cost c o “cost” is not a simple concept. it is s important ... · pdf filefour...
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Chapter 3Chapter 3 DIRECT COSTDIRECT COST
Chapter 4 INDIRECT COSTS
Ir. Haery Ir. Haery SihombingSihombing/IP/IPPensyarah
Fakulti Kejuruteraan PembuatanUniversiti Teknologi Malaysia Melaka
C
O
S
T
COST
““CostCost”” is not a simple concept. It is is not a simple concept. It is
important to distinguish between important to distinguish between
four different types four different types -- fixedfixed, variable, , variable,
averageaverage andand marginalmarginal..
Monetary measure of resources given up to Monetary measure of resources given up to
attain an objective (such as acquiring a good attain an objective (such as acquiring a good
or delivering a service)or delivering a service)
AA costcost may be defined as a sacrifice or may be defined as a sacrifice or
giving up of resources for a particular giving up of resources for a particular
purpose.purpose.
Costs are frequently measured by the Costs are frequently measured by the
monetary units that must be paid for monetary units that must be paid for
goods and services.goods and services.
COST Cost and Cost TerminologyCost and Cost Terminology
Cost is a resource sacrificed or forgone to achieve
a specific objective.
An actual cost is the cost incurred (a historical cost)
as distinguished from budgeted costs.
A cost object is anything for which a separate
measurement of costs is desired.
Cost AssignmentCost Assignmentis both
Cost Object
TracingDirect CostsDirect Costs
AllocatingIndirect CostsIndirect Costs
Cost and Cost TerminologyCost and Cost Terminology Cost ClassificationsCost Classifications
Association with cost objectAssociation with cost objectCost objectCost object is anything for which management wants to is anything for which management wants to
collect or accumulate costscollect or accumulate costs
Direct Direct -- traceable to a cost objecttraceable to a cost object
Indirect Indirect -- not conveniently or practically traceable not conveniently or practically traceable
to a cost objectto a cost object
treated as overhead treated as overhead
allocatedallocated
Cost Classifications CategoriesCost Classifications Categories Costing SystemCosting System
Cost ObjectCost Object
anything for which a separate measurement of costs is anything for which a separate measurement of costs is
desireddesired
Direct CostDirect Cost
costs that are related to a particular cost object in an costs that are related to a particular cost object in an
economically feasible (Costeconomically feasible (Cost--effective) mannereffective) manner
Cost PoolCost Pool
a grouping of individual cost itemsa grouping of individual cost items
Cost Allocation BaseCost Allocation Base
a factor that is the common denominator for systematically a factor that is the common denominator for systematically
linking an indirect cost or group of indirect costs to a cost linking an indirect cost or group of indirect costs to a cost
objectobject
Cost CategoriesCost Categories
Association with cost objectAssociation with cost object
Reaction to changes in activityReaction to changes in activity
VariableVariable
FixedFixed
MixedMixed
StepStep
Relevant RangeRelevant Range – normal operating range
Cost AllocationCost Allocation
Same issue exists for merchandising firmsSame issue exists for merchandising firms
Easier for merchandising,Easier for merchandising,
purchase price (major)purchase price (major)
shipping cost (minor)shipping cost (minor)
taxes (minor)taxes (minor)
Classification of CostsClassification of Costs
This section concentrates on the big This section concentrates on the big
picture of how manufacturing costs picture of how manufacturing costs
are accumulated and classified.are accumulated and classified.
Cost ObjectiveCost Objective
AA cost objective cost objective oror cost objectcost object isis
defined as anything for which a separate defined as anything for which a separate
measurement of costs is desired.measurement of costs is desired.
Examples include departments, products, activities, Examples include departments, products, activities,
and territories.and territories.
Accounts could be type of cost, to which product, Accounts could be type of cost, to which product,
department?department?
Categories of Manufacturing CostsCategories of Manufacturing Costs
All costs which are eventually All costs which are eventually
allocated to products are classified allocated to products are classified
as eitheras either
1.1. direct materialsdirect materials,,
2.2. direct labourdirect labour, or, or
3.3. indirect manufacturingindirect manufacturing..
DirectDirect--Material CostsMaterial Costs
DirectDirect--material costs material costs include the include the
acquisition costs of all materials that are acquisition costs of all materials that are
physically identified as a part of the physically identified as a part of the
manufactured goods and that may be manufactured goods and that may be
traced to the manufactured goods in an traced to the manufactured goods in an
economically feasible way.economically feasible way.
Example:Steel used tomanufacture
the automobile.
Direct Materials
Materials that are clearly and easilyidentified with a particular product.
DirectDirect--Material CostsMaterial Costs DirectDirect--Labour CostsLabour Costs
DirectDirect--labour costs labour costs include the include the
wages of all labour that can be traced wages of all labour that can be traced
specifically and exclusively to the specifically and exclusively to the
manufactured goods in an economically manufactured goods in an economically
feasible way.feasible way.
Direct Labor
Labor costs that are clearly traceable to, or readily identifiable with, the
finished product.
Example:Wages paid to an
automobile assemblyworker.
DirectDirect--Labour CostsLabour Costs Indirect Manufacturing CostsIndirect Manufacturing Costs
Indirect manufacturing costs Indirect manufacturing costs oror
factory overheadfactory overhead include all costs include all costs
associated with the manufacturing associated with the manufacturing
process that cannot be traced to the process that cannot be traced to the
manufactured goods in an economically manufactured goods in an economically
feasible way.feasible way.
Factory Overhead
All factory costs exceptdirect material and direct labor.
Factory costs that cannot betraced directly to specific units produced.
Examples:Indirect labor – maintenance
Indirect material – cleaning suppliesFactory utility costsSupervisory costs
Indirect Manufacturing CostsIndirect Manufacturing Costs
1. Direct Materials1. Direct Materials
PrimePrime
CostsCosts 2. Direct Labour2. Direct Labour
ConversionConversion
3. Factory Overhead Costs3. Factory Overhead Costs
Prime Costs, Conversion Costs, Prime Costs, Conversion Costs,
and Directand Direct--Labour CostsLabour Costs
Product CostsProduct Costs
Product costs Product costs are costs identified with are costs identified with
goods produced or purchased for resale.goods produced or purchased for resale.
Product CostsProduct Costs
Direct materialDirect material
Measurable part of a productMeasurable part of a product
Direct laborDirect labor
Labor used to manufacture a product or Labor used to manufacture a product or
perform a serviceperform a service
OverheadOverhead
Indirect production costIndirect production cost
Product CostsProduct Costs
Product costs are initially identified as part of Product costs are initially identified as part of the inventory on hand.the inventory on hand.
These product costs (inventoriable costs) These product costs (inventoriable costs) become expenses (in the form of cost of goods become expenses (in the form of cost of goods sold) only when the inventory is sold.sold) only when the inventory is sold.
First appear on the balance sheet in inventory First appear on the balance sheet in inventory accountsaccounts
Transferred to the income statement when Transferred to the income statement when product is soldproduct is sold
Period CostsPeriod Costs
Period costs Period costs are costs are costs
that are deducted as that are deducted as
expenses during the expenses during the
current period without current period without
going through an inventory going through an inventory
stage.stage.
1 2 3
4 5 6 7 8 9 10
11 12 13 14 15 16 17
18 19 20 21 22 23 24
25 26 28 29 30 3127
Selling and administrative costsSelling and administrative costs
Distribution costsDistribution costs
•• Cost to warehouse, transport, and/or deliver Cost to warehouse, transport, and/or deliver
a product or servicea product or service
•• Major impact on managerial decision makingMajor impact on managerial decision making
Period CostsPeriod Costs Period CostsPeriod Costs
Appear on the income statement when Appear on the income statement when
incurredincurred
Expensed when incurredExpensed when incurred
Classification By FunctionClassification By Function
Period costs are expensesPeriod costs are expenses
not charged to the product.not charged to the product.
Administrative Costs
Non-manufacturing costsof staff support and
administrative functions –accounting, data processing,
personnel, researchand development.
Selling Costs
Costs incurred to obtain customer orders and todeliver finished goods
to customers –advertising and shipping.
Period and Products CostPeriod and Products Cost
Raw MaterialsWork in ProcessFinished Goods
2005 BalanceSheet Inventory
Period Costs(Expenses)(Expenses)
Product Costs(Inventory)(Inventory)
Inventory NotSold in 2005
OperatingExpenses
Cost ofGoods Sold
Cost ofGoods Sold
2005 CostsIncurredIncurred
2005 IncomeStatement
2006 IncomeStatement
InventorySold in 2005
Product Cost Product Cost -- DirectDirect
Direct MaterialDirect Material
Conveniently and economically traced Conveniently and economically traced
to cost objectto cost object
Direct LaborDirect Labor
to manufacture a product or perform a service to manufacture a product or perform a service
includes wages paid to direct labor employees, includes wages paid to direct labor employees,
production bonuses, payroll taxesproduction bonuses, payroll taxes
may include holiday and vacation pay, may include holiday and vacation pay,
insurance, retirement benefitsinsurance, retirement benefits
Product Cost Product Cost -- IndirectIndirect
Overhead Overhead -- indirect production costsindirect production costs
Fringe benefits, if cannot be easily traced Fringe benefits, if cannot be easily traced
to productto product
Overtime, if due to random schedulingOvertime, if due to random scheduling
Cost of qualityCost of quality
Prevention costsPrevention costs
Appraisal costsAppraisal costs
Failure costsFailure costs
Product Cost vs. Period CostProduct Cost vs. Period Cost
Product costProduct costAll costs incurred in getting product to saleable conditionAll costs incurred in getting product to saleable condition
Three main elements:Three main elements:
Raw MaterialsRaw Materials
LabourLabour
Factory overheadsFactory overheads
Period costPeriod costAll costs incurred for a period of time regardless of productionAll costs incurred for a period of time regardless of production
Sometimes classified into:Sometimes classified into:
Marketing expensesMarketing expenses
General (administrative) expensesGeneral (administrative) expenses
Financial expensesFinancial expenses
Direct CostsDirect Costs
Direct costs Direct costs can be can be
identified specifically and identified specifically and
exclusively with a given cost exclusively with a given cost
objective in an economically objective in an economically
feasible way.feasible way.
Indirect CostsIndirect Costs
Indirect costs Indirect costs cannot be cannot be
identified specifically and identified specifically and
exclusively with a given cost exclusively with a given cost
objective in an economically objective in an economically
feasible way.feasible way.
Direct vs. Indirect CostsDirect vs. Indirect Costs
Direct CostsDirect CostsMajor costs that can be directly attributable to the final Major costs that can be directly attributable to the final
product or service. Includes:product or service. Includes:
Direct materialsDirect materials
Direct labourDirect labour
Other: subcontractors, tender document preparationOther: subcontractors, tender document preparation
Indirect CostsIndirect CostsAll other costs that cannot be directly attributable to the finaAll other costs that cannot be directly attributable to the finall
product or service. Includesproduct or service. Includes
Indirect materials: factory supplies, small items of materialIndirect materials: factory supplies, small items of material
Indirect labour: admin, cleaning or security staffIndirect labour: admin, cleaning or security staff
Factory overheads; rates, rent, insurance, telephone, Factory overheads; rates, rent, insurance, telephone,
stationerystationery
Classification by TraceabilityClassification by Traceability
Direct costs
Costs incurred for the benefit of one specific cost object.
Examples: material and labor cost for a product.
Indirect costs
Costs incurred for the benefit of more than one cost object.
Example: maintenance expenditures benefiting two or more departments.
