Cost Accounting: Break-Even, Relevant Costs, and Allocation
Break-Even Point and Operating Leverage
The break-even point is the level of operating activity at which revenues cover all fixed and variable costs, resulting in zero profit. It’s the point where total revenues equal total costs. Until break-even sales are reached, the product, service, event, or business segment operates at a loss. To determine the break-even point, the equation for total revenues is set equal to the equation for total costs and then solved for the break-even unit sales volume.
A cost-volume-profit graph shows the relationship between total revenues and total costs. Its usefulness comes from highlighting the break-even point and showing revenue, cost, and profit relationships over a range of activity.
Operating leverage describes the effects that fixed costs have on changes in operating income as changes occur in units sold. Organizations with a high proportion of fixed costs have high operating leverage.
Relevant Costs and Revenues
The relevant financial inputs for decision-making are future cash flows that will differ between the various alternatives being considered. Therefore, only relevant (incremental/differential) cash flows should be considered.
Relevant costs and revenues are required for special studies such as:
- Special selling price decisions.
- Product-mix decisions when capacity constraints exist.
- Decisions on replacement of equipment.
- Outsourcing (Make or buy) decisions.
- Discontinuation decisions.
Decisions should not be based only on items that can be expressed in quantitative terms; qualitative factors must also be considered.
Special pricing decisions are typically one-time-only orders and/or orders below the prevailing market price.
Cost Allocation
Certain activities need to be provided in order to make the cost allocation process possible. These activities include:
- Cost determination
- Cost classification
- The choice of cost allocation accounting method application.
The basic purpose of the cost allocation process is to determine the cost of a product or service.
Besides that basic purpose, cost allocation is performed in order to enable the following purposes:
- To provide information for economic decisions
- To motivate managers and employees
- To justify costs or compute reimbursement
- To measure income and assets for reporting to external parties.
For the purpose of cost allocation, the relevant cost classifications are: traceability to product, management function, and accounting treatment. In order to provide the cost allocation process, all costs of a particular accounting period must be divided into two main categories: (i) product costs or (ii) period costs.
Product costs are capitalized, first as work in progress and then, when products are fully completed, as finished products.
Basically, the cost allocation process is carried out through the following phases:
- The assignment of direct costs to cost objects
- The allocation of indirect costs from a support department to an operating division (manufacturing)
- The allocation of indirect costs from an operating division to products (or services) which are defined as cost objects
- The determination of the cost of a product (by adding the allocated indirect costs to previously assigned direct costs of a particular product).
When deciding which accounting method to apply, the choice of accounting method includes:
- The choice of costs which need to be allocated
- The choice of cost pools
- The choice of appropriate cost allocation bases
- The calculation of cost allocation rate(s).
On the basis of the cost allocation base, cost allocation rates are calculated.
In the cost allocation process, two kinds of accounting methods are needed to be applied:
- Accounting methods for allocating indirect costs of a support department to operating divisions
- Accounting methods for allocating indirect costs from operating divisions to cost objects.
Indirect production costs can be caused by both types of departments – operating and support departments.
Indirect costs of support departments need to be allocated to operating departments and, after that, to products as cost objects.
- Direct method: Allocates support department costs to operating departments only.
- Step-down (sequential allocation) method: Allocates support department costs to other support departments and to operating departments.
- Reciprocal allocation method: Allocates costs by services provided among all support departments.
The direct allocation method is the most widely used method of allocating support department costs. This method allocates the costs of the support department directly to the operating departments. The basic advantage of this method is its simplicity to apply. This method doesn’t require the prediction of the usage of support department services by other support departments.
A main disadvantage of the direct method is its failure to recognize reciprocal services provided among support departments. Because of that disadvantage, direct methods are not considered an accurate and objective method of cost allocation.
The reciprocal allocation method is enforced through the following three steps:
- Expressing support department costs and support departments’ reciprocal relationships in the form of linear equations
- Solving the set of linear equations to obtain the complete reciprocated costs of each support department
- Allocating the complete reciprocated costs of each support department to all other departments (both support department and operating departments) on the basis of the usage percentages (based on total units of service provided to all departments).
Costing Systems
There are 3 basic accounting methods used in manufacturing companies in order to determine the cost of a particular product:
- Job order costing
- Process costing
- Activity based costing
These accounting methods are also considered costing systems whose main purpose is to determine the cost of a product. The first two costing systems are known as traditional costing systems. While the appliance of traditional costing systems depends on the type of a manufacturing process, activity based costing systems can be applied regardless of the type of manufacturing process.
Traditional Costing Systems
The basic distinction between job costing and process costing system is in the determination of the cost object. In job costing, the cost object is a job which consists of a unit or multiple units of distinct products or services. In process costing, cost objects are masses of identical or similar units of a product or service.
Therefore, job costing can be applied in manufacturing which is initiated by a customer’s order, while process costing can be used in mass production which is continually performing and is not initiated by a customer’s order.
These costs are directly assigned to particular products or services which cause their appearance.
Indirect manufacturing costs are usually assigned to products or services using the following cost allocation bases:
- Direct labor hours
- Machine hours
- Direct material costs
- Total direct costs
- Quantity of production