Session A
Classifying costs

1 Introduction

At home, if your expenses or costs are high in comparison to your income, your life can be difficult. Say, for example, that the electricity, gas and telephone bills are all due at the same time and your wages are only enough to pay two of them. What do you do?

Let's assume you negotiate time to pay but realize that the same problem is likely to occur next quarter. You'll have to decide whether to turn down the heating, switch off the lights or cut back on phone calls.

Businesses can find themselves in similar situations. It is up to you and everyone in your organization to be concerned about the costs of whatever you produce or supply, just as you should be concerned about quality.

Business organizations in the private sector who do not control costs may go out of business. Organizations in the public sector with high and increasing costs will need to make severe cuts in their activities and will attract a great deal of criticism from the public and government of the day. As a first line manager, you'll need to be concerned with costs and their control.

In this session we will look at the different kinds of cost and how you can help to control them.

2 Organizational costs

The total costs of an organization are made up of such things as:

     wages and salaries;

     electricity, gas and other utilities;

     purchase of steel, wood, stationery, X-ray plates or whatever raw materials the organization uses;

     payments for services from transport to cleaning.

These costs are deducted from the sales of the organization; the difference is profit. Profit might also be called operating surplus by organizations in the public and voluntary sectors.

Several ways of setting prices are based on the idea of determining costs and then adding a percentage for profit. Identifying costs is, therefore, important.

Sales (or income) – Costs = Profit (or operating surplus) The implication of this is that an organization can either increase its prices or decrease its costs to become more profitable or to alter the level of its operating surplus. But, there are dangers with these courses of action.

Activity 1

Suppose the price of your favourite biscuits was suddenly doubled.

Jot down three things you might do.

You might:

     buy fewer biscuits;

     stop buying the biscuits;

     buy biscuits made by a competitor;

     buy an alternative product, such as cake;

     cut back on something else so you could afford the biscuits.

EXTENSION 1 You can explore the relationship of costs and pricing further in Kirkland's and Howard's book Simple and Practical Costing, Pricing and Credit Control.

People who buy your organization's products may choose one of these options if you increase your prices. You probably don't have much to do with fixing selling prices, but you are in a position to affect costs. By controlling these you can help your organization, and that's what we'll concentrate on.

As a first line manager you will be concerned with the following costs:

     labour costs;

     materials costs;

     overheads.

 

 

3 Labour costs

The total ‘labour cost’ of employing people in the organization comprises the wages or salaries that they receive directly, plus the additional costs to the employer of National Insurance contributions, pension contributions and other benefits. It depends on the type of organization, but the costs of labour are often the most significant cost of all.

If the organization makes something that is sold or supplied, then its total labour cost is often split into direct and indirect labour costs.

Wages that can be identified with a particular product are usually called direct labour costs. Some examples of direct labour are:

Wages that cannot be identified with a particular product are indirect labour costs. Examples of indirect labour can arise from a number of activities, such as:

None of these can be identified directly with a particular item of production, even though they are essential for an organization as a whole.

Direct labour costs will increase or decrease in proportion to the production activity being carried out and for this reason are called variable costs.

Indirect labour costs happen all the time, whether something is being produced or not. They are fixed costs.

We will look at the significance of fixed and variable costs a little later on.

4 Materials costs

In manufacturing, materials costs can often account for more than half of the total costs of production.

In industries such as aero-engineering and computer manufacturing, you can appreciate that the costs of materials such as steel, plastic and microchips will probably make up much of the total costs of the finished product. Conversely, a telephone banking operation or call centre may find that materials costs account for much less than one tenth of total costs.

We already know that labour costs can be broken down into direct and indirect categories. Materials costs can also be divided into:

     direct materials costs;

     indirect materials costs.

Direct materials costs are the costs of materials used in the products, such as:

     wood;

     steel;

     paper;

     component parts;

     ingredients for meals;

     plant food and compost.

Direct materials costs can be identified directly and in total with an item being produced.

Indirect materials costs are the costs of such materials as:

     cleaning products;

     paper and stationery;

     lubricants.

Indirect materials costs CANNOT be identified directly and in total with an item being produced.

If a material is used for different jobs, it may not be possible to identify all the costs as either direct or indirect. Let's look at an example.

Suppose you work for an organization which makes a range of timber products. One of the items is garden sheds, which are all painted. The same paint is used to decorate the factory premises.

Activity 2

Complete the statements below with a suitable word or words.

