costs chapter 31

Question 1

break even point

Answer 1

the level of output at which total costs equal total revenue, when neither a profit nor a loss is made

Question 2

the need for accurate cost information

Answer 2

effective decisions would not be possible without cost data. some business uses of cost information are calculation of profit or loss, pricing decision, measuring performance, setting budgets, resource use and making choices

Question 3

the need for accurate cost information: calculation of profit or loss

Answer 3

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, such as where to locate.

Question 4

the need for accurate cost information: Pricing decisions

Answer 4

marketing managers use cost data to help make pricing decisions for new and existing products.

Question 5

the need for accurate cost information: Measuring performance

Answer 5

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.

Question 6

the need for accurate cost information: Setting budgets

Answer 6

cost information can help to set budgets and plans. These can act as targets for departments to work towards. Actual cost levels can then be compared with budgets.

Question 7

the need for accurate cost information: Resource use

Answer 7

comparing cost data can help in decisions about resource use. For example, if wage rates are very low, then labour intensive methods of production may be preferred over capital intensive ones.

Question 8

the need for accurate cost information: making choices

Answer 8

calculating and comparing the costs of different options can assist managers in their decision-making.

Question 9

types of costs

Answer 9

the financial costs incurred in making a product or providing a service can be classified in several ways. cost classification is not always as clear cut as it seems. allocating costs to each good or service is not usually very straightforward in a business with more than one product. the types are direct costs, indirect costs, fixed costs and variable costs

Question 10

direct costs

Answer 10

these costs can be clearly identified with each unit of production and can be allocated to a cost centre. the two most common direct costs in a manufacturing business are labour and materials. the most important direct costs in a service business is the cost of the goods being sold. examples purchase of materials to make the product, labour cost or salary

Question 11

indirect costs

Answer 11

costs that cannot be identified with a unit of production or allocated accurately to a cost centre. they often referred to as overheads. examples- purchase of tractor, rent or cost of services

Question 12

fixed costs

Answer 12

costs that do not vary with output in the short run

Question 13

variable costs

Answer 13

costs that vary with output

Question 14

total cost

Answer 14

variable cost plus fixed cost

Question 15

semi variable costs

Answer 15

costs that include both fixed and a variable element like a salesperson basic wage plus a commission that varies with sales

Question 16

problems in classifying costs

Answer 16

It is difficult to clearly classify costs into different categories
The exact same cost can be classified differently by different businesses
Every cost can change unexpectedly any time
Some costs belong to one type, but behave like another type
Direct Costs do not equal Variable Costs

Question 17

problems in classifying costs: difficult to clearly costs into different categories

Answer 17

not all costs can be conveniently classified into different types. a cost can belong to any cost depending upon the circumstances

Question 18

problems in classifying costs: The exact same cost can be classified differently by different businesses

Answer 18

Certain costs can be classified as a Variable Cost (VC) for one business, but as a Direct Cost for another business, even when both operate in the same industry of the economy

Question 19

problems in classifying costs: Every cost can change unexpectedly any time

Answer 19

both internal and external business environment is very dynamic and constantly changeable

Question 20

problems in classifying costs: Some costs belong to one type, but behave like another type

Answer 20

When administrative Direct Costs related to different transactions are the same with each transaction, they will behave more like constant Fixed Costs

Question 21

problems in classifying costs: Direct Costs do not equal Variable Costs

Answer 21

Direct costs are expenses that can be directly traced to a product, while variable costs vary with the level of production output.

Question 22

approaches to costing

Answer 22

calculating the cost of each product is not easy. managers use two main methods to help with this costing process: full costing and contribution costing

Question 23

problem with costing methods

Answer 23

In calculating the cost of a product, both direct labour and direct materials should be easy to identify and allocate to each product but 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 and, therefore, many ways that a product could cost. 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.

Question 24

cost centre

Answer 24

a part of an organization to which costs may be charged for accounting purposes

Question 25

profit centres

Answer 25

a section of a business to which both costs and revenues can be allocated, so profit can be calculated

Question 26

benefits of using cost and profit centres

Answer 26

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.

Question 27

overheads

Answer 27

these are indirect expenses of a business classified into production overheads, selling and distribution overheads, administration overheads and finance overheads

Question 28

overheads: production overheads

Answer 28

including factory rent and rates, depreciation of equipment and power.

Question 29

overheads: selling and distribution overheads

Answer 29

including warehouse, packing and distribution costs, and salaries of sales employees.

Question 30

overheads: administration overheads

Answer 30

including office rent and

rates, clerical and executive salaries.

Question 31

overheads:

Answer 31

including office rent and rates, clerical and executive salaries.

