Different Cost Concepts - Essay Example

June 24, 2009 Mr. ABC, Human Resource Manager Mr. XYZ Analysis of different cost concepts The different concepts related to costs are stated below: Fixed Cost refers to those expenses which do not vary with increase or decrease in production level. Total amount of fixed cost remains constant with all levels of production. Fixed cost per unit varies according to the level of production for a given period of time. Like rent of the factory building, salary of plant manager, and depreciation are all considered to be fixed costs. Variable Cost refers to those expenses which vary with increase or decrease in production level. Total amount of variable cost changes with the level of production. However, the variable cost per unit is fixed for a specific level of production or cost. It will vary in total amount proportionately with some measures of business activity, like costs associated with power, maintenance, etc. Indirect Cost is the cost incurred for the common benefit of multiple cost objectives. Like indirect material, indirect labor etc. Whereas Direct Cost are those cost which can be traced to a specific cost objective or costs which is easily traceable by per unit and allocated through cost centers. Like direct material, direct labor etc. Manufacturing Cost is the name of aggregate resources of direct material, direct labor and FOH which is allocated in manufacturing the product. Manufacturing costs are also referred to as production costs. Manufacturing cost also describes how much cost is incurred on each unit produced. By estimating the manufacturing cost, the management is able to value the units produced in a year, cost of goods sold and inventory, which ultimately, is reported in the income statement and balance sheet of the company. Manufacturing costs include all cost from acquisition of material to conversion into finished goods. Packing material, fuel expense, lubricants, depreciation on factory equipments, wages, repair and maintenance, all contribute to the manufacturing cost. Product Costs are those costs which are identifiable with the product either directly or indirectly. Product cost mainly consists of direct materials, direct labor, and factory overhead. These costs provide no substantial benefit until the product is sold. Moreover, if the product is sold it is recorded as Cost of Goods Sold in the books of accounts and then COGS is matched against the revenue (matching principle) generated by selling the product. In short, product costs are those costs which are treated as inventory that is ready for sale. They are treated as assets until the products are sold (Garrison, 2004). All those cost which are not attributed to product cost are treated as Period Cost. Period cost is treated as expensed and directly reported to income statement in the period when they are incurred. Period cost are not debated over purchase or cost of goods manufactured. Period cost include all selling expenses, general and administration expenses, interest expense and income tax expense (Garrison, 2004). In short, Period costs are reported on the income statement separated from the cost of goods sold section. The period cost is deducted from gross profit. Period cost is not essentially the part of the manufacturing process so therefore period cost is not treated as a cost of inventory (Meigs et al, 1999). An Opportunity Cost means to get or select the benefit of one alternative by rejecting the other opportunity. It is the cost associated with the best forgone alternative. The opportunity costs is not present in the books of accounts but it is relevant and appropriate with respect to managerial decision making. Like if a students decides to attend summer school rather than accepting a job of making $500 a week, than the true cost of attending school is more than just books, meals, housing etc and the opportunity cost is $500. Sunk Costs are not relevant in decision making because these costs have been incurred and cannot be changed. Like in the oil exploration industry where the firm examines the feasibility of a project but every time they couldn't succeed so in order to do the cost in the form of feasibility is called sunk cost if the project is rejected (Myers, Brealey and Marcus, 2001). Operating Leverage is a tool to measure how much profit responds to the changes in sales volume. Cost structure is varying from firm to firm and industry to industry because of the relationship between variable and fixed cost (Myers, Brealey and Marcus, 2001). Operating leverage is the best tool to assess the sensitivity of the cost and profit. The operating leverage is calculated as follows: Operating leverage factor = Contribution margin in dollars / Net Income before tax Break Even Analysis helps in assessing the sales volume at which revenues and total cost are equal at position of a neither profit nor loss. This analysis helps the management to make better decisions in line with the state of the business (Berry, 2008). Risk Factor: in this sort of analysis it is the prime responsibility of the management to evaluate the fluctuation of material prices, wage rate, etc, because these factors make an impression on the variable cost of the company. Moreover, also assess the business and product life cycle like changes in people's perception towards company's product, seasonal factors, etc, which also result in a negative impact on the selling price of the product. So, all these risk factors are pivotal and the management should consider all these factors to make more profit out of the product (Berry, 2008). Cash Break-Even Analysis indicates the minimum amount at which the sales generates a positive cash flow stream for the company over the years. The formula of cash break even analysis is stated below: Cash Breakeven Point = (fixed costs - depreciation) / contribution margin per unit. Degree of Operating Leverage (DOL) measures the percentage change in profit due to the percentage change in sales. The magnitude of operating leverage also makes an impact on profit and sales (Myers, Brealey and Marcus, 2001). Moreover, operating leverage increases with fixed costs. DOL = percentage change in profits/percentage change in sales Limitations of Operating Leverage: Some of the limitations of operating leverage are stated below: The DOL are not properly debated over the price elasticity and the output rate of the firm. Any change in the parameters of business risks also impacts the DOL. The Cost Volume Profit (CVP) analysis is a tool to show the relationship between the various ingredients of profit planning. Per unit sales price, per unit variable cost, fixed costs and sales volume. The CVP analysis integrates the relationship between the cost and profits, and sales volume. The management should realize the importance of CVP: In CVP analysis we determine the breakeven point. In accordance with the selling price we assess the desired profit of the product. It is easy to evaluate the increase or decrease of fixed and variable cost on profit. Determines the cost and revenue at different levels of production. Financial Leverage is the degree at which investor utilizes its borrowed money that is densely leveraged due to the risk associated, like bankruptcy if the investor fails to repay its debt. Impact on Earnings: Financial leverage also makes an impact on the earnings of the company because it is the prime responsibility of the management to repay its loan along with the interest because of that on one hand interest expense cuts the operating profit of the company on the other hand company also takes the tax benefit out of the interest expense. Limitations to the use of Financial Leverage: Financial leverage sometimes brings curse on the value of the company's stock and also the fear of negative credit rating or bankruptcy. Sometime, restrictions are imposed by debt financing agencies on companies not allowing them to take more debt Combining Operating and Financial Leverage: The combination of both the leverages provides appropriate assessment of the firm's assets, liabilities, net income, etc. Both the leverages also debate over the liquidity position of the company and signal the company's management to assess the risk. Degree of Combined Leverage: Degree of Combined Leverage (DCL) evaluates the percentage change in EPS due to the percentage in sales. This ratio also enables the management to evaluate the company's financial and operating leverage and also the variations, if they exist. In addition, DCL also assesses the overall risks of the firm. The formula of DCL is stated below: While doing all these analysis, one important aspect should be kept into perspective, and that is factors such as the fluctuation in interest rate, sales price, etc makes an impact on the overall assessment of this analysis. Reference Brealey, Richard A., Stewart C. Myers, Alan J. Marcus, (2001). Fundamentals of Corporate Finance. New York. McGraw Hill Berry, Tim (2008-04-14). Break Even Analysis. Retrieved June 24, 2009, from Bplans.com Web site: http://articles.bplans.com/writing-a-business-plan/break- even-analysis/131 Garrison, Ray H, Eric Noreen, Peter C. Brewer (2004). Managerial Accounting. Meigs, Robert F., Mary A.Meigs, Mark Bettner, Ray Whittington. Accounting: The basis for Business Decisions.10. McGraw Hill Read More