ELEMENTS OF COST

Direct Cost – this is a cost that can be traced in full to product/service being made.

i.e. – cost of materials
– labour other costs
= Prime Costs

Indirect Cost – cost incurred in the course of making a product that cannot be traced directly and in full to that product.

Total of Indirect Costs
= Overheads

Prime costs + overheads = Total Cost

Costs can also be classified as fixed or variable.
Variable costs will vary with the volume of production; whereas fixed costs have to be paid regardless of volume activity.

COST UNIT
A quantitative unit of product/service in relation to which costs may be ascertained and expressed.

Unit selected must be appropriate to the business.
e.g. Single item Batch; Contract; Job

COST CENTRE
A location, person or item of equipment for which may be ascertained, related to cost units and used for control purposes e.g. A Production Department; Service Department e.g. Maintenance;Admin Dept e.g. Personnel Distribution

Shared costs e.g. Rent, Rates, Electricity can be allocated to cost centres- Absorption Costing

MARGINAL COSTING

Alternative method of costing to absorption costing

Need to identify variable costs- i.e those that would not be incurred if the product was not made

A very important concept of marginal costing is contribution

Contribution is the difference between the selling price and variable costs

Need to calculate contribution per unit; this can be done either by using selling price and variable costs (if available) or by dividing total contribution by number of units sold

Contribution can be seen as what a business earns on a product before it takes into account its fixed costs which it cannot alter

Contribution – fixed costs = profit

Example
Rain Ltd makes a product, the splash which has a variable cost of £6 and a sales price of £10 per unit.

Production in September could be: a) 10,000 units; b) 15,000 units or c) 20,000

Fixed costs per month £45,000

What is the total contribution, contribution per unit and profit based on the 3 levels of production?

Breakeven Analysis

This is an application of marginal costing and it basically highlights the point in terms of sales at which neither a profit nor loss occurs i.e breakeven point
If breakeven point is when neither profit nor loss occurs, it follows that:
Breakeven point is when total sales- total costs= nil, or
Contribution – fixed costs =nil

To calculate the number of units need to sell to break even:

Fixed costs
Contribution per unit

Breakeven in £ = breakeven in units x selling price per unit

Example

Expected sales 10,000 units £80,000
Variable costs per unit £5 per unit
Fixed costs £21,000

Calculate breakeven point in terms of units and revenue

Further example

Butterfingers Ltd manufactures one product for which the following is available:

Sales 15,000
Selling price per unit £24

Direct labour £120,000
Direct material £75,000

Production overhead £240,000, of this 1/6 is variable (and based on sale 0f 600 units)

Calculate total contribution, contribution per unit and breakeven point in units & £

If a company can anticipate how many units it need to sell to breakeven, it follows that a business can anticipate how many units it has to sell to achieve a target profit.

To calculate how many units need to be sold to achieve a certain profit, the calculation becomes:

FC + target profit
Contribution per unit

How many units must a business sell if it wishes to make a profit of £70,000 and its fixed costs are £120,000? CPU £12

Costing questions

1. Widgets Ltd produces the widget details of which are as follows:

Selling price £30 per unit
Variable costs £10 per unit

Fixed costs (rent) £50,000 per annum

i) How many units must be sold to break even? ii) If rent goes up by 10% and the company aims to make a profit of £30,000 what output is needed?