ME290 Global Engineering Professional Seminar Engineer

ME290
Global Engineering
Professional Seminar
Engineering Standards
and Professional Societies
Lecture-1
ABET* requirement: General Criterion 3. Student Outcomes
using
appropriate learning strategies
Engineering Standards and
Professional Societies
*ABET (Accreditation Board for Engineering and Technology,
Inc.) is an organization that accredits post-
secondary education programs.
Professional Organizations for Mechanical Engineers
• American Society of Mechanical Engineers (ASME)
• Institution of Mechanical Engineers (IMechE)
• International Academy for Production Engineering (CIRP)

• Society of Automotive Engineers (SAE)
• Society of Manufacturing Engineers (SME)
• American Society of Heating, Refrigerating, and Air-
Conditioning Engineers (ASHRAE)
• Society for Experimental Mechanics (SEM)
• Acoustical Society of America (ASA)
• American Society for Nondestructive Testing (ASNT)
• American Welding Society (AWS)
• Association of Energy Engineers (AEE)
• American Society for Testing and Materials (ASTM)
and many others.
Role of Professional Associations
Most professional associations perform the following functions:
• Advocate on behalf of public policy or broad professional
issues
affecting members
• Circulate standards for professional preparation and practice
• Provide educational training and professional development
programs
• Publish and disseminate research, information and opinion
• Assist members with career development issues
• Create opportunities for professional peers to interact
• Keep members up to date
Common Characteristics
• Legally incorporated non-profit entities.

• Governing board of elected and/or appointed individuals.
• Operations are managed by volunteers.
• Relatively small office staffs to provide administrative
services.
• Funded primarily through member dues, institutional
memberships, fees for programs/services, publications, and
grants.
• Exercise of power limited to small number of members
• International participation.
• Online presence.
Benefits of Involvement
• Enhance one’s development
• Administrative and professional skills
• Gain new perspectives and knowledge
• Develop leadership skills and orientation to the profession
• Career placement opportunities
• Stronger sense of professional identity
• Colleagues and professional networks
• Exchange of ideas
• Opportunities for continued interactions and get-togethers
• Make a contribution to the association
• Help and/or influence the profession and its direction
• Shape professional practice and accreditation standards

Benefits of Student Membership
• Professional development
• Networking opportunities
• Seminars and conferences
• Education/training
• Exclusive online resources
• Discounted or free publications
• Resume building
• Job hunting
Example: American Society of Mechanical
Engineers (ASME)
https://www.asme.org
Professional membership
https://www.asme.org/about-asme/professional-
membership/member-benefits
https://www.asme.org/about-asme/professional-
membership/member-benefits

Example: American Society of Mechanical Engineers
(ASME)
https://www.asme.org
Student membership is possible
https://www.asme.org/
https://www.asme.org/
Engineering Standards
Some Definitions
Standard: A standard is a document that defines the
characteristics of a product, process or service, such as
dimensions, safety aspects, and performance requirements.
Code: Laws or regulations that specify minimum standards to
protect public safety and health such as codes for construction
of
buildings. Voluntary standards are incorporated into building
codes
Specification: A set of conditions and requirements of precise
and
limited application that provide a detailed description of a
procedure,
process, material, product, or service for use primarily in
procurement
and manufacturing. Standards may be referenced or included in
specifications.

Technical Regulation: A mandatory government requirement
that
defines the characteristics and/or the performance requirements
of
a product, service or process (see also Regulation).
International Bodies
• The world's leading developers of International
Standards:
• ANSI and (U.S. National Committee (USNC)) are the
U.S. clearing house for Standards and a founding
member of ISO.
Why Standards are Used?
• They provide a “Legal,” or at least enforceable, means to
evaluate acceptability and sale-ability of products and/or
services
• They can be applied globally
• Standards are a “COMMUNICATION” tool that allows all
users to speak the same language when reacting to products

or processes
• They, ultimately, are designed to protect the public from
questionable designs, products and practices
• They teach us, as engineers, how we can best meet
environmental, technical, health, safety, quality and societal
responsibilities
International
Standards
National Standards
Local Standards
Standards can be classified as local, national or international.
Local
standards are developed by companies when national or
international standards are not available.
End of “Engineering Standards and Professional Societies”
Lecture-1
MONASH
BUSINESS
SCHOOL

Chapter 8 (including appendix)
Activity Based Costing
For this topic you should be able to:
Recognise problems with traditional product costing systems
Describe the key features of activity-based costing (ABC)
Be able to use the ABC model to calculate product costs
Explain differences between product costs prepared under ABC
and those under traditional costing
Recognise what types of organisations benefit from ABC and
explain what these benefits are
Outline the impediments to introducing ABC and its limitations,
and ways to overcome these.
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Features of traditional product costing systems
Direct material and direct labour costs are traced to products
Overheads are aggregated into very large cost pools, sometimes
for individual departments but often for the whole organisation
(plant)

Manufacturing overhead costs are allocated to products using a
predetermined overhead rate, either plant wide or departmental
Manufacturing overhead rate is calculated using some measures
of production volume (for example direct labour hours or
machine hours)
Non-manufacturing costs are not assigned to products
Slide ‹#›
Direct materials
Overhead costs
Indirect materials
Indirect labour
Production facility costs
Etc.
Overhead cost pool
Plant-wide or departmental
Individual products or services
(cost objects)

Direct Labour
Trace
Trace
Allocate
Traditional costing systems
(using volume based cost driver)
Last week’s lecture
Slide ‹#›
Failure to adapt to the changing business environment
Increasing levels of non-volume-driven manufacturing overhead
costs
Increasing proportions of non-manufacturing costs
Problems with traditional product costing systems
Causes of changes in cost structures include:
Increased automation
Increasing product diversity and complexity
Increased emphasis on upstream and downstream areas of the
value chain, for example, customer demand for improved
service, quality, marketing and customer support
Steve Jobs hated this (Click here)
Indicators of problems with a product costing system
Traditional product costing systems are likely to result in
inaccurate product costs when:

product diversity increases
the proportion of direct labour costs decreases and the
proportion of manufacturing overhead costs increases
the proportion of manufacturing overhead costs, not rel ated
directly to production volume, increases
non-manufacturing costs that are product-related become
substantial
Slide ‹#›
Activity-based costing
A method that can be used to measure both the cost of cost
objects and the performance of activities
Can help solve problems such as:
Distorted product costs
Poor cost control
Activity:
A unit of work performed within the organisation
Slide ‹#›
Traditional approach (from week 6) …
Slide ‹#›

ABC approach
Resource Drivers
Activity
Drivers
Slide ‹#›
Direct materials
Transport equipment costs
Testing materials cost pool
Allocated using number of materials tested
Individual products or services or other cost objects
Direct Labour
Overhead costs:
Trace

Allocate using activity cost drivers
Activity Based Costing (ABC)
Supervisors’ salaries
Inspectors’ salaries
Other resource costs
Inspection cost pool
Allocated using number of units inspected
Set-up machines cost pools
Allocated using number of set-ups
Trace or allocate using resource drivers
Activity cost pools:
Slide ‹#›
Be careful…
Do not confuse overhead costs with activity cost pools (see
previous slide)
Overhead costs represent all the manufacturing (and/or non-
manufacturing) costs of the organisation
These are allocated to activity cost pools using resource drivers
Activity cost pools are an amalgamation of the overhead costs
that are used to carry out a particular activity.

