Skip to main content

Cost Analysis for Decision-Making

Managerial Decision Making: Key Concepts These notes cover essential concepts in managerial decision-making, focusing on cost behavior, pricing, risk, and various strategic decisions. I. Transfer Pricing

  • Definition: Transfer price is the price used when one division within the same company supplies a product to another division.
  • Relevance of Additional Cash Flow: When considering selling plant and equipment, the "what about one-time additional cash flow" question is crucial for evaluating the overall impact.
  • Simplifying Assumptions: Many companies may ignore one-time cash flows for simplicity. If a company decides to consider these, the easiest way is to adjust the fixed cost exclusive to that division.
  • Decision Maker's Caution: The decision maker must be careful in identifying all relevant factors. II. Discontinuing Product or Closing Down Division
  • Restructuring as a Management Buzzard: Restructuring, often driven by management decisions, can quickly go wrong for various reasons, affecting the firm's future significantly.
  • Evaluation Process: Restructuring involves a process where firms constantly evaluate divisions and products to decide whether to continue or close them down.
  • Contribution and Disinvestment: Products and divisions that offer a negative contribution (sales revenue less variable costs are negative) are prime candidates for disinvestment. A negative contribution means the sales price of the product is below its variable cost, indicating it's not even contributing to covering its direct costs.
  • Long-Term Impact: We need to consider the long-term impact of discontinuation. Our analysis needs to be transparent, and the reason for the discontinuation of a loss-making product should be clearly documented.
  • Strategic Reasons for Discontinuation: In both cases, discontinuation should often be based on strategic reasons beyond just short-term financial performance.
  • Opportunity Cost of Fixed Costs: If a product or division is discontinued, the fixed costs associated with it are not necessarily eliminated. These fixed costs might be recovered by other divisions or continue to be incurred, taking away from the profits of other divisions. III. Operating Risk and Financial Leverage
  • Meaning of Operating Risk: This refers to the business risk related to profit. Our focus is on maintaining a positive side of the business by maximizing the contribution margin, which is crucial for most decisions.
  • Types of Risk:
    • Risk associated with operations: Related to the core business activities.
    • Risk arising out of borrowing: Related to financial structure and debt.
  • Operating Risk Measurement: Operating risk measures business-related risk due to the presence of fixed costs like depreciation, managerial salaries, and other overheads. High fixed costs increase operating risk.
  • Degree of Operating Leverage (DOL): Measures how much a percentage change in sales volume affects profit.
    • A low DOL indicates that the fixed cost is low, and the reverse is also largely true (high DOL implies high fixed costs).
  • Degree of Financial Leverage (DFL): Measures how a percentage change in PBIT affects Profit Before Taxes (PBT).
  • Total Leverage: The multiplication of operating leverage and financial leverage.
    • Total Leverage = DOL* DFL = Contribution/PBT
    • DOL relates PBIT sensitivity to sales (Operating Risk).
    • DFL relates EPS sensitivity to EBIT (Financial Risk).
    • Total Leverage relates EPS sensitivity to sales (Total Risk). IV. Cost-Volume-Profit (CVP) Analysis
  • Foundation: The framework discussed is called cost-volume-profit analysis. It shows how volume affects cost and, in turn, affects profit.
  • Assumptions of CVP Analysis:
    • Revenue, variable cost, and contribution are constant per unit and linear within the relevant range.
    • Total fixed cost is constant within the relevant range.
    • Mixed costs can be separated into fixed and variable components.
    • Sales and production are equal, with no major fluctuations in inventory levels.
    • No capacity addition during the period.
    • Sales mix is constant in a multi-product firm scenario.
    • No inflation; inflation does not affect contribution or PBT.
    • Labor productivity and technology remain constant.
  • Limitations: Many of these assumptions may not hold in reality, making it difficult to develop a framework without some assumptions. Despite limitations, CVP analysis is relevant in decision-making.
  • Uses of CVP Analysis:
    • Useful for measuring Break-Even Point (BEP) and profit planning.
    • Useful in several areas like pricing of special orders, make-or-buy decisions, and closing down unprofitable products or units.
  • Importance of Assumptions: We need to remember the assumptions behind CVP analysis and be careful when applying it for decision-making. V. Break-Even Point (BEP) and Margin of Safety
  • Additional Units and Profit: Any additional unit sold above the BEP contributes to the profit pool.
