CLASSIFICATION OF COSTS, PROFITS, CONTRIBUTION

1. CLASSIFICATION OF COSTS, PROFITS, CONTRIBUTION Costs Quick Quiz Cost Centres and Profit Centres Case Study This button will bring you back here Will show when a topic ends Exit

2. Costs, Profit, Contribution and Break-Even Analysis 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 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 The problem with this is how to accuratelydefinethe costs and how toallocatethe costs to the various products and departments The management accountant classifies costs into fixed and variable costs or direct and indirect costs

3. 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 in the short run in relation to changes in output e.g. rent, insurance and depreciation. These costs are linked to time rather the level of business 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

4. 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 isoverheads Direct Costs– costs that can be directly identified with a product or cost centre. They are mainly variable costs but can include some fixed costs e.g. the rent of a building solely used for one product. They are also referred to asprime costs

5. Total Cost Total Cost– this is the addition of all fixed and variable costs (plus any semi-variable costs) Where fixed costs form a significant part of total costs it is important for a business to maximise sales so that the fixed cost element is spread across as many units as possible The total cost is used by the business to see how much finance is required for each level of output

6. 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 £30,000 Average 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 suitablemark-up

7. 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 Contribution Per Unit– This is the difference between the selling price per unit and the variable cost per unit 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

8. Break-Even Analysis / Margin of Safety / Profit Break-evenprovides 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 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 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 Thus the profit for the firm would be 2,000 units x £10 contribution per unit = £20,000 Exit

9. Quick Quiz Q1 Which of the following fixed costs does not affect cash flow? Rent Insurance Depreciation To make 1 unit of product X the following are required: Material Costs: 2 kg of raw materials at £5 per kg Packing costs at £4 per unit Labour Costs: 2.0 hours of machining time at £10 per hour 1.5 hours of finishing time at £8 per hour What is the total variable cost of making 1 unit of product X? What is the total variable cost of making 1,000 units of product X?

10. 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 from 1,000 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.

11. 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. What is the contribution per unit? What is the break-even point? What is the margin of safety? What is the total cost of making 15,000 units? How much sales revenue will be generated by selling 15,000 units? How much profit will be generated if the firm achieves its sales target? Draw a break-even chart showing the above information. Repeat the exercise – assuming one change – the firm plans to make and sell 20,000 units. Exit

12. Cost centres and profit centres The Changing Nature of Business– 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 The Impact of Increased 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 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

13. Cost centres and profit centres The Disadvantages of Becoming A Global Operator • Decision making becomes centralised • As the company grows the decision makers become isolated and lose touch with the customers • Increased size makes communications and decision making much more complex • The company loses touch with the market place and becomes de-sensitised to changes occurring within the external environment • The company becomes complacent and loses its innovative drive

14. Cost centres and profit centres Delegated Decision Making- this provides the means to overcome the problems caused by becoming a global operator 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 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

15. Cost centres and profit centres The manager of a cost centre is only responsible for keeping costs within stated budget limits. He has no responsibility for sales or profits 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

16. Cost Centresare sections of a business to which costs can be charged Cost Centres and Profit Centres 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 hospital wards, operating theatres, and specialist sections such as the X-ray department, pathology department In a college, examples of cost centres are the teaching departments, or particular sections of departments, e.g. the administrative office

17. Cost Centres and Profit Centres A Profit Centrerepresents a segment of a business to which separate activities can be analysed 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 The manager will be given the authority to make decisions within specified limits (delegated decision making) Delegated budgetis the amount of money the manager can spend without having to refer to a higher level manager for approval 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

18. Case Study THE SITUATION– Your name is Edward West and you are the Managing Director of West Perfumes Ltd (WPL). This is a family business and produces scented 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 to finance the development of new products and upgrade its manufacturing equipment. However, P&G want sales and profits to increase by 30% within the next 12 months. 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?

19. Management Accountingis 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 Case Study Management accounting uses information from past transactions as an aid to financial decision making, planning and controlfor the future The management of a business needs information from which to work. It needs to know accurate costs of individual products or services, together with the total costs of running the business WPL’s 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?

20. Case Study But the factory itself may be a profit centre, its manager being responsible for sales as well as production 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 Explain why WPL is a profit centre for P&G? Explain how P&G’s organisational structure overcomes the disadvantages of being a global operator? Exit