Simple Costing

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Simple Costing
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It is necessary if we are organising the
production of manufactured articles or the
provision of services to be able to answer
questions such as
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At what price should we sensibly sell each
product (or will we make a profit if we use the
price the Marketingfolk suggest ?)
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At what price should we sensibly sell each
product (or will we make a profit if we use the
price the Marketingfolk suggest ?)Will we make a
profit, and if so how much ?
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At what price should we sensibly sell each
product (or will we make a profit if we use the
price the Marketingfolk suggest ?)Will we make a
profit, and if so how much ?How many products
must we sell before we break even ?
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We are not sure how many we can sell, but we have
some statistical market info. How can we use it
to determine how many to make ?
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The demand from our customers is greater than we
can supply. Will it be a paying proposition to
work some overtime to make more products ?
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Someone comes along from Outer Mongolia or
somewhere prepared to buy quite a lot of our
products but cannot afford to pay the full price
-- will it pay us to reduce it to persuade
him/her to buy ?
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To answer such questions, it is likely to be
beneficial to construct a simple Mathematical
Model as follows.
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The term suggests a good-looking lad or lass who
is good at sums, but it does not mean that ! For
what it does mean, read on ...
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We start with the (usually reasonable) assumption
that our total costs of production partly depend
on time and , if we further assume for the moment
that we only make one type of article, partly
depend on the number of articles we make.
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It is also probable that we must make a (largish)
one-off payment initially to buy the machinery
etc. that we need to make the article ...
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but it is possible to budget that cost as part
of the time cost by taking the view that we are
paying it off over the anticipated total time
that we are manufacturing the articles.
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A simple first scenarioIt costs us 70 000 to
buy our equipment in the first place. We sell
each article for 100 and the materials to make
it cost 30 per item.
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We make 20 articles per week. Ignoring interest
charges and other like complications, how long
will it be before we begin to make a profit ?
(This is called Breakeven Analysis).
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The answer proceeds by commonsense.
.
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The answer proceeds by commonsense.
.
Each item is sold for 100 - 30 70 more than
it cost to buy the materials for it, so each one
contributes 70 towards the 70000 the equipment
cost..
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We must therefore sell 70000/70 1000 articles,
so it will take 1000/20 50 weeks.
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Have we ignored anything likely to be significant
in practice ?
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Have we ignored anything likely to be significant
in practice ?I think we probably have -- what
about heating and lighting our factory, the
rates, tax etc? Is "Jones the Bank" likely to
charge us interest if we borrow the 100 000 from
her/him? (Yes!)
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Things are often more complicated than they seem
but the following approach is often helpful.
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Many firms base their strategy on the following
headings
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Fixed Time Cost (incurred, for example, per week
regardless of whether production is taking place
or not) -- capital charges, rates, some of the
power bills, usually wages for the normal working
week for employees.
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Variable Time Cost (incurred whenever production
is taking place but regardless of how much is
actually being made) -- overtime and contract
wages and more of the power bills. It is often
possible to incorporate this cost in with the ...
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Unit Cost -- what it costs per article produced
-- materials and the remainder of the power bill.
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We will apply this idea to the simple scenario
and we will now also assume that the 70 000 was
borrowed originally and it is to be paid off over
five years at a rate of 800 per week including
the interest ...
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(actually a high rate of interest -- a loan
shark must have got in on the act). With the
cost information we have at the moment, we have
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Fixed Time Cost 800 per weekVariable Time
Cost zeroUnit Cost 30 per unit
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This tells us that, at our previous production
rate of 20 articles per week, our weekly costs
will be 800 30 x 20 1 400 per week.
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Our weekly surplus is therefore 600 .. but there
are a number of things we have not allowed for.
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Rent? Heating ? Lighting ? Rates ?
Maintenance of our equipment ?
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A Simple Example for you (based on one in
Essential Elements of Management Accounting by
Jill and Roger Hussey)
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A taxi business has the following costs per
quarter (13 weeks).Drivers Pay -- 2 800Fuel
and Oil -- 1 200Servicing -- 500Taxation and
Insurance -- 1 250Depreciation -- 950
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Making reasonable assumptions where appropriate,
calculate1) The overall cost per mile,
regarding ALL costs as just being
mileage-dependent and assuming 15 000
mile/quarter. This cost is known as the
Absorption Cost per mile.