     The paint used on the factory is ___________ ___________ materials cost.

     The paint used on the garden sheds is __________ _________ materials cost.

The paint used on the factory premises is an indirect materials cost, because it cannot be identified in total or directly with the making of sheds.

The paint used on the garden sheds is a direct materials cost, because it can be identified in total and directly with the making of sheds.

 

5 Overheads

Costs that are incurred but that are not easily identified with any particular process or product are called overheads. General overheads include:

     insurance of stocks of materials and finished goods, machinery and people;

     heating and lighting;

     rates.

We have already seen two other types of overhead. Wages of people not directly involved in production or directly providing a service (indirect labour) are classed as labour overheads. Examples are:

     security staff;

     maintenance fitters;

     managers and supervisors;

     secretaries and reception staff.

Indirect materials are materials overheads: safety clothing and cleaning materials are examples.

Activity 3

Which of the following are direct and which indirect material or labour costs?

Materials used in these ways are direct materials costs, and the wages of work teams whose time is spent entirely on manufacturing or service provision are direct labour costs. The receptionist's salary is an indirect labour cost or labour overhead.

Now let's complete our examination of cost headings with how we can collect together types of materials, labour and general overheads.

     Factory or operations overheads.

These include general overheads, such as factory or operations centre heating, lighting, rent and rates; labour overheads, such as supervisory and reception staff; and materials overheads, such as stationery, safety clothing and cleaning materials.

     Selling and distribution overheads.

These include general overheads such as sales office and despatch centre heating and lighting, advertising and catalogues and maintenance of cars and lorries, and labour overheads, such as sales staff commission and expenses.

     Administration overheads.

These include accounting and financial costs, the hire of and depreciation of computers, office supplies and stationery, maintenance and depreciation of the building and its contents. They comprise a mix of materials, labour and general overheads.

Manufacturing organizations make things. But retail organizations are in the business of buying and selling – trading in other words. Insurance companies, chartered accountants and surveyors do not sell goods in any form. They sell a service that doesn't involve any processing of materials or selling of goods. Let's look at cost headings in such organizations.

Activity 4

Tick the relevant boxes for each classification of cost that you would expect to find in a retail organization and a service organization, respectively.

You probably felt quite confident in ticking all three categories of overhead for both types of organization, and the goods for resale category for the retailer. But does either organization have direct labour, and does the service organization have direct materials? The answer is: yes, if they choose to do so. In other words, an organization can choose whether or not to classify items as direct or indirect, operational or overheads, depending on what it wants to achieve with its cost classifications. We shall come back to this important idea later.

Let's look first at another important way of classifying costs, not by means of their element but by their behaviour.

6 Fixed and variable costs

You will remember that we have already said that costs which vary with output are called variable costs. Costs which don't are called fixed costs.

Let's look at an example of each.

     Variable cost

A baker sells bread in paper bags and cakes in boxes. The packaging material is directly related to the output of bread and cakes and is a variable cost.

     Fixed cost

EXTENSION 1
Sometimes fixed costs can be converted to variable costs. Take a look at Kirkland's and Howard's book Simple and Practical Costing, Pricing and Credit Control which illustrates how this works.

The monthly repayments of a mortgage on the baker's shop is not affected in any way by how much bread or how many cakes are sold, so this is a fixed cost. That doesn't necessarily mean that fixed costs don't change. Mortgage repayments can change, because interest rates change, but the reasons for the change are not related to the output of bread and cakes.

Often, production wages are variable as they vary with output. If a hospital increases the number of patients treated, more nurses have to be taken on or extra overtime paid. Variable costs need not vary exactly in proportion to output or service provision. If a sudden drop in demand occurs, it's unlikely that people would immediately be laid off.

Activity 5

June Hamilton manages one of a chain of small shops. Some of the costs incurred by her shop are listed below. Some of these costs vary, depending on the amount of business June's shop does, and some stay the same, regardless of how well the business is doing.

Tick the appropriate boxes to identify costs which vary and which remain the same.

I would say that rent, rates, electricity and insurance would stay the same, regardless of the amount of business June's shop does. Commission on sales and packaging materials vary depending on how much is sold. Wages stay the same in the short term but can be varied if business improves or worsens dramatically.

Costs which remain the same whether the level of business activity rises or falls are called fixed costs.

Costs which vary with changes in the amount of business beings done are called variable costs.

Distinguishing between fixed and variable costs can sometimes be quite a complex issue as we have seen in the case of wages.

