Activity 28.1 (page 509): Types of costsrevision.peterhouse.co.zw/Business Studies/AS Business...

1 Chapter 28 © Cambridge University Press 2010

Costs2828Activity 28.1 (page 509): Types of costs

1 Identify one indirect cost for each of these businesses:

a building fi rm• a high-street bank• a TV repairer• an oil-fi red power station.• [4]

2 Explain why the cost is indirect in each case. [4]

An indirect cost cannot be identifi ed as arising from the production of the good or provision of the service.

Business Indirect cost Explanation

building fi rm purchase of a digger

Th e digger will be used on many building jobs.

high-street bank cleaning costs Th is is not directly linked to the provision of banking services to customers.

TV repairer tools Th is cost is not related to a particular repair job.

oil-fi red power station

canteen costs for employees

It is not possible to identify these costs with a unit of production.

3 Identify one direct cost for each of these business activities:

a carpenter making a wardrobe• an insurance company issuing a new motor-insurance policy• a brewery delivering beer to a hotel• a bank agreeing an overdraft • an oil-fi red power station. • [5]

Business Direct cost

carpenter making a wardrobe wood

insurance company issuing a new motor-insurance policy postage

brewery delivering beer to a hotel fuel

bank agreeing an overdraft cost of bank-clerk time

oil-fi red power station oil


4 Why do you think it is important to identify the direct costs of producing a product? [5]

Identifi cation of direct costs may help set prices.• Price can be set to at least cover the direct costs and contribute to indirect costs.• Cost data can be used to help set budgets and these will act as targets for the • business.Calculating the direct costs of diff erent options will help make decisions about • what to produce.Direct costs need to be identifi ed if they are to be charged to a cost centre.•

Activity 28.2 (page 511): Classifying costs

1 Classify these costs by ticking the appropriate boxes in the following table. [8]

Cost Direct Indirect Fixed Variable

Rent of factory

Management salaries

Electricity

Piece-rate labour wages of production staff

Depreciation of equipment

Lease of company cars

Wood and other materials used in production

Maintenance cost of special machine used to make one type of wooden chair

Note: It is acceptable to categorise these costs diff erently.

2 Explain why you have classifi ed these costs in the way you have. [8]

Costs classifi ed as being fi xed do not vary directly with the level of output in • the short term. For example, rent will not change as output changes; even if the output of chairs and tables is zero, rent will still be paid in the short term.Costs classifi ed as being variable costs do vary directly with the level of output. • For example, as labour is paid on a piece-rate system, then, as more is produced, the cost will increase.Direct costs such as labour, wood and the maintenance cost of the special • machine relate directly to the production of specifi c chairs and tables.Indirect costs are the overheads involved in running a business and are not • directly related to production. For example, management salaries and the lease of company cars cannot be identifi ed with a unit of production.It is possible to argue that a cost such as electricity can be viewed in a number • of diff erent ways. As electricity is used to run machinery, then as production increases the cost will also increase. However, the cost of lighting is largely independent of output and is, therefore, fi xed.


Activity 28.3 (page 512): Break-even charts

1 Draw a break-even chart using these data. [8]

0 5000 10000 15000 20000Output

25000 30000 35000

Variable cost

Fixed cost

Total cost

Break-even output

Sales revenue

1500000Break-even point

1000000

500000

0

Reve

nue

cost

s

2 Show the break-even point and identify the break-even level of output. [2]

3 Identify from the graph the profi t expected at maximum capacity. [2]

Profi t = revenue less costs = 1,350,000 − 1,250,000 = $100,000

4 What is the margin of safety at an output level of 25,000 units? [1]

Th e margin of safety at 25,000 units is 5,000 units.

