Chapter 28.

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FLASHCARDS IN UNIT 5. CHAPTER 28. COSTS DECK (13)

Important concepts in costing methods (4) (Name)

• Cost centres

• Profit centres

•Over heads

• Units costs

Def. Cost centres

Give examples

A section of a business, such as a department, to which costs are allocated or charged.

E.g.

• Manufacturing business: products, factories, departments.

• School: different subjects

Def. Profit centres

Give examples

A section of a business to which both costs and revenues can be allocated - so profit
can be calculated.

E.g.

• Each branch of a chain of shops

• Each department of the department store

• In a multi-product firm, each product in the overall portfolio of the business.

Benefits and Limitations of dividing operations into cost and profit centres (3)

Benefits:

• Provide targets for managers and staff to work towards

• The targets can be used to assess performance

• Aids decision making

Limitations:

• Profit centres can have unnecessary competition

• Some costs (like indirect costs) can be impossible to allocate and cost and profit
centres accurately

• Reasons for bad or good performance of a profit centre can be due to external factors

5
 How are overheads classified (4 main groups)

• Production overheads e.g. rent, depreciation of equipment

• Selling and distribution overheads e.g. salary, packing

• Administration overheads e.g. rent and rates

• Finance overheads e.g. interest on loans

How to calculate unit cost?

Unit cost = total cost of producing the product/ number of units produced

Def. Full/absorption costing method

A method of costing in which all fixed and variable costs are allocated to products or
services.

Further explanation: Total overheads are allocated using one or more methods. E.g.
Can be divided on the basis of office space taken up by each product or service.

Benefits and limitations of full/absorption costing methodsp

Benefits:

• Easy to calculate and understand

• Relevant to single product business

• All costs are allocated - no costs are 'ignored'

• Good basis for pricing decisions in one product firms

Limitations:

• Costs may not be allocated on the basis of actual expenditure e.g. A product can take
up more space but use low-cost and easy-to-maintain machinery

• Cost figures can be misleading

• Must be used on the same basis to give accurate comparisons between years

Def. Marginal/contribution costing method

Costing method that allocated only direct costs to cost/profit centres, not overhead
costs.

This method concentrated on marginal costs and contribution of a product.

10

Explain marginal costs and contribution of a product

• Marginal cost: cost of producing an extra unit (variable direct cost). e.g. if producing
100 units if $400 000, and 101 units is $400 050, then the marginal cost is $50.

• Contribution of a product is revenue gain from selling a product minus its marginal
costs. (Not the same as profit as profit is calculated after deduction of overheads.) e.g. If
the 101st unit is sold for $70, then contribution is $20.

11

Using costing methods to decide whether to stop making a product

Using marginal costing method: showing managers which product or service is making
the greatest or least contribution to overheads and profits.

Using full costing method: The manager may decide to stop producing a good that
seemed to be making a loss, even though it might still make positive contribution. This
will reduce overall profits of the business. This is because the fixed overhead costs will
still have to be paid with less contribution to pay them.
12

Should a business accept a contract or a purchase at below full cost? (decide using
costing methods)

If a firm has spare capacity or if it is trying to enter a new market, the business can offer
below full cost contracts or purchases.

E.g. Hotels can offer lower prices (below costs) in off peak seasons because it is better
to earn some contribution than to leave rooms empty.

However,

• Existing customers may learn lower prices are being offered and demand similar
treatment. If all services and products are sold below costs, it is unlikely that profits will
be made.

• High prices can be the key feature in establishing the exclusivity of a brand -> lower
prices ruin image

• Lower priced goods can be resold into high prices market.

13

Benefits and limitation of contribution costing

Benefits:

• Avoids inaccuracies with allocating overhead costs

• Excess capacity is used more effectively

Limitations:

• Not appropriate for 1 product businesses as the revenue has to cover all of the fixed
costs

• Products with low contribution can be a part of the range, and getting rid of that
product can make the whole range less appealing.
• Overheads may be completely overlooked and contribution can be confused with
profit.