These costs are then applied collectively to cost objects (for
example, products) using a common activity cost driver
Slide ‹#›
Activity-based vs. traditional product costs
Traditional product costing is based on the use of volume-based
cost drivers
Not all aspects of manufacturing overhead vary with production
volume, for example fixed costs
Activity-based costing recognises both volume-based and non-
volume-based cost drivers
In ABC, the quantity of activity drivers consumed by a product
often depends on whether the activity is performed for each
unit, batch or product line.
Slide ‹#›
Traditional costing treats all costs as unit level
Ignores product level and facility level costs
Also ignores batch size
Units produced in large batches consume a relatively low cost
per unit of batch costs
For example, imagine the setup cost per batch of units is $200
and in August 100 units were produced in each batch …..
Therefore, the setup costs per unit is $2
Scenario 1: In September, the units produced per batch
increased to 300 due to higher consumer demand. However,
despite the increase in batch size, it still costs $200 to setup the
batch leading to a setup cost of $0.67 per unit
Scenario 2: In September, the setup cost per batch of units
increased to $250 due to the introduction of more sophisti cated

machinery. However, despite the increased cost, 100 units per
batch are still made leading to a setup cost of $2.50 per unit.
Slide ‹#›
Traditional costing systems tend to overcost high-volume,
relatively simple products and undercost low-volume, complex
products
High-volume, simple products may use less activities
Low-volume, complex products may use more activities
Traditional costing does not recognise these differences
Slide ‹#›
An activity-based costing model
The costing view (ABC)
Measures the cost of activities
Assigns activity costs to cost objects (e.g. products)
Activity-based management view (ABM)
Provides information to manage activities, managing costs and
other sources of customer value
Three types of cost drivers
Resource drivers (ABC)
Activity drivers (ABC)
Root-cause cost drivers (ABM)
Slide ‹#›
The ABC framework

Slide ‹#›
Activity-based costing terminology
Resource driver
A cost driver used to estimate the cost of resources (i .e.
overhead costs) consumed by an activity
Activity driver
A cost driver used to estimate the cost of an activity consumed
by the cost object
Bill of activities
Identifies the activities, the activity cost per unit of activity
driver, the quantity of activity drivers consumed, and therefore,
the cost of the activities consumed by the product
STEP ONE
STEP TWO
STEP THREE
Slide ‹#›
The ABM framework
Slide ‹#›
Activity-based management terminology
Root-cause cost drivers
The underlying factors that cause activities to be performed and
their costs to be incurred
Used to monitor and control what is happening in a business
Provide information about root causes of activities, their value
to customers, and appropriate performance measures to use.
Can potentially be different to the activity driver

Slide ‹#›
The research department sends out blood samples for
examination to an external pathology lab.
What is the cost driver of this activity?
For cost estimation purposes: Number of blood samples sent
For cost management purposes: Skill level of staff
Research Cost - $1.5 million – Pharmaceutical Company
Remember Week 2??
The costing view
Step one: Measuring the cost of activities
Use resource drivers to assign overhead costs to separate cost
pools (for example, activity centres) for each activity
Determine the total cost for each type of activity
Step two: Assigning activity costs to products
Choose an appropriate activity driver for each activity
Calculate cost per unit of activity driver
Assign activity costs to cost objects using activity drivers
Prepare a bill of activities for each major product
Determine the total cost for each product (equals the cost of
activities used to produce each product)
Total Cost of activity
Total quantity of its activity driver
Slide ‹#›

Activity-based hierarchy of costs and activities
Unit level activities
Performed for each unit of product
Batch level activities
Performed for each batch of product
Product level (or product-sustaining) activities
Performed for specific products or product families
Facility level (or facility-sustaining) activities
Required to support the business as a whole, not caused by any
particular product (so arbitrary calculation may still be
inevitable unfortunately)
Doesn’t matter if there are 100 or 150 units in the batch – same
cost!
Slide ‹#›
The costing view: Bill of activities
Product: Hensley Tooth
Slide ‹#›
Lecture illustration
Yummy's Bakery makes a number of different cakes and
pastries. Two of its best-selling products are the Lamington and
the Vanilla Slice.
It has a budgeted overhead amount of $425,000 for the coming
year. It anticipates 2,000 direct labour hours.
400 Lamingtons can be produced an hour. 500 Vanilla Slice can
be produced an hour.

The prime cost for a Lamington is $0.30 and $0.50 for a Vanilla
Slice.
On the next slide is a list of the main activities performed at
Yummy and their annual costs. These costs represent an
allocation of all the bakery’s overhead costs. They were
allocated to activities using resource drivers.
Five potential activity cost drivers and the annual quantity of
each activity driver are also listed.
Slide ‹#›
Lecture illustration contd….
Activity Activity Cost
Process Receivables $15,000
Process Payables $25,000
Program Production $28,000
Load mixer $14,050
Operate mixer $45,900
Clean mixer $6,900
Fill trays $16,000
Set up ovens $50,000
Bake cakes $130,000
Pack cakes $80,000
Activity cost drivers Quantity
Kg processed 200,000
No. batches 1,000
No. cakes produced 800,000
No. invoices 5,000
No. purchase orders 2,500

Slide ‹#›
Lecture illustration contd….
The data for the Lamington and the Vanilla Slice is as follows:
The bakery also spent $2,150 in development and testing costs,
of which $860 was spent on developing the Lamington and
$1,290 spent on developing the Vanilla Slice. The rent of the
facility that makes the Lamingtons and Vanilla Slices is
$12,000.
LAMINGTON
Activity cost drivers Quantity used
No. batches 100
No. purchase orders 200
No. invoices 500
Kg processed 30,000
VANILLA SLICE
Activity cost drivers Quantity used
No. batches 200
No. purchase orders 800
No. invoices 1,000
Kg processed 50,000

Slide ‹#›
Lecture illustration contd…
Required:
Using traditional costing, with direct labour hours as a cost
driver, calculate the product cost for the Lamington and Vanilla
Slice.
Select an appropriate driver for each of the activities identified.
Calculate cost per unit of activity driver for the activities listed.
Use the information in parts 2 and 3 to determine a cost per unit
for the Lamington and Vanilla Slice.
After all this: Reflect on the difference of calculating product
costs using
this method and what we did last week!
Slide ‹#›
Lecture illustration solution
Question One
Budgeted overhead $425,000
Budget volume of cost driver 2,000 DLHrs
Predetermined overhead rate $212.50 per DLH
Lamington Vanilla Slice
400 produced/ hour = 0.0025 DLHrs 500 produced/ hour = 0.002
DLHrs

per unit per unit
Applied overhead $0.53Applied overhead $0.43
plus prime cost $0.30plus prime cost $0.50
Total cost $0.83Total cost $0.93
Slide ‹#›
Lecture Illustration
Solution
(cont’d)
Question Two
Activity Activity Driver
Process Receivables No. invoices
Process Payables No. purchase orders
Program Production No. batches
Load Mixer No. batches
Operate Mixer Kg processed
Clean Mixer No. batches
Fill Trays No. cakes produced
Set up Ovens No. batches
Bake Cakes No. batches
Pack Cakes No. cakes produced

Cake Driver – get it?!
Slide ‹#›
Question Three
Activity Activity Cost Activity Driver Quantity Cost/unit
of activity driver
Receivables $15,000 No. invoices5000 $
Payables $25,000 No. purchase orders2500 $
Program Production $28,000 No. batches1000 $
Load Mixer $14,050 No. batches1000 $
Operate Mixer $45,900 Kg processed200000 $
Clean Mixer $6,900 No. batches1000 $
Fill Trays $16,000 No. cakes produced800000 $
Set up Ovens $50,000 No. batches1000 $
Bake Cakes $130,000 No. batches1000 $
Pack Cakes $80,000 No. cakes produced800000 $
Slide ‹#›

Question Four
ActivityActivity DriverCost/unit of Lamington quantityAnnual
Cost
activity driver
Process ReceivablesNo. invoices $3.00 500 $1,500
Process PayablesNo. purchase orders $10.00 200 $2,000
Program ProductionNo. batches $28.00 100 $2,800
Load MixerNo. batches $14.05 100 $1,405
Operate MixerKg processed $0.23 30,000 $6,885
Clean MixerNo. batches $6.90 100 $690
Fill TraysNo. cakes produced $0.02 100,000 $2,000
Set up OvensNo. batches $50.00 100 $5,000
Bake CakesNo. batches $130.00 100 $13,000
Pack CakesNo. cakes produced $0.10 100,000 $10,000
Develop and Test $ 860
Rent $6,000
$52140
Production volume100,000
Overhead cost/unit$0.52
Prime cost per unit$0.30
Total cost per Lamington$0.82

