CAPE

MANAGEMENT OF
BUSINESS
UNIT 2
Costing
LEARNING OBJECTIVES
1. Outline the different costs of production
2. Describe the approaches to costing
3. Calculate operating profit using marginal and
absorption costing
4. Analyse and calculate the concepts under breakeven
analysis
5. Plot breakeven charts
6. Analyse the ‘make or buy’ decisions of firm
WHAT ARE THE COSTS OF PRODUCTION?
The financial costs incurred in making a product or
providing a service can be classified in several ways.
Cost classification is not always as clear-cut as it seems
and allocating costs to each product is not usually very
straightforward in a business with more than one
product. Some costing methods require this allocation to
be made, some do not.
The most important categories are:
■ direct costs
■ indirect costs
■ fixed costs
■ variable costs
■ marginal costs.
DIRECT COSTS
These are those costs that can be directly traced to the cost
object under consideration. Examples are steel and plastic
used in the manufacture of a car.
The two most common direct costs in a manufacturing
business are labour and materials. The most important
direct cost in a service business, such as retailing, is the
cost of the goods being sold.

1. Direct materials are all materials that become an

integral part of the finished product. Examples are the
steel used to make an automobile and the wood to make
furniture. Glues, nails and other minor items are called
indirect materials (or supplies) and are classified as part of
factory overhead.
2. Direct labour is the labour directly involved in making
the product. Examples of direct labour costs are the wages
of assembly line and the wages of machine tool operators
in a machine shop. Indirect labour such as wages of
supervisory personnel, store-keepers and security guards,
is classified as part of factory overhead.
3. Direct expenses are those incurred in the production of a
particular product, such as the rental of a machine to work
on a particular product.
 INDIRECT COSTS
These are cots that are difficult to directly trace to a specific
costing object. Factory overhead items are all indirect costs.
Costs shared by different departments, products, or jobs called
common costs or joint costs, are also indirect costs. National
advertising that benefits more than one product and sales
territory is an example of an indirect cost.
1. Indirect Labour: The wages or salaries paid to the workers
which are not directly involved in production, not making the
product. Examples are, maintenance worker wage, raw
material storekeeper salary, factory manager's salary, factory
supervisor's salary, etc.
2. Indirect Material: Materials that cannot be directly
traceable or identifiable. It will not become a major part of
product. Also the other materials used in factory which do not
become the part of product at all. Examples are, cleaning
materials, lubricants, nails, glue, buttons, etc.
3. Indirect Expenses: The expenses which are not specific to
the production but without those, production cannot be
possible. These are intangible expenses. Examples are,
factory rent and rates, factory electricity bills, machine
depreciation, factory repairs and maintenances, etc.
 HOW ARE COSTS AFFECTED BY THE LEVEL OF
OUTPUT?
It is important for management to understand that not all
costs will vary directly in line with production increases or
decreases. In the short run − the period in which no
changes to capacity can be made − costs may be classified
as follows:
■ Fixed costs: These remain fixed no matter what the level
of output, such as rent of premises.
■ Variable costs: These vary as output changes, such as
the direct cost of materials used in making a washing
machine or the electricity used to cook a fast-food meal.
Semi variable costs include both a fixed and a variable
element, for example the electricity standing charge plus
cost per unit used, salesperson’s fixed basic wage plus a
commission that varies with sales.
■ Marginal costs: These are the additional costs of
producing
one more unit of output, and will be the extra variable
costs needed to make this extra unit. So the marginal
costs involved in making one more wooden table are the
additional costs of wood, glue and screws plus the labour
costs incurred.
FIXED COST & VARIABLE COST
$

