Job-order costing is a traditional costing method where the quantity of each production material used in manufacturing a product determines the amount of overhead, labor and material costs that are charged to that particular product. Different products require different quantities of materials and labor; some products may require higher quantities of raw materials, while others may require more labor time (Atrill, P. & McLaney, E. 2009).
Job-order costing is mainly appropriate organizations which produce diverse products, such as clothes (Atrill, P. & McLaney, E. 2009).
Activity Based Costing
Activity based costing is a costing method which charges manufacturing overhead costs to products by first assigning costs to the activities that have directly led to the overhead being incurred; then charging the cost of those activities only to the products that utilized those activities. For example, cost of special engineering or special testing would only be charged to products which actually use those activities, rather than all products which use machine hours (Atrill, P. & McLaney, E. 2009).
Factors that have led to increased popularity of Activity based costing are:
- increased manufacturing overhead costs,
- Lack of correlation between manufacturing overhead costs and productive machine hours or direct labor hours,
- Increased diversity of products and customers’ demands, and
- Difference in the size of batches of products produced (Atrill, P. & McLaney, E. 2009)
Process costing is a costing method which considers the process that products go through in the manufacturing process when charging production costs to products. Each sub process within the manufacturing process has a standard amount of overhead, labor and material costs which are charged to each batch run. Process costing is mainly appropriate for organizations that produce only one type of goods such as beverages, food, nails and screws. Costs are charged to each batch of products in similar amounts at each process as they go through the manufacturing processes (Atrill, P. & McLaney, E. 2009).
Similarities between job-order and process costing
The only similarity between job-order and process costing is that they are both traditional methods of charging production costs to products.
Differences between job-order and process costing
The main difference between job-order and process costing is that Job-order costing charges overhead, labor and material costs each product depending on the quantity of each production material used in manufacturing that particular product, while Process costing charges costs to the different products based on the production process used to manufacture the products.
Another difference between job-order and process costing is that Job-order costing is more appropriate to organizations which produce several different types of products each period, while Process costing is more appropriate to organizations that have repeated manufacturing processes which produce homogeneous goods.
Cost-volume-profit analysis focuses on costs, revenues, volume of output and profits; and it divides total costs into fixed and variable costs (Wilkinson, N. 2005).
Cost-volume-profit analysis examines how changes in the volume of output affect changes in total costs and in profits (Wilkinson, N. 2005).
Cost-volume-profit analysis is useful in deciding the price of a product, the minimum number of units of a product which need to be sold in order to make profit, and the best proportions of several products to form a sales mix (Wilkinson, N. 2005).
Contribution margin is an important concept in Cost-volume-profit analysis, and is calculated by deducting variable costs from the sales revenue (Wilkinson, N. 2005).
The break-even point is the minimum output level needed for sales of a product to be profitable, and is calculated by dividing fixed costs by the contribution margin. At that point, contribution margin is equal to fixed costs; total costs equal total revenues; and the net profit is zero (Wilkinson, N. 2005).
The following assumptions are made when determining the break-even point:
- Fixed costs do not change
- Variable costs only vary in line with variations in output
- Selling price per unit of output does not change
- The only factor which affects total cost is the volume of output (Wilkinson, N. 2005).
The relationship between total costs and total revenues at different output levels is presented in the break-even chart. The point at which the profit line cuts the output axis is the break-even point (Wilkinson, N. 2005).
Approaches to break-even analysis
There are three approaches to break-even analysis:
- The equation method
- The contribution margin method
- The graphical method
The equation method
The equation states that Profit = Sales – (Variable Expenses + Fixed Expenses)
at breakeven point, profit = 0,
Therefore, Sales – (Variable Expenses + Fixed Expenses) = 0
The contribution margin method
The Contribution Margin per unit is calculated by subtracting variable costs per unit from the selling price per unit.
The Breakeven Point is calculated by dividing the Fixed costs by the contribution Margin per unit.
The graphical method
Under this approach, the units are plotted on the X-axis, while the dollars for sales revenue and costs are plotted on the Y-axis. The point at which the profit line cuts the output axis is the break-even point.