Slide ‹#›
Question Four
ActivityActivity DriverCost/unit of Vanilla Slice Annual Cost
activity driverquantity
Process ReceivablesNo. invoices $3.00 1,000 $ 3,000
Process PayablesNo. purchase orders $10.00 800 $ 8,000
Program ProductionNo. batches $28.00 200 $ 5,600
Load MixerNo. batches $14.05 200 $ 2,810
Operate MixerKg processed $0.23 50,000 $11,475
Clean MixerNo. batches $6.90 200 $ 1,380
Fill TraysNo. cakes produced $0.02 100,000 $ 2,000
Set up OvensNo. batches $50.00 200 $10,000
Bake CakesNo. batches $130.00 200 $26,000
Pack CakesNo. cakes produced $0.10 100,000 $10,000
Develop and Test $ 1,290
Rent $ 6,000
$87555
Production volume 100,000
Overhead cost/ unit $0.88
Prime cost per unit $0.50
Total Cost per Vanilla Slice $1.38

Slide ‹#›
Compare costs
Lamington Vanilla Slice Traditional $0.83 $0.93
Activity Based $0.82 $1.38
Slide ‹#›
When to use ABC?
When overhead costs are a significant proportion of total cost,
and a large part of overhead is not directly related to production
volume
When the business has a diverse product range, and an
individual product’s use of resources differs from its use of
When production activity involves diverse batch sizes and
product complexity
Proportion of product-related costs such as research and
development, customer support and so on are increasing relative

to manufacturing costs
There are likely to be high costs associated with making
inappropriate decisions, based on inaccurate product costs
The cost of designing, implementing and maintaining the ABC
system is relatively low due to sophisticated IT support
Slide ‹#›
When to use ABC – four key questions
1. Does the organisation make more than one product?
2. Does the organisation make multiple products using different
processes?
3. Does the organisation have a high proportion of non-unit
level costs?
4. Are overheads a significant proportion of total costs?
The organisation should definitely use ABC!
No
Yes
No

Yes
No
Yes
No
Yes
If an organisation makes one product, overhead cost per unit is
simply total overhead costs divided by units produced.
If different products are made using similar processes, then the
overhead costs relating to those processes will be largely
identical, negating the need for ABC.
If most overhead costs are unit based, then overhead drivers
will probably be volume-based drivers – traditional costing
systems are usually able to capture these reasonably effectively
Though the organisation exhibits all the prior characteristics
aligned with ABC use, if overhead costs are not significant then
the implementation of ABC potentially outweighs the benefits
Slide ‹#›
Different forms of ABC

Simple approach: allocates manufacturing overhead costs to
products
ABC system for indirect costs: allocates manufacturing
overhead costs and non-manufacturing costs to products
Comprehensive system: allocates all product-related costs,
except direct materials, to products and is used for activity
management
Slide ‹#›
Slide ‹#›
Which costs should be included in an ABC system?
Depends on the purpose of the system, which depends on the
needs of management and on the problems that need to be
addressed.
A decision to include activity-based management (ABM) in an
ABC system will influence the range of costs included in the

system, as well as the type of cost drivers identified
Slide ‹#›
Variations in forms of ABC
Actual (past) or budgeted costs are analysed
Cost objects, other than products, are included
For example, the costs of using particular suppliers or the cost
of servicing particular customers
Implementation of ABC is a one-off project or an ongoing
system
ABC is used to cost just one part of a business, with other parts
relying on more traditional methods
Slide ‹#›
Impediments to introducing ABC
The benefits of ABC can be significant but the take-up rate has
been relatively slow. Why?

Lack of awareness of ABC
Uncertainty about the potential benefits of ABC
Concerns about the extensive resources required to implement
ABC
Resistance to change from managers and employees
Slide ‹#›
Impediments to introducing ABC
Behavioural issues in implementing activity-based costing
ABC may require substantial changes to:
The way businesses are managed
The type of data that is collected
Collection and analysis procedures
Implementation requires the time and effort of many people
across the organisation (not just accountants!)
These changes can be perceived as threatening and therefore
may be resisted

Slide ‹#›
41
Overcoming impediments of ABC
ABC must be accompanied by a change management plan that
takes into account the extent of change needed and the
personalities involved
Bottom-up change management (as opposed to top-down) may
give employees some degree of ownership of any changes
caused by ABC
Management must be seen as committed to the change process,
but also willing to let their employees play a major role in
developing and implementing ABC.
Slide ‹#›
Limitations of activity-based costing

Facility level costs
When a high level of facility level costs is allocated to
products, an arbitrary element enters the product cost
These costs bear no obvious relationship to products
In lecture illustration: rent was split equally between products.
Could we do better? Allocate based on square footage used to
make products? Is that feasible/necessary?
Use of average costs in decision making
Batch, product level and facility level costs that have been
divided by the number of units produced (as in lecture
illustration) can lead to product costs that are of limited use for
decision making if there is any element of customisation
Slide ‹#›
Complexity
The cost of updating an ABC system can be very high although
it may be needed to avoid producing outdated, irrelevant
information
The level of complexity increases when the system is used for
both activity management and product costing

Activity-based management requires extensive and detailed
analysis of costs and activities
Slide ‹#›
ABC can be difficult to implement in service firms
High levels of facility costs, so potential for many arbitrary
allocations
Individual activities are difficult to identify because they are
non-repetitive
A non-repetitive production environment makes it difficult to
identify service outputs (so what is the cost object?)
Despite these issues, ABC is used in many major Australian
service organisations
Slide ‹#›
Acknowledgement
Some of the slides contained in this presentation were adapted
from:

PowerPoint slides to accompany Management Accounting:
Information for managing and creating value 8e
Copyright © 2018 McGraw-Hill Australia Pty Ltd
Slide ‹#›
46
MONASH
BUSINESS
SCHOOL
Chapter 7 (excluding appendix)
A Closer Look at Overhead Costs
1

Explain the nature of overhead costs.
Describe general principles for allocating indirect costs to cost
objects.
Allocate overhead costs to products using plant-wide and
departmental rates.
Allocate support department costs to production department
using direct, step-down and reciprocal methods.
Recognise costs & benefits of alternative approaches to
allocating overheads.
Identify best practice in overhead allocation
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And always….
Understand why overhead cost allocation is important and
useful to managerial decision making
Critically analyse different options for allocating overhead costs

and assess which would be most applicable to different contexts
To recap prior lectures….
Manufacturing overhead costs: all manufacturing costs other
than direct material and direct labour costs
Cannot be traced economically to individual products
Non-manufacturing costs: all costs incurred outside of
manufacturing – for example research & design, human
resources, customer support
4
To recap prior lectures….
Cost assignment can take two forms:
Direct costs can be traced directly to products
Indirect costs (for example, those on the previous slide) cannot
be traced to cost objects; therefore they need to be allocated
A cost pool is a collection of costs that are allocated to cost
objects:
Have a common allocation base (i.e. common cost driver)

Often used to simplify the allocation process
5
Inspection costs
Quality Training
Data Storage
Salaries of IT
staff
Cleaning
Rent
Council Rates
Quality Control
Property
Computing
Product
or department

?
?
See example on next slide
Depending on whether job or process costing used
6
A cost allocation base is some factor or variable that allows us
to allocate costs in a cost pool to cost objects
Preferably a cost driver
A cost driver is an activity or factor that causes a cost to be
incurred
Determining cost allocation bases
For example: Quality Control cost pool (last slide)
Cost driver could be # of inspections
Product A is inspected more often than product B
So…more quality control overhead is allocated to Product A

7
Identifying overhead cost drivers
What is the major factor that causes the overhead cost to be
incurred?
To what extent does the overhead cost vary in proportion with
the cost driver?
How easy is it to measure the cost driver?
Helps increase accuracy of cost prediction
Helps keep cost prediction manageable
Tension?
8
Why bother allocating overhead costs?
Reliable product costs are important for a range of management
decisions