Activity 28.4 (page 513): Location decisions and break-even

1 Use the data above to calculate, for each site:break-even level of output• margin of safety• total maximum profi t assuming all units sold.• [9]

Break-even: FC ÷ unit

contribution Safety margin

Maximum profi t:

TR – TC

Site A 60,000 ÷ (6 − 3)= 20,000 units

40,000 − 20,000= 20,000

240,000 − 180,000= $60,000

Site B 80,000 ÷ (6 − 2.50)= 22,858 units

50,000 − 22,858= 27,142

300,000 − 205,000= $95,000

2 Advise the business on which location to choose. You should explain your break-even results in your answer. [10]

A number of factors should be taken into account:Site A has a lower break-even level of output and it will, therefore, be easier to • achieve a level of sales at which a profi t can be made.Site B’s break-even level of output is over 10% more than site A’s. • Assuming that the business expects to operate at maximum capacity • whichever site is chosen, then site B has a much greater margin of safety;


that is, sales can be up to 27,142 units below expectation and it will still break even.Site A has a much smaller capacity and, therefore, if sales are strong, the fi rm • will have to consider expanding sooner than at site B.Th e profi t at site B, assuming all output can be sold at $6, is greater, by over • 50%, than at site A.At capacity, the average cost of production at site A is $4.50, whereas, at site B, • the average cost is only $4.10. If sales are expected to be above 40,000, then site B will be more profi table. • Th e level of sales at which profi ts would be the same can be calculated as follows:

Profi t site A = profi t site B Let Q = output and sales 6Q − 3Q − 60,000 = 6Q − 2.5Q − 80,000 3Q − 60,000 = 3.5Q − 80,000 0.5Q = 20,000 Q = 40,000

Evaluation may consider:Answers could focus on issues of risk associated with reaching the break-even level of sales. Much will depend on the expected level of sales in the market – if it is above 40,000, then site B off ers a more profi table outcome.

3 List fi ve other factors that the business should consider before making this location decision. [5]

capital required to start production at each site• availability of suitable labour• impact on existing employees• room for expansion• planning issues• impact on local community•

Activity 28.5 (page 514): Windcheater Car Roofracks

1 Drawing the two break-even charts for these options would assist the owner in making this decision, but other issues may have to be considered as well.

Construct break-even charts for these two options. Identify the break-even point • for each.What is the maximum profi t obtainable in each case?• If demand next year is expected to be 7,000 units, what would be the margin of • safety in both cases?Which option would you advise the owner to choose? Give both numerical and • non-numerical reasons for your decision. [16]


400,000Option 1

350,000

300,000

250,000

200,000

150,000

100,000

50,000

00 2000 4000 6000 8000 10000

Cos

ts, r

even

ue (

$)

Output

Fixed costsTotal costsTotal revenue


Option 2350,000

300,000

250,000

200,000

150,000

100,000

50,000

00 2000 4000 6000 8000

Cos

ts, r

even

ue (

$)

Output

Option 1 Option 2

Break-even output is 4,500 unitsMargin of safety is 7,000 − 4,500 = 2,500 unitsMaximum profi t = 5,500 × 18 = $99,000

Break-even output is 3,000 unitsMargin of safety is 7,000 − 3,000 = 4,000 unitsMaximum profi t = 4,500 × 20 = $90,000

Relevant points include:Option 2 has a much lower break-even level of output.• Option 2 has a larger margin of safety.• Option 2 may require retraining of employees.• Option 1 will result in a signifi cant increase in fi xed costs and is more risky.• Option 1 can meet increasing demand. Option 2 off ers little scope for • increasing demand, and could lead to dissatisfi ed customers.With option 1, Windcheater can gain a higher market share.• Option 1 has a higher maximum profi t, but only by 10%. It might be necessary • for Windcheater to reduce the price to sell the extra units.At the expected sales level, option 1 will make a profi t of $45,000 compared to • $80,000 for option 2.Consideration will need to be given to which option will cause the most • disruption to customers in the short term.Th e investment cost of each option will need to be considered.• Th e new machinery might have an impact on quality.•

Evaluation may consider:Option 2 appears to be a lower-risk option as the break-even level of sales is very low. However, as sales are expected to be 7,000 units, option 1 has a good margin of safety, almost 56%, and it off ers greater scope for future sales growth. Option 2 could reach capacity very quickly and then the fi rm would have to think again about expansion.

