What is the total cost concept in managerial accounting?
2. Example of the total cost concept in accounting
Let’s assume that Miracle Company (a fictitious entity) manufactures and sells computer equipment. The company uses the total cost concept to determine the selling price of its products. The following information is available for Miracle Company:
Miracle Company |
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Step |
Manufacturing costs: |
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Direct materials |
100,000 units x $6 |
$ 600,000 |
|
Direct labor |
100,000 units x $8 |
$ 800,000 |
|
Variable factory overhead |
100,000 units x $4 |
$ 400,000 |
|
Fixed factory overhead |
$ 200,000 |
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1 |
Total manufacturing cost |
$ 2,000,000 |
|
Selling and administrative (S&A) expenses: |
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Variable expenses |
100,000 units x $3 |
$ 300,000 |
|
Fixed expenses |
$ 100,000 |
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2 |
Total S&A expenses |
$ 400,000 |
|
3 |
Total cost |
$2,000,000 + $400,000 |
$ 2,400,000 |
Expected number of units to be sold |
100,000 units |
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4 |
Total cost per unit |
$2,400,000 ÷ 100,000 units |
$ 24.00 per unit |
Total assets |
$ 6,400,000 |
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Desired rate of return |
15% |
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5a |
Desired profit |
$6,400,000 x 15% |
$ 960,000 |
5b |
Markup percentage |
960,000 ÷ 2,400,000 |
40% |
5c |
Markup per unit |
$24 per unit x 40% |
$ 9.60 per unit |
6 |
Selling price |
$24.00 + $9.60 |
$33.60 |
As we can see from this example, the calculation of the selling price of a product under the total cost approach is fairly simple and straightforward. To determine the selling price, we simply needed to estimate the unit product cost and decide how much profit we want. One of the weaknesses of this method, as well as other cost-plus methods, is that we have ignored the demand for the product and relied on our forecast of the future sales. Essentially, we have assumed that customers want to buy the number of units we have estimated to be produced and sold and are willing to pay the price the company decided to charge (i.e., $33.60).
The only way Miracle Company will receive the desired rate of return (i.e., 15% in our example) is if the customers buy the projected number of units (i.e., 100,000). If the company sells less than 100,000 units, the rate of return will be less than 15%. If the company sells more than 100,000 units, the rate of return will be greater than 15%.
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