5.2 Costs and Revenues IBBM

Management Decisions and Cost Business decisions cannot be made without cost information. Why? Profit or loss cannot be calculated without knowing COST Marketing will use COST information to determine pricing COST records are useful in comparing to past performance and help set budgets COST data can help determine the use of resources…use labor hours or buy automated equipment?

Production Costs The financial costs incurred in making a product or providing a service. Costs are classified into categories: Direct Costs Indirect Costs Fixed Costs Variable Costs Semi-Variable Costs Marginal Costs

Direct Costs Direct Costs Costs can be clearly identified with each unit of production and can be allocated to a cost center. Direct costs of a hamburger in a fast-food restaurant is the cost of meat…. You name another Direct cost for a automobile repair shop servicing a car is the labor of the mechanic…You name another Direct cost for a business studies department is the salary of the business teacher…You name another Common direct costs in manufacturing are labor and materials. Common direct costs in a service business is the cost of goods sold.

Indirect Costs Indirect Costs Costs which cannot be identified with a unit of production – also known as overhead costs Indirect cost to a farm is the purchase of a tractor…. You name another Indirect cost to a automobile repair shop is rent… You name another Indirect cost of running a school is the cost of cleaning… You name another

Indirect Costs Indirect Costs can be classified into 4 groups: Production overheads – factory rent, equipment depreciation, electricity Selling and distribution overheads – warehouse, packing, and distribution costs Administration overheads – office rent, clerical salaries Finance overheads – interest on loans

Costs are affected by Output Some costs vary with output of production and some costs do not change. Costs can be classified: Fixed costs – These remain constant no matter what happens to production output (rent) Variable costs – These vary as production output changes (quantity of raw materials used) Semi-Variable costs – These include both fixed and variable costs (account charge for electricity plus the electricity used) Marginal costs – The additional variable cost of producing one more unit

Revenue Revenue is the income received from the sale of a product Total Revenue is the total income from the sale of ALL units of the product (quantity X price)

Don’t confuse Revenue, Cash Flow, and Profit Remember: Revenue is not the same as cash received from sales. Revenue is recorded at the time of sale not at the time cash is received. Remember: Revenue is not the same as profit. All costs of operating the business are subtracted from revenue to determine profit.

Contribution to Fixed Costs Contribution per Unit Is the selling price of a product less variable costs per unit. Total Contribution Is the total revenue from the sale of a product less total variable costs of producing it. Contribution is NOT profit. Contribution is what a product “contributes” towards fixed costs, and once these are paid, towards the profits of the business.

Cost and Profit Centers Cost Center: A section of a business, such as a department, to which costs can be allocated. Examples: products, departments, factories, process or stage of production Profit Center: A section of a business to which both costs and revenues can be allocated. Examples: branch offices, departments in a store, multi-product firms – each product line HL

Benefits of Costs and Profit Centers Managers and staff will have targets to work towards. Targets can be compared with actual performance and identify areas of strength and weakness. Individual performances of divisions allow managers to be assessed and compared. Work can be monitored and decisions made about the future – keep producing, raise prices, shut down area HL

Problems with Costs and Profit Centers Managers and workers may think they are most important to the business. Damaging internal competition can occur. Indirect costs may be impossible to allocate accurately to centers and they can be applied inaccurately or arbitrarily. Reasons for good or bad performance may be due to external factors. HL

Contribution Costing A costing method that only allocates direct costs to cost/profit center and does NOT include overhead costs. Focused on 2 accounting concepts Marginal cost is the cost of producing an extra unit. (Total cost of producing 500 units is $5000 and the total cost of producing 501 units is $5005, then the marginal cost is $5.) Contribution costing is the amount the product contributes to covering fixed costs and profit. (If 501st unit sells for $25 and the marginal cost was $5, then $20 can be contributed towards fixed costs.) HL

Contribution Costing and Decision-Making If a company makes more than one product, contribution costing shows management how much each product is contributing to fixed costs and profits. Marginal costing assists managers in deciding whether to accept an order below the full cost of the product. Example: Hotels offer low rates during off-peak seasons. Airlines sell seats at a discount 2 days prior to the planes departure date. Reasoning: It is better to earn a contribution than leave the rooms or airplane seats empty. HL

Dangers of Contribution Costing and Price Determination Existing customers learn of the lower prices for others and demand similar treatment; then earning a profit is unlikely. When high prices establish exclusivity of a brand, then lower prices can destroy image. If there is no excess capacity, contribution pricing may cost sales at full price. Lower priced goods can be purchased by others and resold for a higher price. HL

A Story…. Sue is a dress maker who pays $45 a day to use a workshop. She makes 3 dresses a day and sells them for $30 each. Materials cost her $8 a dress. Fixed costs per dress $15 ($45/3 dresses) Material Costs per dress $8 Total Unit Cost $23 One day she has orders for only 2 dresses. She received an inquiry for 1 dress at $20. Should she accept the order? Does NOT accept, she will lose $1 Sales of 2 dresses @ $30 = $60 Cost 2 dresses @ $8 = $16 + Total fixed costs $45=$61 $1 loss She accepts, she will make a profit of $11 Sales of 2 dresses @$30 + sale of 1 dress @ $20 = $80 Cost 3 dresses @ $8 = 24 + total fixed costs $45 = $69 $11 profit Dress 3 has a contribution cost of $12 ($20 - $8) HL

Contribution Costing Summary Ignoring overhead costs does not consider that some products actually do have higher fixed costs than others. Contribution costing may not be appropriate for single product firms. Products may be produced because of their contribution when a new product should be considered or launched. Qualitative factors need to be considered: Does the product promote the companies image? Does it complete the product range? And eliminating would reduce the appeal of the product? HL