COST MEASUREMENTUnit 9 Management Accounting

LEARNING OUTCOME

Calculate costs using appropriate techniques

TOPICS

Review of Last session

Group ReportingDifferent Costing Methods

Costing methodsGroup Works

REVIEW OF LAST SESSION

COST TERMS

Cost object is anything for which a separate measurement of costs is desired.

Direct costs of a cost object are costs that are related to the particular cost object and can be traced to it in an economically feasible way.

Indirect costs of a cost object are costs that are related to the particular cost object but cannot be traced to it in an economically feasible way.

Cost pool is a grouping of individual cost items.

Cost allocation base is a factor that is the common denominator for systematically linking an indirect cost or group of indirect costs to a cost object.

ABSORPTION COSTING

ABSORPTION COSTING

A managerial accounting cost method of expensing all costs associated with manufacturing a particular product.

Absorption costing uses the total direct costs and overhead costs associated with manufacturing a product as the cost base.

INVENTORY COSTS IN ABSORPTION

inventory costs are made up of the following under Absorption Costing:

• Direct Labor; • Direct Materials; and • Manufacturing Overhead (regardless

of whether it is fixed or variable)

Under absorption costing system, the product cost consists of all variable as well as all fixed manufacturing costs i.e., direct materials, direct labor and factory overhead (FOH). 

VARIABLE/ DIRECT COSTING

VARIABLE/DIRECT COSTING

Method in which the cost of a product or operation is determined by allocating to it an appropriate portion of the variable (direct) costs.

Direct costing treats fixed costs (overheads such as administrative and selling costs) as period costs (associated with time and not output).

When variable costing system is used, the fixed cost (both manufacturing and non-manufacturing) is treated as a period or capacity cost and therefore is not included in the product cost.

COMPARING ABSORPTION & DIRECT COSTING

SAMPLE

A company manufactures and sells 5000 units of product X per year . Suppose one unit of product X requires the following costs:

Direct materials: $5 per unit Direct labor: $4 per unit Variable manufacturing overhead: $1 per unit Fixed manufacturing overhead: $20,000 per year The unit product cost of the company is computed as follows:Absorpti

on Costing

Variable Costing

$5 $5$4 $4$1 $1$4* -——- ——-$14 $10

Sunshine company produces and sells only washing machines. The company uses variable costing for internal reporting and absorption costing for external reporting. The data  for the year 2010 is given below:

Company produced and sold 8,000 machines during the year 2010. Required: Compute unit product cost under variable costing and

absorption costing.

Direct materials $150/unitDirect labor $45/unitvariable manufacturing overhead $25/unit

Fixed manufacturing overhead $160,000 per yearFixed marketing and administrative expenses $110,000 per year

Variable marketing and administrative expenses $15/unit sold

SOLUTION

Absorption Costing

Variable Costing

Materials $150 $150

Labor $45 $45

Variable overhead $25 $25

Fixed overhead $20* –

——- ——-

240 220

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DIFFERENCE BETWEEN ABSORPTION AND MARGINAL COSTING

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Absorption costing Marginal costing

Treatment for fixed manufacturing overheads

Fixed manufacturing overheads are treated as product costing. It is believed that products cannot be produced without the resources provided by fixed manufacturing overheads

Fixed manufacturing overhead are treated as period costs. It is believed that only the variable costs are relevant to decision-making.Fixed manufacturing overheads will be incurred regardless there is production or not

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Absorption costing Marginal costing

Value of closing stock

High value of closing stock will be obtained as some factory overheads are included as product costs and carried forward as closing stock

Lower value of closing stock that included the variable cost only

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Absorption costing Marginal costing

Reported profit

If the production = Sales, AC profit = MC Profit

If Production > Sales, AC profit > MC profitAs some factory overhead will be deferred as product costs under the absorption costing

If Production < Sales, AC profit < MC profitAs the previously deferred factory overhead will be released and charged as cost of goods sold

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ARGUMENT FOR ABSORPTION COSTING

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Compliance with the generally accepted accounting principles

Importance of fixed overheads for production Avoidance of fictitious profit or loss

