Costs and Costing Systems

Cost Units – units of output to which costs can be charged

A cost is simply an item of expenditureCosts 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 total Cost per unit

Variable cost Total 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

exceptionsExamples 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/fixedDirect costs Indirect costs

Variable costs Direct 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 costs Depreciation 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 revenueLessDirect materialsDirect labourProduction overheads= Gross profitLessSelling overheadsDistribution overheadsAdministrative

expensesR 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