What products should we produce?
What prices should we charge our customers?
How profitable are particular product lines?
What value are our goods in inventory? (last week’s lecture)
9
Allocating overheads in process costing
Two possible approaches:
A plant-wide rate
All overheads are placed in one large cost pool (not
disaggregated by department)
A single cost driver is used to allocate overheads to products
Departmental rates
Overheads are allocated to departments based on departments’
usage of overhead costs
Separate cost driver used for each department to allocate
overheads to products

The difference is the cost driver and type of cost pool used
Plant-wide rate
A plant-wide rate is a single overhead rate that is calculated for
the entire production plant
One cost pool – all overhead costs included within it
Three steps:
Identify the overhead cost driver
Calculate the overhead rate per unit of cost driver
Apply the manufacturing overhead cost to the product based on
the predetermined overhead rate and the product’s actual
consumption of the cost driver
11
Plant-wide rate
Plant-wide overhead rate
=

Budgeted manufacturing overhead
Budgeted level of cost driver
Applied overhead
Plant-wide overhead rate
Actual quantity of cost driver consumed by the product
=
×
Step 2:
Step 3:
12
Lecture illustration #1
Based on the results of lecture illustration #1, consider the
following information:
Product XYZ is produced in the two production departments (P1
and P2).

Product XYZ’s prime cost is $250 per unit
Production of XYZ requires 4 DLHrs in P1 and 15 DLHrs in P2
Required:
Calculate the unit manufacturing cost of product XYZ.
7-14
Calculating product cost
14
Departmental rates
Departmental overhead rates recognise that overheads in each
department may be driven by different cost drivers

For example…
Paint department might be labour intensive (cost driver = direct
labour hours)
Assembly might be machine intensive (cost driver = machine
hours)
15
Departmental rates
Two-stage cost allocation for department overhead rates
Stage one: Overhead costs are assigned to production
departments (separate cost pool for each department)
Step 1: Overhead costs are allocated to all departments
Step 2: Support department costs are reassigned to overhead
cost pools in the production departments
16

Departmental rates: Stage One
Total cost pool of production department will be overhead costs
allocated directly to it (Step 1) and costs allocated to it from
support departments (Step 2)
Products don’t pass through these departments so we must
allocate their costs to production departments in order to cost
products
7-18
18
Departmental rates
Stage two: overhead costs are applied to products
Manufacturing overhead rates are calculated for each production
department

7-19
Predetermined manufacturing overhead rate
=
Budgeted manufacturing overhead
Budgeted level of cost driver
Applied overhead
Predetermined overhead rate
Actual quantity of cost driver consumed by the product
=
×
19
Let’s do stage two first
We’ll come back to stage one
afterwards

20
Lecture illustration #1 continued
Stage two:
Based on the results of lecture illustration #1, consider the
and P2).
Production of XYZ requires 1 DLHrs in P1 and 15 DLHrs in P2
Production of XYZ requires 17 MHrs in P1 and 2 MHrs in P2
Required:

7-22
Calculating product cost
22
Stage One: Allocating support department costs
Informs user departments of the cost of the services that they
are using, to assist them with planning and control of that usage
Allocation methods include:
Direct: supports department costs to be allocated directly to
production departments
Step-down: partially recognises the services provided by one
support department to another
Reciprocal services: fully recognises the provision of services
between support departments
23
Children’s Health Clinic

Administration
Housekeeping
Medical Department
Dental Department
Medical Patient Visit
Dental Patient Visit
Support Departments
Operating Departments
Cost Objects
Administration

Housekeeping
Medical Department Cost Pool
Dental Department Cost Pool
Medical Patient Visits
Dental Patient Visits
Direct Method
Allocate support department costs directly to production

departments - ignores the support administration and
housekeeping provide to each other
Stage 2
Stage 1
Administration
Housekeeping
Step-down Method: Step 1
First allocate costs of support department that provides services
to the greatest number of other support departments (i.e. DO
NOT count production departments)
Housekeeping

Step-down Method: Step 2
Then allocate costs of second support department (inclusive of
allocated costs from first support department) to production
departments only
Stage 2
Stage 1

Administration
Housekeeping
Reciprocal Method: Step 1
Simultaneously allocate costs among support departments
Administration
Housekeeping

Reciprocal Method: Step 2
Then…allocate these revised support costs from Step 1 to
production departments
Stage 2
Stage 1
7-30
Cost drivers
Round all calculations to two decimal places
Required:
Allocate support department costs to production departments
and
calculate a predetermined overhead rate for each production

department
* The final sum of cost pools in P1 and P2 should equal this
amount
to apply production department costs to products in Stage 2
to apply support department costs to production departments in
Stage 1
*
30
16
1040
Ignore
Allocate support department costs directly to production
departments
Direct Method
* From slide 30
*

*
*
*
*
*
Production departments share of support department costs based
on cost driver
+
+
=
=
Step-down Method – Two important rules
Which support department should you allocate first?
First check to see if the question has specified which
department to allocate first
If not, allocate first the support department which provides
service to greatest number of other support departments – Rule
1
What if there is a tie?

Consider lecture illustration #2: both quality control and
material handling provide services to one other support
department
In this case, allocate first the support department with the
largest overhead budget (in lecture illustration #2 – material
handling) – Rule 2
Step-Down Method (cont’d)
16
1200
Ignore (only allocating MH fully)
+
+
=
=
+
Step 1: Allocate Material Handling costs to all departments
* From slide 30
Step 2: Allocate Quality Control costs (inclusive of allocated
costs from Material Handling) directly to production

departments
Basis for share of support department costs
*
*
*
*
*
*
5-33
Reciprocal Method
Specify equations for total operating costs of each support
department:
QC = 27,000 + MH x 160/1200
MH = 33,000 + QC x 2/18
And solve them as simultaneous equations:
therefore QC = 27,000 + (33,000 + QC/9) x 16/120
therefore QC = $31,872.18

and MH = $36,541.35
Now refer back to Lecture illustration
5-34
34
Reciprocal Method (cont’d)
1200
+
=
+
Basis for share of support department costs
+
+
=
18
Allocate revised support department costs directly to production
departments
* From slide 30

*
*
*
*
5-35
Based on the results of lecture illustration#2, consider the
and P2).
Production of XYZ requires 10 MHrs in P1 and 8 DLHs in P2
Required:
7-36

36
Lecture Illustration #3 (cont’d)
5-37
37
Which allocation method is best?
If using plant-wide rate - select a cost driver that is common to
all products
Where reciprocal relationships are strong, the reciprocal
services method may be appropriate
However, the direct method is often used when the cost of
obtaining information regarding services between support
departments is too high (….and not worth the effort) or there
are not many (or significant) intra-support department activities

Choice should be based on costs versus benefits
Consider allocation bases and their accuracy
Beware of arbitrary and inaccurate cost allocation
The accuracy of costing systems often depends more on the cost
drivers chosen rather than overall overhead allocation method
7-38
38
Budgeted vs. actual overhead rates
Trade-off between timeliness and accuracy
Budgeted rates calculated prior to the commencement of the
year
More timely
Actual rates calculated after the end of the year
More accurate
Usually budgeted costs and budgeted amounts of cost drivers
are used to calculate overhead rates rather than actual costs and
actual amounts of cost drivers
7-39

39
Over what period should overhead rates be set?
Yearly rates are generally used for internal decision making
Monthly rates tend to fluctuate due to price changes and
seasonal factors
A normalised overhead rate is an overhead rate calculated over
a relatively long period
Smooths out fluctuations in overhead rates, therefore smoothing
out product costs
7-40
40
The arbitrary nature of these cost allocation methods is a
limitation of traditional product costing systems
In the lecture illustration, despite the increased accuracy of the
departmental method in comparison to the plant-wide rate, we
still allocated overhead costs to products based on volume-

based cost drivers
Non-volume-based cost drivers
Not all aspects of manufacturing overhead vary with production
volume
Need to be careful allocating fixed costs with a volume-based
cost driver
Activity-based costing recognises both volume-based and non-
7-41
Volume vs. non-volume based cost drivers
41
Acknowledgement
Some of the slides contained in this presentation were adapted
from:

