a

continuous process. Costs are accumulated for each process. And then total cost of a process is divided by the number of units produced to arrive at cost per unit.

• Operations Costing: Involves cost ascertainment for each operation.

• Operating or services costing: It is applied to services; cost units are passenger –kilometer, room per day, bed per day.

Methods of costing – Types…..•Multiple or composite costing – Application of more than one method of costing in respect of the same product. Used in industries where a number of components are separately manufactured and then assembled into a final product.

•Single, output or unit costing: Applied to a context where output produced are identical, the cost per unit is found by dividing the total cost by the number of units produced.

Techniques of costing – Types…..•Standard costing – Standard cost is predetermined as target of performance and actual performance is measured against the standard.

•Budgetary control: By comparing actual with planned / budgeted performance

•Marginal costing: Only variable cost is allocated to individual cost centers or cost units

Techniques of costing – Types…..• Total Absorption costing – Both fixed and variable

costs are charged to products.

• Uniform Costing: It is not a technique but a situation wherein several undertakings use the same costing principle and practices.

Element of cost•Cost object•Cost •Cost unit•Cost center•Profit center•Cost driver

Cost object• It is an activity or item or operation for which a

separate measurement of costs is desiredA cost object is anything for which a separate

measurement of costs is desired.• A product, a product line, an organizational unit

• E.g. the cost of operating the personnel department of a company, the cost of a repair job, and the cost for control

Cost • It is the amount of expenditure incurred on a specific cost object

•Total cost = quantity used * cost per unit (unit cost)

Cost unit• It is a quantitative unit of product or service in which costs are ascertained, e.g. cost per table made, cost per meter of cloth

Cost Centre• Cost center is a location, person, or item of equipment

(or group of these) for which costs may be ascertained and used for the purpose of control

• It refers to a section of the business to which costs can be charged.

• E.g. the rent, rates and maintenance of buildings; the wages and salaries of store keepers

Profit centre• It is location or function where managers are accountable for sales revenues and expenses

•E.g. division of a company that is responsible for the sales of products

Cost Drivers•A cost driver is a measure of activity or volume level; increases in a cost driver cause variable/total costs to increase.

•The relevant range is the span of activity levels for which the cost behavior patterns hold.

Cost ClassificationThe different bases of cost classification are:(1) By time (Historical, Pre-determined).(2) By nature or elements (Material, Labour and Overhead).(3) By degree of traceability to the product (Direct, Indirect).(4) Association with the product (Product, Period).(5) By Changes in activity or volume (Fixed, Variable, Semi-variable).(6) By function (Manufacturing, Administrative, Selling, Research and development, Preproduction).(7) Relationship with accounting period (Capital, Revenue).(8) Controllability (Controllable, Non-controllable).(9) Cost for analytical and decision-making purposes (Opportunity, Sunk, Differential, Joint, Common, Imputed, Out-of-pocket Marginal, Uniform, Replacement).(10) Others (Conversion, Traceable, Normal, Avoidable, Unavoidable, Total).

By Time• (a) Historical Costs: These costs are ascertained after they are

incurred. Such costs are available only when the production of a particular thing has already been done. They are objective in nature and can be verified with reference to actual operations.

• (b) Pre-determined Costs: These costs are calculated before they are incurred on the basis of a specification of all factors affecting cost. Such costs may be:

• (i) Estimated costs: Costs are estimated before goods are produced; these are naturally less accurate than standards.

• (ii) Standard costs: This is a particular concept and technique. This method involves:

• (a) setting up predetermined standards for each element of cost and each product;

• (b) comparison of actual with standard to find variation;

• (c) pin-pointing the causes of such variances and taking remedial action.

By accounting period•Costs can be capital and revenue.

•Capital expenditure provides benefit to future period and is classified as an asset.

•Revenue expenditure benefits only the current period and is treated as an expense.

By Degree Of Traceability• Direct Costs: The direct costs are those which can be

easily traceable to a product or costing unit or cost center or some specific activity, e.g. cost of wood for making furniture. It is also called traceable cost.

