By Iram Afnan 0332-6923451
By Iram Afnan 0332-6923451
9609
• Helps calculate profit or loss accurately
• Supports pricing decisions for products
• Allows performance comparison over time
• Used to set budgets and cost targets
• Aids efficient use of resources
• Helps managers compare options and make better decisions
▪ Direct Costs ▪ Indirect Costs (Overheads)
• Costs that can be clearly identified • Costs shared by the whole business
with a specific product or cost centre
• Cannot be easily allocated to one
• Examples: cost centre
• Fast-food business: meat for
burgers • Examples:
• Farm: tractor purchase
• Garage: mechanic’s labour
• Supermarket:
• School Business dept: Business
promotion/advertising
teacher’s salary
• Garage: rent
• Main direct costs in manufacturing: • School: cleaning costs
labour and materials
• Main direct cost in services/retail:
cost of goods sold
▪ Fixed Costs ▪ Variable Costs
• Do not change with the level of • Change directly with output
output
• Increase when production increases
• Paid even when output is zero
▪ Semi-Variable Costs
• Examples: rent, insurance, salaries
• Contain both fixed and variable
elements
• Examples:
• Fixed electricity charge + cost per
unit used
• Basic salary + commission
• Classifying costs is not always easy or worthwhile in practice
• Some costs can fall into more than one category
▪ Labour Costs
• Usually direct and variable
• Can become fixed when workers are paid despite low output
• May become indirect (overheads) if not linked to specific output
• Examples:
• TV presenter on a fixed salary
• Administrative and sales staff salaries
▪ Often fixed in the short run
▪ Electricity Costs
• Can be directly allocated if usage is accurately measured
• In practice, tracking usage may not be cost-effective
• Usually treated as an indirect overhead
• Calculating the cost per product is difficult, mainly due to overheads
• Two main costing methods used by managers:
Full costing and Contribution costing
▪ Costing Methods:
• Direct costs (labour, materials) are easy to allocate
• Indirect costs (overheads) must be shared between products
• Different methods of apportioning overheads → different product costs
• This creates problems for:
• Pricing decisions
• Accepting new orders
• Deciding whether to continue production
▪ Important Costing Concepts ▪ Profit Centres
▪ Cost Centres • Parts of a business responsible for both
costs and revenue
• Units where costs are collected
• Examples:
• Examples:
• Branches of retail chains
• Manufacturing: products,
departments, processes • Departments in a store
• Hotel: restaurant, bar, rooms • Individual products
• School: subject departments ▪ Benefits:
• Set targets for staff and managers
• Measure and compare performance
• Help decision-making (e.g. keep open
or close a unit)
▪ Overheads ▪ Average Cost (Unit Cost)
• Indirect costs not linked to one • Cost of producing one unit of output
product
• Formula:
• Types: Average cost = Total cost ÷ Number
• Production: rent, depreciation, of units produced
power
• Example:
• Selling & distribution: transport,
$1,000,000 ÷ 20,000 desks = $50 per
sales salaries
desk
• Administration: office rent, clerical
salaries • Important for pricing decisions
• Finance: loan interest
▪ Meaning
• Full costing allocates all costs (direct + indirect) to each product
• Most suitable for single-product businesses
▪ Stages in Full Costing
1. Identify and total direct costs
2. Calculate total overheads for the period
3. Add direct costs and overheads to get total cost
4. Divide by output to find average (unit) cost
▪ Example
• Output = 5,000 pumps
• Direct costs = $100,000
• Overheads = $50,000
• Total cost = $150,000
• Unit full cost = $30 per pump
▪ Allocation of Indirect Costs
• Necessary when producing more than one product
• Methods include:
• Proportion of direct costs
• Proportion of factory space
• Proportion of labour costs
• Proportion of output
▪ ⚠ Poor allocation can lead to wrong pricing decisions
▪ Uses of Full Costing
• Best for single-product firms
• Ensures all costs are included
• Useful for cost-plus pricing
• Allows performance comparisons over time (if same method used)
▪ Limitations of Full Costing
• Overhead allocation may be inaccurate
• Can give misleading cost figures
• Risky for decision-making
• Unit cost changes if output level changes
• Allocation method must stay consistent over time
