5.4 Costs

Learning objectives

5.4.1Cost information• Cost information- the need for accurate cost information- different types of costs: fixed, variable, direct and indirect 5.4.2Costing approaches• Approaches to costing: full, contribution- the differences between full and contribution costing- the uses and limitations of the full costing method- the nature of the technique of contribution costing- the difference between contribution and profit- the limitations of contribution costing- situations in which contribution costing would be and would not be used 5.4.3Cost information uses• Uses of cost information- cost information for decision-making purposes, e.g. average, marginal, total costs- how costs can be used for pricing decisions- how costs can be used to monitor and improve business performance, including using cost information to calculate profits- contribution costing as a means to help make special order decisions 5.4.4Break-even analysis• Break-even analysis- the meaning and importance of break-even analysis- calculation and interpretation of break-even level of output, contribution, margin of safety and level of profit (in numeric and graphic form)- the uses and limitations of break-even analysis

Cost type	Exact question answered	Definition and examples
Fixed	Does total cost change directly with output in the relevant short-run range?	Total does not vary directly with output: rent, insurance, salaried management; may step up when capacity/site changes
Variable	Does total cost change as output/activity changes?	Total rises/falls with output: materials, unit packaging, piece-rate labour, sales commission
Direct	Can it be identified/traced economically to a product, job or cost centre?	Direct materials/labour or dedicated machine cost for that output
Indirect	Supports multiple outputs/whole operation and cannot be accurately/economically traced to one unit/centre	Shared rent, utilities, administration, depreciation or marketing overhead

Behaviour and traceability are separate axes. Flour for one pizza is direct-variable. A designer's annual salary dedicated to one product can be direct-fixed over the period. Factory power may be indirect-variable; shared rent is usually indirect-fixed within current capacity. Classify for the decision, period and activity range.

$\text{Total cost}=\text{total fixed cost}+\text{total variable cost}$

Need for accurate cost information	If inaccurate
Set prices/contribution and calculate profit/margin	Underpricing may not cover cost; overpricing may reduce demand
Budget, forecast cash/finance and allocate resources	Shortfall, overspending or idle resources
Calculate break-even, target profit and margin of safety	Wrong sales target and risk judgement
Compare products, cost centres, suppliers, locations, methods or outsourcing	Wrong activity may be cut/expanded; waste stays hidden
Monitor actual versus budget/time/competitor performance	False efficiency signal and weak corrective action

To reduce variable cost, negotiate/bulk-buy inputs, redesign product/process, reduce waste/defects, improve productivity, logistics or energy use—but test quality, inventory, workforce, cash and supplier risks. Accuracy is an estimate for a new business: state assumptions, update actuals and use ranges/sensitivity where uncertainty is high.

Fixed does not mean permanent and variable does not mean unpredictable. Direct does not mean variable: always identify whether the classification is about output behaviour or traceability.

Approach	What is assigned/measured	Best use	Core limitation
Full costing	All fixed and variable, direct and allocated indirect/overhead costs are assigned to products/cost centres	Long-run cost recovery/pricing, product/centre profitability, inventory/external reporting	Indirect-cost allocation basis can be arbitrary; unit full cost changes with output and may include costs unchanged by a short decision
Contribution costing	Revenue minus variable cost, by unit/product/order/centre; fixed costs are treated separately	Short-run product mix, spare-capacity/special order, break-even and whether activity contributes to fixed cost	Ignores product-specific use/need for fixed capacity in the measure; cost splitting/linearity can be imprecise and unsuitable alone for long-run pricing/reporting

$\text{Full cost per unit}=\text{direct cost per unit}+\text{allocated indirect/overhead cost per unit}$

$\text{Contribution per unit}=\text{selling price per unit}-\text{variable cost per unit}$

$\text{Profit}=\text{total contribution}-\text{fixed costs}$

At price $50 and variable cost$ 30, contribution is $20 per unit. Selling 400 units gives$ 8,000 total contribution. If fixed costs are $6,500, profit is$ 1,500. Positive contribution helps cover fixed costs; profit appears only after all fixed costs are covered.

Situation	Safer primary approach and reason
Normal long-run price/product viability	Full cost plus market/demand evidence, because all capacity/overhead must ultimately be financed
Temporary special order with spare capacity and unchanged fixed cost	Contribution/incremental costing, because only extra revenue and costs change—then test strategic effects
Product mix under a scarce resource	Contribution (ideally per limiting factor) to compare what each option adds
External statements/inventory valuation	Required full-cost/reporting rules, not contribution alone
Capital-intensive or multi-product business	Use contribution cautiously; fixed costs/allocation and shared capacity are too important to ignore

Contribution is not profit and positive contribution is not proof a product should continue forever. Full costing is not perfectly objective: the chosen overhead allocation can change reported product cost.