42
Dept & PW approachesLecture Illustration #1Plant-wide and
departmental overhead ratesProduction deptsP1P2Plant-
wideOverhead$35,000$42,000$77,000Total budgeted
drivers3,000MHr400MHr3,400MHr200DLHr4,0 00DLHr4,200D
LHrPlant-wide approach (using DLHrs)Plant-wide approach
(using DLHrs)P1P2Plant-wideTotal budgeted
overhead$77,000Total budgeted driver 4,200DLHrPlant-wide
allocation rate$18.33per DLHr$18.33per DLHr$18.33per
DLHrDepartmental approach (using DLHs as cost
driver)Departmental approachP1P2Plant-wideTotal budgeted
overhead$35,000$42,000Total budgeted driver
200DLHr4,000DLHrDepartmental allocation rate$175per
DLHr$10.50per DLHrNow choose the most appropriate cost
driver for each departmentsNotice that P1 is "machine
intensive"and P2 is "labour intensive". What does this imply for
choice of driver?Departmental approach using alternative
driversP1P2Plant-wideTotal budgeted

3,000MHr4,000DLHrDepartmental allocation rate$11.67per
MHr$10.50per DLHr
Sheet1Lecture Illustration #1Plant-wide and departmental
overhead ratesProduction deptsP1P2Plant-
drivers3,000MHr400MHr3,400MHr200DLHr4,000DLHr4,200D
allocation rateDepartmental approach (using DLHs as cost
200DLHr4,000DLHrDepartmental allocation rate0Now choose
the most appropriate cost driver for each departmentsNotice that
P1 is "machine intensive"and P2 is "labour intensive". What
does this imply for choice of driver?Departmental approach
using alternative driversP1P2Plant-wideTotal budgeted
3,000MHr4,000DLHrDepartmental allocation rate
2x2 support dept allocnfor reciprocal
method:p=0.1333333333q=0.1111111111Lecture Illustration
#2Production deptsOverheadDriver volDriver
unitP1$35,0003,000MHrP2$42,0004,000DLHrSupport
DeptsQuality Control$27,000Material Handling$33,000Total

overhead$137,000Support Dept service Provisiontotal
volumeunitsQuality ControlMaterial HandlingP1P2Quality
Control18CPUs210616Material
Handling1200Employees1602008401040a. DIRECT
METHODQuality ControlMaterial HandlingP1P2TotalDept
Overhead$27,000$33,000$35,000.00$42,000.00Allocate Quality
Control10/16$16,875.006/16$10,125.00Allocate Material
Handling200/1040$6,346.15840/1040$26,653.85Totals$58,221.
15$78,778.85$137,000Quantity of cost
driver3,0004,000Departmental OH rates:$19.41$19.69per
MHrper DLHrb. STEP DOWN METHODQuality
ControlMaterial HandlingP1P2TotalDept
Overhead$27,000$33,000$35,000.00$42,000.00Allocate
Material
Handling20/100$4,400200/1200$5,500.00840/1200$23,100.00A
llocate Quality
Control$31,40010/16$19,625.006/16$11,775.00Totals$60,125.0
0$76,875.00$137,000Quantity of cost
MHrper DLHr3. RECIPROCAL METHODQuality
ControlMaterial HandlingP1P2TotalDept
Overhead$27,000$33,000$35,000.00$42,000.00Allocate Quality
Control$31,872.1810/18$17,706.776/18$10,624.06Allocate
Material
Handling$36,541.35200/1200$6,090.23840/1200$25,578.95Tota

l$58,797.00$78,203.01$137,000Quantity of cost
MHrper DLHr
Product CostLecture illustration #3Unit cost calculation for
product XYZ:1. Using Direct Method Prime costs$
250.00Overhead cost:P1$ 194.10(10Mhr x $19.41)P2$
157.52(8 DLhr x $19.69)Total unit cost of XYZ $
601.622. Using Step Down Method Prime costs$
250.00Overhead cost:P1$ 200.40(10Mhr x $20.04)P2$
153.76(8 DLhr x $19.22)Total unit cost of XYZ $604.163.
Using Reciprocal MethodPrime costs$ 250.00Overhead
cost:P1$ 196.00(10Mhr x $19.60)P2$ 156.40(8 DLhr x
$19.55)Total unit cost of XYZ $ 602.40NOTE THE
VARIATION IN FINAL PRODUCT COST DEPENDENT ON
METHOD USED
Lecture Illustration #1
Plant-wide and departmental overhead rates
Production deptsP1P2Plant-wide
Overhead$35,000$42,000$77,000
Total budgeted drivers3,000MHr400MHr3,400MHr
200DLHr4,000DLHr4,200DLHr
Plant-wide approach (using DLHrs)
Plant-wide approach (using DLHrs)P1P2Plant-wide
Total budgeted overhead $77,000
Total budgeted driver 4,200DLHr

Plant-wide allocation rate
Unit cost calculation for product XYZ:
Prime costs250.00$
Overhead cost:348.27$
(4 + 15 DLhrs x $18.33)
Total unit cost of XYZ 598.27$
Dept & PW approachesLecture Illustration #1Plant-wide and
departmental overhead ratesProduction deptsP1P2Plant-
200DLHr4,000DLHrDepartmental allocation rate$175per
DLHr$10.50per DLHrNow choose the most appropriate cost
driver for each departmentsNotice that P1 is "machine
intensive"and P2 is "labour intensive". What does this imply for
choice of driver?Departmental approach using alternative
3,000MHr4,000DLHrDepartmental allocation rate$11.67per

MHr$10.50per DLHr
Sheet1Lecture Illustration #1Plant-wide and departmental
overhead ratesProduction deptsP1P2Plant-
200DLHr4,000DLHrDepartmental allocation rateper DLHrNow
choose the most appropriate cost driver for each
departmentsNotice that P1 is "machine intensive"and P2 is
"labour intensive". What does this imply for choice of
driver?Departmental approach using alternative
3,000MHr4,000DLHrDepartmental allocation rate
2x2 support dept allocnfor reciprocal
method:p=0.1333333333q=0.1111111111Lecture Illustration
#2Production deptsOverheadDriver volDriver
unitP1$35,0003,000MHrP2$42,0004,000DLHrSupport
DeptsQuality Control$27,000Material Handling$33,000Total

Plant-wide allocation rate$18.33per DLHr$18.33per
DLHr$18.33per DLHr
Departmental approach (using DLHs as cost driver)
Departmental approachP1P2Plant-wide
Total budgeted overhead$35,000$42,000
Total budgeted driver 200DLHr4,000DLHr
Departmental allocation rateper DLHr
Now choose the most appropriate cost driver for each
departments
Notice that
P1 is "machine intensive"
and
P2 is "labour intensive"
. What does this imply for choice of driver?
Departmental approach using
alternative driversP1P2Plant-wide
Total budgeted overhead$35,000$42,000
Total budgeted driver 3,000MHr4,000DLHr
Departmental allocation rate
Using separate cost drivers
Prime costs250.00$
Overhead cost:
P1198.39$
(17 Mhrs x $11.67)
P2157.50$

(15 DLhrs x $10.50)
Total unit cost of XYZ $605.89
Production deptsOverheadDriver volDriver unit
P1
$35,0003,000
Machine hours (MHrs)
P2
$42,0004,000
Direct labour hours (DLHrs)
Support Depts
Quality Control
$27,000
Material handling$33,000
Total overhead$137,000
Support Dept service
Provision
total
volumeunits
Quality
Control
Material
handlingP1P2
Quality Control
18employees2106
Material handling

1200m
2
160200840
Provision
total volumeunits
Quality
Control (QC)
Material
Handling
(MH)P1P2
Quality Control (QC)18
employees2106
Material Handling (MH)1200
m
2
160200840
1. DIRECT METHOD
Quality
Control
(QC)
Material
Handling
(MH)P1 shareP1P2 shareP2Total
Dept Overhead$27,000$33,000$35,000$42,000$137,000

