28 - Costs

Question 0

What are production costs?

Answer 0

These are financial costs incurred in the making of a product or providing a service

The main categories are:

• Direct costs
• Indirect costs
• Fixed costs
• Variable costs
• Marginal costs

Question 1

What are the uses of cost data?

Answer 1

• Costs are a key factor in the profit equation and in making important decisions. Profits or losses cannot be be calculated without accurate cost data also
  e. g. Deciding where to locate
• Cost data are of great importance to a firms departments. Marketing managers would use this information to determine their pricing strategies
• Cost records can be used to compare a firms current performance to their past performances and asses the businesses position and assist managers in decision making to help improve business performance
• Past cost data can also be used to set future budgets. This allows a firm to predict future expenditures and prepare for them
• The comparison of cost data allows a business to make decisions about resource use and management

Question 2

What are direct costs?

Answer 2

These are costs that can be clearly identified with each unit of production

Question 3

What are indirect costs?

Answer 3

These are costs that cannot be identified with a unit of production or allocated accurately to a cost centre

-These are also referred to as overheads, for example:
An indirect cost to a farm is the purchase of a Tractor
An indirect cost to a super market is the promotional expenditure
An indirect cost to a garage is rent

Question 4

What are the 3 main types of costs?

Answer 4

Costs can be classified as follows
-Fixed costs -these are costs that do not vary with output in the short run e.g rent

-Variable costs -these are costs that vary with output
These include direct costs and semi variable costs

-Marginal costs -the extra cost of producing one or more units of output
Marginal costs can also be defined as the change in total costs resulting from a one unit change in output

Question 5

What are semi variable costs?

Answer 5

These are costs that have both a fixed and a variable element to them

For example, Phone bills can be semi variable as consumers pay a fixed rate for their plan each month, but that bill may increase with additional text messages or long distance calls.

Question 6

What are the problems of classifying costs?

Answer 6

In practice it might be difficult to classify costs

Some products can have different classification e.g.
-Telephone charges are considered as variable costs and can be directly allocated to each range of product made however, in practice it may not be worthwhile for busy factories and would be considered as an indirect over head expense

-Not all direct costs are variable costs e.g
If a hotel buys a new juicing machine for the bar department, this is a direct cost to the bar department but the cost of the machine will not vary with the number of orange juices being served

Question 7

What is the break even analysis?

Answer 7

This is a form of analysis that is widely used by businesses as it provides useful information. It is expressed through a chart

It can be useful in
-Marketing decisions, e.g identifying the impact of a price increase or decrease

• Operations management decision, e.g The purchase of new equipment with lower variable costs
• Choosing between two locations for a new factory

Question 8

What are the advantages and dis advantages of the break even analysis?

Answer 8

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-The charts are relatively easy to construct and interpret

• The analysis provides useful guidelines to management on break even points, margin of safety, profit or loss levels at different rates of output
• Comparisons can be made between different options by constructing new charts to show changed circumstances
• The break even analysis can assist managers in decision making, e.g location

Disads
-It is unrealistic to assume that costs as sales would progress an the steady manner shown by the straight lines. It is very likely that the gradients of the lines would change

• Not all costs can be conveniently classified as fixed costs or variable costs. There are also semi variable costs which are not accounted for
• There is no allowance made for inventory levels on the break even point, it assumes all units would be produced and sold. This would be unlikely unless a firm uses just in time inventory management
• It is unlikely that fixed costs will remain unchanged as they are only fixed for a set period of time

Question 10

What is the break even point of production?

Answer 10

This is the level of output at which total costs are equal to total revenue. It’s a point where neither profit or loss is made

• It can be undertaken either through the graphical method or equation method
• Break even level of output = Fixed costs / Contribution per unit

Question 11

What is the margin of safety?

Answer 11

This is the amount by which the sales level exceeds the break even point

• The greater the margin of safety of a business, the more potential profit there is to make
• High value added products usually have a greater margin of safety as they normally generate more sales revenue

Question 12

What is contribution per unit?

Answer 12

This is the money a from has once the variable cost per unit has been deducted from the price at which a product is sold

• Contribution or unit = Selling price - variable cost per unit
• The contribution concept is useful for determining the minimum possible price at which to sell a product.