• Indirect Costs : The indirect costs are difficult to trace to a single product or it is uneconomic to do so. They are common to several products, e.g. salary of a factory manager. It is also called common costs.

Direct and Indirect.• Costs may be direct or indirect with respect to a particular division

or department. For example, all the costs incurred in the Power House are indirect as far as the main product is concerned but as regards the Power House itself, the fuel cost or supervisory salaries are direct. It is necessary to know the purpose for which cost is being ascertained and whether it is being associated with a product, department or some activity.

• Direct cost can be allocated directly to costing unit or cost center. Whereas Indirect costs have to be apportioned to different products, if appropriate measurement techniques are not available. These may involve some formula or base which may not be totally correct or exact.

By Function

• Manufacturing costs: all costs incurred inside the factory associated with transforming raw materials into a finished product

• Nonmanufacturing Costs: an organization’s other costs

Manufacturing Costs• Direct manufacturing costs are traced or

assigned to the products that created those costs and include the cost of material and the cost of labor that is paid based on the amount of work done

• Indirect manufacturing costs include costs of equipment, as well as the wages and benefits paid to production supervisors and workers who provide the general capacity to undertake production activities in the factory

Indirect Manufacturing Costs

• More difficult to trace to products because these costs have a cause-and-effect relationship with capacity rather than with individual units of production

• Assigning to a product involves allocating what is deemed to be a fair share of the indirect cost to that product

• Generally allocated based on the product’s use of the various capacity resources

Nonmanufacturing Costs (1 of 2)

• Distribution costs involve delivering finished products to customers

• Examples are freight and the salaries of shipping and delivery personnel

• Selling costs include sales personnel salaries and commissions and other sales office expenses

• Marketing costs include advertising and promotion expenses

Nonmanufacturing Costs• After-sales costs involve dealing with customers after

the sale and include warranty repairs and the cost of maintaining help and complaint lines

• Research and development costs include expenditures for designing and bringing new products to the market

• General and administrative costs include expenses, such as the chief executive officer’s salary and legal and accounting office costs, that do not fall into any of the above categories

By Elements of costs - Materials• Material cost : cost of commodities supplied to an

undertakingDirect materials cost: those costs which are incurred for and conveniently identified with a particular cost unit, process or department.

Ex: cost of raw material Indirect materials cost: those costs which cannot be conveniently identified with a particular cost unit, process or department.

Ex: cost of material that are inexpensive but may or may not physically become part of the finished goods

Elements of costs – Labour cost• Labour cost : cost of remuneration (wages, salaries,

commissions, bonuses, etc etc) of the employees of an undertaking - Direct labour cost: wages paid to workers directly engaged in the production process.

Eg: Wages of machine operator- Indirect labour cost: those wages which cannot be

conveniently identified with a particular cost unit, process or department

Elements of costs – Expenses• Expenses: The cost of services provided for an undertaken

- Direct Expenses: those expenses which can be identified with and allocated to cost centers or units.

Eg: Royalty paid, depreciation of a plant used- Indirect Expenses: All indirect costs other than indirect materials

and labor. They cannot be directly identified with a particular job, process or work order and are common to cost units or cost centersEx: Rent and rates, lighting and power

Elements of costs – Price cost• Direct Material +Direct labour +Direct Expenses

Elements of costs – Overheads• Indirect Material +Indirect labour +Indirect expenses

Overheads are divided intoa. Production overheadsb. Office and administration overheadsc. Selling and distribution overheads

Elements of costs – Production Overheads• Indirect Material such as coal, oil grease, stationary

in factory office• Indirect labour such as work manager’s salary, salary

of factory office staff, salary of inspector and supervisors, watchman, sweeper

• Indirect Expenses such as factory rent, depreciation of plant, repairs and maintenance of plant, insurance of factory building, factory lighting and power, internal transport expenses

Elements of costs – Office and administration overheads

• Indirect Material such as stationary used in administration office, postage, etc

• Indirect labour such as salary of office staff, Directors, watchman, sweeper

• Indirect Expenses such as office rent, insurance of office building, office lighting and power, telephone, depreciation of office furniture, office a/c, sundry office expenses

Elements of costs – Selling & distribution overheads

• Selling cost: cost of seeking to create and stimulate demand and of securing orders such as ads, samples and free gifts, salaries of salesmen

• Distribution cost: cost of making packed product available for dispatch and returning of empty packages for reuseIndirect Material such as stationary used in sales office, packing mat, cost of samples, price list, oil for delivery vansIndirect labour such as salary of sales staff, salary of of MD, Directors, watchman, sweeperIndirect Expenses such as advertising, traveling expenses, showroom expenses, carriage outwards, rent of warehouse, bad debts, insurance of goods in transit etc.