Fixed Cost vs. Variable CostFixed Cost vs. Variable Cost
Fixed costsFixed costsThose costs that in total will remain the same for a period Those costs that in total will remain the same for a period
of time and over a relevant range or output. Includes:of time and over a relevant range or output. Includes:
Rent, rates, insurance, depreciationRent, rates, insurance, depreciation
Variable costsVariable costsThose costs that in total will tend to increase as output Those costs that in total will tend to increase as output
level increase. Includes:level increase. Includes:
Direct Materials and Direct LabourDirect Materials and Direct Labour
Overhead Cost AllocationOverhead Cost Allocation
Assign indirect costs to one or more cost objectsAssign indirect costs to one or more cost objects
To determine full absorption cost (GAAP)To determine full absorption cost (GAAP)
To motivate managementTo motivate management
To compare alternative courses of action for To compare alternative courses of action for
planning, controlling, and decision makingplanning, controlling, and decision making
Allocation process should be Allocation process should be
rationalrational andand systematicsystematic
Allocating OverheadAllocating Overhead
ActualActual Cost SystemCost System
Product CostProduct Cost
Direct MaterialsDirect Materials
Direct LaborDirect Labor
OverheadOverhead
Cost UsedCost Used
ActualActual
ActualActual
ActualActual
Allocating OverheadAllocating Overhead
Actual Cost SystemActual Cost System
The Actual Cost System is not timelyThe Actual Cost System is not timely
All costs must be known before All costs must be known before calculating product costcalculating product cost
Allocating OverheadAllocating OverheadActual vs. NormalActual vs. Normal
Product CostProduct Cost
Direct Materials
Direct Labor
Overhead
Actual Cost Actual Cost
SystemSystem
Actual
Actual
Actual
Normal Cost Normal Cost
SystemSystem
Actual
Actual
PredeterminedPredetermined
Overhead RateOverhead Rate
Cost behavior means how a cost will react to changes in the level of business activity.
Total fixed costs donot change when activity changes.
Total variable costschange in proportionto activity changes.
Classification By BehaviorClassification By Behavior
Activity
Co
st
Activity
Co
st
Cost behavior means how a cost will react to changes in the level of business activity.
Total fixed costs donot change when activity changes.
Total variable costschange in proportionto activity changes.
Classification By BehaviorClassification By Behavior
Product Cost BehaviorProduct Cost Behavior
Direct MaterialDirect Material VariableVariable
Direct LaborDirect Labor VariableVariable
OverheadOverhead Variable, Fixed, or MixedVariable, Fixed, or Mixed
Cost Item Behavior Traceability Function
Material Variable Direct Product
Assembly Wages Variable Direct Product
Advertising Fixed Indirect Period
Production Manager's Salary Fixed Indirect Product
Office Depreciation Fixed Indirect Period
Cost Item Behavior Traceability Function
Material Variable Direct Product
Assembly Wages Variable Direct Product
Advertising Fixed Indirect Period
Production Manager's Salary Fixed Indirect Product
Office Depreciation Fixed Indirect Period
Potential Multiple Cost Classifications
EXERCISEEXERCISE
Direct and Indirect CostsDirect and Indirect Costs
Direct Costs
Example: Oak wood used
in Mfg. of chairs.
Indirect Costs
Example: salary of the
Plant night watchperson.
COST OBJECT
Example: 50 Oak
Chairs produced in
May.
Direct and Indirect CostsDirect and Indirect CostsExampleExample
Direct Costs:
Maintenance Department $40,000
Personnel Department $20,600
Assembly Department $75,000
Finishing Department $55,000
Assume that Maintenance Department costs are
allocated equally among the production departments.
How much is allocated to each department?
Direct and Indirect CostsDirect and Indirect CostsExampleExample
Allocated$20,000
Maintenance
$40,000
AssemblyDirect Costs
$75,000
FinishingDirect Costs
$55,000
$20,000
Cost Behavior PatternsCost Behavior PatternsExampleExample
Bicycles by the Sea buys a handlebar
at $52 for each of its bicycles.
What is the total handlebar cost when
1,000 bicycles are assembled?
Cost Behavior PatternsCost Behavior PatternsExampleExample
1,000 units × $52 = $52,000
What is the total handlebar cost
when 3,500 bicycles are assembled?
3,500 units × $52 = $182,000
Cost Behavior PatternsCost Behavior PatternsExampleExample
Bicycles by the Sea incurred $94,500 in
a given year for the leasing of its plant.
This is an example of fixed costs with
respect to the number of bicycles assembled.
Cost Behavior PatternsCost Behavior PatternsExampleExample
What is the leasing (fixed) cost per bicycle
when Bicycles assembles 1,000 bicycles?
$94,500 ÷ 1,000 = $94.50
What is the leasing (fixed) cost per bicycle
when Bicycles assembles 3,500 bicycles?
$94,500 ÷ 3,500 = $27
Cost DriversCost Drivers
The cost driver of variable costs is the level
of activity or volume whose change causes
the (variable) costs to change proportionately.
The number of bicycles assembled is a
cost driver of the cost of handlebars.
Relevant RangeRelevant RangeExampleExample
Assume that fixed (leasing) costs are $94,500
for a year and that they remain the same for a
certain volume range (1,000 to 5,000 bicycles).
1,000 to 5,000 bicycles is the relevant range.
Relevant RangeRelevant RangeExampleExample
0
20000
40000
60000
80000
100000
120000
0 1000 2000 3000 4000 5000 6000
Volume
Fix
ed C
ost
s
$94,500
Relationships of Types of CostsRelationships of Types of Costs
Direct
Indirect
Variable Fixed
Total Costs and Unit CostsTotal Costs and Unit CostsExampleExample
What is the unit cost (leasing and handlebars)
when Bicycles assembles 1,000 bicycles?
Total fixed cost $94,500
+ Total variable cost $52,000 = $146,500
$146,500 ÷ 1,000 = $146.50
Total Costs and Unit CostsTotal Costs and Unit CostsExampleExample
0
50000
100000
150000
200000
0 500 1000 1500
Volume
Tota
l C
ost
s
$94,500
$94,500 + $52x
$146,500
Use Unit Costs CautiouslyUse Unit Costs Cautiously
Assume that Bicycles management uses a
unit cost of $146.50 (leasing and wheels).
Management is budgeting costs for
different levels of production.
What is their budgeted cost for an
estimated production of 600 bicycles?
600 × $146.50 = $87,900
Use Unit Costs CautiouslyUse Unit Costs Cautiously
What is their budgeted cost for an estimated
production of 3,500 bicycles?
3,500 × $146.50 = $512,750
What should the budgeted cost be for an
estimated production of 600 bicycles?
Use Unit Costs CautiouslyUse Unit Costs Cautiously
Total fixed cost $ 94,500
Total variable cost ($52 × 600) 31,200
Total $125,700
$125,700 ÷ 600 = $209.50
Using a cost of $146.50 per unit would
underestimate actual total costs if output
is below 1,000 units.
Use Unit Costs CautiouslyUse Unit Costs Cautiously
What should the budgeted cost be for an
estimated production of 3,500 bicycles?
Total fixed cost $ 94,500
Total variable cost (52 × 3,500) 182,000
Total $276,500
$276,500 ÷ 3,500 = $79.00
MerchandisingMerchandising
Merchandising companiesMerchandising companies
purchase and then sell tangible productspurchase and then sell tangible products
without changing their basic formwithout changing their basic form.
ServiceService
Service companies
provide services or intangible
products to their customers.
Labor is the most significant cost category.
Types of InventoryTypes of Inventory
Manufacturing-sector companies
typically have one or more of the
following three types of inventories:
1. Direct materials inventory
2. Work in process inventory (work
in progress)
3. Finished goods inventory
Types of InventoryTypes of Inventory
Merchandising-sector companies hold
only one type of inventory – the
product in its original purchased form.
Service-sector companies do not
hold inventories of tangible products.
Classification ofClassification of
Manufacturing CostsManufacturing Costs
Direct materials costs
Direct manufacturing labor costs
Indirect manufacturing costs
Inventoriable CostsInventoriable Costs
Inventoriable costs (assets)…
become cost of goods sold…
after a sale takes place.
Period CostsPeriod Costs
Period costs are all costs in the income
statement other than cost of goods sold.
Period costs are recorded as expenses of the
accounting period in which they are incurred.
Flow of Costs Flow of Costs ExampleExample
Bicycles by the Sea had $50,000 of direct
materials inventory at the beginning of the period.
Purchases during the period amounted to
$180,000 and ending inventory was $30,000.
How much direct materials were used?
$50,000 + $180,000 – $30,000 = $200,000
Flow of CostsFlow of CostsExampleExample
Direct labor costs incurred were $105,500.
Indirect manufacturing costs were $194,500.
What are the total manufacturing costs incurred?
Direct materials used $200,000
Direct labor 105,500
Indirect manufacturing costs 194,500
Total manufacturing costs $500,000
Flow of CostsFlow of CostsExampleExample
Assume that the work in process inventory
at the beginning of the period was $30,000,
and $35,000 at the end of the period.
What is the cost of goods manufactured?
Beginning work in process $ 30,000
Total manufacturing costs 500,000
Ending work in process 35,000
Cost of goods manufactured $495,000
Flow of CostsFlow of CostsExampleExample
Assume that the finished goods inventory
at the beginning of the period was $10,000,
and $15,000 at the end of the period.
What is the cost of goods sold?
Beginning finished goods $ 10,000
Cost of goods manufactured 495,000
Ending finished goods 15,000
Cost of goods sold $490,000
Flow of CostsFlow of CostsExampleExample
Work in Process
Beg. Balance 30,000 495,000
Direct mtls. used 200,000
Direct labor 105,500
Indirect mfg. costs 194,500
Ending Balance 35,000
Flow of CostsFlow of CostsExampleExample
Work in Process
495,000
Finished Goods
10,000 490,000
495,000
15,000
Cost of Goods Sold
490,000
Manufacturing CompanyManufacturing Company
MaterialsInventory
FinishedGoods
Inventory
Revenues
Cost ofGoods Sold
INCOME STATEMENT
PeriodCosts
InventoriableCosts
BALANCE SHEET
Equals Operating Income
whensalesoccur
deduct
Equals Gross Margindeduct
Work inProcess
Inventory
Merchandising CompanyMerchandising Company
INCOME STATEMENTBALANCE SHEET
whensalesoccur
InventoriableCosts
MerchandisePurchases
Inventory
Revenuesdeduct
Cost ofGoods Sold
Equals Gross Margindeduct
PeriodCosts
Equals Operating Income
PrimePrime CostsCosts——allall direct mfg. costsdirect mfg. costs
Direct
Materials
Direct
Labor
Prime
Costs+ =
Prime CostsPrime Costs
What are the prime costs for Bicycles by the Sea?
Direct materials used $200,000
+ Direct labor 105,500
= $305,000
Conversion CostsConversion Costs
Direct
Labor
Manufacturing
Overhead+ =Conversion
Costs
IndirectLabor
IndirectMaterials Other
Conversion CostsConversion Costs
What are the conversion costs for
Bicycles by the Sea?
Direct labor $105,500
+ Indirect manufacturing costs 194,500
= $300,000
Conversion cost = all mfg. cost except direct materials
Measuring CostsMeasuring Costs
Requires JudgmentRequires Judgment
Manufacturing labor-cost classifications
vary among companies.
The following distinctions are generally found:
Direct manufacturing labor
Manufacturing overhead
Measuring CostsMeasuring Costs
Requires JudgmentRequires Judgment
Manufacturing overhead
Indirect labor Managers’ salaries Payroll fringe costs
Forklift truck operators (internal handling of materials)
Janitors Rework labor
Overtime premium Idle time
Measuring CostsMeasuring Costs
Requires JudgmentRequires Judgment
Overtime premium is usually
considered part of overhead.
Assume that a worker gets $18/hour
for straight time and gets
time and one-half for overtime.
Measuring CostsMeasuring Costs
Requires JudgmentRequires Judgment
How much is the overtime premium?
