To determine the value of closing stock which is required for the financial statements viz. the profit and loss account and the balance sheet.

Direct materials £X

Direct labour £X

Direct expense £X

-----

Prime cost £X

Production overheads £X

-----

Production cost £X

-----

Also some businesses use a cost plus pricing strategy. The product cost is calculated and a mark up percentage is added to arrive at a selling price which gives a reasonable gross profit which in turn can cover the non-production overheads and leave a satisfactory net profit.

(b) Decision making - Cost behaviour

The classification of costs into variable, fixed and semi-fixed is important in terms of decision-making and cost control, activities that comprise the fundamentals of the management accounting function.

Variable costs are those costs which increase/decrease with the level of production and sales. In a manufacturing company the variable production costs change directly with the level of production.

Fixed costs can be either committed fixed costs or discretionary fixed costs. Fixed costs are termed fixed because they do not change in response to changes in the level of activity. It should be noted that they are not fixed because they do not change because cost items like rent is often subject to revision.

Semi-fixed/semi-variable costs are costs which move in the same direction but not at the same rate as the level of activity. The semi-fixed/semi-variable cost contains a fixed and a variable element. For example, the electricity bill contains a fixed or standing charge and and the variable aspect which depends on usage.

Cost ascertainment

It is important that the management accountant can determine the variable and fixed costs and there are a number of techniques to assist in separating the fixed and variable elements of semi-fixed or semi-variable costs.

Analysing costs by direct observation of the resources required to convert materials into a finished product and applying costs to these activities. Direct materials, direct labour and machine time can be established quite easily.

By inspecting the accounts the accountant can classify costs as being variable or fixed.

High-low method. This method entails selecting the period of highest and lowest levels of activity and comparing the changes in costs that result from the two levels.

Example

Output 10000units £30000

15000units £40000

£40000 - £30000 = £10000/

15000units - 10000= 5000units = £2per unit.

The fixed costs therefore are £10000.

The scattergraph or regression chart.

Costs

Output

On the scattergraph total costs are plotted against output at a number of different activity levels. Then a ‘line of best fit’ is drawn through some of the coordinates. Where this line coincides with the Y axis this represents the level of fixed costs. Once this is established it is simple to calculate the other costs which are not fixed ie. the variable costs. The assumption is that at zero output the business still has to meet the fixed costs- the periodic costs related to time.

MARGINAL COSTING

FOR

DECISION MAKING

Lesson 2

Marginal Costing - a technique for short-run decision-making

One of the main functions of management is decision-making. Many of the decisions are of a short-term nature. Only rarely is a manager faced with a decision which has a long term impact eg. buying a new machine, expanding the factory, take-over of another company. Since most of the decisions have a short-term impact it can be assumed that the capacity of the factory will not change. Therefore fixed or periodic costs are not affected by tactical short-run decisions. The only costs which are affected are variable costs ie. those costs which vary directly with the level of activity of the factory. These would include direct materials, direct labour and variable overheads.

Also all the decisions comprise a choice between alternative courses of action. Therefore, past costs can have no relevance for future decisions. Past costs can consist of sunk costs or committed costs.

In marginal costing all costs are classified according to how they behave. They are either variable or fixed. The fixed costs are treated as periodic ie. they are related to time. Examples of fixed costs would be rent, rates, insurance, depreciation etc. These costs stay constant in the short-term regardless of the decision that management takes. Therefore, in making decisions, in choosing between different alternative courses of action management identifies the variable costs and treats the fixed costs as irrelevant.

To summarize the technique of marginal costing:

· Costs are classified as either fixed or variable.

· In the short-run all fixed costs remain unchanged and therefore treated as irrelevant.

· The only relevant costs are variable costs ie. those costs which increase/decrease as output increases/decreases.

Definition: Marginal costing is a costing principle whereby variable costs are charged to cost units and the fixed costs attributable to the relevant period are written off in full against the contribution for that period. (ICMA)

Marginal cost = variable cost = direct materials

Direct labour

Direct expense

Variable overhead

Contribution = sales revenue - variable(marginal) costs

Contribution is the amount which helps to pay off the fixed costs and any excess represents profit. Contribution is not profit.