If there is excess capacity, the minimum acceptable price for a special order must cover:

Cost Analysis and Pricing in Distance Education Seppo Alaluusua Context: Although this article does not mention cost analysis in relation to distance education except in the title, it defines basic cost terminology and describes methods for assessing costs that should be useful to managers and planners. Source: Alaluusua, Seppo. 1992. "Cost Analysis and Pricing in Distance Education." Epistolodidaktika, no. 1, pp. 15-30. Copyright: Reproduced with permission. Cost Behavior, Cost Concepts and Cost Models All costs incurred by an institute result from decisions made by individuals in the organisation. 'Know your costs' is an essential theme for any manager; cost concepts are relevant only if they influence a decision, and cost data are relevant only if they are useful to a cost concept. Some cost terminology Among other categories, classifications of costs can be made by: Degree of averaging Total costs Unit costs Behaviour in relation to fluctuations in activity Variable cost Fixed cost Other cost Ease of traceability Direct costs/traceable costs Indirect costs Management function Manufacturing costs Selling costs Administrative costs Time when computed Historical costs Predetermined (via cost 'prediction') or budgeted costs Timing of charges against revenue Production costs Period costs Unit costs and total costs The total bill for a senior class dance may be estimated at $400; but the bill is much more meaningful to the class members when it is stated as an amount per couple or per person. If 200 students attend, the unit cost is $2 person; if 50 attend, the unit cost becomes $8 per person. The unit cost will determine the price-perhaps even the decision whether to hold the dance at all-because the total cost will be the same no matter how many students buy tickets. But this $400 total cost is difficult for the class members to interpret unless it is tied to some measure of volume (activity) that represents utilisation. The division of a total cost by the number of times it will be utilised (in terms of units of activity or volume) yields the unit cost. Generally, unit costs should be expressed in terms most meaningful to the individuals who are responsible for incurring the costs. The unit is not always a physical product; the unit (i.e. the base of the fraction) should be the definable statistic of volume or activity which is most closely correlated with the behaviour of the cost. The base, or unit, will differ-it might be the number of orders processed, the number of lines billed in a billing department, the number of admissions to a theatre, the number of pounds handled in a warehouse, the hours of labour worked in an assembly department, the number of rides in an amusement park, the seat-miles on an airline, or the dollar sales in a grocery store. Variable costs Variable costs are uniform per unit, but their total fluctuates in direct proportion to the total of the related activity or volume. Fixed cost determinants Fixed costs, in contrast, are affected by long-range, management-control planning decisions and by strategic planning decisions. The strategic planning decisions that determine production and marketing capacity occur at relatively infrequent intervals, whereas the management-control decisions resulting in fixed costs occur frequently. The difference in decision level and frequency results in two kinds of fixed costs: committed fixed costs and planned fixed costs. Committed fixed costs result from decisions to acquire productive capacity. Long-term lease commitments and depreciation costs tend to remain constant for long periods of time, and these costs change when a decision is made to change capacity. Planned discretionary fixed costs result from decisions on staff levels, levels of advertising expenditure, research expenditure levels, and so on. Decisions affecting these costs are usually made annually, and the costs can be increased or decreased in the short run. The committed fixed costs originate in plant capacity decisions, and the planned fixed costs originate in decisions on the use of that capacity. Advertising expense is a planned fixed cost, incurred by a company to generate a sales volume that allows its plants to operate at efficient levels. Planned expenditures on sales personnel are made for the same reason. Staff levels in administrative functions are planned fixed costs, and the level of these costs is planned by considering the number of personnel required to perform the planned level of work. Consequently, managers can increase planned fixed costs whenever they decide to do so. The relevant level of fixed expense is different for different decisions. For example, shutdown fixed costs are usually lower than the operating fixed costs of a plant. The shutdown fixed cost level is relevant for planning decisions involving plant shutdowns, and the operating fixed costs are relevant for planning and control decisions related to utilising the plant efficiently. Short-range pricing decisions during periods of excess capacity frequently ignore fixed costs, but long-range pricing policy must consider expected future levels of fixed costs. Traceable fixed costs These are fixed costs associated with a certain product, segment, department, etc. Avoidable costs These are costs that will be eliminated if a particular product, service or corporate segment is discontinued. Often all or a majority of the traceable fixed costs are avoidable (short run/long run). Contribution margin concept Contribution margin is the excess of revenues over all variable costs related to a particular sales volume. A product line's contribution margin represents its net contribution to paying off fixed costs and providing profits. Following is the net income (loss) computed for Reed Products, Inc., using the contribution approach: Symbols 500 1,000 1,500   $ $ $ S Sales revenue ($45 per unit) 22,500 