cost information for decision-making purposes, e.g. average, marginal and total costs

5.4 Costs – Uses of Cost Information

Learning Objective

Understand how accurate cost information – total, average, marginal and contribution – is obtained, classified and applied in a range of business decisions.

Why Accurate Cost Data Matter

• Provides a reliable basis for setting selling prices that cover costs and generate profit.
• Enables effective budgeting, forecasting and performance‑evaluation (variance analysis).
• Supports control of operations by identifying where efficiencies can be gained or where costs are out of control.
• Ensures that make‑or‑buy, product‑line, shutdown and capacity decisions are based on the true cost of producing each unit.

Classification of Costs

1. By Behaviour

Cost Type	Definition	Typical Example
Fixed Cost (FC)	Does not vary with output in the relevant range.	Rent of factory premises
Variable Cost (VC)	Changes in direct proportion to output.	Raw‑material cost per unit
Mixed (Semi‑variable) Cost	Contains a fixed component and a variable component.	Telephone bill (fixed line charge + per‑minute charge)

2. By Traceability

Cost Category	Definition	Example
Direct Cost	Can be directly linked to a specific product, service or department.	Direct labour on a specific product line
Indirect Cost	Cannot be directly traced to a single product; allocated by a suitable basis.	Factory supervision salaries, depreciation of plant

3. By Function

• Product (Manufacturing) Costs – incurred to bring a product to its present location and condition (e.g., direct materials, direct labour, production overheads).
• Period (Non‑manufacturing) Costs – incurred in the period in which they are incurred (e.g., selling, distribution and administrative expenses).

4. By Management Control

• Controllable Costs – can be influenced by the manager in the short run (e.g., variable labour, electricity usage).
• Uncontrollable Costs – cannot be altered in the short run (e.g., rent, insurance premiums).

Key Cost Concepts & Formulas

Cost Concept	Formula	Interpretation
Total Cost (TC)	\(TC = FC + VC\)	All costs incurred to produce a given level of output.
Average Fixed Cost (AFC)	\(AFC = \dfrac{FC}{Q}\)	Fixed cost per unit of output.
Average Variable Cost (AVC)	\(AVC = \dfrac{VC}{Q}\)	Variable cost per unit of output.
Average Total Cost (ATC)	\(ATC = \dfrac{TC}{Q}=AFC+AVC\)	Overall cost per unit of output.
Marginal Cost (MC)	\(MC = \dfrac{\Delta TC}{\Delta Q}\)	Additional cost of producing one more unit.
Contribution (C)	\(C = TR - VC\)	Revenue left after covering variable costs.
Contribution per Unit (\(C_u\))	\(C_u = P - AVC\)	Amount each unit contributes toward fixed costs and profit.
Contribution Margin Ratio (CMR)	\(CMR = \dfrac{C_u}{P}\times100\%\)	Contribution expressed as a percentage of selling price.

Using Cost Information in Decision‑Making

1. Pricing Decisions
   • Short‑run: price must be ≥ AVC to cover variable costs and avoid a loss on each unit produced.
   • Long‑run: price must be ≥ ATC to cover all costs (fixed + variable) and earn a normal profit.
   • Contribution per unit helps evaluate the effect of discounts, promotions or price increases on profitability.
2. Product‑Line Decisions
   • Calculate \(C_u\) for each product; discontinue or redesign products with negative or very low contribution.
   • Use ATC to spot products that are overall inefficient (high total cost per unit).
   • Apply MC to decide whether expanding output of a profitable product adds to profit (produce while MC ≤ price).
3. Make‑or‑Buy (Outsource) Decisions
   • Determine the relevant in‑house cost – usually the marginal or variable cost of the required output.
   • Compare this figure with the supplier’s quoted price, adding any additional transaction or quality‑control costs.
4. Shutdown Decision (Short‑Run)
   • If market price < AVC → shut down temporarily; variable costs cannot be covered.
   • If AVC ≤ price < ATC → continue operating, absorbing part of the fixed‑cost loss.
5. Capacity & Expansion Planning
   • Observe the shape of the MC curve; a rising MC indicates that the firm is approaching its capacity limit.
   • Cost‑curve analysis can forecast the impact of new equipment, extra shifts or a larger plant on AFC, AVC and MC.
6. Budgeting, Forecasting & Performance Evaluation
   • Cost data underpin the production budget, cash‑flow forecast and profit‑and‑loss budget.
   • After the period, compare actual TC, AVC and MC with budgeted figures.
   • Calculate variances:
     • Favourable variance = Budgeted – Actual (when Actual < Budgeted).
     • Unfavourable variance = Actual – Budgeted (when Actual > Budgeted).
     Analyse the cause (price change, efficiency, volume effect) and take corrective action.

Worked Example – Cost Calculations & Decision Implication

A company produces 1 000 units. Fixed costs are $20 000 and total variable costs are $30 000.

• Total Cost (TC): \(TC = 20{,}000 + 30{,}000 = \$50{,}000\)
• AFC: \(\dfrac{20{,}000}{1{,}000} = \$20\) per unit
• AVC: \(\dfrac{30{,}000}{1{,}000} = \$30\) per unit
• ATC: \(\dfrac{50{,}000}{1{,}000} = \$50\) per unit

If output is increased to 1 100 units and total cost rises to $55 500, the marginal cost of the extra 100 units is:

\[ MC = \frac{55{,}500 - 50{,}000}{1{,}100 - 1{,}000} = \frac{5{,}500}{100} = \$55 \text{ per unit} \]

Market price = $60 per unit.

• Additional revenue = \(60 \times 100 = \$6{,}000\)
• Additional cost (MC) = \(55 \times 100 = \$5{,}500\)
• Incremental profit = \$6 000 – \$5 500 = **\$500** (positive → increase output is justified).

Worked Example – Variance Analysis (Budget vs. Actual)

Item	Budgeted (1 000 units)	Actual (1 000 units)	Variance	Interpretation
Fixed Cost (FC)	$20 000	$20 000	0	On target – fixed costs are generally uncontrollable in the short run.
Variable Cost (VC)	$30 000	$31 500	Unfavourable $1 500	Higher material price or lower labour efficiency.
Total Cost (TC)	$50 000	$51 500	Unfavourable $1 500	Overall cost over‑run; investigate variable‑cost drivers.

Typical Cost‑Curve Diagram (placeholder)

Summary

• Accurate cost data are the foundation for pricing, product‑line, make‑or‑buy, shutdown, capacity and budgeting decisions.
• Classify costs by behaviour, traceability, function and control to ensure the right figures are used in each decision.
• Average costs (AFC, AVC, ATC) assess overall efficiency; marginal cost guides incremental choices.
• Contribution per unit and the contribution margin ratio reveal how each sale helps cover fixed costs and generate profit.
• Short‑run pricing must at least cover AVC; long‑run pricing must cover ATC.
• Budgetary control relies on cost data to set targets, calculate variances and trigger management‑by‑exception actions.