Ass#2 Step 2 – Chapter 6

Understanding Key Cost Relationships

I find it interesting to read that it is critical that managers must understand the costs of a firm. I previously worked as a manager and area manager for a well-known business in town and their financials were very hush-hush. The only thing I was allowed to see was our takings for the week, I was not allowed and knew nothing about the business’s costs. I 100% agree if I had the access to view more financial information, I personally could have set stronger goals and boundaries for the business, myself and the staff.

When a firm has inventories the business has incurred a cost for manufacturing or buying a product, but when balancing these reports not all inventory will have been sold. This means that the costs will not match as the unsold inventory will not yet have generated revenue. The same thing goes for the following month when inventory has sold, but costs were paid in previous months report. The financial reports will not have matched the projected costs and benefits of economic activities for the period. To balance the reports the cost of our products is turned into an asset (Inventories). We do not include them as an expense until the products have sold (Cost of goods sold).

Most common types of direct costs to a business are wages/labour costs and the materials used to manufacture a product. Indirect costs to a business are things such as electricity, building maintenance and council rates. Variable costs to a business are generally direct costs such as materials used in manufacturing.

When calculating production costs, there are some cases during the manufacturing process where products can appear very similar to other products. These products are unidentifiable until the later stages of manufacturing. In this case, to calculate their individual production costs you have to calculate an average price across all the products that are produced at every step of production.

Costs that are not associated directly with a business’s products are usually classified as period costs. Period costs are typically an expense that does not have the potential to generate economic benefits for the firm in the future.

Absorption rate - → Total indirect costs of an operating department / level of activity

I didn’t realise how much is involved in business costs! There is literally no stone unturned and every minute thing is accounted for somewhere. I knew that the business’s obviously need to cover their costs to break even and/or make profit but I had no idea it was monitored in so much detail and to that extent. My eyes have opened to a new angle of business. I can definitely agree on how much help all these details would be to a manager to help them run a business as efficiently as possible.

All of the calculations and graphs at the end of the chapter helped summarise my understanding of the readings. I am more confident with this subject now, everything is now making sense and falling into place.