Measure	Formula/meaning	Decision use
Total cost	Fixed cost + total variable cost	Overall profit, budget/finance need, full pricing and plan comparison
Average cost	Total cost ÷ output	Unit-cost trend, cost-plus pricing and scale/competitor comparison—sensitive to output/allocation
Marginal cost	Change in total cost ÷ change in output (cost of extra output)	Extra unit/order/output decision when capacity and other effects are known
Contribution	Revenue − variable cost; per unit price − variable cost	Break-even, product mix and short-run order effect before fixed cost
Profit	Revenue − total cost = total contribution − fixed cost	Overall financial performance—not cash flow

Management use	How accurate cost data helps
Pricing	Establish cost floor/required margin and test price changes against demand/competition/value
Performance	Calculate profit, compare actual/budget/prior period/competitor and locate waste or high-cost centres/products
Planning/resource allocation	Budget, forecast cash/finance, compare location/method/make-or-buy/investment and set target output
Cost improvement	Identify avoidable waste, supplier/process/productivity opportunities while checking quality/revenue effects

If revenue is $50m, direct costs$ 10m and indirect costs $20m, total cost =$ 30m and profit = $20m. If previous profit was$ 22m, change = $20m −$ 22m = −$2m. State direction and units; rising revenue can coexist with falling profit if costs rise faster.

For a special order: (1) confirm spare capacity—otherwise include contribution displaced from normal sales, (2) identify future incremental materials/labour/delivery/setup and any fixed cost that changes, (3) calculate incremental revenue minus incremental relevant cost, (4) accept financially only if positive, then test payment risk, lower-price precedent, existing customers, quality, brand and long-run capacity.

A past development cost that cannot change is sunk and should not decide the next action; an opportunity cost such as displaced normal contribution is relevant even without a new invoice. Full allocated overhead is relevant only to the extent it changes or must be covered for the decision horizon.

Average, marginal and total costs answer different questions. A special order above variable cost is not automatically attractive if it uses scarce capacity, changes fixed cost, cannibalises normal sales or damages future pricing/brand.

Break-even is the output/sales level where total revenue equals total cost, so profit is zero. Below it the model shows a loss; above it contribution has covered fixed cost and the model shows profit.

$\text{Contribution per unit}=\text{selling price per unit}-\text{variable cost per unit}$

$\text{Break-even output}=\frac{\text{fixed costs}}{\text{contribution per unit}}$

$\text{Margin of safety}=\text{actual/current sales or output}-\text{break-even sales or output}$

$\text{Profit}=\text{total contribution}-\text{fixed costs}=(\text{output}-\text{break-even output})\times\text{contribution per unit}$

Price $5, variable cost$ 2 and fixed cost $12,000: contribution =$ 3; break-even = 12,000 ÷ 3 = 4,000 units. At sales of 5,500 units, margin of safety = 1,500 units and profit = 1,500 × $3 =$ 4,500. To earn a target profit, use (fixed cost + target profit) ÷ contribution per unit.

Read a break-even chart: horizontal axis = output/sales volume; vertical axis = cost/revenue. Fixed-cost line starts above zero and is horizontal; total-cost line starts at fixed cost and rises with variable cost; total-revenue line normally starts at zero and rises by selling price. Their intersection is break-even. The vertical gap at a chosen output is profit/loss; the horizontal gap from break-even to current output is margin of safety.

Change	Model effect, other things equal
Higher price	Contribution rises; break-even falls—but demand may fall
Lower variable cost	Contribution rises; break-even falls—check quality/supplier/workforce effects
Lower fixed cost	Break-even falls—check lost capacity/service
Higher fixed or variable cost / lower price	Break-even rises and margin of safety/profit falls at unchanged sales

Uses	Limitations/assumptions
Set minimum/target sales, compare price/cost/location/equipment/product plans, assess margin of safety/risk and support business plans/finance	Assumes constant price/unit variable cost and fixed cost within range, linear relationships, output sold equals output produced, clear fixed/variable split and usually one/stable product mix; ignores demand, capacity, qualitative/external change

Break-even is zero profit, not target profit. It is a planning/what-if aid—not a demand forecast or automatic decision. If capacity is below calculated break-even, the plan cannot break even without changing capacity, price or costs.

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—5.5 BudgetsRead

5.4 Costs

Learning objectives

Classify costs by behaviour and traceability before using them

Full costing covers all costs; contribution costing isolates what output adds

Use the cost measure that changes the decision

Break-even converts contribution into an output threshold and safety buffer

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