Costs and Costing Systems Cost Units – units of output to which costs can be charged A cost is simply an item of expenditure Costs are defined as the normal business expenses incurred in bring the goods (or services) to their present location and condition.

Cost centres A cost centre is a responsibility centre in which the manager accountable for direct costs only An individual part of the business where costs are incurred and can easily be recorded The manager responsible for the centre has control over costs but not revenue Example: Personnel/HRM department Finance department R and D department Transport department Warehouse & stock control department Buying department In all the above cases the department incurs costs but does not earn revenue A item of equipment (such as an office photocopier) can also be regarded as a cost centre

Fixed and Variable costs (classified by behaviour) Fixed Costs Costs that do not vary with the level of output or sales – they are unaffected by changes in the level of activity Examples of fixed costs: rent and rates, insurance costs, some energy costs, equipment and machinery, salaries, interest charges and depreciation Conclusion: as output rises within the relevant range so average fixed costs (fixed costs per unit) fall. Variable Costs Variable costs are defined as costs that vary in proportion to the level of business activity (i.e. production and sales) Examples : the cost of raw materials, direct labour costs, piece rate labour charges, direct energy costs Therefore as output rises, so do variable costs and as output falls, so do variable costs Short term decisions making is primarily concerned with variable costs

Semi – Variable Costs These are costs which are party affected by the level of activity but not in direct proportion. This is because they combine a fixed and a variable element Examples: –Telephone bill with fixed rental and a charge per unit –Vehicle hire: fixed sum plus a rate per mile over a specified mileage Cost in totalCost per unit Variable costTotal VC change as activity changes VC per unit remains the same Fixed cost Total FC remain the same when activity changes FC per unit falls as output rises

Direct and Indirect costs (Classified by traceability) Direct costs - costs which are wholly and exclusively identifiable with whatever is being costed. They are directly associated with output Direct costs are mainly variable costs but could be fixed (e.g. rent of a building solely used for one product) Direct costs consist of: –Cost of direct materials used in a specific product –Direct labour costs – employees clearly identified with a specific product –Direct expenses – any direct costs other than direct materials and direct labour costs Total direct costs are known as prime costs

Indirect costs - costs of production not easily associated with the production of specific goods and services. These overhead costs may be allocated on some arbitrary basis to specific products or departments Indirect cost are known as overhead costs In general they are also fixed costs but there are exceptions Examples of indirect costs Rent Rates Interest payments Cost of administration Indirect labour cost. e.g. wages of supervisory staff Indirect materials cost E.g. factory cleaning materials, lubricating oil

Direct/variable and indirect/fixed Direct costsIndirect costs Variable costsDirect costs which are variable include cost of materials and direct labour Energy costs to power machinery within a factory are variable but because of the difficulty of linking use to particular products they are treated as indirect. Fixed costsDepreciation on a machine dedicated to a particular product is a fixed cost but is also direct. Similarly rent on premises used for a single product. Costs which are indirect and fixed include the cost of administration and rent on premises

Costing systems Absorption costing - Absorption Costing absorbs the total cost of the whole business in to each unit or “ What does it cost to make one unit of output?” Calculating the absorption cost of one unit Total Direct costs + Total indirect costs/ units of output = the cost of producing one unit. Absorption Costing Statement Sales revenue Less Direct materials Direct labour Production overheads = Gross profit Less Selling overheads Distribution overheads Administrative expenses R and D costs = Net profit

Marginal costing Marginal Costing is the cost of producing one extra unit of output An accounting system in which variable costs are charged to cost units and fixed costs of the period are written in full against aggregate contribution The valuation of a product solely on the basis of variable costs Marginal cost statements Sales revenue Less variable costs (direct labour, direct materials, variable production overheads, variable selling and distribution overheads) Equals contribution Less total fixed costs (production overheads, selling overheads, distribution overheads, administrative expenses) Equals net profit before tax

Definition of contribution Contribution is the difference between sales revenue and variable cost It is the amount remaining after variable costs have been deducted from sales revenue Contribution is not the same as profit since we reach a figure for contribution we have only deducted variable costs and not fixed costs Total contribution equals sales revenue minus variable costs General Rule (when using contribution to assess different options) If the total contribution is less then the total fixed costs then it will not be profitable to produce and will incur a loss. If the Contribution is equal to the total fixed costs, there will neither be a profit or a loss. If contribution is higher then a profit will incur and will be worthwhile producing.

Contribution per unit As well as total contribution it is also useful to calculate the contribution that each unit of sales produces Contribution per unit is revenue per unit (price) minus variable costs per unit Contribution to what? In the first instance it is contribution to fixed costs Once fixed costs have been covered it is contribution to profits Total contribution = total fixed costs + profit Therefore, profit = total contribution minus total fixed costs

Strengths of the concept It is useful in decision making It avoids the need for arbitrary division of fixed costs It provides a flexible basis for pricing decisions Weaknesses of the concept Ignores fixed costs Some costs are difficult to classify as fixed or variable In the longer term, fixed costs can change thus invalidating earlier decisions based on contribution