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2) The Time Cost and the Unit Cost (assumed as
cost/mile) again assuming 15 000 mile/quarter.
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Which of these costs would be the better guide
to (a) how much per mile we should charge in
normal taxi operation ...
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...and (b) whether we could charge less on
occasion to secure, for example, a booking to
Heathrow Airport, and still make a profit ?
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Here is a more complicated example, taken from a
past exam paper.
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Quality Ltd. is a manufacturer who produces a
single model of wrist-watch. A Profit and Loss
Budget has been prepared for the coming financial
year which is based on an anticipated sales level
of 20,000 watches per annum.
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Required(a) Calculate the break-even point in
terms of both number of watches sold and sales
revenue. (b) Calculate the "margin of
safety" in terms of watches sold and as a
percentage.
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(c) Calculate the profit or loss if the forecast
sales is changed to 10,000 watches per year. You
can assume that the variable cost per unit and
total fixed costs remain the same. (d) Illustrat
e the answers of (a), (b) and (c) with a suitable
graph/chart.
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The AnswerWe will assume that the Variable
Costs are all directly proportional to the number
of watches sold.
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We are first told that the annual sales are
expected to be 20 000 watches and the receipts
from selling them are expected to be 500 000.
Each watch will therefore sell for (500 000/20
000) 25.
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If we sell n watches, therefore, we expect to
receive 25n.
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Making the watches will cost us 150 000
regardless of how many we make, plus an amount
per watch made totalling 300 000 if we make 20
000 watches as planned.
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This must be 300 000/20 000 15 per watch, or
15n in all if, as before, we sell n watches.
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Our total cost will therefore be (150 000 15n).
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(a) The Break-Even point is reached when we
receive the same total sum from selling our
watches as it costs us to make them.
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This means that 25n 150000 15n
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This means that 25n 150000 15nand n 150
000/10 15 000 watches.
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(b) Actually we intend to sell 20 000 watches --
5 000, or 33.3, more than breakeven -- and this
is the Margin of Safety.
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(c) If we only sell 10 000 watches, we will
receive 10 000 x 25 250 000 from selling them
...
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but making them will cost us 150 000 15 x
10000 300 000. We will therefore make a LOSS
of 50 000.
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(d) Here is the graph.
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What if things are not certain ?
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Problems can arise if we are not sure how many
items produced we can sell. If we do not make
enough, we lose the opportunity of making profits
on the ones we could have sold ... but if we make
too many, we have incurred costs unnecessarily.
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It is often possible, through experience or
market research, to establish probabilities
regarding likely demand for the product.
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We will revert to the watch example and discover
from sales and our market research department
that our wholesalers order in multiples of 2000
and our sales probabilities are expected to be
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If we make 16 000 watches, it is quite simple --
we will sell them all !
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Making them will cost (15n 150 000) 390
000, whilst we will sell them for 25n 400
000.We will therefore make 10 000 profit.
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If we make 18 000 watches, it will cost us 420
000. We will sell them all 95 of the time for
25 x 18 000 450 000 ...
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but 5 of the time we will only sell 16 000 ...
for 400 000 as we calculated above.
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We now use the probabilities to calculate our
expected sales receipts0.95 x 450 000 0.05 x
400 000 447 500.
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Our expected profit is therefore 447 500 -
420 000 27 500.
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We will now do the one for 24 000 watches made
(Over to you will feature 20 000 and 22 000
!)
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Cost 150 000 24 000 x 15 510 000Receipts
if we sell them all 25 x 24 000 600 000
(prob. 20 )Receipts if we sell 22 000 25 x
22 000 550 000 (prob. 20 )
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Receipts if we sell 20 00025 x 20 000 500
000 (prob. 35 )Receipts if we sell 18 000
25 x 18 000 450 000 (prob. 20 )Receipts
if we sell 16 000 25 x 16 000 400 000
(prob. 5 )
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For the expected outcome, we multiply the sales
figure by the probability of its occurrence and
add up the results.
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600 000 x .2 550 000 x .2 ..... 515 000
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So we now expect a profit of only 5 000, though
it is interesting to note that a loss will result
60 of the time ....
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Over to you ....(Do please come to your
practice session this week !)