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M03_ATRI3622_06_SE_C03.QXD 90 CHAPTER 3 5/29/09 3:30 PM Page 90 COST–VOLUME–PROFIT ANALYSIS business’s products. Neither C nor D is incorporated into A or B. Costings (per unit) for the products are as follows: A £ 15 25 5 20 65 £70 Variable materials Variable labour Other variable costs Fixed costs Selling price (per unit) B £ 20 10 3 8 41 £45 C £ 16 10 2 8 36 D £ 17 15 2 12 46 There is an outside supplier who is prepared to supply unlimited quantities of products C and D to the business, charging £40 per unit for product C and £55 per unit for product D. Next year’s estimated demand for the products, from the market (in the case of A and B) and from other production requirements (in the case of C and D), is as follows: Units A 5,000 B 6,000 C 4,000 D 3,000 For strategic reasons, the business wishes to supply a minimum of 50 per cent of the above demand for products A and B. Manufacture of all four products requires the use of a special machine. The products require time on this machine as follows: Hours per unit 0.5 0.4 0.5 0.3 A B C D Next year there are expected to be a maximum of 6,000 special-machine hours available. There will be no shortage of any other factor of production. Required: (a) State, with supporting workings and assumptions, which quantities of which products the business should plan to make next year. (b) Explain the maximum amount that it would be worth the business paying per hour to rent a second special machine. (c) Suggest ways, other than renting an additional special machine, that could solve the problem of the shortage of special-machine time. 3.8 Gandhi Ltd renders a promotional service to small retailing businesses. There are three levels of service: the ‘basic’, the ‘standard’ and the ‘comprehensive’. On the basis of past experience, the business plans next year to work at absolutely full capacity as follows: Service Basic Standard Comprehensive Number of units of the service 11,000 6,000 16,000 Selling price £ 50 80 120 Variable cost per unit £ 25 65 90 M03_ATRI3622_06_SE_C03.QXD 5/29/09 3:30 PM Page 91 EXERCISES The business’s fixed cost totals £660,000 a year. Each service takes about the same length of time, irrespective of the level. One of the accounts staff has just produced a report that seems to show that the standard service is unprofitable. The relevant extract from the report is as follows: Standard service cost analysis Selling price per unit Variable cost per unit Fixed cost per unit Loss £ 80 (65) (20) (5) (£660,000/(11,000 + 6,000 + 16,000)) The producer of the report suggests that the business should not offer the standard service next year. Required: (a) Should the standard service be offered next year, assuming that the quantity of the other services could not be expanded to use the spare capacity? (b) Should the standard service be offered next year, assuming that the released capacity could be used to render a new service, the ‘nova’, for which customers would be charged £75, and which would have variable cost of £50 and take twice as long as the other three services? (c) What is the minimum price that could be accepted for the basic service, assuming that the necessary capacity to expand it will come only from not offering the standard service? 91 M04_ATRI3622_06_SE_C04.QXD 5/29/09 10:35 AM Page 92 4 Full costing INTRODUCTION Full (absorption) costing is a widely used approach that takes account of all of the cost of producing a particular product or service. In this chapter, we shall see how this approach can be used to deduce the cost of some productive activity, such as producing a unit of product (for example a tin of baked beans), providing a unit of service (for example, a car repair) or creating a facility (for example, building an Olympic athletics stadium). The precise approach taken to deducing full cost will depend on whether each product or service is identical to the next or whether each job has its own individual characteristics. It will also depend on whether the business accounts for overheads on a segmental basis. We shall look at how full (or absorption) costing is carried out and we shall also consider its usefulness for management purposes. This chapter considers the traditional, but still very widely used, form of full costing. In Chapter 5 we shall consider activity-based costing, which is a more recently developed approach. LEARNING OUTCOMES When you have completed this chapter, you should be able to: l Deduce the full (absorption) cost of a cost unit in a single-product environment. l Deduce the full (absorption) cost of a cost unit in a multi-product environment. l Discuss the problems of deducing full (absorption) cost in practice. l Discuss the usefulness of full (absorption) cost information to managers. M04_ATRI3622_06_SE_C04.QXD 5/29/09 10:35 AM Page 93 WHY DO MANAGERS WANT TO KNOW THE FULL COST? Why do managers want to know the full cost? As we saw in Chapter 1, the only point in providing management accounting information is to help managers make more informed decisions. There are broadly four areas where managers use information concerning the full cost of the business’s products or services. These are: 1 Pricing and output decisions. Having full cost information can help managers to make decisions on the price to be charged to customers for the business’s products or services. Linked to the pricing decisions are also decisions on the number of products or services that the business should seek to provide to the market. 