TOPIC 6: COSTING

THE TWO MAIN CLASSIFICATIONS OF COST:

• Indirect vs Direct costs
• Fixed vs Variable costs

DIRECT COSTS - can be allocated to a particular product and these costs usually vary with the level of
production. E.g., direct materials; direct labour and direct expenses/variable overheads such as rental of
machinery to work on a particular product. The sum of the direct materials, direct labour and direct
expenses are referred to as Prime Cost. Direct materials may include Inventory of raw materials at the
beginning of the period, plus Purchases and Carriage Inwards of Raw Materials, Less Inventory of Raw
Materials at the end of the period.

INDIRECT COSTS - cannot be allocated directly to the manufacture of a named product, e.g., cost of
supervision. It includes indirect labour, indirect materials (such as lubricants for machinery or protective
clothing) and indirect expenses (such as rent or insurance) where some portion of the indirect cost may be
allocated to Production/Factory Expenses under the Manufacturing Account. While the other to
General/Admin Expenses in the Profit and Loss Account of the Income Statement. The sum of the
indirect materials; indirect labour and indirect expenses are referred to as Factory Overheads.

FIXED COSTS - stay the same for a given period of time over a given output, e.g., rent. Fixed Costs are
those elements that are not varying with output in the short run. These include land & buildings (rent),
business taxes, license fees, machinery & equipment and any other elements that may be required before
the business starts to produce. The fixed cost does not vary in the short run where at least one FOP is
fixed. (Draw diagram to illustrate).

When production is equal to zero, fixed cost will equal total cost. Average fixed costs (Total Fixed Cost /
Total Output) tend to fall as output increases since it is spread over a larger quantity of output, but it never
reaches zero. In modern times there will be a high proportion of fixed cost to total cost as businesses are
becoming more capital-intensive.

VARIABLE COSTS - vary with the level of production, e.g., materials. Variable costs grow with higher
levels of production. If there are only variable costs, at zero production the total costs will be zero.
Examples of variable costs will include labor, raw materials, electricity bills, cash on hand and any other
elements that may vary as production changes in the short run. However, in the long run, all FOP are
variable. (Draw diagram to illustrate).
Variable cost is usually high when production now starts as the process is inefficient and workers are
inexperienced leading to high wastage and high cost per unit of output (as indicated by point A on the
PPF). As production increases, the process becomes more efficient and effective and workers become
more skilled resulting in the business experiencing increasing economies of scale and lower costs per unit
of output (as indicated by point B on the PPF). Long-run output decisions are concerned with economies
of scale when all factor inputs are variable.

When a business begins to operate on the curve it is maximizing Economies of Scale

where the business and workers are most efficient and effective leading to lowest cost per unit of output
(point C on the PPF). After this point the resources begin to be strained and costs of production start to
increase once again leading to diseconomies of scale being experienced. This leads the Average Variable
Cost Curve (Total Variable Cost / Total Output) to be U shaped as well as the Average Total Cost Curve
(Total Cost / Total Output).

A COST CENTRE - refers to the cost allocated to a specific unit of operations when producing a good
or
service and can be categorized as follows:

• A geographical location, e.g., a factory, sales region or department.

• A person, e.g., a director, salesperson or maintenance worker.
• An item of equipment, e.g., a photocopier, telephone line or vehicle.

BENEFITS OF COST CENTRES FOR MANAGERS

• They provide a very sound foundation for a costing system.
• They enable managers to make comparisons between the cost of operating a cost centre and the benefit
it provides.

COSTING - is the process of measuring the likely consequences of a business activity and provides the
following benefits:

• They provide managers with financial information on which to base decisions.

• They help to identify the profitable activities, avoid waste and provide information for cost cutting
strategies.

• Can assist the marketing department in setting the price of products.

ABSORPTION COSTING - is a method of costing which involves charging or ‘absorbing’ all the costs
associated with business operations individually to a particular cost centre. It uses “full cost” method
which includes the fixed and variable costs of production.

THE MAIN PRINCIPLE OF ABSORPTION COSTING - is that all the overheads costs are
‘absorbed’ by cost centres, i.e., all overheads are included when calculating the cost of producing a
particular item,fixed and variable. Such costing is useful:

• To set price

• To value stock for the balance sheet and to calculate the cost of stocks used /sold in the period

• To establish the profitability of different products

The format for calculating gross profit using the Absorption Costing system is as follows:
ADVANTAGES OF ABSORPTION COSTING:
• Easy to calculate and understand
• Particularly relevant for single-product businesses
• All costs are allocated
• It is a good basis for pricing in single product firms
• A portion of the fixed cost is incorporated into the value of closing inventory allowing for the costs of
the period to be matched accurately with the revenues of the same period.
• It gives a more accurate cost of production, so prices can be set based on total costs and not just variable
costs.
• It is accepted as a method for external reporting.
WHAT ARE THE DISADVANTAGES OF ABSORPTION COSTING?
• There is no attempt to allocate each overhead cost to cost centres on the basis of actual expenditure
incurred.
• Arbitrary methods of overhead allocation can lead to inconsistencies between departments and products.
• It is sometimes dangerous to use this cost method for making decisions because the cost figures arrived
at can be misleading.
• It is essential to allocate on the same basis over time, otherwise sensible year-on-year comparisons
cannot be made.
• It is difficult to apportion indirect costs accurately to each unit when a firm produces a very wide range
of products.

MARGINAL/CONTRIBUTION COSTING

MARGINAL COST - is the cost of increasing output by one more unit, i.e. the change in total cost by
producing one additional unit of output.

