Transcript IB2 Ch 31 Costs and Revenues

5.2 Costs and Revenues
Chapter 31
Management Decisions and Cost
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Business decisions cannot be made without
cost information. Why?
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Profit or loss cannot be calculated without
knowing COST
Marketing will use COST information to determine
pricing
COST records are useful in comparing to past
performance and help set budgets
COST data can help determine the use of
resources…use labor hours or buy automated
equipment?
Production Costs
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The financial costs incurred in making a product or
providing a service.
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Costs are classified into categories:
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Direct Costs
Indirect Costs
Fixed Costs
Variable Costs
Semi-Variable Costs
Marginal Costs
Direct Costs
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Direct Costs
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Costs can be clearly identified with each unit of
production and can be allocated to a cost center.
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Direct costs of a hamburger in a fast-food restaurant is
the cost of meat…. You name another
Direct cost for a automobile repair shop servicing a car
is the labor of the mechanic…You name another
Direct cost for a business studies department is the
salary of the business teacher…You name another
Common direct costs in manufacturing are labor and materials.
Common direct costs in a service business is the cost of goods sold.
Indirect Costs
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Indirect Costs
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Costs which cannot be identified with a unit of
production – also known as overhead costs
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Indirect cost to a farm is the purchase of a tractor….
You name another
Indirect cost to a automobile repair shop is rent…
You name another
Indirect cost of running a school is the cost of cleaning…
You name another
Indirect Costs
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Indirect Costs can be classified into 4 groups:
1. Production overheads –
factory rent, equipment depreciation, electricity
2. Selling and distribution overheads –
warehouse, packing, and distribution costs
3. Administration overheads –
office rent, clerical salaries
4. Finance overheads –
interest on loans
Costs are affected by Output
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Some costs vary with output of production and some
costs do not change.
Costs can be classified:
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Fixed costs –
These remain constant no matter what happens to
production output (rent)
Variable costs –
These vary as production output changes (quantity of raw
materials used)
Semi-Variable costs –
These include both fixed and variable costs (account
charge for electricity plus the electricity used)
Marginal costs –
The additional variable cost of producing one more unit
Revenue
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Revenue is the income received from the
sale of a product
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Total Revenue is the total income from the
sale of ALL units of the product
(quantity X price)
Don’t confuse Revenue, Cash Flow, and Profit
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Remember: Revenue is not the same as
cash received from sales.
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Revenue is recorded at the time of sale not at the
time cash is received.
Remember: Revenue is not the same as
profit.
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All costs of operating the business are subtracted
from revenue to determine profit.
Contribution to Fixed Costs
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Contribution per Unit
Is the selling price of a product less variable costs
per unit.
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Total Contribution
Is the total revenue from the sale of a product less
total variable costs of producing it.
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Contribution is NOT profit. Contribution is what a
product “contributes” towards fixed costs, and once
these are paid, towards the profits of the business.
Cost and Profit Centers
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Cost Center: A section of a business, such as a
department, to which costs can be allocated.
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Profit Center: A section of a business to which both
costs and revenues can be allocated.
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Examples: products, departments, factories, process or
stage of production
Examples: branch offices, departments in a store, multiproduct firms – each product line
Benefits of Costs and Profit Centers
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Managers and staff will have targets to work
towards.
Targets can be compared with actual
performance and identify areas of strength
and weakness.
Individual performances of divisions allow
managers to be assessed and compared.
Work can be monitored and decisions made
about the future – keep producing, raise prices,
shut down area
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Problems with Costs and Profit Centers
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Managers and workers may think they are
most important to the business.
Damaging internal competition can occur.
Indirect costs may be impossible to allocate
accurately to centers and they can be applied
inaccurately or arbitrarily.
Reasons for good or bad performance may
be due to external factors.
Contribution Costing
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A costing method that only allocates direct costs to
cost/profit center and does NOT include overhead
costs.
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Focused on 2 accounting concepts
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Marginal cost is the cost of producing an extra unit.
(Total cost of producing 500 units is $5000 and the total cost of
producing 501 units is $5005, then the marginal cost is $5.)
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Contribution costing is the amount the product contributes
to covering fixed costs and profit.
(If 501st unit sells for $25 and the marginal cost was $5, then $20 can be
contributed towards fixed costs.)
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Contribution Costing and DecisionMaking
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If a company makes more than one product,
contribution costing shows management how much
each product is contributing to fixed costs and
profits.
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Marginal costing assists managers in deciding
whether to accept an order below the full cost of the
product.
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Example: Hotels offer low rates during off-peak seasons.
Airlines sell seats at a discount 2 days prior to the planes
departure date. Reasoning: It is better to earn a
contribution than leave the rooms or airplane seats empty.
Dangers of Contribution Costing and
Price Determination
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Existing customers learn of the lower prices
for others and demand similar treatment; then
earning a profit is unlikely.
When high prices establish exclusivity of a
brand, then lower prices can destroy image.
If there is no excess capacity, contribution
pricing may cost sales at full price.
Lower priced goods can be purchased by
others and resold for a higher price.
A Story….
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Sue is a dress maker who pays $45 a day to use a workshop. She
makes 3 dresses a day and sells them for $30 each. Materials
cost her $8 a dress.
Fixed costs per dress
$15 ($45/3 dresses)
Material Costs per dress $8
Total Unit Cost
$23
One day she has orders for only 2 dresses. She received an inquiry for 1
dress at $20. Should she accept the order?
Does NOT accept, she will lose $1
Sales of 2 dresses @ $30 = $60
Cost 2 dresses @ $8 = $16 + Total fixed costs $45=$61
$1 loss
She accepts, she will make a profit of $11
Sales of 2 dresses @$30 + sale of 1 dress @ $20 = $80
$11 profit
Dress 3 has a contribution cost of $12 ($20 - $8)
Cost 3 dresses @ $8 = 24 + total fixed costs $45 = $69
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Contribution Costing Summary
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Ignoring overhead costs does not consider that some products
actually do have higher fixed costs than others.
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Contribution costing may not be appropriate for single product
firms.
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Products may be produced because of their contribution when a
new product should be considered or launched.
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Qualitative factors need to be considered:
 Does the product promote the companies image?
 Does it complete the product range? And eliminating would
reduce the appeal of the product?
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