BAFS Study Notes: Cost Accounting for Decision-making

Hello! Ever wondered how big companies like Apple or a local Cha Chaan Teng make smart financial choices? How do they decide whether to launch a new product, accept a special order, or even drop a menu item that isn't selling well? The answer lies in Cost Accounting!

In this chapter, we're going to become business detectives. We'll learn how to look at different costs and figure out which ones are important for making decisions and which ones we should ignore. This is a super practical skill that managers use every single day to guide their companies to success. Don't worry if it sounds tricky at first – we'll break it down with simple examples you can relate to!


1. The Right Costs for the Right Decision

Before we can make a decision, we need to know which information to use. In accounting, this means separating relevant costs from irrelevant costs. It's like packing for a trip – you only pack what's relevant for your destination!

What makes a cost 'relevant'?

A cost is relevant if it meets two conditions:

  • It's a future cost (it hasn't happened yet).
  • It differs between your choices (it changes depending on which option you pick).
Key Types of Relevant & Irrelevant Costs

1. Sunk Costs (The Irrelevant Ones!)

A sunk cost is money that has already been spent and cannot be recovered. Since it's a past cost, it's the same no matter what you decide to do now. Therefore, sunk costs are ALWAYS irrelevant to future decisions.

Analogy Time: Imagine you bought a non-refundable $100 concert ticket last week. Today, your friend invites you to a party on the same night. The $100 you spent on the ticket is a sunk cost. It's gone, whether you go to the concert or the party. So, you should NOT think, "I have to go to the concert to get my money's worth." Instead, you should just decide which event you'd enjoy more!

Business Example: A company spent $50,000 on market research for a new type of soft drink. The research showed that people probably won't like it. The $50,000 is a sunk cost and should not be considered when deciding whether to cancel the project.

2. Incremental Costs (The Relevant Ones!)

An incremental cost (also called a differential cost) is the additional cost you will incur if you choose a particular option. Since it's a future cost that differs between alternatives, it is ALWAYS relevant.

Business Example: A bakery is considering accepting a special order for 100 extra cakes. The incremental costs would be the extra flour, sugar, eggs, and electricity needed to bake those 100 cakes. The bakery's monthly rent would not be an incremental cost because it has to be paid anyway.

3. Opportunity Costs (The Hidden Relevant Ones!)

An opportunity cost is the potential benefit that is given up when you choose one alternative over another. It’s the "cost" of the missed opportunity. This is not a cost you actually pay with money, but it's very important and is ALWAYS relevant for decision-making.

Analogy Time: You have a Saturday free. You can either work your part-time job and earn $400, or you can go to the beach with friends. If you choose to go to the beach, your opportunity cost is the $400 you gave up. If you choose to work, your opportunity cost is the fun and relaxation you missed at the beach.

Business Example: A company owns a warehouse. It can either use the warehouse to store its own products or rent it out to another company for $10,000 per month. If the company chooses to use the warehouse itself, the opportunity cost is the $10,000 rental income it is giving up.

Key Takeaway: Relevant vs. Irrelevant Costs

When making a decision...

  • DO consider: Incremental Costs & Opportunity Costs.
  • DO NOT consider: Sunk Costs & any future costs that are the same for all options.

2. Applying Cost Concepts: Common Business Decisions

Let's put our new knowledge to work! Here are some common scenarios where managers need to analyze costs to make the best choice. For each one, the goal is to compare the relevant costs and benefits of each option.

Decision 1: 'Hire, Make or Buy'

This is when a company decides whether to produce a part or component internally (make) or buy it from an outside supplier (buy). Note that 'hire' here means the same as 'buy'.

Step-by-step Guide:

  1. List all the costs of making the item internally. Only include the variable costs (like materials, direct labour) and any EXTRA fixed costs. Do NOT include general factory rent or other fixed overheads that will exist anyway.
  2. List the cost of buying the item from the supplier (the purchase price).
  3. Consider any opportunity cost. If making the item uses factory space that could be used for something else profitable, that lost profit is an opportunity cost of 'making'.
  4. Compare the total relevant cost of 'making' with the total relevant cost of 'buying' and choose the cheaper option.

Watch Out! A common mistake is to include a share of the company's total fixed costs (like factory rent) in the 'make' cost. This is wrong! The rent will be paid whether you make the part or not, so it's irrelevant unless making the part requires renting a NEW space.


Decision 2: 'Accept or Reject an Order at a Special Price'

This happens when a customer offers to buy a large quantity of a product, but at a lower price than usual. This is usually a one-off deal.

Step-by-step Guide:

  1. Calculate the incremental revenue from the special order (units x special price).
  2. Calculate all the incremental costs of fulfilling the order. This is usually just the variable costs of production.
  3. If the incremental revenue is GREATER than the incremental costs, the order will add to the company's profit, and it should be accepted (assuming the company has spare capacity).

Did you know? Airlines do this all the time! They sell last-minute empty seats for cheap. As long as the ticket price covers the variable costs (like a snack and some fuel), it's extra profit for them because the plane was going to fly anyway!


Decision 3: 'Retain or Replace Equipment'

This is the decision of whether to keep using an old machine or buy a new, more efficient one.

Step-by-step Guide:

  1. Identify the relevant costs for both options (retain vs. replace) over a specific period (e.g., the next 5 years).
  2. Relevant costs for retaining include future running costs and repair costs.
  3. Relevant costs for replacing include the purchase price of the new machine and its future running costs. The disposal value (trade-in value) of the old machine is a relevant benefit of replacing.
  4. IMPORTANT: The original price and the current book value of the old machine are SUNK COSTS and are therefore IRRELEVANT.
  5. Compare the total relevant costs of each option and choose the cheaper one.

