Cost Classification

This blog is dedicated to C1 students of Cima and for all those who want to refresh their sporadic memories of cost classification and its behavior.

So let’s talk about cost classification for product behavior. As later on knowledge of cost behavior is tested in cima exams and in practical life one gets to make better and effective decisions.

Cost classification for Product behavior:

In the management focus nature of expense is important whether a cost is variable or fixed. Hence decision are taken based on the classification

There are three major types of cost

1.     Fixed cost

2.     Variable cost

3.     Semi variable/fixed cost

·        Fixed cost:

It the one that remains constant and it doesn’t change in total and it has nothing to do with the change in volume. However in case of average fixed cost it drops with the level of activity

Example:

Rent in a factory remains the same despite the number of units produced in it. If we analyze this in the average fixed cost/unit then with the larger number of units produced we are in a better position to exploit the rental premises.

 ·        Variable cost

Variable cost is the one that changes in total in relation to the change in volume. It includes direct material, direct labor, direct expense and variable overheads. Variable cost in average remains constant with the number of units produced.

Example:

In any pizza joint, the higher the number of pizza’s produced will result in higher total variable cost due to the increase in the material ( pizza ingredients) ,labor ( cook) variable overheads( increase in customer care staff, increase in ordering cost of raw materials)

·        Semi variable/fixed cost

Its part variable and part fixed.

Example:

Electricity bills where ascertain charge (line rent) is to be paid irrespective of the number of calls made. This is fixed cost

And the cost per calls made is known as the variable cost. So the total bill contains

Total bill= fixed cost + variable cost

Cost classification for assigning cost to cost objects

   Costs are assigned to objects for the purpose of profitability study, pricing and cost control so they are thus classified as direct or indirect cost.

Direct cost:

It’s the one that can be easily traced to its cost object.

Example:

The cost of flour, yeast or chicken will be a direct cost for the Chicken pizza as it is the constituent of the product.

Indirect cost:

It’s the one that can’t be traced easily for the particular cost object or in other words does not play active part in the product and is just a compliment to the product.

Example:

The cost of waiter in the Pizza Joint will be an indirect cost as he/she is not fully committed to serve the customers just ordering pizza but they gladly serve customers who orders pasta etc other  dishes available

Common cost:

It’s a cost that is common to the number of cost objects but can’t be traced individually. It’s a particular type of indirect cost.

How to utilize the T4 20 minutes

The 20 minutes reading time in Cima exams are very important and often the deciding factor between success and failure. However when it comes to T4 exam it becomes highly important due to its time constrained nature.

As in T4 exam the game is all about prioritization, lay out and calculation. So its recommended that in these 20 min students must not to forget to work upon the techniques.

So here are my tips to do as soon as you get hold of T4 question paper

• Immediately look out for priorities. The criteria for priorities is impact and urgency. For example if an issue has impact (low market share of a product if the decision is not undertaken in short time) then it will top the list. And it will be higher than the high urgency issue (where in two days you have to address the report to the board – of a small scale opportunity with low revenue/profit etc).
• After setting out the priorities, points regarding the discussion in the report should be written but care should be taken to not to waffle.
• Calculation is the second most important thing to be done in the 20 minutes after setting the priorities as not only will it get you the application marks of 15 but also will set out the direction of the report. Thus a candidate can verify/ reassess their priorities further. However its advisable to not to be incessant over it.
• And if the time remains then 5 minutes should be spent on introduction lay out, conclusion and drawing charts for appendix, SWOT /PESTEL.

This can not be done unless practiced a number of times with the available mocks or previous past papers with preferably an ashranti time calculator.

MM theory and Traditional Theory -- Financial strategy

Financial Strategy is one of the most tricky paper of strategic level. It disguise as a easy calculation cum theory paper that can be considered a piece of cake at first sight. However, the examination itself is where the f3 jinne comes out of the bottle. Time constraint, calculation – number crunch and the answer to be discussed in a most precise way to please the examiner.  Sweating, breathing heavily ? Well don’t need to J

Today im going to write about the most assessed topic of MM and traditional theory. Its one of the examiner’s favorite topic together with the CAPM that I will discuss later in another blog.

Traditional theory is where the cost of equity increases as the cost of debt increases and that increase the WACC ultimately after a certain point known as the * optimum point*  where the  WACC is the lowest . At optimum point wacc is the lowest and value of the firm is maximum ( due to the inversely proportional relationship between the two) . However when the debt is taken too much with high cost of debt it will increase financial risk and Ke. Automatically accelerating Wacc thereby minimizing the value of firm.

MM theory has two assumptions one is with tax and the other is without tax . It has the assumption that a firm that is identical in all respect apart from capital structure should have the same value.

MM without tax  has Wacc remaining as a constant. The cost of debt remains constant until it increases. It can be explained that cost of debt is taken as Rf ( risk free rate) hence its constant. However the increase in gearing will increase the risk perceived by debt holders ( kd) so Kd increases after a certain point. There is consequently  a fall in Ke ( cost of equity) as more investors come  to get high return on equity.

MM with tax on the other hand is where the tax element in the cost of debt is taken into account with Kd( 1-t) being tax deductible. MM with tax assumes that debt lowers the Wacc due to its lower issue cost and with tax saved on it.  The Ke however increases due to the high financial risk with high debt taken.

This is what MM and traditional model theory is all about and in F3 candidates are often asked to explain it, differentiate between it and numerical questions that comes are also based on it. 

PS: 

This question#04 on MM is self fullfilling to understand the concept further. It is also advised that the diagram is to be practiced for further understanding and ease for remembering purpose

https://secure.cimaglobal.com/Documents/Student%20docs/2010%20syllabus%20docs/F3/F3%20November%202010%20Answers.pdf