28
Costs
Activity 28.1 (page 509): Types of costs
1
Identify one indirect cost for each of these businesses:
•
•
•
•
2
a building firm
a high-street bank
a TV repairer
an oil-fired power station. [4]
Explain why the cost is indirect in each case. [4]
An indirect cost cannot be identified as arising from the production of the good or
provision of the service.
3
Business
Indirect cost
Explanation
building firm
purchase of a
digger
The digger will be used on many
building jobs.
high-street bank
cleaning costs
This is not directly linked to the provision
of banking services to customers.
TV repairer
tools
This cost is not related to a particular
repair job.
oil-fired power
station
canteen costs for
employees
It is not possible to identify these costs
with a unit of production.
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-fired 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-fired power station
oil
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4
Why do you think it is important to identify the direct costs of producing a product? [5]
•
•
•
•
•
Identification 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 different options will help make decisions about
what to produce.
Direct costs need to be identified 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
Rent of factory
3
3
Management salaries
3
3
Electricity
3
Piece-rate labour wages of production staff
3
3
3
Depreciation of equipment
3
3
Lease of company cars
3
3
Wood and other materials used in
production
3
Maintenance cost of special machine used
to make one type of wooden chair
3
Variable
3
3
Note: It is acceptable to categorise these costs differently.
2
Explain why you have classified these costs in the way you have. [8]
•
•
•
•
•
Costs classified as being fixed 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 classified 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 specific 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 identified with a unit of production.
It is possible to argue that a cost such as electricity can be viewed in a number
of different 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, fixed.
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Activity 28.3 (page 512): Break-even charts
1
Draw a break-even chart using these data. [8]
Revenue costs
1500000
Variable cost
Break-even point
Fixed cost
1000000
Total cost
500000
0
Break-even output
Sales revenue
0
5000 10000 15000 20000 25000 30000 35000
Output
2
Show the break-even point and identify the break-even level of output. [2]
3
Identify from the graph the profit expected at maximum capacity. [2]
Profit = 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]
The margin of safety at 25,000 units is 5,000 units.
Activity 28.4 (page 513): Location decisions and break-even
1
2
Use the data above to calculate, for each site:
• break-even level of output
• margin of safety
• total maximum profit assuming all units sold. [9]
Break-even: FC ÷ unit
contribution
Safety margin
Maximum profit:
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
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 profit 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;
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•
•
•
•
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 firm
will have to consider expanding sooner than at site B.
The profit 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 $4.10.
If sales are expected to be above 40,000, then site B will be more profitable.
The level of sales at which profits would be the same can be calculated as
follows:
Profit site A = profit site B
Let Q = output and sales
6Q − 3Q − 60,000 = 6Q − 2.5Q − 80,000
3Q − 60,000 = 3.5Q − 80,000
0.5Q = 20,000
Q = 40,000
Evaluation may consider:
Answers could focus on issues of risk associated with reaching the break-even level
of sales. Much will depend on the expected level of sales in the market – if it is above
40,000, then site B offers a more profitable outcome.
3
List five other factors that the business should consider before making this location
decision. [5]
•
•
•
•
•
•
capital required to start production at each site
availability of suitable labour
impact on existing employees
room for expansion
planning issues
impact on local community
Activity 28.5 (page 514): Windcheater Car Roofracks
1
Drawing the two break-even charts for these options would assist the owner in
making this decision, but other issues may have to be considered as well.
•
•
•
•
Construct break-even charts for these two options. Identify the break-even point
for each.
What is the maximum profit obtainable in each case?
If demand next year is expected to be 7,000 units, what would be the margin of
safety in both cases?
Which option would you advise the owner to choose? Give both numerical and
non-numerical reasons for your decision. [16]
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Option 1
400,000
Fixed costs
Total costs
Total revenue
350,000
300,000
250,000
200,000
150,000
100,000
Fixed costs
Total costs
Total revenue
300,000
Costs, revenue ($)
Costs, revenue ($)
Option 2
350,000
250,000
200,000
150,000
100,000
50,000
50,000
0
0
0
2000 4000 6000 8000 10000
Output
0
2000 4000 6000 8000
Output
Option 1
Option 2
Break-even output is 4,500 units
Margin of safety is 7,000 − 4,500 =
2,500 units
Maximum profit = 5,500 × 18 = $99,000
Break-even output is 3,000 units
Margin of safety is 7,000 − 3,000 =
4,000 units
Maximum profit = 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 significant increase in fixed costs and is more risky.
• Option 1 can meet increasing demand. Option 2 offers little scope for
increasing demand, and could lead to dissatisfied customers.
• With option 1, Windcheater can gain a higher market share.
• Option 1 has a higher maximum profit, 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 profit of $45,000 compared to
$80,000 for option 2.
• Consideration will need to be given to which option will cause the most
disruption to customers in the short term.
• The investment cost of each option will need to be considered.
• The new machinery might have an impact on quality.
Evaluation may consider:
Option 2 appears to be a lower-risk option as the break-even level of sales is very
low. However, as sales are expected to be 7,000 units, option 1 has a good margin
of safety, almost 56%, and it offers greater scope for future sales growth. Option 2
could reach capacity very quickly and then the firm would have to think again about
expansion.
