Understanding Costs
Financial Reference Sheets
Future Practice Owner.
Declaration
Please note:
All financial information shared in this document is fictional data that has been created for learning purposes. It is not representative of any true financial data for Vets for Pets or Companion Care. This reference sheet has been based on the initial ‘costing’ created by the CMI, and hosted as part of Management Direct.
Original content and information is, therefore, copyright 2017 Chartered Management Institute.
Future Practice Owner.
Understanding Costs
What are costs?
There are many different ways to define the term ‘costs,’ but for this reference sheet, we can describe it as the amount of resources provided or consumed in exchange for production, goods or services. To elaborate, when we refer to the cost of a product, we are referring to how much capital or value has been used to create the product. And when we talk about the price of a product, this refers to how much money a consumer would need to pay to acquire it.
Clarification of costs
Fixed: Costs that do not vary within a budget period with differing levels of activity. Variable: Costs that vary with the level of activity.. Direct: Costs that can be identified directly with a product or cost centre and, therefore, allocated directly. Indirect: costs that cannot be directly identified with a particular product or cost centre and are, therefore, apportioned to cost centres/products according to a method of cost absorption. Controllable: Costs that are influenced by a budget holder or other member of the management team.
Future Practice Owner.
Understanding Costs
What are costs?
Cost Examples
Fixed: Rent
Variable:
Waste disposal Labour costs Utility costs
Salaries Property tax or rent
Direct:
Indirect:
Surgical equipment Medical supplies Internal Marketing POS
Office supplies Facility maintenance Admin support
Controllable Costs: Medical supply ordering Colleague overtime Equipment maintenance
Future Practice Owner.
Controlling a Budget
Costing Methods
Here are three examples of commonly used costing methods, which you may come across or choose to utilise.
1.Marginal Costing
This method of costing keeps variable and fixed costs separate.
It shows the gross profit or contribution that a selling price less variable costs makes to a pool of fixed costs.
£10 £4 £6 (*60%)
Unit selling price Unit variable costs Unit contribution (gross profit)
*Gross margin = 60% (£6/£10)
If the total fixed costs were £6,000 p.a. then the company would have to sell 1,000 units to break- even and cover the fixed costs (£6,000/£6 = 1,000 units). If the company sells more than 1,000 units p.a. then it will start to make a net profit.
Future Practice Owner.
Controlling a Budget
Costing Methods
2. Absorption and standard costing
Absorption costing is a method that absorbs all costs (both variable and fixed) into product costs. The most common method of absorption costing is standard costing. This method is often used in manufacturing companies. It does have the advantage that the full cost of a product can be identified. Unfortunately, it can be complicated and is often not understood by managers, especially when it is fully integrated into the financial accounts of a business. The fully integrated standard costing system of absorption costing sets standards for costs and measures performance against variances from standards.
Video Spotlight: Absorption Costing (Tabaldi)
Standards will be set for:
Material prices Material qualities Labour rates Labour times allowed Overhead absorption rates
Future Practice Owner.
Controlling a budget
3. Activity based costing (ABC)
Activity Based Costing (ABC) is another technique that ultimately allocates indirect costs to products. ABC assigns costs to activities and then to products. Traditional costing methods assign overhead costs to products based on average absorption rates. ABC links indirect costs to products by allocating indirect costs to activities and then to products based on their usage of the activities. This method identifies cause-and-effect relationships in an attempt to accurately allocate costs to products. It is most useful when indirect cost allocation accuracy is important and when indirect costs form a large proportion of total costs. Activity based costing can be a useful aid to strategic decisions concerning processes, outsourcing and selling prices. However, there is an element of complexity as with all costing systems that absorb and redirect costs.
Four steps for activity based costing:
Recognise and list the activities in the value chain that are related to the production process of the product. Estimate a total cost for each of the activities listed in '1' above. Compute a cost-driver rate for each activity based on an allocation method that has a direct link to the cost of the activity. Apply these activity costs to products using the cost-driver rate
Future Practice Owner.
Controlling a budget
Cost reccomendations & considerations
Avoid confusing cost with price. The cost of a product is determined by internal factors. The price that a product is offered to the market is the cost plus a margin that will ultimately be determined by market forces
Avoid getting confused with overhead absorption methods of costing unless it is vital for the business.
Avoid making incorrect product sales/strategy decisions based upon misleading product costs.
Future Practice Owner.
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