5.13 - Uses of Cost Information
Uses of different types of cost information
Cost information plays a vital role in business operations, helping managers make informed decisions about pricing, profitability, budgeting, and strategic choices. Different types of costs provide specific insights that guide these processes.
Applications of different cost types:
- Average cost data - Helps businesses set appropriate selling prices.
- Total cost data - Crucial for determining overall profit or loss.
- Total cost information in budgeting - Supports the budgeting process for monitoring and improving business performance.
- Marginal cost information - Used in decision-making with contribution costing.
How contribution costing aids product decisions
Contribution costing focuses on the contribution each product makes towards covering fixed costs and generating profit.
Formula for contribution per unit
Where:
- Selling price per unit = The price at which each unit is sold (£)
- Variable cost per unit = Costs that vary with production, such as materials or labour (£)
Benefits for product management
- Identifying high and low contributors - Shows which products make the greatest or least contribution to overheads and profit.
- Impact of discontinuing products - If a product has a positive contribution, stopping its production will reduce overall profits.
- Maintaining profitability - Fixed overhead costs will still need to be paid, but with reduced contribution to cover them.
Using contribution costing for special order decisions
Contribution costing is particularly useful for evaluating one-off or special orders, especially when a business has unused capacity.
Criteria for accepting special orders
It helps decide whether to accept orders at prices below full cost when spare capacity exists. Special orders below full cost but above marginal cost can increase total profits. Fixed overhead costs are paid anyway, so any extra contribution increases profit.
Real-world example in service industries
For example, restaurants might offer discounted meals during slow periods to generate some contribution rather than having empty tables.
Dangers of special order pricing
While special order pricing can enhance profits in the short term, it carries risks that businesses must consider to avoid long-term damage.
Potential risks to business operations
- Customer expectations - Existing customers may demand similar low prices.
- Overall financial losses - Selling all products just above marginal cost could lead to overall loss.
- Brand damage - Could destroy exclusivity of brand image.
- Capacity constraints - Without excess capacity, it may reduce full-price sales.
- Market disruption - Lower-priced goods may be resold into a higher-priced market by customers.
Situations where contribution costing is appropriate or not
Contribution costing is a valuable tool in specific scenarios but may not suit all business contexts. Understanding when to apply it ensures accurate decision-making.
Scenarios suitable for contribution costing
- Avoiding indirect cost allocation issues
- Decisions on products or profit centres
- Utilising excess capacity
- Special order evaluations
Scenarios where contribution costing is less suitable
- Varying indirect costs - When some products cause higher indirect costs than others.
- Single-product businesses - For single-product firms that must cover fixed costs with revenue from one product.
- Expansion or new product development - When making decisions about business expansion or developing new products.
- Retaining suboptimal products - May lead to maintaining products just because of positive contribution when better alternatives exist.
- Emphasis on qualitative factors - When qualitative factors like product image are important to the business.