# Financial Modeling

Essay by huici91University, Bachelor'sB, April 2014

University of Sunderland Bachelor of Arts (Hons) Business and Management

Introduction

Cost model assignment is allocation of consumed resources activities or objects. The purpose of using cost assignment model is to help an organization identify the source and expenditure involved in an operation and the destination of the costs and overhead. This assignment is focus on analysis of cost assignment model. I will start from background of company, study case and two scenarios. In literature review, it will going to discuss about cost, cost assignment model, strengths and weakness of cost assignment model. It also will explain sensitivity analysis of two scenarios. This assignment will be end with conclusion. Calculation of number and formula will be shown at appendix.

2.0 Background of Company

Merry Land's Chocolate is a factory that process chocolate and sell it out to all world. Merry Land's Chocolate Factory currently offers 4 flavors of chocolates through catalog and gourmet.

The company's major cost is that of the direct labour and direct materials; however, the processes of making chocolate and consume a substantial amount of manufacturing overhead cost. The company uses relatively little machine hour.

Some of Merry Land's Chocolate are very popular and sell in large volumes, but a few of the newer types sell in very low volumes. Merry Land's prices its chocolate at cost (including overhead) and every flavor of chocolate will sell with the same price that is ÃÂ£50.

All product are similar, usually they are produced in production runs of 200 units and sold in batches of 100 units.

Currently, production overheads are absorbed using a factory-wide machine hour rate. Total production overheads for period 1 are ÃÂ£ 360,000.Calculation refer to appendix 1 and 2.

 Product Dark Chocolate White Chocolate Hazelnut Chocolate MilkChocolate Total Cost Per Unit ÃÂ£ ÃÂ£ ÃÂ£ ÃÂ£ Sales Mix 20 25 20 35 100 Production Units 800 1000 800 1400 4000 Direct Material 45 35 30 25 Direct Labour 25 35 35 25 Machine Hour Per Unit 5 4 4 3

The overheads have been further analyzed as follows:

 Costs ÃÂ£ Cost Driver Set Up Cost 5250 Number of Production Runs Stores Receiving 3600 Requisitions Raised Inspection/Quality Control 2100 Number of Production Runs Materials Handling & Dispatch 4620 Order Executed

2.1 Scenario 1

Merry Land's Chocolate factory have make customer survey to make preparation the quality that have to produce for Valentine day for 4 flavor of chocolate. According to the result of survey, customer first choice of chocolate is milk chocolate, follow by white chocolate, hazelnut chocolate and dark chocolate. Therefore, Merry Land's Chocolate has made decide as table below.

 Product Dark Chocolate White Chocolate Hazelnut Chocolate MilkChocolate Total Cost Per Unit ÃÂ£ ÃÂ£ ÃÂ£ ÃÂ£ Actual Sales Mix 20 25 20 35 100 Actual Production Units 800 1000 800 1400 4000 New Sales Mix 15 25 15 45 100 New Production Units 600 1000 600 1800

Merry Land's Chocolate factory decided to increase sales mix of milk chocolate for 10% that is 45%. Besides that, dark chocolate and hazelnut chocolate will decrease from 800 units to 600 units and white chocolate will still remain the same quantity as actual. Calculation refer to appendix 3 and 4.

2.2 Scenario 2

After auditor make calculation on Merry Land's Chocolate factory, Manager realize that their factory still left 40% of capacity. Merry Land's Chocolate factory decided to fully using the capacity that left to produce more quantity of products, so that, Merry Land's Chocolate factory will increase 1600 units.

 Product Dark Chocolate White Chocolate Hazelnut Chocolate MilkChocolate Total Cost Per Unit ÃÂ£ ÃÂ£ ÃÂ£ ÃÂ£ Actual Sales Mix 20 25 20 35 100 Actual Production Units 800 1000 800 1400 4000 New Sales Mix 20 25 20 35 100 New Production Units 1120 1400 1120 1960 5600

Merry Land's Chocolate factory decided to maintain sales mix of all products and will increasing production units from 4000units to 5600units. Therefore dark chocolate and hazelnut chocolate will increase from 800 units to 1120 units, white chocolate will increase 400 units more from actual amount (1000units) and milk chocolate will increase from 1400 units until 1960 units. Calculation refer to appendix 5 and 6.

