BU247 Chapter Notes - Chapter 2: Outsourcing, Sunk Costs, Opportunity Cost

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Chapter 2: Using Costs in Decision Making
How Management Accounting Supports Internal Decision Making
Pricing
-Use cost information in the pricing decision in 2 ways:
When organization faces market-determined price, organization uses product cost
information to decide if its cost structure will allow it to compete profitably
When organizations can set its price, they’ll set a price that’s an increment of its
product’s cost – cost plus pricing
Product Planning
-Target Costing: 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
-Sets organization’s direction for budget period
-Budgets provide basis for earnings forecasts that senior execs issue to stock market
Performance Evaluation
-Compare actual results from the budget period with expectations reflected in the budget to
assess how well the organization did
Contracting
-Cost reimbursement contracts, organizations are reimbursed their cost + increment for g/s
they provide under contract
-Governments are frequent and large-scale users of cost reimbursement contracts – often
prescribe costing standards that organizations must use when computing reimbursement costs
Variable and Fixed Costs
Variable Costs
-Variable Cost: Increases proportionally with changes in the activity level of some variable
-Cost Driver: A variable that causes a cost
-Variable Cost = Variable cost per unit of the cost driver x Cost driver units
-Variable cost line is a straight line that starts at the origin and has a constant slope that equals
the variable cost of wood per unit of the cost driver
Fixed Costs
-Fixed Costs: Cost that doesn’t vary in short run with specified activity
-Depends on amount of resource acquired rather than amount used – capacity-related costs
-Total Cost = Variable Cost + Fixed Cost
Cost-Volume Profit Analysis
-Risk associated with decisions made (probability of breaking even or earning target profit)
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-Cost-Volume-Profit (CVP) Analysis: Uses concepts of variables and fixed costs to identify profit
associated with various levels of activity
-Profit = Revenue – Variable costs – Fixed costs
Developing and Using the CVP Equation
-Contribution Margin: Difference between total revenue and total variable cost
-Contribution Margin Per Unit: Contribution that each unit makes to cover fixed costs and
providing a profit
-Contribution Margin Ratio: Ratio of contribution margin per unit to selling price per unit
-General CVP equation:
Profit = Unit sales x (Price per unit – Variable cost per unit) – Fixed cost
Profit = Contribution margin per unit x Units produced and sold – Fixed costs
-Unit sales required to produce target profit:
Units needed to be sold =
-Huge cost of developing new products in some industries = close attention to required
breakeven sales as a measure of project’s risk
Variations on the Theme
-Target Profit = Contribution margin per unit x Required unit sales – Fixed cost
-With income tax:
Target Profit = [(Contribution margin per unit x Required unit sales) – Fixed cost] x (1 –
Tax Rate)
Financial Modeling and What-If Analysis
-What-If Analysis: Organization’s financial circumstances are modeled by equation that can be
manipulated when answering question used in this analysis
-Use understanding about cost behaviour to answer important strategic decisions
-Incremental Profit = Incremental contribution margin – Incremental cost
The Multiproduct Firm
-Breakeven Point: When profit is 0
-Bundle Approach: Most direct and intuitive approach to handle the multiproduct CVP analysis
The Assumptions Underlying CVP Analysis
-Price per unit and variable cost per unit (and therefore contribution margin per unit) remain
same over all levels of production
-All costs can be classified as either fixed or variable or can be decomposed into a fixed and
variable component
-Fixed costs remain the same over all contemplated levels of production
-Sales = Production
Other Useful Cost Definitions
Mixed Costs
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Document Summary

Use cost information in the pricing decision in 2 ways: When organization faces market-determined price, organization uses product cost information to decide if its cost structure will allow it to compete profitably. When organizations can set its price, they"ll set a price that"s an increment of its product"s cost cost plus pricing. Target costing: focus efforts in product and process design on developing a product that has a good profit potential in view of market requirements. Projects or forecasts costs for various levels of production and sales activity. Budgets provide basis for earnings forecasts that senior execs issue to stock market. Compare actual results from the budget period with expectations reflected in the budget to assess how well the organization did. Cost reimbursement contracts, organizations are reimbursed their cost + increment for g/s they provide under contract. Governments are frequent and large-scale users of cost reimbursement contracts often prescribe costing standards that organizations must use when computing reimbursement costs.

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