2
The owner of Windcheater Car Roofracks discovers that the fixed costs for option 1
will in fact be 20% greater than planned. Use a break-even chart to determine the
new break-even point and then use the equation to verify it. [10]
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Option 1
400,000
Costs, revenue ($)
350,000
300,000
250,000
Fixed costs
Total costs
Total revenue
200,000
150,000
100,000
50,000
0
0
2000
4000
6000
Output
8000
10000
Fixed costs will rise to: 1.2 × 81,000 = $97,200
Break-even output = fixed costs ÷ unit contribution
= 97,200 ÷ 18
= 5,400 units
3
In option 2 the increase in fixed 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:
• The new machinery will reduce the labour costs per unit due to the increased
efficiency.
• 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.
The break-even point = fixed costs ÷ unit contribution
= 62,000 ÷ (40 − 19.50)
= 3,025 units
A 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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A
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 fixed costs between the pump and the fan in proportion to the use of
direct labour in producing each product. [6]
Pump: allocated fixed cost = 15/22 × 200,000 = $136,364
or 0.682 × 200,000
Fan: allocated fixed 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 = $7.09
2
Give reasons why you would or would not be satisfied with these results for decision
making, such as establishing market prices for the two products. [6]
Relevant points may include:
• Decision to apportion fixed costs according to direct labour is fairly arbitrary;
total direct costs or direct materials could have been used.
• Market price established can be sure of covering full costs of production. No
costs have been ignored.
• Linking price to full cost does not take into account competition or market
conditions. Contribution costing may be useful.
• The full unit cost will only be accurate if the actual output level is the same as
that used in the calculation. A change in output of the products will change the
allocated overhead.
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A
3
Draw up a new full-costing statement, basing your division of the overheads on total
direct costs (i.e. labour and materials) for each of the products. [6]
Direct costs
Apportioned overhead
Total cost
4
Pump ($)
Fan ($)
250,000 (53.2%)
106,400 (0.532 × 200,000)
356,400
220,000 (46.8%)
93,600 (0.468 × 200,000)
313,600
Recalculate the unit cost for each product on the assumption that the firm actually
produces 60,000 pumps and 30,000 fans, and comment on your result. [9]
Assuming that direct costs change in proportion to the level of output and indirect
costs are unchanged, then:
Direct costs
Apportioned overhead
Total cost
Unit cost
Pump ($)
Fan ($)
300,000 (64.5%)
129,000 (0.645 × 200,000)
429,000
7.15
165,000 (35,5%)
71,000 (0.355 × 200,000)
236,000
7.86
•
The unit cost of the fan has increased significantly, by approximately 10%, and
the unit cost of the pump has decreased by approximately 8%.
• This is a significant change from a pricing perspective.
• This illustrates the importance of a change in output to the unit cost of
production, if indirect costs are apportioned in some arbitrary manner.
Note: If no change was made to direct costs, then the unit costs would be as follows:
Total cost
Unit cost
Pump ($)
Fan ($)
356,400
5.94
313,600
10.45
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 benefits and drawbacks of using
this form of organisation. Check with your bursar / college accountant the accuracy of
your answer. [4]
•
•
•
•
•
2
human resources department
estates (maintenance of grounds and buildings)
business studies and economics department
mathematics department
IT resources and support
Explain the difference between a cost centre and a profit centre. [4]
A cost centre is a part of the business to which costs can be allocated, whereas a profit
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 identified in 1 above are, in fact, profit centres.
Explain your answer. [4]
In the examples above, the business studies department and the mathematics
department are both profit centres. This is because the number of students studying
in each department generates identifiable 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 profit 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 profit on Y = 11,000 − 5,000 = $6,000
Z: total contribution = $800. Allocated overheads = 20% of $10,000 = $2,000
Total profit on Z = 800 − 2,000 = −$1,200
4
Calculate the impact on the total profit 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 profit if Z is produced is 2,500 + 6,000 − 1,200 = $7,300
If Z is dropped, then the total profit, 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 profit 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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A Activity 28.10 (page 521): Bureau Office Supplies Ltd
1
Use the contribution / marginal-costing approach to calculate whether the new order
will add to the profits 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
Thus, the local authority order will make a total contribution of $15,000. This will
add to the $15,000 of profit, assuming that there is no increase in overheads or
knock-on effect 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
• It may be possible to gain other,
•
•
•
•
•
$15,000. This will increase profits
by $15,000, other things being
equal.
There is spare capacity, so
accepting the order will increase
capacity utilisation. This will help
control average costs of production.
There will be more effective use of
fixed assets.
It will avoid having to reduce the
hours of workers.
There may be subsequent orders
from the local authority.
Accepting the order will increase
market share.
•
•
•
more profitable, orders. Once the
local authority order is accepted,
the business may have to reject
other orders from new/existing
customers.
If other customers find out that the
local authority has secured a low
price, they will try to negotiate lower
prices as well.
Is there sufficient capacity to fulfil the
order? If not, it may cause disruption
to other customers. This will depend
on the time period given to fulfil the
order.