3.0 Literature Review

3.1 Definition of Cost

Amount must be paid or give up in order to get something. In business, the cost is usually a monetary valuation of effort, materials, resources and time consumption and utility, risk occurs, the opportunity to give up in the production and delivery of the goods or services. All costs are costs, but not all costs (such as occur in the acquisition of a profitable assets). We need to know the cost to understand the definition of the elements of accounting data is essential to form a cost model to identify the location of an organization.(Business dictionary.com, 2014)

3.2 Definition of Cost Assignment

Cost distribution involves the cost of an account of the account or responsible for the cost. For example, a purchase order is the cost of purchasing assigned to different objects. Cost allocation is by assigning path and cost drivers. Homework path identification source account and target accounts. Cost driver identification measures or, on the basis of basic principle, need to do the work, that is, from the cost of the purchase order whether need evenly allocated to each cost object, based on some defined percentage, or based on some criteria, such as the number of purchase orders each cost object. Define cost drivers and distribution path to make proper task and all kinds of cost accounting organization. Cost assignment model based on theory of Activity based costing. (Venture line,2014)

3.3 Strengths and Weakness of Cost Allocation Model

3.3.1 Strengths of Cost Allocation Model

There are few causes for cost allocation is very important. An accurate distribution costs in an organization, so that it can know exactly what kind of cost in the operation of the organization in a specific area. This is not only the important information to consider when creating an operating budget, but also key in calculation of tax that must be paid to the local, state and federal tax authorities. In many countries around the world, the way of cost allocation will affect how many organizations pay tax, make it any government must abide by the laws and regulations and the allocation of costs within the organization. (Wisegeek, 2014)

Another advantage of cost allocation is simple to track expenses internal planning purposes. Some costs are the indirect costs and benefits of multiple regions, there is still a need to allocate the direct costs are reasonable and accurate way. Even if the incremental cost, which means that they stretch out several accounting periods, ensure proper allocation can make a big difference to the cost of each unit within the business or other entity in its share of the work of the overall budget. Obviously, a unit will exceed the allocated budget, can take steps to cut unnecessary service cost, at the same time to find a way to adjust the overall budget allows to continue to support the basic functions. (Wisegeek, 2014)

All types and sizes of organizations to participate in the task of cost allocation. Companies use this strategy as a planning tool and stay within budget. Non-profit entities using the tool,

to provide the services as much as possible, its members, at the same time, the most effective use of its resources. Even families can make use of the concept of cost allocation in the planning of operating budget. The correct recognition and distribution costs, the allocation method can help provide financial planning focus and structure, is extremely difficult.(Wisegeek, 2014)

3.3.2 Weakness of Cost Allocation

1) The cost of distribution is not controlled

Tracking organizational units and individual income and cost of the manager is needed by responsibility accounting and the related responsibility to generate revenue and cost control and the cost allocation is consistent with responsibility accounting. However, only a few managers control the cost. (Jiambalvo, 2001)

2) Arbitrary Allocation

As might be expected, cost allocation fairness is heating management discussion. Unfortunately, the cost of distribution is essentially arbitrary. It is impossible to determine the "true" or "right" distribution. ( Jiambalvo, 2001)

3) Allocation of fixed costs that make the fixed costs appear to be vriable costs

The cost allocation may be fixed costs in a variable. When this happens, on the basis of the combination of fixed cost or unit is another potential problem. Examples include fixed general administrative wage and management cost. These charges should be at production in a one-time allocation. Because as production increases, more and more fixed costs added that despite the fact that, by definition, fixed costs are static, not change to changes in activity level. ( Jiambalvo, 2001)

4) Allocation of manufacturing overhead to products using too few overhead cost pools

Use only one or two cost allocation cost pool can lead to serious distortion product cost. Although easy to implement and use, this method is not accurate. Use only one or two cost allocation cost pool can lead to serious distortion product cost. Although easy to implement and use, this method is not accurate. ( Jiambalvo, 2001)

5) Use of only volume-related allocation bases

Some manufacturers will produce the products to use only measures of production such as labor hours, machine hours. Not all overhead costs are related to volume is the problem. ( Jiambalvo, 2001)

3.4 Meaning of Activity-Based Costing (ABC)

Activity-based costing (ABC) is a cost allocation to cost calculation method of object, such as product or customer, activity-based cost to object. An activity is the consumption of resources. Activities include tasks such as ordering materials, processing purchase orders, set up the machine. Company for the cost of resources, such as factories, machinery, and workers. The movements of the resource consumption, and producing the product or service activity based costing to the customer. Goal is to allocate the cost approach reflects the consumption of each activity execution resources quantity production of specific products. ( Davis and Davis, 2012)

To Produce

That are consumed by

Aquire

Cost Resources Activities Product

Figure 1: Illustrates the basic concepts of overhead usage in an activity-based costing

