Costing Primer

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Basics of Costing

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Costing Primer

  1. 1. AN INTRODUCTION TO COSTING & PRICING PRIMER ON COSTING
  2. 2. AGENDA <ul><li>CLASSIFICATION OF COSTS </li></ul><ul><li>BREAK EVEN ANALYSIS </li></ul><ul><li>MARGINAL COSTING </li></ul><ul><li>CONTRIBUTION </li></ul><ul><li>LEVERAGE </li></ul><ul><li>PRICING CONCEPTS </li></ul><ul><li>PRICING APPROACHES </li></ul><ul><li>PRICING STRATEGIES </li></ul>PRIMER ON COSTING
  3. 3. CLASSIFICATION OF COSTS <ul><li>BASED ON BEHAVIOR </li></ul><ul><li>BASED ON FUNCTIONALITY </li></ul><ul><li>BASED ON RELEVANCE TO PROJECT </li></ul>PRIMER ON COSTING
  4. 4. BASED ON BEHAVIOR <ul><li>FIXED COST </li></ul><ul><ul><ul><li>Do not vary with units produced </li></ul></ul></ul><ul><ul><ul><li>Insurance of factory, MD fee </li></ul></ul></ul><ul><li>VARIABLE COST </li></ul><ul><ul><ul><li>Vary directly with number of units produced </li></ul></ul></ul><ul><ul><ul><li>Raw Materials </li></ul></ul></ul><ul><li>SEMI-VARIABLE COST </li></ul><ul><ul><ul><li>Partly Fixed and Partly Variable </li></ul></ul></ul><ul><ul><ul><li>Telephone Bills </li></ul></ul></ul>PRIMER ON COSTING
  5. 5. FIXED COST IS VARIABLE VARIABLE COST IS FIXED COMMENT!!!!! PRIMER ON COSTING
  6. 6. BREAK-EVEN ANALYSIS FC TC VC BEP MS COSTS / REVENUES NO. OF UNITS PRODUCED / SOLD X Y REV PRIMER ON COSTING
  7. 7. BREAK-EVEN ANALYSIS BREAK EVEN POINT <ul><li>NO PROFIT NO LOSS </li></ul><ul><li>ALL FIXED COSTS ABSORBED </li></ul><ul><li>FURTHER PRODUCTION INCURS ONLY VARIABLE COST COMPONENT </li></ul><ul><li>MARGINAL COSTING </li></ul>PRIMER ON COSTING
  8. 8. BREAK-EVEN ANALYSIS PRIMER ON COSTING BREAK EVEN = FIXED COSTS SELLING PRICE - VARIABLE COST
  9. 9. <ul><li>MARGINAL : UNIT INCREASE ; ONE MORE UNIT PRODUCED </li></ul><ul><li>WHAT IS THE COST INCURRED </li></ul><ul><li>IN THE PRODUCTION OF ONE MORE UNIT OF THE SAME ITEM ? </li></ul><ul><li>KEEP BREAK EVEN CAPACITY AS LOW AS POSSIBLE </li></ul><ul><li>OFFERS PRICING FLEXIBILITY </li></ul>MARGINAL COSTING PRIMER ON COSTING
  10. 10. <ul><li>FAIRLY NEW CONCEPT </li></ul><ul><li>GIVES GREATER CONTROL TO DECISION MAKING </li></ul><ul><li>SELLING PRICE - VARIABLE COST PER UNIT </li></ul><ul><li>FIXED COMPONENT HAS BEEN ABSORBED </li></ul>CONTRIBUTION PRIMER ON COSTING
  11. 11. CONTRIBUTION SELLING PRICE - VARIABLE COST/ UNIT CONTRIBUTION - FIXED COST/ UNIT PROFIT/ UNIT PRIMER ON COSTING
  12. 12. The following information is available about ABC International Selling price per Unit = Rs.20/- Variable cost per Unit= Rs.12/- Total Fixed Costs = Rs. 560,000/- a) What is the Break Even output ? b) What is the Profit earned when the output is 100,000 units ? c) What is the break even sales in rupees ? BREAK EVEN ANALYSIS EXAMPLE PRIMER ON COSTING
  13. 13. BREAK EVEN ANALYSIS SOLUTION BREAK EVEN OUTPUT = FC / (SP - VC) = 560,000 / (20-12) = 70,000 UNITS PROFIT AT 100,000 = Q (P - V) - F = (100,000 (20-12)) - 560,000 = Rs.240,000/- BREAK EVN SALES = BEQ * P = 70,000 * 20 = Rs.1,400,000 PRIMER ON COSTING