The various elements of cost

By Changes in activity or volume (Cost behavior)•Costs can be classified according to how they behave with respect of changes in activity levels into:

•Variable•Fixed•Semi-variable

• Variable Cost: Variable costs are those costs that vary directly and proportionately with the output e.g. direct materials, direct labour. It should be kept in mind that the variable cost per unit is constant but the total cost changes corresponding to the levels of output. It is usually expressed in terms of units, not in terms of time.

• Fixed Costs: The cost which is incurred for a period, and which, within certain output and turnover limits, tends to be unaffected by fluctuations in the levels of activity (output or turnover).

• These costs are incurred so that physical and human facilities necessary for business operations, can be provided. These costs arise due to contractual obligations and management decisions. They usually arise with the passage of time and not with production and are expressed in terms of time. Examples are rent, property-taxes, insurance, supervisors' salaries etc.

• Semi-fixed (Semi-Variable) costs: Such costs contain fixed and variable elements. Because of the variable element, they fluctuate with volume and because of the fixed element; they do not change in direct proportion to output.

• Semi-fixed costs change in the same direction as that of the output but not in the same proportion.

•As an example of a semi-fixed cost, a company must pay a certain amount to maintain minimum operations for a production line, in the form of machinery depreciation, staffing, and facility rent. If the volume of production exceeds a certain amount, then the company must hire additional staff or pay overtime, which is the variable component of the semi-fixed cost of the production line.

By ProductProduct Costs: Product costs are those which are traceable to the product and included in inventory values. In a manufacturing it comprises the cost of direct materials, direct labour and manufacturing overheads. Product cost is a full factory cost. Product costs are used for valuing inventories which are shown in the balance sheet as asset till they are sold

Period Costs: Period costs are incurred on the basis of time such as rent, salaries, etc., include many selling and administrative costs essential to keep the business running. Though they are necessary to generate revenue, they are not associated with production, therefore, they cannot be assigned to a product.

Cost classified for analytical and decision Making

Analytical and decision making according to relevance to decision-making are:

- Costs relevant to decision-making- Costs irrelevant to decision-making

(A) Relevant cost : Marginal cost• Marginal cost is the incremental cost of producing the next

unit.

• When costs are linear and the level of activity is within the relevant range, marginal cost is the same as variable cost per unit.

• Marginal Cost is relevant for decision-making, as this cost will be incurred in future for additional units of production.

Relevant cost : Differential cost• Differential Cost: The difference in total cost between

alternatives, calculated to assist decision making". Differential cost is the increase or decrease in total costs resulting out of change in the level of activity or pattern or method of production.

• Differential costs is useful in planning and decision making and helps to choose the best alternative. It helps management to know the additional profit that would be earned if idle capacity is used or when additional investments are made.

Opportunity costs are the benefits of an alternative one gives up when that alternative is not chosen. It is the value of sacrifice made or benefit of opportunity foregone in accepting an alternative course of action.

• Example: Capital is invested in plant and machinery. It cannot be now invested in shares or debentures. The loss of interest and dividend that would be earned is the opportunity cost.

• Opportunity costs are not recorded in the books. It is important in decision making and comparing alternatives.

• Opportunity costs are sometimes difficult to measure because they are associated with something that did not occur.

Opportunity costs are always relevant in decision making.

Relevant cost : Opportunity cost

Relevant cost : Out of Pocket Cost• Out of Pocket Cost: It involves payment to outsiders i.e. gives

rise to Cash Expenditure as opposed to such costs as depreciation which don't involve any cash expenditure.