45,000 67,500 VC Less variable costs ($25 per unit) 12,500 25,000 37,500 CM Contribution margin 10,000 20,000 30,000 FC Less fixed costs 20,000 20,000 20,000 NI Net income (loss) ($10,000)   –   $10,000 (S-VC=CM)-FC=NI Contribution margin (CM) is what remains after variable costs are subtracted from total sales. So the break-even point (BE) can be expressed as the point at which contribution margin (CM) minus total fixed costs (FC) equals zero. That is, break-even occurs when CM - FC = 0. III Cost-Volume-Profit Analysis and Planning One of the analytical planning tools that helps managers to evaluate the profit impact of alternative combinations of prices and costs is cost-volume-profit analysis. No laborious and lengthy cost study is needed to identify total company fixed costs each time a company-wide cost-volume-profit analysis is wanted. Furthermore, managers of revenue-generating segments can easily evaluate the contribution impact of different combinations of prices, promotion costs and sales volume. Product managers, territory sales managers, and individual salesmen can also use cost-volume-profit analysis to find answers to many questions that require fast answers. Questions such as the following can be readily answered with cost-volume-profit analysis techniques. How many units must be sold to earn a specified amount of profit? To break even? How much will a revenue-generating segment contribute to overall profit? What will net profit be if a given sales volume is realised? What will happen to profits if prices are increased? Decreased? Will additional advertising be profitable? What is the profit impact of changes in company cost structure? The data, such as unit cost and fixed costs, used to answer these questions, are readily available in the product cost records and in the budgets. Although data collection for cost-volume-profit analysis is relatively easy in a direct cost system, the accountant who uses this tool must keep in mind that it does have some limitations. First of all, the analysis presents a highly simplified framework for looking at a complex process. For example, the accountant who prepares a cost-volume-profit analysis of a problem assumes that price and cost remain constant and that volume is the onny factor that can vary. Competitive reaction to changes in the volume of goods sold by the company and possible cost changes at different levels of output are ignored. Yet this simplicity, through its isolation of one factor for analysis, is also one of the strengths of cost-volume-profit analysis. It allows an accountant or manager to focus his attention on the profit impact of price and cost changes; he can then use his judgement to adjust the results of the analysis for possible changes in competitor activity or in cost relationships. The cost behaviour patterns used in cost-volume-profit analysis are linear. That is, the unit cost is assumed to be constant throughout the range of activity under consideration, and the fixed costs are assumed to be constant for the time period covered by the analysis. A linear total cost relationship also means that unit variable costs remain constant, and this assumption is valid for most cases in which production remains within the normal range of production activity. If production volume exceeds the normal range of production, unit costs may be higher than the unit cost used in the analysis. The same is true for activity levels below the normal range; unit costs may increase as output drops because of plant inefficiencies at low volume. The mix of products sold must also be considered. Cost-volume-profit analysis assumes that the mix of products sold by the company, or by one at its segment's, remains constant throughout the normal range of output. If the mix of products varies at different volume levels, the accountant must recognise that his analysis is faulty at the volumes at which the mix changes. Figure 1 provides one means of analysing cost-volume-profit relationships. The horizontal line at the $20 level represents fixed costs that remain constant for the entire range of activity under consideration. The dotted line that begins at the origin represents the total variable costs that increase in direct proportion to increases in output (i.e. variable cost per unit remains constant). The total cost line is simply the vertical summation of the variable and fixed cost lines. The revenue line is a 45° line drawn from the origin, and the point at which it crosses the total cost line represents the break-even point. The hatched area to the left of the break-even point includes the volume levels at which the revenue line is below total costs; at these volume levels the company operates at a loss. To the right of the break-even point the revenue line is above the cost line, and the company earns a profit at these volume levels. Another measure that can be related to the break-even chart is called the margin of safety. This measure indicates the dollar amount or percentage by which planned sales exceed the break-even point. For example, assume that $100 of sales is planned for the graph illustrated in Figure 1. The margin of safety is $50, the amount by which the planned sales of $100 exceed the break-even point of $50. This computation and the percentage margin of safety appear in Figure 2. Sales $100 Variable costs 60 Marginal income 40 Marginal income percentage 40% Fixed costs 20 Profit $20 Break-even point =             fixed costs             =  20  = $50 marginal income percentage .40 Margin of safety 1. Dollar amount   Budgeted sales $100 Break-even sales 50 Margin of safety $50 2. Percentage   dollar margin of safety  =  $50  = 50% budgeted sales $100
Margin of safety	50%

Figure 2

The margin of safety tells roughly how much planned sales may decline before losses are incurred. A low margin of safety usually indicates that management should attempt to increase sales volume, increase selling prices, or reduce costs.

