Solutions to Assignments
MCO-05 Accounting for Managerial Decisions
Question 1
(a) Distinguish among variable, fixed and semi-variable costs. Why is this distinction important?
A cost that doesn’t change in a short term, irrespective of how the volume of production or the sales may change is the fixed cost. This cost is usually a constant cost for a basic operation of businesses or in other words it is a basic operating cost of a business which is crucial and can’t be avoided. The value of fixed cost determines the cost of the product and thus the profit and loss incurred by the business.
We can understand the fixed cost with the help of many examples. For example, if you are living in a rented place, you must have negotiated the cost of the place or the rent for a term that is on the rental agreement. This cost will not change as long as the rental agreement is valid. The rent is the fixed cost here. Similarly, another example is the property tax. Fixed costs are usually incurred at regular intervals (for example monthly rent) so sometimes we call them the period costs.
These are the costs that vary as the total cost to the organization when the output (number of items or services produced by the unit/business) varies. In other words, we say that a variable cost varies in exactly the same proportion as the output varies.
Therefore, as sales increase the variable costs will increase. For example, a variable cost for a bakery would be the cost of the flour. Similarly, in other businesses, the variable cost will be determined by the raw materials and the output of the business. For example, with massage therapy, oil may be used and there may be the cost of laundering one or two towels. This will constitute the variable cost.
Thus we see that the variable costs are those costs which vary directly in proportion to change in the volume of production/output. Hence we can say that the cost which changes in the same proportion as the units produced, is the variable cost. Some of the examples of variable cost are direct expenses, direct labour, direct material etc.
This cost is a cost which has elements of both fixed cost as well as the variable cost. So a cost that contains the components of both the fixed as well as the variable cost is said to be a semi-variable cost. In other words, we say that a cost that remains fixed up to a certain level of production and changes with the change in the volume of production beyond this level is a semi-variable cost. We can see the fixed part as a base level cost that is always incurred while as the variable portion of the cost is an additional cost which changes as we change the volume of production.
- Formula For Semi-Variable Costs
We can understand the concept of semi-variable cost with the help of some of the following examples. For example, a popular cellular network provides you with a certain service for a fixed nominal charge. Say, for example, you get 1 GB data per day if you subscribe to a monthly plan of ‘x’ rupees. So this ‘x’ rupees is a fixed cost which will not change unless you start to use more data than 1 GB. In case your data usage exceeds 1 GB, the same company will charge you extra money. This charge will be proportional to the amount of extra data that you use. Let this extra charge be ‘y’ rupees per unit of extra data used. Then the cost of the final bill will be:
Cost (C) = x + Ny;
where ‘N’ is the number of units that you consumed apart from the 1 GB that cost you x rupees.
The semi-variable costs can thus be separated into two terms. The fixed cost portion and the variable portion. We write:
Semi-variable cost = Fixed cost + variable cost
Variable cost per unit = change in cost/change in output
As a result, the semi-variable cost is also called the mixed cost and a semi-fixed cost.
- Why Variable Costs Are Important
The important point about variable costs is that they do not rise and fall based upon the company’s activities. In fact, they can rapidly increase, decrease or eliminate your profit margin and lead your company into a sudden profit or a steep loss. In addition, variable costs are important to consider when establishing prices. In short, knowing and managing variable costs is essential as you respond to changes in the marketplace and in your company’s growth patterns.
- How to Use Costs to Your Company’s Advantage
A solid understanding of your company’s fixed and variable costs is what allows us to identify the profitable price level for its products or services. You can use this knowledge to identify your break-even point, which is the number of units or dollars at which total revenues equal total costs.
You can also use this information to identify economies of scale, which is rooted in the fact that as output increases, fixed costs are spread over a larger number of output items (products or services).
Break-even analysis is an important assessment method that all business owners should perform.
There is a lot more we could discuss when it comes to fixed and variable costs. To dig in deeper, we encourage you to review the resources shared below, and stay tuned for future articles on our blog with examples and other details relating to costs.
(b) How cash flow statement is different from income statement? What are the additional benefits to different users of accounting information from cash flow statement?
- Difference of Definition of Income Statement and cash flow statement
The income statement is one of the major parts of the financial statement. It is used to represent the revenues, gains, expenses and losses from operating and non-operating activities of the company. When the total revenues (including gains) exceed the total expenses, then the result would be the net income while if the total expenses (including losses) exceed total revenues, then the result would be the net loss.
Here operating activities state the activities which are related to the day-to-day business of the company like manufacturing, purchasing, selling and distribution of goods and services. Non- operating activities means the activities which are related to purchase or sale of investments, assets, payment of dividend; taxes; interest and foreign exchange gains or losses.
The cash flow statement is also an important part of the financial statement of a company. It is used to represent the cash inflows and outflows during the year from operating, investing and financing activities. The statement reflects the position of cash and cash equivalents at the beginning and end of the accounting year. It shows the movement of cash during the period.
Here operating activities include the basic activities of the company like manufacturing, purchasing, selling and distribution of goods and services. Investing activities include the purchase and sale of investments and assets. Financing activities include the issue and redemption of shares or debentures and other financing activities related to the dividend, interest, etc.
The major difference between an income statement and cash flow statement is cash, i.e. the income statement is based on an accrual basis (due or received) while the cash flow statement is based on the actual receipt and payment of cash.
The income statement is classified into two main activities operating and non-operating, whereas the cash flow statement is divided into three activities operating, investing and financing.
The income statement is helpful in knowing the profitability of the company, but the cash flow statement is useful in knowing the liquidity and solvency of business which determines the present and future cash flows.
Incomes statement is based on accrual system of accounting, wherein incomes and expenses of a financial year are considered. On the other hand, cash flow statement is based on cash system of account, which only considers actual money inflows and outflows in a particular financial year.
The income statement by to taking into account various records and ledger accounts. As against this, cash flow statement is prepared considering the income statement and balance sheet.
Depreciation is considered in the income statement, but the same is excluded from cash flow statement because it is a non-cash item.
The preparation of the income statement and the cash flow statement is mandatory for all business organisations. The two statements are used by the readers (stakeholders, i.e. creditors, investors, suppliers, competitors, employees, etc.) of financial statement to know about the company’s performance, stability and solvency position. These statements are also used for the purpose of internal and tax audit.
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