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Chapter 32: Costs
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- 1costs problemIn calculating the cost of a product, both direct labour and direct materials should be easy to identify and allocate or charge to each product. However, overheads, or indirect costs, cannot be allocated directly to particular units of production but must be ‘shared’ between all of the items produced by a business so how much does a product cost to produce? This uncertainty causes potential problems when pricing products, when deciding whether to continue producing it and when deciding whether to accept a new order for the product.
- 2Cost CentreA section of a business, such as a department, to which costs can be allocated or charged.
- 3Profit CentreA section of a business to which both costs and revenues can be allocated – so profit can be calculated.
- 4Benefits of dividing operations into cost and profit centres: 4- Managers and staff will have targets to work towards – if reasonable and achievable, should have positive impact on motivation
- These targets can be used to compare with actual performance and help identify those areas performing well and not so well
- The individual performances of divisions and their managers can be assessed and compared
- Work can be monitored and decision made about the future - 5Limitations to using these centres: 3- Managers and workers may consider their part of the business to be more important than the whole organisation itself. Could be damaging competition between profit centres to gain new orders
- Some costs – indirect costs – can be impossible to allocate to cost and profit centres accurately and this can result in arbitrary and inaccurate overhead-cost allocations.
- Reasons for good or bad performance of one particular profit centre may be due to external factors not under its control - 6Overheads are usually classified into 4 main groups:1. Production overheads: include factory rent and rates and power
2. Selling and distribution overheads: include warehouse, packing and distribution costs and salaries of sales staff
3. Administration overheads: include office rent and rates, clerical and executive salaries
4. Finance overheads: include interest on loans. - 7Unit costs and euqationThe average cost of producing each unit of output:
Unit cost = total cost of producing this product / number of units produced - 8Full costingA method of costing in which all fixed and variable costs are allocated to products, services or divisions of a business.
Also known as absorption costing – accountants calculate the total overheads incurred by the business and share or ‘apportion’ them on the basis of one or more methods of allocation. Total overheads could be divided between products and cost centres on the basis of the proportion of total direct labour costs that each accounts for. Or factory and administration overheads could be apportioned to products on the basis of the proportion of factory or office space taken up by each product or service. Full costing means that all of the costs of the business have been allocated to the products, services or divisions of the business. - 9Full costing advantages: 4- Relatively easy to calculate and understand – unless each overhead cost is absorbed by using a different basis, which makes the process more complex
- Particularly relevant for single-product businesses as there is no uncertainty about what share of overheads should be allocated to which product
- All costs are allocated (compared to contribution costing) so no costs are ignored
- A good basis for pricing decisions in single product firms – if full unit cost is calculated this could be used for mark-up pricing - 10Full costing disadvantages: 5- No attempt to allocate each overhead cost to cost/profit centres on the basis of actual expenditure incurred.
- Arbitrary methods of overhead allocation can lead to inconsistencies between departments and products
- Sometimes dangerous to use this cost method for making decisions, as the cost figures arrived can be misleading
- If full costing is used it is essential to allocate on the same basis over time; otherwise sensible year on year comparisons can’t 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 - 11Contribution or Marginal CostingCosting method that allocates only direct costs to cost/profit centres, not overhead costs.
- 12Doesn’t apportion on the most appropriate way to apportion or share out overhead costs. Instead concentrates on 2 very important accounting concepts:1. Marginal costs – the cost of producing an extra unit. This extra cost will clearly be a variable direct cost
2. The contribution of a product is the revenue gained from selling a producing less its marginal (variable direct) costs. Not the same as profit which can only be calculated after overheads have been deducted. The unit contribution = sale price – marginal cost - 13The statement avoids apportioning overhead costs between products but are needed to calculate the profit or loss of the business. Marginal costing shows managers which product or services is making the greatest or least contribution to overheads and profits. If full costing were used instead a manager could decide to stop producing a good that seemed to be making a loss even though it may still be making a positive contribution and end up reducing the overall profits of the business. This is because the fixed overhead costs will still have to be paid – but will be reduced contribution to pay them. Should a business accept a contract or a purchase offer at below full cost?If a firm has spare capacity or is trying to enter a new market segment, marginal or contribution costing assists managers in deciding whether to accept an order at below the full cost of the product or service. Hotels often offer low rates o customers in off-peak seasons, arguing it’s better to earn a contribution from additional guests than to leave rooms empty. Sometimes can lead to an increase in the total profits of the business due to the fixed overhead costs being paid anyway and if an extra contribution can be earned, profits will increase.
- 14limitations of accepting a contract or purchace offer below full cost 4- Existing customers may learn of the lower prices being offered and demand similar treatment. If all goods or services being sold by a business are sold at just above marginal cost, this could make earning a profit very unlikely
- 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 contribution cost may be losing sales based on the full cost price
- Sometimes lower-priced goods or services may be resold into the higher-priced market
Many businesses do use contribution-cost pricing but try to make sure that there is no leak into the higher-priced market. - 15Contribution costing advantages 3- Overhead costs are not allocated to cost centres, so contribution costing avoids inaccuracies and arbitrary allocations of these costs
- Decisions about a product or department are made on the basis of contribution to overheads – not profit or loss based on what may be an inaccurate full-cost calculations
- Excess capacity is more likely to be effectively used, as orders or contracts that make a positive contribution will be accepted - 16Contribution costing disadvantages 3- By ignoring overhead costs until the final calculation of the business’s profit or loss, contribution costing doesn’t consider that some products and departments may actually incur much higher fixed costs than others. Single-product firms have to cover the fixed costs with revenue from the single product, so using contribution costing is unlikely to be appropriate
- Emphasises contribution in decisions making. 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 tie, 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. Also, 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 - 17contribution and full costing notesFull costing can be useful for single-product firms and as a quick guideline to the costs of products. However, it does have serious flaws for multi-product businesses as the approach doesn’t’ apportion overheads on a real basis. May be inaccurate or misleading. So could be used to make comparisons of costs calculated on the same basis over time but should not be widely used for decisions making.
Contribution or marginal costing is now the most widely used method for decision-making as it accepts that fixed overhead costs must be paid during a particular time period, regardless of the level of production. Should help management take appropriate decisions when faced with the option. However if overheads are set aside for costing purposes, there is a danger that they could be overlooked altogether. Could mean that contribution is confused with profits and pricing decisions or products could ignore the fixed-cost element. Eventually overheads have to be paid for and this must not be forgotten.
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- A level AL Business (Unit 5: Finance and Accounting) Karteikarten am Chapter 32: Costs, erstellt von HRYN red am 18/04/2022.
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