$18 × 50% = $9 per overtime hour
If this worker works 44 hours on a given
week, how much are his gross earnings?
Direct labor 44 hours × $18 = $792
Overtime premium 4 hours × $ 9 = 36
Total gross earnings $828
Many Meanings of Product CostMany Meanings of Product Cost
A product cost is the sum of the costs
assigned to a product for a specific purpose.
1. Pricing and product emphasis decisions
2. Contracting with government agencies
3. Preparing financial statements for external
reporting under generally accepted
accounting principles
ManufacturingInventory
Classifications
Balance Sheet of a ManufacturerBalance Sheet of a Manufacturer
RawMaterials
FinishedGoods
Work inProcess
Completedproductsfor sale.
Materialswaiting to beprocessed.
Partially completeproducts.
Material to whichsome labor and/or
overhead havebeen added.
Balance Sheet of a ManufacturerBalance Sheet of a Manufacturer
RawMaterials
FinishedGoods
Work inProcess
BeginningMerchandise
Inventory
BeginningFinished Goods
Inventory
Cost of GoodsPurchased
Cost of GoodsManufactured
EndingMerchandise
Inventory
EndingFinished Goods
Inventory
Cost of GoodsSold
Merchandiser Manufacturer
+
_
+
==
_
The major difference
Income Statement of a ManufacturerIncome Statement of a Manufacturer
Manufacturing Company
Cost of goods sold:
Beg. finished
goods inv. 14,200$
+ Cost of goods
manufactured 234,150
= Goods available
for sale 248,350$
- Ending
finished goods
inventory (12,100)
= Cost of goods
sold 236,250$
Merchandising Company
Cost of goods sold:
Beg. merchandise
inventory 14,200$
+ Purchases 234,150
= Goods available
for sale 248,350$
- Ending
merchandise
inventory (12,100)
= Cost of goods
sold 236,250$
Cost of goods sold for manufacturers differs only Cost of goods sold for manufacturers differs only
slightly from cost of goods sold for merchandisers.slightly from cost of goods sold for merchandisers.
Income Statement of a ManufacturerIncome Statement of a Manufacturer
DirectMaterial
DirectLabor
ManufacturingOverhead
PrimeCost
ConversionCost
Manufacturing costs are oftencombined as follows:
Income Statement of a ManufacturerIncome Statement of a Manufacturer
What type of account is the manufacturing goods in process account?
a. Income statement expense account.
b. Balance sheet inventory account.
c. Temporary clearing account for directmaterial and direct labor.
d. Holding account for manufacturingoverhead and direct labor.
QuestionQuestion
The primary distinction between product and period costs is . . .
a. Product costs are expensed in the periodincurred.
b. Product costs are directly traceable toproduct units.
c. Product costs are inventoriable.
d. Period costs are inventoriable.
QuestionQuestion
Finished GoodsBeginning Inventory
Cost of GoodsManufactured
FinishedGoodsEnding
Inventory
RawMaterialsBeginningInventory
RawMaterials
Purchases
Raw MaterialsEnding Inventory
Costof
GoodsSold
Work in ProcessBeginning Inventory
Direct Labor
FactoryOverhead
Raw MaterialsUsed
Sales activityProduction activityMaterialsactivity
Flow of Manufacturing ActivitiesFlow of Manufacturing Activities
Work in ProcessEnding Inventory
Cost of all goods completed and transferred Cost of all goods completed and transferred from work in process to finished goods from work in process to finished goods
during a reporting period.during a reporting period.
Direct Materials UsedDirect Materials Used++ Direct LaborDirect Labor++ Factory OverheadFactory Overhead== Total Manufacturing CostsTotal Manufacturing Costs++ Beginning Work in ProcessBeginning Work in Process–– Ending Work in ProcessEnding Work in Process== Cost of Goods ManufacturedCost of Goods Manufactured
Statement of Cost of Goods ManufacturedStatement of Cost of Goods Manufactured
Let’s take a look at Rocky
Mountain Bikes’Statement of Cost
of Goods Manufactured.
Statement of Cost of Goods ManufacturedStatement of Cost of Goods Manufactured
ROCKY MOUNTAIN BIKES
Statement of Cost of Goods Manufactured
For Year Ended 31 December 2005
Direct materials used in production 85,500$
Direct labor 60,000
Total factory overhead costs 30,000
Total manufacturing costs for the period 175,500$
Add: Beginning work in process inventory 2,500
Total cost of work in process 178,000$
Less: Ending work in process inventory 7,500
Cost of goods manufactured 170,500$
Statement of Cost of Goods ManufacturedStatement of Cost of Goods Manufactured
ROCKY MOUNTAIN BIKES
Statement of Cost of Goods Manufactured
For Year Ended 31 December 2005
Direct materials used in production 85,500$
Direct labor 60,000
Total factory overhead costs 30,000
Total manufacturing costs for the period 175,500$
Add: Beginning work in process inventory 2,500
Total cost of work in process 178,000$
Less: Ending work in process inventory 7,500
Cost of goods manufactured 170,500$
Exh.
18-16
Computation of Cost of Direct Material Used
Beginning raw materials inventory 8,000$
Add: Purchases of raw materials 86,500
Cost of raw materials available for use 94,500$
Less: Ending raw materials inventory 9,000
Cost of direct materials used in production 85,500$
Statement of Cost of Goods ManufacturedStatement of Cost of Goods Manufactured
ROCKY MOUNTAIN BIKES
Statement of Cost of Goods Manufactured
For Year Ended 31 December 2005
Direct materials used in production 85,500$
Direct labor 60,000
Total factory overhead costs 30,000
Total manufacturing costs for the period 175,500$
Add: Beginning work in process inventory 2,500
Total cost of work in process 178,000$
Less: Ending work in process inventory 7,500
Cost of goods manufactured 170,500$
Include all direct labor costs incurred during the
current period.
Statement of Cost of Goods ManufacturedStatement of Cost of Goods Manufactured
ROCKY MOUNTAIN BIKES
Statement of Cost of Goods Manufactured
For Year Ended 31 December 2005
Direct materials used in production 85,500$
Direct labor 60,000
Total factory overhead costs 30,000
Total manufacturing costs for the period 175,500$
Add: Beginning work in process inventory 2,500
Total cost of work in process 178,000$
Less: Ending work in process inventory 7,500
Cost of goods manufactured 170,500$
Computation of Total Manufacturing Overhead
Indirect labor 9,000$
Factory supervision 6,000
Factory utilities 2,600
Property taxes, factory building 1,900
Factory supplies used 600
Factory insurance expired 1,100
Depreciation, building and equipment 5,300
Other factory overhead 3,500
Total factory overhead costs 30,000$
Statement of Cost of Goods ManufacturedStatement of Cost of Goods Manufactured
ROCKY MOUNTAIN BIKES
Statement of Cost of Goods Manufactured
For Year Ended 31 December 2005
Direct materials used in production 85,500$
Direct labor 60,000
Total factory overhead costs 30,000
Total manufacturing costs for the period 175,500$
Add: Beginning work in process inventory 2,500
Total cost of work in process 178,000$
Less: Ending work in process inventory 7,500
Cost of goods manufactured 170,500$
Beginning work in process inventory is carried over from the
prior period.
Statement of Cost of Goods ManufacturedStatement of Cost of Goods Manufactured
ROCKY MOUNTAIN BIKES
Statement of Cost of Goods Manufactured
For Year Ended 31 December 2005
Direct materials used in production 85,500$
Direct labor 60,000
Total factory overhead costs 30,000
Total manufacturing costs for the period 175,500$
Add: Beginning work in process inventory 2,500
Total cost of work in process 178,000$
Less: Ending work in process inventory 7,500
Cost of goods manufactured 170,500$
Ending work in process inventory contains the cost of unfinished
goods, and is reported in the current assets section of the balance sheet.
Statement of Cost of Goods ManufacturedStatement of Cost of Goods Manufactured
CHAPTER 3CHAPTER 3
DIRECT COSTDIRECT COST
Direct CostingDirect Costing
Alternative method of costingAlternative method of costing
Relatively newRelatively new
More useful costing method for management More useful costing method for management
planning and decision makingplanning and decision making
Also know as variable costing as most direct costs Also know as variable costing as most direct costs
are variable with respect to level activitiesare variable with respect to level activities
Main difference between Main difference between ‘‘absorptionabsorption’’
costing and direct costing is in the costing and direct costing is in the
treatment of fixed manufacturing overheadtreatment of fixed manufacturing overhead
Treatment of Fixed Manufacturing Treatment of Fixed Manufacturing
OverheadOverhead
Fixed manufacturing costs is not treated as a Fixed manufacturing costs is not treated as a product cost instead it is treated as a period costproduct cost instead it is treated as a period cost
That is, it is written off (expensed) in the period in which That is, it is written off (expensed) in the period in which
it is incurred rather than included as a cost when it is incurred rather than included as a cost when determining the cost of inventory determining the cost of inventory
If fixed manufacturing costs are excluded from the cost of If fixed manufacturing costs are excluded from the cost of inventory when using direct costing then inventory @ end inventory when using direct costing then inventory @ end of an accounting period will be lower than the value is of an accounting period will be lower than the value is
using absorption costing this will effect both the balance using absorption costing this will effect both the balance sheet and profits sheet and profits
ST 10.1ST 10.1Mts Manufactured 9000
Mts Sold 8600
Direct Materials 42,300.00$ 4.70$
Direct Labour 54,000.00$ 6.00$
Fixed Factory overhead 72,000.00$ 8.00$
Variable factory overhead 36,000.00$ 4.00$
204,300.00$ 22.70$
22.70$
Manufacturing cost per metre
Total costs 204,300.00$
Number of Metres produced 9,000
Manufacturing cost per metre 22.70$
Product cost using absorption costing
Direct material costs 42,300.00$
Direct labour costs 54,000.00$
Fixed Factory overhead 72,000.00$
Variable factory costs 36,000.00$
Product cost using absorption costing 204,300.00$
Product cost using direct costing
Direct material costs 42,300.00$
Direct labour costs 54,000.00$
Variable factory costs 36,000.00$
Product cost using direct costing 132,300.00$
ST 1ST 1
Value of closing inventory using absorption costing
Metres Produced 9,000
less Metres sold 8,600
Closing Stock 400
Product cost/no of metres produced 22.70$ cost per metre
Value of closing inventory using absorption costing 9,080.00$
Value of closing inventory using direct costing
Metres Produced 9,000
less Metres sold 8,600
Closing Stock 400
