Understanding Business Accounting For Dummies, 2nd Edition (89 page)

Making optimal choices:
You often must choose one alternative over others in making business decisions. The best alternative depends heavily on cost factors, and you have to be careful to distinguish
relevant
costs from
irrelevant
costs, as described in the section ‘Relevant versus irrelevant (sunk) costs', later in this chapter.

In most situations, the book value of a fixed asset is an
irrelevant
cost. Say the book value is £35,000 for a machine used in the manufacturing operations of the business. This is the amount of original cost that has not yet been charged to depreciation expense since it was acquired, and it may seem quite relevant. However, in deciding between keeping the old machine or replacing it with a newer, more efficient machine, the
disposable value
of the old machine is the relevant amount, not the un-depreciated cost balance of the asset. Suppose the old machine has only a £20,000 salvage value at this time; this is the relevant cost for the alternative of keeping it for use in the future - not the £35,000 that hasn't been depreciated yet. In order to keep using it, the business forgoes the £20,000 it could get by selling the asset, and this £20,000 is the relevant cost in this decision situation. Making decisions involves looking at the future cash flows of each alternative - not looking back at historical-based cost values.

Sharpening Your Sensitivity to Costs

The following sections explain important distinctions between costs that managers should understand in making decisions and exercising control. Also, these cost distinctions help managers better appreciate the cost figures that accountants attach to products that are manufactured or purchased by the business. In a later section we focus on the special accounting methods and problems of computing product costs of
manufacturers
. Retailers purchase products in a condition ready for sale to their customers - although the products have to be removed from shipping containers and a retailer does a little work making the products presentable for sale and putting the products on display.

Manufacturers don't have it so easy; their product costs have to be ‘manufactured' in the sense that the accountants have to compile production costs and compute the cost per unit for every product manufactured. We cannot exaggerate the importance of correct product costs (for businesses that sell products, of course). The total cost of goods (products) sold is the first, and usually the largest, expense deducted from sales revenue in measuring profit. The bottom-line profit amount reported in the profit and loss account of a business for the period depends heavily on whether its product costs have been measured properly. Also, keep in mind that product cost is the value for the stock asset reported in the balance sheet of a business.

Direct versus indirect costs

Direct costs:
Can be clearly attributed to one product or product line, or one source of sales revenue, or one organisational unit of the business, or one specific operation in a process. An example of a direct cost in the book publishing industry is the cost of the paper that a book is printed on; this cost can be squarely attached to one particular phase of the book production process.

Indirect costs:
Are far removed from and cannot be obviously attributed to specific products, organisational units, or activities. A book publisher's phone bill is a cost of doing business but can't be tied down to just one step in the book's editorial and production process. The salary of the purchasing officer who selects the paper for all the books is another example of a cost that is indirect to the production of particular books.

Indirect costs are allocated according to some methods to different products, sources of sales revenue, organisational units, and so on. Most allocation methods are far from perfect, and in the last analysis end up being rather arbitrary. Business managers should always keep an eye on the allocation methods used for indirect costs, and take the cost figures produced by these methods with a grain of salt.

The cost of filling the fuel tank in driving your car from London to Bristol and back is a direct cost of making the trip. The annual road tax that the government charges you is an indirect cost of the trip, although it is a direct cost of having the car available during the year.

Fixed versus variable costs

Fixed costs
remain the same over a relatively broad range of sales volume or production output. For example, the cost of renting office space doesn't change regardless of how much a business's sales volume increases or decreases. Fixed costs are like a dead weight on the business. Its total fixed costs form the hurdle that the business must overcome by selling enough units at high enough profit margins per unit in order to avoid a loss and move into the profit zone. (Chapter 9 explains the break-even point, which is the level of sales needed to cover fixed costs for the period.)

Variable costs
increase and decrease in proportion to changes in sales or production level. If you increase the number of books that your business produces, the cost of the paper and ink also goes up.

Breaking even