Lecture 2: Why do we care about costs?
Hi guys, so why do we care about costs? Picture yourself as part of this table-making company that Layla started. So, these are all the costs she spent in the first month and let's assume she only made one table.
Before we look at the costs, why do you think Layla started this company? What is the aim of a company or business? It's to make a profit. What is a profit? A profit is when our sales exceed our costs, so costs are an important part of the profit calculation.
Now picture this: We made this one table, and now we want to sell it to a customer. So what are we going to charge for this table? What will the selling price be? That's one of the decisions that Layla has to make. To set the selling price we know our sales must exceed our costs, so which of these costs would we include in the cost of the first table? Will it be all of it or only some of the costs?
It's unlikely that the selling price of the first table will cover all of these costs. It will be a very expensive table, and no one will probably buy a table at that price. So, we’ll probably have to sell more than one table.
That's the next decision we need to make. How many tables are we going to manufacture per month and how many tables do we need to sell in order to make this company profitable? So that's another decision.
Now once we know how many tables we need to make, we can prepare a budget to make sure that we have enough resources available to keep production running; to make that amount of tables. So planning, that’s the next part of management accounting (the second area).
Now Layla walked through a market; she looked at competitors’ tables just to see what's out there and to get some ideas, and now she sees the prices of the tables, and that's way lower than what she estimated she'd be charging for the tables. If she charges way more than their competitors, she will not get any customers. If her selling price is set by competitors and the tables out in the market, she will need to limit her costs in order for her sales to exceed a cost and to be profitable. So, she has to control her resource consumption somehow.
She needs to make sure that they don't overspend on making the tables. You can see that's the three areas of management accounting; decision-making, planning and control. For all of those we need costs and when to decide which cost do we use and how do we use them in the decision-making, planning and control.
Then lastly, for reporting purposes, she needs to value the inventory. So if we made one table in the first month and we didn't sell the table, it will be part of our inventory or stock at the end of the month. We'll still have it, and we'll put it on our statement of financial position, and we need to allocate a value to that one table to report it.
Now, which of these costs do we take into account for that inventory evaluation? So these are some of the questions that we need to answer when looking at these costs.