Costing and decision making

A business produces 15 000 units per year. The total costs of running the factory, advertising and selling the goods are calculated at £90 000. The cost per unit is therefore £6. This is the simplest form of costing.

The following are some examples of decisions in which an analysis of costs is essential.

1. Make or buy? A business uses a large quantity of a certain component in assembling its product. The component is not difficult to make and it is suggested that it would be both more convenient and cheaper if the business was to make it itself. Can it be produced more cheaply than the market price?

2. Entering a market All businesses have a level of profit which they consider acceptable. On entering a new market with a given market price a business will need an accurate assessment of costs to estimate whether or not it will be able to achieve this profit level.

3. Cease or continue production? Although a business may be losing money on a product it may be profitable for it to continue to manufacture while the costs of production are fixed. In economic terms this would be known as the short run, defined more precisely as the period of time in which at least one factor of production was fixed in supply. A business can continue to produce in the short run provided it can sell enough to cover its variable costs.

4. Accept or reject an order A business may be offered a contract at a price that does not cover the full cost of producing the goods. If the business is operating at less than full capacity it may still be advantageous for it to accept the order.

Each of the situations outlined above will require a different cost analysis and a different method of costing.

Costing would be a relatively simple operation if:

• all costs could be clearly allocated to one product or area of production. This is known as a cost centre. If you look again at the definitions of costs you will see that overheads and indirect costs may be used by several cost centres. The marketing department may be responsible for several products. How much time does any one person in that department spend on any one product? It may vary with the time of year, or if a product is having unusual problems, and it may also vary according to the role of the person. A product may be of minimal importance to the departmental manager but require a great deal of time from a clerical assistant.

• all decisions were of the same type. All make and buy decisions require the same type of costing definitions and the records to be kept could be standardized.

• the situation did not change. Unless a business has a very dominant position in the market it will have to take note of its competitors' pricing and promotion policies. Government decisions will also change the environment in which the business operates by increasing taxation or reducing its spending. We can also mention trade unions, changes in consumer buying behaviour, changes in social attitudes and decisions by foreign governments as some of the variables that might cause a business to analyze its costs.

In practice the complexity of the situations faced by a business enterprise and the wide variety of decisions management is called upon to make have led to the development of a number of costing techniques each of which isolates the relevant information required by a decision and/or control problem.

2. Comprehension check.

Working in pairs, answer the questions.

a) In what cases can an analysis of costs be essential and helpful for a business?

b) Can you define a cost center as the term used in this text?

c) What are the main problems associated with allocating costs to a product?

d) Why is it reasonable for a business to use different methods of costing?

3. Read the text again. Find and write down a word or word-combinations in the text that mean the same as following definitions. They are in the same order as they appear in the text.

a. all the money that a business must spend to produce something or provide a service	b. controlling and organizing something such as business or organization	c. a try to persuade people to buy a product or service by announcing it on television, on the Internet, in newspapers
d. a process of studying or examining a problem in detail in order to understand it or explain it	e. to build something by putting all its parts together	f. to manufacture
g. the price that a product can be sold for at a particular time	h. starting to take part in a particular activity or work in a particular job	i. standard, degree
j. reasonable, agreeable	k. valuation, appraisal	l. to say what you think an amount or value will be, either by guessing or by using available information to calculate it
m. to stop, to bring to a stop	n. paying, lucrative	o. near term
p. to pay off, to redeem	q. to refuse, to deny	r. likely to make something or someone more successful, beneficial
s. a unit of a business enterprise to which costs of production can be allocated	t. indirect costs of production	u. to change, to diversify
v. office employee	w. a company that sells the same goods or services as another company	x. the process of attracting people’s attention to a product or event
y. conduct	z. someone’s opinions or feelings about something, especially as shown by their behaviour