Another big chapter to read this week.
Chapter six looked like another large reading/comprehension activity like chapter four, but once I got started reading, I found the key concepts interesting and I was able to really see the meaning behind these concepts (I hope).
Managers understanding of relationships
The key concepts that I have identified from reading this chapter include:
- The relationship between a customer and a firm is one of exchange of value.
- Costs of a firm involves things such as resources, money and value leaving the firm.
- To assist managers in their endeavours to understanding value exchanges and gaining insights for their firm – one must attach cost to cost objects (which would need to be accurate and will help managers find out how firms incur costs.
- A key task of a manager is to understand the relationships of their firm’s costs to various activities or aspects of activities. This gives managers assistance with future planning, setting goals and objectives for the future whilst motivating their employees to achieve outcomes that have better results for the business.
- A manager having strong understandings of the firm’s previous and current costs involved in making and providing services to customers is crucial to a manger understanding what costs might be like in the future which assists them greatly with making future plans for their firm.
- Profitability each year is usually calculated by adding all costs and revenue – it is a usual practice to have a measure of profits per year. A manager needs to have an understand of what contributes to profits each year e.g. a particular item out of their product list that sells better than another.
The above key concepts to me really bring home the notion that managers judgments and decisions have an impact on the future performance of a company and the more information collected about things such as costs and profits, managers are able to inspire their employees and make decisions for the best outcomes for their firm. In my other units of study, the idea of managers inspiring employees to perform to their best has been an idea that has come up with my observational behaviour unit, which I found to be an interesting link and something I enjoyed making a connection with.
Cost Objects
A key concept for managers which assist them engaging with the costs of their firm is cost objects which are parts of a business that costs can be assigned and measured being, specific services or products, or can be apart of a firm’s process or be defined as a business activity.
- Costs can be allocated to basic units of work such as the cost to store items in a warehouse or costs associated with the recruiting process and questions that managers ask themselves include things like: how many different products? What are the prices per product? Outsource manufacturing? What actions are to be taken for an underperforming store? All of these questions assist managers make decisions – their decisions are based on the way costs are allocated within their firm.
- Future expected costs forecasts take into consideration past costs so a manager’s understanding of the current costs is critical.
Products as cost objects
A type of cost objects would be products. Keeping track of inventory assists with calculating profit per period.
Profit equals revenue less expenses
Time lags – there is a time lag between when a firm creates its product (by buying it or manufacturing it) and when it receives revenue for it (by selling it), Accurual Accounting is therefore important and used so that it can match expected benefits and costs of activity to profit for a set period.
By putting the costs of products into an asset/ inventory account – they get included as an expense until they are sold and revenue is received – ensuring that they do not overestimate or underestimate potential profits. Ultimately, managers will be able to tell what products sell better than others and can make decisions for best use of marketing budgets focuses on such a product or linking to lessor known products.
Direct and Indirect costs
Another key concept identified was the idea that there are direct and indirect costs and that we allocate both to a cost object.
I found it easy to understand that Direct cost allocation is usually rather simple as a clear link from the cost to the product can be seen with examples such as material costs or labour.
Indirect costs being somewhat more difficult makes sense as it involves more of a thought process. With indirect costs we allocate portions of costs to a cost object where the link or cause of cannot be seen so easily.
The diagram from the study guide I have tried to recreate so that I do not forget this important key concept.
Job and process costing – cost accounting systems
Job-costing is one way to allocate costs to products. Where each job or process (e.g. overhead, labour, materials) is allocated separately to an individual job.
Process costing is a way to allocate a mass of similar massively produced products to a direct product where the process items may not be easily identified separately until the end of the process so instead of allocating to a specific product or group, we allocate them to a manufacturing process first. Then eventually allocate portions to a cost object.
With regards to this concept, I found the chocolate manufacturing plant a great example so that I could really see in my mind the different sections that make different chocolates and how one such company would be using the same materials to produce a variety of different products.
Product and Period Costs
Period costs are costs of business not clinging to a specific product. Product costs get included as an expense for the period that they were incurred. This shows the judgement that these costs have been incurred during that period which it contributed to revenue and their profit.
Costs become expenses once the product the cost is associated with is sold; prior to this it is considered an economic resource or asset. These can also be called work-in progress or finished goods inventories. On the other hand, Period Costs become expenses when directly incurred and have no future potential.
Product and Period costs are crucial for external sources to understand inventory and profit of a firm when reviewing financial statements.
Functional based and activity based systems – to allocate indirect costs
The two main methods to allocating indirect costs to products being the functional based and activity based systems.
I found it interesting to note that there is no regulated way to present accounting information to management, which means they can decide to use any approach they deem fit. I would much prefer a set way! Like most of this unit, it is surprising!
On the other hand, exteral viewers have set approaches that need to be followed when presenting financial information to them.
Operating and Support Departments
I have again noted down a diagram from the study guide to assist with remembering this key concept.