During the period of high sales, the production is small than the sales, a smaller number of fixed manufacturing overheads are charged and a higher net profit will be obtained under marginal costing

Absorption costing is better in avoiding the fluctuation of profit being reported in marginal costing

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ARGUMENTS FOR MARGINAL COSTING

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More relevance to decision-making Avoidance of profit manipulation

Marginal costing can avoid profit manipulation by adjusting the stock level

Consideration given to fixed cost In fact, marginal costing does not ignore fixed

costs in setting the selling price. On the contrary, it provides useful information for break-even analysis that indicates whether fixed costs can be converted with the change in sales volume

TRADITIONAL COSTING

TRADITIONAL COSTING

The allocation of manufacturing overhead (indirect manufacturing costs) to products on the basis of a volume metric such as direct labor hours or production machine hours.

As manufacturing becomes more sophisticated the manufacturing overhead costs usually increase while the direct labor hours or production machine hours decrease. Hence, the direct labor or machine hours are unlikely to be the root cause of the manufacturing overhead

EXPENSE ALLOCATIONS

Traditional cost accounting systems assign operating expenses to products with a two-stage procedure:

1. Expenses are assigned to production departments

2. Production department expenses are assigned to the products

Departmental structure influences the first-stage allocation process

EFFECT OF DEPARTMENTAL STRUCTURE Departments that have direct

responsibility for converting raw materials into finished products are called production departments

Service departments perform activities that support production, such as:

• Machine setup

• Production engineering• Production scheduling– All service department costs are indirect

support activity costs because they do not arise from direct production activities

• Machine maintenance

TWO-STAGE COST ALLOCATION

Conventional product costing systems assign indirect costs to jobs or products in two stages

1. In the first stage: System identifies indirect costs with various

production and service departments Service department costs are then allocated

to production departments

2. The system assigns the accumulated indirect costs for the production departments to individual jobs or products based on predetermined departmental cost driver rates

TWO-STAGE COST ALLOCATION (2 OF 2)

ALLOCATING SERVICE DEPARTMENT COSTS TO PRODUCTION DEPARTMENTS

There are three ways that companies allocate service department costs to production departments: Direct allocation Sequential allocation Reciprocal allocation

The last two are used when service departments consume services provided by other departments

PATIENTAID EXAMPLEStep 1 of Stage 1 cost allocations (given)

DIRECT ALLOCATION METHOD The direct allocation method is a

simple method that allocates the service department costs directly to the production departments Allocations to production departments

are based on each production department’s relative use of the applicable cost driver

Possibility that some of the activities of a service department may benefit other service departments as well as production departments is ignored

ALLOCATION BASES VALUES

ALLOCATION RATIOS

300,000 / 1,200,000 = 0.250

Based on relative allocation basis value

ALLOCATION OFSERVICE DEPARTMENT COSTS Multiply service department cost by the allocation

ratios

$160,000 x 0.250 = $40,000

STAGE 2 COST ALLOCATIONS Stage 2 allocations

Require the identification of appropriate cost drivers for each production department

Assign production department costs to jobs and products while they are worked on in the departments

Conventional cost accounting systems use unit-related cost drivers

Dividing the indirect costs accumulated in each production department by the total number of units of the corresponding cost driver results in cost driver rates for each department

PATIENTAID STAGE 2 The Casting Department allocates its

indirect costs to jobs based on machine hours, with total capacity for Casting equaling 6,000 machine hours

Total indirect costs for Casting, after the allocation from service departments in Step 2 of Stage 1 was $216,000

As a result, Casting allocates indirect costs to jobs at a rate of $36.00 per machine hour= $216,000/6,000 hours

PATIENTAID STAGE 2 If Job J189-4 uses 40 machine hours while

in the Casting Department, Casting will allocate $1,440 of its indirect costs to Job J189-4= 40 hours x $36.00 per hour

Each department will allocate indirect costs to Job J189-4 in a similar manner, and Casting will allocate some costs to all jobs in a similar manner

To determine the total cost of Job J198-4, add the Direct Material and Direct Labor cost assigned in each department and the indirect cost allocated from each department

To determine the cost per unit, divide the total cost by the number of units in Job J189-4

ACTIVITY BASED COSTING

ACTIVITY-BASED COSTING (OVERHEAD)

An accounting method that identifies the activities that a firm performs, and then assigns indirect costs to products.