Question 32

average cost

Answer 32

total cost divided by the number of units produce. provides useful information for business managers. referred to as unit cost

Question 33

formula for average cost

Answer 33

total cost of producing this product/number of units produced

Question 34

costing methods: full costing technique

Answer 34

a method of costing in which all indirect and direct costs are allocated to the products, services or divisions of a business. it is not a problem the business is producing only one type of product

Question 35

stages of full costing technique

Answer 35

identifying and adding 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

Question 36

full costing: allocating indirect cost

Answer 36

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 like the proportion of total factory space taken up by each product or proportion of total labour costs incurred

Question 37

uses of full costing

Answer 37

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.

Question 38

limitations of full costing

Answer 38

There is no attempt to allocate each overhead cost to cost centres or profit centres on the basis of actual expenditure incurred.
Inappropriate methods of overhead allocation can lead to inconsistencies between departments and products.
It can be risky to use this cost method 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.

Question 39

contribution costing

Answer 39

costing method that allocates only direct costs to cost centres and profit centres, not overhead costs. solves the problem of deciding on the most appropriate way to allocate or share out overhead costs between products-it does not allocate them. this method concentrates on marginal cost and contribution of a product

Question 40

marginal costing

Answer 40

the additional cost of producing one more unit of output

Question 41

contribution of product

Answer 41

the revenue gained after all the expenses that can be allocated to particular products. this is not profit. profit is calculated after overheads have also been deducted

Question 42

uses of contribution costing

Answer 42

average cost is often used to help set prices. total cost information is also essential for profit or loss, it is also essential for the budgetary process, which is a key way of monitoring and improving the business performance. marginal cost information is used in decision making when contribution costing is used

Question 43

contribution and decisions on stopping selling a product

Answer 43

if a business sells more than one product, contributions costing shows managers which product is making the greatest or least contribution to overheads and profit. full costing helps a manager decide to stop producing a product that seemed to be making a loss. stopping production of a product while it is earning a positive contribution will reduce the overall profits of business because the fixed overhead costs will still have to be paid, but there will be reduced contribution to pay for them

Question 44

contribution costing and special order decisions

Answer 44

if a business has spare capacity or if it is trying to enter a new market segment, contribution costing assists managers in deciding whether to accept an order at a price below the full cost of the product. special order contracts at a price below full unit cost 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

Question 45

dangers to contribution costing and special order decisions

Answer 45

Existing customers may realize 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.

Question 46

situations when contribution costing would be used

Answer 46

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 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 decisions making on special order decisions

Question 47

situations when contribution costing would not be used

Answer 47

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.

As in all areas of decision-making, qualitative factors may be important too, such as the image a product gives the business.

Question 48

break even analysis

Answer 48

uses cost and revenue data to determine the break even point of production. it can be undertaken by graphical method(break even chart) or equation method

Question 49

use of break even analysis

Answer 49

widely used in business as it provides useful information for decision making. helps business owner to make sure they are not making a loss and at least breaking even at current output levels

Question 50

information shown on a break even chart

Answer 50

fixed costs
total cost (addition of fixed and variable costs)
revenue (obtained by multiplying selling price by output level)

Question 51

features of break even chart

Answer 51

The fixed cost line is horizontal, showing that fixed costs are constant at all output levels.

Sales revenue starts at the origin (0) because if no sales are made, there can be no revenue.

The variable cost line starts from the origin (0) because if no goods are produced, there will be no variable costs. It is drawn to aid your understanding of how the chart is constructed. It is not necessary to interpret the chart and is often omitted.

The total cost line begins at the level of fixed costs, the difference between total and fixed costs being accounted for by variable costs.

Question 52

margin of safety

Answer 52

the amount by which the current output level exceeds the break even level of output. can be expressed as a percentage of the break even point. minus sign tells us the production level is below break even

Question 53

things that a break even chart shows

Answer 53

the point at which the total costs and sales revenue is the break even point. the space between the current output and break even point is the safety margin (only if the current output is more than the break even point)

Question 54

the break even equation

Answer 54

break even level of output= fixed cost/contribution per unit

Question 55

how break even equation can be used to determine a target profit

Answer 55

the target profit can be added to the fixed cost and treat as an extra fixed cost

Question 56

using break even charts to show potential situation of the business

Answer 56

The charts can be redrawn showing a potential new situation and this can then be compared with the existing position of the business. Care must be taken in making these comparisons, as forecasts and predictions are usually necessary.

Question 57

benefits of break even analysis

Answer 57

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.

Question 58

limitations of break even analysis

Answer 58

The assumption that costs and revenues are always represented by straight lines is unrealistic. Some variable costs do not change directly with output.

The revenue line could be influenced by the price reductions needed to sell a high level of output. The combined effects of these changing assumptions could create two break-even points in practice

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.