Production Costs

The financial costs incurred in making a product or providing a

service.

Costs are classified into categories:

Direct Costs

Indirect Costs

Fixed Costs

Variable Costs

Semi-Variable Costs

Marginal Costs
Direct Costs

Costs can be clearly identified with each unit of production and can
be allocated to a cost center.
Direct costs of a hamburger in a fast-food restaurant is the cost
of meat, and ..
Direct cost for an automobile repair shop servicing a car is the
labor of the mechanic, and
Common direct costs in manufacturing are labour and materials.

Common direct costs in a service business is the cost of goods sold.

Indirect Costs
Costs which cannot be identified with a unit of
production also known as overhead costs

Indirect cost to a farm is the purchase of a tractor.

Indirect cost to a automobile repair shop is rent

Indirect cost of running a school is the cost of cleaning

Indirect Costs can be classified into 4 groups:

1. Production overheads
factory rent, equipment depreciation, electricity
2. Selling and distribution overheads
warehouse, packing, and distribution costs
3. Administration overheads
office rent, clerical salaries
4. Finance overheads
interest on loans
Costs are affected by Output
Some costs vary with output of production and some
costs do not change.

Costs can be classified:

Fixed costs
These remain constant no matter what happens to
production output (rent)
Variable costs
These vary as production output changes (quantity of raw
materials used)
Semi-Variable costs
These include both fixed and variable costs (account
charge for electricity plus the electricity used)
Marginal costs
The additional variable cost of producing one more unit
Revenue

Revenue is the income received from the

sale of a product

Total Revenue is the total income from the

sale of ALL units of the product
(quantity X price)
Dont confuse Revenue, Cash Flow, and Profit

Remember: Revenue is not the same as cash received

from sales.
Revenue is recorded at the time of sale not at the time

cash is received.

Remember: Revenue is not the same as profit.

All costs of operating the business are subtracted from

revenue to determine profit.

Remember: Cash Flow is when the money is actually

deposited into your bank account or given to you as cash
Then it can be counted as an inflow
Contribution to Fixed Costs

Contribution per Unit

Is the selling price of a product less variable costs
per unit.

Total Contribution
Is the total revenue from the sale of a product less
total variable costs of producing it.

Contribution is NOT profit. Contribution is what a

product contributes towards fixed costs, and once
these are paid, towards the profits of the business.
 Cost and Profit Centers

Cost Center: A section of a business, such as a

department, to which costs can be allocated.
Examples: products, departments, factories, process or
stage of production

Profit Center: A section of a business to which

both costs and revenues can be allocated.
Examples: branch offices, departments in a store, multi-
product firms each product line

PM
 Benefits of Costs and Profit Centers

Managers and staff will have targets to work towards.

Targets can be compared with actual performance and

identify areas of strength and weakness.

Individual performances of divisions allow managers to

be assessed and compared.

Work can be monitored and decisions made about the

future keep producing, raise prices, shut down area

PM
 Problems with Costs and Profit Centers

Managers and workers may think they are

most important to the business.
Damaging internal competition can occur.
Indirect costs may be impossible to allocate
accurately to centers and they can be applied
inaccurately or arbitrarily.
Reasons for good or bad performance may
be due to external factors.

PM
 Contribution Costing

A costing method that only allocates direct costs to

cost/profit center and does NOT include overhead
costs.

Focused on 2 accounting concepts

Marginal cost is the cost of producing an extra unit.
(Total cost of producing 500 units is $5000 and the total cost of
producing 501 units is $5005, then the marginal cost is $5.)
Contribution costing is the amount the product contributes
to covering fixed costs and profit.
(If 501st unit sells for $25 and the marginal cost was $5, then $20 can be
contributed towards fixed costs.)

PM
Contribution Costing and Decision-Making

If a company makes more than one product,

contribution costing shows management how much
each product is contributing to fixed costs and
profits.

Marginal costing assists managers in deciding

whether to accept an order below the full cost of the
product.
Example: Hotels offer low rates during off-peak seasons.
Airlines sell seats at a discount 2 days prior to the planes
departure date.
Reasoning: It is better to earn a contribution than leave the
rooms or airplane seats empty.
Dangers of Contribution Costing and
Price Determination
Existing customers learn of the lower prices
for others and demand similar treatment; then
earning a profit is unlikely.
When high prices establish exclusivity of a
brand, then lower prices can destroy image.
If there is no excess capacity, contribution
pricing may cost sales at full price.
Lower priced goods can be purchased by
others and resold for a higher price.
A Story.
Sue is a dress maker who pays $45 a day to use a workshop. She
makes 3 dresses a day and sells them for $30 each. Materials
cost her $8 a dress.
Fixed costs per dress $15 ($45/3 dresses)
Material Costs per dress $8
Total Unit Cost $23
One day she has orders for only 2 dresses. She received an inquiry for 1
dress at $20. Should she accept the order?

Does NOT accept, she will lose $1

Sales of 2 dresses @ $30 = $60
Cost 2 dresses @ $8 = $16 + Total fixed costs $45=$61 $1 loss

She accepts, she will make a profit of $11

Sales of 2 dresses @$30 + sale of 1 dress @ $20 = $80
$11 profit
Cost 3 dresses @ $8 = 24 + total fixed costs $45 = $69
Dress 3 has a contribution cost of $12 ($20 - $8)
Contribution Costing Summary
Ignoring overhead costs does not consider that some products
actually do have higher fixed costs than others.

Contribution costing may not be appropriate for single product

firms.

Products may be produced because of their contribution when a

new product should be considered or launched.

Qualitative factors need to be considered:

Does the product promote the companies image?

Does it complete the product range? And eliminating would

reduce the appeal of the product?