1.2 Rationales for costing and understanding costs

Question 1

If we understand and calculate costs we can use this info in a number of ways

Answer 1

• Determining the cost to manufacture a product or provide a service, which can be used to record costs in the FS
• The cost per unit can be used to value inventory in SOFP
• Cost info can inform decisions on products and services, such as selling price
• Knowing the profit (or contribution) can help determine the products and services we should supply and in what qty
• The cost can act as a benchmark for future performance, differences from expected (standard) cost can be calculated (variances) and evaluated

Question 2

Cost unit definition…

Answer 2

• A unit of product or service in relation to which costs are ascertained (ie anything for which it is possible to ascertain the cost)
• The cost unit selected will depend on factors, such as amount of info available and the purpose for which it will be used
• A cost unit can be anything which is measurable and useful for cost control purposes
• Not all cost units will be for tangible items, ie cost per chargeable hour

Question 3

Cost centre definition…

Answer 3

• Is a production or service location, a function, an activity or an item of equipment for which costs are accumulated
• It is a type of responsibility centre and it is used as a collecting place for costs
• The costs that are attributed to the cost centre are determined for the period and the this total is related to the cost units which have passed through the cost centre

Question 4

Cost object definition

Answer 4

A product, service, centre, activity, customer or distrubtion channel in relation to which costs are ascertained

Question 5

There are four main ways to classify costs:

Answer 5

• By behaviour
• By element
• By function
• By nature

Question 6

Classification of costs according to their behaviour

Answer 6

• Before calculating costs we need to understand how different costs behave
• This is essential in areas of planning, decision making and control, particularly for short term budgeting
• Cost behavior refers to the way in which costs are affected by fluctuations in level of activity

Question 7

Costs are classified by three types of behaviour

Answer 7

• Fixed costs - costs which don’t change in total as the activity level changes (rent, rates, insurance & executive salaries)
• Variable costs - costs which change in total in direct proportion to changes in the activity level (direct material & labour and variable overheads)
• Semi variable costs - costs which have both fixed and variable elements (gas & electricity)

Question 8

The high-low method

Answer 8

• Can be used to analyse semi variable costs into their fixed and variable elements
• This method picks out the highest and lowest activity levels from the available data and investigates the change in cost which occur between them, using following process:
  1. Determine the variable cost per unit
  2. Find the fixed cost
  3. Calculate the expected cost

Question 9

Classification of costs according to their element

Answer 9

• Material - includes costs of obtaining and receiving them
• Labour - all related employment costs
• Expense costs - regularly incurred costs of running the business

Question 10

Classification of costs by function

Answer 10

• Production costs - relate to manufacture of a product. Ie: direct materials, labour & expenses and production overheads (SOPL - COS)
• Non production costs - not directly involved but required to support the overall activity of the org. Ie: admin costs, selling & distribution costs and finance costs

Question 11

Classification of costs according to their nature

Answer 11

• Direct costs - can be directly traced to the cost object that we are trying to cost (total of all direct costs is Prime Cost)
• Indirect costs - cannot be directly traced to a single cost object, includes:
  • Production overheads (rent, rates, insurance)
  • Non-production overheads (admin costs, selling & distribution costs and finance costs)

Question 12

The cost transformation model - Changes to help businesses achieve and maintain their cost-competitiveness:

Answer 12

• Creating a cost conscious culture (aim to be cost leader, everyone in org should be involved, technology plays a role)
• Understanding cost drivers (critical evaluation of current systems, plan to reduce drivers of costs)
• Managing risks of a cost conscious culture (consider what might get in the way of cost transformation objectives, ie avoiding reduced quality and customer satisfaction)
• Connecting products with profitability (understand what drives costs for each product and accurate allocation of shared costs)
• Maximising value from new products (potential profitability should be assessed before production begins, and should be flexible so that can satisfy many customer segments)
• Consider the environmental impact of products (negative impacts can add costs and damage reputation and sales)