2 Th e owner of Windcheater Car Roofracks discovers that the fi xed costs for option 1 will in fact be 20% greater than planned. Use a break-even chart to determine the new break-even point and then use the equation to verify it. [10]


400,000

350,000

300,000

250,000

200,000

150,000

100,000

50,000

00 2000 4000 6000

Output

Option 1

8000 10000C

osts

, rev

enue

($)


Fixed costs will rise to: 1.2 × 81,000 = $97,200

Break-even output = fi xed costs ÷ unit contribution = 97,200 ÷ 18 = 5,400 units

3 In option 2 the increase in fi xed costs is now planned to be $8,000 and the direct costs fall by $2.50 per unit:

explain why the direct costs might fall• determine the new break-even point.• [9]

Direct costs might fall because:Th e new machinery will reduce the labour costs per unit due to the increased • effi ciency.Less direct labour may be required.• Materials are being bought in larger quantities and there may be discounts.• Wastage of materials is reduced due to the new machinery.• Fewer mistakes may be made.•

Th e break-even point = fi xed costs ÷ unit contribution = 62,000 ÷ (40 − 19.50) = 3,025 units

Activity 28.6 (page 516): Heath Electronics Ltd

1 Calculate the direct labour costs for:

pump production • fan production.• [6]

Direct labour costs for pump production = 40,000 + 80,000 + 30,000 = $150,000 Unit direct labour cost = 150,000 ÷ 50,000 = $3.00

Direct labour costs for fan production = 10,000 + 40,000 + 20,000 = $70,000 Unit direct labour cost = 70,000 ÷ 40,000 = $1.75

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2 Calculate the total direct labour cost for both products. [2]

Total direct labour costs = 150,000 + 70,000 = $220,000

3 Express:

the direct labour cost of the pump • the direct labour cost of the fan as a percentage of the total direct labour cost.• [4]

Pump = 150,000 ÷ 220,000 × 100 = 68.2% Fan = 70,000 ÷ 220,000 × 100 = 31.8%

4 Divide the total fi xed costs between the pump and the fan in proportion to the use of direct labour in producing each product. [6]

Pump: allocated fi xed cost = 15/22 × 200,000 = $136,364 or 0.682 × 200,000 Fan: allocated fi xed cost = 7/15 × 200,000 = $63,636 or 0.318 × 200,000

5 Calculate total costs for each product. [4]

Total cost for pump = 250,000 + 136,364 = $386,364 Total cost for the fan = 220,000 + 63,636 = $283,636

Activity 28.7 (page 518): Return to Heath Electronics

1 Calculate the unit cost of both the pump and the fan using the full costing results. [4]

Full cost for pump = 386,364 ÷ 50,000 = $7.73 Full cost for the fan = 283,636 ÷ 40,000 = $7.09

2 Give reasons why you would or would not be satisfi ed with these results for decision making, such as establishing market prices for the two products. [6]

Relevant points may include:Decision to apportion fi xed costs according to direct labour is fairly arbitrary; • total direct costs or direct materials could have been used.Market price established can be sure of covering full costs of production. No • costs have been ignored.Linking price to full cost does not take into account competition or market • conditions. Contribution costing may be useful.Th e full unit cost will only be accurate if the actual output level is the same as • that used in the calculation. A change in output of the products will change the allocated overhead.

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3 Draw up a new full-costing statement, basing your division of the overheads on total direct costs (i.e. labour and materials) for each of the products. [6]

Pump ($) Fan ($)

Direct costsApportioned overheadTotal cost

250,000 (53.2%)106,400 (0.532 × 200,000)356,400

220,000 (46.8%)93,600 (0.468 × 200,000)313,600

4 Recalculate the unit cost for each product on the assumption that the fi rm actually produces 60,000 pumps and 30,000 fans, and comment on your result. [9]

Assuming that direct costs change in proportion to the level of output and indirect costs are unchanged, then:

Pump ($) Fan ($)

Direct costsApportioned overheadTotal costUnit cost

300,000 (64.5%)129,000 (0.645 × 200,000) 429,0007.15

165,000 (35,5%)71,000 (0.355 × 200,000)236,0007.86

Th e unit cost of the fan has increased signifi cantly, by approximately 10%, and • the unit cost of the pump has decreased by approximately 8%.Th is is a signifi cant change from a pricing perspective.• Th is illustrates the importance of a change in output to the unit cost of • production, if indirect costs are apportioned in some arbitrary manner.