Product cost/no of metres produced 14.70$ cost per metre
Value of closing inventory using direct costing 5,880.00$
St.2St.2Sales 462,500
Less COGS
Opening Inventory -
Cost of production
Direct materials Used 97,000
Direct labour used 64,020
Variable factory overhead incurred 54,320
Fixed factory overhead 106,700
322,040
Less Closing inventory 14,940 307,100
Gross profit 155,400
Less Operating expenses
Marketing Expenses 45,325
Administrative Expense 92,500
Financial Expense 9,460 147,285
Net profit 8,115
Closing inventory
Production 19400 units
Sale 18500 units
Closing inventory 900 units
Costof production/# of production units 16.60$ per unit
322040/19400
Closing inventory 14,940.00$
ST.3ST.3
Sales 462,500
Less Variable Costs
Opening Inventory -
Cost of production
Direct materials Used 97,000
Direct labour used 64,020
Variable factory overhead incurred 54,320
215,340
Less Closing inventory 9,990 205,350
Contribution Margin 257,150
Less Fixed Costs
Manufacturing 106,700
Marketing Expenses 45,325
Administrative Expense 92,500
Financial Expense 9,460 253,985
Net profit 3,165
Closing inventory
Production 19400 units
Sale 18500 units
Closing inventory 900 units
Costof production/# of production units 11.10$ per unit
215340/19400
Closing inventory 9,990.00$
Reconciliation of reported profits Reconciliation of reported profits
–– absorption and direct costingabsorption and direct costing
The difference in profits between the absorption The difference in profits between the absorption and direct costing is caused by the amount of and direct costing is caused by the amount of fixed overhead in the opening and closing fixed overhead in the opening and closing inventories because they are excluded when using inventories because they are excluded when using direct costingdirect costing
To reconcile profits using absorption costing to To reconcile profits using absorption costing to profits using direct costing you add back fixed profits using direct costing you add back fixed costs in opening inventory using absorption costs in opening inventory using absorption costing and deduct fixed costs in closing inventory costing and deduct fixed costs in closing inventory using absorption costingusing absorption costing
Self test problem 4Self test problem 4
Part aPart a
Absorption Costing
August September
Product Costs
Directy materials 5000 5500
Direct labour 25000 27500
Variable manufacturing overheads 5000 5500
Fixed manufacturing overheads 44000 44000
79000 82500
no of litres produced 100000 110000
cost per litre 0.79$ 0.75$
Self test problem 4Self test problem 4
Part bPart bRevenue Statement using the Absorption Costing Method
August September Total
Sales (sale price * # of litres sold) 117,600 117,600.00$ 235200
0
Less COGS 0
Opening Inventory 15,800 17,380 15,800
Cost of production 0
Direct materials Used 5000 5500 10500
Direct labour used 25000 27500 52500
Variable factory overhead incurred 5000 5500 10500
Fixed factory overhead 44000 44000 88000
94,800 99,880 177,300
Less Closing inventory 17,380 25,500 25,500
77,420 74,380 151800
Gross profit 40,180 43,220 83400
Less Operating expenses 0
Selling & Administrative expenses 30,000 30,000 60000
Net profit 10,180 13,220 23400
3,040
Closing inventory
Opening Stock 20,000 22,000
add Production 100000 110000
less Sale 98000 98000
Closing inventory 22,000 ltrs 34,000 ltrs
Cost of production/# of production units 0.79$ 0.75$
79000/100000 84080/110000
Closing inventory 17,380.00$ 25,500.00$
Self test problem 4Self test problem 4
Part CPart C
Variance in Profit b/w August & September
Variance is due to the amount of fixed factory overhead component of cost of goods sold
August September
Fixed production costs 44000 44000
Production in ltrs 100000 110000
Fixed costs per litre 0.44$ 0.40$
Fixed costs in opening inventory
opening inventory (ltrs)* fixed cost per ltr 8,800.00$ 9680 ( Aug closing balance)
Fixed costs incurred 44000 44000
Less fixed cost in closing inventory
closing inventory (ltrs)* fixed cost per ltr 9680 13600
43,120.00$ 40080
difference b/w sept & Aug 3040
equals defference in net profit
ST 4 Part DST 4 Part DRevenue Statement using the Direct Costing Method
August September Total
Sales (sale price * # of litres sold) 117,600 117,600 - 235200
Less Variable Costs
Opening Inventory (variable component only) 7,000 7,700 7000
Cost of production
Direct materials Used 5,000 5500 10500
Direct labour used 25,000 27500 52500
Variable factory overhead incurred 5,000 5500 10500
42,000 46,200 80500
Less Closing inventory 7,700 11,900.00$ 11,900.00$
34,300 34,300 68,600.00$
Contribution margin 83,300 83,300 166600
Less Fixed Costs 0
Manufacturing 44,000 44,000 88000
Selling & Admin Exp 30,000 30,000 60000
74,000 74000 148000
Net profit 9,300 9,300 18600
Closing inventory
Opening Stock 20,000 22,000
add Production 100000 110000
less Sale 98000 98000
Closing inventory 22,000 ltrs 34,000 ltrs
Cost of production/# of production units 0.35$ 0.35$
35000/100000) (38500)/110000
Closing inventory 7,700.00$ 11,900.00$
ST4 part (e)ST4 part (e)
Net profit using absorption costing 10,180 13,220 add Fixed costs in opening inventory
using absorption costing 8,800.00$ 9680
18,980 22,900 Less Fixed costs in closing inventory
using absorption costing 9680 13600
Net Profit using direct costing 9,300 9,300
Reporting variable marketing and Reporting variable marketing and
administrative expenseadministrative expense –– direct costingdirect costing
Revenue statement using direct costing:Revenue statement using direct costing:
Is divided into 2 main areasIs divided into 2 main areas
Variable costs and fixed expensesVariable costs and fixed expenses
Shows Variable Shows Variable nonnon-- manufacturingmanufacturing expenses expenses
and fixed non manufacturing expenses and fixed non manufacturing expenses
separately separately
Shows the variable Shows the variable nonnon-- manufacturingmanufacturing
expenses after the variable COGS expenses after the variable COGS
(manufacturing exp) but before the net (manufacturing exp) but before the net
contribution margin linecontribution margin line
ST.5ST.5 $ $ $
Sales 274,543
Less Variable costs
Cost of goods sold
Inventory 1 July 26,485
Variable costs of production
Diect materials 45,965
Direct labour 46,980
Variable factory overheads 22,698 115,643
142,128
Less Inventory 30 June 25,660 116,468
Gross contribution Margin 158,075
less variable marketing expense 16,258
Net Contribution Margin 141,817
less Fixed Costs
Factory Overhead 72,458
Marketing & Admin Exp 57,632 130,090
Net Profit 11,727
Revenue Statements with applied Revenue Statements with applied
factory overheadsfactory overheads
There may be a variance between factory There may be a variance between factory overheads applied and actual factory overheads overheads applied and actual factory overheads incurredincurred
Any underAny under--oror--overover--applied overhead may be applied overhead may be added or subtracted from the COGSadded or subtracted from the COGS
In absorption costing the underIn absorption costing the under--oror--overover--appliedappliedoverhead may include both variable and fixed overhead may include both variable and fixed elementselements
However in direct costing However in direct costing underunder-- oror-- over applied over applied overhead will only include variable fixed overhead overhead will only include variable fixed overhead as the fixed overhead is not applied but written as the fixed overhead is not applied but written off as a period cost off as a period cost
ST 6 Part AST 6 Part A
Product cost using direct costing
Direct material costs 2.00$
Direct labour costs 1.50$
Variable factory costs 1.00$
Product cost using direct costing 4.50$
Product cost using absorption costing
Direct material costs 2.00$
Direct labour costs 1.50$
Variable factory overheads 1.00$
Fixed factory overhead 2.50$ 75000/30000(normal capacity)
Product cost using absorption costing 7.00$
ST 6 Part B Calculations ST 6 Part B Calculations
Calculations July August
Value of Opening & Closing inventory using absorption costing
Opening Stock In Units 4,000.00 6,000.00
Unit Cost 7.00$ 7.00$
28,000.00$ 42,000.00$
Closing Stock 6,000.00 3,000.00
Unit Cost 7.00$ 7.00$
42,000.00$ 21,000.00$
Value of Opening & Closing inventory using direct costing
Opening Stock In Units 4,000.00 6,000.00
Unit Cost 4.50$ 4.50$
18,000.00$ 27,000.00$
Closing Stock 6,000.00 3,000.00
Unit Cost 4.50$ 4.50$
27,000.00$ 13,500.00$
Under- or over-applied fixed factory overhead
Budgeted & Actual fixed overhead 75,000.00$ 75000
Fixed overhead applied (32000*$2.50) 80,000.00$ 72500 29000*$2.50
Under- or (over) applied fixed overhead 5,000.00-$ 2500
overapplied underapplied
ST 6 Part BST 6 Part B
Revenue statements using absorption costing
Sales (Sales in Quantity * $9) 270,000.00$ 288000
Less COGC
Inventory @ Beginning (@ $7) 28,000.00$ 42,000.00$
Cost of production (units produced *$7) 224,000.00$ 203,000.00$
252,000.00$ 245,000.00$
Less Closing inventory 42,000.00$ 21,000.00$
210,000.00$ 224,000.00$
Add Under/ over applied Overhead 5,000.00-$ 2500
205,000.00$ 226,500.00$
Gross profit 65,000.00$ 61,500.00$
Less Marketing & Admin costs
Variable ( Units sold *.3) 9,000.00$ 9,600.00$ Fixed 36,000.00$ 36,000.00$
45,000.00$ 45,600.00$
Net profit 20,000.00$ 15,900.00$
ST 6 Part CST 6 Part C
Revenue statements using direct costing
Sales (Sales in Quantity * $9) 270,000.00$ 288000
Less COGC
Inventory @ Beinginning @ $4.5 18,000.00$ 27,000.00$
Cost of production (units produced *$4.5) 144,000.00$ 130,500.00$
162,000.00$ 157,500.00$
Less Closing inventory 27,000.00$ 13,500.00$
135,000.00$ 144,000.00$
Gross contribution margin 135,000.00$ 144,000.00$
Less Variable Costs
VariableMarketing Costs ( Units sold *.3) 9,000.00$ 9,600.00$
Contribution Margin 126,000.00$ 134,400.00$
Less Fixed Costs
Manufacturing Costs 75,000.00$ 75,000.00$
Fixed marketing, admin & finance 36,000.00$ 36,000.00$
111,000.00$ 111,000.00$
Net profit 15,000.00$ 23,400.00$
ST 6 Part DST 6 Part D
Net profit using absorption costing 20,000 15,900
add Fixed costs in opening inventory using absorption
costing4000 units @ $2.5 10000 15000 6000 units @ $2.5
30,000 30,900
Less Fixed costs in closing inventory using absorption
costing6000 units @ $2.5 15,000.00$ 7,500.00$ 3000 units @ $2.5Net Profit Using Direct costing 15,000.00$ 23,400.00$
ST 6 Part dST 6 Part d
Sales is only one component of ProfitsSales is only one component of Profits
Profits is also affected by the difference Profits is also affected by the difference between Quantity produced and between Quantity produced and Quantity sold.Quantity sold.