  14. 14. BREAK EVEN ANALYSIS MARGIN OF SAFETY <ul><li>SAFETY MEASURE </li></ul><ul><li>LEVEL OF SALES ABOVE BREAK EVEN SALES VALUE </li></ul><ul><li>PREFERABLE TO BE MAINTAINED HIGH </li></ul>PRIMER ON COSTING
  15. 15. BREAK EVEN ANALYSIS P / V RATIO <ul><li>PROFIT / VOLUME RATIO </li></ul><ul><li>SENSITIVITY OF SYSTEM TO CHANGES IN VARIABLES </li></ul><ul><li>P / V RATIO = (CONTRIBUTION MARGIN / VALUE OF SALES) </li></ul><ul><li>HIGHER THE BETTER </li></ul>PRIMER ON COSTING
  16. 16. BREAK EVEN ANALYSIS MARGIN OF SAFETY AND P / V RATIO <ul><li>HOW MUCH PROFIT DOES EACH UNIT ABOVE BEP CONTRIBUTE ? </li></ul><ul><li>EFFECTIVELY, MARGINAL COSTING !!! </li></ul><ul><li>PROFIT = P / V RATIO * MARGIN OF SAFETY </li></ul>PRIMER ON COSTING
  17. 17. CONCEPT OF LEVERAGE <ul><li>EFFECT OF THE PRESENCE OF A FIXED COMPONENT </li></ul><ul><li>LEVERAGE : GREATER OUTPUT FOR LOWER INPUT ! </li></ul><ul><li>FINANCIAL LEVERAGE AND OPERATING LEVERAGE </li></ul><ul><li>FINANCIAL LEVERAGE - DEBT / EQUITY </li></ul><ul><li>HIGHER THE FIXED COMPONENT ; HIGHLY LEVERAGED </li></ul>PRIMER ON COSTING
  18. 18. OPERATING LEVERAGE <ul><li>DUE TO PRESENCE OF FIXED COSTS </li></ul><ul><li>HIGHER THE FIXED COST, HIGHER THE OPERATING LEVERAGE </li></ul><ul><li>HIGHLY LEVERAGED ; BREAK EVEN INCREASES </li></ul><ul><li>BEYOND THAT PROFITS ARE HIGH; BELOW THAT LOSSES ARE HIGH </li></ul><ul><li>ELSE BREAK EVEN DECREASES </li></ul><ul><li>AND PROFITS AND LOSSES ARE NOT SO PRONOUNCED </li></ul>PRIMER ON COSTING
  19. 19. OPERATING LEVERAGE PRIMER ON COSTING FC TC VC COSTS / REVENUES NO. OF UNITS REV 0 100 200 300 400 500 100 200 300 400 500
  20. 20. OPERATING LEVERAGE FC = 80 (APPROX) ; VC = 4 (APPROX) BREAK EVEN AT 200 UNITS PRIMER ON COSTING
  21. 21. OPERATING LEVERAGE PRIMER ON COSTING FC TC VC COSTS / REVENUES NO. OF UNITS REV 0 100 200 300 400 500 100 200 300 400 500
  22. 22. OPERATING LEVERAGE FC = 100 (APPROX) ; VC = 8 (APPROX) BREAK EVEN AT 120 UNITS PRIMER ON COSTING
  23. 23. DEGREE OF OPERATING LEVERAGE <ul><li>DEGREE OF SENSITIVITY </li></ul><ul><li>CHANGE IN OPERATING INCOME WRT CHANGE IN UNITS SOLD </li></ul><ul><li>(% Change in EBIT) / (% Change in Units Sold ) </li></ul><ul><li>* EBIT - EARNINGS BEFORE INTEREST AND TAX </li></ul>PRIMER ON COSTING
  24. 24. TYPES OF BREAK EVEN <ul><li>1. ACCOUNTING BREAK EVEN </li></ul><ul><li>2. CASH BREAK EVEN </li></ul><ul><ul><ul><li>Based on Operating Cash Flows </li></ul></ul></ul><ul><ul><ul><li>Is there a cash flow problem every year ? </li></ul></ul></ul><ul><li>2. FINANCIAL BREAK EVEN </li></ul><ul><ul><ul><li>Based on Net Present Value Criterion </li></ul></ul></ul><ul><ul><ul><li>To undertake the project or not </li></ul></ul></ul>PRIMER ON COSTING
  25. 25. INTER-RELATIONSHIPS PRIMER ON COSTING
  26. 26. BASED ON FUNCTIONALITY <ul><li>PRIME COST </li></ul><ul><li>Related to prime activity of producing goods </li></ul><ul><li>Direct Labour, Direct material, Direct Expenditure </li></ul><ul><li>PRODUCTION OVERHEADS </li></ul><ul><li>Overall production related </li></ul><ul><li>Electricity in plant, consumables </li></ul><ul><li>ADMINISTRATIVE OVERHEADS </li></ul><ul><ul><ul><li>Manager salaries, Interests </li></ul></ul></ul><ul><li>SELLING AND DISTRIBUTION OVERHEADS </li></ul><ul><ul><ul><li>Salesman Commissions, Ad expenditure </li></ul></ul></ul>PRIMER ON COSTING
