Appunti del corso Business economics and organization

OST LASSIFICATION FOR ECISION AKING

It classifies costs as:

• Differential Costs – The costs and benefits that differs between two separate alternatives (costs

that don’t differ are irrelevant and should be ignored).

A future cost that differs between two alternatives is known as Differential Cost.

A future revenue that differs between two alternatives is known as Differential Revenue.

• Opportunity Costs – Potential benefit that is given up when one alternative is selected over the

other (they’re not usually found in accounting records).

• Sunk Costs – Cost that has already been occurred and cannot be changed regardless of the

alternative chosen (they’re irrelevant and should be ignored when making decisions).

In the short-term, if a company decides to stop the production of a product, not all operating costs due

to that product cease to exist:

• An Avoidable Cost is a cost that is not incurred if the activity is not performed (raw material

cost, direct labor cost).

• An Unavoidable Cost is a cost that is still incurred even if the activity is not performed (fixed

indirect costs, indirect work)

In the long term all costs are avoidable. 16 | P a g e

C C A C

OST LASSIFICATION FOR SSIGNING COSTS TO OST OBJECTS

It divides costs in:

• Direct Costs – Cost that can be easily traced to a specific cost object.

• Indirect Costs – Cost that cannot be easily traced to a specific cost object (resources common

to several cost objects

K P

EY OINTS

For purposes of valuing inventory and determining values for balance sheet and income statement, costs

are classified into product costs or period costs.

Product costs are assigned to inventory and are considered an asset if products are sold.

At the time of sale, product costs become cost of sales in the income statement.

Period costs are recognized directly in the income statement as accrued costs in the period in which

they are incurred.

2.3 C -V -P R

OST OLUME ROFIT ELATIONSHIPS

Cost-Volume-Profit analysis helps managers to choose what products to offer, what price to charge,

what marketing strategy to use, etc.

Its primary purpose is to estimate how profits are affected by the following 5 factors:

• Selling prices (constant),

• Sales volume,

• Unit variable cost,

• Total fixed costs,

• Mix of products sold (considered constant.

The Contribution Income Statement is helpful to managers in judging the impact on profits of changes in

selling price, cost, or volume. The emphasis is on cost behavior.

The Contribution Margin (CM) is the amount remaining from sales revenue after variable expenses have

been deducted: = − = −

It is the amount available to cover fixed expenses and then to provide the profits for the period.

= − = −

The Unit Contribution Margin (Unit CM) is the difference between the selling price and the variable unit

cost: 17 | P a g e

= − = −

As the Unit CM increases, the Break-Even Point decreases.

= × ° − = × −

The Contribution Margin Ratio (CM Ratio) is the difference between a company’s sales and variable

expenses, expresses as a percentage:

= =

The CM Ratio can be calculated with both Total values and with Unit values.

The Variable Costs Ratio (or Variable Expense Ratio) is the ratio between the variable expenses and

sales:

= =

T

he CV Ratio can be calculated with both Total values and with Unit values.

The relationship between CM Ratio and CV Ratio is:

= −

Break-Even Point (BEP) – If all fixed costs are covered by the contribution margin, the company has

reached the Break-Even Point (point at which total revenues equal total costs).

Once Break-Even is reached, operating income will increase by the unit contribution margin for each

additional unit sold.

If there were no sales, the company’s loss would be equal to its fixed costs.

= − − = − −

At Break-Even Point:

= + = +

The Unit Sales needed to break even can be computed as follows:

= =

− −

Break Even Sales expressed in value can be calculated by multiplying the break-even sales level by the

unit sales price: = ×

Alternatively, it can be calculated by dividing Fixed Costs over Contribution Margin:

=

18 | P a g e

The same formulas can be adjusted in the following way to achieve a target revenue:

∗

+

∗

= − ∗

+

∗

=

The Margin of Safety is the amount by which sales can drop before losses are incurred:

= − = −

The higher the Margin of Safety, the lower the risk of not breaking even and incurring in loss.

The proportion of fixed and variable costs in an organization is important in determining the stability of

a company:

• High Fixed Costs – high fluctuations in operating income due to changes in sales.

• Low Fixed Costs – low fluctuations and general resiliency to changes in sales.

The Operating Leverage can measure how sensitive operating income is to a change in sales: at high

operating leverage, a small percentage increase in sales can produce a larger percentage increase in

operating income.

= =

The Sales Mix refers to the relative proportion in which a company’s products are sold.

The idea is to achieve the mix that will achieve the greatest profit.

Profit will be greater if high-margin rather than low-margin items make up a relatively large proportion

of total sales.

Changes in the Sales Mix can cause variations in a company’s profits.

K P

EY OINTS

CVP analysis helps determine the most favorable combination of variable costs, mixed costs, sales price

and volume, and mix of products sold as long as following assumptions are verified:

• Sales price is constant.

• Costs are linear and can be decomposed into variable and fixed elements.

• Sales mix is constant.

• Inventory does not change in manufacturing firms (the number of units produces is the same as

the number of units sold) 19 | P a g e

2.4 D A : T K D M

IFFERENTIAL NALYSIS HE EY TO ECISION AKING

In the short run, fixed costs cannot be avoided.

Some decisions the enterprise could make are:

• Elimination of product lines.

• Acceptance of a new order.

• Make-or-Buy decisions.

• Introduction of a new project.

The 6 key concepts for decision making are:

1) Define the two alternatives.

2) Identify the criteria to choose among them:

a. Relevant Costs and Relevant Benefits should be considered when making decisions.

b. Irrelevant Costs and Irrelevant Benefits should be ignored when making decisions.

3) Operate the Differential Analysis, focusing on the future costs and benefits that differ between

the alternatives (everything else is irrelevant and should be ignored).

4) Sunk Costs are always irrelevant when choosing among alternatives.

5) Future costs and benefits that do not differ between alternatives are irrelevant.

6) Opportunity costs also need to be considered when making decisions (it’s a potential benefit

that is given up when one alternative is selected over another.

An avoidable cost is one that can be eliminated, in whole or in part, by choosing one alternative over

another.

One of the most important decisions managers make is whether to add or drop a business segment,

after an accurate analyzation of the financial impact of doing so.

The analysis consists of comparing the costs and revenues related to alternative actions to define the

differential result arising from a decision compared to the starting situation:

• Only relevant costs and revenues have to be considered (values that are avoidable in alternative

situations than the starting).

• Irrelevant costs don’t have to be considered (costs that are present in the same magnitude in all

alternatives compared.

Sometimes it’s helpful to keep a line that is “losing money” in order to compensate a part of the fixed

costs of the company.

Including unavoidable common fixed costs could make a product line appear to be unprofitable, when in

fact dropping the product line would decrease the company’s overall net operating income.

A Special Order is a one-time order that is not considered part of the company’s ongoing business.

In the short term, it is not always appropriate to reject orders with prices below full industrial cost.

When analyzing a special order, only the incremental costs and benefits are relevant.

Since the existing fixed manufacturing overhead costs would not be affected by the order, they are Not

relevant.

A plant operating at full capacity does not necessarily employ each machine and each person at the

20 | P a g e

maximum possible rate.

Even one machine is enough to limit the amount of overall output and thus impose a constraint on

production capacity – Bottleneck.

When a mana