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Contribution costing for special order decisions

Business Studies Notes and

Related Essays

Uses of Cost Information

 A Level/AS Level/O Level

Your Burning Questions Answered!

Explain the various uses of cost information within an organization.

Describe how contribution costing can assist management in making special order decisions.

Discuss the advantages and disadvantages of using contribution costing for special order decisions.

Analyze the impact of fixed and variable costs on special order profitability.

Evaluate the role of cost accounting in supporting the decision-making process for special orders.

Uses of Cost Information: Making Smart Business Decisions

Businesses don't just track costs for the sake of it. They use this valuable information to make crucial decisions that can impact their profitability and overall success.

1. Pricing Decisions:

-Cost-plus pricing: Imagine you're selling handmade jewelry. To set a price, you'll consider the cost of materials, your time (labor), and other overhead costs like rent. You add these costs together and then add a markup percentage for profit, resulting in your selling price. This is cost-plus pricing - simple and straightforward.

-Competitive pricing: Let's say you're selling lemonade at a summer fair. You analyze your competitors' prices, the quality of their lemonade, and the market demand. You might decide to offer a slightly lower price to attract more customers, even if it means a smaller profit margin. This is competitive pricing, where you adjust your prices based on the market.

-Value-based pricing: We know Apple products are generally more expensive than comparable devices. Why? Because Apple focuses on design, user experience, and brand reputation. They price their products based on the perceived value they offer, even if the production costs are similar to competitors. This is value-based pricing, where you set your price based on the perceived benefits and value your product brings to customers.

2. Cost Control and Efficiency:

-Understanding where your money goes: By tracking costs, businesses can identify areas where they are spending too much or where they can improve efficiency. This allows them to optimize their processes and reduce unnecessary expenses. For example, a restaurant might analyze their food waste and find ways to reduce it, saving money on ingredients.

-Comparing performance: Imagine you're running a clothing store. By comparing your sales figures and costs across different seasons, you can see which seasons are most profitable and adjust your inventory and marketing strategies accordingly. Tracking costs helps you measure your performance and identify areas for improvement.

3. Decision-Making and Strategic Planning:

-Should we invest in new equipment? By analyzing the cost of the new equipment, its potential benefits (like increased production), and the return on investment, businesses can intelligently decide whether this investment is worthwhile.

-Should we accept a special order? Companies often receive offers for large, one-time orders. To determine if accepting the offer is beneficial, they analyze the costs associated with fulfilling this order (materials, labor, shipping) and compare it to the potential revenue. This helps them make a sound decision based on potential profitability.

Contribution Costing: Helping Make Special Order Decisions

What is Contribution Costing?

Contribution costing is a method of cost accounting where we focus on the difference between sales revenue and variable costs. This difference is called the "contribution margin," and it represents the amount of money available to cover fixed costs and contribute to profit.

How it Works:

1. Identify variable costs: These are costs that change directly with the level of production. For example, in a bakery, the cost of flour used for cakes is a variable cost because it increases as the number of cakes baked increases.

2. Identify fixed costs: These costs remain constant regardless of the production level. Rent for the bakery is a fixed cost, as it remains the same whether you bake 10 cakes or 100 cakes.

3. Calculate the contribution margin: This is the difference between the selling price and the variable cost per unit. Example: If a cake sells for $10 and the variable cost per cake is $5, the contribution margin is $5.

Special Order Decisions:

Contribution costing is particularly helpful for making special order decisions, especially when you have spare capacity. For example:

-Scenario: A bakery normally sells 100 cakes per day at $10 each. They have the capacity to make 150 cakes, but they usually only sell 100. They receive a special order for 20 cakes at $7 each.

-Analysis: -Variable cost per cake: Assuming the variable cost per cake is $5, the contribution margin per cake is $5 ($10 selling price - $5 variable cost). -Special order impact: Even though the special order is at a lower price ($7), it still contributes $2 per cake ($7 selling price - $5 variable cost) towards covering the fixed costs and generating profit.

-Decision: Since the special order contributes to covering the fixed costs and generates additional profit, accepting the order is beneficial even if the price is lower than the regular selling price.

Key Takeaway:

Contribution costing provides a clear framework for analyzing special orders and making informed decisions based on their potential contribution to profit. It encourages businesses to think beyond just the selling price and consider the impact on both variable costs and fixed costs.

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