Does the order increase overheads?
Evaluation may consider:
It is important to recognise that an order that makes a positive contribution is worth
considering. However, it does not follow that the order should be accepted; that will
depend on the other factors outlined above.
A suitable judgement might observe that: assuming there is no impact on overheads,
sufficient spare capacity exists and no other orders are anticipated, Bureau Office
Supplies Ltd should accept the order.
Activity 28.11 − answer provided on Student's CD-ROM.
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Revision case study 1 (page 524): Decision time at the pottery
1
Draw a break-even graph to represent these data, identifying the break-even level of
production and the margin of safety. [6]
Costs, revenue ($)
25000
20000
Fixed costs
15000
Total costs
10000
Revenue
5000
0
0
1000 2000 3000 4000 5000 6000 7000 8000
Output
Break-even level of output is 2,667 units.
Margin of safety = 5,000 – 2,667 = 2,333 units.
2
The manager is considering two options in an effort to increase profits:
•
•
Purchase a new energy-efficient kiln. This would raise fixed 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 profit and the safety margins. [10]
Students should draw new graphs showing the following results:
3
Original
Purchase kiln (fixed
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
Profit
$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
Advise the firm, 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 significantly, there is a drop in
profits as the price cut applies to all units sold, and, consequently, the unit
contribution is reduced to only $1.20. This does not achieve the manager’s
objective.
• If the estimate of demand is correct, then the price cut will increase the margin
of safety.
• The price cut does increase sales and will increase market share.
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•
•
Purchasing the kiln reduces the direct cost of production to the extent that
profit is higher if sales are as estimated.
The 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 profit, 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 profit than
making no change.
Revision case study 2 (page 525): Abbey Restaurant
1
What are the forecast average monthly profit figures for the two menu options? [6]
Profit = TR − TC
Current menu:
sales turnover = $12,000
variable cost = 5 × 600 = $3,000
overheads = $7,000
profit = 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
profit = 10,080 − 8,880 = $1,200
2
Calculate the break-even level of output of both options (show your workings). [6]
Break-even = fixed 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:
• Profit 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 profits 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.
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•
•
•
•
4
The problem for Phil is that the unit contribution from the new menu is much
lower than from the existing menu; $10 compared to $15. There is a significant
reduction in the price charged and a proportionately smaller reduction in unit
variable costs.
The increase in customers is insufficient to make the new menu more profitable;
customer numbers would have to rise to 800 per month to make the same profit
as for the current menu.
The 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.
What other, non-financial, factors should Phil consider before taking the final
decision? Explain their significance to Phil’s business. [9]
•
•
•
•
•
If no change is made, will the number of customers continue to fall? If so, then
the level of profit will continue to decrease.
Can Phil recruit a suitably qualified 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? The competition may
already benefit 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.
A 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 profit/loss made by each size of case. [2]
Profit = 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 costs
Vanity case = 75,000 − 30,000 = $45,000
Small suitcase = 72,000 − 35,000 = $37,000
Medium suitcase = 20,000 − 12,000 = $10,000
Large suitcase = 37,500 − 20,000 = $17,500
4
Jill Grealey wanted to stop production of the medium-sized case. She said to the
finance director, ‘If we stop making this case, then our total profits will rise.’ The
finance 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:
• Profit with medium-sized case = $60,000
• Profit without medium-sized case (assume no change in sales of other cases
or overhead costs) = $50,000. The reduction in profit 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.
• There could be an impact on employees.
• It may be possible to use equipment to make some other more profitable
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 profit 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. Therefore, accepting the
booking would increase profits, other things being equal, by $500. If the
booking is refused, overheads will not change.
• The 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.
• The organisation will go to other hotels if the Imperial refuses the booking.
• The Friends of the General Hospital are influential. If the hotel provides a good
service, it may lead to further conference bookings.
• The 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 find 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 differences, with a simple worked example, between full-costing and
contribution-(marginal-) costing methods. [10]
Full costing:
• When using full costing, a firm 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 difficult to allocate as they do not arise from the
production of a specific product. Therefore, 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:
This focuses on direct costs of production and excludes indirect costs.
Contribution costing is often used as a basis for setting prices by multi-product
firms or when considering additional orders for a product.
•
•
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Worked example:
OJC Ltd produces juices for sale to supermarkets. It has fixed 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
Cranberry
juice
Total
Orange juice
Apple juice
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
Profit
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
Profit
12,353
(2,824)
16,471
26,000
Contribution is defined as the difference between revenue and its marginal
(variable direct) costs. In the full-cost statement, the fixed overheads have been
allocated on the basis of total direct cost. Therefore, 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]
This 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.
This means that the product will be making a contribution to the fixed costs of the
business, which have to be paid irrespective of whether production of the lossmaking product is ceased or not.
Thus, in the example above, on the basis of full costing, the apple juice is a lossmaking product. However, if production of apple juice stops, then, other things
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being equal, the apportioned fixed costs would have to be re-apportioned to the
other products. Therefore, total profit 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 firm must consider
whether the increased production can be sold and, if so, at what price.
• The loss-making product may be an important part of the firm’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. The product may make
an important statement about the firm’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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