Appunti Business Economics

Outsourcing Decisions and Cost-Volume-Profit Analysis

OR– To outsource the production of that product or service

• Such a decision will involve both quantitative and qualitative factors

• It is important that outsourcing decisions are based on the right information:

Relevant costs and relevant income:

– costs/income that will be different under the ‘make’ alternative and the ‘buy/outsourcing’ alternative

(Incremental costs/income)

This implies that we need to identify:

Avoidable costs:

– costs that will be avoided if the outsourcing decision is accepted

Unavoidable costs:

– costs that will still be incurred under either options

Opportunity costs:

– costs of forgoing benefits associated to the alternative decision

Summary

• CVP analysis is an important part of the planning process and serves as a useful decision-making tool in the short-term

• An understanding of fixed, variable and mixed costs is necessary to execute break-even analysis

• CVP and break-even

Analyses can be conducted for single-product/service entities and multi-product/service entities.

• Extensions to the basic CVP analysis and break-even calculations:
• Analysis of the operating leverage
• Contribution margin per limiting factor
• Make or buy decisions (outsourcing)

Costing and pricing in an entity

1. Introduction
• Costs recorded in the financial statements are aggregated
• They do not provide sufficiently detailed information to assist in both day-to-day management and strategic management
• It is important for an entity to understand why costs are incurred
• This will require the costs to be assigned to the specific objects of interest to management
• What is the profitability of individual products, markets, services or customers?
• How much does each product contribute to overall profit?
• Which product or service should be dropped?
• Where are the opportunities for cost reduction?
• What is the value of inventory?

1. What is (or should be) the relation between costing and pricing?

2. Cost object and Costing system

• A cost is a resource
• Measured in monetary terms
• Used to achieve a particular objective

A cost object is basically anything for which a separate measurement of cost is desired

• Products, services, customers, business units or geographic regions

Costs must be assigned to the specific cost object that caused the cost to be incurred

Costing system: system used by entities to collect and report the cost of resources used by particular cost objects

Traditionally, costing systems focused on determining the inventory value of manufactured products for external financial reporting

• Focus on a specific cost object: the product

Costing systems are now used at all stages of the internal value chain

• The internal value chain represents all the linked activities undertaken within an entity: from R&D,

design, production and distribution, to customer service– Focus on multiple cost objects: products, activities, business units…•

In what follows, we are going to introduce:

1. A general approach to determine the full cost of a cost object
2. The most common methods used to determine the inventoriable product cost
3. Issues concerning the relation between costing and pricing

3. Determining the full cost of a cost object

full cost•

A costing system allows to measure of the cost objects

Full cost consists of–

• Direct costs PLUS
• Allocated indirect costs

Can be traced

Cannot be traced

Has to be allocated

Direct costs•

can be traced directly to the cost object

Relationship to a single cost object: cost/benefit test

The classification of a direct cost is subject to a to assess costof tracing costs to cost objects–

Need of a tracking system

Indirect costs overheads)•

(a.k.a. are those costs that are used for the benefit ofmultiple

cost objects

• Relationship to multiple cost objects:
• These costs need to be assigned (allocated) to all cost objects which receive the benefit of the resources
• Cost allocation: assignment of indirect costs to cost objects that make use of the resource
• Cost allocation:
• Enables to determine the full cost of the cost object
• cost driver
• Is based on the identification of an appropriate (or allocation base) cost driver
• The cost driver should explain the use of the cost pool by the cost object
• cost pool
• A is a grouping of similar costs (i.e. that can be explained by the same cost driver)
• The selection of an inappropriate cost driver will lead to an incorrect cost allocation and affect decision making
• The accuracy of the cost allocation is increased if there is a cause and effect relationship between the cost driver and the cost pool

In other words, it is important to select variables that cause resources to be consumed (cause/effect criterion):

• E.g. Allocating machine costs based on the cost object's use of machine time

The determination of a full cost for a business unit consists of a 4-step cost assignment process

Step 1: Overview of cost assignment

• This involves identifying
• relevant cost objects
• number and type of cost pools
• appropriate cost drivers to allocate indirect costs

Step 2: Determining indirect cost rates for each cost pool

Indirect cost rate = indirect cost to be allocated

Step 3: Allocating indirect costs to cost objects

Allocated cost = Indirect cost rate X Cost object usage

Step 4: Determining the full cost of each cost object

Full cost = Direct costs + Allocated costs

4. Determining the inventoriable product cost

• Inventoriable product cost
• represents the cost of converting raw material into a finished product
• Inventoriable product costs are used

Specifically for financial reporting:

• It is used to determine the book value of inventory on the balance sheet and the cost of sales in the income statement (if the product is sold)
• Only manufacturing costs are included

Any costs incurred to support entity activities that are non-manufacturing in nature (e.g. selling and admin costs) are called period costs

• An inventoriable product cost is in line with GAAP/IFRS which exclude all non-period costs (manufacturing costs) for the purpose of financial reporting of inventory in the financial statements
• Used for external reporting and internal decision making

On the contrary, a full product cost is calculated by using all costs, both manufacturing and non-manufacturing (i.e. period)

• Used for internal decision making

Type of costing system used to determine inventoriable product cost is influenced by an entity's product range and processes

The most common examples are Process

Costing system:

• Used by entities that produce large numbers of identical items (single product or very similar products) in a continuous process
• In the process costing system:
• Direct costs are the costs of raw materials
• Indirect costs are the conversion costs: costs incurred to convert the direct materials to a finished product (labour and overheads)
• Conversion costs are grouped into one cost pool and allocated by dividing the costs by the number of units of output
• In other words, the cost driver is the number of units
• Process costing suitable for operations that:
• Produce homogeneous products that receive equal doses of conversion costs
• Are characterized by continuous processes
• Typical examples: food, chemicals and oil industries

Job costing system:

• Used by entities producing different products (multi-product)
• A job costing system is used when the costs need to be assigned to different products (jobs) on an

On an individual basis, the costs associated with production can be categorized as follows:

• Direct costs include:
• Labour, which is used directly in the production process
• Raw materials that are converted into the finished product
• Indirect manufacturing costs are all the other costs incurred in the factory

Since there is a significant variation in the products manufactured, information is tracked about the costs associated with each specific job. The job order costing system will create a job cost record, which will report the direct materials and direct labour actually used for each job.

The activity-based costing system is an extension of the job costing system. In this system:

• Indirect costs are preliminarily associated with activity cost pools
• The cost of activities is allocated with more precise cost drivers

Activity-based costing (ABC) is a methodology for more precisely allocating overheads. ABC works best in complex environments, where there are many machines, products, and processes.

A deeper analysis of an entity's processes, with the aim of identifying the activities for which resources are used (activity cost pools) and more precise cost drivers:

• Main advantage: high accuracy
• Main disadvantage: large number of cost pools

Greater the cost of managing the system.

Pricing:

Cost-based pricing:

• Applies a mark-up to some calculation of product or services cost
• Mark-up = cost per unit * (1+x%)
• Simple, but prices could be either higher or lower than customers are willing to pay

Market-based pricing:

• Based on some measures of customer demand
• Difficult to estimate, but allows managers to make better decisions about sales volumes and whether to sell products or services, leading to more success in entity strategies

Factors influencing product pricing:

• Peak load pricing: When different prices are charged at different times to reduce capacity constraints
• Price skimming: When a higher price is

• Price discrimination: Setting different prices for different customers (e.g., if it is based on race or religion)
• Predatory pricing: The act of setting prices low to drive competitors out of the market and then raising prices once competition is removed
• Collusive pricing: When two or more organizations conspire to