Chapter 31 Costs Flashcards
Types of costs
Cost centre: the section of a business such as a department or a product, that incurs costs
-Direct costs: these costs can be clearly identified with each unit of production and can be allocated to a cost center. e.g. Labour and materials could be direct costs.
-Indirect costs: costs that cannot be identified with a unit of production or allocated accurately to a cost centre
-Fixed costs: Costs that do not vary with output in the short run
-Variable costs: These vary as output changes such as the direct cost of materials used in making a washing machine.
Problems in classifying costs
- Are labour costs necessarily variable or direct costs? Definitely not, the business will keep paying workers even when there is no demand and the workers still come to work, in the short run. Wages then become overhead costs. The salaries of admin staff are always considered to be an indirect cost, fixed in the short run.
- Telephone charges in a busy factory could directly be allocated to each range of products made, as long as an accurate and reliable record was kept of the purpose of each call. In practise this may not be worth while and will be considered as an indirect
expense.
Costing methods
- Cost Centre: Section of Business to which costs can be allocated or charged.
- Profit Centre: Section of Business to which both costs and revenues can be allocated as to calculate profit.
- Overheads: Costs that stay fixed or unchanged regardless of changes in production units.
- Average Costs: Average cost of producing each unit of output
Cost Centre
- Cost Centre: Section of Business to which costs can be allocated or charged. Depends on the business:
- In a school = different subjects
- In manufacturing = each stage of production
- In hotel = restaurant, rooms, spa,
conference, casino
Benefits of a Cost and Profit centre
- Have targets to work towards
- Targets used to compare
with performance and identify issues - Individuals can be assessed and compared
- Work monitored for future decisions
Problems of a Cost and Profit centre
- Damaging competition between centres
- Indirect cost impossible to allocate to cost/profit centres = results in random and inaccurate allocations
External factors outside of centres control can influence results
Overhead groups
- Production
- Selling and distribution
- Administration
- Finance
Full costing techniques
Method of costing in which all fixed and variable costs are allocated to product/services/divisions. Also known as absorption costing
then overheads are shared based on method of allocation. Based on: Proportion of direct labour costs Office space taken
Full Costing Advantages
MIS EC
- Easy to calculate and
understand
- Relevant for single product
businesses
- No costs are ignored
- Good for calculating mark up pricing
Full Costing Disadvantages
- There is no attempt to allocate each overhead cost to cost centres or profit centres on the basis of actual expenditure incurred. For example, a product may take up a large proportion of factory space but use low-cost and easy-to-maintain machinery. Should all overheads be allocated on the basis of factory space?
- Inappropriate methods of overhead allocation can lead to inconsistencies between departments and
products. - It can be risky to use this cost method for making decisions. The cost figures arrived at can be misleading. See the section on ‘Contribution costing and decision-making’.
- 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.
Should a firm stop making a product?
- Marginal costing shows which product is least contributing to overheads.
- Only that product should be stopped. Full costing could calculate wrong product
Should business accept contract at
purchase offer below full cost?
- Sometimes better to earn a contribution than to not gain
anything from service already running. - Could in future lead to increase in profits - because fixed costs are still having to be paid
-BUT, customers could always want that price, could destroy brand image, could be making a loss, can be resold to other markets at higher price
When to use contribution costing
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 an 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 decision-making on special order decisions.
When to not use contribution costing
- 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. Perhaps a brand-new product should be launched instead that could, in time, 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.
Break-even analysis uses
- Break-even analysis can be used to make decisions in potential new
situations. And this can be compared with the existing position of the business. - A Marketing decision - the impact of a price increase.
- An operations-management decision - the purchase of new equipment with lower variable costs
- Choosing between two locations for a new factory.