An activity based costing (ABC) system recognizes the relationship between costs, activities and products, and through this relationship assigns indirect costs to products less arbitrarily than traditional methods.

assigns manufacturing overhead costs to products in a more logical manner than the traditional approach of simply allocating costs on the basis of machine hours.

Activity based costing first assigns costs to the activities that are the real cause of the overhead.

It then assigns the cost of those activities only to the products that are actually demanding the activities.

WHAT IS ACTIVITY BASED COSTING?

Activity Based Costing (ABC) involves the identification of the factors which cause the costs of an organisation’s major activities.

INTRODUCTION

The direct costs are easy to ascertain as one knows the labour and material, etc. that went into the product.

The indirect cost of overheads are quite different.

This unit will introduce Absorption Costing (traditional costing) and then compare it to Activity Based Costing.

The unit then looks at Activity Based Costing in more detail by recognising the types of cost drivers, designing an ABC system, and, finally, considering the Resource Consumption Model.

STAGES OF EXPENSE ALLOCATION

ACTIVITY BASED COSTING

TRADITIONAL COSTING

STAGE 1

allocates indirect costs to cost centres

allocates indirect costs to cost centres

STAGE 2

use many different typesof volume-based and non volume-based cause and effect second stagedrivers.

uses a limitednumber of different types of second stage volume-based allocation

REASONS FOR DEVELOPMENT OF ABCModern manufacturing environment An increase in support services (such as

production scheduling). These services assist in the manufacture of

a wide range of products. They are unaffected by changes in

production volume. They vary instead with the range and

complexity of products. An increase in overheads as a

proportion of total costs.

INADEQUACIES OF ABSORPTION COSTING

Implies all overheads are related to production volume.

Developed at a time when organisations produced only a narrow range of products and when overheads were only a small fraction of total costs.

Tends to allocate too great a proportion of overheads to high-volume products (which cause relatively little diversity) and too small a proportion to low-volume products (which cause greater diversity and use more support services).

A COMPARISON ABSORPTION COSTING VS. ACTIVITY BASED COSTING

ABSORPTION COSTING [TRADITIONAL METHOD]

Absorption costing is an old method of product costing which aims to include in the total cost of a product (unit, job and so on) an appropriate share of an organisation’s total overhead.

Product costs are built up using absorption costing by a process of allocation, apportionment and overhead absorption.

STAGES TO APPORTIONING OVERHEADS

(1) The first stage of overhead apportionment involves sharing out (or apportioning) the overheads within general overhead cost centres between the other cost centres using a fair basis of apportionment.

(2) The second stage of overhead apportionment is to apportion the costs of service cost centres (both directly allocated and apportioned costs) to product cost centres.

The final stages (stage 3 and 4) in absorption costing is the absorption into product costs (using overhead absorption rates) of the overheads which have been allocated and apportioned to the product cost centres.

COMPUTE A company is preparing its production overhead budgets and

determining the apportionment of those overheads to products. Cost centre expenses and related information have been budgeted as follows.

REQUIRED

Calculate overhead totals for all departments by using direct apportionment as an appropriate basis for apportionment.

Note: Service overheads of stores and maintenance are allocated on the basis of direct labour and machine usage respectively.

STAGE 1

1. The Indirect Expense of Materials and indirect wages can be directly allocated to the production cost centres XYZ and to the service department’s stores and maintenance (as these actually occurred in the departments).

2. The overheads of Rent and Rates, Building Insurance, Power, light and heat, and depreciation need to be apportioned (i.e. shared out) using a fair and suitable basis.

CONT...

We could use:(i) value of machinery(ii) power(iii) direct labour hours(iv) machine hours, and(v) Area

Which would be the most appropriate basis to use for rent and rates?From this list the most suitable is area.

