Managing Finance and Budgets Lecture 5. Session 5 - Costing & Pricing (1) LEARNING OUTCOMES ...

Managing Finance and Budgets

Lecture 5

Session 5 - Costing & Pricing (1)

LEARNING OUTCOMES Understand the different ways of classifying costs and be

able to classify a wide variety of costs typically found in SMEs, VCOs and large organisations in order to critically analyse a situation and use the data to inform decision-making

Understand and choose relevant cost analysis techniques to analyse situations typically found in SMEs, VCOs and large organisations

Contents of the Lecture

A: Concepts and Definitions of Costing B: Break-Even Analysis C: Full (Absorption)Costing

A: Concepts and Definitions

Key Concepts

What is Cost Analysis? Objectives of Cost Analysis Cost definitions Cost behaviour Break-even analysis Full (absorption) costing

What is Cost Analysis?

Cost is defined as the amount of resources, sacrificed in order to

achieve an objective. is usually measured in monetary terms.

Cost Analysis is the classification and scrutiny of the different components

which make up the cost of achieving the objective. In resale will involve such elements as original price (historic

cost), and staff wages (outlay costs). In manufacturing it will involve such elements as labour, raw

materials, (direct costs); salaries, phone bill (indirect costs).

Objectives of Cost Analysis

Cost Analysis is used for: Decision-making - e.g. pricing, whether to go ahead with a

particular project etc Planning - setting targets for production, distribution etc Controlling (production, sales etc.) Evaluation of activities (in financial terms) Motivation (providing feedback)

Cost definitions

Historic cost - actual cost paid for an item or activity Opportunity cost - cost of not doing something Outlay cost - cost incurred to achieve an objective Sunk cost - cost incurred before the decision point is

reached Committed costs - costs which will be incurred regardless

of the decision Disposal cost - disposal may result in a cash gain, but a

“book” loss (if the value is less than the “book” value) It is essential to include relevant costs and exclude

irrelevant costs when making decisions

Activity One

A garage has an old car standing around which it bought several months ago for £3,000. The car needs a replacement engine before it can be sold. It is possible to buy a reconditioned engine for £300. It would take a mechanic (who paid is £8 per hour) 7 hours to fit the engine. At present the garage is short of work, but the owners are reluctant to lay off any mechanics or even to cut down their basic working week because skilled labour is difficult to find and an upturn in repair work is expected soon. Without the engine the car could be sold for an estimated £3,500. Identify the following:

Historic cost of the carOutlay cost if the car is to be repairedOpportunity cost of the car and sunk cost of the carRelevant costs to consider in deciding whether or not to repair the car

What is the minimum price to sell the car for to justify carrying out the work?How would the minimum price change if the garage were busy at the moment, and the mechanic’s time could be charged to other customers at £12 per hour.

Activity One Solution (1)

Historic cost £3,000

What we paid for the car originally

Outlay cost (to repair) £300

NB We disregard labour costs of £8 x 7 = £56 because the mechanics are already paid, but not employed.

Opportunity cost £3,500

What we think we can sell the car for now

Sunk cost £3,000

What we have currently spent on the car to date

Relevant costs to consider :

Opportunity Costs + Outlay Costs = £3500 + £300 = £3800

£3,800 is the minimum price that the garage will sell the car for

in order to justify carrying out the work.

Activity One Solution (2)

If the garage were busy, with the mechanic’s time charged at £12 per hour.

Historic cost 3,000What we paid for the car originally

Outlay costs (to repair) Engine £300Labour Costs £12 x 7 = £84 £384

Relevant costs to consider :Opportunity Costs + Outlay Costs = £3500 + £384 = £3884

£3,884 is the minimum price that the garage will sell the car for in order to justify carrying out the work.

NB: What we could charge for their labour, rather than what it costs us.

NB: What we could charge for their labour, rather than what it costs us.

Cost behaviour

Variable Costs • vary in (more or less) direct proportion to the volume of

activity Fixed Costs –

• stay (more or less) the same regardless of the volume of activity

• may vary in the longer term, but not directly in relation to activity

Semi-fixed (or semi-variable) Costs • have a fixed and a variable element to them - e.g.

telephone, electricity

Activity Two

Identify a range of Fixed and a range of Variable Costs for each of the following types of organisation:

Manufacturing company

Hotel

Supermarket

Activity Two Solution

Fixed Costs Variable Costs

Manufacturing Rent/Rates

Cleaning

Raw Materials

Transport

Hotel Rates/Mortgage

Cleaning

Food, Laundry

Supermarket Rates/Lease

Admin Salaries

Goods,

Some wages

B: Break-Even Analysis

Break-even analysis

This Analysis identifies: The Fixed and Variable Costs in producing the item. The level of sales activity needed to cover an organisation’s

fixed costs.

Break-even analysis – An example

A manufacturing company has Fixed Costs of £5,000, and variable costs of £100 per unit. Each unit is sold for £250. How many units need to be sold to break even?