•Cash for the decision at hand avoided or saved, if a particular proposal under consideration is not accepted.

•Such costs are relevant when make or buy decision is to be made.

Relevant cost: Imputed Costs• Imputed Costs: Some costs are not incurred and are useful

while taking decision pertaining to a particular situation. These costs are known as imputed or notional costs and they do not enter into traditional accounting systems (no payment has been made).

• Examples: Interest on internally generated funds or notional rent etc.

•Where alternative capital investment projects are being evaluated, it is necessary to consider.

Relevant cost: Replacement Costs• Replacement Costs: This is the cost of replacing an

asset at current market values e.g. when the cost of replacing an asset is considered, it means the cost of purchasing the asset at the current market price is important and not the cost at which it was purchased.

•It is the cost of replacement at current market price and is relevant for decision-making.

Relevant cost: Common Costs• Common Costs: Common costs are those costs which are

incurred for more than one product, job, territory or any other specific costing object. They are not easily related with individual products and hence are generally apportioned.

• The cost of services employed in the creation of two or more outputs which is not allocable to those outputs on a clearly justified basis.

• It should be kept in mind that management decisions influence the incurrence of common costs e.g. rent of the factory is a common cost to all departments located in factory.

Relevant cost: Discretionary costs• Discretionary costs are periodic costs incurred foractivities that management may or may not determine are worthwhile.• Can be cut for (short periods of time) with minimal damage to long term goals• Discretionary costs are relevant for decision making only if they vary across the alternatives under consideration.

(B) Irrelevant Costs: (Not useful for decision making): Sunk costs

• Sunk costs are costs that were incurred or sunk in the past.• Firm has obsolete stock of materials originally purchased

for $50,000 which can be sold as scrap now for $18,000 or can be utilised in a special job, the value of stock already available $50,000 is a sunk cost and is not relevant for decision-making.

• The difference between the purchase price of an asset and its salvage value is a sunk cost.

• Sunk costs is not relevant for decision making.

Irrelevant Costs : Absorbed Fixed Costs:• Fixed Costs do not change due to increase or decrease

in activity• Fixed Costs are absorbed in cost of production at a

normal rate, they are irrelevant for managerial decision-making.

• However if Fixed Costs are specific, they become relevant.

Irrelevant Costs: Committed Costs:• Cost in respect of which decision has already been taken, and

such decision cannot be altered.• e.g. entering into irrevocable agreements for Rent, Technical

Collaboration, etc.• should be contrasted with Discretionary Costs, which are

avoidable costs.• 1) long term in nature. • 2) can’t be significantly reduced, even over short periods of time

without changing the long term goals of the company.

What Information is Relevant for Decision Making?• Information is relevant if:

• Differs across the alternatives, and• Is about the future.

• Relevant information can be quantitative or qualitative• Information is irrelevant if:

• Does not vary with the option chosen or action takenIrrelevant information is NOT useful in decision making!

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Product cost• Product cost are related to the goods purchased or

produced for resale• If the products are sold, the product cost will be

included in the cost of goods sold and recorded as expenses in current period

• If the products are unsold, the product costs will be included in the closing stock and recorded as assets in the balance sheet

Prime Costs

DirectMaterials

DirectLabor

PrimeCosts+ =

Prime cost is the combination of a manufactured product's costs of direct materials and direct labor. In other words, prime cost refers to the direct production costs.  Indirect manufacturing costs are not part of prime cost.

Conversion Costs

DirectLabor

ManufacturingOverhead+ = Conversion

Costs

IndirectLabor

IndirectMaterials Other

Conversion cost is the production cost of converting raw materials into finished product

Cost accumulation•Prime cost = direct materials + direct labour•Production cost = Prime cost + factory overhead

OR = Direct materials + Conversion cost

•Total cost = Prime cost + Overheads (admin, selling, distribution cost)

OR = Production cost + period cost (administrative, selling,

distribution and finance cost)

After the break

Cost-Volume-Profit Analysis

units

$

Total Costs (TC)

Total Revenue (TR)

CVP Analysis and the Breakeven Point

• The breakeven point (BEP) is where total revenue equal total costs.

