602 Management Accounting David Xu Id: 65990771 Session Preparation Assignment (SPA) #2 Understanding Key Cost Relationships 1. Read Chapter 2 of SN, Key meanings in the Chapter. Understanding key cost in a firm is the most important issue in management accounting. That is because business survives on value exchange. Customers and business are willing to exchange money and services (products) based on the costs. How products cost can effect a firm’s financial health is very important for managers. Cost objects are the different aspects of a firm’s operation, or products, it is essential concept in management accounting.
If not properly handled, cost objects can hinder, not help, the manager to understand to company’s reality. The example here is very easy to explain the situation. Also cost objects are vital to planning, motivation, and controlling. In some cases, manager makes decision to close or open new store in a region based on the cost objects. We can also see products as cost object, normally happen in manufacture business. Because accrual accounting makes a number of judgement and assumptions and all that are subjective, so it is common that managers sometimes understate or overstate a company’s profits in a period.
Direct cost and indirect cost VS Raw Material and Maintenance cost The main business in NZ and Australia are service business, mostly dealing with people. Cadbury is a good example for manufacture business. Product cost and period cost. The later is a new concept and is not difficult to understand. Apportion indirect cost. Deciding indirect cost in a company is often not straightforward and sometimes involving a number of judgements and assumptions. We can attach overhead cost to products to better understanding the reality. Function based costing system Predetermined Overhead Absorption rates
Activity based costing systems Variable costs are normally direct costs, it is used in the cost of work-in-progress and finished good inventories of products. Fixed and variable costs VS Rates and Raw Materials Variable cost and company’s activity level Cost-Volume-Profit Analysis Use of function can help to understand the analysis Very good example to explain the case Contribution margin = Sales – Variable Costs Managers have to make some assumption to in terms of how cost and profits may change at different level of activity 2. Think back to your answers to Section 3 in SPA#1. hat might be the key costs of Ryman Healthcare Ltd? What might be the key issues facing Ryman in terms of managing its costs? Why do you think this? What might be the key cost relationship that you would need to deeply understand in order to be able to manage the business of Ryman Healthcare? The key costs according to the principles of cost objects, they can be: 1) Costs to maintain the retirement villages, including nursing cost, medical cost, etc. 2) Costs to construct retirement villages, including building materials, mortgages and interests, etc. ) Costs to market in selling the retirement village units, including advertise, commercials, etc. 4) Logistics costs, includes warehouse, etc. 5) Overheads, including power, rates, security, etc. If I am the CEO of Ryman Healthcare, I think the key issues in managing the costs will be: 1) Hidden costs between different departments in the company. These costs are usually indirect costs in Ryman Healthcare Ltd, like costs to fix leaky buildings in the village units, ever increasing financial costs in the recession economy. ) How to properly apportion indirect costs to Ryman’s main service, occupation rights of individual retirement village units. We have to make some judgement and assumptions in the process. For example, when fix a leaky buildings, the costs can be categorized in building maintenance costs; when financial costs increases because of the financial crisis (more difficult to borrow money), it can be categorized to construction costs. 3) To analysis the fixed and variable costs in the company. Fixed costs are staff wages, electricity, rates, etc. variable osts are village unit construction cost, outsourcing nursing cost when extra help needed, etc. The key task here is to increase profits and also put the variable costs under control, which is big challenge to CEO in Ryman Healthcare. 4) Use different methods in dealing different department of the company. We can use functional-based costing system method in construction department, and use activity-based costing system in nursing department in apportioning of the indirect costs. Key cost relationship in Ryman Healthcare: The cost relationship can be best expressed in Cost-Volume-Profit Analysis (CVP).
Function y is variable cost and x is number of village unit, then y = f(x). We assume that variable cost is straight-line function, which means when village units increases, the variable costs (costs to run the villages) increase in the same trend. In reality, when running a retirement village, it has a minimum cost regardless how many units are occupied. We call this minimum cost is M. We also use C as cost to run each unit, the total variable costs can be represented as: Y = M + C x X Y: variable cost M: minimum cost to run a village, it is fixed cost C: cost to run one village unit
X: number of village units From the financial statements of Ryman, it has $40 million profits last year, way above break-even point, so we will focus on minimising the total cost. In the above function, if we increase the number of units X, and keep fixed cost at a certain level, then the average fixed cost per unit will reduce. Here we also assume that cost to run per unit is hard to reduce and unchanged at a certain level of village units, and used as constant here. In this CVP analysis, CEO of Ryman Healthcare can deeply understand the cost relationship between fixed cost and variable costs.