MARGINAL/CONTRIBUTION COSTING is a costing method in which fixed costs are separated and
the other costs are apportioned to products. It charges variable cost to the production of the product and
fixed costs are then incorporated when drafting the P&L Account. Under the marginal costing principles,
all production costs are valued at VARIABLE COSTS ONLY.

***When making decisions to shut down or continue operating we look at the ability of the business to
cover its variable cost as no matter what decision is made, we still have to cover the fixed costs.***
CONTRIBUTION is the amount of money left over after a sale when all the direct/variable costs have
been met.

Contribution = selling price – marginal/variable/direct costs

MARGINAL COSTING METHOD IS USEFUL in the following situations:

● Whether or not to accept an order
● Whether or not to continue in business
● Make or buy decisions
● Whether or not to eliminate a product or department
THE ADVANTAGES OF MARGINAL COSTING
• Easy to calculate
• Difficulties of apportionment avoided.
• Able to assess the contribution of each product/department and the sales mix.
• Allows marginal cost pricing to be adopted for special orders.
• It looks at the business as a whole rather than small parts in isolation.
• It can be readily used for current, or even possible future situations, as well as for historical assessments.

THE DISADVANTAGES OF MARGINAL COSTING

• For long term pricing, overheads need to be taken into account, otherwise prices might be fixed at a
lower level than is necessary to cover total costs.
• Difficult to separate overheads into fixed and variable costs
• It may give the impression that fixed costs are divorced from production or are less important than
variable costs.
• Contribution may be confused with profit.
• Profit may be distorted under this system as closing inventory does not reflect fixed costs
• This costing method is not recognized for external reporting

BREAKEVEN ANALYSIS

THE BREAKEVEN POINT - is the level of sales at which there is neither a profit nor a loss, i.e., the
total income and the total costs are equal.

ASSUMPTIONS:
● Costs are classified as either fixed or variable
● selling price remains constant
● volume of output is the only factor that affects costs and revenue
● the factors of production are constant

ADVANTAGES OF USING BREAKEVEN ANALYSIS:

● Calculation is simple
● It highlights the profit or loss at different levels of output
● It shows how a firm's profit or sales will be affected by changes in prices or costs
● Firms are aware of level of sales that will cover their fixed costs
● Firms can determine the level of sales needed to make a certain level of profitability
● Provides a useful way of looking at cost-output and revenue relationships.
● Can be used in decision making regarding price to be charged and/or quantity to be sold to achieve a
target level of profits.

DISADVANTAGES OF USING BREAKEVEN ANALYSIS:

● Results can be misleading as it assumes that all output is sold
● The effectiveness of breakeven analysis depends on the accuracy of the data
● To construct a breakeven chart takes time

Breakeven point in units = Fixed Costs ÷ Contribution per unit

Contribution per unit = Selling Price – Variable Cost

Breakeven point in sales = Fixed Costs ÷ Contribution to Sales Ratio

Contribution to Sales Ratio (C/S Ratio) = Contribution per unit ÷ Selling Price

Level of Sales to result in Target Profit

In Units = (Fixed Costs + Target Profit) / Contribution per unit

In Sales = {(Fixed Costs + Target Profit) / Contribution per unit} x Selling Price
 Profits = Total Revenue – Total Cost

Total Revenue = Selling Price × Output

Total Cost = Fixed Cost + Variable Cost

THE MARGIN OF SAFETY - is the range of output between the breakeven level and the current level
of
output, over which a profit is made. It shows the amount by which sales could fall before the firm starts to
make a loss.

CALCULATION OF MARGIN OF SAFETY = Actual Sales or Current output level – breakeven

output
level

MARGIN OF SAFETY AS A PERCENTAGE = (Margin of Safety / Expected Sales) x 100

EXAMPLE:
If breakeven point is 5 000 units and the firm is operating at an output level of 7 500 units, then the
Margin of Safety = 7 500 – 5 000 = 2 500 units
Margin of Safety as a Percentage = (2 500 / 5 000) x 100 = 50%
On a graph the margin of safety would be between the Breakeven Point and the Actual Sales Output
which would be greater than the Breakeven Point.
*NOTE
PLOTTING THE GRAPH
• Plot the sales line from the given figures.
• Plot the fixed costs line. This line will be parallel to the horizontal axis.
• Plot the total costs line which begins at FIXED COST where FC = TC at ZERO units of output.
• The breakeven point is represented by the meeting of the sales revenue line and the total cost line.
MAKE OR BUY DECISIONS

A MAKE OR BUY DECISION - is the choice between producing a component or a service and
purchasing it from an outside source. Factors that could influence the firm’s decision include:

▪ The variable cost or marginal cost involved to produce versus the cost to buy from another company
as the fixed costs would be incurred no matter what
▪ The firm may be the only one producing the product
▪ It may want to produce its own brand
▪ The firm may want to ensure that the product is always available instead of depending on another
supplier

EXAMPLES OF MAKE OR BUY DECISIONS:

• Whether a company should manufacture its own components, or else buy the components from an
outside supplier.
• Whether a construction company should do some work with its own employees, or whether it should
subcontract the work to another company.
• Whether the design and development of a new computer system should be entrusted to in-house data
processing staff or whether an external software house should be hired to do the work.

EXAMPLE
Undecided Ltd. manufactures a component to be used in the production of component X. The costs
associated with its current production of 20 000 units are as follows:

▪ Direct Materials (DM) $500

▪ Direct Labour (DL) $1 000
▪ Variable Overheads (VO/H) $750
▪ Fixed costs (FC) $1 000

The component could be bought at a cost of $2 000. Should the company make or buy the product.
SOLUTION: Marginal Cost per unit = (DM + DL + VO/H) = $500 + $1000 + $750 = $2 250
The company should buy the component as it is cheaper and stop manufacturing it themselves.