Ch. 7: The Relevance and Behavior of Costs

Cost Behavior

- fixed costs remain constant when changes occur to the volume of activity - variable costs vary according to the level of business activity *knowing the weight of both types of cost is important for decision makers

Two risks of outsourcing

1) loss of quality control; potential unreliability of new supplier 2) expertise & spécialisation; firms should focus on their core competencies.

Brief the three criteria of a Relevant Cost

1) must relate to the objectives of the business 2) must be a projected future cost 3) must vary with the decision (cost & revenues) *without all three conditions, the cost is irrelevant

Three Weaknesses of Break-Even Analysis

1) non-linear relationships; total revenue lines are not straight in reality 2) stepped fixed costs; caution when making assumptions 3) multi-product businesses; difficult to pinpoint contribution for various products

Activities that are capital intensive tend to have high operating gearing. Why?

Capital equipment gives rise to added fixed costs, it can also give rise to lower variable costs.

Management Accounting Utility

Provides more detail than can be found on one of the three financial statements *includes non-financial information

What three factors create the BEP formula?

Sales revenue, variable costs, and fixed costs. *if the volume of activity is expected to be only just about the BEP, this may suggest that it is a risky venture.

Contribution Per Unit

The bottom half of the break-even formula - sales revenue less variable cost per unit * contributes towards meeting fixed costs and if there's excess, it then contributes to profit.

What if a business can't reach its BEP?

When a business fails to reach BEP, steps must be taken to remedy the problem immediately - increase sales revenues or reduce costs - less the firm is driven out of business

Stepped Fixed Costs

additional costs incurred if a firm is at capacity and wishes to expand -fixed elements can vary with time

What is 'Cost'?

an amount sacrificed to achieve a particular objective

BEP Formula

b = fixed costs / sales revenues - variable cost per unit

What are irrelevant costs?

costs not weighed in the decision-making process (past costs)

What are outlay costs?

future amounts spent to achieve an objective

Outsourcing

obtaining services or products from a subcontractor

Marginal Analysis

only costs and revenues that vary with a decision are considered; minor alterations in the level of activity - Marginal Cost (additional cost of producing one unit) tends to be equal with variable cost per unit.

What are Relevant Costs?

only the relevant factors, the opportunity costs and value of benefits from taken no new action *involved in the decision-making process

Break-Even Chart

shows the relationship of cost, volume, and profit over a range of activity.

Contribution Margin Ratio

the extent to which sales revenue is eaten away by variable costs 100 x ( contribution / sales revenue)

Margin of Safety

the extent to which the planned volume of output or sales lies above the BEP - the high the margin of safety, the higher the operating profit.

Break-Even Analysis (BEP)

the level of activity where total revenues is equal to total costs. *where revenues and costs are not equivalent, a profit or loss has been made

What is a historic cost?

the purchase price of a good or service

Operational Gearing

the relationship between contribution and fixed costs - imagine the intermeshing gears of two wheels - a movement in one of the wheels (output volume) causes a more-than-proportionate movement in the other (profit)

What is an Opportunity Cost?

the value of being deprived of the next best opportunity by pursuing a particular course of action