Allocate QC10/16$16,8756/16$10,125$27,000
Allocate MH200/1040$6,346840/1040$26,654$33,000
Totals$58,221$78,779$137,000
Quantity of cost driver3,0004,000
Departmental OH rates:$19.41$19.69
per MHrper DLHr
Provision
total volumeunits
Quality
Control (QC)
Material
Handling
(MH)P1P2
employees2106
m
2
160200840
2. STEP DOWN METHODQC share
Quality
Control
(QC)MH share
Material

Handling
(MH)P1 shareP1P2 shareP2Total
Dept Overhead$27,000$33,000$35,000$42,000$137,000
Allocate
MH160/1200$4,400200/1200$5,500840/1200$23,100$33,000
Allocate QC$31,40010/16$19,6256/16$11,775$31,400
Totals$60,125$76,875$137,000
per MHrper DLHr
Provision
total volumeunits
Quality
Control (QC)
Material
Handling
(MH)P1P2
employees2106
m
2
160200840
3. RECIPROCAL METHODQC share

Quality
Control MH share
Material
Handling P1P2Total
Dept Overhead$27,000$33,000$35,000$42,000$137,000
Allocate QC$31,87210/18$17,7076/18$10,624$28,331
Allocate MH$36,541200/1200$6,090840/1200$25,579$31,669
Total$58,797$78,203$137,000
per MHrper DLHr
1. Using Direct Method
Prime costs250.00$
Overhead cost:
P1194.10$
(10Mhr x $19.41)
P2157.52$
(8 DLhr x $19.69)
2. Using Step Down Method
Prime costs250.00$
Overhead cost:
P1200.40$
(10Mhr x $20.04)
P2153.76$

(8 DLhr x $19.22)
Total unit cost of XYZ $604.16
3. Using Reciprocal Method
Prime costs250.00$
Overhead cost:
P1196.00$
(10Mhr x $19.60)
P2156.40$
(8 DLhr x $19.55)
NOTE THE VARIATION IN FINAL PRODUCT COST
DEPENDENT ON METHOD USED
Chapter 5
Process Costing and Operation Costing
No reproduction or posting of this material, except as provided
in the Copyright Act 1968, is permitted without the written
permission of Monash University, Faculty of Business and
Economics.
MONASH
BUSINESS
SCHOOL

Week 5 and 6 are going to be tough!!
Try and keep on top of your work – don’t fall behind
It will get easier
I PROMISE
Understand how a process costing system operates where work
in process (WIP) inventories are involved
Assign total production costs to completed units and WIP
inventory using the Weighted Average method
Assign total production costs to completed units and WIP
inventory using First-in-First-out
Process costing and spoilage
Understand in what contexts operation or hybrid costing would
be appropriate and explain how it could work in these particular
contexts
□

□
□
□
□
Job costing and process costing are two extremes of the
continuum of conventional product costing systems
Job costing systems accumulate the costs of each job
Process costing systems accumulate the cost of each process
then average these costs across all units produced
Many businesses use a combination of job and process costing;
this is called hybrid costing
Job Costing vs. Process Costing

Slides prepared by
Two main steps:
Estimate the cost of the production process
Calculate the average cost per unit by dividing the cost of the
process by the number of units produced
Process costing can occur where there is no opening or closing
WIP inventory (remember the simple example from last week?)
More complex process costing accounts for WIP inventory
Process Costing
Simple Process Costing: Packaged Cereal
Cleaning & Mixing cost / unit… $250,000 / 80,000 = $3.125
/unit
Packaging cost / unit .…………$150,000 / 80,000 = $1.875 /unit
Total product cost……………… $ 5.00 /unit
Note also: The value of completed units =80,000 x $5=
$400,000
4-7

inventory
No WIP at end of each work shift since health regulations
require the machines to be cleaned each day.
# units produced (i.e. number of boxes of cereal): 80,000
Required: Calculate the product cost for June.June
periodCleaning & mixingPackagingDirect materials $
130,000 $ 20,000Direct labour $ 40,000 $
30,000Mfg Overhead $ 80,000 $ 100,000Total $
250,000 $ 150,000
FROM LAST WEEK’S LECTURE!
7
To Think About…
What if there was work-in-process inventory? For example,
some units are 20% finished, some 70% finished
What would the product cost for June be given that not all
manufacturing processes (and therefore costs) have been
completed?

Remember this question from last week??
8
Now Imagine….
The health regulations did not apply in the packaging
department, so within it there may be partially completed units
at the start and end of each month.
Now the cost of packaging per unit no longer = total cost for the
department ÷ the number of units worked on. Why?
Previously, Packaging cost / unit
= $150,000 / 80,000 = $1.875 /unit
But now, what should the denominator be?
Now we have two inventories:
(1) completed units, and
(2) partially completed units

9
WIP inventory
Not all products are complete at the beginning or end of the
accounting period (usually a month)
Sometimes production costs differ from month to month
So …. when WIP exists, production costs should be calculated
by taking into account:
Units started in the previous month (beginning WIP) and
completed in the current month … maybe at a different cost
Units started and completed during the current month
Units that are incomplete at the end of the month (ending WIP)
…. and therefore, haven’t consumed all their costs yet
Process Costing with WIP
Materials costs are an input into production at various stages
for example, 50% of materials are applied to production at the
beginning of the production process, the remainder (50%) when

the product is 70% completed or converted
Remember conversion costs from Week 2?!
The cost of converting material into a product
Conversion cost = direct labour + manufacturing overhead
We usually assume that conversion costs are applied uniformly
throughout the production process (rather than applied at
distinct points in the production process as above in relation to
material costs)
Partially completed goods at the beginning or end of the
accounting period are converted to equivalent units for costing
purposes
Equivalent units:
The amount of production inputs that have been applied to the
physical units in production
Physical units are all units currently in production whether
complete or incomplete

Conversion of WIP inventory into equivalent units provides the
basis for calculating product cost
5 Physical Units
2.5 Equivalent Units
Equivalent Units
Calculation of equivalent units:

For WIP of 10,000 litres of a carbonated beverage:
100% complete for direct materials, which were all added at the
50% complete for conversion costs, assuming that conversion
cos
equivalent units of conversion
Process Cost Report
Uses of the Process Costing Report
Enables managers to estimate and value the cost of inventories
Inventory values become an input into the Cost of Goods
Manufactured, Cost of Goods Sold and Income Statement
remember from Week 2?
The unit costs for materials, conversion and in total:
Provide key inputs into management decisions relating to
product price and product mix
Provide a basis for assessing product profitability
Used for control purposes by comparing unit costs over time or

with industry benchmarks
Steps in Process Costing
1. Analyse the physical flow of units
2. Calculate the equivalent units
3. Calculate the unit costs
4. Analyse the total costs
Products are costed using one of two assumptions about product
flow:
Weighted average method
First-in, first-out (FIFO) method
FIFO assumes that the WIP inventory is completed before the
production of new units commences
The weighted average does not make this assumption; it does
not distinguish between opening WIP units and units started
during current period
Comparison of Weighted Average and FIFO

Let's say you are a furniture store and you purchase 200 chairs
for $10 and then 300 chairs for $20, and at the end of an
accounting period you have sold 100 chairs.
Weighted Average Cost:
Cost of a chair: $8,000 divided by 500 = $16/chair
Cost of Goods Sold: $16 x 100 = $1,600
Remaining Inventory: $16 x 400 = $6,400
FIFO:
Cost of Goods Sold: 100 chairs sold x $10 = $1,000
Remaining Inventory: (100 chairs x $10) + (300 chairs x $20) =
$7,000
The weighted average cost method is most commonly used
where inventories are piled or mixed together and cannot be
differentiated, such as chemicals, oils, etc.

