31. Costs Flashcards
The need for accurate cost information
1. Calculation of profit or loss: costs are a key factor in the profit equation To calculate profits or losses, accurate cost information is required. If businesses do not keep a record of their costs, they will be unable to take profitable decisions
2. Pricing decisions: marketing managers use cost data to help make pricing decisions for new and existing products.
3. Measuring performance: cost information allows comparisons to be made with past periods of time. In this way, the efficiency of a department or the profitability of a product may be measured and assessed over time.
4. Setting budgets: cost information can help to set budgets and plans. These can act as targets for departments to work towards.
5. Making choices: calculating and comparing the costs of different options can assist managers in their decision-making. For example, comparing the costs of different production machinery or alternative locations can increase the chance of the most profitable decision being made.
Types of costs
1. Direct costs:
These costs are easy to identify as being incurred by a particular cost centre. The two most common direct costs in a manufacturing business are labour and materials. The most important direct cost in a service business, such as retailing, is the cost of the goods being sold.
2. Indirect costs are often referred to as overheads. They are incurred by the business, but they cannot easily be divided up between cost centres.
* a farm is the purchase of a tractor
* a supermarket business is its promotional expenditure
3. Fixed costs: These do not change when the level of output changes, for example, the rent of a factory or shop.
4. Variable costs: These vary as output changes, for example, the direct cost of materials used in making a washing machine or the electricity used to cook a fast-food meal.
Costing methods: a major problem
Overheads, or indirect costs, cannot be allocated directly to particular units of production. They must be shared between all of the items produced by a business. There is more than one way of sharing or apportioning these costs. This uncertainty causes potential problems when pricing products, when deciding whether to continue producing them, and when deciding whether to accept a new order for the product.
Cost and profit centers
Cost centres
Examples of cost centres are:
* in a manufacturing business: products, departments, factories, particular processes or stages in production, such as assembly
* in a hotel: the restaurant, reception, bar, room letting and conference section
* in a school: different subject departments.
Different businesses will use different cost centres as appropriate to their own needs.
Profit centres
Examples of profit centres are:
* each branch of a chain of shops
* each department of a department store
* in a multi-product firm, each product in the overall portfolio of the business.
The benefits of using cost and profit centres
- Managers and employees have targets to work towards. If these are reasonable and achievable, this should have a positive impact on motivation.
- These targets can be used to compare with actual performance and help identify those areas that are performing well and not so well.
- The individual performances of divisions and their managers can be assessed and compared.
- Work can be monitored and decisions made about the future. For example, should a profit centre be kept open or should the price of a product be increased?
Overhead
- Production overheads: including factory rent and rates, depreciation of equipment and power.
- Selling and distribution overheads: including warehouse, packing and distribution costs, and salaries of sales employees.
- Administration overheads: including office rent and rates, clerical and executive salaries.
- Finance overheads: including interest on loans.
Full Costing technique
Full costing allocates all costs to each product. If the business is only producing one type of product, then this is not a problem. In this case, the stages in full costing are:
* Identify and add up all of the direct costs.
* Calculate the total overheads of the business for a given time period.
* Add the total direct costs of making the product.
* Calculate the average cost of producing each product by
dividing total costs by output.
additional points
* A method of allocating indirect costs has to be selected and used.
* This method should not change over time, or cost comparisons over time will be difficult.
* Indirect costs can be allocated using several methods. Proportion of total direct costs was used above, but other methods include:
* proportion of total factory space taken up by each product
* proportion of total labour costs incurred
* proportion of the output of each product to total output.
Uses of full costing
- Full costing is particularly relevant for single-product businesses. In these businesses there is no uncertainty about the share of overheads to be allocated to the product.
- All costs are allocated so no costs are left out of the calculation of total full cost or unit full cost.
- Full costing is a good basis for pricing decisions in single product firms. If the full unit cost is calculated, this could then be used for cost-plus pricing.
- Full costing data can be compared from one time period to another to assess performance, as long as the same method of allocating overheads is used.
Limitations of full costing
- There is no attempt to allocate each overhead cost to cost centres or profit centres on the basis of actual expenditure incurred. For example, a product may take up a large proportion of factory space but use low-cost and easy-to-maintain machinery. Should all overheads be allocated on the basis of
factory space? - Inappropriate methods of overhead allocation can lead to inconsistencies between departments and products.
- It can be risky to use this cost method for making decisions. The cost figures arrived at can be misleading.