Some accountants and managers criticise the break-even chart because of its emphasis on breaking even; these individuals want the analysis to emphasise profits instead of break-even points.

Accordingly, the so-called profit graph has been developed and the sample in Figure 3 reveals the elements of such a graph. In constructing the profit graph, a break-even line is drawn parallel to the horizontal axis and a profit line is drawn from a point on the vertical axis equal to the loss incurred of zero sales volume (fixed costs). The slope of the profit line is determined by the marginal income ratio (i.e. the higher the marginal income ratio, the steeper the slope, and vice versa). Thus the impact of changes in the marginal income ratio on the break-even point and on profits can be easily demonstrated with the profit graph by changing the slope of the profit line.

The area to the left of the break-even point in this graph represents the volume levels at which marginal income is less than fixed costs. To the right of the break-even point is the profit area, and the amount of profit is measured by the vertical distance between the break-even line and the profit line.

Figure 4 demonstrates the effect on the graph of high marginal income ratios. The slope of the profit line is steeper in Figure 4 than in Figure 3 because the percentage of marginal income is 60% in Figure 4 and only 40% in Figure 3: the steeper the profit line, the lower the break-even point, and vice versa.

The effect of fixed cost changes is illustrated in Figure 5. Here the fixed costs have increased 50% above the fixed costs that were present in Figure 3. The former profit line is indicated by the dashed line, and the new profit line is parallel to the former one; the distance between the two is equal to the increase in fixed costs. The new break-even point has increased from $50 to $75, an increase of 50%. This is the same percentage increase as the increase in fixed costs; in fact, the new break-even point will always change by the same percentage as the percentage change in fixed costs.

The break-even chart and the profit graph are most fruitfully employed as a means of presenting financial information in a graphical form. These graphs provide a readily understood picture of cost-volume-profit relationships for decision makers who are uncomfortable with numbers. Or, even if the decision makers working with numerical analyses, the graphical presentation of data furnishes a useful summary of the significant relationships.

For instance, if fixed costs are high, volume fluctuations usually result in wide fluctuations in profit. On the other hand, a business with low fixed costs generally experiences narrower swings in profit, as volume varies, than the firm with high fixed costs. Both these relationships can be concisely demonstrated by shifting the lines on the graph.

If a company with fixed costs wants to improve profit it can attempt to reduce fixed expenses or to increase sales volume. Reduction of committed fixed costs requires long-range planning, but planned fixed expenses can be reduced in the short run if declining profits make such a move necessary. However, it must be remembered that low fixed costs do not of themselves indicate a good profit structure, for some of the most important approaches to cost reduction require fixed cost increases to reduce variable costs or to increase revenue.

Cost-volume-profit analysis can be used for short-term planning decisions that affect revenue-generating segments as well as for those planning decisions that affect the entire company.

Summary

Break-even analysis is especially useful when considering volume and plant expansion.

Break-even analysis is basically an analytical technique for studying the relations between:

• fixed costs;
• variable costs; and
• profits.

If a firm's costs were all variable, the problem of break-even volume would never arise. By having some variable and some fixed costs, the firm must suffer losses up to a given volume.

If the firm is to avoid losses, its sales must cover all costs—those that vary directly with production and those that do not change as production levels change.

Break-even analysis is a device for determining the point at which sales will just cover total costs.

In break-even analysis, linear (straight line) relationships are generally assumed.

IV Cost Allocation—A Fascinating Task

Cost allocation, or assignment, is important to every part of management accounting, including the determination of unit costs for products and services. Some operating costs (direct costs) can be easily traced and assigned to products or services, but other costs (indirect costs) must be assigned by using some form of allocation method. The need for cost allocation goes beyond just identifying product of service costs. Every report a company's accountants prepare requires some form of cost allocation. Depreciation expense on a building, for example, is often allocated to the departments housed in that building. Depreciation expense is originally established by allocating an investment's total cost to various time periods. Even the president's salary is allocated to the various divisions of a company.

In accounting for operating costs, each cost must be assigned to products, services, departments or jobs before accounting reports can be prepared. Management accountants have three major tasks in preparing internal accounting documents:

1. They must find product or service unit costs.
2. They must work out cost budgets and cost controls for management.
3. They must prepare reports to aid and support management decisions.

Each task requires proper cost allocation procedures.

