As ClassificationofCosts,Profit,Contribution

8/8/2019 As ClassificationofCosts,Profit,Contribution

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CLASSIFICATION OF COSTS,

PROFITS, CONTRIBUTION

Costs

Quick Quiz

Case Study

Cost Centres and Profit Centres

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Costs, Profit, Contribution

and Break-Even Analysis

These costs are then allocated as accurately as

possible to the cost centres that generate them. In

this way centres are made aware of their

responsibility to control costs

Cost Classification and Cost Allocation

In order to make meaningful decisions a manager

must have cost data for each product, department

and function of the business

The problem with this is how to accurately define

the costs and how to allocate the costs to the

various products and departments

The management accountant classifies costs into

fixed and variable costs ordirect and indirect costs


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Fixed, Variable and

Semi- Variable Costs

Variable Costs expenses that alter in the

short run to changes in output e.g. raw

materials, packaging and components. They

are payments for the use of inputs

Fixed Costs expenses that do not alter inthe short run in relation to changes in outpute.g. rent, insurance and depreciation. Thesecosts are linked to time rather the level ofbusiness activity

Semi Variable Costs expenses that vary

with output but not in direct proportion e.g.

maintenance costs. They often comprise a

fixed element and a variable element


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Direct and Indirect Costs

Indirect Costs costs that cannot

be allocated accurately to a cost

centre or product e.g. administration

costs, management salaries or

maintenance costs. Another term for

this is overheads

irect Costs costs that can be directly identified with aproduct or cost centre. They are mainly variable costs but caninclude some fixed costs e.g. the rent of a building solely usedfor one product. They are also referred to as prime costs


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Total Cost

Total Cost this is the addition of all fixedand variable costs (plus any semi-variablecosts)

The total cost is used by the business tosee how much finance is required for each

level of output

Where fixed costs form a significant part of

total costs it is important for a business tomaximise sales so that the fixed cost

element is spread across as many units as

possible


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Average Cost / Selling Price Per Unit

For example:

Variable costs are 10 per unit of production

Costs for 1,000 units are:

Fixed Costs 20,000 (These do not increase with production)

Variable Costs 10,000

Total Costs 30,000Average Cost per unit = 30,000 / 1,000 units = 30 per unit

Average Cost Per Unit + Percentage Mark-up = Selling Price

30 + 50% = 45

Average Cost this is the cost per unit of production and is found by

dividing total cost by total output. Average cost can be used to establish

the basic price level by adding on a suitable mark-up


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Total Revenue / Contribution Per Unit

Total Revenue This is the amount of money a business

receives from selling its products. It is calculated by multiplying

the number of units sold by the the unit price

For example:

Selling Price Per Unit 20

Variable Cost Per Unit 10

Contribution Per Unit 10

Contribution is used to pay the fixed costs and generate a profit

Contribution Per Unit This is the difference between the sellingprice per unit and the variable cost per unit


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Break-Even Analysis /

Margin of Safety / Profit

Break-even provides the firm with its first target i.e.

covering all of its costs. Any sales beyond the break-even

point(BEP) will then generate a profit

Thus the profit for the firm would be 2,000 units x 10 contribution per unit= 20,000

The Margin of Safety (MOS) is the difference between the planned level of sales

and the BEP. If the firm planned to sell 12,000 units. The MOS would be 12,000

10,000 = 2,000 units

For example: A firm has fixed costs of 100,000, variable costs (VC) of 10

per unit and a selling price (SP) of 20 per unit.

BEP = Fixed Costs / Contribution per unit (i.e. SP VC)

BEP = 100,000 / 20 - 10 = 10,000 units

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Quick Quiz

Q2 A firm has the following fixed costs:

Rent 5,000 Rates 4,000

Insurance 3,000 Depreciation 8,000

It makes and sells product X the variable costs are 10 per unit.

What is the total cost of making 1,000 units?

What is the total cost of making:

2,000 units 5,000 units 10,000 units 20,000 units

Q3 What will be the selling price per unit if production is increased from1,000 to 2,000 units and the mark-up is increased to 75%?

Q4 Using the information from the previous quiz calculate the total

revenue generated from the sale of 1,000 units and 2,000 units.


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Quick Quiz

Q5 A firm has fixed costs of 200,000 variable costs of 20 per unit and

a selling price of 40 per unit. It plans to make and sell 15,000 units.

Repeat the exercise assuming one change the firm

plans to make and sell 20,000 units.

Draw a break-even chart showing the above information.

How much profit will be generated if the

firm achieves its sales target?

How much sales revenue will be

generated by selling 15,000 units?