Decision 4: 'Sell or Process Further'

Some products can be sold at an intermediate stage or processed more to be sold for a higher price. The question is: is the extra processing worth it?

Step-by-step Guide:

  1. Calculate the incremental revenue from processing further. This is the final selling price minus the intermediate selling price.
  2. Calculate the incremental cost of the further processing.
  3. If the incremental revenue is GREATER than the incremental cost, you should process further.

Business Example: A timber company can sell rough wooden planks for $50 each. Or, it can sand and varnish them for an extra cost of $10 per plank and sell them for $70 each.
- Incremental revenue = $70 - $50 = $20
- Incremental cost = $10
Since $20 > $10, it's profitable to process them further!


Decision 5: 'Eliminate or Retain an Unprofitable Segment'

Sometimes a product line or department looks like it's losing money. Should the company shut it down?

Step-by-step Guide:

  1. Look at the segment's income statement. Identify the revenue it brings in.
  2. Identify the costs that would disappear if the segment was eliminated. These are called avoidable costs (usually all variable costs and some specific fixed costs, like the segment manager's salary).
  3. Compare the lost revenue with the avoidable costs.
  4. If the lost revenue is GREATER than the costs you avoid, shutting it down will actually decrease the company's total profit. In this case, you should retain the segment.

Why? Because the 'unprofitable' segment might still be contributing towards covering the company's overall common fixed costs (like the CEO's salary or head office rent). If you shut it down, that contribution is lost, but the common fixed costs remain!


3. Cost-Volume-Profit (CVP) Analysis

CVP analysis is a powerful tool that helps managers understand the relationship between costs, sales volume (how much you sell), and profit. It helps answer questions like, "How many units do we need to sell to not lose money?" or "How much profit will we make if we sell 1,000 units?"

The Key Ingredient: Contribution Margin

Before we can do CVP, we need to understand the contribution margin. This is the money from sales that is left over to 'contribute' towards covering fixed costs and then generating profit.

Contribution Margin per unit = Selling Price per unit – Variable Cost per unit

Breakeven Point: The "No Profit, No Loss" Zone

The breakeven point is the level of sales where total revenue equals total costs. At this point, profit is exactly zero.

There are two ways to calculate it:

1. Breakeven Point in Units: How many items you need to sell.

$$ \text{Breakeven Point (units)} = \frac{\text{Total Fixed Costs}}{\text{Contribution Margin per unit}} $$

2. Breakeven Point in Sales Dollars: How much sales revenue you need.

$$ \text{Breakeven Point (\$)} = \frac{\text{Total Fixed Costs}}{\text{Contribution Margin Ratio}} $$

(Where Contribution Margin Ratio = Contribution Margin per unit / Selling Price per unit)

Target Profit Analysis: Aiming for a Goal

What if you don't just want to break even, but want to make a specific amount of profit (a target profit)? Just add the target profit to your fixed costs!

$$ \text{Units to sell for Target Profit} = \frac{\text{Total Fixed Costs + Target Profit}}{\text{Contribution Margin per unit}} $$
Margin of Safety: Your "Buffer Zone"

The margin of safety tells you how much your sales can drop before you start making a loss. It's the difference between your actual or budgeted sales and your breakeven sales. A bigger margin of safety is better!

Margin of Safety = Actual (or Budgeted) Sales – Breakeven Sales

CVP for Multiple Products

Most companies sell more than one product. To do CVP analysis, we need to calculate a weighted-average contribution margin based on the sales mix (the proportion of each product sold).

Step-by-step Guide:

  1. Calculate the contribution margin per unit for each product.
  2. Determine the sales mix (e.g., for every 3 units of Product A, we sell 1 unit of Product B. The mix is 3:1).
  3. Calculate the weighted-average contribution margin per unit.
  4. Use this weighted-average figure in the normal breakeven formula to find the total number of units to break even.
  5. Use the sales mix to figure out how many units of each specific product that is.
Quick Recap: CVP Formulas
  • Breakeven (units): Fixed Costs / CM per unit
  • Target Profit (units): (Fixed Costs + Target Profit) / CM per unit
  • Margin of Safety: Actual Sales - Breakeven Sales

4. Dealing with Scarcity: Limiting Factors

Sometimes, a company doesn't have enough of a particular resource to meet all the demand for its products. This scarce resource is called a limiting factor. It could be machine hours, labour hours, or a specific raw material.

When you have a limiting factor, you need to decide which products to make to maximize your profit. The trick is to prioritise products that give you the most profit per unit of the scarce resource.

Step-by-step Guide to Maximising Profit:

  1. Confirm there is a limiting factor (i.e., you don't have enough of the resource to produce everything customers want).
  2. Calculate the contribution margin per unit for each product.
  3. Calculate the contribution margin per unit of the limiting factor for each product. The formula is:
    $$ \frac{\text{Contribution Margin per unit}}{\text{Amount of Limiting Factor per unit}} $$
  4. Rank the products from highest to lowest based on the result from Step 3.
  5. Create the optimal production plan by producing the highest-ranked product first, up to its maximum demand, then the second-highest, and so on, until the scarce resource runs out.

Common Mistake Alert! Do not rank products based on their contribution margin per unit. You MUST rank them based on the contribution margin per unit of the limiting factor. A product might have a high profit per unit, but if it uses up a lot of the scarce resource, it might be less profitable overall than another product.

And that's it! By understanding these key concepts, you can start thinking like a manager, making informed decisions that help a business thrive. Keep practising with examples, and you'll master it in no time!