  • Calculating Profit: We can calculate profit as: (Margin of safety units) x (Contribution percent).
  • Contribution Margin: Equal to sales less variable cost.
  • Contribution per Unit: Selling price - Variable cost.
  • Total Contribution: Fixed cost + Desired profit.
  • Units to Achieve Target Contribution: Total Contribution / Contribution per unit.
  • Break-Even Quantity: Fixed cost / Contribution margin per unit. Also expressed in terms of capacity.
  • Break-Even Capacity: Generally used when presenting a new project proposal for funding.
  • Margin of Safety: The difference between current sales and break-even sales.
  • Break-Even Volume: Required to cover fixed costs. VI. Multi-Product Situation and Sales Mix
  • Complexity: Today, it's common for firms to offer multiple products.
  • New Product Introduction: Introducing a new product model adds costs and can reduce profitability. BEP computation requires adjustments in a multi-product situation.
  • Sales Mix Bag Concept: We first need to identify the desired or planned sales mix. Once we have a sales mix, we can use a concept called "sales mix bag." This bag consists of a number of units of different products as per the sales mix.
  • Contribution per Sales Mix Bag: Suppose we roll one such bag containing different quantities of products as per the sales mix. The contribution we get from all these products is the contribution per unit of different products per sales mix bag.
  • Total Contribution on Selling a Bag: Total contribution on selling a bag of sales mix = (Contribution per unit of different products) x (Number of units of the product in the bag).
  • Break-Even Sales Mix Bag: The break-even sales mix bag is then converted into the required number of units for different products that will generate enough to achieve one bag of sales mix.
  • Profit Planning: Profit planning is also done using the sales mix bag concept.
  • Achieving Desired Profit: BEP and quantity required to achieve desired profit change when the sales mix changes.
  • New Product Launch: When introducing a new product, the company should keep in mind its impact on fixed cost and the break-even point. In many organizations, marketing and R&D teams prioritize new product launches, even if they miss meeting the cost targets. VII. Make or Buy Decision
  • Focus on Core Activities: Many firms want to concentrate only on core activities and outsource all other activities.
  • Competition and Cost Leadership: How do you face competition? There are many options, and one is acquiring cost leadership.
  • Outsourcing for Cost Competitiveness: Firms outsource or buy components from third parties to achieve cost competitiveness.
  • Marginal Costing Structure: How is a marginal costing structure useful in taking such decisions?
  • Strategic Outsourcing: Firms also outsource for strategic reasons to restrict their activities to core areas as core components and outsource the rest.
  • Relevant Costs: What costs are relevant to decisions in favor of outsourcing vs. internal manufacturing or performing activities internally?
  • Fixed Costs in Make-or-Buy: Normally, fixed costs are not considered while taking decisions. However, in outsourcing decisions, fixed costs are considered if they can be eliminated when we opt for outsourcing. VIII. Pricing Decisions
  • Factors Influencing Pricing: Pricing strategy depends on market conditions and the nature of the order/customer. Aggressive pricing increases sales but can affect profitability.
  • Cost-Based Internal Price: Managers arrive at a cost-based internal price. It consists of cost plus desired profit. This is a minimum price that a firm would expect to sell the product for.
  • Market-Based Pricing: Once the marketing team provides a price in the price range based on competitors' prices, managers check whether the market price is equal to or more than the internal price.
  • Recovering Variable Cost in the Short Run: The price at a minimum is expected to cover the variable cost of the product.
  • Strategic Relaxation of Pricing Rule: Only for a very short period or for certain strategic reasons, the above rule can be relaxed, and we can sell the product below the variable cost.
  • Long-Run Pricing: In the long run, the price should give a positive contribution, and fixed cost is covered through volume.
  • Special Orders and Export Market Pricing: Generally decided on the basis of marginal cost, which is a variable cost. IX. Optimal Product Mix (Resource Constraints)
  • Objective: Firms operate in a world of resource constraints. Optimal allocation of resources to maximize profit is a key decision area for managers.
  • Machine Hour Constraint: If machine hours are a constraint, we consider contribution per machine hour for decision-making.
