Bases of cost allocation (02)

Question 1

What is a Cost centre?

Answer 1

A cost centre refers to a section of a business, such
as departments, to which cost can be allocated.

Examples of cost centres in a
manufacturing business are the products, departments, factories, particular
processes or stages in the production, such as an assembly station.

Examples of cost
centres in a service-oriented business such as a hotel will be the restaurant,
reception, bar, room letting, and conference section.

Question 2

What are the importance of costing>

Answer 2

-Profit calculation
-Pricing decisions
-Performance measurement
-Resource allocation

Question 3

What are the different approaches to calculate the cost of a product or service?

Answer 3

-Full costing
-Marginal costing

Question 4

What is full costing

Answer 4

Full costing is a method of costing in which all fixed and variable costs are allocated
to products, services or divisions of a business.

This method requires accountants to
calculate total overheads incurred by the business and apportion them on a basis of
one or more methods of allocation.

For example, overheads could be apportioned
according to the proportion of direct labour costs each product accounts for, or the
proportion of factory space or office space taken up by each good or service.

Question 5

What are the usefulness of full costing?

Answer 5

 Full costing is relatively easy to calculate and understand, particularly for single-
product businesses, as it is clear how the overheads should be allocated.

 All costs are allocated (compared with marginal costing) so no costs are
‘ignored’. This means that management will be able to make accurate decisions.
 Full costing is a good basis for pricing decisions in single product firms. If the full
unit cost is calculated, managers could use it to mark-up pricing.

Question 6

What are the limitations of full costing?

Answer 6

 There is no attempt to allocate overheads based on actual expenditure incurred.
For example, a product may take up a large proportion of factory space but use
low cost machinery. Allocating based on factory space may be inaccurate.
 Arbitrary methods of overhead allocation can lead to inconsistencies between
departments and products. Also, if management did not use the same basis of
allocation over time, meaningful 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 and the unit cost will vary.
 Using full costing approach for making decisions also carries a risk because the
cost figures arrived at can be misleading.

Question 7

What is marginal costing?

Answer 7

Marginal costing, also known as contribution costing, is a costing method that
allocates only variable costs to cost centres, not overheads.

Question 8

What are the key concepts marginal costing focuses on?

Answer 8

-Marginal cost
-Contribution

Question 9

How do you calculate contribution?

Answer 9

Contribution = Sales revenue – Total variable cost

OR

Unit contribution = Selling price per unit – Variable cost per unit

Question 10

What is marginal costing used for?

Answer 10

 Make or buy
 Accept or reject a special order
 Keep or drop
 Breakeven analysis

Question 11

What are the usefulness of marginal costing?

Answer 11

 Overhead costs are not allocated to cost centres, so marginal costing avoids
inaccuracies and arbitrary allocations of these costs.
 Decisions about a product or department are made based on contribution to
overheads, not ‘profit or loss’ based on what may be an inaccurate full-cost
calculation.
 Excess capacity is more likely to be effectively used, as orders or contracts that
make a positive contribution will be accepted.

Question 12

What are the limitations of marginal costing?

Answer 12

 By ignoring overhead costs until the final calculation of profit or loss,
contribution costing does not consider that some products and departments
may actually incur much higher fixed costs than others.
 It emphasises contribution in decision-making. It may lead managers to choose
to maintain the production of goods just because of a positive contribution.
 As in all areas of decision-making, qualitative factors may be important too, such
as the image a product gives the business. In addition, products with a low
contribution may be part of a range of goods produced by the firm and to cease
producing one would reduce the appeal of the whole range.

Question 13

What is the formula to calculate the break even output?

Answer 13

Break-even level of output =

Fixed costs/Contribution per unit

For example, if fixed costs are $200 000 and the contribution per unit is $50, break-
even quantity is

Break-even quantity =
200 000/50 = 4000 units

Question 14

Note:
The same method can be used if a manager wants to determine a target
profit level and establish the level of output required to achieve it. The target profit
is treated as if it was an extra fixed cost.

Answer 14

Suppose the target profit is $25 000.

Level of output =

(200 000+25000)/50 = 225 000/50 = 4500 units

Question 15

What are the usefulness of breakeven analysis?

Answer 15

 Breakeven 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. Charts could be amended to show the
possible impact on profit and break-even point if selling price changes.
 The equation produces a precise break-even result.
 Break-even analysis can be used to assist managers when making important
decisions such as locating decisions, whether to buy new equipment, and which
project to invest in.

Question 16

What are the limitations of breakeven analysis?

Answer 16

 It is unrealistic to assume costs and revenues are always represented by straight
lines. Not all variable costs change directly with output.
 Not all costs can be conveniently classified into fixed and variable costs. The
introduction of semi-variable costs will complicate break-even analysis.
 No allowance is made for inventory levels. It is assumed all units produced are
sold, which is unrealistic in practice.
 Fixed costs are unlikely to remain unchanged at different output levels.

Question 17

SUMMARY

Answer 17

In summary, the following are covered in this topic:
1. The costs incurred in making a product or providing a service can be classified
into direct and indirect costs, or fixed and variable costs.
2. Cost data plays an important role in management decisions. Having up-to-date
costing data gives management an edge over competitors as they are able to
make accurate decisions.
3. Costing methods are techniques used to calculate the costs of operating a
department or division.
4. Full costing attempts to allocate or apportion all costs to cost centres
5. Marginal costing focuses on allocating only variable costs, and if goods or
services make a contribution, this could be used to help pay overheads.
6. The marginal costing approach aids decision-making in the following situation;
make or buy component parts, accept or reject a special order, keep or drop a
product and break-even analysis.
7. Break-even analysis can be used to calculate the break-even level of output and
the margin of safety.

8. Both quantitative and qualitative factors need to be considered in decision-
   making.