2 Exercising control. Managers need information to help them make decisions that are aimed at getting the business back on course if plans are not being met. Budgets are typically expressed in full cost terms. This means that periodic reports that compare actual performance with budgets need to be expressed in the same full cost terms. 3 Assessing relative efficiency. Full cost information helps managers to compare the cost of doing something in one way, or place, with its cost if done in a different way, or place. For example, a car manufacturer may find it useful to compare the cost of building a particular model of car in one of its plants, rather than another. This could help them decide on where to locate future production. 4 Assessing performance. The level of profit, or income, generated over a period is an important measure of business performance. To measure profit, or income, we need to compare sales revenue with the associated expenses. Where a business produces a product or renders a service, a major expense will be the cost of making the product or rendering the service. Logically this is the full cost of whatever was sold. Measuring income provides managers (and other users) with information that can help them make a whole range of decisions. Later in the chapter we shall consider some of the issues surrounding these four purposes. Figure 4.1 shows the four uses of full cost information. Figure 4.1 Uses of full cost by managers Managers use full cost information for four main purposes. 93 M04_ATRI3622_06_SE_C04.QXD 94 CHAPTER 4 5/29/09 10:35 AM Page 94 FULL COSTING Now let us consider Real World 4.1. REAL WORLD 4.1 Operating cost An interesting example of the use of full cost for pricing decisions is occuring in the National Health Service (NHS). In recent years, the funding of hospitals has radically changed. A new system of Payment by Results (PBR) requires the Department of Health to produce a list of prices for an in-patient spell in hospital that covers different types of procedures. This list, which is revised annually, reflects the prices that hospitals will be paid by the government for carrying out the different procedures. For 2007/8, the price list included the following figures: £4,967 for carrying out a hip replacement operation £4,293 for treating a stroke These figures are based on the full cost of undertaking each type of procedure in 2006/7 (but adjusted for inflation). Full cost figures were submitted by all NHS hospitals for that year as part of their annual accounting process and an average for each type of procedure was then calculated. Figures for other procedures on the price list were derived in the same way. Source: Cole, A. and Robjent, G., ‘Payment by results – Policy in focus’, Chartered Society of Physiotherapists, 20 June 2007. When considering the information in Real World 4.1, an important question that arises is ‘what does the full cost of each type of procedure include?’ Does it simply include the cost of the salaries earned by doctors and nurses during the time spent with the patient or does it also include the cost of other items? If the cost of other items is included, how is it determined? Would it include, for example, a charge for l the artificial hip and drugs provided for the patient l equipment used in the operating theatre l administrative and support staff within the hospital l heating and lighting l maintaining the hospital buildings l laundry and cleaning? If the cost of such items is included, how can an appropriate charge be determined? If, on the other hand, it is not included, are the figures of £4,967 and £4,293 potentially misleading? These questions are the subject of this chapter. What is full costing? ‘ Full cost is the total amount of resources, usually measured in monetary terms, sacrificed to achieve a particular objective. It takes account of all resources sacrificed to achieve that objective. Thus, if the objective were to supply a customer with a product or service, the cost of all aspects relating to the production of the product or provision M04_ATRI3622_06_SE_C04.QXD 5/29/09 10:35 AM Page 95 SINGLE-PRODUCT BUSINESSES ‘ ‘ of the service would be included as part of the full cost. To derive the full cost figure, we must accumulate the elements of cost incurred and then assign them to the particular product or service. The logic of full costing is that the entire cost of running a particular facility, say an office, is part of the cost of the output of that office. For example, the rent may be a cost that will not alter merely because we provide one more unit of the service, but if the office were not rented there would be nowhere for the staff who provide the service to work, so rent is an important element of the cost of each cost unit of that service. A cost unit is one unit of whatever is having its cost determined. This is usually one unit of output of a particular product or service. In the sections that follow we shall first see how full costing is applied to a singleproduct business and then consider how it is done for a multi-product one. Single-product businesses The simplest case for which to deduce the full cost per unit is where the business has only one product or service, that is, each unit of its production is identical. Here it is simply a question of adding up all of the elements of cost of production incurred in a particular period (materials, labour, rent, fuel, power and so on) and dividing this total by the total number of units of output for that period. Activity 4.1 Fruitjuice Ltd has just one product, a sparkling orange drink that is marketed as Orange Fizz. During last month the business produced 7,300 litres of the drink. The cost incurred was made up as follows: Ingredients (oranges and so on) Fuel Rent of premises Depreciation of equipment