Chemicals bought two months ago cannot be differentiated from
those bought yesterday, as they are all mixed together
When to Use Weighted Average or FIFO
FIFO often used in foodstuffs and other goods that have a
limited shelf life, because the oldest goods need to be sold
before they pass their sell-by date
June periodCleaning & mixingPackagingDirect materials $
130,000 $ 20,000Direct labour $ 40,000 $
250,000 $ 150,000
Lecture Illustration 1 (contd. from cereal example)
Calculate the following using the WA and FIFO methods:
1. What is the value of units completed in June?
2. What is the value of the WIP inventory at end of June?
Finished Goods Work in Process (WIP)

Round all calculations to two decimal places
22
80,000 units were started in June by the Packaging department.
There were 10,000 units in WIP from May. Assume this WIP is
40% complete in relation to consumption of DL and OH, but
each unit has 100% of its DM requirement since all packaging
materials are made available (or added) at the beginning of the
process (This is a common assumption in process costing).
The value of this opening WIP inventory was $12,000; this is
made up of $2,000 of DM cost and $10,000 of conversion costs.
At the end of June, there were 4,000 partially completed units
and these were 70% converted (but contained 100% of their
DM)
Further information…..

23
Weighted Average Method
Step one: analyse the physical flow of units
10,000 + 80,000 = ? +4,000
86,000
Physical units in beginning WIP
Physical units started
Physical units completed and transferred out
Physical units in ending WIP
+
=
+

Start Preparing the Process Cost Report….
Fill in the physical flow of units
(from last slide)
Fill in the conversion %
?
?
?
?
Next step: calculate the equivalent units here
Calculate equivalent units for units completed and transferred
out & ending WIP
The equivalent units in beginning WIP are not identified
separately;
This is a key feature of the weighted average method
Step Two: Calculate the Equivalent Units
Not included for WA method

Step three: calculate the unit costs
The cost per equivalent unit for DM is the total direct material
costs divided by the total equivalent units for DM
The cost per equivalent unit for conversion cost is the total
conversion cost divided by the total equivalent units for
conversion
Under the weighted average method the cost per equivalent unit
is based on the total costs incurred including the cost of
beginning WIP
Weighted Average Method: Step 3
From Step 2 (Slide 26)
Included under WA method but not FIFO
22,000/90,000
etc.....
(Round to 2 decimal places here)

From slides 22 and 23
$0.24 + $1.58
Step four: analyse the total costs
Calculate (as per the question on slide 25) the following:
The cost of units completed in June
The cost (to date) of closing WIP at the end of June
From Step 3
From Step 1
100% complete!
100% complete for direct material!
Only 70% complete so… only 2,800 (4,000 x 70%) equivalent

units of conversion costs incurred
Oh no … wait
There’s another method!
First-in-First-out (FIFO)
Finished – yaaay!!!!
Different assumptions regarding inventory (see slide 21)
So how does the process cost report differ under FIFO?

Step 1: Identical to weighted average method
Step 2: Equivalent units in opening WIP are subtracted from
total equivalent units to give equivalent units of new production
for the month
Step 3: Costs of opening inventory are not used in the
calculation of costs per equivalent unit
Step 4: The cost to finish beginning WIP units, and the cost of
units started and finished in the current month are calculated
separately
Step one: analyse the physical flow of units
Identical to the weighted average method
10,000 + 80,000 = ? +

4,000
86,000
Physical units completed and transferred out
+
=
+
First in First Out (FIFO) Method
Start Preparing the Process Cost Report….
Fill in the physical flow of units
(from last slide)
Fill in the conversion %
?
?
?
?
Next step: calculate the equivalent units here

Step two: calculate the equivalent units
Under FIFO the equivalent units in opening WIP are subtracted
from total equivalent units to give equivalent units of new
production for the current month (June)
– key difference
Calculate EQU as usual
Subtract opening equivalent units
Key difference is the treatment of the beginning WIP
Under the weighted average method the cost of beginning WIP
and equivalent units of work done on WIP are included in the

calculation of the average cost per equivalent unit
Under FIFO the cost per equivalent unit is based only on costs
incurred in the current month
Step three: calculate the unit costs
The cost per equivalent unit for DM is the direct material cost
incurred during the current month divided by the new equivalent
units added during the current month (June)
The cost per equivalent unit for conversion cost is the
conversion cost incurred during the current month divided by
the new equivalent units added during the current month (June)
Costs of opening inventory are not used in this calculation – key
difference

From Step 2
Blank
Blank
From slide 22
130,000/84,800
etc.....
(Round to 2 decimal places here)
$0.25 + $1.53
Step four: analyse the total costs
Assumes that the units in beginning WIP are completed and
transferred out first
Therefore, the costs of the beginning WIP are not mixed with
the new costs incurred during the current month
…..so we have to calculate three separate costs:
The cost to finish beginning WIP units (inclusive of costs
incurred in May) – key difference

The cost of units started and finished in June
The cost (to date) of closing WIP at the end of June
From Step 3
From Slide 23
Opening WIP was 40% converted; therefore, in June, to
complete these units, 6,000 EQU (10,000 x 60%) of conversion
costs were incurred
Refer to slides 35 and 36 – 86,000 units were completed &
transferred out in June. However, 10,000 of these came from
opening WIP – we have already calculated the cost of these
units above. Therefore, 76,000 (86,000 – 10,000) were started
and finished in June
100% complete!
Only 70% complete so… only 2,800 (4,000 x 70%) equivalent
units of conversion costs incurred
100% complete for direct material!

Process Costing and Spoilage
Spoilage cost: the cost of defective products and wasted
resources that cannot be recovered by rework or recycling
Spoiled units are also costed using cost per equivalent unit
Spoilage is accounted for depending on whether it is normal or
abnormal:
Normal spoilage: inherent in the production process and occurs
even under efficient operating conditions
Included as part of the cost of good units completed
Abnormal spoilage: should not occur under efficient operating
conditions
Costs of abnormal spoilage are expensed
Physical flow of units with spoilage

Physical units completed and trans’d out
=
+
spoiled units
+
+
Total units to account for
Total units accounted for
43

Hybrid Costing Systems
Some businesses have repetitive production processes but
produce a narrow range of products that differ in some
significant aspects:
Different material inputs
Different combinations of specific production processes

Click to edit Master text styles
Second level
Third level
Fourth level
Fifth level

46
Operation costing is a hybrid costing system
Used in a batch manufacturing environment
Contains features of both job costing and process costing
A product initially uses different raw materials, and is then
finished using a common process that is the same for a group of
products; or
A product initially has identical processing for a group of
products, and is then finished using more product-specific
procedures
A company manufactures watches in lots of 1,000
The watch casings and workings for all 1,000 units are
identical, so the company simply adds up the cost of the
production run and divides by 1,000 units to arrive at the per-
unit cost
However, watch straps are custom-made for the wrist size of the
customer, and use a variety of unique materials

These costs are compiled for each individual watch
Thus, we have process costing for one portion of the production
process (the watch casings and workings) and job costing for
another portion (the watch bands)
Hybrid Costing Systems: Watches
A company builds unique, custom-designed race cars
It uses job costing to compile the cost of each car
However, all cars are then run through a paint shop, which is
essentially a fixed cost
The cost of the paint booth is allocated equally to all of the cars
run through it, which is process costing
Thus, we use job costing for the first part of the production
process and process costing for the second part
Hybrid Costing Systems: Race Cars
Hybrid Costing System

Acknowledgement
Some slides contained in this presentation were adapted from:
52
2. Equivalent Units
1. Physical Units# units
% complete
wrt
conversion
Packaging
DM
Packaging
Dept
Conversion
WIP 1st June10,00040%

Units started in June (transferred in from C&M)
80,000
Total units to account for90,000
Units completed & transferred out in June
86,000100%86,00086,000
WIP 30 June4,00070%4,0002,800
Total units accounted for90,00090,00088,800
3. Costs to Account for & Unit CostsTotal
WIP 1st June$2,000$10,000
Costs incurred during June$20,000$130,000
Total costs to account for:$22,000$140,000
Cost / EQU (Weighted Average method)$0.244$1.577$1.821
4. Calculation of Inventory values:
86,000$156,608
(86,000 x $1.821)
WIP 30 June4,000$978$4,414$5,392
(4000 x $0.244)(2,800 x $1.577)
Total costs to account for:$162,000
2. Equivalent Units
% complete
wrt
conversion
Packaging