UNITS SOLD SALES VALUE FIXED COSTS VARIABLE COSTS PROFIT/LOSS

10 2,500 5,000 1,000 3,500-

20 5,000 5,000 2,000 2,000-

30 7,500 5,000 3,000 500-

40 10,000 5,000 4,000 1,000+

50 12,500 5,000 5,000 2,500+


Fixed, Variable & Total Costs

0

2000

4000

6000

8000

10000

12000

10 20 30 40 50

FixedCosts

VariableCosts

Total Costs

The Total Cost is just the sum of the Fixed cost and the Variable Cost

The Total Cost is just the sum of the Fixed cost and the Variable Cost


Break-Even Analysis

-5000

0

5000

10000

15000

10 20 30 40 50

Total Costs

Sales

Profit/Loss

The Break-Even Point is where the Total Costs Line intersects the Sales Line.

The Break-Even Point is where the Total Costs Line intersects the Sales Line.

At this point:

Profit/ Loss = ZERO

(about 35 items sold)

At this point:

Profit/ Loss = ZERO

(about 35 items sold)

Break-Even Analysis Calculation The Break-even point can be calculated as follows:

Sales (No. of items) to break even =

Fixed Costs . Sales per unit - Variable costs per unit

In the example, our break-even point was: 5,000 250-100

= 33.33 items

Break-Even Analysis Some Terms

Contribution =

Sales Revenue per Unit – Variable costs per unit.

This is the denominator of the Break Even calculation

In our example:

Contribution = 250 – 100 = £150 per unit

Break-Even Analysis Calculation Some Terms

Margin of safety = extent to which planned output or volume is above the break-even point)

This can be calculated by Margin of Safety = (Planned Sales – Break-Even Sales) * Contribution

For example, if we planned to have sales of 45 items, our margin of safety would be:

(45 - 33.33) * (£150) = £1750.50

Break-Even Analysis Calculation Some Terms

Operating Gearing • This is the relationship between fixed costs and contribution (i.e.

how many units have to be sold to pay Fixed Costs

Sales & Fixed Costs

0

5000

10000

15000

10 20 30 40 50

Fixed Costs

Sales

In our example, 20 units needed to be sold just to recoup the fixed cost.

In our example, 20 units needed to be sold just to recoup the fixed cost.

Activity Three

Company A Company B

FIXED COSTS £ 10,000 £ 54,000

UNIT SALES PRICE £ 20 £ 20

VARIABLE COSTS PER UNIT £ 10 £ 2

PLANNED SALES 2000 units 5000 units

Calculate the following for each Company:

Contribution per Unit

Break-even point and Margin of safety

Profit at planned sales, twice planned sales and

1/2 x planned sales

Which company has the higher operating gearing and what effect does this have?

Activity Three: Company A Solution

Company AFIXED COSTS £ 10,000UNIT SALES PRICE £ 20VARIABLE COSTS PER UNIT £ 10

PLANNED SALES 2000 units

Contribution per Unit: £20 -£10 = £10Break-even point: £10000/£10 = 1000Margin of safety: (2000 –1000) x £10 = £10,000

Profit at planned sales = £10,000 twice planned sales = £30,000 1/2 x planned sales = NIL

Activity Three: Company B Solution

Company BFIXED COSTS £ 54,000UNIT SALES PRICE £ 20VARIABLE COSTS PER UNIT £ 2

PLANNED SALES 5000 units

Contribution per Unit: £20 -£2 = £18Break-even point: £54000/£18 = 3000Margin of safety: (5000 –3000) x £10 = £20,000

Profit at planned sales = £20,000 twice planned sales = £110,000 1/2 x planned sales = £9,000 Loss

Activity Three – Operational Gearing

Company A Company B

FIXED COSTS £ 10,000 £ 54,000UNIT SALES PRICE £ 20 £ 20VARIABLE COSTS PER UNIT £ 10 £ 2PLANNED SALES 2000 units 5000 units

Ratio of Fixed Cost to 100:1 18,000:1Variable Cost

B has Higher Operational Gearing.• If output is higher than expected, (e.g. double) then profits can rise

dramatically.• For B profits are 5.5 times that expected • For A, profits are 3 times that expected,

• If output is lower than expected, (e.g. half) profits can turn into become serious losses.• For A, profit is NIL, but for B the loss is £9,000

Break-even analysis

Assumes simplicity! Uses linear relationships between sales prices, costs and

volume Does not allow for “stepped” fixed costs Focuses on one product line

Marginal costing

One response to this is use Marginal Analysis This dispenses with fixed costs, as these are static,

unchangeable and not totally relevant, choosing to focus on the direct costs of producing additional sales.

