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Chapter 3

Chapter 3 BU247.docx

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Greg Clark

BU247 Chapter 3 – Using Costs in Decision Making Week 2 How Management Accounting Supports Internal Decision Making Pricing -Organizations use cost information in the pricing decision in two ways -In markets where the organization faces a market-determined price, the organization will use product cost information to decide whether its cost structure will allow it to compete profitably -In markets where the organization can set its price, organizations will often set a price that is an increment of its product cost – an approach called cost plus pricing Product Planning -Organizations use a tool called target costing to focus efforts in product and process design on developing a product that has a good profit potential in view of market requirements Budgeting -Projects or forecasts costs for various levels of production and sales activity Performance Evaluation -Managers compare the actual results from the budget period with expectations that were reflected in the budget to assess how well the organization did in light of its expectations Contracting -Organizations are reimbursed their cost plus an increment for the goods or services they provide under the contract Variable and Fixed Costs Variable Costs -One that increases proportionally with changes in the activity level of some variable -Because there are many possible types of variables, for convenience, a common term used for a variable that causes a cost is cost driver Variable cost = Variable cost per unit of the cost driver x Cost driver units -The convention is to use variable cost to refer to the total variable cost and variable cost per unit as the variable cost per unit of the cost driver -Variable cost per unit of the cost driver is the total variable costs -Cost driver units is the number of units produced Fixed Costs -A cost that does not vary in the short run with a specified activity -Depends on the amount of a resource that is acquired rather than the amount that is used -Fixed costs are often called capacity-related costs Total cost = Variable cost + Fixed cost Cost-Volume-Profit Analysis -Uses the concepts of variable and fixed costs to identify the profit associated with various levels of activity Profit = Revenue – Total costs BU247 Chapter 3 – Using Costs in Decision Making Week 2 Developing and Using the CVP Equation -The difference between total revenue and total variable cost is called the contribution margin -The contribution margin per unit is the contribution that each unit makes to covering fixed costs and providing a profit -The contribution margin ratio is the ratio contribution margin per unit to selling price per unit Profit = Unit sales x (Price per unit – Variable cost per unit) – Fixed cost Units needed to be sold = target profit + fixed cost contribution margin per unit -By convention we always round up when finding the required unit sales with this type of analysis Variations on the Theme Target profit = Contribution margin per unit x Required unit sales – Fixed cost Financial Modeling and What-If Analysis -The organization`s financial circumstances are modeled by an equation that can be manipulated when answering the questions used in a what-if analysis -Decision makers can use their understanding about cost behaviour to answer important
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