Note: If no change was made to direct costs, then the unit costs would be as follows:

Pump ($) Fan ($)

Total costUnit cost

356,4005.94

313,60010.45

Activity 28.8 (page 518): Cost centres at school

1 Identify and list four possible cost centres within your own school or college. Discuss with the managers or heads of these cost centres the benefi ts and drawbacks of using this form of organisation. Check with your bursar / college accountant the accuracy of your answer. [4]

human resources department• estates (maintenance of grounds and buildings)• business studies and economics department• mathematics department• IT resources and support•

2 Explain the diff erence between a cost centre and a profi t centre. [4]

A cost centre is a part of the business to which costs can be allocated, whereas a profi t centre is a part of the business to which both costs and revenues can be allocated.

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3 Explain whether any of the cost centres identifi ed in 1 above are, in fact, profi t centres. Explain your answer. [4]

In the examples above, the business studies department and the mathematics department are both profi t centres. Th is is because the number of students studying in each department generates identifi able revenues for the college. It is not possible to allocate any revenue to the human resources department or IT resources and support.

Activity 28.9 (page 520): Should Product Z be dropped?

1 Calculate the unit contribution of each product. [4]

Unit contribution = price less unit variable cost. Y = 30 − 19 = $11 Z = 21 − 19 = $2

2 If annual output is all sold, calculate the total contribution of each product. [4]

Total contribution = unit contribution × sales Y = 11 × 1,000 = $11,000 Z = 2 × 400 = $800

3 Calculate the profi t or loss made by each product using full costing at the current output level. [6]

Y: total contribution = $11,000. Allocated overheads = 50% of $10,000 = $5,000 Total profi t on Y = 11,000 − 5,000 = $6,000

Z: total contribution = $800. Allocated overheads = 20% of $10,000 = $2,000 Total profi t on Z = 800 − 2,000 = −$1,200

4 Calculate the impact on the total profi t of the business if production of Product Z is stopped. (Do not forget that the overhead costs allocated to Product Z will still have to be paid). [6]

Total profi t if Z is produced is 2,500 + 6,000 − 1,200 = $7,300 If Z is dropped, then the total profi t, assuming no change in sales of X and Y, is: Total contribution of X and Y less total overheads = 5,500 + 11,000 − 10,000 = $6,500

Stopping production of Z causes a drop in profi t of $800 as the contribution made by product Z is lost but in the short term there will be no change in overheads.

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Activity 28.10 (page 521): Bureau Offi ce Supplies Ltd

1 Use the contribution / marginal-costing approach to calculate whether the new order will add to the profi ts of the business or not. [10]

Unit contribution = selling price – direct costs = 70 − (25 + 30) = $15 Total contribution = unit contribution x sales = 15 × 1,000 = $15,000 Th us, the local authority order will make a total contribution of $15,000. Th is will

add to the $15,000 of profi t, assuming that there is no increase in overheads or knock-on eff ect on other sales.

2 Prepare a brief report, containing your marginal-costing statement, to the board, together with a recommendation on whether to accept the order or not. Consider both quantitative and qualitative factors in coming to your recommendation. [15]

Relevant points to include in a report include:

For Against

There is a positive contribution of • $15,000. This will increase profits by $15,000, other things being equal.There is spare capacity, so • accepting the order will increase capacity utilisation. This will help control average costs of production.There will be more effective use of • fixed assets.It will avoid having to reduce the • hours of workers.There may be subsequent orders • from the local authority.Accepting the order will increase • market share.

It may be possible to gain other, • more profi table, orders. Once the local authority order is accepted, the business may have to reject other orders from new/existing customers.If other customers fi nd out that the • local authority has secured a low price, they will try to negotiate lower prices as well. Is there suffi cient capacity to fulfi l the • order? If not, it may cause disruption to other customers. Th is will depend on the time period given to fulfi l the order.Does the order increase overheads?•

Evaluation may consider:It is important to recognise that an order that makes a positive contribution is worth considering. However, it does not follow that the order should be accepted; that will depend on the other factors outlined above.

A suitable judgement might observe that: assuming there is no impact on overheads, suffi cient spare capacity exists and no other orders are anticipated, Bureau Offi ce Supplies Ltd should accept the order.

