5.4 COSTS

• Cost information


  The need for accurate cost information
• Different types of costs

  • Fixed
  • Variable
  • Direct
  • Indirect
• Full costing


  Approach to costing that allocates all fixed and variable costs to products or services
• Contribution costing


  Costing method that allocates only direct costs to cost/profit centres, not overhead costs
• Differences between full and contribution costing


  • Full costing allocates all costs, contribution costing only allocates direct costs
• Full costing


  • Uses "apportionment" to allocate fixed and variable costs to products/services
  • Easier to calculate direct labour and materials costs
  • More difficult to allocate indirect/overhead costs accurately
• Contribution costing


  • Only includes variable/direct costs, ignores fixed/overhead costs
  • Identifies contribution (sales price - variable costs) instead of profit
• Contribution costing is used to help make special order decisions
• Break-even analysis


  Technique to calculate and interpret break-even level of output, contribution, margin of safety and level of profit
• Break-even analysis


  • Can be calculated in numeric and graphic form
  • Has uses and limitations
• Overhead costs


  Ongoing administrative expenses that cannot be attributed to a specific business activity but are necessary for the business to function
• Main groups of overheads

  • Production overheads
  • Selling and distribution overheads
  • Administration overheads
  • Finance overheads
• Unit cost


  The average cost of producing each unit of output
• Cost information is used for decision-making, pricing, monitoring and improving business performance, and calculating profits
• Marginal cost is the extra cost of producing one more unit of output
• Contribution is the difference between sales price and variable costs
• Marginal costing identifies contribution instead of profit
• When accepting a special order, the decision should be based on marginal cost rather than full cost
• Absorption costing allocates a portion of fixed costs to each product, while marginal costing does not
• Marginal costing layout shows sales, variable costs and contribution, while full costing layout shows sales, variable costs, fixed costs and profit
• Comparing the two methods, full costing is easier to calculate but more difficult to allocate overhead costs accurately
• Absorption costing


  Allocate/apportion fixed cost to each product
• Marginal costing


  Do not allocate/apportion fixed cost to each product but deduct the total fixed cost from the total contribution
• Marginal costing helps management take appropriate decisions when faced with the option
• One drawback - if overheads are set aside for costing purpose, there is a danger that they could be overlooked. This mean that contribution is confused with profit, pricing decisions for products could ignore the fixed-cost element but eventually overheads have to be paid for.
• Cost information for decision-making purposes

  Average, marginal, total costs
• How costs can be used to monitor and improve business performance

  Using cost information to calculate profits
• Contribution costing


  As a means to help make special order decisions
• Calculation and interpretation of break-even level of output, contribution, margin of safety and level of profit

  Numeric and graphic form
• Break-even point is the level of output at which total costs equal total revenue. It is the point where the company is neither making a profit or a loss.
• Break-even point can be calculated in two ways

  1. The graphical method

  2. The equation method
• Break-even analysis


  • Costs/Revenue vs Output/Sales
• A higher price or lower price does not mean that break even will never be reached
• The break even point depends on the number of sales needed to generate revenue to cover costs
• The break even chart is NOT time related
• Margin of safety


  The amount by which the sales level exceeds the break-even level of output
• Margin of safety


  Current output - B.E output
• Profit


  Margin of safety x contribution per unit
• Total cost = VC + FC
• Cost per unit = Total cost / Output