Approaches to Costing (CIE A Level Business)

• Businesses can choose how to calculate the costs of manufacturing products
  
  • They need to account for both direct costs, such as raw materials, components and direct labour, and indirect costs, including overheads such as rent, rates, selling costs and administration expenses
    
    
• Two of the most commonly used methods are
  • Full costing
    • This method allocates all costs, direct and indirect, equally across all products a business manufactures
  • Contribution costing
    • This method allocates only direct costs to products manufactured by a business
    • Indirect costs are covered and profits generated by contribution

• If a business manufactures one type of product, full costing can be used to allocate all costs, direct and indirect, equally across all products
  
  

Diagram: Stages in full Costing

Full costing involves dividing the total costs by the volume of output

• When a business manufactures more than one product it needs to decide how to allocate indirect costs across the range of products
  • Each product may incur a different proportion of indirect costs 
    • E.g. they may require more workers, machinery or factory space, or may be manufactured in greater volumes
      
      
  • These decisions are unlikely to be straight-forward and should remain constant over time
    • Inappropriate allocation of costs can lead to incorrect pricing decisions
      
    • Using different methods makes comparison over time difficult
      
      
  • Allocations of indirect costs must be calculated first, before the full cost can be determined

Uses of full Costing

• Full costing is a simple method that is particularly useful when a business manufactures just one type of product or where determining the allocation of indirect costs across more than one product is straightforward
  
  
• All costs are allocated to manufactured products, meaning managers can plan for a guaranteed profit if prices are set higher than the full cost
  
  
• Decision-making and performance can be measured and assessed over time, as long as the method of allocating indirect costs remains the same
   

Limitations of full Costing

• Determining the allocation of indirect costs can be difficult
  • A decision has to made about whether indirect costs should be allocated according to labour used, factory space used, machinery or storage space used, or whether other factors such as the level of output would be more appropriate
  • The method used should remain consistent to allow for comparisons over time
    
    
• Full costing is often used to predict costs
  • If actual output levels differ to those used in full costing calculations, calculations will be inaccurate
  • Inappropriate pricing decisions made using these predicted costs could affect the level of profit made on sales

• Contribution costing is a method of costing where direct costs are allocated to products or departments of a business

  • It assumes that indirect costs must be paid during a particular time period, regardless of the level of production for each product

  • Each profitable product contributes towards paying these overheads
    
    

• These products or departments are often referred to as cost centres or profit centres
  
  

Diagram: Calculating Contribution

Contribution is calculated by subtracting the average direct costs of production from the intended selling price

• Contribution costing can help a business determine the most worthwhile products to sell
  • Those which make the greatest contribution to fixed costs and profit should be retained
  • Those making a small contribution to fixed costs and profit may also be retained, as long as continuing to do so meets business objectives, as phasing them out would reduce profit
  • Those with negative contribution to fixed costs and profit should be phased out, leading to increased profit
    
    

Example: Lickety Split Desserts

• Lickety Split Desserts is a seaside ice cream café
• It sells a range of ice cream and sorbet-based desserts
• The table below shows a contribution analysis for its top-selling products
   

Contribution Analysis for Lickety Split's Top-Selling Desserts

Contribution Analysis

• Nutty Surprise is the strongest product
  • It earns the highest contribution ($5.70) to indirect costs per product sold
    
    
• ChocoLick is the weakest product
  • It earns the lowest contribution ($3.35) to indirect costs per product sold
  • Twice as many ChocoLick as Ice Magic desserts would need to be sold to generate the same level of contribution
    
    
• This positive contribution from all of Lickety Split's profitable products can go towards paying the indirect costs of operating the café
• Once these indirect costs are covered in full, Lickety Split will make a profit

• Contribution and profit are related concepts, but there is an important difference
  
  

Diagram: Contribution & Profit

Contribution is the difference between selling price and direct costs that can be used to cover the payment of indirect costs and contribute to profit

• Contribution shows the difference between the sales price and direct costs for specific products
  
  • This contributes to the payment of indirect costs
  • Once indirect costs are fully covered, contribution goes towards the profit of the business

• As indirect costs are not considered in calculations, there is no guarantee that a business will make a profit
  
  
• It ignores the fact that some products may incur higher indirect costs than others
  
  
• The potential of products that make a small or negative contribution now but may be more successful in the future is often ignored
  
  
• Qualitative factors such as the ability of a business to maintain a full product range, or the image a product contributes to the business are overlooked
  • E.g. As one of its heritage products, Cadbury's Turkish Delight is retained in the company's product range, despite making a minimal contribution to fixed costs and profit

• Managers often have to decide whether to accept a special order at a lower price than it would normally charge
  • If spare capacity exists, it may be tempting to accept the order
  • As long as the special order details are not shared with existing customers, it could be an effective way to attract a new customer
  • However, if indirect costs are increased by accepting the order, it may be more difficult to justify
    
    
• Contribution costing can determine whether accepting the order will make a positive contribution to indirect costs and whether it will increase profit
  • In many cases, unprofitable special orders may be worthwhile as they can make a positive contribution to indirect costs