Under the absorption method the Under the absorption method the opening stocks of each accounting opening stocks of each accounting period contain a fixed manufacturing period contain a fixed manufacturing component carried forward from the component carried forward from the previous periodprevious period
ST problem 7 (a)ST problem 7 (a)Fixed Factory Overhead Recovery Rate
Budgeted Fixed factory Overhead 150,000$
Budgeted Direct labour Hours 15000
10$ per direct labour hour
Variable Factory Overhead Recovery Rate
Budgeted Variable factory Overhead 45,000$
Budgeted Direct labour Hours 15000
3$ per direct labour hour
Combined Factory overhead rate
Budgeted Fixed factory Overhead 150,000$
Budgeted Variable factory Overhead 45,000$
195,000$
Budgeted Direct labour Hours 15000
13$ per direct labour hour
7(b)7(b)Under- or over-applied combined factory overhead
Actual fixed overhead 154,000.00$
Actual Variable Overhead 48,000.00$
Combined Factory Overhead 202,000.00$
Combined overhead applied (15,000 direct labour
hrs *$13/hr) 195,000.00$
Under-applied fixed overhead 7,000.00$
Under- or over-applied Fixed factory overhead
Actual fixed overhead $154,000.00
Fixed overhead applied (15,000 direct labour hrs
*$10/hr) $150,000.00
Under-applied fixed overhead $4,000.00
Under- or over-applied Variable factory overhead
Actual Variable overhead $48,000.00
Actual variable overhead applied (15,000 direct
labour hrs *$3/hr) $45,000.00
Under-applied fixed overhead $3,000.00
7 c7 c
Calculations
Product cost using absorption costing
Direct material costs 2.00$
Direct labour costs 1.00$
Fixed Factory overhead 5.00$ $10/direct labour hour*15000hours/30000units
Variable factory overheads 1.50$ $3/direct labour hour*15000hours/30000units
Product cost using absorption costing 9.50$
Product cost using direct costing
Direct material costs 2.00$
Direct labour costs 1.00$
Variable factory costs 1.50$
Product cost using direct costing 4.50$
7 c7 c calculations contcalculations cont
WIP Finished goods Total
Value of Opening & Closing inventory using absorption costing
Opening Stock In Units - 4,000.00
Unit Cost 9.50$ 9.50$
-$ 38,000.00$ 38,000.00$
Closing Stock - 8,000.00
Unit Cost 9.50$ 9.50$
-$ 76,000.00$ 76,000.00$
Value of Opening & Closing inventory using direct costing
Opening Stock In Units - 4,000.00
Unit Cost 4.50$ 4.50$
-$ 18,000.00$ 18,000.00$
Closing Stock - 8,000.00
Unit Cost 4.50$ 4.50$
-$ 36,000.00$ 36,000.00$
7 c7 cRevenue statements using absorption costing
Sales 338,000.00$
Less COGC
Inventory @ Beginning 38,000.00$
Cost of production (units produced *$9.5) 285,000.00$
323,000.00$
Less Closing inventory 76,000.00$
247,000.00$
Add Under/ over applied Overhead 7,000.00$
254,000.00$
Gross profit 84,000.00$
Less Marketing & Admin costs 51,380.00$ (18100+33280)
Net profit 32,620.00$
7 d7 dRevenue statements using direct costing
Sales 338,000.00$
Less COGC
Inventory @ Beinginning 18,000.00$
Cost of production (units produced *$4.5) 135,000.00$
153,000.00$
Less Closing inventory 36,000.00$
117,000.00$
Add Underapplied Variable o/head $3,000.00
120,000.00$
Gross contribution margin 218,000.00$
Less Variable Costs
Variable Marketing & Admin Exp 33,280.00$
Contribution Margin 184,720.00$
Less Fixed Costs
Manufacturing Costs (fixed factory o/head) 154,000.00$ actual not budgeted
Fixed- Marketing & admin 18,100.00$
172,100.00$
Net profit 12,620.00$
7 (e)7 (e)Statement of Reconciliation
Net profit using absorption costing 32,620
add Fixed costs in opening inventory using
absorption costing
4000 units @ $5 20000
52,620
Less Fixed costs in closing inventory using
absorption costing
8000 @ $5 40000
12,620.00$
Alternatively
Increase in inventory of 4000 units * fixed Factoy o/h $5 = 20000
(32620-12620) = 20000
Job Costing & Direct CostingJob Costing & Direct Costing
Direct costing can be:Direct costing can be:integrated with job, process or operation integrated with job, process or operation costingcosting
Used together with standard costing and Used together with standard costing and activity based costingactivity based costing
Fixed manufacturing overhead is debited Fixed manufacturing overhead is debited to the general ledger to an account to the general ledger to an account called fixed factory overheadcalled fixed factory overhead
CHAPTER 4CHAPTER 4
INDIRECT COSTINDIRECT COST
Costing for indirect costsCosting for indirect costs
On completion of this topic you should be able On completion of this topic you should be able
toto
Calculate the total cost of a cost unit using Calculate the total cost of a cost unit using
absorption costing methodsabsorption costing methods
Describe the problems associated with Describe the problems associated with
apportioning and absorbing indirect costsapportioning and absorbing indirect costs
Independent studyIndependent study
Progress test and practice question(s) as setProgress test and practice question(s) as set
The Story So Far The Story So Far ……
Absorption costingAbsorption costing isis ‘‘a method of costing that, in a method of costing that, in
addition to direct costs, assigns a proportion or all the addition to direct costs, assigns a proportion or all the
production overheads to the cost units. Costs are first production overheads to the cost units. Costs are first
allocated or apportioned to the cost centres, where allocated or apportioned to the cost centres, where
they are absorbed into the cost unit using one or more they are absorbed into the cost unit using one or more
absorption ratesabsorption rates’’ (Collis and Hussey, 2007, p. 241)(Collis and Hussey, 2007, p. 241)
The purpose of absorption costing is to find the The purpose of absorption costing is to find the total total
costcost of a cost unit for valuing stock, planning and of a cost unit for valuing stock, planning and
controlling production costs and determining the controlling production costs and determining the
selling priceselling price
TheThe absorption approachabsorption approach is used by is used by
many firms and is a costing approach many firms and is a costing approach
that considers all factory overhead (both that considers all factory overhead (both
variable and fixed) to be product variable and fixed) to be product
((inventoriableinventoriable) costs that become an ) costs that become an
expense in the form of manufacturing expense in the form of manufacturing
cost of goods sold only as sales occur.cost of goods sold only as sales occur.
The Story So Far The Story So Far ……
Main stages in absorption costing Main stages in absorption costing
Identify cost centres according to their function
(eg production department)
Collect indirect costs in cost centres
on the basis of allocation or apportionment
Determine overhead absorption rate (OAR)
for each production cost centre (eg cost per machine hour)
Charge indirect costs to products using OAR and a measure
of the product’s consumption of the cost centre’s cost
Overhead analysisOverhead analysis
The first stage in absorption costing is to prepare The first stage in absorption costing is to prepare
anan overhead analysis overhead analysis which shows the allocation which shows the allocation
or apportionment of the production overheads to or apportionment of the production overheads to
the production cost centresthe production cost centres
In the previous lecture we carried out an overhead In the previous lecture we carried out an overhead
analysis for Cotswold Coolers, which allocated analysis for Cotswold Coolers, which allocated
and apportioned the total production overheads of and apportioned the total production overheads of
££97,400 between the bottling department and the 97,400 between the bottling department and the
warehouse on what was considered to be a fair warehouse on what was considered to be a fair
basisbasis ……
Cotswold CoolersCotswold Coolers
Overhead analysisOverhead analysis
Overhead Total £
Basis Bottling £
Warehouse£
Indirect materials 1,500 Allocated 900 600Indirect labour 45,000 No. of employees 30,000 15,000Rent and rates 27,000 Area 9,000 18,000Electricity 6,000 Area 4,000 2,000Depreciation 8,000 Value of machinery 6,000 2,000Supervision 21,000 No. of employees 14,000 7,000Stock insurance 500 Value of stock 100 400Total 109,000 64,000 45,000
Production Overhead AbsorptionProduction Overhead Absorption
The next stage is to find a means of absorbing the The next stage is to find a means of absorbing the
production overheads for each cost centre into the production overheads for each cost centre into the
cost units passing through themcost units passing through them
An overhead absorption rate (OAR) is An overhead absorption rate (OAR) is ‘‘a means of a means of
attributing production overheads to a product or attributing production overheads to a product or
serviceservice’’ (Collis and Hussey, 2007, p. 241)(Collis and Hussey, 2007, p. 241)
The three most commonly used OARs areThe three most commonly used OARs are
The cost unit overhead absorption rateThe cost unit overhead absorption rate
The direct labour hour overhead absorption rateThe direct labour hour overhead absorption rate
The machine hour overhead absorption rateThe machine hour overhead absorption rate
Exercise 1Exercise 1
Cost unit OARCost unit OAR
TheThe cost unit cost unit OAROAR is the simplest to use and the is the simplest to use and the
formula isformula is
Cost centre overheadsCost centre overheads
Number of cost units passing throughNumber of cost units passing through
104,000 units were produced during the period104,000 units were produced during the period
Production overheads were Production overheads were ££64,000 for the 64,000 for the
bottling department and bottling department and ££45,000 for the 45,000 for the
warehousewarehouse
RequiredRequired
Using the formula, calculate the cost unit OAR Using the formula, calculate the cost unit OAR
for each cost centrefor each cost centre
Solution 1Solution 1
Cost unit OARCost unit OAR
££0.43 per 0.43 per
unitunit££0.62 per 0.62 per
unitunitCost unit OARCost unit OAR
104,000104,000104,000104,000Number of cost Number of cost
unitsunits
££45,00045,000££64,00064,000Cost centre Cost centre
overheadoverhead
WarehouseWarehouseBottlingBottlingFormulaFormula
Ros has decided to use the cost unit OAR to absorb thewarehouse production overheads into the cost of a bottle of water (the cost unit)
Direct Labour Hour OARDirect Labour Hour OAR
An alternative is the An alternative is the labour hour labour hour OAROAR
Cost centre overhead costsCost centre overhead costs
Total direct labour hoursTotal direct labour hours
Cotswold Coolers cannot use this OAR because the Cotswold Coolers cannot use this OAR because the
firm does not use a pay scheme that is linked firm does not use a pay scheme that is linked
directly to the productdirectly to the product
The labour hour OAR is typically used to absorb The labour hour OAR is typically used to absorb
production overheads where the firm operates a production overheads where the firm operates a
timetime--based pay scheme and the level of direct based pay scheme and the level of direct
labour hours in production cost centre is highlabour hours in production cost centre is high
Exercise 2Exercise 2
Machine hour OARMachine hour OAR
An alternative is the An alternative is the machine hour machine hour OAROAR
Cost centre overhead costsCost centre overhead costs
Total machine hoursTotal machine hours
104,000 units were produced during the period104,000 units were produced during the period
Production overheads were Production overheads were ££64,000 for the 64,000 for the bottling department and bottling department and ££45,000 for the 45,000 for the warehousewarehouse
Total machine hours were 16,000 for the bottling Total machine hours were 16,000 for the bottling department and 2,000 for the warehousedepartment and 2,000 for the warehouse
RequiredRequired
Using the formula, calculate the machine hour Using the formula, calculate the machine hour OAR for each cost centreOAR for each cost centre
Solution 2Solution 2
Machine hour overhead absorption rateMachine hour overhead absorption rate
££22.50 per 22.50 per
m/hourm/hour££4.00 per 4.00 per
m/hourm/hourMachine hour Machine hour
OAROAR
2,0002,00016,00016,000Total machine Total machine
hourshours
££45,00045,000££64,00064,000Cost centre Cost centre
overheadoverhead
WarehouseWarehouseBottlingBottlingFormulaFormula
To reflect the high number of machine hours in the bottlingdepartment, Ros has decided to use the machine hour OAR for absorbing the production overheads into the cost of a bottle of water (the cost unit)
Exercise 3Exercise 3
Production cost per unitProduction cost per unit
Direct costs per unit areDirect costs per unit are
Mineral water Mineral water ££0.30; bottle, lid and label 0.30; bottle, lid and label ££0.750.75
The OAR in the bottling department will be The OAR in the bottling department will be
££4.00 per machine hour (from Exercise 2)4.00 per machine hour (from Exercise 2)
The OAR in the warehouse will be The OAR in the warehouse will be ££0.430.43
per unit (from Exercise 1)per unit (from Exercise 1)
RequiredRequired
Complete the production cost statement and Complete the production cost statement and
calculate the production cost per unitcalculate the production cost per unit
Pro formaPro forma Cotswold CoolersCotswold Coolers
Production cost statement (1 unit)Production cost statement (1 unit)
£ £Direct materials Mineral water 0.30 Bottle, lid and label 0.75
Prime cost ?Production overheads Bottling dept ? Warehouse ? ?
Production cost ?