THE CALCULATION IS:

THE SAME APPROACH OF APPOINTMENT WAS ADOPTED FOR INSURANCE, POWER HEAT AND HIGH AND DEPRECIATION. THE BASIS FOR APPOINTMENT HAS BEEN SHOWN ON THE RIGHT HAND SIDE OF THE TABLE

IN THE TABLE IT CAN BE SEEN THAT THE SERVICE COST OF £33,011 (STORES) AND £21,572 (MAINTENANCE) NEEDS TO BE REAPPORTIONED TO THE PRODUCTION UNITS. A SUITABLE BASIS FOR REAPPORTIONING STORES APPEARS TO BE DIRECT LABOUR AND MAINTENANCE MACHINE USAGE.

Therefore, using direct labour to reapportion stores

REAPPORTION MAINTENANCE BASED ON MACHINE USAGE.

STEP 2

Step 3

Calculate separate overhead absorption rates for each production cost centre.

ABSORPTION RATES ARE:

X = 58672/ 10000 = £5.87

Y = 67502/ 10000 = £6.75

Z = 49786/ 10000 = £2.49

STEP 4

Assigning cost-centre overheads to products Now suppose: Direct costs were £120 per unit. Total number of units for Product A was 100. Each

department takes 1 hour to produce Product A:

ABC AND TRADITIONAL COMPUTATION

REQUIRED

Calculate costs for traditional Absorption Costing

Calculate costs for Activity Based Costing.

ABSORPTION COSTING METHOD

Direct costs for ABC are exactly the same as for Absorption Costing. Observe carefully how the cost drivers (scheduling and material handling) are multiplied by the number of runs to obtain the overhead amount for the products.

699.40

23,079.40

879.40

43.97

56,459.40

CALCULATIONS

OVERHEAD CALCULATIONS Total overheads/ Machine hours = Absorption Rate Machine hours (3)

A 20x1 = 20B 20x2 = 40C 200 x 1 = 200D 200 x 2 = 400Total = 660

Absorption rate = Total overheads/ Machine hours= 23080/ 660= £34.97 per machine hour

Overheads (4)A £34.97 x 1hr x 20 = £699.40B £34.97 x 2hr x 20 = £1,398.80C £34.97 x 1 x 200 = £6,994D £34.97 x 2 x 200 = £13,988

ACTIVITY BASED COST METHOD

CALCULATIONS

SUMMARY

43.97 221.48

CONCLUSION

The figures suggest that the traditional volume-based absorption costing system is flawed.

(a) It under allocates overhead costs to low-volume products (here A and B) and over-allocates overheads to higher-volume products (here Z in particular)

(b) It under allocates overhead costs to smaller-sized products (here A and C with just one hour of work needed per unit) and over allocates overheads to larger products (here B and D)

COST DRIVERS

A cost driver is a factor which causes a change in the cost of an activity.

VOLUME-BASED AND NON-VOLUME-BASED COST DRIVERS

ABC systems rely on a greater number and variety of second stage cost drivers. The term ‘variety of cost drivers’ refers to the fact that ABC systems use both volume-based and non volume-based cost drivers.

Volume-based drivers are appropriate where the activities are performed each time a unit of the product or service is produced. In contrast, non-volume related activities are not performed each time aunit of the product or service is produced.

ACTIVITY COST DRIVERS

Activity cost drivers consist of transaction and duration drivers.

Transaction drivers, such as the number of purchase orders processed, number of customer orders processed, number of inspections performed and the number of set-ups undertaken, all count the number of times an activity is performed.

DESIGNING AN ABC SYSTEM

Step 1 Identify an organisation’s major activities. Activities are identified by carrying out

activity analysis.

Step 2 Identify the factors which determine the size of the costs of an activity/cause the costs of an activity.

These are known as cost drivers.

Step 3 Collect the costs associated with each cost driver into what are known as cost pools.

TOPICS FOR RESEARCH

Inventory Valuation oFIFOoLIFOoAVCOoStandard Costing

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REQUIRED

Calculate costs using appropriate techniques

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END OF SESSION