Costing & Profitability

1. Costing & Profitability Alison Lane Senior Lecturer Glamorgan Business School

2. Why are Accountants so concerned with ‘cost’ ? • Generally speaking, the price charged for a product should exceed its cost otherwise no profit Problem How do we define cost ?

3. Approaches to Costing • Full Cost • Total Absorption Cost • Marginal Cost

4. Full Costing • Establish direct cost of product / service / department (cost centre / profit centre) • Add on an additional element of cost to cover indirect costs (possibly a % uplift in proportion to direct costs)

5. Full Costing Example

6. Absorption Costing • A method of costing which assigns both direct and indirect costs to products / services / departments. Same as Full Costing ? • No – Key difference is in the way overheads are allocated • Indirect costs are allocated in proportion to use

7. Absorption Costing Example

9. Profit Comparison

10. Marginal Costing • An accounting system in which variable costs are charged to products / services / departments, and fixed costs for the period are charged in full against aggregate contribution How is this different from full and absorption costing ?

11. Absorption and Full Costing Direct costs are distinguished from indirect costs Indirect costs are divided or allocated between departments or products Marginal Costing Variable costs are distinguished from fixed costs There is no attempt to divide overhead costs

12. Marginal Costing Example

13. Advantages and Disadvantages of different approaches • Full Costing Advantages - Relatively simple - Includes an element of overhead cost in total production cost therefore complies with SSAP 9 Disadvantages - To general to support a detailed planning & control system

14. Absorption Costing Advantages - More sophisticated version of full costing, costs are allocated in relation to relative consumption - Identifies total production cost therefore complies with financial reporting requirements - Informs pricing decisions Disadvantages - Arbitrary decisions on allocation bases - Time consuming - Potentially misleading (traditional volume based allocation or activity based?)

15. Marginal Costing Advantages - No arbitrary allocation of overheads - Under / over absorption is avoided - Relatively simple to operate - Fixed costs are often irrelevant for short run decision making Disadvantages - Can lead to under-pricing - Does not comply with GAAP as no element of fixed cost is absorbed into stock valuation

16. Costing & Decision Making • Should the sports equipment retailer continue to sell all three types of product ? Which products are most profitable ? Implications of closing a department How could the overall profitability of the business be improved ?

17. Further Decision Making Scenarios A manufacturer has been offered a special contract to make equipment for a customer who is willing to pay £20,000 providing certain delivery requirements can be met. The management accountant has provided the following costing for the job; £ Materials 3,000 Labour (1,600 hours) 8,000 Variable overheads 4,000 Allocated Fixed Overheads 8,000 £23,000

18. Should the order be accepted? Sales Revenue is less than the total cost so don’t accept…. But…. - Does the business have spare capacity? • Is business operating above breakeven point? • Would overhead costs increase as a result of taking the contract?

19. The business is currently making a profit but has 3000 hours of spare labour capacity. Due to specialist skills they don’t want to get rid of any staff in the short term. There are no additional overhead costs specific to the contract . How might this affect the decision ?

20. Full Cost Marginal Cost £ £ Materials 3,000 3,000 Labour (1,600 hours) 8,000 0 Variable overheads 4,000 4,000 Allocated Fixed Overheads 8,000 0 £23,000 Sales Revenue £20,000 £20,000 Profit / (Loss) (£3,000) £13,000