Solution 3Solution 3
Cotswold CoolersCotswold Coolers
Production cost statement (1 unit)Production cost statement (1 unit)
£ £Direct materials Mineral water 0.30 Bottle, lid and label 0.75Prime cost 1.05Production overheads Bottling dept (0.15 machine hour x £4.00) 0.60 Warehouse (cost unit OAR) 0.43 1.03Production cost 2.08
Exercise 4Exercise 4
Apportioning nonApportioning non--production overheadsproduction overheads
The final step is to apportion the nonThe final step is to apportion the non--production production overheads (eg administration, selling and overheads (eg administration, selling and distribution, research and development costs)distribution, research and development costs)
A simple method is to add a percentage based on A simple method is to add a percentage based on the following formulathe following formula
NonNon--production overheadsproduction overheads x 100x 100
Production costProduction cost
RequiredRequired
Using the formula, calculate the percentage if Using the formula, calculate the percentage if nonnon--production overheads are production overheads are ££43,250 and the 43,250 and the production cost is production cost is ££216,320216,320
Solution 4Solution 4
Apportioning nonApportioning non--production overheadsproduction overheads
NonNon--production overheads are production overheads are ££43,250 and the 43,250 and the
production cost is production cost is ££216,320216,320
NonNon--production overheadsproduction overheads x 100x 100
Production costProduction cost
== ££43,25043,250 x 100x 100
££216,320216,320
= 20% of production cost= 20% of production cost
If we also add a If we also add a gross profit mark upgross profit mark up of 50% of the of 50% of the
production cost, we can production cost, we can calculate the selling price calculate the selling price ……
Cotswold CoolersCotswold Coolers
Total cost (1 unit)Total cost (1 unit)
£ £Direct materials
Mineral water 0.30Bottle, lid and label 0.75
Prime cost 1.05Production overheads
Bottling dept (0.15 machine hour x £4.00) 0.60Warehouse (cost unit OAR) 0.43 1.03
Production cost 2.08Non-production overheads (£2.08 x 20%) 0.42Total cost 2.50Profit (£2.08 x 50%) 1.04Selling price 3.54
Using predetermined absorption ratesUsing predetermined absorption rates
NormallyNormally predetermined overhead absorption rates predetermined overhead absorption rates (based on estimates) are used because the actual (based on estimates) are used because the actual
figures are not available until the end of the periodfigures are not available until the end of the period
Where the predetermined overheadWhere the predetermined overhead that has beenthat has been
absorbed is higher than the actual overhead, the absorbed is higher than the actual overhead, the
variance is known as variance is known as overabsorptionoverabsorption and this and this
reduces expenses in the profit and loss accountreduces expenses in the profit and loss account
Where the predetermined overhead that has beenWhere the predetermined overhead that has been
absorbed is lower than the actual overhead, the absorbed is lower than the actual overhead, the
variance is known as variance is known as underabsorptionunderabsorption and this and this
increases expenses in the profit and loss accountincreases expenses in the profit and loss account
INCOME STATEMENTINCOME STATEMENT
TheThe income statementincome statement oror profit and loss profit and loss
statementstatement summarizes the firmsummarizes the firm’’s revenues and s revenues and
expenses over a period of time (a month, a expenses over a period of time (a month, a
quarter, or a year)quarter, or a year)
The income statement is used to evaluate The income statement is used to evaluate
revenue and expenses that occur in the interval revenue and expenses that occur in the interval
between consecutive balance sheet statements.between consecutive balance sheet statements.
RevenuesRevenues –– Expenses = Net Profit (Loss)Expenses = Net Profit (Loss)
Here is an example of an Income StatementHere is an example of an Income Statement10,78010,780Total operating incomeTotal operating income
17,25017,250Total operating expenseTotal operating expense
510510Lease paymentsLease payments
900900General and administrativeGeneral and administrative
18501850DepreciationDepreciation
930930Selling and promotionSelling and promotion
22802280Indirect CostsIndirect Costs
46404640MaterialsMaterials
61406140LaborLabor
Cost of Goods and Services SoldCost of Goods and Services Sold
Operating ExpensesOperating Expenses
28,03028,030Total Operating RevenuesTotal Operating Revenues
--870870(minus) returns and (minus) returns and
allowancesallowances
$28,900$28,900
SalesSales
Operating RevenuesOperating Revenues
Operating Revenues and Operating Revenues and
ExpensesExpenses
$7,310$7,310Net Profit (loss) for year 2005Net Profit (loss) for year 2005
3,9303,930Income Taxes (35%)Income Taxes (35%)
11,24011,240Net Income Before TaxesNet Income Before Taxes
460460Total NonTotal Non--operating incomeoperating income
--120120(minus) Interest payments(minus) Interest payments
180180Interest Interest
receiptsreceipts
$400$400RentsRents
NonNon--operating Revenues and operating Revenues and
ExpensesExpenses
10,78010,780Total operating incomeTotal operating income
SOME FINANCIAL RATIOS DERIVED SOME FINANCIAL RATIOS DERIVED
FROM INCOME STATEMENTFROM INCOME STATEMENT
Interest Coverage = Total Income / Interest paymentsInterest Coverage = Total Income / Interest payments
(28,610 (28,610 --17,250) /120 = 94.717,250) /120 = 94.7
Net profit ratio = Net profit / Net sales revenueNet profit ratio = Net profit / Net sales revenue
7,310 / 28,030 = 0.261 = 26.1%7,310 / 28,030 = 0.261 = 26.1%
TRADITIONAL COST ACCOUNTINGTRADITIONAL COST ACCOUNTING
Direct Costs:Direct Costs:
Direct material :Direct material : all material that is used in all material that is used in manufacturing a productmanufacturing a product
Direct labor:Direct labor: wages of the direct touch labor needed wages of the direct touch labor needed to build one unit to build one unit
Indirect Costs:Indirect Costs: also known as overheadalso known as overhead
Shipping and receivingShipping and receiving
Quality controlQuality control
EngineeringEngineering
Rent, Insurance, etcRent, Insurance, etc
All other expenses which are not direct labor or direct All other expenses which are not direct labor or direct materialmaterial
ABSORPTION COSTINGABSORPTION COSTING
To allocate indirect cost (OH) to different To allocate indirect cost (OH) to different products accountants use quantities such as products accountants use quantities such as directdirect--labor hours, directlabor hours, direct--labor cost, material labor cost, material cost, or total direct cost as the metric.cost, or total direct cost as the metric.
For example, if direct laborFor example, if direct labor--hours is the metric hours is the metric to use, then overhead will be allocated based to use, then overhead will be allocated based on overhead dollar per directon overhead dollar per direct--labor hour.labor hour.
Then each product will Then each product will absorb absorb (or be (or be allocated) overhead costs, based on the direct allocated) overhead costs, based on the direct labor hours it consumes. labor hours it consumes.
ABSORPTION COSTINGABSORPTION COSTING
RRii*total direct *total direct
cost per unitcost per unit$OH/total $OH/total
Direct costDirect costTotal direct Total direct
costcost
RRii*DM cost per *DM cost per
unitunit$OH/total DM $OH/total DM
costcostDM costDM cost
RRii*DL cost per *DL cost per
unitunit$OH/total DL $OH/total DL
costcostDL costDL cost
RRii*DL hours *DL hours
per unitper unit$OH/total DL $OH/total DL
hourshoursDL hoursDL hours
Unit allocation Unit allocation
of OH costof OH costUnit allocation Unit allocation
rate rate RateRate,, RRii
Metric, iMetric, i
ExampleExampleTotal Overhead is $850,000Total Overhead is $850,000
$900$900$550$550Materials cost Materials cost
(each)(each)
$500$500$400$400Labor cost Labor cost
(each)(each)
400400750750Number of Number of
Units per yearUnits per year
PremiumPremiumStandardStandard
ExampleExampleTotal Overhead is $850,000Total Overhead is $850,000
$900$900$550$550Materials cost Materials cost
(each)(each)
$500,000$500,000$200,000$200,000$300,000$300,000Total labor costTotal labor cost
$360,000$360,000
$500$500
400400
PremiumPremium
$772,500$772,500
TotalTotal
$412,500$412,500Total materials costTotal materials cost
$400$400Labor cost (each)Labor cost (each)
750750Number of Units Number of Units
per yearper year
StandardStandard
ExampleExampleTotal Overhead is $850,000Total Overhead is $850,000
$1.100324$1.100324$1.100324$1.100324Overhead Overhead
materialmaterial
$850,000$850,000$340,000$340,000$510,000$510,000Allocation by laborAllocation by labor
$360,000$360,000$412,000$412,000Material costMaterial cost
$396,117$396,117
1.701.70
$200,000$200,000
PremiumPremium
$850,000$850,000
$500,000$500,000
TotalTotal
$453,884$453,884Allocation by Allocation by
materialmaterial
1.701.70Overhead/laborOverhead/labor
$300,000$300,000Labor costLabor cost
StandardStandard
Unit cost based on $DL allocation of OHUnit cost based on $DL allocation of OH
500*1.70 = 850500*1.70 = 850400*1.70 = 680400*1.70 = 680OH (DL cost.)OH (DL cost.)
2250225016301630Unit costUnit cost
500500400400DLDL
900900550550DMDM
PremiumPremiumStandardStandard
Unit cost based on $DM allocation of OHUnit cost based on $DM allocation of OH
900*1.100 = 900*1.100 =
990990550*1.100 = 550*1.100 =
605605OH (DM cost.)OH (DM cost.)
2390239015551555Unit costUnit cost
500500400400DLDL
900900550550DMDM
PremiumPremiumStandardStandard
CONCLUSIONSCONCLUSIONS
Direct costs are allocated to the cost unitDirect costs are allocated to the cost unit
Production overheads are allocated or apportioned Production overheads are allocated or apportioned to the cost centres on a fair basis and absorbed to the cost centres on a fair basis and absorbed into the cost unit using an appropriate OARinto the cost unit using an appropriate OAR
NonNon--production overheads can be absorbed into production overheads can be absorbed into the cost unit by adding a percentage based on the the cost unit by adding a percentage based on the proportion of nonproportion of non--production overheads to the production overheads to the total production costtotal production cost
But a limitation of absorption costing is that it is But a limitation of absorption costing is that it is based on arbitrary decisions about the basis for based on arbitrary decisions about the basis for apportionment and absorption of overheadsapportionment and absorption of overheads
CHAPTER 5CHAPTER 5
MARGINAL COSTMARGINAL COST
Using direct (marginal) costingUsing direct (marginal) costing
for decision makingfor decision making
The Direct Costing method (Marginal costing) is an The Direct Costing method (Marginal costing) is an inventory valuation / costing model that includes inventory valuation / costing model that includes only the variable manufacturing costs:only the variable manufacturing costs:
direct materials (those materials that become an direct materials (those materials that become an integral part of a finished product and can be integral part of a finished product and can be conveniently traced into it)conveniently traced into it)
direct labor (those factory labor costs that can be direct labor (those factory labor costs that can be easily traced to individual units of product. Also easily traced to individual units of product. Also called touch labor)called touch labor)
-- only variable manufacturing overhead in the cost only variable manufacturing overhead in the cost of a unit of product. The entire amount of fixed of a unit of product. The entire amount of fixed costs are expenses in the year incurred.costs are expenses in the year incurred.
What is Direct Costing?What is Direct Costing? The Principles of Marginal CostingThe Principles of Marginal Costing
1.1. For any given period of time, fixed costs will be the For any given period of time, fixed costs will be the
same, for any volume of sales and production same, for any volume of sales and production
(provided that the level of activity is within the (provided that the level of activity is within the ‘‘relevant relevant
rangerange’’). Therefore, selling an extra item of product or ). Therefore, selling an extra item of product or
service:service:
Revenue will increase by the sales value of the item soldRevenue will increase by the sales value of the item sold
Costs will increase by the variable cost per unitCosts will increase by the variable cost per unit
Profit will increase by the amount of contribution earned Profit will increase by the amount of contribution earned
from the extra itemfrom the extra item
2. 2. The volume of sales falls by one item The volume of sales falls by one item the profit will the profit will fall by the amount of contribution earned from the item.fall by the amount of contribution earned from the item.
