Managing Finance and Budgets

1. Managing Finance and Budgets Lecture 5

2. 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

3. Contents of the Lecture • A: Concepts and Definitions of Costing • B: Break-Even Analysis • C: Full (Absorption)Costing

4. A: Concepts and Definitions

5. Key Concepts • What is Cost Analysis? • Objectives of Cost Analysis • Cost definitions • Cost behaviour • Break-even analysis • Full (absorption) costing

6. 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).

7. 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)

8. 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

9. 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 car Outlay cost if the car is to be repaired Opportunity cost of the car and sunk cost of the car Relevant 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.

10. 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.

11. Activity One Solution (2) If the garage were busy, with the mechanic’s time charged at £12 per hour. Historic cost3,000 What we paid for the car originally Outlay costs (to repair) Engine £300 Labour 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.

12. 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

13. 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

14. Activity Two Solution

15. B: Break-Even Analysis

16. 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.

17. 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 5,0005,000 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+

18. Break-even analysis – An example The Total Cost is just the sum of the Fixed cost and the Variable Cost

19. Break-even analysis – An example The Break-Even Point is where the Total Costs Line intersects the Sales Line. At this point: Profit/ Loss = ZERO (about 35 items sold)

20. 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

21. 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

22. 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

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

24. 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?

25. Activity Three: Company A Solution Company A FIXED COSTS £ 10,000 UNIT SALES PRICE £ 20 VARIABLE COSTS PER UNIT £ 10 PLANNED SALES 2000 units Contribution per Unit: £20 -£10 = £10 Break-even point: £10000/£10 = 1000 Margin 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

26. Activity Three: Company B Solution Company B FIXED COSTS £ 54,000 UNIT SALES PRICE £ 20 VARIABLE COSTS PER UNIT £ 2 PLANNED SALES 5000 units Contribution per Unit: £20 -£2 = £18 Break-even point: £54000/£18 = 3000 Margin 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

27. Activity Three – Operational Gearing 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 Ratio of Fixed Cost to 100:1 18,000:1 Variable 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

28. 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

29. 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)

30. C: Full Costing

31. 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

32. 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

33. 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

34. 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

35. 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 Lager Ingredients 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

36. Activity Four Solution Method 1

37. Activity Four Solution Method 2

38. Activity Four Solution Method 3

39. Activity Five “The full cost of pursuing an objective is effectively the long-run break-even selling price.” What does this mean?

40. 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”

41. 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?

42. 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.)

43. 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)