1.1 Activity-based costing

ABC – is a cost model used to assign manufacturing overheads to different products produced by a manufacturing entity based on the premise that products consume activities, and activities consume resources which incur costs.

ABC assists in reducing product cost distortion by creating a cost pool for activities that can identified as cost drivers and then assigning overheads to products based on the actual number of separate activities they require for completion.

1.2 Traditional vs ABC costing

Total manufacturing costs (product costs) consist of direct costs (direct materials and direct labour) and indirect costs (overheads).

The difference between traditional costing and ABC is how overhead costs are allocated to ach product.

Direct costs are calculated in the same way for both traditional costing systems and ABC.

1.3 Calculating product overhead costs using ABC

Involves 5 steps:

1.Identify the major activities
The first step is to identify the activities that consume resources.

2. Quantify and assign overhead costs to each activity cost centre

Overhead costs are assigned to particular activities on the basis of cause-and-
effect cost drivers.

3. Determine the cost driver and cost driver volume associated with each activity
A cost driver is an activity that causes a cost to be incurred.
4. Determine the cost driver rate (activity cost/cost driver volume)
The cost driver rate is calculated as the activity cost divided by the cost driver
volume.

5. Assign the cost of activities to products according to the product’s demand for activities
By multiplying the cost driver rate by the number of the cost driver units
consumed by product.

1.3 Advantages and limitations of ABC

Advantages of ABC

• Improved cost estimation and product pricing
• Improved understanding of overheads

Disadvantages of ABC
It is time consuming
It may be expensive to buy, implement and maintain an ABC system

1.3 Advantages and limitations of ABC

Advan

2.1 Introduction

Cost behaviour analysis involves separating mixed costs into variable and fixed costs.

Cost measurement involves measuring past costs to predict future costs for decision making purposes.

Costs classification involves grouping costs according to:

• Identity (materials, labour or expenses)
• Function (manufacturing, administrative and or selling and distribution)
• Variability (fixed, variable or semi-variable)
• Controllability (controllable or uncontrollable0

2.2 Variable, fixed and mixed costs

Variable cost: Cost that varies with the volume of production output or sales revenue of a company.

Fixed cost:  Cost that remains unchanged regardless of the volume of production output or sales revenue of a company.

Mixed cost: Cost that has both a fixed component and a variable component

1. Introduction

CVP analysis enables management to plan and cope with planning decisions.

Underlying assumptions

• Costs and revenue exhibit a linear behaviour throughout a given activity range
• Costs can be accurately classified as either fixed or variable
• Costs are affected by changes in activity levels
• There is a short-term planning period

2. Economist vs accountant’s view

Economist

•  Views a whole range of activity
• 2 break-even points

Accountant

• Views only a relevant range over a short period of time
• Only one break-even

3. Break-even analysis

Break-even analysis determines the break-even point, that is, the level of sales where profits are Rnil (total revenue = total cost)

Break-even point (units) = fixed costs/ unit contribution margin

Break-even point (sales) = fixed costs/ unit contribution ratio
Or
Brea-even units x selling price per unit

1. Introduction

Expected value– sum of the weighted values associated with a decision
Certainty – circumstances where all the outcomes are known and decision-making is without risk
Uncertainty – circumstance where the outcomes are not known and the probabilities of the possible outcomes cannot be assigned
Risk – the probability of damage, liability or other negative consequences arising from internal or external vulnerabilities which may be mitigated through pro-active risk management
Probability – the likelihood an event, condition or outcome will occur

2. Attitudes towards risk

1. Risk-taker – an individual who is fearless of risk and uncertainty and is willing to take a chance in the hope of achieving a highly favourable outcome.
2. Risk-averter – an individual who is fearful of risk and prefers a more certain outcome.
3. Risk-neutral – an individual who is indifferent to alternatives that yield an equal return and will vouch for the alternative the yields a higher average profit in the long- term.

3. Expected value theory

Expected value theory– takes into account the possible outcomes as well the probability of occurrence of each alternative presented to management in the decision -making process.

Advantages of expected value theory

• Aids decision-making when faced with two or more alternatives
• Considers a range of outcomes, with each outcome being assigned a probability equating to the likelihood of the outcome occurring

Limitations of expected value theory

• Expected values are calculated from probability distributions, which are only reliable if they are repeated a number of times, and are not necessarily representative of once-off decisions
• Gives rise to averages and presents an outcome that is unlikely to be achieved

4. Maximin, maximax and regret criteria

Maximin
Assumption: the worst possible outcome will always occur and the decision-maker should select the option that has the highest possible outcome. The maximin criteria seeks to maximise the minimum possible contribution.

Maximax
Assumption: the best possible outcome will always occur and the decision-maker should select the option with the highest possible outcome. This usually entails choosing the option with the highest risk.

Regret (minimax) criteria
Assumption: having chosen a less favourable outcome, the decision-maker regrets not having chosen another alternative at the time the decision was made.

5. Decision trees

Decision trees – a decision-making tool that uses a tree-like graph of possible courses of action and their possible outcomes.

Decision trees assist in identifying which strategy will provide the highest expected value or most favourable outcome.

A decision tree is drawn from left to right and consists of decision nodes, chance nodes and end nodes.

Decision modes – represented by squares. The value of a decision node in decision trees is calculated as the greater of the two alternatives.

Chance nodes – represented by circles. The value of a decision node in decision trees is calculated as the expected values of probabilities.

1. Introduction

Pricing policyis the standard procedure used by a company to set its retail prices for its goods or services.

Variable influencing pricing policy

Internal factors

• Company strategy, including marketing strategy
• Manufacturing and administrative costs
• Consistency with the basic pricing philosophy

External factors

• Nature of market
• Market competition and price elasticity of demand
• Economy

2. Market penetration pricing strategy

Market penetration pricing strategy: Involves setting a low selling price initially in order to attract new customers.

Advantages

• Enable a new entrant to achieve a relatively high market share quickly
• Encourages cost control and efficiency early on in the product’s life cycle

Disadvantages

• That low prices and profit margins might not be sustainable in the long-term
• The potential adverse impact on the perception of product quality as some customers may associate low prices with poor quality

3. Target costing

A target cost is the maximum cost that can be incurred on a product for a company to earn the required profit margin from the product at a given selling price.

Advantages of target costing

• Enables companies to proactively achieve their strategic objectives
• Ensures appropriate planning before the commencement of actual production and marketing

Disadvantages

• Requires the development of detailed cost information
• Requires the buy-in and coordination of many stakeholders within the organisation

4. Transfer pricing policy

A transfer pricing policy involves the setting, analysis, documentation, and adjustment of charges between related parties.

Objectives of transfer pricing

• Preserve divisional autonomy without prejudice to the group
• Provide information for divisional performance evaluation

Factors influencing transfer prices

• Market and economic conditions
• Competition

4. Different methods of transfer pricing

Market- based – are based on the existing selling prices of goods or services in the external market.
Cost-based – estimates all costs of a product that approximates its full cost
Negotiated – appropriate when some market imperfections exist but can result in divisional conflicts. The transfer price is negotiated between the buying and selling divisions.