Costing and pricing decisions

Costs are defined as the normal business expenses incurred in bring

the goods (or services) to their present location and condition.

Cost Units – units of output to which costs can be charged

Direct and Indirect costs(Classified by traceability)

• Direct costs - costs which are wholly and exclusively identifiable with whatever is being costed. They are directly associated with output

• Direct costs are mainly variable costs but could be fixed (e.g. rent of a building solely used for one product)

• Direct costs consist of: – Cost of direct materials used in a specific product– Direct labour costs – employees clearly identified with

a specific product– Direct expenses – any direct costs other than direct

materials and direct labour costs• Total direct costs are known as prime costs

Indirect costs - costs of production not easily associated with the production of specific goods and services. These overhead costs may be allocated on some arbitrary basis to specific products or departments

• Indirect cost are known as overhead costs• In general they are also fixed costs but there are

exceptionsExamples of indirect costs• Rent• Rates• Interest payments• Cost of administration• Indirect labour cost. e.g. wages of supervisory staff• Indirect materials cost• E.g. factory cleaning materials, lubricating oil

• A cost centre is a location, or a function, or an activity or an item of equipment. Each cost centre acts as a collecting place for certain costs before they are analysed further.

• All costs should be recorded as a direct cost of a cost centre. Even 'overhead costs' are directly traceable to an office or an item of expense and there should be an overhead cost centre to cater for these costs.

• Once costs have been traced to cost centres, they can be further analysed in order to establish a cost per 'cost unit'. Alternatively, some items of cost may be charged directly to a cost unit, for example direct materials and direct labour costs.

Profit centres

A profit centre is accountable for costs and income. It may also be called a business centre, business unit or strategic business unit.

Profit centre managers should normally have control over how income is raised and how costs are incurred. Not infrequently, several cost centres will comprise one profit centre.

Fixed and Variable costs(classified by behaviour)

Fixed Costs• Costs that do not vary with the level of output or sales – they are unaffected

by changes in the level of activity• Examples of fixed costs: rent and rates, insurance costs, some energy

costs, equipment and machinery, salaries, interest charges and depreciation• Conclusion: as output rises within the relevant range so average fixed costs

(fixed costs per unit) fall. Variable Costs• Variable costs are defined as costs that vary in proportion to the level of

business activity (i.e. production and sales)• Examples : the cost of raw materials, direct labour costs, piece rate labour

charges, direct energy costs• Therefore as output rises, so do variable costs and as output falls, so do

variable costs• Short term decisions making is primarily concerned with variable costs

Direct/variable and indirect/fixedDirect costs Indirect costs

Variable costs Direct costs which are variable include cost of materials and direct labour

Energy costs to power machinery within a factory are variable but because of the difficulty of linking use to particular products they are treated as indirect.

Fixed costs Depreciation on a machine dedicated to a particular product is a fixed cost but is also direct. Similarly rent on premises used for a single product.

Costs which are indirect and fixed include the cost of administration and rent on premises

Marginal costing

• Marginal Costing is the cost of producing one extra unit of output

• An accounting system in which variable costs are charged to cost units and fixed costs of the period are written in full against aggregate contribution

• The valuation of a product solely on the basis of variable costs

Marginal cost statements• Sales revenue• Less variable costs (direct labour, direct materials,

variable production overheads, variable selling and distribution overheads)

Equals contribution• Less total fixed costs (production overheads, selling

overheads, distribution overheads, administrative expenses)

Equals net profit before tax

• Contribution - is the difference between sales revenue and variable cost

• It is the amount remaining after variable costs have been deducted from sales revenue

• Contribution is not the same as profit since we reach a figure for contribution we have only deducted variable costs and not fixed costs

• Total contribution equals sales revenue minus variable costs

Contribution to what?• In the first instance it is contribution to fixed

costs• Once fixed costs have been covered it is

contribution to profits• Total contribution = total fixed costs + profit• Therefore, profit = total contribution minus total

fixed costs

Contribution per unit• As well as total contribution it is also useful to

calculate the contribution that each unit of sales produces

• Contribution per unit is revenue per unit (price) minus variable costs per unit

Strengths of the concept• It is useful in decision making• It avoids the need for arbitrary division of fixed costs• It provides a flexible basis for pricing decisions Weaknesses of the concept• Ignores fixed costs• Some costs are difficult to classify as fixed or variable• In the longer term, fixed costs can change thus

invalidating earlier decisions based on contribution

Relevant and Irrelevant costs• The costs which should be used for decision making are often

referred to as relevant costs.• A relevant cost is a future cash flow arising as a direct

consequence of a decision. Relevant costs are: (a) Future costs (b) Cash flows(c) Is a direct consequence of a decision

A number of terms are used to describe costs that are irrelevant for decision-making because they are either not future cash flows or they are costs which will be incurred anyway, regardless of the decision that is taken.

• Sunk Costs• Committed costs• Notional Costs• Fixed costs (not always)• Direct and Indirect (depending on the situation)