  27. 27. BASED ON FUNCTIONALITY PRIMER ON COSTING DIRECT LABOUR DIRECT MATERIALS DIRECT EXPENSES PRIME COST PRODUCTION OVERHEADS WORKS COST SELLING AND DISTRIBUTION OVERHEADS ADMINISTRATIVE OVERHEADS COST OF PRODUCTION COST OF GOODS SOLD PROFIT SELLING PRICE
  28. 28. BASED ON RELEVANCE TO PROJECT <ul><li>OPPORTUNITY COST </li></ul><ul><li>Cost forgone in adopting a project in favour of another </li></ul><ul><li>Cost forgone by not adopting a project </li></ul><ul><li>Returns forgone if the same had been invested elsewhere </li></ul><ul><li>SUNK COST </li></ul><ul><li>Already committed </li></ul><ul><li>Cannot be recovered </li></ul><ul><li>DIFFERENTIAL COSTS </li></ul><ul><ul><ul><li>Additional expense due to some change / addition </li></ul></ul></ul><ul><ul><ul><li>Caused by specific decisions taken </li></ul></ul></ul><ul><li>REPLACEMENT COST </li></ul><ul><ul><ul><li>Cost of replacing an existing asset </li></ul></ul></ul>PRIMER ON COSTING
  29. 29. PRICING CONCEPTS PRICE <ul><li>AMOUNT OF MONEY CHARGED FOR A PRODUCT / SERVICE </li></ul><ul><li>VALUE THAT A CUSTOMER EXCHANGES FOR PERCEIVED BENEFITS </li></ul><ul><li>ONLY P TO PROVIDE REVENUES </li></ul>PRIMER ON COSTING
  30. 30. PRICING CONCEPTS ART ZONE COST OF PRODUCTION CUSTOMERS’ LIMIT ECONOMIC CONDITIONS COMPETITORS’ PRICES LOSS LEADER PREMIUM NEW SEGMENT FOOL HARDY PRIMER ON COSTING
  31. 31. PRICING CONCEPTS PRIMER ON COSTING PERCEIVED VALUE COST PREMIUM VALUE FOR MONEY ECONOMY OVER PRICED
  32. 32. PRICING CONCEPTS 1. COST PLUS PRICING <ul><li>COST PLUS STANDARD MARK UP </li></ul><ul><li>UNIT COST = VC +(FC / UNIT COST) </li></ul><ul><li>PRICE = UNIT COST / (1 - DESIRED RETURN) </li></ul>PRIMER ON COSTING
  33. 33. PRICING CONCEPTS 2. BREAK EVEN / TARGET PROFIT PRICING <ul><li>PRICE AT WHICH BREAK EVEN IS ACHIEVED </li></ul><ul><li>PRICE AT WHICH TARGET PROFIT IS MADE </li></ul><ul><li>BEP = FC / CONTRIBUTION </li></ul>PRIMER ON COSTING
  34. 34. PRICING CONCEPTS 2. BREAK EVEN / TARGET PROFIT PRICING PRIMER ON COSTING
  35. 35. PRICING CONCEPTS 3. VALUE BASED PRICING <ul><li>BASED ON BUYERS’ PERCEPTION OF VALUE </li></ul><ul><li>WHAT THEY WOULD PAY NOT WHAT I WOULD OFFER </li></ul>4. COMPETITOR BASED PRICING <ul><li>GOING RATE </li></ul>PRIMER ON COSTING
  36. 36. PRICING STRATEGIES 1. MARKET SKIMMING 2. MARKET PENETRATION 3. PRODUCT LINE 4. OPTIONAL PRODUCT 5. CAPTIVE PRODUCT 6. BY PRODUCT 7. PRODUCT BUNDLING 8. DISCOUNT AND ALLOWANCE cash, quantity, functional, seasonal discounts trade in, promotional allowances 9. SEGMENTED customer, product form, location, time 10. PSYCHOLOGICAL 11. PROMOTIONAL 12. GEOGRAPHIC fob, uniform, zone, basing point, freight absorption 13. INTERNATIONAL 14. BUS STATION PRIMER ON COSTING
  37. 37. THANK YOU PRIMER ON COSTING

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