• CVP analysis looks at the relationship between selling prices, sales volumes, costs, and profits.

BEP in units

BEP in sales $

How is CVP Analysis Used?• CVP analysis can determine, both in units

and in sales dollars:• the volume required to break even

• the volume required to achieve target profit levels

• the effects of discretionary expenditures

• the selling price or costs required to achieve target volume levels

Q2: CVP Calculations for a Single Product

where F = total fixed costs

P = selling price per unit

V = variable cost per unit

P - V = contribution margin per unit

Q2: CVP Calculations for a Single Product

To find the breakeven point in units, set Profit = 0.

Profit -

FQP V

Units required to achieve targetpretax profit

where F = total fixed costs

P = selling price per unitV = variable cost per unitP - V = contribution margin per unit

Profit -

FQP V

Units required to achieve target

pretax profit

• To analyze CVP in terms of total revenue instead of units.

• The contribution margin ratio can be written in terms of total revenues (TR) and total variable costs (TVC).

Q2: CVP Calculations for a Single Product

To find the breakeven point in sales $, set Profit = 0.

ProfitFCMR

Sales $ requiredto achieve target

pretax profit

where F = total fixed costs

CMR = contribution margin ratio

Total Revenue Total Variable CostsTotal Revenue

CMR Note that CMR

can also be computed as

• Use the forecast information about volume (12,000 bikes) to determine the contribution margin ratio.

Breakeven Point• Managers often want to know the level of activity required to break

even.• We can calculate the breakeven point from any of the preceding CVP

formulas, setting profit to zero.• Depending on which formula we use, we calculate the breakeven

point in either number of units or in total revenues.

Bill’s Briefcases makes high quality cases for laptops that sell for $200. The variable costs per briefcase are $80, and the total fixed costs are $360,000. Find the BEP in units and in sales $ for this company.

Q2: Breakeven Point Calculations

BEP in units 0FP V

$360,000$200 /unit $80 /unit

$360,000 3,000 units$120 /unit

( ) /F

P V P

$360,000 $600,00060%

BEP in sales $ 0FCMR

$360,000

($200 $80) / $200

units

$1000s TC

TR

3000

$600

Q2: CVP GraphDraw a CVP graph for Bill’s Briefcases. What is the pretax profit if Bill sells 4100 briefcases? If he sells 2200 briefcases? Recall that P = $200, V = $80, and F = $360,000.

$360

41002200

Profit at 4100 units = $120 x 4100 - $360,000.

$132,000

-$96,000

Profit at 2200 units = $120 x 2200 - $360,000.

More easily: 4100 units is 1100 units past BEP, so profit = $120 x 1100 units; 2200 units is 800 units

before BEP, so loss = $120 x 800 units.

How many briefcases does Bill need to sell to reach a target pretax profit of $240,000? What level of sales revenue is this? Recall that P = $200, V = $80, and F = $360,000.

Q2: CVP Calculations

Units needed to reach target pretax profit ProfitF

P V

$360,000 $240,000

$120 /unit

5,000 units

$600,000 $1,000,00060%

( ) /F

P V P

Sales $ required to reach target pretax

profit$240,000FCMR

Of course, 5,000 units x

$200/unit = $1,000,000, too.

But sometimes you only know the CMR and not the selling price per unit, so this

is still a valuable formula.

• After-tax profit is calculated by subtracting income tax from pretax profit. The tax is usually calculated as a percentage of pretax profit.

Income Tax• The Spotted Cow Creamery is a popular ice cream emporium near a

university in Munich, Germany. Information for the most recent month (amounts in euros) appears here.

Income statement:

How many briefcases does Bill need to sell to reach a target after-tax profit of $319,200 if the tax rate is 30%? What level of sales revenue is this? Recall that P = $200, V = $80, and F = $360,000.

