Costing & Profitability

Alison Lane
Senior Lecturer
Glamorgan Business School
Why are Accountants so concerned with
‘cost’ ?
• Generally speaking, the price charged for a product
should exceed its cost otherwise no profit

Problem

How do we define cost ?

Approaches to Costing
• Full Cost

• Total Absorption Cost

• Marginal Cost
Full Costing

• Establish direct cost of product / service / department

(cost centre / profit centre)

• Add on an additional element of cost to cover indirect

costs (possibly a % uplift in proportion to direct costs)
 Full Costing Example
Golf £ Gym £ Outdoor £ Total £

Direct Costs

Cost of items for resale 540,000 395,000 420,000 1,355,000

Employee wage costs 120,000 80,000 160,000 360,000

660,000 475,000 580,000 1,715,000

Indirect costs

Share of general overheads 42692 30725 37517 110935

Full Cost 702,692 505,725 617,517 1,825,935

% share of total direct cost 38% 28% 34%

Absorption Costing
• A method of costing which assigns both direct and
indirect costs to products / services / departments.

Same as Full Costing ?

• No – Key difference is in the way overheads are

allocated
• Indirect costs are allocated in proportion to use
 Absorption Costing Example
Overhead costs Cost Basis Golf Gym Outdoor

Rent 28000Area 8842 5895 13263

Light & heat 15000Area 4737 3158 7105

Cleaning 5340Area 1686 1124 2529

Supervisors salaries 45900Staff 15300 10200 20400

Insurance -Buildings 6678Area 2109 1406 3163

Insurance -employees 10017Staff 3339 2226 4452

Total 110935 36013 24009 50913

 Golf £ Gym £ Outdoor £ Total £

Direct Costs

Cost of items for resale 540,000 395,000 420,000 1,355,000

Employee wage costs 120,000 80,000 160,000 360,000

660,000 475,000 580,000 1,715,000

Indirect costs

Apportioned overheads 36013 24009 50913 110935

Full Cost 696,013 499,009 630,913 1,825,935

 Profit Comparison
Full Costing Golf £ Gym £ Outdoor £ Total £

Sales Revenue 975,000 485,000 855,000 2,315,000

Less

Full Cost 702,692 505,725 617,517 1,825,935

Profit 272,308 -20,725 237,483 489,065

Absorption Costing Golf £ Gym £ Outdoor £ Total £

Sales Revenue 975,000 485,000 855,000 2,315,000

Less

Full Cost 696,013 499,009 630,913 1,825,935

Profit 278,987 -14,009 224,087 489,065

Marginal Costing
• An accounting system in which variable costs are
charged to products / services / departments, and
fixed costs for the period are charged in full against
aggregate contribution

How is this different from full and absorption costing ?

• Absorption and Full Costing • Marginal Costing

• Direct costs are • Variable costs are

distinguished from indirect distinguished from fixed
costs costs

• Indirect costs are divided or • There is no attempt to divide

allocated between overhead costs
departments or products
 Marginal Costing Example
Marginal Costing Golf £ Gym £ Outdoor £ Total £

Sales Revenue 975,000 485,000 855,000 2,315,000

Less Variable Costs

Goods for resale 540,000 395,000 420,000 1,355,000

Employee wages 120,000 80,000 160,000 360,000

Contribution 315,000 10,000 275,000 600,000

Less Fixed costs

Overheads 110,935

Profit 489,065
Advantages and Disadvantages of
different approaches
• Full Costing
Advantages
- Relatively simple
- Includes an element of overhead cost in total
production cost therefore complies with SSAP 9
Disadvantages
- To general to support a detailed planning &
control system
• Absorption Costing
Advantages
- More sophisticated version of full costing, costs
are allocated in relation to relative consumption
- Identifies total production cost therefore
complies with financial reporting requirements
- Informs pricing decisions
Disadvantages
- Arbitrary decisions on allocation bases
- Time consuming
- Potentially misleading (traditional volume based allocation
or activity based?)
• Marginal Costing
Advantages
- No arbitrary allocation of overheads
- Under / over absorption is avoided
- Relatively simple to operate
- Fixed costs are often irrelevant for short run
decision making
Disadvantages
- Can lead to under-pricing
- Does not comply with GAAP as no element of fixed cost
is absorbed into stock valuation
Costing & Decision Making
• Should the sports equipment retailer continue to sell
all three types of product ?

Which products are most profitable ?

Implications of closing a department

How could the overall profitability of the business be

improved ?
Further Decision Making Scenarios
A manufacturer has been offered a special contract to make
equipment for a customer who is willing to pay £20,000
providing certain delivery requirements can be met. The
management accountant has provided the following costing for
the job;
£
Materials 3,000
Labour (1,600 hours) 8,000
Variable overheads 4,000
Allocated Fixed Overheads 8,000
£23,000
Should the order be accepted?
Sales Revenue is less than the total cost so don’t accept….
But….
- Does the business have spare capacity?
- Is business operating above breakeven point?
- Would overhead costs increase as a result of taking the
contract?
• The business is currently making a profit but has
3000 hours of spare labour capacity. Due to specialist
skills they don’t want to get rid of any staff in the short
term. There are no additional overhead costs specific
to the contract .

How might this affect the decision ?

 Full Cost Marginal Cost
£ £
Materials 3,000 3,000
Labour (1,600 hours) 8,000 0
Variable overheads 4,000 4,000
Allocated Fixed Overheads 8,000 0
£23,000
Sales Revenue £20,000 £20,000
Profit / (Loss) (£3,000) £13,000