As we may be selling a number of different items, this avoids unrealistic and arbitrary apportionment of the indirect costs

Allows us to identify the true costs of additional sales (or the MINIMUM price for which an item should be sold)

(see M & A for further details)

C: Full Costing

Full (absorption) costing

An analysis of the FULL cost of achieving a particular objective

Used for pricing purposes, and to measure costs (e.g. valuing stock or assets)

Widely used though focuses on past costs rather than future or outlay costs

Full costing - Example

RUSTIC BREWERIES

COST of producing 10,000 pints of bitter in 1 month

Ingredients £ 1,000

Labour £ 2,000

Fuel £ 500

Rental of brewery £ 425

Depreciation £ 75

Other Overheads £ 6,000

Total cost = £10,000 = £1 per pint

Complications: Justification of depreciation, Stock

Work-in-progress, Other products

Job costing

Producing an analysis of the FULL cost of a particular output by assigning all DIRECT costs plus an appropriate share of INDIRECT costs

DIRECT costs are those costs which can be directly identified with units of output

INDIRECT costs cannot be directly attributed to units of output

DIRECT COSTS can be VARIABLE or FIXED INDIRECT COSTS can be VARIABLE or FIXED

Job costing - Allocating Indirect Costs

Range of methods used to allocate indirect costs e.g. As a % of total quantity of units produced Labour cost as % of Total Labour (Direct Labour Hours) Product weight, Machine Time Segmentation - using different methods for different o’heads By department - dependent on amount of time spent in each

department (e.g. finishing, handling,) No method is “correct” though DLH tends to be most popular

Activity Four

Calculate the COST of producing 5,000 pints of bitter and 2,300 pints of lager in 1 month using the Direct Costs & the three

methods of allocating overheads shown below.

DIRECT COSTS Bitter LagerIngredients 10p per pint 25p per pint

Labour 20p per pint 10p per pint

Fuel 5p per pint 10p per pint

Brewery/Depreciation £500 Overheads £ 5,000

Method 1: Allocate overheads according to pints produced

Method 2: Allocate overheads according to % of labour cost

Method 3: Allocate overheads according to overall direct cost of production

Activity Four Solution Method 1

DIRECT COSTS Bitter Lager INDIRECT COSTS

Ingredients 0.10 0.25 Depreciation 500 Labour 0.20 0.10 Overheads 5,000

Fuel 0.05 0.10

Units Produced 5,000 2,300Total Direct Cost 1,750 1,035

Method 1

Overheads 3,767 1,733 £ 5,500 / 7300 X Number producedTotal Full Cost 5,517 2,768

Cost per pint 1.10 1.20

Rustic Breweries




Fuel 0.05 0.10


Method 2

Overheads 4,455 1,045 Total labour costs = 5000 x 0.20 + 2300 x 0.10 = £1,230Total Full Cost 6,205 2,080 Bitter labour cost as % of total labour cost = 1000/1230=81%

Cost per pint 1.24 0.90 Lager labour cost as % of total labour cost = 230/1230=19%Bitter overheads = £5,500 x 81% = £4,455Lager overheads = £5,500 x 19% = £1,045

Rustic Breweries




Fuel 0.05 0.10


Method 3

Overheads 3,465 2,035 Total direct costs = 5000 x 0.35 + 2300 x 0.45 = £2,785Total Full Cost 5,215 3,070 Bitter direct cost as % of total direct cost = 1750/2785=63%

Cost per pint 1.04 1.33 Lager direct cost as % of total direct cost = 1035/2785=37%Bitter overheads = £5,500 x 63% = £3,465Lager overheads = £5,500 x 37% = £2,035

Rustic Breweries

Activity Five

“The full cost of pursuing an objective is effectively the long-run break-even selling price.”

What does this mean?

Activity Five - Solution

“The full cost of pursuing an objective is effectively the long-run break-even selling price.”

• If the analysis has been performed correctly, then selling the item for its full cost, should do just that, precisely recover the cost of producing it.

• This is just another way of saying we would neither make a profit or a loss, but just “break even”

Activity Six

You work in the costing department of a budget airline. What items need to be taken into account when trying to calculate the unit cost of transporting a passenger from one destination to another?

Activity Six - Solution

What items need to be taken into account when trying to calculate the unit cost of transporting a passenger?

This is not an exhaustive list:• Airport Service/Tax Charges• Air Traffic Control Charges• Maintenance & Replacement (Labour & Parts)• Cleaning • Depreciation of Aircraft• Fuel & other running costs• Food costs• Baggage handling costs• Staff salaries (cabin and ground)• Admin Costs (booking, travel agent commission etc.)

Seminar Five - Activities

Preparation: read Chapters 8, 9 and 10 Describe key concepts:

Objectives of cost analysis

Cost definitions

Cost behaviour & Break-even analysis

Full (absorption) costing Exercises 10.4 (page 337) and 10.8 (page 340)

Managing Finance and Budgets Lecture 5. Session 5 - Costing & Pricing (1) LEARNING OUTCOMES ...

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