In-Depth Overview of Costing, Cash Flows, and Capital Budgeting

Cost Function

  • Cost Function Formula: ( Y = a + (b * X) )

    • ( Y ): Total cost
    • ( a ): Fixed cost component
    • ( b ): Variable cost per unit
    • ( X ): Measure of activity

  • Fixed Costs: Costs that do not change with the level of activity within a relevant range.

  • Variable Costs: Costs that change in total with the level of activity but are constant on a per-unit basis.

  • Mixed Costs: Costs that contain both fixed and variable components.

  • High-Low Method: A method to estimate variable and fixed costs using the highest and lowest levels of activity from data.

  • Outlier: An observation that lies very far away from the rest of the data points in a scatterplot.

Absorption vs Variable Costing

  • The difference between Net Income (NI) under Absorption Costing (ACNI) and Variable Costing (VCNI) is driven by changes in inventory.

    • Inventory changes affect fixed manufacturing overhead allocation.

  • Contribution Margin (CM):

    • ( CM = \text{Revenues} - \text{All Variable Costs} )

  • Breakeven Point: The level of sales at which total revenues equal total costs.

    • ( \text{Breakeven Point (in units)} = \frac{\text{Fixed costs}}{\text{Contribution Margin per Unit}} )

Financial Concepts

  • Operating Leverage: Measure of how sensitive the operating income is to changes in sales volume.

    • ( \text{Operating Leverage} = \frac{CM}{\text{Net Income}} )

  • Margin of Safety: The amount by which revenues exceed the breakeven point.

  • Relevant Cash Flow: A cash flow that will occur in the future and varies based on the decision made.

  • Joint Costs: Costs incurred before the split-off point in a sell-or-process further decision.

Capital Budgeting

  • Balanced Equation: ( \text{Beginning Balance} + \text{Additions} = \text{Ending Balance} + \text{Transfers Out} )

  • Capital Budgeting: The process of selecting long-term assets and making capital investment decisions.

  • Payback Period: The time it takes for an investment to generate cash flows to recover its initial cost.

    • Payback period formula: ( \text{Payback Period} = \frac{\text{Initial Investment}}{\text{Annual Cash Flow}} )

  • Accounting Rate of Return (ARR): Average annual income divided by initial investment.

    • ( \text{ARR} = \frac{\text{Average Annual Income}}{\text{Initial Investment}} )

  • Internal Rate of Return (IRR): The discount rate at which the Net Present Value (NPV) of an investment equals zero.

  • Post Audit: A follow-up analysis conducted on a capital project once it is implemented to evaluate its actual performance against projections.

  • Net Present Value (NPV): A positive NPV indicates that the return of the investment exceeds the discount rate.

Key Relationships

  • Contribution Margin Ratio (CMR): ( \text{CMR} = \frac{\text{Contribution Margin}}{\text{Sales Revenue}} )
  • Contribution Margin at Breakeven: Equal to total fixed costs.