A2 Accounting Unit 1 Lesson 1 Classification of Costs

By the end of this lesson You will Be able to Classify costs in relation to output and time, or product Know why firms need to understand their costs

Why do firms need to understand costs? Profit =Revenue - Costs So, firms need to understand their costs if they wish to improve their profit

Costs can be classified in relation to Output and Time Long run Scale of operations can be changed Product Do change with production Short run Scale of operations cannot be changed Fixed Do not vary with output in the short run Variable Do vary directly with output in the short run Direct Can be directly related to product or service Indirect Can be directly related to product or service

Revising Manufacturing Accounts Prime Cost = Cost of materials consumed + direct costs (e.g. labour/power) Prime cost + factory indirect (or overhead) expenses = or – adjustment for work in progress Cost of finished goods = In costing the product, the main way in which costs are analysed above is direct and indirect

Costs, revenue and profit Total Cost = Fixed Cost + variable cost Profit = total revenue – (fixed costs + variable costs) Profit = total revenue – total costs There are a number of costing techniques that use fixed and variable costs. Break even analysis Absorption costing Marginal Costing

Fixed Cost shown by graph 0 Cost in £ Number of items made (Output) FC As the level of output increases, the fixed costs stay exactly the same

Activity-1 Sarah Reavenall operates two hairdressing salons, one in Bromsgrove and the other in Redditch In your book, write down 4 examples of costs that are likely to be fixed for this business Rent Insurance Cleaning Staff salaries …could all be fixed costs Explain why! Do fixed costs stay the same irrespective of the level of output, even where there is a massive rise in the level of output? Think in terms of the Rent cost for Sarah’s business

Step change in Rent Costs 0 Cost in £ Number of items made (Output) FC As the salon becomes more popular, additional accommodation needs to be rented. This will cause a “step” in the rent cost. Further popularity can result in another “step” etc

Variable Cost shown by graph 0 Cost in £ Number of items made (Output) VC As the level of output increases, so does the variable cost

Activity-2 Sarah Reavenall operates two hairdressing salons, one in Bromsgrove and the other in Redditch In your book, write down 2 examples of costs that are likely to be variable for this business Lotions and other materials used Laundry costs to wash towels …could all be variable costs Explain why! In some cases, costs have both an element of fixed and variable cost about them e.g. electricity may be fixed for heating/lighting but variable for power to hairdryers

For Sarah’s Salon For a hairdressing business most costs will be FIXED. However, there will be some variable costs. Total Costs = fixed costs + variable costs This can be shown by graph on the next slide

Sarah’s Salon 0 Cost in £ Number of hair do’s (Output) FC 1. Why does Sarah have a fixed cost of £ at zero output TC What is the total cost of 2000 hair do’s? 3. What is the variable cost of 2000 hair do’s?

For Sarah’s Salon Once we know the TOTAL COSTS we can find Sarah’s BREAK EVEN POINT (BEP) Sarah will break even when sales (total revenue) equals total costs This can be shown by graph on the next slide

Sarah’s Salon Break Even Point 0 Cost in £ Number of hair do’s (Output) FC 1. Why does Total Revenue (Sales) start at zero output? TC What is Sarah’s break even output? TR (sales)

For Sarah’s Salon Sarah’s break even point can be worked out not only by CHART but also by CALCULATION There are 2 formulae needed to work out Sarah’s BEP First we need to find the CONTRIBUTION made towards the FIXED COSTS and PROFIT of Sarah’s business Contribution = Selling price – Variable cost Once we know the contribution, we can calculate BEP Break Even Point (BEP) = Fixed Costs Contribution

Calculate Sarah’s BEP If Sarah charges £25 per hair do, has fixed costs of £ and variable costs of £5 per hair do. How many hair do’s will she need to break even. Using the 2 formulae on the previous slide show your calculation of Sarah’s BEP How does your answer compare with that given on the graph you looked at earlier?

Homework Please do the 3 questions from A2 Unit 7 Worksheet 1 for our next lesson Make sure all the activities in this lesson have been completed before you do the homework This includes the Lesson summary on the final slide

Summary Work with your partner on any question you are not sure of …otherwise write your answer in your book 1. Define fixed cost and variable cost 2. What is a semi-variable cost? 3. Under what circumstances could total cost be £40000 at zero output? 4. How much profit is earned at the BEP? 5. What does CONTRIBUTION mean? 6. Give the formula to calculate the BEP