A2 Accounting

Unit 1 Lesson 1

Classification of Costs

By the end of this lessonBy the end of this lesson

Youwill

Be able to

Classify costs in relation to output and time, or product

Know why firms need to understand their costs

Why do firms need to understand costs?Why do firms need to understand costs?

Profit = Revenue - Costs

So, firms need to understand their costs if they wish to improve their profit

Costs can be classified in relation to

Output and Time

Long runScale of

operations can be changed

Product

Do change with production

Short runScale of operations

cannot be changed

FixedDo not vary with

output in the short run

VariableDo vary directly

with output in the short run

DirectCan be

directly related to product or service

IndirectCan be

directly related to product or service

Revising Manufacturing AccountsRevising Manufacturing Accounts

Prime Cost =Cost of materials consumed + direct costs

(e.g. labour/power)

Prime cost + factory indirect (or overhead) expenses = or – adjustment for work in progress

Cost of finished goods =

In costing the product, the main way in which costs are analysed above is direct and indirect

Costs, revenue and profitCosts, revenue and profit

Total Cost = Fixed Cost + variable cost

Profit = total revenue – (fixed costs + variable costs)

Profit = total revenue – total costs

There are a number of costing techniques that use fixed and variable costs.

Break even analysis

Absorption costing

Marginal Costing

Fixed Cost shown by graphFixed Cost shown by graph

0

Cost in £

Number of items made (Output)

FC

As the level of output increases, the fixed costs stay exactly the same

Activity-1Activity-1Sarah Reavenall

operates two hairdressing salons, one in Bromsgrove and the other in Redditch

In your book, write down 4 examples of costs that are likely to be fixed for this business

Rent

Insurance

Cleaning

Staff salaries …could all be fixed costs

Explain why!

Do fixed costs stay the same irrespective of the level of output, even where there is a massive rise in the level of output?

Think in terms of the Rent cost for Sarah’s business

Step change in Rent CostsStep change in Rent Costs

0

Cost in £

Number of items made (Output)

FC

As the salon becomes more popular, additional accommodation needs to be rented. This will cause a “step” in the rent cost. Further popularity can result in another “step” etc

Variable Cost shown by graphVariable Cost shown by graph

0

Cost in £

Number of items made (Output)

VC

As the level of output increases, so does the variable cost

Activity-2Activity-2Sarah Reavenall

operates two hairdressing salons, one in Bromsgrove and the other in Redditch

In your book, write down 2 examples of costs that are likely to be variable for this business

Lotions and other materials used

Laundry costs to wash towels …could all be variable costs

Explain why!

In some cases, costs have both an element of fixed and variable cost about them

e.g. electricity may be fixed for heating/lighting but variable for power to hairdryers

For Sarah’s SalonFor Sarah’s Salon

For a hairdressing business most costs will be FIXED. However, there will be some variable costs.

Total Costs = fixed costs + variable costs

This can be shown by graph on the next slide

Sarah’s SalonSarah’s Salon

0

Cost in £

Number of hair do’s (Output)

FC

1. Why does Sarah have a fixed cost of £30 000 at zero output

TC

30 000

40 000

2000

2. What is the total cost of 2000 hair do’s?

3. What is the variable cost of 2000 hair do’s?

For Sarah’s SalonFor Sarah’s Salon

Once we know the TOTAL COSTS we can find Sarah’s BREAK EVEN POINT (BEP)

Sarah will break even when sales (total revenue) equals total costs

This can be shown by graph on the next slide

Sarah’s Salon Break Even PointSarah’s Salon Break Even Point

0

Cost in £

Number of hair do’s (Output)

FC

1. Why does Total Revenue (Sales) start at zero output?

TC

30 000

40 000

2000

2. What is Sarah’s break even output?

50 000

1500

TR (sales)

For Sarah’s SalonFor Sarah’s SalonSarah’s break even point can be worked out

not only by CHART but also by CALCULATION

There are 2 formulae needed to work out Sarah’s BEP

First we need to find the CONTRIBUTION made towards the FIXED COSTS and PROFIT of Sarah’s business

Contribution = Selling price – Variable cost

Once we know the contribution, we can calculate BEPBreak Even Point (BEP) = Fixed

Costs

Contribution

Calculate Sarah’s BEPCalculate Sarah’s BEP

If Sarah charges £25 per hair do, has fixed costs of £30 000 and variable costs of £5 per hair do. How many hair do’s will she need to break even. Using the 2 formulae on the previous slide show your calculation of Sarah’s BEP

How does your answer compare with that given on the graph you looked at earlier?

HomeworkHomework

Please do the 3 questions from A2 Unit 7 Worksheet 1 for our next lesson

Make sure all the activities in this lesson have been completed before you do the homework

This includes the Lesson summary on the final slide

SummarySummary

Work with your partner on any question you are not sure of …otherwise write your answer in your book

1. Define fixed cost and variable cost

2. What is a semi-variable cost?3. Under what circumstances could total cost

be £40000 at zero output?4. How much profit is earned at the BEP?5. What does CONTRIBUTION mean?6. Give the formula to calculate the BEP