Now that you've examined elements of costs and how they can be classified into separate headings which may, or may not, vary with the level of activity in the workplace, we're ready to start examining ways in which we can use this information.

 

 

7 Break-even analysis

A simple technique called break-even analysis is widely used by all kinds of organizations. It allows an organization to see the minimum level of operations it must maintain to at least cover its fixed costs – its break-even point.

This determines the level of production and sales a business needs to break even – that is, to make no profit but no loss.

To use break-even analysis to plan operations, we have to classify all costs, as we have already done, into fixed costs and variable costs.

For instance, a shop might be looking at whether it can continue in business over the summer period. All its staff have to be given at least one month's notice of dismissal. For the three month period, therefore, it would be best to treat wages as a fixed cost.

Let's see how it would work.

Unique Double Glazing expects to sell 1,000 window units at £200 each.

It expects fixed costs (rates, management salaries, machine maintenance, etc.) to be £50,000. Variable costs (materials, direct wages etc.) per window are £100 per unit.

We can anticipate the following.

     Each window unit sold adds £200 to income but £100 to costs (the £50,000 fixed costs will exist no matter what the level of sales). The £100 surplus on each window unit sold is called contribution per unit.

     When the contribution from each window unit sold matches the fixed cost, the break-even point, at which Unique makes no profit and no loss, has been reached.

In our example, we have the following:

fixed costs £50,000

contribution per unit £100

If the company sells 500 units, which is 50 per cent of its target, it will have broken even. If it sells more, it will make a profit: if it sells fewer, it will make a loss.

Remember, the company expects to sell 1,000 units, and profit equals sales minus costs (both fixed and variable).

Activity 6

Calculate the business target profit for Unique Double Glazing if expected sales are achieved.

I hope your calculations worked out something like this.

We can also express this as:

500 units above break-even × £100 (contribution) = £50,000.

Activity 7

What will be the position if Unique Double Glazing sells:

a 600 units?

b 400 units?

a If the business sells 600 units, that is 100 units more than the break-even point. The profit will then be 100 £100 £10,000 profit.

b If sales only reach 400 units, that is 100 units below break-even, and the business will make a loss of 100 £100 £10,000 loss.

Break-even analysis is useful in helping to:

These are major decisions, and not necessarily ones in which first line managers will become involved. We shall look at them in Session C.

So how is break-even analysis useful in practice? Well, it helps to focus the minds of everyone in the organization on the need to control costs (and generate income).

For instance, you might be manager of a newsagent, with staff costs per hour of £20. You sell The Times newspaper at 40p per copy. This means you have to sell 50 copies of The Times per hour to break even, assuming you sell nothing else and have no other costs (£20/40p). In practice, of course, you would have had to buy your stock of The Times from a wholesaler, so reducing the amount you make on the sale. You can see that a quiet hour or day, therefore, is money pouring down the drain.

 

Activity 8

Identify how much it costs your organization to employ you by the hour by calculating your hourly wage rate and adding about 10% for National Insurance.

If you work in a commercial organization, work out your organization's break-even point for you in terms of sales of one of your products.

If you work in a non-profit organization, work out how much extra funding is needed so that the organization continues to make neither a profit nor a loss.

Make your notes on a separate sheet of paper.

You may find it useful from now on to think of the effects on the break-even point for your workplace of any increase in how much it pays you and how hard you work.

8 The need to control costs

It's sometimes difficult to decide which costs are fixed and which variable. In the longer term, virtually nothing is fixed. We usually regard business rates, for example, as a fixed cost as they are a payment demanded by the local authority, and outside the control of the business. But rates vary between one town and another, and may increase or decrease from year to year. A business can reduce its rates bill. It can move!

Fixed costs are fixed over a period of time, and that timescale is linked to the scale of decision making that takes place in the organization. For instance, a power generator has to make very long-term plans. It is not easy to move a power station! But the situation for an employment agency is far more fluid. On a day-to-day level, the important distinction we have to make is between the costs we can control and those we cannot.

Activity 9

Tick the costs below that you think you can influence at work.

Quarterly electricity cost.
Rent of the firm's premises.
Rental cost of each telephone line.
Quarterly cost of telephone calls.

Large airlines use a ‘hub and spoke’ model to spread high fixed servicing costs over many aircraft. All flights go to a hub airport where there are flights to hundreds of possible final destinations (spokes).

The cost of electricity and telephone calls made can be kept down by your own efforts.