CVP Calculations

First convert the target after-tax profit to its target pretax profit:After-tax profit $319,200Pretax profit $456,000(1 Tax rate) (1 0.3)

Units needed to reach target pretax profit

$360,000 $456,000 6,800 units$120 /unit

Sales $ needed to reach target pretax

profit

$360,000 $456,000 $1,360,00060%

Suppose that Bill’s marketing department says that they can sell 6,000 briefcases if the selling price is reduced to $170. Bill’s target pretax profit is $210,000. Determine the highest level that his variable costs can be so that he can make his target. Recall that F = $360,000.

Using CVP to Determine Target Cost Levels

Use the CVP formula for units, but solve for V:

Q = 6,000 units $360,000 $210,000$170/unit V

If Bill can reduce his variable costs to $75/unit, he can meet his goal.

$75/unitV

$360,000 $210,000$170/unit $95/unit6,000 units

V

Uncertainties in Bill’s Decision• After this analysis, Bill needs to consider several issues

before deciding to lower his price to $170/unit.

• How reliable are his marketing department’s estimates?• Is a $5/unit decrease in variable costs feasible?

• Will this decrease in variable costs affect product quality?• If 6,000 briefcases is within his plant’s capacity but lower than his current sales level, will the increased production affect employee morale or productivity?

Using CVP to Compare Alternatives• CVP analysis can compare alternative cost structures or selling

prices. • high salary/low commission vs. lower salary/higher commission

for sales persons• highly automated production process with low variable costs per

unit vs. lower technology process with higher variable costs per unit and lower fixed costs.

• The indifference point between alternatives is the level of sales (in units or sales $) where the profits of the alternatives are equal.

• broad advertising campaign with higher selling prices vs. minimal advertising and lower selling prices

Currently Bill’s salespersons have salaries totaling $80,000 (included in F of $360,000) and earn a 5% commission on each unit ($10 per briefcase). He is considering an alternative compensation arrangement where the salaries are decreased to $35,000 and the commission is increased to 20% ($40 per briefcase). Compute the BEP in units under the proposed alternative. Recall that P = $200 and V = $80 currently.

Using CVP to Compare Alternatives

First compute F and V under the proposed plan:F = $360,000 - $45,000 decrease in salaries = $315,000

V = $80 + $30 increase in commission = $110

Then compute Q under the proposed plan:Units needed to breakeven 0FQ

P V

$315,000 3,500 units$200 /unit - $110/unit

Determining the Indifference Point Compute the volume of sales, in units, for which Bill is indifferent between the two alternatives.

The indifference point in units is the Q for which the profit equations of the two alternatives are equal.

$90$120Contribution margin per unit$315,000$360,000Total fixed costs

Proposed PlanCurrent Plan

Profit (current plan) = $120Q - $360,000Profit (proposed plan) = $90Q - $315,000

$120Q - $360,000 = $90Q - $315,000

$30Q = $45,000 Q = 1,500 units

CVP Graphs of the Indifference PointDraw a CVP graph for Bill’s that displays the costs under both alternatives. Notice that the total revenue line for both alternatives is the same, but the total cost lines are different.

TC-current plan

TR

units

$1000s

3000

$600

$360

3500

$315

TC-proposed plan

1500

BEP for the current plan

BEP for the proposed plan

indifference point between the plans

TC-current plan

TR

units

$1000s

3000

$600

Comparing Alternatives

$360

3500

$315

TC-proposed plan

1500

The current plan breaks even before the proposed plan.

At 1500 units, the plans have the same total cost.

Each unit sold provides a larger

contribution to profits under the current

plan.

Uncertainties in Bill’s Decision• Hopefully Bill is currently selling more than 1500

briefcases, because profits are negative under BOTH plans at this point.

• Therefore, it seems the current plan is preferable to the proposed plan.

However, . . .

• The total costs of the current plan are less than the those of the proposed plan at sales levels past 1500 briefcases.

Uncertainties in Bill’s Decision. . . this may not be true because the level of future sales is always uncertain.

• What if the briefcases were a new product line?

• The plans may create different estimates of the likelihood of various sales levels.

• Estimates of sales levels may be highly uncertain.• The lower fixed costs of the proposed plan may be safer.

• Salespersons may have an incentive to sell more units under the proposed plan.

•Questions?