costing profitability

8/7/2019 Costing Profitability

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Costing & Profitability

Alison LaneSenior Lecturer

Glamorgan Business School


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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 ?


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Approaches to Costing Full Cost

Total Absorption Cost

Marginal Cost


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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)


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Full Costing ExampleGolf Gym Outdoor Total Direct Costs

Cost of items for resale 540,000 395,000 420,000 1,355,000

Employee wage costs 120,000 80,000 160,000 360,000

660,000 475,000 580,000 1,715,000

Indirect costs

Share of general overheads 42692 30725 37517 110935

Full Cost 702,692 505,725 617,517 1,825,935

% share of total direct cost 38% 28% 34%


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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


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Absorption Costing ExampleOverhead costs Cost Basis Golf Gym Outdoor

Rent 28000Area 8842 5895 13263

Light & heat 15000Area 4737 3158 7105

Cleaning 5340Area 1686 1124 2529

Supervisors salaries 45900Staff 15300 10200 20400

Insurance -Buildings 6678Area 2109 1406 3163

Insurance -employees 10017Staff 3339 2226 4452

Total 110935 36013 24009 50913


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Golf Gym Outdoor Total

Direct Costs

Cost of items for resale 540,000 395,000 420,000 1,355,000

Employee wage costs 120,000 80,000 160,000 360,000

660,000 475,000 580,000 1,715,000

Indirect costs

Apportioned overheads 36013 24009 50913 110935

Full Cost 696,013 499,009 630,913 1,825,935


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Profit ComparisonFull Costing Golf Gym Outdoor Total

Sales Revenue 975,000 485,000 855,000 2,315,000

Less

Full Cost 702,692 505,725 617,517 1,825,935

Profit 272,308 -20,725 237,483 489,065

Absorption Costing Golf Gym Outdoor Total

Sales Revenue 975,000 485,000 855,000 2,315,000

Less

Full Cost 696,013 499,009 630,913 1,825,935

Profit 278,987 -14,009 224,087 489,065


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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 ?


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Absorption and Full Costing

Direct costs are

distinguished from indirectcosts

Indirect costs are divided or

allocated between

departments or products

Marginal Costing

Variable costs are

distinguished from fixedcosts

There is no attempt to divide

overhead costs


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Marginal Costing ExampleMarginal Costing Golf Gym Outdoor Total

Sales Revenue 975,000 485,000 855,000 2,315,000

Less Variable Costs

Goods for resale 540,000 395,000 420,000 1,355,000

Employee wages 120,000 80,000 160,000 360,000

Contribution 315,000 10,000 275,000 600,000

Less Fixed costs

Overheads 110,935

Profit 489,065


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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


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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 allocationor activity based?)


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Marginal Costing

Advantages

- No arbitrary allocation of overheads

- Under / over absorption is avoided

- Relatively simple to operate

- Fixed costs are often irrelevant for short rundecision making

Disadvantages

- Can lead to under-pricing

- Does not comply with GAAP as no element of fixed costis absorbed into stock valuation


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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 beimproved ?


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Further Decision Making ScenariosA manufacturer has been offered a special contract to makeequipment for a customer who is willing to pay 20,000providing certain delivery requirements can be met. Themanagement accountant has provided the following costing forthe job;

Materials 3,000

Labour (1,600 hours) 8,000

Variable overheads 4,000

Allocated Fixed Overheads 8,000

23,000


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Should the order be accepted?Sales Revenue is less than the total cost so dont 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?


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The business is currently making a profit but has

3000 hours of spare labour capacity. Due to specialist

skills they dont want to get rid of any staff in the short

term. There are no additional overhead costs specificto the contract .

How might this affect the decision ?


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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

costing profitability

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