Activity 28.11 − answer provided on Student's CD-ROM.

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Revision case study 1 (page 524): Decision time at the pottery

1 Draw a break-even graph to represent these data, identifying the break-even level of production and the margin of safety. [6]

25000

20000

15000

10000

5000

00 2000 30001000 4000 6000 70005000

Output8000

Cos

ts, r

even

ue (

$)

Fixed costs

Total costs

Revenue

Break-even level of output is 2,667 units. Margin of safety = 5,000 – 2,667 = 2,333 units.

2 Th e manager is considering two options in an eff ort to increase profi ts:

Purchase a new energy-effi cient kiln. Th is would raise fi xed costs by $1,000 per • year but reduce variable costs to $1.20 per pot. Output would remain unchanged.Reduce price by 10%. Market research indicates that this could raise sales by 20%.•

By drawing two new graphs, compare the break-even points of all three situations (including the original), the total levels of profi t and the safety margins. [10]

Students should draw new graphs showing the following results:

Original

Purchase kiln (fi xed

costs = $5,000) Reduce price ($2.70)

Break-even 2,667 5,000 ÷ 1.80 = 2,778 4,000 ÷ 1.2 = 3,334

Margin of safety

2,333 5,000 − 2,778 = 2,222 6,000 − 3,334 = 2,666

Profi t $3,500 (3 × 5,000) − (5,000 + 1.2 × 5,000) × $4,000

(2.7 × 6,000) − (4,000 + 1.5 × 6,000) = $3,200

3 Advise the fi rm, on the basis of your results, whether to remain as it is or to adopt one of the two options above. Justify your answer. [10]

Relevant points include:Although cutting price may increase demand signifi cantly, there is a drop in • profi ts as the price cut applies to all units sold, and, consequently, the unit contribution is reduced to only $1.20. Th is does not achieve the manager’s objective.If the estimate of demand is correct, then the price cut will increase the margin • of safety. Th e price cut does increase sales and will increase market share.•


Purchasing the kiln reduces the direct cost of production to the extent that • profi t is higher if sales are as estimated.Th e margin of safety is reduced, if the kiln is purchased, due to the higher • break-even level of output.

Evaluation may consider:As the objective is to increase profi t, the manager will prefer purchasing the kiln. However, the success of the investment is dependent on estimated sales being accurate. If the sales are above 3,333 units, then the investment will generate more profi t than making no change.

Revision case study 2 (page 525): Abbey Restaurant

1 What are the forecast average monthly profi t fi gures for the two menu options? [6]

Profi t = TR − TC Current menu:

sales turnover = $12,000 variable cost = 5 × 600 = $3,000 overheads = $7,000 profi t = 12,000 − 10,000 = $2,000

New menu: sales turnover = 14 × 600 × 1.2 = $10,080 variable cost = 4 × 720 = $2,880 overheads = $6,000 profi t = 10,080 − 8,880 = $1,200

2 Calculate the break-even level of output of both options (show your workings). [6]

Break-even = fi xed costs ÷ unit contribution

Current menu: break-even = 7,000 ÷ (20 − 5) = 467 customers

New menu: break-even = 6,000 ÷ (14 − 4) = 600 customers

3 On the basis of your results to 1 and 2, would you advise Phil to adopt the new menu? Explain your answer. [10]

On the basis of the results to the above questions, the answer is no. Relevant points include:

Profi t from new menu is $800 less than current situation.• Break-even output for new menu is 133 customers per month more than the • current situation.As profi ts will fall and the target number of customers required to break-even • will increase this suggests that the new menu is not a good idea.


Th e problem for Phil is that the unit contribution from the new menu is much • lower than from the existing menu; $10 compared to $15. Th ere is a signifi cant reduction in the price charged and a proportionately smaller reduction in unit variable costs.Th e increase in customers is insuffi cient to make the new menu more profi table; • customer numbers would have to rise to 800 per month to make the same profi t as for the current menu.Th e margin of safety for the current menu is 133 customers compared to 120 • customers for the new menu.However, if customer numbers for the current menu continue to fall, then there • is a case for changing to the new, lower-priced menu.

