the need for accurate cost information

5.4 Costs – Cost Information

5.4.1 Why Accurate Cost Information Is Essential

Accurate cost data underpins virtually every managerial decision. It enables a business to:

• Set selling prices that cover all costs and deliver the desired profit.
• Prepare realistic budgets and cash‑flow forecasts.
• Control operations by comparing actual costs with standards or budgets.
• Monitor the performance of departments, products or projects.
• Make strategic choices such as make‑or‑buy, outsourcing, product‑line expansion or special‑order acceptance.

5.4.2 Consequences of Inaccurate Cost Data

• Over‑pricing – loss of market share.
• Under‑pricing – reduced profit margins.
• Budget overruns and cash‑flow problems.
• Misallocation of resources and poor investment decisions.
• Misleading performance reports that demotivate staff.

5.4.3 Types of Costs (Syllabus Requirement)

The Cambridge syllabus distinguishes four cost categories: fixed, variable, direct and indirect (overheads).

5.4.3.1 Full Costing vs. Contribution Costing

• Full (Absorption) Costing
  • All production costs – fixed + variable, direct + indirect – are allocated to units of product.
  • Used for external financial reporting and for decisions where total cost coverage is required.
  • Limitations: can distort short‑term decisions because fixed overheads are spread over all units, even when capacity is under‑utilised.
• Contribution (Marginal) Costing
  • Only variable costs are assigned to units; fixed costs are treated as period costs.
  • Highlights the contribution each unit makes toward covering fixed costs and profit.
  • Useful for short‑term pricing, special‑order and make‑or‑buy decisions.
  • Limitations: not acceptable for external reporting; ignores the need to allocate fixed overheads when assessing long‑term profitability.

5.4.4 Approaches to Costing (Methods)

5.4.5 Uses of Cost Information (Syllabus Requirement)

• Pricing – Determine a selling price that covers the unit cost and provides the target profit.
  Example: Unit cost = £12 (variable £8 + allocated fixed £4). Desired profit = 20 % of cost → Desired profit = £2.40.
  Suggested selling price = £12 + £2.40 = £14.40.
• Budgeting & Forecasting – Use expected fixed and variable costs to prepare profit budgets, cash‑flow forecasts and variance analysis.
  Example: Expected sales = 5 000 units; variable cost per unit = £8; fixed costs = £30 000.
  Profit budget = (5 000 × £8) + £30 000 = £70 000 total cost; compare with expected revenue to forecast profit.
• Performance Monitoring & Control – Compare actual costs with standards or budgets to identify inefficiencies and take corrective action.
• Special‑Order Decisions – Assess whether to accept a one‑off order at a price below the normal selling price by analysing the incremental (marginal) cost.
• Profit Analysis – Analyse product‑line profitability, calculate contribution margins and break‑even points.
• Break‑Even & Contribution‑Margin Analysis – Determine the sales level at which total revenue equals total cost and the margin of safety around that point.

5.4.6 Break‑Even and Contribution Analysis

5.4.6.1 Calculating the Break‑Even Point (Units)

\[ Q_{BE}= \frac{ \text{Total Fixed Costs} }{ \text{Contribution Margin per Unit} } \]

Contribution Margin per Unit = Selling Price per Unit – Variable Cost per Unit.

5.4.6.2 Contribution Margin (Total)

\[ \text{Total Contribution}= \text{Contribution Margin per Unit} \times \text{Quantity Sold} \]

5.4.6.3 Margin of Safety

Units:

\[ \text{Margin of Safety (units)} = \text{Actual (or Expected) Sales (units)} - Q_{BE} \]

Percentage:

\[ \text{Margin of Safety \%}= \frac{ \text{Margin of Safety (units)} }{ \text{Actual (or Expected) Sales (units)} } \times 100 \]

5.4.6.4 Graphical Representation (Brief Description)

• X‑axis: Output (units); Y‑axis: Cost / Revenue (£).
• Two lines: Total Cost (fixed + variable) and Total Revenue (price × units).
• The intersection point is the break‑even point.
• Area to the right of the break‑even point represents profit; area to the left represents loss.

5.4.6.5 Limitations of Break‑Even Analysis

• Assumes selling price and variable cost per unit remain constant.
• Assumes all costs are either wholly fixed or wholly variable (ignores semi‑variable costs).
• Ignores changes in inventory levels and economies of scale.
• Based on a single product or a constant sales mix for multi‑product firms.

5.4.7 Cost Information for Decision‑Making

When evaluating alternatives, managers should consider three cost concepts:

• Average (Unit) Cost – Total cost ÷ total output; useful for long‑term pricing and full‑costing decisions.
• Marginal (Incremental) Cost – The extra cost of producing one additional unit; central to contribution costing and special‑order analysis.
• Total Cost – Sum of all fixed and variable costs for the chosen level of activity; required for break‑even and profit‑planning.

Decision‑Making Steps (Aligned with the Syllabus)

1. Identify the **relevant costs** – costs that will change as a result of the decision (usually marginal costs).
2. Exclude **sunk costs** – costs already incurred and unrecoverable.
3. Include **opportunity costs** – the benefit foregone by not choosing the next best alternative.
4. Calculate the net effect on profit or cash flow using the appropriate cost concept (total, average or marginal).
5. Choose the alternative that best meets the objective (e.g., maximising profit, market share, or strategic fit).

5.4.8 Key Formulae (Quick Reference)

All symbols are expressed in £ unless otherwise stated.

• \( \text{Total Cost}= \text{Fixed Cost}+ \text{Variable Cost} \)
• \( \text{Contribution Margin per Unit}= \text{Selling Price per Unit}- \text{Variable Cost per Unit} \)
• \( \text{Total Contribution}= \text{Contribution Margin per Unit}\times \text{Quantity Sold} \)
• \( Q_{BE}= \dfrac{ \text{Fixed Cost} }{ \text{Contribution Margin per Unit} } \)
• \( \text{Margin of Safety \%}= \dfrac{ \text{Actual Sales} - \text{Break‑Even Sales} }{ \text{Actual Sales} } \times 100 \)

5.4.9 Suggested Diagram – Flow of Cost Information into Business Decisions