Knowing the cost of an item, or an activity makes it possible to calculate the profit of that item or activity. This is very important. Sometimes businesses are not aware that they are making a loss on a specific item or activity because some of the costs that should be attributed to that product or activity have been absorbed elsewhere - so that one part of the business is subsidising another part. There are two main components of cost:
1. Direct costs that can be associated directly with the production of a unit of a product or service e.g. raw materials, and labour costs that can be specifically associated with that particular unit.
2. Indirect costs that can not be tied down to specific units of output. For example, in a factory producing several different types of chocolate bars, management costs and other overheads such as lighting and heating may not be able to be tied down to particular product lines. These indirect costs then need to be apportioned in a sensible way among the various product lines.
Direct and indirect costs
There are several ways of absorbing these indirect costs. For example, they could be absorbed among different chocolate bar lines according to the floor space that each line takes up in the factory, or according to the sales revenue of each line, or by some other method. Using such an approach the direct costs can then be divided up into the various production lines and then into the number of units coming off the line.
A factory produces 10,000 chocolate bars of a specific type each day (along with several other chocolate bars on other parts of the factory floor). The direct cost of producing each bar is calculated at 20 pence (to cover raw material, and direct labour costs). In addition, it is calculated that each product line should absorb £1,000 of indirect costs per day (the method of absorbing the costs having been calculated in proportion to the sales revenue of each product line). This means that 10p of overhead cost is allocated to each unit of production from that line.
Total cost per unit is therefore:
20p direct cost plus 10p indirect cost = 30p.
If the chocolate bars are sold on to retailers at 35p each, then we can see that each bar is making a profit of 5p. (If the total cost per unit had been more than 35p then there would have been a case for either raising price, or discontinuing that line).
Direct costs according to CIMA are expenditures which can be economically identified with a specific saleable cost unit. Indirect costs are therefore ones which can not be directly identified with specific saleable cost units.