Introduction
Budgeting process requires valuable consideration to various important factors. Of them, cost profit/benefit analysis is a vital step, as it correlates expenditure of a financial intervention with its intended profits and gives an idea of the net loss or profit of implementing that action. However, running such analysis needs careful consideration of related aspects, mainly costs, income and surplus (C1apperton & Phillngamells, 2005, p. 43). In addition, it may be necessary to consider some other factors when there is excess change in the level of activity (C1apperton & Phillngamells, 2005, p. 43). Hence, it is essential to focus on the way in which each of the above elements is observed in detail.
Costs
The total costs of an activity can be classified into direct and indirect costs, and fixed and variable costs (C1apperton & Phillngamells, 2005, pp.32-34). Such classification makes it easier to manage finances by prioritizing the needs.
Direct and Indirect Costs
The expenditure that is applicable directly to a specific product or activity comes under direct costs (C1apperton & Phillngamells, 2005, p. 32). Labour and material costs are the common identifiable costs. On the other hand, indirect or overhead costs cannot be directly related to an activity (C1apperton & Phillngamells, 2005, p. 33). For example, costs such as those of maintenance, cleaning and training are difficult to include under direct costs (C1apperton & Phillngamells, 2005). As a result, direct costs are comparatively easier to calculate and allocate. However, factors such as the level of an organization’s information system influence the division of costs into either direct or indirect ones (C1apperton & Phillngamells, 2005, p. 34).
Fixed and Variable Costs
Having a comprehensive idea on fixed and variable costs is very essential in cost analysis; as they are often influence the intended outcomes.
Fixed costs do not often change with the level of activity (C1apperton & Phillngamells, 2005, p. 34). Standard costs such as employee salaries and equipment costs are fixed to certain extent, after which a change in fixed costs in the form of stepped costs may arise (C1apperton & Phillngamells, 2005, p. 35). On the other hand, variable costs change depending on the level of activity. For example, expenditure on drugs in a healthcare setting is considered as variable, as it varies with the number of patients (C1apperton & Phillngamells, 2005, p. 34).
As it is not always possible to observe cost behavior in a precise manner, different kinds of cost estimation are used, such as absorption costing and marginal costing. Absorption costing includes total costs related to an activity with no change in fixed costs (C1apperton & Phillngamells, 2005, p. 36). However, the element of variable costs influences absorption costs in line with the level of activity. This method requires the estimation of total costs of an activity along with the number of units of activity to find out cost per unit activity (C1apperton & Phillngamells, 2005, p. 36).
Marginal costing, in contrast, includes only additional costs that occur as a result of change in an activity (C1apperton & Phillngamells, 2005, p. 39). As fixed costs do not change without a major change in an activity, marginal costing makes it easier to identify reducible costs clearly, thereby increasing the scope for profit generation (C1apperton & Phillngamells, 2005, p. 39). However, marginal costs may not be helpful for longer periods due to the necessity to consider overall costs frequently to avoid any loss from ignoring actual costs (C1apperton & Phillngamells, 2005, p. 39).
Cross-Charging and Internal Recharging
Cross-charges are costs of services departments or services of an organization, where as internal recharging is the estimation of charges for services to internal customers of an organization (C1apperton & Phillngamells, 2005, p. 44&46). Though they are difficult to calculate, an accurate estimation of total costs requires including these charges also.
Income
Priority based allocation of funds to maintain balance between income generated and money spent is a vital aspect of budgeting process (C1apperton & Phillngamells, 2005, p. 51). The best way to avoid losses is to spend amount in accordance with the proportionate income generation (C1apperton & Phillngamells, 2005, p. 51).
Surplus or Loss
It largely depends on proper estimation of all related costs and adequate implementation of effective plan of action. Factors such as unexpected change in situations such as price rise may lead to a difference between budgeted and actual costs. Moreover, reasons like incompetence, errors and/or negligence may lead to losses (C1apperton & Phillngamells, 2005, p. 50). Therefore, a detailed analysis of financial requirements and consequences of an activity should not be ignored.
Example Case Study
Consider the case of a production manager who wants to buy a new machine worth £1000. It is assumed that this machine can replace two workers who are currently doing that particular work and is expected to show 50 percent more efficiency. The machine is supposed to last for 5years.
Fixed costs for the machine: Cost of buying
Electricity charge
Possible tax on it
Interest rate if it is purchased on loan
Variable costs: Maintenance and servicing costs.
Firstly, the cost of the machine per month is calculated by dividing the total cost of the machine after adding all expenses with 12 x 5. This amount is compared to the cumulative monthly salary of the two employees. Moreover, this is added to the value obtained by dividing 50 percent more work with the number of work hours per month to calculate additional months and expenses with the two employees. This value is compared with the cost of acquiring the new machine to look for the resultant effect. However, variable costs do play a role in influencing the overall expenses of the machine, as more work may result in a rise in maintenance charges.
Conclusion
All in all, cost profit analysis is an essential element in financial decision making process to correctly assess the profitability of a product or service.
Reference
C1apperton, A. & Phillngamells. (2005). Working with Budgets. Crown.