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Managing Finance and Budgets Seminar 5

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Seminar Five - Activities Preparation: read M & A Chapters 8, 9 and 10 Describe key concepts: Objectives of cost analysis Cost definitions Cost behaviour & Break-even analysis Full (absorption) costing Exercises 10.4 (page 337) and 10.8 (page 340)

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Starting Points (1) Define what is meant by the following: Historic Cost Past Cost Opportunity Cost Sunk Cost Committed Cost Outlay Cost .When and in what circumstances can costs be regarded as relevant or irrelevant?.

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Summary of the relationship between relevant and irrelevant costs Costs which are the same irrespective of which decision is made Relevant costs Irrelevant costs Future costs which vary with the decision under consideration Past costs Costs which were incurred as a result of a past decision Opportunity costs The cost of being deprived of the next best option Outlay costs Future cash outflows which vary with the decision Future cash outflows which do not vary with the decision Outlay costs

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Starting Points (2) Define what is meant by the following: Fixed Cost Variable Cost Consider a Hairdressing Salon. Can you give some examples of: Fixed costs Variable costs

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The behaviour of costs Those that stay fixed (the same) when changes occur to the volume of activity Those that vary according to the volume of activity Costs may be broadly classified as: Fixed Variable

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Starting Points (3) Interpreting Graphs The next three slides show the level of cost against volume of activity for different types of costs. Explain what the graph shows in each case.

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Cost (£) Volume of activity (units of output) F Graph of fixed cost(s) against the level of activity

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Rent cost (£) Volume of activity R Graph of rent cost against the level of activity

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Cost (£) Volume of activity 0 Graph of cost of lotions and other materials against the level of activity

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Electricity cost (£) Volume of activity 0 The slope of this line gives the variable cost per unit of activity Graph of electricity cost against the level of activity Fixed cost element

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Break-Even Analysis (1) Explain what is meant by the ‘Break-Even’ point. The next two slides show various components required to calculate the ‘Break-Even’ point. What do the slides show? Interpret what is happening. State the Break-Even Formula. Where does this formula come from?

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Cost (£) Volume of activity (units of output) 0 F Total cost Fixed costs Variable costs Graph of total cost against the level of activity

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Cost (£) Volume of activity (units of output) 0 F Total cost Fixed costs Variable costs Break even point Total sales service Break-even chart

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Calculating the break - even point Fixed costs________________ Sales revenue per unit – Variable costs per unit b =

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Profit (£) Volume of activity 0 Loss Profit Break even point Loss (£) Fixed cost Profit-volume chart

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Break-Even Analysis (2) Cottage Industries sells 500 baskets per month. Fixed costs are £500 Each basket costs £2 in materials and £10 labour. Baskets are sold at £14 each. Calculate the ‘Break-Even’ point, in terms of ‘baskets per month. What is the total profit each month?

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Break-even chart for Cottage Industries’ basket making without the machine Cost (£000) Volume of activity (number of baskets) 0 1 Fixed costs Total revenue 5 4 3 2 Total costs 100400300200500

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Break-Even Analysis (2) A machine costing £3000 per month is available, but reduces the other costs to: Fixed costs are £500 Each basket costs £2 in materials and £5 labour. Calculate the new ‘Break-Even’ point, in terms of ‘baskets per month. What is the new total profit each month?

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Break-even chart for Cottage Industries’ basket making with the machine Cost (£000) 1 Fixed costs Total revenue 5 4 3 2 Total costs Volume of activity (number of baskets) 0 100400300200500

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Operational Gearing The Basket-making example highlights the issue of ‘Operational (or Operating) Gearing’. Explain, using the example what this means. Fill in the blanks, using the words high and low: If the volume of trade is ____, a company with ___ operational gearing will tend to have ____ profit compared to a company with ____ operational gearing.

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The effect of operating gearing

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Break-Even Analysis Describe some of the weaknesses of Break-Even Analysis

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Weaknesses of break-even analysis Three general problems: Non-linear relationships Stepped fixed costs Multi-product businesses

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Non-Linear Relationships Cost (£) Volume of activity (units of output) 0 Fixed costs A B Total cost Total revenue

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Fixed cost (£) Duration of activity R Stepped Fixed Costs

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Full Costing What is ‘Full Costing’? What is it used for? Explain the relationships between Full Costs and: Direct and Indirect Costs Fixed and Variable Costs How would you deal with overheads on a departmental basis?

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Uses of full cost information Two main uses: For pricing purposes For income measurement purposes

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Direct and indirect costs These are all other costs: That is, those that cannot be directly measured in respect of each particular unit of output. Two categories of costs: Direct costs Indirect costs or (overheads) Costs that can be identified with specific cost units – the effect of the cost can be measured in respect of each particular output.

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The relationship between direct costs and indirect costs Full cost of the unit Direct costs of the unit Fair share of indirect costs (overheads)

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The relationship between fixed costs, variable costs and total costs Total (or full) costs Fixed costs Variable costs

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The relationship between direct, indirect, variable and fixed costs of a particular job Total (or full) cost of a particular job Indirect costs (overheads) Fixed costs Direct costs Variable costs

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Preparation department Finished goods store Finishing department Machining department * Direct materials * Direct labour * A share of the Preparation Department’s overheads Job A A cost unit passing through the production process

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Costing Jobs M & A Exercise 10.4 M & A Exercise 10.8

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