Fixed Cost

Activity Level
$

Variable cost

Activity Level
SEMI VARIABLE COST
$

Semi Variable cost

Activity Level
MARGINAL COSTING
The marginal cost of an item is its variable cost. The
marginal production cost of an item is the sum of its
direct materials cost, direct labour cost, direct expenses
cost (if any) and variable production overhead cost. So as
the volume of production and sales increases total
variable costs rise proportionately. Fixed costs are then
incorporated when drafting the profit and loss statement.
These costs are written off in the period to which they
relate.
Marginal costing is also the principal costing technique
used in decision making. The key reason for this is that
the marginal costing approach allows management's
attention to be focussed on the changes which result from
the decision under consideration.
THE CONTRIBUTION CONCEPT
The contribution concept lies at the heart of marginal
costing. Contribution can be calculated as follows.
Contribution = Sales price - Variable costs
The idea of profit is not a particularly useful one as it
depends on how many units are sold. For this reason, the
contribution concept is frequently employed by
management.
1. Contribution gives an idea of how much 'money' there
is available to 'contribute' towards paying for the
overheads of the organisation.
2. At varying levels of output and sales, contribution
per unit is constant.
3. At varying levels of output and sales, profit per unit
varies.
4. Total contribution = Contribution per unit x Sales
volume.
Profit = Total contribution - Fixed overheads
 Marginal costing income statement
Sales xxxxxxx
Variable production costs:
Direct labour xxx
Direct materials xxxxx
Direct expenses xx
xxxxxx
Less closing stock (xxx) (xxxxx)
Contribution xxx
Less fixed costs and other expenses (xx)
Operating profit xx
Valuation of inventory - opening and closing inventory
are valued at marginal (variable
 EXAMPLE
A firm manufactures and sells a single product. The
details of its statistics are outlined below:
Selling price $80
Direct materials $15
Direct labour $11
Variable overheads $9
Fixed overheads $40 000 per month.
The fixed overheads were absorbed on the basis of an
expected production of 60 000 units for the month. If the
actual production and sales amounted to 60 000 units for
the month, calculate:
1. Contribution per unit
2. Total contribution
3. Total profit for the month.

Contribution per unit = Selling Price – Total Variable cost

= 80 – (15 + 11 + 9 )
= 80 – 35
= $45
Total Contribution = Contribution per unit x # of units sold
= 45 x 60 000 units
= $2,700,000

Marginal costing income statement

$,000 $,000
Sales 4,800
Variable production costs:
Direct labour 660
Direct materials 900
Direct expenses 540
(2100)
Contribution 2,700
Less fixed costs and other expenses (40)
Operating profit 2,660
ADVANTAGES OF MARGINAL COSTING
1. It is easily understood and is useful in terms of budgetary
control since the contribution that is calculated can be
used for comparisons
2. Managers can use the information provided in making
decisions in terms of pricing, ‘make or buy’ decisions or
introducing new products, among other things
3. Since the calculation of contribution does include fixed
costs, it eliminates the need for fixed costs to be absorbed
into production and so prevents the technicality of over-
and under absorption
4. Since closing inventory is valued at only variable cost, it
prevents a portion of the fixed costs from being carried
over into the next period
5. The profits under marginal costing are calculated on the
basis of sales volume rather than production unit.
6. It helps with short-term decision-making in the forms of
– break-even analysis
– margin of safety
– target profit
– contribution sales ratio
– limiting factors
– ‘special order’ pricing
DISADVANTAGES OF MARGINAL COSTING
1. There can be difficulty in separating overheads into
variable and fixed costs
2. Since fixed costs are ignored, this approach may not
be useful for long-term planning and decisions
because variable costs should not be the only basis on
which these decisions are made
3. It is argued that the profit under marginal costing is
distorted because the closing inventory does not
reflect fixed costs
4. This method of costing is not recognised for external
reporting purposes.
ABSORPTION COSTING
Absorption costing answers the question, ‘What does it
cost to make one unit of output?’
The absorption cost of a unit of output is made up of the
following costs:
$
Direct materials xx
add Direct labour xx
add Direct expenses x
add Production overheads (fixed and variable) x
equals ABSORPTION COST xxx
Note that the production overheads comprise the factory
costs of indirect materials, indirect labour, and indirect
expenses.
The Wyvern Bike Company makes 100 bikes each week and
its costs are as follows:
Direct materials $4,000
Direct labour $5,000
Production overheads $5,000
The selling price of each bike is $200.
As an accounts assistant at the Wyvern Bike Company, you
are asked to:
• calculate the absorption cost of producing each bike
• calculate the total profit each week
Absorption cost per bike
Total costs per week: $
Direct materials 4,000
Direct labour 5,000
Production overheads 5,000
Total cost 14,000
The absorption cost of producing one bike is:
Total cost = $14,000 = $140 per bike
Units of output 100 bikes
Profit each week
Selling price (100 bikes x $200) 20,000
less Total cost 14,000
equals Profit for the week 6,000
Absorption Costing Income Statement
Details $ $
Sales xxxxxx
Production costs:
Direct labour xx
Direct materials xx
Direct expenses x
Fixed costs (manufacturing) xx
xxxx
Less: Closing stock (x) (xxx)
Gross profit xxx
Less: Expenses or overheads (x)
Net profit xx
ADVANTAGES OF ABSORPTION COSTING
1. A portion of fixed cost is incorporated into the value of
closing inventory. This allows the costs of the period
to be matched accurately with the revenues of the
same period
2. It gives a more accurate cost of production, so that
prices can be set based on total costs and not just
variable costs
3. It is a more realistic method of costing, since both
fixed and variable costs are incorporated
4. It is accepted as a method for external reporting
5. It avoids the need to separate costs into fixed and
variable costs, as some costs are semi-variable and
are difficult to separate.
DISADVANTAGES OF ABSORPTION COSTING