- If full costing is used, it is essential to allocate overheads on the same basis over time as otherwise sensible year-on-year comparisons cannot be made.
- The full unit cost will only be accurate if the actual level of output is equal to that used in the calculation. A fall in output will push up the allocated overhead costs per unit.
Contribution costing
Contribution costing solves the problem of deciding on the most appropriate way to allocate or share out overhead costs between products – it does not allocate them at all. Instead, the method concentrates on two very important accounting concepts:
* Marginal cost – the cost of producing an extra unit – is a variable direct cost. For example, if the total cost of producing 100 units is $400 000 and the total cost of producing 101 units is $400 050, the marginal (or extra) cost is $50.
* The contribution of a product is the revenue gained from selling a product less its marginal (variable direct) costs. This is not the same as profit. Profit can only be calculated after overheads have also been deducted.
Contribution costing and decisions on stopping selling a product
If a business sells more than one product, contribution costing shows managers which product is making the greatest or least contribution to overheads and profit. If full costing were used instead, a manager could decide to stop producing a product that seemed to be making a loss. However, if it is still making a positive contribution, what would happen to profit if production was stopped? In cases such as this, stopping production of a product while it is earning a positive contribution will reduce the overall profits of the business. This is because the fixed overhead costs will still have to be paid, but there will be reduced contribution to pay for them.
Limitations of contribution costing
- Existing customers may realise lower prices are being offered to new customers and demand a similar price. If all goods or services being sold by a business are sold at just above marginal cost, then this could lead to an overall loss being made.
- When high prices are a key feature in establishing the exclusivity of a brand, then to offer some customers lower prices could destroy a hard-won image.
- Where there is no excess capacity, sales at a price based on contribution cost may be reducing sales based on the full cost price.
- In some circumstances, lower-priced goods or services may be resold into the higher-priced market by customers themselves.
Contribution costing and special order decisions
If a business has spare capacity and customer offers a special order contract at a price below full unit cost, this can lead to an increase in the total profits of the business. This is because the fixed overhead costs are being paid anyway and any
extra contribution earned will increase profit.
Situations when contribution costing would be used
- Contribution costing avoids inaccuracies and arbitrary indirect cost allocations and gives a contribution, not a profit total. Contribution costing can therefore be used in setting prices that just cover the direct costs of production.
- Decisions about a product or profit centre are made on the basis of its contribution to indirect costs – not profit or loss based on what may be an inaccurate full cost calculation. Contribution costing can therefore be used in decision-making over whether to close a cost/profit centre.
- Excess capacity is more likely to be effectively used, if special orders or contracts that make a positive contribution are accepted. Contribution costing can therefore be used in decision-making on special order decisions.
Situations when contribution costing would not be used
- By ignoring indirect costs, contribution costing does not take into account that some products may result in much higher indirect costs than others. In addition, single-product firms have to cover the fixed costs with revenue from this single product, so using contribution costing would not be used in this case.
- Contribution costing would not be used when making decisions about business expansion or developing new products. All costs of these developments will need to be considered, not just the direct costs.
- Contribution costing may lead managers to choose to maintain the production of goods just because of a positive contribution. Perhaps a brand-new product should be launched instead that could, in time, make an even greater contribution.
- As in all areas of decision-making, qualitative factors may be important too, such as the image a product gives the business.
The benefits of break-even analysis
- Charts are relatively easy to construct and interpret.
- Analysis provides useful guidelines to management on break even points, safety margins and profit/loss levels at different rates of output.
- Comparisons can be made between different options by constructing new charts to show changed circumstances.
- The equation produces a precise break-even result.
- Break-even analysis can be used to assist managers when taking important decisions, such as location decisions, whether to buy new equipment and which project to invest in.
The limitations of break-even analysis
- The assumption that costs and revenues are always represented by straight lines is unrealistic. Some variable costs do not change directly with output. For example, labour costs may increase as output reaches its maximum due to higher shift payments or overtime rates.
- Not all costs can be easily classified into fixed and variable costs. The introduction of semi-variable costs will make the technique much more complicated.
- The break-even chart makes no allowance for inventory levels. It is assumed that all units produced are sold. This is unlikely to always be the case in practice.
- It is also unlikely that fixed costs will remain unchanged at different output levels up to maximum capacity.
- For new businesses, break-even data will be based on forecasts and these could be inaccurate.