Major benefits to be gained from budgeting
The Major benefits to be gained from budgeting are:
Budgeting forces management to plan ahead for the future, thus allowing them to focus on problems before they actually occur, so that they can take corrective measures in good time, rather than ‘knee-jerk’ solutions.
budgeting allows managers to allocate scarce resources to the most financially rewarding areas.
By comparing actual to budgeted performance, managers are able to take corrective actions to bring the operation back on target. The causes of variations can also be investigated.
Budgeting ensures that all managers work in the best interest of the company, by sticking to the formal plan adopted by a budget.
managers use the budgeting process to exchange information concerning goals, ideas, and achievements. They then ensure that each of their activities are aimed at enhancing the firm’s overall operation.
when realistic goals are set during budgeting, the managers are motivated to work hard towards achieving those goals.
The impact of standard costing
Unrealistic Standards normally de-motivate workers. If standards are lower than what workers can reasonably achieve, then they would only achieve the low standards. On the other hand, if standards are too high, the workers will realize that it is impossible to attain them. This will result in frustration, and they will not even try to achieve any standards.
If both workers and management participate in setting standards, they would more readily identify with those standards and would personally strive to attain them.
Methods of capital budgeting
The following are the Methods of capital budgeting:
- Payback period,
- Discounted Payback period,
- Net Present Value,
- Profitability Index,
- Internal Rate of Return
- Modified Internal Rate of Return
The payback period calculates how long it would take for a firm to recover the amount of money it invests in a project from the cash flows generated from the project. Companies normally have a required payback period, in which case the company would only accept a project if it has a payback period that is equal to or less than the company’s required payback period. If the company is choosing between competing projects, the company would accept the project with the lowest payback period (Graham, Smart, & Megginson, 84).
The Discounted payback period calculates how long it would take for a firm to recover the amount of money it invests in a project from the discounted cash flows generated from the project. The only difference between this method and the payback period method is that here cash flows are discounted, since the money is to be received in the future, and will be less valuable than money today. The decision criteria is the same as that of the payback period method (Brigham, E., & Ehrhardt, M. 2008).
Net Present Value
Under the net present value method of evaluation, the present value of all money that a project is expected to generate during its life is computed by multiplying those cash flows by the present value interest factor at the firm’s cost of capital. The present value of the cash outflows is then subtracted from the present value of the money expected to be received to get the net present value of the project. If a project has a positive net present value, it means that the present value of the money to be received is higher than the present value of the money to be spent on the project. For a project with a negative net present value, it means that the present value of the money to be received is less than the present value of the money to be spent on the project. Such a project will increase the value of the firm by the amount of the project’s net present value. A project is accepted if it has a net present value that is higher than zero, which means that the present value of the money to be received is higher than the present value of the money to be spent on the project. If the company is choosing between competing projects, the company would prefer the project with the highest payback period (Graham, J., Smart, S., Megginson, W. 2009).
The Profitability Index is calculated by dividing the present value of project’s cash flows by the required initial capital outlay (Block, S., & Hirt, G. 2006).
The project should only be accepted if its Profitability Index is greater than 1.
Internal Rate of Return
The Internal Rate of Return is the discount rate at which a project has a net present value of zero. A project should only be accepted if its Internal Rate of Return is higher than the company’s weighted average cost of capital (Emery, D., Finnerty, J., & Stowe, J. 2007).
Atrill, P. & McLaney, E. (2009) Management accounting for decision makers. Harlow, England: Financial Times/Prentice Hall
Block, S., & Hirt, G. (2006). Foundations of financial management. Irwin: Mc Graw.
Brigham, E., & Ehrhardt, M. (2008). Financial management: theory and practice. Florence: Cengage Learning.
Emery, D., Finnerty, J., & Stowe, J. (2007). Corporate Financial Management. Prentice Hall: Pearson Education, Inc.
Graham, J., Smart, S., Megginson, W. (2009). Corporate Finance: Linking Theory to what Companies Do. South Western Educational Publishing.
Wilkinson, N. (2005) Managerial economics: a problem-solving approach. Cambridge University Press.