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