lecture 6 - full costing

7/30/2019 Lecture 6 - Full Costing

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PGBM01

Financial Management & Control

Lecture 6 Full Costing

Francis Kuagbela

Senior Lecturer of Accounting & Finance

The university of Sunderland

School of Business & Law 1


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Learning Outcomes

Distinguish between direct costs andindirect costs

Allocate indirect costs absorption (full)costing

Explain absorption (full) costing

overhead recovery rate

Limitations of absorption costing


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The Product

Direct

Materials

Direct

Labour

Manufacturing

Overhead

Manufacturing Costs


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Direct and Indirect costs

Direct costs those costs clearlyattributable to the production of a

particular item or service intervention. Indirect costs those costs that are not

attributable to a particular product,

instead they serve several products.


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Direct Materials

Those materials that become an integral partof the product and that can be conveniently

traced directly to it.

Example: A radio installed in a car


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Direct Labour

Those labour costs that can be easily traced toindividual units of product.

Example: Wages paid to car assembly workers


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Manufacturing costs that cannot be traceddirectly to specific units produced.

Manufacturing Overhead

Examples: Indirect labor, indirect materials and other

manufacturing expenses (light, heat insurance .)

Wages paid to employees

who are not directlyinvolved in production

work.Examples: maintenance

workers, cleaners and

security guards.

Materials used to supportthe production process.

Examples: lubricants andcleaning supplies used in the

car assembly plant.


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Classifications of Costs

DirectMaterials

DirectLabour

ManufacturingOverhead

Prime

Cost

Conversion

Cost

Manufacturing costs are oftencombined as follows:


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Nonmanufacturing Costs

Marketing and selling costs . . . Costs necessary to get the order and deliver

the product.

Administrative costs . . .All executive, organizational and clerical costs.

All these costs are considered indirect


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Profit & loss account

000

Sales (turnover) XXX

Cost of sales (XXX)

Gross profit XXX

Distribution and selling costs (XXX)

Administrative expenses (XXX)

Operating profit XXX

Net interest receivable and other income XXXProfit from ordinary activities before taxation XXX

Taxation on profit of ordinary activities (XXX)

Profit after tax XXX

Dividends proposed (XXX)

Retained profit for the financial year XXX

Direct costs + some indirect costs

Indirect costs


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Classification of costs

Cost of sales include

Direct materials (direct cost)

Direct labour (direct cost)

MFG overheads (indirect costs)

Distribution and selling costs (allindirect)

Administrative expenses (all indirect)


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Dealing with indirect costs

The key question is:

Whether or not indirect costs areto be considered as part of productcosts

There are two opinions:

1 They can be ignored marginal(variable) costing

2 They can be apportioned in some way-absorption costing


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Marginal (variable) Costing

In marginal costing overheads (indirectcosts) are not included in the cost ofgoods produced

Products make a contribution towardspaying for the overheads and thenmaking a profit

Danger in not having enough

contribution to cover the overheads

Unable to measure each products profit


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Cost profile

Product A B Combined

Units 1500 1500

Labour hours 2.5 2

Machine Hours 0.5 1.5

Labour cost per hour 5 5Material cost per unit 6.5 7.5

Selling price per unit 22 22

Total labour hours 3750 3000 6750

Total machine hours 750 2250 3000

Total overhead 10000


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Product contribution statements

Marginal CostingA B Combined

Sales ? ? ?

Direct labour ? ? ?

Direct Material ? ? ?

Contribution ? ? ?

Overhead 10000

Profit


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Sales 33000 33000 66000

Direct labour 18750 15000 33750

Direct Material 9750 11250 21000

Contribution 4500 6750 11250

Overhead 10000

Profit 1250


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Sales 33000 33000 66000

Direct labour 18750 15000 33750



Overhead 10000Does A or B make more profit?

Profit ? ? 1250


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Absorption (Full) Costing

Seeks to allocate the overheads fairlybetween the different products

Knowing what the full cost of producinga product can be very useful in settingthe price

It can also help us assess theprofitability of different products


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Overhead allocation

But the question is:

How can we allocate the indirect costs

between products in a suitable and fairmanner?

There is no correct allocation method!


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Absorption Costing

Common allocation methods used in thepast have included:

Direct labour hours spent making a

product/delivering a service Machine hours the time spent using

special machinery in making a product

Find a standard (expected) cost perlabour or machine hour


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Overhead recovery rates

Total overhead/total labour hours =Overhead recovery rate per labour hour

OR

Total overhead/total machine hours =Overhead recovery rate per machine hour


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Cost profile


Units 1500 1500

Labour hours 2.5 2







Overhead recovery rate per labour hour = ?


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Cost profile


Units 1500 1500

Labour hours 2.5 2






10000

Overhead recovery rate per labour hour

= 10000/6750hrs = 1.48/hr


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Full Cost Statements

Absorption Costing - labour hours

A B Combined

Sales 33000 33000 66000

Direct labour 18750 15000 33750

Direct Material 9750 11250 21000Contribution 4500 6750 11250

Overhead ? ? 10000

Profit ? ? 1250


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Absorption Costing - labour hours

A B Combined

Sales 33000 33000 66000

Direct labour 18750 15000 33750

Direct Material 9750 11250 21000Contribution 4500 6750 11250

Overhead 5556 4444 10000

Profit -1056 2306 1250


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Absorption Costing - machine hours

A B Combined

Sales 33000 33000 66000

Direct labour 18750 15000 33750



Overhead ? ? 10000

Profit ? ? 1250


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Cost profile


Units 1500 1500

Labour hours 2.5 2







Overhead recovery rate per machine hour = ?


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Cost profile


Units 1500 1500

Labour hours 2.5 2






10000

Overhead recovery rate per machine hour

= 10000/3000hrs = 3.333/hr


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Absorption Costing - machine hours

A B Combined

Sales 33000 33000 66000

Direct labour 18750 15000 33750



Overhead 2500 7500 10000

Profit 2000 -750 1250


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Absorption Costing Issues

Several cost allocation methods available- use can be arbitrary

Different types of cost can be allocatedusing different methods

No perfect method exists

The overhead absorbed into cost is the

budgeted overhead - not the actualoverhead incurred

Absorption costing can send out wrongsignals with regard to product profitability


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Different allocation methods can give different

results!

A B Combined

Labour Hours

Profit -1056 2306 1250

Machine Hours

Profit 2000 -750 1250


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Units 30000 42000

Labour hours 0.25 0.6


Labour cost per hour 12 12

Material cost per unit 3 4




Total overhead 28,000

Cost profile

Work out the full profit for A and B using both labour hour

and machine hour recovery rates


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Absorption costing

Overhead recovery rate (labour hours)= 28,000/32700 = 0.8563

Overhead recovery rate (machinehours) = 28,000/11,700 = 2.393


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Labour Hour

Absorption A B Combined

Sales 210,000 504,000 714,000

Labour

90,000

(30,000 x

0.25 x 12)

302,400

(42,000 x 0.6

x 12) 392,400

Materials

90,000

(30,000 x 3)

168,000

(42,000 x 4) 258,000

Contribution 30,000 33,600 63,600

Overheadrecovery

(0.8563/LH) 6,422 21,578 28,000

Full Profit 23,578 12,022 35,600


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Machine Hour Absorption A B Combined

Sales 210,000 504,000 714,000

Labour 90,000 302,400 392,400

Materials 90,000 168,000 258,000Contribution 30,000 33,600 63,600

Overhead recovery

(2.393/MH) 17,949 10,051 28,000

Full Profit 12,051 23,549 35,600


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End of session 6

36

lecture 6 - full costing

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