Question

As a cost and management accountant you always advocate about the use of cost volume profit (CVP) analysis and activity based costing in different cost management scenario. That’s why management of the PQR Limited wants you to explain the following issues for their next cost management move for the organisation.

Required:

1. What is a cost driver? What is the cost driver in conventional cost volume profit (CVP) analysis? How is the cost driver measured in conventional CVP analysis?     


2. In activity–based costing, costs are classified into unit level, batch level, product level and facility level. How are these categories typically handled in CVP analysis, where there are only two categories available: fixed or variable?     



3. In an environment where activity–based costing is necessary and appropriate, is the relevance of conventional CVP analysis enhanced or diminished? Explain.     



4. Explain the additional limiting assumption of using CVP analysis under activity–based costing.
    




5. PQR Limited makes major household appliances such as refrigerators, stoves and dishwashers. Sales are heavily dependent upon the number of housing starts and the level of disposable income. Next year the number of housing starts in Victoria is expected to be the same as this year; however, about two-thirds of these starts will be for rental units compared to a historical average of one-third. The remaining housing starts will be for single-family homes and up market units. PQR generally makes two levels of each product: the economy model (fully functional, but with few special features) and the prestige model (with the most popular special features). PQR Limited assumes a product mix of 40 per cent economy and 60 per cent prestige. Describe how the change in the percentage of rental units in housing starts could create a problem with the stable product mix assumption.    

Answer 1

1. A cost driver means to

· Identify activities and determine measures of output for each activity.

· Then relate each output measure to the resources necessary to produce it.

· Any output measure that causes cost is called a cost driver.

For example

· Activity: spare parts delivery to production shed

· Measure: number /Weight of parts received

· Drives: use of moving trolley/its fuel costs

· Research staff salaries- number of new products proposals.

· Salaries of product engineers- complexity of new product.

· Labor wages- hours

· Supervisor salary- number supervised

The cost driver in conventional cost volume profit (CVP) analysis

· Add or Drop a Product. A decision unit will add (drop) a product if the   incremental revenues   from   the   product   are   greater (less)   than the incremental costs   of   producing   and distributing the product. In general, the incremental costs consist of the incremental cash outlay costs plus the opportunity costs of using the capacities to produce the product. The firm will have positive opportunity costs if it has the option of diverting the capacities from the current product and use them to produce another product. The question of whether to add a product generally arises in job-shop operations, where a decision to bid on a new order constitutes a decision to add a new   product   (the   order). The capacity needed to work on   the new order is available to the decision unit, and the firm must decide whether to devote the capacity to the new order, to other products (other orders), or let it remain idle.

· Make or Buy a Unit. A firm may have capacities available that it can use to manufacture a subunit   rather   than   to   purchase   the   subunit   from   an   outside   supplier. Firms   can   make   this decision each operating period, opting to make the unit in some periods and purchase it in others. The firm will manufacture the unit if the incremental costs of purchasing exceed the incremental costs of manufacturing. The incremental costs of manufacturing are the incremental outlay costs plus the opportunity costs of devoting the capacities to the subunit. The latter will be zero if the capacities would otherwise stand idle. These costs will   be positive   if the firm   could use the capacities devoted to   the   subunit to manufacture   another   profitable   product, such   as a main product or another type of subunit.

· Sell now or process further. Generally, a decision unit will process a product further rather than sell it immediately if the incremental revenues from processing exceed the incremental costs of processing. The incremental revenues are measured by the difference between the selling price of the unit after processing and the selling price if sold immediately times the number of units to be processed.   The   incremental   costs   are   the incremental   outlay   costs of   processing   and   the opportunity costs of using the capacities to process the product. Deciding to use a resource in a particular way   causes   a manager to give up the   opportunity to use the resource in   alternative ways. The lost opportunity is a cost   that the manager must take into account   when making a decision. Opportunity cost is the contribution to income that is forgone (rejected) by not using a limited resource in its next-best alternative use.

2. Activity-based costing is an extension of traditional volume-based costing that treats manufacturing overhead as a complex set of costs with multiple cost drivers.

Activity-based costing is a costing system that focuses on individual activities as the cost objects. An activity is an event, task or unit of work with a specified purpose; for example, designing products, starting up machines, operating machines, moving and distributing products.

The unit level, batch level, product level and facility level are handled in CVP analysis as below:

Unit-level resources and activities: Unit-level resources are used for each unit of product. In other words, as one more unit of product is produced, the usage of unit-level resources increases. Materials used for production, components used for each unit, and energy such as electricity are among the unit-level resources, because these resources must be consumed for every unit of products produced.

Batch-level resources and activities: Batch-level resources are used as a result of producing a group of similar products. For example, specialized labor of technicians, and materials necessary to setup the equipment every time a batch of products is produced can be regarded as batch-level resources.

Product-level resources and activities: Product-level resources are required as a result of the decision to have a specific product line. Specialized equipment, software, and specialized labor of engineers required to design a product can be given as examples to product-level resources.

Facility-level resources and activities: Facility-level resources are necessary to provide a general capacity to produce the products. These activities are required the entire production process to occur. For example, operating a plant is a facility-level activity because the plant is necessary for the entire production process to be performed. Likewise, facility-level activities cause a consumption of facility-level resources.

3. The traditional cost-volume-profit analysis uses only volume-based cost drivers such as the number of units produced. Therefore, costs are categorized as fixed or variable with respect to the number of units of products produced. All of the costs that do not change with respect to sales volume are accepted as fixed under the traditional CVP analysis. However, there are some costs such as the batch-level and product-level costs that are fixed with respect to volume-based cost drivers, but variable with respect to other cost drivers, rather than production volume. In this case, the use of the traditional CVP analysis will be misleading for managerial decision-making process because it will not provide managers with the correct prediction of costs. By contrast, the activity-based CVP analysis will use multiple cost drivers to estimate the costs for the coming periods.

Hence, the activity-based CVP analysis will provide better prediction of costs and much more complete picture of break-even analysis. Therefore, just as activity-based costing was shown to improve cost management and decision-making, it also produces organizational benefits when coupled with CVP model.

4. Below is the list of the additional limiting assumption of using CVP analysis under activity–based costing

a. Number of units of products produced is the only revenue and cost driver. In other words, only an increase in the number of units of products produced and sold causes increase in level of revenues and costs.

b. Total costs are divided into a fixed component and variable component that is variable with respect to volume of output.

c. Selling prices are constant within the relevant range, productivity is constant within the relevant range, and variable cost per unit is constant within the relevant range.

d. Traditional cost-volume-profit analysis covers a single product. When traditional CVP analysis covers multiple products, it assumes that sales mix will remain constant as the total number of units sold changes.

e. Fixed costs are fixed within the relevant range. Relevant range is the limit of cost-driver activity level within which a specific relationship between cost and cost driver is valid. Although fixed costs are unchanging with respect to cost driver (only volume-based cost driver), this rule is true only within reasonable limits. For example, rent costs, which are generally fixed, will rise if increased production requires additional building.

f. All units produced are sold.