wk 8: Long term decisions

What are long term decisions

• decisions made with no constraints. All costs and inputs are able to varied in the long run

• more likely to have long term effects on profitability.

  • eg. long term pricing, activity based management, outsourcing

What are relevant costs and revenue

costs/revenue that are expected to change between alternatives and are expected in future.

Absorption vs Variable costing: what is capacity

the infrastructure, resources and assets needed so we have the ability to produce a given volume of output(factory rent, supervisor salary, HR, delivery vehicle maintenance)

How do we find fixed costs/unit

We get the capacity cost which is the cost required to produce a desired volume of output (not what was actually produced)

Fixed cost/unit=Fixed manufacturing cost/Output volume

Absorption vs Variable costing

Absorption costing

• all manufacturing costs are absorbed into inventory and hence sit there until inventory is sold and go into cogs. Non-manufacturing costs are period costs, but fixed manufacturing costs and DM,DL go into inventory (product costs)

Variable costs

• only variable manufacturing costs go into inventory (variable direct manufacturing costs and variable moh)

• CM separates variable from fixed costs

• then fixed moh and fixed and variable non-moh are treated as period costs

How does absorption and variable costing affect operating profit

When production>what we sell

ABSORPTION COSTING

• it leads to a higher profit

• because the manufacturing costs are split across more output and if not sold it remains in inventory not cogs

• less expenses→more profit

VARIABLE COSTING

• leads to a lower profit

• even tho the variable manufacturing costs go to inventory, the fixed moh go into period costs.

When production=what we sell

• both absorption and variable costing lead to the same profit

When production<what we sell

ABSORPTION COSTING

• operating profit is lower, cuz more cogs are expensed

VARIABLE COSTING

• operating profit is higher

What should the difference in profit be under ac and vc

Fixed MOH per unit x change in inventory units=0.45×200k

Direction of inventory impact on profit

when inventory increases: AC is higher (hence there is adverse incentive to produce a lot to make profit look better)

when inventory decreasing: VC is higher

How to get rid of adverse incentives from absorption costing

• use variable income statements to evaluate managerial performance

• extend time used to evaluate managerial performance

• adopt jit inventory system

• include non-financial info in criteria.

AC benefits and limitations

PROS

• complies with regulations

• provides full product costing which can be useful for long term pricing decisions

CONS

• may encourage adverse behaviour

• leads to higher inventory holding which has risks ie. damage, theft etc, obsolescence

VC benefits and limitations

PROS

• good for short term decision making by splitting fixed and variable costs

• less dysfunctional behaviour

CONS

• not always clear if smth is fixed or variable costs

• cost breakdown can be commercially sensitive

• external reporting may not be appropriate

Determining Long term price-3 main infleunces for pricing non commodity products

1. base on customers: perceived value of product

2. competitors: what other companies charge

3. costs: what it costs the business to make and deliver the product

Alternative long term pricing approaches

TARGET PRICING: using customers + competitors

• develop product that satisfies customer needs

• choose target price

• decide on target profit/unit (markup)

• derive target cost per unit=target price-target profit/unit

• perform value engineering so that actual cost<target cost

COST PLUS PRICING: finding costs + markup

• price= cost base + markup

• markup designed based on ROI (the return investors want on the capital they invested)

Finding cost base

• depends on company or will tell you in question

  • it could be fixed + variable costs

  • or direct + indirect costs

• use correct allocation base (reflects underlying cost driver) to allocate costs to each product

Value engineering

• there are value added activities(costs customers are willing to pay for) and non-value added activities (customer does want to pay for. Cost of rework due to errors. Rush orders of materials caused by poor planning )

locked in vs incurred costs

Locked in costs: not yet incurred but will certainly be in future

incurred cost: actually happens when resource is used up which can happen long after cost is locked in.

Fixed costs in future

• in the future fixed costs become relevant

• 
  

Activity based management

ABM is using ABC infor to improve performance and profitability

when is customer profitability important and why do we assign costs to customers

• When individual customers demands differ a lot

• Ie. they buy materially diff product mix

• require diff levels of organisational support

WHY

• priortise profitable ones

• offer discounts when needed to get more business from low cost customers

• negioate changes in customer behaviour that lower costs to serve them

• last resort stop serving unprofitable ones

Order processing costs

• custom costs assigned to customers including processing costs and sales visit costs (mainly fixed), if customer is dropped it doesn’t change in short run (so cost per order rises) but does in long run