Labour £ 390 85 350 75 880 What is the full cost per litre of producing Orange Fizz? This figure is found by simply adding together all of the elements of cost incurred and then dividing by the number of litres produced: £(390 + 85 + 350 + 75 + 880)/7,300 = £0.24 per litre In practice, there can be problems in deciding exactly how much cost was incurred. In the case of Fruitjuice Ltd, for example, how is the cost of depreciation deduced? It is certainly an estimate, and so its reliability is open to question. The cost of raw materials may also be a problem. Should we use the relevant cost of the raw materials (in this case, almost certainly the replacement cost), or the actual price paid for it (historic cost)? If the cost per litre is to be used for some decision-making purpose (which it should be), the replacement cost is probably more logical. In practice, however, it seems that historic cost is more often used to deduce full cost. It is not clear why this should be the case. 95 M04_ATRI3622_06_SE_C04.QXD 96 CHAPTER 4 ‘ 5/29/09 10:35 AM Page 96 FULL COSTING There can also be problems in deciding precisely how many units of output were produced. If making Orange Fizz is not a very fast process, some of the drink will probably be in the process of being made at any given moment. This, in turn, means that some of the cost incurred last month was for some Orange Fizz that was work in progress at the end of the month, so is not included in last month’s output quantity of 7,300 litres. Similarly, part of the 7,300 litres might well have been started and incurred cost in the previous month, yet all of those litres were included in the 7,300 litres that we used in our calculation of the cost per litre. Work in progress is not a serious problem, but some adjustment for the value of opening and closing work in progress for the particular period needs to be made if reliable full cost information is to be obtained. This approach to full costing, which can be taken where all of the output consists of identical, or near identical items (of goods or services), is often referred to as process costing. Multi-product businesses Most businesses produce more than one type of product or service. In this situation, the units of output of the product, or service, will not be identical and so the approach used with litres of Orange Fizz in Activity 4.1 is inappropriate. Although it is reasonable to assign an identical cost to units of output that are identical, it is not reasonable to do this where the units of output are obviously different. It would not be reasonable, for example, to assign the same cost to each car repair carried out by a garage, irrespective of the complexity and size of the repair. Direct and indirect cost To provide full cost information, we need to have a systematic approach to accumulating the elements of cost and then assigning this total cost to particular cost units on some reasonable basis. Where cost units are not identical, the starting point is to separate cost into two categories: direct cost and indirect cost. ‘ ‘ ‘ l Direct cost. This is the type of cost that can be identified with specific cost units. That is to say, the effect of the cost can be measured in respect of each particular cost unit. The main examples of a direct cost are direct materials and direct labour. Thus, in determining the cost of a motor car repair by a garage, both the cost of spare parts used in the repair and the cost of the mechanic’s time would be part of the direct cost of that repair. Collecting elements of direct cost is a simple matter of having a costrecording system that is capable of capturing the cost of direct materials used on each job and the cost, based on the hours worked and the rate of pay, of direct workers. l Indirect cost (or overheads). These are all other elements of cost, that is, those that cannot be directly measured in respect of each particular cost unit (job). Thus, the rent of the garage premises would be an indirect cost of a motor car repair. We shall use the terms ‘indirect cost’ and ‘overheads’ interchangeably for the remainder of this book. Indirect cost is also sometimes known as common cost because it is common to all of the output of the production unit (for example, factory or department) for the period. Real World 4.2 gives some indication of the relative importance of direct and indirect costs in practice. M04_ATRI3622_06_SE_C04.QXD 5/29/09 10:35 AM Page 97 MULTI-PRODUCT BUSINESSES REAL WORLD 4.2 Counting the cost A recent survey of 176 UK businesses operating in various industries, all with an annual turnover of more than £50 million, was conducted by Al-Omiri and Drury. They discovered that the total cost of the businesses’ output, on average, is split between direct and indirect costs as follows: All 176 businesses Manufacturing businesses (91) Service and retail businesses (85) Direct cost Per cent 69 75 49 Indirect cost Per cent 31 25 51 For the manufacturers, the 75 per cent direct cost was, on average, made up as follows: Direct materials Direct labour Other direct costs Per cent 52 14 9 Source: Al-Omiri, M. and Drury, C., ‘A survey of factors influencing the choice of product costing systems in UK organisations’, Management Accounting Research, December 2007, pp. 399 – 424. A more extensive recent survey of management accounting practice in the US, with nearly 2,000 responses, showed similar results. Like the UK survey (above), this tended to relate to larger businesses. About 40% were manufacturers and about 16% financial services; the remainder were from a range of other industries. This survey revealed that, of total cost, indirect cost accounted for between 