3.3. Profit measurement should be based on an analysis of Profit measurement should be based on an analysis of
total contribution. Since fixed costs relate to a period of total contribution. Since fixed costs relate to a period of
time, and do not change with increases or decreases in time, and do not change with increases or decreases in
sales volume, it is misleading to charge units of sale sales volume, it is misleading to charge units of sale
with a share of fixed costswith a share of fixed costs
4.4. When a unit of product is made, the extra costs When a unit of product is made, the extra costs
incurred in its manufacture are the variable production incurred in its manufacture are the variable production
costs. Fixed costs are unaffected, and no extra fixed costs. Fixed costs are unaffected, and no extra fixed
costs are incurred when output is increasedcosts are incurred when output is increased
The principles of marginal costingThe principles of marginal costing Features of Marginal costingFeatures of Marginal costing
1. Cost Classification1. Cost Classification
TThe marginal costing technique makes a he marginal costing technique makes a
sharp distinction between variable costs and sharp distinction between variable costs and
fixed costs. It is the variable cost on the fixed costs. It is the variable cost on the
basis of which production and sales policies basis of which production and sales policies
are designed by a firm following the are designed by a firm following the
marginal costing techniquemarginal costing technique
2.2. StockStock//InventoryInventory ValuationValuation
Under marginal costing, inventory/stock for Under marginal costing, inventory/stock for
profit measurement is valued at marginal profit measurement is valued at marginal
cost. It is in sharp contrast to the total unit cost. It is in sharp contrast to the total unit
cost under absorption costing methodcost under absorption costing method
Features of Marginal costingFeatures of Marginal costing
3.3. MarginalMarginal ContributionContribution
Marginal costing technique makes use of Marginal costing technique makes use of
marginal contribution for marking various marginal contribution for marking various
decisions. Marginal contribution is the decisions. Marginal contribution is the
difference between sales and marginal cost. difference between sales and marginal cost.
It forms the basis for judging the It forms the basis for judging the
profitability of different products or profitability of different products or
departmentsdepartments
Features of Marginal costingFeatures of Marginal costing
CostCost--VolumeVolume--Profit AnalysisProfit Analysis
Systematic method of examining the relationship Systematic method of examining the relationship
between changes in activity and changes in total between changes in activity and changes in total
sales revenue, expenses and net profitsales revenue, expenses and net profit
CVP analysis is subject to a number of underlying CVP analysis is subject to a number of underlying
assumptions and limitationsassumptions and limitations
The objective of CVP analysis is to establish what The objective of CVP analysis is to establish what
will happen to the financial results if a specified will happen to the financial results if a specified
level of activity or volume fluctuateslevel of activity or volume fluctuates
CVP Analysis AssumptionsCVP Analysis Assumptions
All other variables remain constantAll other variables remain constant
A single product or constant sales mixA single product or constant sales mix
Total costs and total revenue are linear functions Total costs and total revenue are linear functions
of outputof output
The analysis applies to the relevant range onlyThe analysis applies to the relevant range only
Costs can be accurately divided into their fixed and Costs can be accurately divided into their fixed and
variable elementsvariable elements
The analysis applies only to a shortThe analysis applies only to a short--time horizon time horizon
ComplexityComplexity--related fixed costs do not changerelated fixed costs do not change
CVP DiagramCVP DiagramA Mathematical Approach to A Mathematical Approach to
CVP AnalysisCVP AnalysisNP=NP=PxPx--(a+bx(a+bx),),
NPNP –– net profitnet profit
xx –– units soldunits sold
PP –– selling priceselling price
bb –– unit variable costunit variable cost
aa –– total fixed coststotal fixed costs
BreakBreak--Even and Related FormulasEven and Related Formulas
TRTR ––Profit = FC + VCProfit = FC + VC
Contribution = TR Contribution = TR –– VCVC
Profit = Contribution Profit = Contribution –– FCFC
BreakBreak--eveneven (units)(units) = FC/Contribution per unit= FC/Contribution per unit
BreakBreak--eveneven (sales revenue)(sales revenue) =FC/PV ratio, =FC/PV ratio, wherewhere PVPV
(profit(profit -- volume) ratio = Contribution/Selling volume) ratio = Contribution/Selling
priceprice
Margin of SafetyMargin of Safety
Indicates by how much sales may decrease Indicates by how much sales may decrease
before a loss occursbefore a loss occurs
Margin of safety (units)= Profit/Contribution Margin of safety (units)= Profit/Contribution
per unitper unit
Margin of safety (sales revenue) = Profit/PV Margin of safety (sales revenue) = Profit/PV
ratioratio
RangeRange ofof GGoodsoods PPlanninglanning (1)(1)
40 49040 49014 49014 490101012 00012 000101014 00014 0001414ContributionContribution
4902 0422 04211--3 9343 934--332 3822 38222ProfitProfit
120 010120 01035 45835 458242451 93451 934434332 61832 6183333CostsCosts
40 00040 00012 44812 4486615 93415 934131311 61811 6181212FC (FC (allocatedallocated))
80 01023 01023 010151536 00036 000303021 00021 0002121VCVC
120 50037 50037 500252548 00048 000404035 00035 0003535PricePrice((salessales))
totaltotalperper unitunittotaltotalperper unitunittotaltotalperper unitunit
150015001200120010001000
CCBBAA
28 49028 49014 49014 4901010000014 00014 0001414ContributionContribution
-11 510--6 2006 200--440000--5 3105 310--55ProfitProfit
84 01084 01043 70043 7002929000040 31040 3104040CostsCosts
40 00040 00020 69020 69066000019 31019 3101919FC (FC (allocatedallocated))
44 01023 01023 0101515000021 00021 0002121VCVC
72 50037 50037 5002525000035 00035 0003535PricePrice((salessales))
totaltotalperper unitunittotaltotalperper unitunittotaltotalperper unitunit
150015000010001000
CCBBAA
Increases in Activity Level Increases in Activity Level (unlimited)(unlimited)
61 49061 49014 49014 490101012 00012 000101035 00035 0001414ContributionContribution
11 4902 0422 04211--3 9343 934--3323 38223 382+915022ProfitProfit
161 510161 51035 45835 458242451 93451 934434364 11864 1183333CostsCosts
50 00012 44812 4486615 93415 934131311 61811 618+100001212FC (FC (allocatedallocated))
111 510111 51023 01023 010151536 00036 000303052 50052 500+315002121VCVC
173 000173 00037 50037 500252548 00048 000404087 50087 500+525003535PricePrice((salessales))
totaltotalperper unitunittotaltotalperper unitunittotaltotalincrementincrementperper unitunit
150015001200120025002500
CCBBAA
Increases in Activity Level Increases in Activity Level (limited)(limited)
1200007000TotalTotal labourlabour demanddemand
19000600060007000700060006000DemandDemand inin unitsunits
maxmax hourshours113322RankRank
4,833,334,67ContributionContribution perper hourhour
223333NumberNumber ofof labourlabour hourshours usedused
40 49040 49014 49014 4901012 00012 0001014 00014 00014ContributionContribution
4902 0422 04211--19 87119 871--17172 3822 38222ProfitProfit
120 01035 45835 458242467 87167 871575732 61832 6183333CostsCosts
40 00012 44812 4488831 87131 871272711 61811 6181212FC (FC (allocatedallocated))
80 01023 01023 010151536 00036 000303021 00021 0002121VCVC
120 50037 50037 500252548 00048 000404035 00035 0003535PricePrice((salessales))
totaltotalperper unitunittotaltotalperper unitunittotaltotalperper unitunit
150015001200120010001000
CCBBAA
PricingPricingPrice is 250 $ per unitPrice is 250 $ per unit
choice 1choice 1 better qualitybetter quality ((higher pricehigher price,,higher FChigher FC)) choice 2choice 2 lower pricelower price
25 00025 00025 00025 000CapacityCapacity
20 00020 00015 00015 000BEPBEP
1 440 0001 440 0001201202 000 0002 000 000200200ContributionContribution
1 437 6001201201 997 000200200ProfitProfit
962 400962 40080801 003 0001 003 000100100CostsCosts
2 4002 4003 0003 000FC (FC (allocatedallocated))
960 000960 00080801 000 0001 000 000100100VCVC
2 400 0002 400 0002002003 000 0003 000 000300300PricePrice((salessales))
totaltotalperper unitunittotaltotalperper unitunit
12 00012 00010 00010 000
2211
To PTo Produceroduce oror to Bto Buyuy
00002000020000100100ProfitProfit
1800001800001501501600005050CostsCosts
xxxx100000100000FC (FC (allocatedallocated))
xxxx60000600005050VCVC
180000150150180000180000150150PricePrice((salessales))
totaltotalperper unitunittotaltotalperper unitunit
1200120012001200
BuyBuy ((unlimitedunlimited))ProduceProduce
000000100100ProfitProfit
1500001500001501501500005050CostsCosts
xxxx100000100000FC (FC (allocatedallocated))
xxxx50000500005050VCVC
150000150150150000150000150150PricePrice
totaltotalperper unitunittotaltotalperper unitunit
1000100010001000
BuyBuy ((unlimitedunlimited))ProduceProduce
AdvantagesAdvantages
Direct costing is simple to understand Direct costing is simple to understand
It provides more useful information for decisionIt provides more useful information for decision--makingmaking
Direct costing removes from profit the effect of inventory Direct costing removes from profit the effect of inventory
changeschanges
Is effective in internal reporting for frequent profit Is effective in internal reporting for frequent profit
statements and measurement of managerial performancestatements and measurement of managerial performance
Direct costing avoids fixed overheads being capitalized in Direct costing avoids fixed overheads being capitalized in
unsaleableunsaleable stocksstocks
The effects of alternative sales or production policies can The effects of alternative sales or production policies can
be easier assessed thus the decisions yield the maximum be easier assessed thus the decisions yield the maximum
return to businessreturn to business
By concentration on maintaining a uniform and consistent By concentration on maintaining a uniform and consistent
marginal costmarginal cost practical cost control is greatly facilitatedpractical cost control is greatly facilitated
DisadvantagesDisadvantages
The separation of costs into fixed and variable is difficult The separation of costs into fixed and variable is difficult
and sometimes gives misleading results and sometimes gives misleading results
Direct costing underestimates the importance of fixed costsDirect costing underestimates the importance of fixed costs
Full costing systems also apply overhead under normal Full costing systems also apply overhead under normal
operating volume and this shows that no advantage is operating volume and this shows that no advantage is
gained by direct costinggained by direct costing
Under direct costing, stocks and work in progress are Under direct costing, stocks and work in progress are
understated. The exclusion of fixed costs from inventories understated. The exclusion of fixed costs from inventories
affect profit, and true and fair view of financial affairs of anaffect profit, and true and fair view of financial affairs of an
organization may not be clearly transparentorganization may not be clearly transparent
Volume variance in standard costing also discloses the Volume variance in standard costing also discloses the
effect of fluctuating output on fixed overhead. Marginal effect of fluctuating output on fixed overhead. Marginal
cost data becomes unrealistic in case of highly fluctuating cost data becomes unrealistic in case of highly fluctuating
levels of production, e.g., in case of seasonal factories. levels of production, e.g., in case of seasonal factories.
