5.2. Costs Flashcards
Define cost centre
a section of a business, such as a department, to which costs can be allocated or charged
e.g.
- in manufacturing business: products, departments, factories, particular processes or stages in production
- in a hotel: restaurant, reception, bar
- in a school: different subject departments
Define profit centre
a section of a business to which both costs and revenues can be allocated (so profit can be calculated)
e.g.
- 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
Define contribution
The difference between sales and variable costs of production. Formulae: Contribution = total sales less total variable costs. Contribution per unit = selling price per unit less variable costs per unit
Why do businesses divide opperations into cost and profit centres?
- Managers and staff will have targets to work towards
- These targets can be used to compare with actual performance and help with improvements
- The individual performances of divisions and their managers can be assessed and compared
- Work can be monitored and decisions made about the future
Problems with classifying cost and profit centres
- Managers and workers may consider their part of the business to be more important => damaging competition
- Some indirect costs cannot be allocated to either cost or profit centres accuratelu
- Reasons for good or bad performance may be due to external factors
3 types of overheads
- Production overheads: factory rent and rates, depreciation of equipment and power
- Selling and distribution overheads: warehouse, packing and distribution costs and salaries of sales staff
- Administration overheads: office rent and rates, clerical and executive salaries
- Finance overheads: interest on loans
Define full/absoprtion costing
a method of costing in which all fixed and variable costs are allocated to products or services
Uses of full costing
- Relevant for single-product businesses
- All costs are allocated so no costs are ignored
- Easy to calculate and understand
- Good basis for pricing decisions in single product firms - if the full unit cost is calculated, this could be used for mark-up pricing
- Particularly relevant for single-product businesses
Limitations of full costing
- Unsuitable for irregular orders e.g Volume of orders go up and down → seems like fixed cost fluctuate with the level of production but it’s not → contribution is more suitable
- Arbitrary methods of overhead allocation → inconsistencies b/w departments and products because each product consume differently proportion of fixed costs
- Inadequate for managerial decision making
- Only accurate if the actual level of output is equal to that used in the calculation
- Qualitative factors is important too → should not cease to produce an item just bc it has low contribution
Define marginal/contribution costing
Costing method that allocates only direct costs to cost/profit centres, not overhead costs
The nature of the technique of contribution costing
Solves the problem of deciding on the most appropriate way to apportion/share out overheads costs - it does not apportion them. Focuses on marginal costs (cost of producing an extra unit) and contribution
Limitations of contribution costing
- By ignoring overhead costs until the final calculation of profit and loss account, products and department may incur much higher fixed costs than others
- Managers may only choose to maintain production of goods just because of positive contribution which is not equivalent to increased profit
- Qualitative factors have to be taken into consideration. E.g. image of the business
Situations to use and not to use contribution costing
To use:
- Fluctuating orders’ volume
- Compare potential profitability of different products within firm → used in making strategic decision
Not to use:
- Single-product firms
- Not ideal as standard for pricing method because it leaves out fixed costs
Difference between contribution and profit
Contribution margin is used to review the variable costs included in the production cost of an individual item. In comparison with gross profit margin, it is a per-item profit metric, as opposed to the total profit metric given by gross margin.