34 per cent for retailers (lowest) and 42 per cent for manufacturers (highest), with other industries’ proportion of indirect cost falling within the 34 per cent to 42 per cent range. Financial and commercial businesses showed an average indirect cost percentage of 38 per cent. Source: 2003 Survey of Management Accounting, Ernst and Young, 2003. Activity 4.2 A garage bases its prices on the direct cost of each job (car repair) that it carries out. How could the garage collect the direct cost (labour and materials) information concerning a particular job? Usually, direct workers are required to record how long was spent on each job. Thus, the mechanic doing the job would record the length of time worked on the car by direct workers (that is, the mechanic concerned and any colleagues). The stores staff would normally be required to keep a record of the cost of parts and materials used on each job. A ‘job sheet’ will normally be prepared – perhaps on the computer – for each individual job. Staff must get into the routine of faithfully recording all elements of direct labour and materials applied to the job. 97 M04_ATRI3622_06_SE_C04.QXD 98 CHAPTER 4 5/29/09 10:35 AM Page 98 FULL COSTING Job costing ‘ ‘ The term job costing is used to describe the way in which we identify the full cost per cost unit (unit of output or ‘job’) where the cost units differ. To cost (that is, deduce the full cost of) a particular cost unit, we first identify the direct cost of the cost unit, which, by the definition of direct cost, is fairly straightforward. We then seek to ‘charge’ each cost unit with a fair share of indirect cost (overheads). Put another way, cost units will absorb overheads. This leads to full costing also being called absorption costing. The absorption process is shown graphically in Figure 4.2. Figure 4.2 The relationship between direct cost and indirect cost The full cost of any particular job is the sum of those costs that can be measured specifically in respect of the job (direct costs) and a share of those costs that create the environment in which production (of an object or service) can take place, but which do not relate specifically to any particular job (overheads). Activity 4.3 Sparky Ltd is a business that employs a number of electricians. The business undertakes a range of work for its customers, from replacing fuses to installing complete wiring systems in new houses. In respect of a particular job done by Sparky Ltd, into which category (direct or indirect) would each of the following cost elements fall? l l l l l the wages of the electrician who did the job depreciation of the tools used by the electrician the salary of Sparky Ltd’s accountant the cost of cable and other materials used on the job rent of the premises where Sparky Ltd stores its inventories of cable and other materials Only the electrician’s wages earned while working on the particular job and the cost of the materials used on the job are included in direct cost. This is because it is possible to measure how much time (and therefore the direct labour cost) was spent on the particular job and the amount of materials used (and therefore the direct material cost) in the job. All of the others are included in the general cost of running the business and, as such, must form part of the indirect cost of doing the job, but they cannot be directly measured in respect of the particular job. M04_ATRI3622_06_SE_C04.QXD 5/29/09 10:35 AM Page 99 MULTI-PRODUCT BUSINESSES It is important to note that whether a cost is direct or indirect depends on the item being costed – the cost objective. To refer to indirect cost without identifying the cost objective is incorrect. Activity 4.4 Into which category, direct or indirect, would each of the elements of cost listed in Activity 4.3 fall, if we were seeking to find the cost of operating the entire business of Sparky Ltd for a month? The answer is that all of them will form part of the direct cost, since they can all be related to, and measured in respect of, running the business for a month. Naturally, broader-reaching cost objectives, such as operating Sparky Ltd for a month, tend to include a higher proportion of direct cost than do more limited ones, such as a particular job done by Sparky Ltd. As we shall see shortly, this makes costing broader cost objectives rather more straightforward than costing narrower ones. It is generally the case that direct cost is easier to deal with than indirect cost. Full (absorption) costing and the behaviour of cost We saw in Chapter 3 that the full cost of doing something (or total cost, as it is usually known in the context of marginal analysis) can be analysed between the fixed and the variable elements. This is illustrated in Figure 4.3. Figure 4.3 The relationship between fixed cost, variable cost and total cost The total cost of a job is the sum of the cost that remains the same irrespective of the level of activity (fixed cost) and that which varies according to the level of activity (variable cost). ‘ The apparent similarity of Figure 4.3 to Figure 4.2 seems to lead some people to believe that variable cost and direct cost are the same and that fixed cost and indirect cost (overheads) are the same. This is incorrect. The notions of fixed and variable are concerned with cost behaviour in the face of changes in the volume of activity. The notions of direct and indirect, on the other hand, are concerned with the extent to which cost elements can be measured in respect of particular cost units (jobs). The two sets of notions are entirely different. Though it may be true that there is a tendency for fixed cost elements to be indirect (overheads) 99