The main purpose of any cost accounting system is to determine the true costs of a product. If a company has only one product, it is the true costs of the same, as shown in the profit and loss account. The problem is complicated processing more than one product. (BamberÃ¯Â¼ÂBrown and Harrison, 2008)

There are various accounting systems which have been developed over time. Product Cost would be different under different systems. Under "Traditional Cost Accounting" (TCA), only Manufacturing Costs are considered as Product Costs. On the other hand, "Activity Based Costing" (ABC) would add up Manufacturing costs and Selling, General & Administrative Expenses (SG&A) for the same purpose. Economic Value Added (EVA) only considers Cost of Funds provided by banks, bond-holders and owners. As such, ABC & EVA combined would embrace all costs. (Bamber, Brown and Harrison, 2008)

4.0 Sensitivity Analysis of the Merry Land's Chocolate Factory

Given the previous uncertainties that were mentioned, another preparation to help predict the outcome of a decision if a situation changes can through the use of the sensitivity analysis; thus allowing the Merry Land's Chocolate factory to account for the financial changes that may affect the profit margins, revenue and overhead.

A technique used to determine how different an independent variable values will impact a particular dependent variable in a given set of assumptions. The technology used in a specific range, will depend on one or more input variables, such as the impact of the change of interest rate, this will be the price of the bond. (Investopedia, 2014)

To see how the uncertainty of the market demand will affect the Merry Land's Chocolate factory the cost assignment model has been altered to illustrate this. By changing the sales mix of the production unit (which will be seasonal factor) by increasing sales mix of milk chocolate, decrease sales mix of dark chocolate and hazelnut chocolate which not popular at Valentine day. The profit that will be get will decrease, see appendix 2.

4.1 Sensitivity Analysis of Scenario 1

 Actual Product Dark Chocolate White Chocolate Hazelnut Chocolate Milk Chocolate Cost Per Unit ÃÂ£ ÃÂ£ ÃÂ£ ÃÂ£ Sales Mix 20 25 20 35 Production Units 800 1000 800 1400 Selling Price Per Unit 50 50 50 50 Cost Per Unit 38 33 33 28 Profit/Loss 12 17 17 22 68 After Sales Mix change Product Dark Chocolate White Chocolate Hazelnut Chocolate Milk Chocolate Cost Per Unit ÃÂ£ ÃÂ£ ÃÂ£ ÃÂ£ Sales Mix 20 25 20 35 Production Units 800 1000 800 1400 Selling Price Per Unit 50 50 50 50 Cost Per Unit 38 33 34 28 Profit/Loss 12 17 16 22 67

After doing market survey, the most popular product is milk chocolate. So that factory make a decision to produce more milk chocolate and decrease other flavor of chocolate that not popular during Valentine day. Due to changes of sales mix, other product still remain the same cost per unit except hazelnut chocolate that make manufacturing cost per unit increase from ÃÂ£33 to ÃÂ£34. It will affect profit per unit decrease and also will affect overall of the total profit of a company.

4.2 Sensitivity Analysis of Scenario 2

Nevertheless, Merry Land's Chocolate factory still left 40% of capacity. Therefore, factory decided to increase production of all products. It will show in appendix 3.

 Actual Product Dark Chocolate White Chocolate Hazelnut Chocolate Milk Chocolate ÃÂ£ ÃÂ£ ÃÂ£ ÃÂ£ Production Unit 800 1000 800 1400 Selling Price Per Unit 50 50 50 50 Cost Per Unit 38 33 33 28 Profit/Loss 12 17 17 22 68 Increase 40 % of production unit Product Dark Chocolate White Chocolate Hazelnut Chocolate Milk Chocolate ÃÂ£ ÃÂ£ ÃÂ£ ÃÂ£ Production Unit 1120 1400 1120 1960 Selling Price Per Unit 50 50 50 50 Cost Per Unit 36 31 32 26 Profit/Loss 14 19 18 24 75

According to the figure above, there were happened increasing of 40 % for every product. Therefore, cost per unit for every product decrease ÃÂ£2.It mean that increasing production unit, it will affect cost per unit decrease and increase profit of the product. In the result, total profit per unit for four products increasing from ÃÂ£ 68 to ÃÂ£75 and it different ÃÂ£ 6.

5.0 Conclusion

Overall of the cost assignment model has shown how the changes of production units during different cases will affect the result of cost assignment model. However, it still can easy be calculate the wrong results through the use of allocation, despite this is makes organizations more aware to understand the operational cost associated with each department. As the cost assignment model give an in depth analysis all areas it allows Merry Land's Chocolate factory visualize how the business will respond if circumstance were change.

UGB317 Financial Modeling