Disadvantages (2)Disadvantages (2)
Application of fixed overhead depends on estimates and Application of fixed overhead depends on estimates and
there may be under or over absorption of the same there may be under or over absorption of the same
Control affected by means of budgetary control is also Control affected by means of budgetary control is also
accepted by many. In order to know the net profit, we should accepted by many. In order to know the net profit, we should
not be satisfied with contribution and hence, fixed overhead not be satisfied with contribution and hence, fixed overhead
is also a valuable item. A system which ignores fixed costs is is also a valuable item. A system which ignores fixed costs is
less effective since a major portion of fixed cost is not taken less effective since a major portion of fixed cost is not taken
care of under marginal costing care of under marginal costing
In practice, sales price, fixed cost and variable cost per unit In practice, sales price, fixed cost and variable cost per unit
may vary. Thus, the assumptions underlying the theory of may vary. Thus, the assumptions underlying the theory of
marginal costing sometimes becomes unrealistic. For long marginal costing sometimes becomes unrealistic. For long
term profit planning, absorption costing is the only answerterm profit planning, absorption costing is the only answer
Direct vs. Absorption (full) costingDirect vs. Absorption (full) costing
Direct costingDirect costing
are regarded as period costs (writtenare regarded as period costs (written
as a lump sum to the profit and lossas a lump sum to the profit and loss
account)account)
are assigned to the productsare assigned to the products
are period costsare period costs
are added to the variableare added to the variable
manufacturing cost of sales tomanufacturing cost of sales to
determine total manufacturing costsdetermine total manufacturing costs
Absorption costingAbsorption costing
are allocated to the products are allocated to the products
(included in inventory valuation)(included in inventory valuation)
are assigned to the productsare assigned to the products
are period costsare period costs
are assigned to the productsare assigned to the products
Fixed manufactured overheads
Variable manufacturing costs
Non-manufacturing overheads
Fixed manufacturing costs
Direct vs. Absorption (full) costingDirect vs. Absorption (full) costing
Direct costingDirect costing
Profit is a function of Profit is a function of
salessales
Are recommended where Are recommended where
indirect costs are a low indirect costs are a low
proportion of an proportion of an
organizationorganization’’s total costss total costs
is used for managerial is used for managerial
decisiondecision--making and making and
controlcontrol
used mainly for internal used mainly for internal
purposespurposes
Absorption costingAbsorption costing
Profit is a function of both Profit is a function of both
sales and productionsales and production
Assigns indirect costs to Assigns indirect costs to
cost objectscost objects
is widely used for cost is widely used for cost
control purpose esp. in control purpose esp. in
the long runthe long run
consistent for external consistent for external
reportingreporting
THE ENDTHE END
CHAPTER 6 STANDARD COSTCHAPTER 6 STANDARD COST
Ir. Haery Ir. Haery SihombingSihombing/IP/IPPensyarah
Fakulti Kejuruteraan PembuatanUniversiti Teknologi Malaysia Melaka
STANDARD COSTSSTANDARD COSTS
WHAT ARE STANDARD COST ?WHAT ARE STANDARD COST ?Standard costs are the expected costs of manufacturing Standard costs are the expected costs of manufacturing
the productthe product..
WHAT ARE STANDARD COST SYSTEM?WHAT ARE STANDARD COST SYSTEM?
1. A standard costs system is a method of setting cost 1. A standard costs system is a method of setting cost
targets and evaluating performancetargets and evaluating performance
2. Target or expected costs are set based on a variety of 2. Target or expected costs are set based on a variety of
criteria, and actual performance relative to expected criteria, and actual performance relative to expected
targets is measuredtargets is measured
STANDARD COSTSSTANDARD COSTS
WHAT ARE STANDARD COST SYSTEM?WHAT ARE STANDARD COST SYSTEM?
3. Significant difference between expectations and 3. Significant difference between expectations and
actual results are investigatedactual results are investigated
4. Consistent with the themes developed throughout 4. Consistent with the themes developed throughout
this class, standard cost systems are means of helping this class, standard cost systems are means of helping
managers with decision making and controlmanagers with decision making and control
Standard Direct Labor costsStandard Direct Labor costs ==
Expected Wage Rate Expected Wage Rate XX Expected Number of HoursExpected Number of Hours
Standard Direct Material CostStandard Direct Material Cost ==
Expected Cost of Raw Materials Expected Cost of Raw Materials XX Expected Number of Units ofExpected Number of Units of
Raw MaterialRaw Material
Standard Overhead CostsStandard Overhead Costs ==
Expected Fixed OH Expected Fixed OH ++ Expected Variable Overhead Expected Variable Overhead XX Expected Expected
NumNumber of Units to be Producedber of Units to be Produced
STANDARD COSTSSTANDARD COSTS
TARGET COSTINGTARGET COSTING
1. The market place determines the selling 1. The market place determines the selling
price of the future productprice of the future product
2. The company determines the profit margin 2. The company determines the profit margin
they desire to achieve on his productthey desire to achieve on his product
3. The difference between the selling price 3. The difference between the selling price
and the profit margin is the target costand the profit margin is the target cost
WHY USE A STANDARD COST SYSTEMWHY USE A STANDARD COST SYSTEM
TARGET COSTINGTARGET COSTING
1. Standard are important for decision making1. Standard are important for decision making•• How we produce our productHow we produce our product
•• How we price our productHow we price our product
•• Contract billingContract billing
2. Monitor Manufacturing2. Monitor Manufacturing•• Large variances may indicative of problems in Large variances may indicative of problems in
productionproduction
3. Performance Measurement3. Performance Measurement•• Deviations between actual and standards are often Deviations between actual and standards are often
used as measure of a managerused as measure of a manager’’s performances performance
•• Who sets the standard ?Who sets the standard ?
TARGET COSTINGTARGET COSTING
HOW DO WE SET THE STANDARDS ?HOW DO WE SET THE STANDARDS ?
Theoretically the standard should be expected cost Theoretically the standard should be expected cost
of producing the productof producing the product
General practices:General practices:•• Prior years performancePrior years performance
•• Expected future performance under normal operatingExpected future performance under normal operating
•• Optimistic (Motivator)Optimistic (Motivator)
TARGET COSTINGTARGET COSTING
Important considerations in setting standardImportant considerations in setting standard
1. Why are senior managers using standard•• PricingPricing
•• Performance measurementPerformance measurement
•• Production decisionsProduction decisions
2. What happens if managers fail to meet the
standards ?
3. Standard are supposed to represent the
opportunity cost of production
Example : 1Example : 1 Example : 1Example : 1
Example : 1Example : 1 Example : 1Example : 1
• What do we do with the raw materials price
variance ?
• Who do we hold responsible ?
• What do we do with the raw materials
quantity variance?
• Who do we hold responsible ?
Example : 1 Example : 1 (Question)(Question) Direct Labor Wage VarianceDirect Labor Wage Variance
Direct Labor Efficiency VariancesDirect Labor Efficiency Variances STANDARD COSTSSTANDARD COSTS
BUDGETSBUDGETS areare TOTALTOTAL amountsamounts
A STANDARD COSTA STANDARD COST isis
aa PER UNIT BUDGETPER UNIT BUDGET amountamount
Ideal Vs. Normal StandardsIdeal Vs. Normal Standards
AnAn Ideal StandardIdeal Standard is the theoretical bestis the theoretical best--causecause
which assumes 100% efficiencywhich assumes 100% efficiency
AA Normal StandardNormal Standard should represent a level of should represent a level of
efficiency that is attainable under normal efficiency that is attainable under normal
operating conditionsoperating conditions
The setting of the standard is a management The setting of the standard is a management
judgment call and must reflect expected and judgment call and must reflect expected and
acceptable inefficienciesacceptable inefficiencies
Analysis of Direct Material VariancesAnalysis of Direct Material Variances
Analysis of Direct Material VariancesAnalysis of Direct Material Variances
TOTAL VARIANCETOTAL VARIANCE for Direct Materials for Direct Materials
must be analyzed in terms ofmust be analyzed in terms of
Quantity VarianceQuantity Variance
Price VariancePrice Variance
Analysis of Direct Material VariancesAnalysis of Direct Material Variances
Analysis of Direct Material VariancesAnalysis of Direct Material Variances
The Analysis of the Labor VarianceThe Analysis of the Labor Variance worksworks
the same mechanically as the the same mechanically as the Analysis of Analysis of
Direct Materials VariancesDirect Materials Variances
Analysis of Direct Labor VariancesAnalysis of Direct Labor Variances
Direct Materials Direct LaborDirect Materials Direct Labor
Quantity # of HoursQuantity # of Hours
Price Hourly CostPrice Hourly Cost
Analysis of Overhead VariancesAnalysis of Overhead Variances Analysis of Overhead VariancesAnalysis of Overhead Variances
Analysis of Overhead VariancesAnalysis of Overhead Variances Analysis of Overhead VariancesAnalysis of Overhead Variances
Analysis of Overhead VariancesAnalysis of Overhead Variances Example : 2Example : 2 Manufacturing Product CostsManufacturing Product Costs
Direct costsDirect costs----can be traced to units can be traced to units
producedproduceddirect labordirect labor
direct materialsdirect materials
OverheadOverhead----cancan’’t be traced to unitst be traced to unitsindirect laborindirect labor----e.g., janitorial, supervisorye.g., janitorial, supervisory
indirect materialsindirect materials----e.g., miscellaneous suppliese.g., miscellaneous supplies
otherother----e.g., depreciation, utilities, rente.g., depreciation, utilities, rent
allocated to units based on allocated to units based on ““driversdrivers””
Steps in recordingSteps in recording
Place purchases in raw materials inventoryPlace purchases in raw materials inventory
Transfer raw materials inventory to workTransfer raw materials inventory to work--
inin--process inventory when production startsprocess inventory when production starts
Add in direct labor and overhead to WIPAdd in direct labor and overhead to WIP
Transfer costs of completed units to finished Transfer costs of completed units to finished
goods inventorygoods inventory
Steps in recordingSteps in recording
Transfer costs associated with sold goods to Transfer costs associated with sold goods to
CGSCGS
Steps in recordingSteps in recording Steps in recordingSteps in recording
Steps in recordingSteps in recording
EXAMPLE: 3 EXAMPLE: 3 Statement of Cost of Goods ManufacturedStatement of Cost of Goods Manufactured
Beginning work in processBeginning work in process $ 145,000$ 145,000
Raw materials usedRaw materials used $284,000$284,000
Direct laborDirect labor 436,000436,000
Variable overheadVariable overhead 115,200115,200
Fixed overheadFixed overhead 98,88098,880
Current period manufacturing costsCurrent period manufacturing costs 934,080934,080
Total costs to account forTotal costs to account for $1,079,080$1,079,080
Ending work in processEnding work in process 20,88020,880
Cost of goods manufacturedCost of goods manufactured $1,058,200$1,058,200
Statement of Cost of Goods ManufacturedStatement of Cost of Goods ManufacturedRaw Materials UsedRaw Materials Used
Beginning balanceBeginning balance $ 73,000$ 73,000
Purchases of materialsPurchases of materials 280,000280,000
Raw materials availableRaw materials available $353,000$353,000
Ending balance Ending balance 69,00069,000
Total raw materials used Total raw materials used $284,000$284,000
To Statement of Cost of Goods ManufacturedTo Statement of Cost of Goods Manufactured
Schedule of Cost of Goods SoldSchedule of Cost of Goods Sold
Beginning Finished GoodBeginning Finished Good $ 87,400$ 87,400
Cost of Goods ManufacturedCost of Goods Manufactured 1,058,2001,058,200
Cost of Goods Available for SaleCost of Goods Available for Sale $1,145,600$1,145,600
Ending Finished GoodsEnding Finished Goods 91,60091,600
Cost of Goods SoldCost of Goods Sold $1,054,000$1,054,000
From Schedule of Cost of Goods Manufactured
Income StatementIncome Statement
RevenueRevenue xxxxxxxx
Cost of Goods Sold Cost of Goods Sold <<1,054,0001,054,000>>
Gross Profit Gross Profit xxxxxxxx
Operating Expenses Operating Expenses <xxxx> <xxxx>
Operating Income Operating Income xxxxxxxx
From Schedule of Cost of Goods Sold
QuestionsQuestions
What is the difference between a fixed and What is the difference between a fixed and
variable cost? variable cost?
What are the three components of product What are the three components of product
cost?cost?
What are the three inventory accounts for What are the three inventory accounts for
a manufacturing company?a manufacturing company?