One cost DOESN’T fit all

By Andrew Northmore, Director, SouthWestfd

Different types of costs have a number of uses in a business but you have to be careful how they are applied.

For example, costing data could be used in any of the following areas:

• Stock valuation
• Variance analysis (actual costs v budget)
• Decision making – make or buy decisions or pricing decisions for example

Quite often, the stock valuation cost (e.g. in the annual accounts) is developed by the external accountants and is based on UK accounting rules and includes materials, direct labour and overheads. In many cases, the direct labour and overhead expenses are grouped together into one ‘fully absorbed’ rate, i.e. it incorporates all overheads including those that are ‘fixed’ such as rent, rates and most depreciation charges.

What tends to happen then is that companies use the fully absorbed rate when they are making decisions about whether either to make or manufacture in-house or outsource, and also when they are making pricing decisions. This can lead to companies making the wrong decision and in some cases turning away profitable business.

Let me give you an example.

Company A is asked to make a new product that is going to cost them £10, made up of £4 materials and £6 labour and overheads (they are using the fully absorbed rate given to them by their accountants at the year end). They can outsource the product for £9. Company A decides to outsource the product. Did they do the right thing?

The answer to this lies in the split of variable and fixed costs within the £6 of labour and overhead.

Closer investigation reveals that the cost of £6 is made up of £2 direct labour, £1 variable overhead (power, consumables etc) and £3 of fixed overhead.

When they outsource the product, they will pay £9 to the supplier but they will still be paying the £3 of in-house fixed overhead (it is unavoidable in the short term) – so really, the product is costing them £12.

If they had produced the product in-house, the incremental cost would have been material £4, the direct labour £2 and the variable overhead £1 i.e. £7 in total.

In this example, it would have been better to make in-house.

In these types of decisions, it is very important to compare the outsourced price with the Incremental or avoidable cost of producing in-house.

The same is true when setting your selling prices.

Company A is approached by a prospective customer to make a new product. The target price for the product is £10 per unit and they want 10,000 units per annum. Company A is running at 50% of its capacity – it could take on the extra work without adding any additional overheads. Company A costs the new product using current material prices and labour hours at a fully absorbed rate (i.e. including that fixed overhead cost). The total cost is £10. Company A decides not to take on the extra work.

If they had taken the work, they would have received £10 per unit and it would have cost them £7 in materials and other incremental costs, so they would have made a £3 contribution to fixed overheads. By rejecting the work, they have lost £3 per unit or £30,000 per annum.

To make the right decision, it is very important to know the breakdown of costs into its variable and fixed elements and to fully understand cost – volume – profit relationships.

It is also very important to make sure that all of your business does not become marginal – if it does, you might not make enough contribution to cover your fixed overheads and you could end up losing money.

If in doubt, don’t be afraid to ask for advice!