1. The absorption of fixed costs and determining

whether they were over- or under absorbed can
complicate the process
2. It can be complicated to calculate.
MARGINAL & ABSORPTION COSTING INCLUDING
CLOSING STOCK

A firm manufactures and sells a single product. The

details of its statistics are outlined below:
Selling price $80
Direct materials $15
Direct labour $11
Variable overheads $9
Fixed overheads $40 000 per month.
The fixed overheads were absorbed on the basis of an
expected production of 60 000 units for the month. If the
actual production and sales amounted to 55 000 units for
the month, calculate the total profit using:
a) Marginal Costing
b) Absorption Costing
EXERCISE
Chairs Limited commenced business on 1 January 2017. It
manufactures a special type of chair designed to alleviate
back pain. Information on the first year’s trading is as
follows:
number of chairs manufactured 5,000
number of chairs sold 4,500
selling price $130 per chair
direct materials $30 per chair
direct labour $45 per chair
fixed production overheads $100,000
The directors ask for your help in producing profit
statements using the marginal costing and absorption
costing methods. They say that they will use ‘the one that
shows the higher profit’ to the company’s bank manager.
• Closing inventory is always calculated on the basis of
this year’s costs:
marginal costing, variable costs only, ie $30 + $45 = $75
per chair
absorption costing, variable and fixed costs, ie $450,000 ÷
5,000 chairs = $90 per chair
• The difference in the profit figures is caused only by the
closing inventory figures:
$35,000 under marginal costing and $45,000 under
absorption costing – the same costs have been used, but
fixed production overheads have been treated differently.
• Only fixed production overheads are dealt with
differently using the techniques of marginal and
absorption costing – both methods charge non-production
overheads in full to the statement of profit or loss in the
year to which they relate.
MAKE OR BUY’ DECISIONS
From time to time, management is faced with a decision
on whether to make or buy a product or its components.
There are a number of factors that could influence the
firm’s decision on this:
1. The cost involved – the firm will be mindful of the
difference between the cost to buy and the cost to make
and, barring poor quality, this will determine the firm’s
decision
2. The firm may be the only one producing the product
3. It may want to produce its own brand The firm may
want to ensure that the product is always available
instead of depending on an outside supplier
MAKE OR BUY DECISION EXAMPLE
Undecided Ltd manufactures a component to be used in
the production of mind stimulators. The costs for
associated with its current production of 20 000 units are
outlined below:
Direct materials $80 per unit
Direct labour $100 per unit
Variable overheads $17,500
Fixed costs $100,000.
The same component could be bought at a cost of $250.
BREAK EVEN ANALYSIS

Breakeven point represents the minimum level of sales

(revenue or volume) needed to cover total costs (fixed and
variable). At breakeven point, profit is equal to zero
because our total sales income is equal to total
expenditure.

Breakeven point in units = Fixed costs

Contribution per unit
Breakeven point in sales = Fixed costs
Contribution to sales ratio

Contribution to sales ratio (C/S Ratio)

The contribution sales ratio is an important concept – it
indicates the level of contribution that is included in sales
revenue or selling price.
The contribution to sales ratio (C/S ratio)
= Contribution per unit × 100
Selling price
BREAK EVEN ANALYSIS
Target Profit
Level of sales to result in target profit
This can be done on a ‘per unit’ basis or sales volume:
Level of sales to result in target profit (units) =
Fixed costs + target profit
Contribution per unit
Level of sales to result in target profit (sales)
= Fixed costs + target profit × selling price
Contribution per unit

