5.10 - Approaches to Costing
The main methods of costing and allocation of costs
Full costing and contribution costing represent the two primary approaches to determining product costs in a business.
Direct costs, such as labour and materials, can be straightforwardly traced and assigned to specific products. In contrast, overheads – which are indirect costs – cannot be directly linked to individual units, leading to various methods of apportioning them. This creates uncertainty regarding the actual cost of a product, which in turn influences key decisions like setting prices, deciding whether to continue production, and accepting new orders.
Cost centres and profit centres
Cost centres and profit centres help organisations manage and track financial performance by breaking down operations into manageable units.
Cost centres
Cost centres are parts of an organisation where costs are gathered and assigned for monitoring purposes.
Examples of cost centres:
- In a manufacturing business - Components department, assembly lines, finishing departments, quality control stations.
- In a hospital - Emergency department, surgery wing, radiology, outpatient clinic.
- In a university - Academic departments, research centres, administration offices.
Profit centres
Profit centres are sections of an organisation evaluated based on their ability to generate profit.
Examples of profit centres:
- In a restaurant chain - Each individual location.
- In a large electronics retailer - Each section, such as computers, mobile phones, appliances.
- In a diversified company - Each separate product line within the overall range.
The benefits of using cost and profit centres
Implementing cost and profit centres offers several advantages for managing and improving business performance.
Key benefits of cost and profit centres:
- Motivation through targets - They provide specific goals for managers and employees, enhancing drive and focus.
- Performance comparison - They allow evaluation against set targets, highlighting areas of strength and weakness.
- Assessment of performance - They enable the review and comparison of different divisions and managers.
- Monitoring and decision-making - They support ongoing oversight of operations, aiding in informed choices about future activities.
Classification of overheads
Overheads, also known as indirect expenses, are costs not directly tied to production. They are classified into categories to aid in allocation and management.
Categories of overheads:
| Category | Examples |
|---|---|
| Production overheads | Factory rent and rates, depreciation of equipment, power. |
| Selling and distribution overheads | Warehouse costs, packing and distribution expenses, salaries of sales staff. |
| Administration overheads | Office rent and rates, salaries of clerical and executive staff. |
| Finance overheads | Interest on loans. |
Calculating average cost
Average cost, also known as unit cost, indicates the cost per item produced. It is essential for decisions such as pricing products.
Where:
- Total cost of producing this product = Sum of all expenses involved in production (£)
- Number of units produced = Quantity of items manufactured
Worked example - Calculating average cost
A company produces 9,000 chairs at a total cost of £315,000. Calculate the average cost per chair.
Step 1: Identify the values
- Total cost = £315,000
- Number of units produced = 9,000