Perhaps you feel, particularly if you work for a large organization, that the amount of electricity you use or how many telephone calls you make doesn't make any real difference on the overall total.

To some extent you're right. If you turn off lights when you go out of a room or make a shorter telephone call it will make a difference of only a few pounds a quarter. But by setting an example to your work team you can encourage your team members to control costs. You will also exert quite a bit of influence on other people who come into your work area, if they see that you take cost control seriously.

As a general rule, variable costs are more likely to be within your control than fixed costs, and it is these which you can most easily help to keep down by your own efforts.

What can we do about other costs which are not directly within the control of the people involved?

Let's take an example of your work team's time. How much they are paid and their pay scale is probably outside your control. But you can make sure that value for money is obtained for that cost.

Activity 10

This Activity may provide the basis of evidence for your S/NVQ portfolio. If you are intending to take this course of action, it might be better to write your answers on separate sheets of paper. Jot down one way in which you can ensure that you get ‘value for money’ for the cost of your work team's time. Make a note of ways in which you can implement your suggestion. Perhaps you said something like ‘keep them working’, or ‘make efficient use of their time’, or even ‘manage them properly’. You may have started to think in detail about selecting the right people for the job and training them properly. Perhaps you could draw up a time schedule for yourself and your team. Now look at this example.

Activity 11

Shari's work team uses computer screens which are linked to a large computer at head office. Frequently they spend long, frustrating periods in front of the screen waiting for responses from the heavily loaded computer. Response time is slow and seems to be getting worse. She is able to use her work team's time on other jobs so that their time isn't wasted so much, but the real problem doesn't go away. What can she do?

Write down one suggestion.

She could try a number of possibilities, for example:

     ring head office and try to find out what the problem is;

     talk to her manager about it and get him or her to take it up.

If Shari was to report ‘a general feeling’ that response time is getting worse, it may not meet with much reaction. It would be more helpful if she kept a record of the problems and noted exactly what was happening.

In any situation, and equipped with some real evidence, you can:

     identify the scale of the problem yourself;

     convince your manager that you have a problem which you cannot solve on your own.

We'll look at this in detail later in the workbook.

To sum up, we can say that you can tackle problems of costs on three fronts:

     keep down costs which are within your control;

     get value for money for costs which you can't control directly;

     keep records of cost problems which you have identified but can't influence without support.

Self-assessment 1

1     Identify the differences between direct and indirect materials costs.

2     Claire runs a local newspaper. She pays her advertising sales staff on a commission-only basis and her reporters are given a weekly wage. Are the different forms of wage fixed or variable costs?

     the wages of the advertising sales staff are ___________ ___________;

     the wages of the reporters are ___________ ___________.

3     Fill in the missing words in the following sentences.

a Direct labour costs _____________ be _____________ identified with a particular product.

b Wages which _____________ be identified with a particular product are _____________ labour costs.

c Direct labour costs are often _____________ costs because they increase or decrease in proportion to the production being carried out.

4     The Feelgood Health Club has weekly fixed costs of £18,000 per week. There are no variable costs. Each member pays £15 per week to be a member. What is Feelgood's break-even number of members?

5     Sam is a first line manager in a factory assembling PCs. Tick the costs which would be under Sam's control and those which would not.

	Controllable	Not controllable
wastage of components used in the production of PCs
advertising costs of PCs
Sam's basic salary

Answers to these questions can be found on page 121.

9 Summary

     Profit = Sales – Costs.

     Costs are broadly made up of labour costs, materials costs and overheads.

     Labour costs have to be divided into:

     direct labour costs – which can be totally identified with time spent making a particular product or proving a service;

     indirect labour costs – which are identified with work other than making a product or directly providing a service.

     Materials costs, like labour costs, have to be divided into direct and indirect materials costs.

     Costs that relate to supporting the main activity are called overheads. Overheads can include indirect materials and labour, depending on how the organization classifies its costs.

     Costs can be identified as:

     variable – varying with output;

     fixed – incurred regardless of output.

     Each unit an organization sells makes a contribution to fixed costs of its selling price less its variable costs of production. An organization breaks even when its fixed costs are covered by its total contribution. If it sells more it makes a profit; if it sells less it makes a loss.

     The break-even point, at which an organization makes neither a profit nor a loss, is calculated as fixed costs/contribution per unit.

     To control costs:

     continually monitor and minimize costs within your control;

     get value for money from costs you cannot directly control;

     keep records of costs you cannot control without support.