Functional based costing systems
Functional Based Costing Systems (AFBCS) apportion indirect costs based on estimated/assumed relationships between the costs and the function of how they are incurred in their various departments of operational or supporting departments (cost centres).
So because of a cost and how is was incurred, we can make an assumption or estimate that assumed functional relationship between the departments and allocate costs allocated to support departments to a particular operating department then estimate the functional relationship between the operating department and a product, working out the portion of the cost meant for each operational department as the product would move through each operating department with a formula of:
Total indirect costs of an operating department
Level of activity
I found the chocolate example a great help in understanding this concept with the volume of chocolate or the refining steps being examples of the level of activity and try to remember this formula by remembering the chocolate creating process.
I then made a note of common activities (used when moving indirect costs to product costs) being direct material costs, direct labour hours and labour costs.
Predetermined absorption rates
In relation to predetermined absorption rates, I noted this was a reflection of the relationship between total indirect costs of a particular operating department and the level of activity.
Although it can take up to a year to gather the required information, I had noted that this practice is used when an absorption rate is determined for the start of each year and then applied as the year goes on. This would involve using estimates of the level of activity as well as the total indirect costs of the different operating departments.
Product costs are calculated using identified actual costs for direct costs and a predetermined absorption rate for the indirect ones.
The difference in a period between indirect costs incurred and indirect costs absorbed into products is dealt with as a period cost and charged to income and not absorbed into costs of the firm’s products. Therefore it is aimed to have close to actual predetermined absorption rates.
Activity Based Costing Systems
Activity Based Costing Systems (ABCS) try to be more of an accurate system of connecting indirect costs to products (more so than the functional-based costing system).
ABCS recognise the different activities that are being undertaken that use up indirect costs. Once each activity is identified and the cost of each activity is known, then a certain extent is linked to a particular product.
Absorption and variable costing
Absorption and variable costing are common methods used linking costs to products.
Absorption costing – also known as full costing is where both direct and indirect costs are allocated to each product
Variable costing – only attaches variable costs (usually direct costs) to products. They increase/decrease the more of a product is created or sold.
Interestingly, I noted that for external viewers, absorption costing is required by accounting standards, which did make me think that, wouldn’t it be easier to for managers to just use the same accounting standard for managerial accounting as well. I had also noted a point regarding that managers usually only allocate production costs to products, rather than allocating other costs such things as administration or distribution costs.
Fixed and Variable Costs
Managers are required to understand the relationship between the level of activity and cost and how this is so important.
Statistical techniques are utilised to examine these past relationships of various activity levels and costs.
Cost – Volume – Profit analysis
I had noted down an interesting quote here by Frederick Nietzssche (page 13 of the study guide) “no facts – only interpretations”. This is the one quote I believe I will remember regarding accounting and this unit – It is so interesting to me that a subject I thought was straight facts and figures is far more complex and more interpretative than I realised, I am looking forward to seeing what else this unit can throw at me. As I have mentioned in previous KCQs I find fear is a good motivator in this course.
This section of the study guide talks in details regarding the level of activity undertaken by a firm are related to costs, with Martin’s great example that I could understand regarding a band in wellington expressed with the formula of y = f(x).
Where y is the cost of the revenue; and
Where x = the number of tickets the band sold to an event.
With a further formula from the study guide of y = a + bx
The breakeven point is mentioned here which I have heard of previously (my first accounting concept I have heard before) – a moment of yay! The key relationship between variable and fixed costs and the operational risks associated with this relationship.
In my review of this chapter, I then noted down the definition of contribution margin, being the amount of each dollar of sale provided to covering fixed costs of a firm, which contribute to profits.
The formula noted down from the study guide for this is:
Contribution Margin = Sales – Variable Costs
With a note that the contribution margin ratio is the contribution margin divided by the sales revenue.
The contribution margin ratio demonstrates the proportion of each dollar of sales left over after variable costs have been deducted. Being the amount used to pay fixed costs and add to profits.
It is easily seen that the higher the contribution margin ratio, the higher the profit and level of activity but it was also noted that the higher the fixed costs the more potential risk the firm can face and managers should be wary of potential risk and weighing up potential growth with risk when making decisions.
Caveats
This was my last key concept noted, being:
(CVP) analysis is Cost –Volume – Profit analysis.
This concept relates to profits, volume of activity, cost and the relationship between them. This concept covered the assumptions that get made when comparing costs and profits with different levels of activity. I had noted down that one assumption was assuming straight line relationships (which may not be the case in practice) and a second assumption that fixed costs are assumed unchanged within the different levels of activity.
Final thoughts on chapter
This was a long chapter that as you can see above, I have noted down a lot as being key concepts. I have made a few comments on aspects throughout but overall I was just interested to read this chapter and didn’t really have any questions coming out of it, just noting the key concepts and enjoyed putting the pieces of the information together, really picturing the production line of making chocolate in my mind as I was going through ideas mentioned. I especially liked reading about the break-even point, as this is a pretty obvious notion that without profits, continuing a business just doesn’t make sense. I am eager to continuing my readings for the next chapter.
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