Cost Analysis & Decision-making

After studying this section you should be able to:

• classify and analyse a range of costs
• evaluate absorption costing, budgetary control and standard costing as control and planning methods

Absorption costing

Allocation, apportionment and absorption

Overheads are allocated when the cost is incurred wholly by a single department or cost centre. The overhead can then be charged exclusively to that cost centre.

Overheads have to be apportioned when the cost is incurred by more than one cost centre. A good example is factory rent, with the total cost having to be shared between all relevant cost centres in the factory.

The basis of apportionment will vary according to the nature of the overhead. For example:

In absorption costing, all overheads (indirect costs) must be absorbed, i.e. recovered, by the products, otherwise there will be no source of income to pay for these overheads. For example, if a product’s share of total overheads comes to £300 000, this amount needs to be recovered throughout the period when the product is sold.

Absorption methods include:

• direct labour hours – e.g. in a garage, if the budgeted number of direct labour hours is 100 000, each hour spent working on a car will be charged with an extra £3 (i.e. £300 000/100 000), so by the end of the period the £300 000 costs will be recovered
• machine hour rate – e.g. where machinery is heavily used, budgeted machine hours being 50 000 in the period, each hour that a machine is used will be charged at £6 (£300 000/50 000).

Costing methods

There are two main categories: specific order costing – costs are charged directly to cost units – such as job, batch and contract costing, and continuous operation costing – costs have to be apportioned to cost units – such as service and process costing.

• Job costing is used when work is undertaken to a customer’s specific requirements: all costs are charged to the job. Contract costing is similar, though the contract (e.g. for construction of a ship) tends to be for a longer duration.
• Batch costing is used when a quantity of identical articles (such as similar houses on an estate) are manufactured.
• Service (or function) costing is concerned with establishing the costs of services rendered, and controlling these costs (e.g. within a hospital).
• The process costing method is used when products are made in a single process.

KEY POINT - The costing method chosen must suit the manufacturing method.

Budgeting and forecasting

Management by exception

Budgeting helps control the finance available to a business. Budgetary control produces variances that allow managers to compare the expected (budgeted) performance of their department with its actual performance. These individual variances can be broken down into sub-variances. For example, a favourable sales variance might consist of a favourable volume variance – more are sold than had been planned – and an adverse price variance (the actual selling price is below the budgeted level, which may be the reason for the favourable volume variance).

Variances may be controllable by managers. In the above example the sales manager may have made a conscious decision to lower prices and increase sales volume, the product’s price elasticity of demand leading to the increase in total revenue (the overall favourable variance). Other variances may be noncontrollable, e.g. an adverse labour variance being due to a national wage agreement. Managers can only be held responsible for the variances they can control.

Flexing the budget

Budgets and variances must be adjusted for changes in volume. Comparing production budget figures based on an expected output of, say, 3000 units with the actual costs based on an actual output of 3500 units is not comparing like with like. The budget figures have to be flexed – scaled – accordingly, and these amended budget figures can then be compared accurately with the actual ones.

Standard costing

A ‘standard cost’ is a cost estimated by managers from information on expected prices and efficiency levels of production. Like budgets, standard costs provide targets for managers against which their individual performances can be appraised. It is linked with budgetary control: for example, it is easy to establish sales and production budgets once standard costs have been set.

There are three main variance groups in standard costing:

• sales variances – the sales price variance measures the difference between the standard and actual selling prices, and the sales volume variance measures the effect on profit of the difference between the actual and expected numbers sold
• production cost variances – total cost variances are calculated for direct labour, direct materials and production overheads, each being subdivided to show ‘price’ and ‘quantity’ sub-variances.

KEY POINT - Management accounting draws on financial accounting information, but also involves detailed internal analyses through setting budgets and standard costs.

Forecasting cash flow

Any forecast may be inaccurate: for example, any difference between budgeted and actual sales will affect cash inflows. Managers must therefore monitor the accuracy of the cash flow forecast. If it indicates that cash flow must be improved, the managers may:

• calculate and review the cash cycle
• factor debtors, use sale/leaseback or examine other ways of controlling working capital (for example, by reducing stock levels).

It is just as important to identify large cash surpluses as well as large cash deficits, to ensure surplus cash is used efficiently.