Or
Target Profit (Sales revenue) = Fixed Costs + Target Profit
C/S Ratio
BREAK EVEN ANALYSIS
Breakeven analysis is useful to businesses as it enables
them to:
1. Ascertain the profit or loss at different levels of
production and sales
2. Make predictions on the effects of price changes on
sales
3. Determine the breakeven point
4. Determine the margin of safety
5. Examine the relationship between fixed and variable
costs
6. Determine how changes in costs and efficiency will
affect profits.
EXAMPLE
Using the following data, calculate the
breakeven point in units and dollars (sales)
Selling Price = $50
Variable Cost = $40
Fixed Cost = $70,000
ADVANTAGES OF USING BREAKEVEN ANALYSIS
1. Its calculation is fairly simple
2. It highlights the profit or loss at different levels of
output
3. It shows how a firm’s profit or sales will be affected by
changes in price or cost
4. It analysis helps in understanding the relationship
between fixed cost, variable cost and the level of
profitability.
5. It provides the business with a minimum sales level
which the company needs to achieve to avoid losses.
6. It also indicates how any change in selling price would
impact the profitability and BEP.
7. Firms are aware of the level of sales that will cover
their fixed costs
8. It can be used as one of the indicators which help in
deciding whether to manufacture new product yourself
or simply outsource.
9. Firms can determine the level of sales needed to make
a certain level of profit.
DISADVANTAGES OF USING BREAKEVEN ANALYSIS
1. Results can be misleading, since it assumes that all
output is sold and so there is no closing stock
2. Like most calculations, the effectiveness of breakeven
analysis depends on the accuracy of the data
3. There are a number of businesses that produce
multiple products at varying costs and prices
4. To construct a breakeven chart takes time.
EXAMPLE
An organisation manufactures a single product, incurring
variable costs of $50 per unit and fixed costs of $20,000
per month. If the product sells for $70 per unit, then the
breakeven point can be calculated as follows:
We can now draw a few conclusions from the breakeven
chart:
1. Fixed costs are constant over the levels of output
2. Variable costs is the area above the fixed costs line but
below the total cost line and is directly proportional to
output, i.e. it increases as output increases
3. Total revenue and sales volume are directly
proportionate
4. The breakeven point is shown where the total cost line
cuts the total revenue line. At this point, both profit
and loss are equal to zero
5. Losses are made to the left of breakeven point, while
profits are made to the right of breakeven point.
ASSUMPTIONS REGARDING BREAK-EVEN CHARTS
ARE AS UNDER:
(i) Costs are distributed into variable and fixed
components.
(ii) Fixed costs will remain constant and will not change
with change in level of output.
(iii) Variable cost per unit will remain constant during the
relevant volume range of graph.
(iv) Selling price will remain constant even though there
may be competition or change in volume of production.
(v) The number of units produced and sold will be the
same so that there is no operating or closing stock.
(vi) There will be no change in operating efficiency.
(vii) In case of multi-product companies, it is assumed that
the sales mix remains constant.
BREAK-EVEN CHARTS
BREAK-EVEN CHART

$ Total
Cost

B/E Variable
cost

Fixed
Cost

Activity Level
 MARGIN OF SAFETY
The margin of safety is the difference between the expected
level of sales and the breakeven point. The larger the
margin of safety, the more likely it is that a profit will be
made, i.e. if sales start to fall there is more leeway before
the organisation begins to incur losses. (Obviously, this
statement is made on the assumption that projected sales
volumes are above the breakeven point.)

Margin of Safety ($) = Budgeted Sales less Breakeven

sales
Margin of Safety as % =
Budgeted Sales less Breakeven sales x 100
Budgeted Sales

Margin of safety can also be expressed as percentage of

sales Margin of safety × 100
= Total sales
MARGIN OF SAFETY
ADVANTAGES OF MARGIN OF SAFETY
1. It is useful in knowing how much cushion the
company has if sales decline before the company
starts making losses.
2. Higher margin of safety provides freedom to the
management of the company to alter the selling price
of their product in order to gain market share from its
competitors.
3. Higher margin of safety allows the company to spend
more on an advertisement or other activities that can
help in improving sales in the long run.
The margin of safety may be improved by taking the
following steps:
(i) Lowering fixed costs.
(ii) Lowering variable costs so as to improve marginal
contribution.
(iii) Increasing volume of sales, if there is unused capacity.
(iv) Increasing the selling price, if market conditions
permit, and
(v) Changing the product mix as to improve contribution.
A company manufactures and sells a single product that has
the following cost and selling price structure:
$/unit $/unit
Selling price 120
Direct material 22
Direct labour 36
Variable overhead 14
Fixed overhead 12
(84)
Profit per unit 36
The fixed-overhead absorption rate is based on the normal
capacity of 2,000 units per month. Assume that the same
amount is spent each month on fixed overheads.
Budgeted sales for next month are 2,200 units.
You are required to calculate:
(i) the breakeven point, in sales units per month;
(ii) the margin of safety for next month;
(iii) the budgeted profit for next month;
(iv) the sales required to achieve a profit of £96,000 in a month.
BREAK EVEN