What is the total cost of making

15,000 units?

What is the margin of safety?

What is the break-even point?What is the contribution per unit?

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Cost centres and profit centres

The Changing Nature ofBusiness Globalisation of

business, a higher rate of product obsolescence (due to

rapid technological developments) and the increased

sophistication of consumers has led to increased

competitive pressures within all markets

Mergers and Takeovers In all industries there has been increased activity with

regard to takeovers and mergers. This means that there are fewer firms but now

they operate on a global basis thus generating large economies of scale and

reduced costs

The Impact ofIncreased Competition The major impact of this development

has been the drive for all firms to reduce their costs. The most effective way to

achieve this objective is through economies of scale


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Cost centres and profit centresThe Disadvantages of Becoming A Global Operator

The company becomes complacent and loses its innovative drive

The company loses touch with the market place and becomes de-sensitised to changes occurring within the external environment

Increased size makes communications and

decision making much more complex

As the company grows the decision makers

become isolated and lose touch with the

customers

Decision making becomes centralised


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elegated Decision Making - this provides the

means to overcome the problems caused by

becoming a global operator

Autonomous business units this simply means

that each company within the Proctor and Gamble

group is allowed to operate as an independent

company

The directors of each company must comply with

corporate standards and supply reports on their

performance (e.g. costs, sales and profits) on a

periodic basis (e.g. quarterly, annually) to the main

board of directors

How? Proctor and Gamble plc is a global

operator. However, it is not simply one company. It

is actually a large number of companies (100+)which make up the Proctor and Gamble group


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The principle of delegated decision making can then be applied to each

company. This is achieved by subdividing each company into profit centres

and cost centres

A profit centre could be a retail outlet, a brand, a sales force operating in a

geographical location e.g. the North East of England etc. Each profit centre

will have a manager who is responsible for ensuring that sales and profit

targets are achieved. He must also ensure that costs are kept within the

stated budget limits

The manager of a cost centre is only

responsible for keeping costs within statedbudget limits. He has no responsibility for

sales or profits


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Cost Centres are sections of a business to which costs can be charged


In a college, examples of cost centres are the teaching departments, or

particular sections of departments, e.g. the administrative office

A cost centre in a manufacturing business, for example, is

a department of a factory, a particular stage in the

production process, or even a whole factory

In a hospital, examples of cost centres are the hospitalwards, operating theatres, and specialist sections such asthe X-ray department, pathology department


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It generates revenues and incur costs and is a convenient

business unit for the analysis of profit which are generated by

various activities

A designated manager will be responsible for the successful

running of the profit centre

A Profit Centre represents a segment of a business to which

separate activities can be analysed


e.g. for a 12-month period, a manager could have a 200,000 budget and could

spend a maximum of 20,000 on any item without having to seek prior approval

Delegated budget is the amount of money the manager can spend without

having to refer to a higher level manager for approval

The manager will be given the authority to make decisions

within specified limits (delegated decision making)


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Case Study

THE SITUATION Your name isEdward West and you are the

Managing Director of West

Perfumes Ltd (WPL). This is a

family business and producesscented perfumes, which are sold to

a wide range of different retailers

e.g. John Lewis, Marks and

Spencers etc.

The company has recently been taken

over by Proctor and Gamble (P&G).

However, the current board of directors

are being allowed to remain in control.

P&G are investing 5m in West Ltd tofinance the development of new

products and upgrade its

manufacturing equipment.

However, P&G want sales and profits to increase by 30% within the next 12months. You have also been told to reduce the workforce by 20%.

From the viewpoint of West Perfumes Ltd, what are the advantages and

disadvantages of the P&G takeover?


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Management Accounting is concerned with providing the management of a

business with financial recommendations, based on costing information, e.g. the

cost of materials, labour, overheads etc, in order to enable day-to-day and

longer-term plans to be made

WPLs labour costs are 20% higher than the average for a P&G company. Why is

this figure of significance? What action can be taken to reduce this figure? What

will happen if nothing is done to reduce labour costs?

Case Study

The management of a business needs information from which to work. It needsto know accurate costs of individual products or services, together with the total

costs of running the business

Management accounting uses information from past transactions as an aid to

financial decision making, planning and control for the future


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Case Study

But the factory itself may be a profit

centre, its manager being responsible

for sales as well as production

Explain why WPL is a profit centre for P&G?

Explain how P&Gs organisational structure overcomes the disadvantages

of being a global operator?

A complex of machines may act as a

cost centre, and in turn the factory

departments in which the machines

operate can also be cost centres

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As ClassificationofCosts,Profit,Contribution

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