▪ Meaning
• Does not allocate overheads to products
• Focuses only on variable (marginal) costs and contribution
▪ Marginal Cost
• Cost of producing one extra unit
• Equals variable direct cost
• Example:
• Cost of 100 units = $400,000
• Cost of 101 units = $400,050
• Marginal cost = $50
▪ Contribution
• Contribution = Sales revenue – Variable
(marginal) costs ▪ Importance for Decision-Making
• Contribution helps to cover fixed/indirect • Avoids problems of overhead allocation
costs
• Useful for:
• Profit is made only after overheads are • Pricing decisions
covered • Accepting special orders
• Example: • Product continuation decisions
• Selling price = $70
• Shows the direct impact of output on
• Marginal cost = $50 profit
• Contribution per unit = $20
▪ Contribution Costing & Profit
• Total contribution – Total overheads = Profit or
loss
• Example:
• Total contribution = $15,000
• Overheads = $12,000
• Profit = $3,000
▪ General Uses
• Average cost helps in pricing decisions
• Total cost is needed to calculate profit or loss
• Used in budgeting to monitor and improve performance
• Marginal cost is used in contribution costing decisions
▪ Contribution Costing & Special ▪ Dangers of Special Orders
Order Decisions
• Existing customers may demand lower
• Used when there is spare capacity prices
• Helps decide whether to accept orders • Can damage brand image and
below full cost exclusivity
• Earning a positive contribution is • May reduce full-price sales if no
better than leaving capacity unused excess capacity
• Common in off-peak pricing (e.g. • Risk of reselling into higher-priced
hotels) markets
▪ Benefits of Accepting Special Orders
• Fixed costs are already paid
• Extra contribution increases profit
▪ When Contribution Costing Is ▪ When Contribution Costing Is Not
Used Used
• To avoid inaccurate overhead • Single-product firms needing to
allocation cover all fixed costs
• To set prices that cover variable • Decisions on expansion or new
costs product development
• To decide whether to close a • When products cause very different
product or profit centre indirect costs
• To make use of excess capacity • When qualitative factors (e.g. brand
image) are important
• For special order decisions
• May prevent launch of more
profitable new products
• Used to help businesses make decisions
• Shows how much output is needed to cover costs
• Helps entrepreneurs know the minimum sales needed
• Existing firms use it to check they are not making a loss
▪ Methods of Break-even Analysis
• Graphical method (break-even chart)
• Equation method
▪ Graphical Method:
Break-even Chart
• Graph shows costs
and revenue
• Axes:
• X-axis: Output
• Y-axis: Costs &
Revenue
•Fixed costs line
•Horizontal line
•Same at all output
levels
•Sales revenue line
•Starts at the origin (0)
•Increases with output
•Variable cost line
(often omitted)
•Starts at the origin
•Rises with output
•Total cost line
•Starts at fixed costs
•Increases as variable
costs rise
▪ Margin of Safety (MOS) Shows
how much sales can fall before
the business makes a loss
• Formula:
•Break-even = 400 units, Current
output = 600 units
•MOS = 600 – 400 = 200 units
• Compare current vs potential situations (using graphs or calculations)
• Marketing decisions: effect of price increases (sales revenue slope changes)
• Operations decisions: impact of new equipment (changes fixed & variable costs)
• Location decisions: choosing between sites using break-even data
• Helps forecast risk and plan capacity
• Benefits of break even analysis ▪ Limitations of Break-even Analysis
• Provides guidelines for break-even points, • Assumes costs and revenues are straight
margin of safety, and profit/loss at different lines → unrealistic at high output
outputs • Variable costs may rise due to overtime or
shift payments
• Allows comparison of different options (e.g.,
price changes, new equipment) • Revenue may change due to price reductions
for higher sales
• Equation method gives precise break-even • Semi-variable costs complicate classification
results
• Helps managers in decision-making: location, • Assumes all units produced are sold →
equipment purchase, project investment ignores inventory
• Assumes fixed costs remain constant → may
not be true at different output levels
• For new businesses, data is based on
forecasts, which may be inaccurate
• Can lead to multiple break-even points in
practice