  • Limited Labor or Raw Material: If limited skilled labor or raw material is a constraint, we need to compute contribution per labor hour or per raw material, respectively, to make optimal mix decisions. X. Cost Behavior Analysis
  • Regression Analysis: A simple option is to perform regression analysis and, at this time, perform the regression without the intercept.
  • Variable Cost as Percentage of Sales: In a high-low scenario, the variable cost as a percentage of sales is the difference between the costs divided by the revenue.
  • High-Low Method for Variable Cost: Variable cost per unit = (High cost - Low cost) / (High activity - Low activity).
  • Fixed Cost: Total cost at high - (Variable cost per unit x High activity). Example: Behavior of cost.
  • Separation of Costs: The separation of total costs into fixed and variable costs is useful for many decisions. Using this structure, we can assess the break-even point of a product.
  • I. Costing Methods
  1. Absorption Costing (Full Costing)
  • Definition: A method where all costs (both variable and fixed) of production are absorbed (assigned) into the cost per unit of the product. This means that fixed manufacturing overheads are treated as product costs and are allocated to each unit produced.
  • Use: Primarily used for external financial reporting, as required by accounting standards (e.g., GAAP, IFRS). It aims to show the "true" profitability after covering all costs, including fixed overheads.
  1. Marginal Costing (Variable Costing)
  • Definition: A method where only variable costs are assigned to the product. Fixed costs are treated as period costs (expenses of the period in which they are incurred) and are not included in the cost per unit.
  • Use: Primarily for internal decision-making, such as:
    • Pricing decisions: Helps in setting prices based on variable costs and contribution margin.
    • Break-even analysis: Easier to calculate the break-even point as fixed costs are separated.
    • Profitability analysis: Provides a clear view of the contribution each product makes towards covering fixed costs and generating profit.
    • Helps in control and planning: By separating fixed and variable costs, it's easier to manage and plan for cost changes with volume fluctuations. II. Behavior of Cost (Cost Classification)
  • Determinant of Cost: Volume (activity level) is one of the key determinants of cost behavior.
  • Cost Types based on Volume:
    • Costs affected linearly by changes in volume: These are typically variable costs, which increase or decrease directly in proportion to changes in activity volume (e.g., raw materials, direct labor).
    • Costs not affected at all when volume changes: These are fixed costs, which remain constant in total regardless of changes in activity volume within a relevant range (e.g., rent, straight-line depreciation).
    • Costs affected non-linearly when volume changes: These are mixed costs or semi-variable costs, which have both a fixed and a variable component. They change with volume but not in direct proportion (e.g., electricity bills with a fixed service charge plus a variable per-unit charge).
  • Approaches to Classify Costs: There are broadly four approaches to classify costs into fixed and variable components:
    • Accounting Analysis Method:
      • Process: Managers go through each cost item individually and decide whether the cost is fixed or variable based on their knowledge and experience. This is a subjective assessment.
      • Limitation: This method might miss the changing characteristics of the cost structure over time. It calls for periodic assessment of the cost structure.
    • High-Low Method:
      • Process: We identify the highest and lowest activity (volume) levels and their corresponding total costs.
      • Assumption: We assume a linear relationship between volume and cost. The cost will linearly increase as volume increases from the lowest to the highest point.
      • Calculation:
        • Variable Cost per Unit = (Cost at Highest Activity - Cost at Lowest Activity) / (Highest Activity Level - Lowest Activity Level)
        • Fixed Cost = Total Cost at Highest Activity - (Variable Cost per Unit × Highest Activity Level)
        • Alternatively, Fixed Cost = Total Cost at Lowest Activity - (Variable Cost per Unit × Lowest Activity Level)
      • Example: Suppose we have monthly cost data, e.g., electricity bills for different production volumes or sales volumes.
    • Scatter Graph Method:
      • Definition: A visual tool used to identify the relationship between costs and activity levels.
      • Use: By plotting historical cost data against activity levels on a graph, we can visually estimate the fixed and variable components and identify any outliers. A line of best fit can be drawn to represent the cost behavior.
    • Regression Method (Least-Squares Regression):
      • Definition: A statistical technique used to find the most accurate mathematical relationship between cost and activity using a linear equation.
      • Linear Equation: Y = a + bX
        • Y = Total Cost (Dependent variable)
        • a = Fixed Cost (Y-intercept)
        • b = Variable Cost per Unit (Slope of the line)
        • X = Activity Level (Independent variable)
Back to top