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# Unit 9 cost measurement

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### Unit 9 cost measurement

1. 1. Unit 9 Management Accounting COST MEASUREMENT
2. 2. LEARNING OUTCOME Calculate costs using appropriate techniques
3. 3. TOPICS Review of Last session Group Reporting Different Costing Methods
4. 4. REVIEW OF LAST SESSION Costing methods Group Works
5. 5. COST TERMS
6. 6.      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
7. 7. ABSORPTION COSTING
8. 8. 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. 
9. 9. 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) 
10. 10.  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).
11. 11. VARIABLE/ DIRECT COSTING
12. 12. 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). 
13. 13.  When variable costing system is used, the fixed cost (both manufacturing and nonmanufacturing) is treated as a period or capacity cost and therefore is not included in the product cost.
14. 14. COMPARING ABSORPTION & DIRECT COSTING
15. 15. 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: Absorptio n Costing \$5 \$4 \$1 \$4* ——\$14 Variable Costing \$5 \$4 \$1 ——\$10
16. 16.  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: Direct materials Direct labor variable manufacturing overhead Fixed manufacturing overhead Fixed marketing and administrative expenses Variable marketing and administrative expenses   \$150/unit \$45/unit \$25/unit \$160,000 per year \$110,000 per year \$15/unit sold Company produced and sold 8,000 machines during the year 2010. Required: Compute unit product cost under variable costing and absorption costing.
17. 17. SOLUTION Absorption Costing Variable Costing Materials \$150 \$150 Labor \$45 \$45 Variable overhead \$25 \$25 Fixed overhead \$20* – ——- ——- 240 220
18. 18. DIFFERENCE BETWEEN ABSORPTION AND MARGINAL COSTING 18
19. 19. 19 Absorption costing Treatment for Fixed fixed manufacturing manufacturing overheads are overheads treated as product costing. It is believed that products cannot be produced without the resources provided by fixed manufacturing overheads Marginal costing Fixed manufacturing overhead are treated as period costs. It is believed that only the variable costs are relevant to decisionmaking. Fixed manufacturing overheads will be incurred regardless there is production or not
20. 20. 20 Value of closing stock Absorption costing High value of closing stock will be obtained as some factory overheads are included as product costs and carried forward as closing stock Marginal costing Lower value of closing stock that included the variable cost only
21. 21. 21 Absorption costing Marginal costing Reported If the production = Sales, AC profit = MC Profit profit If Production > Sales, AC profit > MC profit As some factory overhead will be deferred as product costs under the absorption costing If Production < Sales, AC profit < MC profit As the previously deferred factory overhead will be released and charged as cost of goods sold
22. 22. ARGUMENT FOR ABSORPTION COSTING 22
23. 23. 23    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
24. 24. ARGUMENTS FOR MARGINAL COSTING 24
25. 25. 25   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
27. 27. 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 
28. 28. 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
29. 29. 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 maintenance • Production engineering • Machine setup • Production scheduling – All service department costs are indirect support activity costs because they do not arise from direct production activities
30. 30. TWO-STAGE COST ALLOCATION Conventional product costing systems assign indirect costs to jobs or products in two stages 1. In the first stage:   2. System identifies indirect costs with various production and service departments Service department costs are then allocated to production departments The system assigns the accumulated indirect costs for the production departments to individual jobs or products based on predetermined departmental cost driver rates
31. 31. TWO-STAGE COST ALLOCATION (2 OF 2)
32. 32. 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
33. 33. PATIENTAID EXAMPLE Step 1 of Stage 1 cost allocations (given)
34. 34. 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
35. 35. ALLOCATION BASES VALUES
36. 36. ALLOCATION RATIOS Based on relative allocation basis value 300,000 / 1,200,000 = 0.250
37. 37. ALLOCATION OF SERVICE DEPARTMENT COSTS  Multiply service department cost by the allocation ratios \$160,000 x 0.250 = \$40,000
38. 38. 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 unitrelated 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
39. 39. 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
40. 40. 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
41. 41. ACTIVITY BASED COSTING
42. 42. 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. 
43. 43. 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. 
44. 44. 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.
45. 45. 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. 
46. 46. STAGES OF EXPENSE ALLOCATION ACTIVITY BASED COSTING STAGE 1 allocates indirect costs to cost centres TRADITIONAL COSTING allocates indirect costs to cost centres STAGE 2 use many different types of volume-based and non volume-based cause and effect second stage drivers. uses a limited number of different types of second stage volume-based allocation
47. 47. REASONS FOR DEVELOPMENT OF ABC Modern 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.
48. 48. 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).
49. 49. A COMPARISON ABSORPTION COSTING VS. ACTIVITY BASED COSTING
50. 50. 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.
51. 51. 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.
52. 52. 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.
53. 53. 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.
54. 54. 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.
55. 55. 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.
56. 56. THE CALCULATION IS:
57. 57. 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
58. 58. 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
59. 59. REAPPORTION MAINTENANCE BASED ON MACHINE USAGE.
60. 60. STEP 2 Step 3 Calculate separate overhead absorption rates for each production cost centre.
61. 61. ABSORPTION RATES ARE:  X = 58672/ 10000 = £5.87  Y = 67502/ 10000 = £6.75  Z = 49786/ 10000 = £2.49
62. 62. 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:
63. 63. ABC AND TRADITIONAL COMPUTATION
64. 64. REQUIRED Calculate costs for traditional Absorption Costing Calculate costs for Activity Based Costing.
65. 65. ABSORPTION COSTING METHOD 699.40 879.40 23,079.4 0 56,459.40 43.97 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.
66. 66. CALCULATIONS
67. 67. OVERHEAD CALCULATIONS     Total overheads/ Machine hours = Absorption Rate Machine hours (3) A 20x1 = 20 B 20x2 = 40 C 200 x 1 = 200 D 200 x 2 = 400 Total = 660 Absorption rate = Total overheads/ Machine hours = 23080/ 660 = £34.97 per machine hour Overheads (4) A £34.97 x 1hr x 20 = £699.40 B £34.97 x 2hr x 20 = £1,398.80 C £34.97 x 1 x 200 = £6,994 D £34.97 x 2 x 200 = £13,988
68. 68. ACTIVITY BASED COST METHOD
69. 69. CALCULATIONS
70. 70. SUMMARY 43.97 221.4 8
71. 71. 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)
72. 72. COST DRIVERS  A cost driver is a factor which causes a change in the cost of an activity.
73. 73. 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.
74. 74. 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.
75. 75. 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.
76. 76. TOPICS FOR RESEARCH Inventory Valuation o FIFO o LIFO o AVCO o Standard Costing Go Top
77. 77. REQUIRED Calculate costs using appropriate techniques Go Top
78. 78. END OF SESSION