4 What other, non-fi nancial, factors should Phil consider before taking the fi nal decision? Explain their signifi cance to Phil’s business. [9]

If no change is made, will the number of customers continue to fall? If so, then • the level of profi t will continue to decrease.Can Phil recruit a suitably qualifi ed chef to continue with the current menu? If • not, then the quality of dishes may decline and cause customer dissatisfaction. If Phil cannot recruit a suitably skilled chef, then this would increase the pressure on the remaining chefs and Phil would need to train a new chef, increasing his costs.Is Phil’s estimate of demand for the new menu accurate? Th e competition may • already benefi t from customer brand loyalty.How would the existing loyal customer base react to the proposed menu • change? Phil may lose existing customers.What will be the impact of any change to the menu on existing chefs? As they • are skilled, they may object to the new simpler dishes. If the chefs do not like the new menu, Phil may lose some of his employees – this may depend on what other restaurant jobs are available in the area.

Revision case study 3 (page 525): Cosmic Cases

1 Calculate the total revenue (price × quantity sold) for each size of case. [4]

Vanity case = 5,000 × 15 = $75,000 Small suitcase = 4,000 × 18 = $72,000 Medium suitcase = 1,000 × 20 = $20,000 Large suitcase = 1,500 × 25 = $37,500

2 Calculate the total profi t/loss made by each size of case. [2]

Profi t = revenue − total costs Vanity case = 75,000 − 45,000 = $30,000 Small suitcase = 72,000 − 47,500 = $ 24,500 Medium suitcase = 20,000 − 22,000 = −$2,000 Large suitcase = 37,500 − 30,000 = $7,500

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3 Calculate the total contribution made by each size of case. [4]

Contribution = revenue − total direct costsVanity case = 75,000 − 30,000 = $45,000Small suitcase = 72,000 − 35,000 = $37,000Medium suitcase = 20,000 − 12,000 = $10,000Large suitcase = 37,500 − 20,000 = $17,500

4 Jill Grealey wanted to stop production of the medium-sized case. She said to the fi nance director, ‘If we stop making this case, then our total profi ts will rise.’ Th e fi nance director was convinced that this would be the wrong decision to make. As a management consultant, write a report to the managing director giving your recommendation for the action to be taken with the medium-sized case. You should justify your recommendation with both numerical and non-numerical factors. [16]

Relevant points include:Profi t with • medium-sized case = $60,000Profi t without • medium-sized case (assume no change in sales of other cases or overhead costs) = $50,000. Th e reduction in profi t is equal to the lost contribution made by the medium suitcases.As some cases are sold as part of a set, then withdrawing the • medium-sized suitcase may lead to a loss of sales of other sizes of suitcase. Customers may wish to buy a matching set of suitcases, so may switch to a competitor’s product. Cosmic cases only come as a set of three. If the • medium-sized suitcase is withdrawn, there may be an impact on material costs due to smaller order quantities?However, it is possible that withdrawing the • medium-sized suitcase could lead to an increase in sales of the other cases. Th ere could be an impact on employees.• It may be possible to use equipment to make some other more profi table • product, e.g. travel bags.Consideration will have to be given to the trend in sales of the • medium-sized cases – e.g. whether the previous six months of trading was typical.Answer must contain a supported recommendation.•

Revision case study 4 (page 526): Midtown Imperial Hotel

1 Calculate the full cost of the conference for the Friends of the General Hospital (including the equipment hire). [4]

Full cost = variable cost + additional cost of audiovisual equipment + allocated overhead. = (15 × 100) + 200 + 1,000 = $2,700

2 Calculate the price that the hotel would normally charge for a conference of this size with the equipment requested. [4]

$2,700 + 50% = 2,700 × 1.5 = $4,050

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3 What would the contribution to the hotel’s overheads and profi t be if the conference suite were let out for $2,200? [2]

Contribution = revenue − additional cost of providing the conference = 2,200 − 1,700 = $500

4 Advise the hotel manager on the advisability of accepting this special request for the use of the conference facilities. Include both quantitative and qualitative data in your answer. [10]

