Costs and Revenue

Costs and Revenue HL ONLY

Standard Level • 5.2.2 Page 630 & 631 • 5.2.3 Page 632 Question b & c only

Learning Objectives • HL - To be able to distinguish between cost centres and profit centres and analyse their value • HL - Analyse product viability using contribution analysis • HL - To knowwhycontribution costing is important

Cost Centre Definition • A department or section of an organisation to which specific costs can be allocated Example - In a hotel – the restaurant, reception etc

Profit Centre Definition • A division or department of a company that has been given authority to run itself within the business with its own profit and loss account • A profit centre must be able to generate revenue, as well as be a centre for the allocation of costs Examples - Each branch of a chain of shops

Use of Cost & Profit Centres • Accounting - Better analysis of individual performances & speedier corrective action • Organisational – Identify which areas are working well and improve decision making • Motivational – Encourages middle managers to make their division the most profitable

Establishing Cost & Profit Centres • Vary according to circumstances • May be… • A product • A group of machines • A department • A location • A person • The choice must be appropriate to the firm

Summary • A cost centre is an area of a business where costs stem from and can easily be recorded (i.e. a department or a person where costs can be identified as being incurred). These costs include wages and salaries, raw materials and capital expenditure (e.g. machinery). Cost centres are used for several reasons: • Allowing the business to see which departments and people are spending the most money. • To see if the departments and people are generating enough benefits for the business with the money that they spend. • Direct costs (i.e. those costs which are incurred directly as a result of production) are easy to allocate to cost centres, but indirect costs (e.g. rent, rates, loan repayments, etc) are far more difficult to allocate to a specific cost centre. • A profit centre is an area of a business where revenue can be identified as being earned, (and, hopefully, profit will be made). • Profit centres generally include different product lines and retail outlets, and they are frequently used by businesses which are large and diversified. They allow a business to see which parts of the business and which products generate the most revenue. The main reasons for using cost-centres include: • Loss-making departments of the business and loss-making products can be easily identified. • Each profit centre can be viewed as operating independently and this can lead to higher levels of motivation amongst the staff in each profit centre. • Overall, the use of cost centres and profit centres allows a business to exercise a degree of financial control over its operations, and to monitor the efficiency and profitability of its various departments and product-lines.

Contributing costing approach • Contribution costing – costing method that only allocates direct costs to cost/profit centres not overhead costs • Contribution costing solves the problem of how to divide overhead costs between products, the method concentrates on two very important concepts • Marginal cost of producing an extra unit • Contribution to fixed costs and profit

Contribution costing and decision making Avoids allocating overhead costs but they are not completely ignored Needed to calculate profit and loss Total contribution is $15000, if total overheads were $12000 then Profit = contribution – overheads Therefore….profit is

Multi-product firms – assessing viability of each product • Where more than one product / service is being provided, contribution costing shows managers which product / service is making the greatest / least contribution to overheads and profit • If costs were evenly distributed a manager may discontinue a product / service that was actually making money

Should a business accept a contract or a purchase offer at below full cost? • If a firm has spare capacity OR if it is trying to enter a new market segment, then marginal costing assists managers in deciding whether to accept an order at below full cost • May have long term profits in some casesbecause • Fixed costs are being paid anyway • If extra costs contribution can be earned, profits will increase

Costs and Revenue