Costs Flashcards
Costing Systems
A costing system is one of the most important elements of a management information system (MIS). It has three broad functions:
- Budget preparation – without a clear identification of costs attributable to activities, and the behaviour of costs, budgets can not be established adequately.
- Managerial control – The costing system allows managers’ actual expenditures to be matched against the budget.
- Performance evaluation – A costing system allows us to identify whether resources are being used efficiently and effectively.
Cost-Volume-Profit Model
The distinction between fixed and variable costs uses a single variable – the volume of activity. Variable costs vary in direct proportion to the volume of activity, whereas within a given capacity range fixed costs do not vary according to activity level. Some costs are fixed over a relatively short range—step costs. The cost behaviours can be shown graphically as fixed costs, variable costs or step costs. CVP is based on the marginal costing technique.
Typical fixed costs are items such as rent, salaries of senior officials, contracted
services prices, leases and depreciation. Typical variable costs are consumables such as materials used in a process or service, royalties, labour if piece rates (paid per unit of output) are used. Step costs increase in ‘steps’ in that they are fixed for a short range and then incur an increase.
Absorption or Full Cost Recovery
The marginal costing approach is useful for one-off decisions but cannot be used for the normal activity, as there is a danger that the full amounts of overheads are not recovered. In this case, a technique known as absorption costing is used where the full cost of the service must be absorbed into the final costs, including all fixed and variable costs.
There are a number of ways of calculating how overheads and fixed costs are apportioned to units. One common method is activity-based costing.
Activity-based Costing (1)
Activity-based costing is based on the view that an organisation is made
up of activities. Activities consume resources, and cost objects (usually
products) result from activities. With ABC the focus is not on the amount
of each type of cost incurred by a department – such as wages, equipment, utilities etc. – but on the costs of the activities undertaken in the department. Costs are therefore assigned to activities.
ABC assumes that production consumes activities, which themselves consume costs according to the volume of their cost drivers.
Activity-based Costing (2)
In an output budgeting system it is necessary to cost outputs. Outputs are made up from activities. In manufacturing production several activities contribute to the product, or the output, and output budgeting involves the grouping of activity costs (cost drivers) against an output. The case can arise where one person contributes through different activities to more than one output. In this case, to get an accurate estimate of the cost (or ‘price’) of the output requires apportioning the time of the person between the activities and therefore the outputs to which he or she contributes. This in turn requires that the salary be divided between the different outputs.
Activity-based costing (3)
The overall purpose of the technique is to calculate what price the product should be sold at in order to recover the costs of production (and make a profit). If a company does not apportion its costs between the products it sells, it is in danger of losing money and going out of business.
Activity-based costing (4)
However, ABC can involve arbitrary decisions, and is by no means scientific – indeed, costing is not a science.
ABC poses several other problems, including
- the neglect of ‘opportunity costs’, which are the costs of alternative uses of the same resources
- the fact that cost ‘drivers’ (the underlying causes of costs) are not always independent of each other, and the level of one driver can
- affect the level of another, and
- the potentially high administrative costs associated with using it.
Output Budget Costing
Output budget costing does not need to be complicated if the existing departmental assignments and cost structures in the chart of accounts more or less reflect the proposed outputs. An efficient chart of accounts with properly designed cost centres, together with a sophisticated output costing system, would limit the need for an ABC system to those areas that operate across many outputs. Therefore, before any development of output-based budget systems takes place, considerable work is needed on how departments are organised, and how their charts of accounts are built.
Managing Costs
Budget management is about achieving specified objectives with a specified amount of money. Hierarchical systems in which controls are based on inputs involve detailed control of the lower management units at the line item level. This type of budgeting is suitable for managmetn systems that that require little delegation or responsibility for financial management because all key decisions are taken in the centre, expenditures are authorised against line items, and virement without central permission is not permitted.
These types of external control arrangements are incompatible with giving more management discretion, as practiced under New Public Management. Under NPM internal control arrangements, managers exercise their own controls within a framework of a hard budget constraint and performance objectives linked to outputs.
Price-based Costing
Under price-based budgeting, an output is priced, rather than costed, in the sense that it is to be purchased. An output is a good or service that is purchased by ministers from the civil administration or the private sector. Prices of outputs are compared: if the private sector can provide the output at a better price, with similar quality, than the civil administrators, then the government may choose to purchase from the private sector. Unit costs are the price ministers are prepared to pay for an output.
In the UK, NHS hosptials are paid a fixed tariff for many clinical activities.
Relevant Costs
When making decisions only relevant costs—costs they you can do something about in the future—should be taken into account.
- Sunk costs* are costs that have been incurred already and cannot be recovered.
- Committed costs* are future costs that cannot be avoided, e.g. PFI payments.