Relevant points include:A positive contribution of $500 would be made. Th erefore, accepting the • booking would increase profi ts, other things being equal, by $500. If the booking is refused, overheads will not change.Th e booking is at the end of February – a slack time for the hotel; it is, • therefore, less likely the hotel will be able to book out its facilities at their normal rate.Accepting the booking will help ensure that staff are kept busy. • It will provide work for waiting staff and may help retain their services for other • functions.Th e organisation will go to other hotels if the Imperial refuses the booking.• Th e Friends of the General Hospital are infl uential. If the hotel provides a good • service, it may lead to further conference bookings.Th e delegates at the AGM may spend money in other parts of the hotel, e.g. • drinks from the bar.It is possible that other groups will fi nd out about the preferential price and, • therefore, be reluctant to pay the hotel’s normal booking fee in the future.

Essay

2 a Explain the main diff erences, with a simple worked example, between full-costing and contribution-(marginal-) costing methods. [10]

Full costing:When using full costing, a fi rm allocates all direct and indirect costs between its • products. Direct costs can be relatively easy to allocate, e.g. material costs and direct • labour costs.Indirect costs are more diffi cult to allocate as they do not arise from the • production of a specifi c product. Th erefore, indirect costs have to be apportioned on the basis of one or more methods of allocation, e.g. in proportion to a product’s share of total direct costs.

Contribution costing:Th is focuses on direct costs of production and excludes indirect costs. • Contribution costing is oft en used as a basis for setting prices by multi-product • fi rms or when considering additional orders for a product.

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Worked example: OJC Ltd produces juices for sale to supermarkets. It has fi xed overhead costs of

$40,000. In the tables below, details of the direct ingredient and other direct costs are given as well as the revenue.

Contribution cost statement for OJC Ltd

Orange juice Apple juice

Cranberry

juice Total

Revenue 80,000 31,000 40,000 151,000

Ingredients 30,000 17,000 7,000 54,000

Other direct costs 16,000 6,000 9,000 31,000

Contribution 34,000 8,000 24,000 66,000

Fixed overheads 40,000

Profi t 26,000

Full cost statement for OJC Ltd

Orange

juice Apple juice

Cranberry

juice Total

Revenue 80,000 31,000 40,000 151,000

Ingredients 30,000 17,000 7,000 54,000

Other direct costs 16,000 6,000 9,000 31,000

Fixed overheads 21,647 10,824 7,529 40,000

Profi t 12,353 (2,824) 16,471 26,000

Contribution is defi ned as the diff erence between revenue and its marginal (variable direct) costs. In the full-cost statement, the fi xed overheads have been allocated on the basis of total direct cost. Th erefore, orange juice is apportioned 46,000 ÷ 85,000 × 40,000 = $21,647.

b Discuss whether it is ever likely to be worthwhile for a business manufacturing high-tech TVs of its own unique design to continue producing one of its products at a loss. [15]

Th is question is primarily about the issue of contribution.

It is worthwhile considering production of a loss-making product, so long as it makes a positive contribution, that is it covers its variable costs of production. Th is means that the product will be making a contribution to the fi xed costs of the business, which have to be paid irrespective of whether production of the loss-making product is ceased or not.

Th us, in the example above, on the basis of full costing, the apple juice is a loss-making product. However, if production of apple juice stops, then, other things

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being equal, the apportioned fi xed costs would have to be re-apportioned to the other products. Th erefore, total profi t would actually fall from $26,000 to $20,000 – the business would lose the $6,000 contribution of the apple juice. In the short run, it is worth producing the apple juice.

Other considerations include:Can production and sales of the other products be increased? In the case of the • high-tech TV manufacturer, it should be possible to switch production from the loss-making product to an alternative TV. However, the fi rm must consider whether the increased production can be sold and, if so, at what price.Th e loss-making product may be an important part of the fi rm’s product • portfolio. For example, it may confer increased status on other TVs in their product range due to its use of cutting-edge technology. Th e product may make an important statement about the fi rm’s position in the market.Will sales increase in the future? • Will production costs decrease in the future? Components for the high-tech TV • may be expensive due to low levels of demand and new methods of production. As suppliers gain experience and improve production methods, costs may fall and thus the TV producer will also face lower costs.

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Activity 28.1 (page 509): Types of costsrevision.peterhouse.co.zw/Business Studies/AS Business...

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