AS/A-Level Business Studies Pack 2. 2 Classifying costs

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1 2 Classifying costs Cost centres How the costs relate to each other: Cost centres are where a business divides up costs into certain centres such as production, marketing, distribution, personnel, administration and maintenance. To use this method is to divide up costs by function. Different locations could also be the cost centres if, for example, the business has a number of regional offices or shops. Direct and indirect costs How the costs relate to the production process: Direct costs relate to the actual production of a product. Every product will require the attention and time of some members of the workforce, called direct labour costs and the use of specific materials and component parts, called direct material costs. There may be other costs such as the time and expertise of specialists needed to bring the product into existence. This might include the hiring of equipment. These costs are called direct expenses. Indirect costs are all of the other costs that are incurred but do not come about as a result of the actual making of the product. Together these costs are sometimes called overheads. These will include the costs of all members of the workforce and management who do not actually make the goods, called indirect labour costs and all materials used in the business that do not contribute to the making of the goods for sale. These are called indirect material costs. The firm will also incur costs that must be paid irrespective of the amount of production and sales. These items, called indirect expenses, will include the payment of rent, interest, heating and lighting. Give examples of indirect material costs. Fixed, variable and semi-variable costs How the costs relate to output: do not change with the amount of output produced. Rent, interest payments, insurance premiums and management salaries are typical examples. These costs are time-based rather than production-based in that they come about as a result of the passage of time rather than as a result of the using up of materials and the manufacturing of output. Whilst they are said to be fixed, they are only fixed in the short-term. In the long-term all factors can vary and so all costs can vary too. Pearson Publishing Tel

2 for Alan Hastings Packaging: 0 50 Variable costs rise and fall with the increase or decrease in the amount of production that is taking place. The costs that change in proportion to output include all direct costs. Semivariable costs are neither fixed nor variable but contain characteristics of both. They change with output, but not in direct proportion to output. An essential supply may have a standing monthly charge no matter how much is used (a fixed element) but there may also be a bill for the amount consumed (variable element). Give three examples of semi-variable costs. Fixed and variable costs for Alan Hastings Packaging: Variable costs Pearson Publishing Tel

3 500 Variable costs 0 50 Total costs for the business will be found by adding together fixed and variable costs. Fixed, variable and total costs for Alan Hastings Packaging: Variable costs Total costs Total costs (FC + VC) Variable costs 0 50 In certain circumstances, variable costs will not increase in such a uniform manner as in the case above. A manufacturer may be in a position take advantage of economies of scale as output increases so that costs per unit will fall. Total costs will continue to rise but the increase in cost will not continue at a uniform rate. Pearson Publishing Tel

4 A-level 7 Ratio analysis Interpretation of accounts The preparation of a company s final accounts will fulfil certain legal obligations but the firm will require analysis if the full benefits of the data are to be realised. The conversion of the financial data to useful information takes place through the use of ratios. Alan Hastings was considering buying a new car. He had decided to spend no more than 9000 on a new vehicle that would be used for company business and also as a family car. Alan was willing to pay for the car on a finance scheme but had an open mind about the way he would pay. He had three factors in mind when choosing a new vehicle: performance, efficiency and the amount he would have to borrow to finance the venture: Factor Performance Efficiency Explanation The maximum speed the car The extent to which the car will represent value for money Measurement Miles or kilometres covered per hour Number of miles covered per litre or gallon of petrol Finance The size of debt and cost of borrowing The amount borrowed compared to the cost of the car and the rate of interest on any loan Formulae used Performance Efficiency Finance Number of miles covered in 60 minutes Number of miles driven using one gallon of petrol Amount of money borrowed 60 minutes One gallon of petrol Total cost of car Once Alan has the data on the vehicles he has in mind, he will be able to convert it into information by creating ratios according to the above formulas. Different cars will have different results and this will help Alan to make an informed decision about the most suitable purchase. Pearson Publishing Tel

5 A-level This case study is an example of using ratios such as miles per hour as a means of comparing different cars. Which other groups or individuals might use ratios to help them in making decisions? Accounting ratios In business, ratios are grouped as follows: Profitability and efficiency (asset usage) Liquidity and gearing Investment. All businesses strive to be efficient. This means attempting to get the maximum value from the resources available. In addition, private sector firms aim to maximise profits. These ratios therefore make an assessment of how well the firm manages its assets to generate profit. The more efficiently assets such as stock and debtors are managed, the more profitable the firm should expect to be. Profitability and efficiency ratios Return on net assets How the assets of the firm have been used to generate profit: Profit before tax and interest Net assets x Profit margin Calculating what proportion of sales are actual profit for the firm: Profit before tax and interest x Asset turnover This ratio is expressed in terms of a number of times. This shows how well the firm is able to generate sales from its available assets: Net assets Stock turnover How well the level of stock is managed in the business. The ratio expresses the speed with which stocks are sold. Firms selling perishable goods will usually have to sell (or turn them over ) quickly. This ratio is expressed in terms of a number of times. If the figure is 12 times it means that the stock is held for a month on average. The figure divided into 365 will show the average number of days that stock is held for: Stocks Pearson Publishing Tel