Terminology

Several terms are unique to the concept of cost allocation and thus are discussed further.

For instance, the forms 'cost allocation' and 'cost assignment' are often used interchangeably, although cost allocation is the more popular of the two. For our purposes cost allocation is the process of assigning a specific cost to a specific cost objective. Understanding such terms as cost centre, cost objective, direct cost, and indirect cost is also vital to the study of cost allocation.

A cost centre is any organisational segment or area of activity for which there is a reason to accumulate costs. Cost centres include the company as a whole, corporate divisions, specific operating plants, departments, and even specific machines or work areas. Once a cost centre has been selected, methods can be worked out to assign costs accurately to that cost centre. Most accounting reports of a cost centre can be prepared only after all the proper cost allocation procedures have been carried out.

A cost objective is the destination of an assigned cost. If the purpose of a certain cost analysis is to evaluate the operating performance of a division or department, the cost objective would be that department or division (cost centre). But if product costing is the reason for accumulating costs, a specific product, order, or an entire contract could be the cost objective. The important point is that cost classification and cost allocation results differ, depending on the cost objective being analysed.

A direct cost is any cost that can be conveniently and economically traced to a specific cost objective. Direct materials costs and direct labour costs are normally thought of as direct costs. However, costs considered direct will vary with individual cost objectives. In general, the number of costs classified as direct increases with the size of the cost objective. If the cost objective is a large division of a company, then electricity, maintenance, and special tooling costs of the division may be classified as direct costs.

An indirect cost is any cost that cannot be conveniently or economically traced and assigned to a specific cost objective. In an actual situation, any production cost not classified as a direct cost is an indirect cost.

Cost drivers

A cost driver is any activity that causes cost to be incurred. Different types of cost allocation procedure are used to assign costs to cost objectives on a causal or beneficial basis. We want to control costs, and to eliminate all unnecessary costs, one must know what caused the cost—what 'drives' the cost. Once the cost driver has been determined, the indirect costs it causes can either be:

1. treated as a legitimate product or service cost and allocated as a part of the conversion costs; or
2. eliminated by eliminating the need for the cost driver itself.

By focusing on cost drivers and the costs associated with each driver, management can get to the root of operating inefficiencies and reduce overall product costs . These cost reductions, price reductions possible, which often helps to increase sales and market share.

Monitoring and evaluating your products

• Existing products
  • make cost analysis once a year
  • price care
• New products
  • in design phase be careful in looking at cost; this phase is very important-many costs are determined;
  • prepare the capital investment evaluation, e.g. by the payback period method;
  • cash flows in different periods;
  • time value of money.

The problems in monitoring and evaluating your products vary a lot depending on how four main areas of activity-academic development, teaching, materials production and distribution, and administration-are organised. What is the organisational structure?

V Effectiveness and Efficiency

Distinctions between effectiveness and efficiency are frequently very helpful in discussing planning and controlling. Effectiveness is the accomplishment of a desired objective. Efficiency is an optimum relationship between input and output. As a colleague has pointed out, the killing of a housefly with a sledge hammer may be effective, but it is not efficient.

In short, two major questions about performance are:

1. Is the manager effective?
2. Is he efficient?

Question (a) often deals with attaining a revenue or volume target. Question (b) is an input-output 'engineering' question; that is, given a particular level of revenue or volume (output), did the manager control his inputs as he should have?

Effectiveness will thus depend upon the quality and quantity of the output. Efficiency will depend not only on these factors but also on the consumption of resources as an input to the system.

Comparisons of the average costs per student and per graduate in distance and conventional teaching systems usually make the assumption that the quality of the teaching and of the outputs (graduates) is the same. Clearly this is by no means always the case. Academic standards can vary enormously not just between conventional and distance systems but also between institutions of the same type.

VI Pricing Decisions

Pricing decisions are more of an art than a science. They stem from the ability to read the market place and are developed throuqh years of experience in dealing with customers and products in an industry. Pricing methods, whatever they are, will yield only decision data.Possible pricing policy objectives include:

• Maintaining and gaining market share
• Selling socially responsible prices
• Maintaining stated rate of return on investment
• Profits.

Social concerns, such as legal constraints and ethical considerations, also often affect pricing policies.

A good starting point for a manager is to develop a price based on the cost of producing a product or service because, if the prices do not cover costs, the company will fall in the long run (if not subsidised by someone).

Is there is excess capacity the minimum acceptable price for a special order must cover?

Which of the following costs are not relevant in a special order decision?

Which of the following costs are relevant to a make or buy decision?