DM
Packaging
Dept
Conversion
80,000
86,000100%
WIP 30 June4,00070%
Total units accounted for90,000
2. Equivalent Units
% complete
wrt
conversion
Packaging
DM
Packaging
Dept
Conversion
80,000

86,000100%86,00086,000
WIP 30 June4,00070%4,0002,800
Total units accounted for90,00090,00088,800
DMConversion
Total units accounted for90,00088,800
WIP 1st June$2,000$10,000
Total costs to account for:$22,000$140,000
Cost / EQU (Weighted Average method)$0.24$1.58$1.82
DMConversion
$0.24$1.58$1.82
86,000$156,520
(86,000 x $1.82)
WIP 30 June4,000$960$4,424$5,384
(4000 x $0.24)(2,800 x $1.58)
2. Equivalent Units
% complete
wrt conversion
Packaging

DM
Packaging Dept
Conversion
80,000
90,000
Units completed & transferred out in
June86,000100%86,00086,000
WIP 30 June4,00070%4,0002,800
90,00090,00088,800
less EQU in WIP 1st June10,0004,000
EQU in June production only
80,00084,800
DMConversion
EQU in June production only
80,00084,800
WIP 1st June
Cost / EQU for June$0.25$1.530$1.78
DMConversion
Cost / EQU for June$0.25$1.53$1.78

Units completed & transf'd out in June
from WIP 10,000$12,000
cost to finish WIP$9,180$9,180
(6,000 x $1.53)
started & finished in June76,000$135,280
(76,000 x $1.78)
TOTAL transfer out$156,460
WIP 30 June4,000$1,000$4,284$5,284
(4,000 x $0.25)(2,800 x $1.53)
Chapter 4
Product Costing Systems
Economics.
MONASH
BUSINESS
SCHOOL

Explain the role of product costing systems in decision-making
Understand the flow of costs through the various manufacturing
accounts
Use basic techniques to allocate manufac turing overhead costs
to products
Distinguish between different types of product costing systems
and understand what types of contexts each are most applicable
to
Estimate product costs using a basic process or job costing
system, and prepare journal entries to record costs
□
□
□
□
□
Product Costing Systems
Accumulate product-related costs and use procedures to assign

them to the organisation’s final products
Can include both manufacturing costs and upstream and
downstream costs
3
Electricity
Rent
Salaries/Wages
Supplies
Depreciation
Equipment
Loading Machine
Operating Machine
Packaging
Moving/Handling
Maintenance
Product Cost

Cost Allocation
For Example: Activity-Based Costing
We will come back to this in Week 7!
Why Do We Need Product Costing Systems?
GAAP requires the determination of the cost of goods sold or
services performed for financial reporting
Many important strategic decisions are made at the product-line
level – for example, product profitability helps guide product
portfolio or pricing decisions (Week 8 topic)
Can help in cost and operational control
5
Different Product Costs for Different Purposes
We need different measures of product costs for different
management decisions.
Only manufacturing costs are included in product costs for
external reporting purposes (e.g. inventory valuation)

For managerial decisions, product costs may include different
combinations of upstream, manufacturing and downstream costs
6
Scope of Product Costs
The types of costs to be included in product costs for
managerial decisions depends on:
The type of managerial decision to be made
Whether the decision has short-term or long-term implications
Managers’ personal preferences

COMPLETELY DEPENDENT ON CONTEXT OF THE
ORGANISATION AND NEEDS OF MANAGERS
When Choosing a Product Costing System…
Cost and benefits of providing various types of cost estimates
must be assessed
Some organisations will use product costs developed for
external reporting due to the high cost
of developing more relevant cost
estimates for managerial decision
making
When Designing a Product Costing System…
9

External Financial Reporting….
Does not require a high level of accuracy or relevance for
product costing - the method simply needs to be systematic and
reasonable
Only manufacturing costs are assigned to products for the
purposes of inventory valuation - as required by Australian
accounting standards
Upstream and downstream costs are expensed in the period in
which they are incurred – Internally, these may be included in
product costs where relevant to managers’ decision making
10
Direct Materials
from suppliers
Employees
Direct Labour
Manufacturing overhead consumed

factory rent
utilities
indirect labour
Etc.
Direct Materials store
Finished Goods Warehouse
Work in Progress
in the factory
Customer
Salesman
Physical Flows in Manufacturing

Second level
Third level
Fourth level
Fifth level
11
Flow of Costs in Manufacturing Businesses
Manufacturing costs flow through several ledger accounts:
Raw materials inventory
Work in process inventory
Finished goods inventory
Cost of goods sold expense
Profit and loss account
12

Allocating Overhead Costs to Products
To estimate the cost of a product we need to identify the cost
of resources used to produce the product
Some resources are consumed directly by products and are
traced directly to each product
Direct material and direct labour
Overhead costs are essential to production but as they have
no observable relationship with the product they need to be
allocated to products
These cost are indirect costs to the product
Inspection costs
Quality Training
Data Storage
Salaries of IT

staff
Cleaning
Rent
Council Rates
Quality Control
Property
Computing
Product
or department
15
Steps in Allocating OH Costs to Products
Aggregate overhead costs into cost pools
Identify the overhead cost driver
the factor that causes the cost to be incurred (remember from
last week?!)
Calculate a predetermined (or budgeted) overhead rate per unit
of cost driver
Eg. If annual OH budget = $ 7.5M
Annual labour budget = 50K hours (and labour hours is the cost

driver)
then budgeted OH rate = $150/hour
Apply manufacturing overhead costs to products at the budgeted
(or predetermined) overhead rate, multiplied by the actual
quantity of cost driver consumed by the product
- E.g. if producing a product required 10 labour hours
$1500 of overhead would be applied to the product ($150 x 10)
16
Accounting for Manufacturing Overhead
Two types of manufacturing overhead are recorded :
Applied manufacturing overhead
Estimate of manufacturing overhead used to manufacture a
product
Applied to products using a predetermined OH rate
Credited to the manufacturing overhead account
Actual manufacturing overhead
Actual manufacturing overhead costs incurred throughout the
accounting period
Might be different to applied manufacturing overhead

Debited to the manufacturing overhead account
17
-Hill Australia Pty Ltd
PowerPoint Slides t/a Management Accounting 5e by Langfield-
Smith
Prepared by Kim Langfield-Smith
Second level
Third level
Fourth level
Fifth level
18
At the end of an accounting period, total actual
manufacturing overhead may not equal total applied
manufacturing overhead

Disposing of underapplied or overapplied overhead at the end
of the accounting period. Two options:
Close the underapplied or overapplied overhead to cost of goods
sold
Or
Prorate the underapplied or overapplied overhead to cost of
goods sold, work in process inventory and finished goods
inventory
Accounting for Manufacturing Overhead
Illustration 1
The following data relate to Fine Furniture Pty Ltd for the year
2017:
Required:
1.Calculate predetermined MOH rate using:

a) Machine Hours b) DL Hrs c) DL Dollars
2. Calculate over/under-applied MOH using each of the cost
drivers
3. Prepare journal entries in relation to MOH costs for the year
(charge any under-/over-applied MOH to COGS)
Budgeted machine hours20,000Budgeted DL
hours40,000Budgeted DL rate$25.00/hrBudgeted MOH
costs$800,000Actual MOH costs$820,000Actual machine
hours22,000Actual DL hours35,000Actual DL rate$26.00/hr
20
Calculations
21
Types of Product Costing Systems
Conventional product costing systems range from job costing to
process costing
Depends on the type of product being produced and the

production environment
22
Slides prepared by
Next week!
Production costs traced to process/department and averaged
across all units produced
Mass production or repetitive processes environment
Used in petrol production, processed food, chemical and
plastics manufacturers

Slides prepared by Kim Langfield-Smith
Process Costing
Used in areas where there are repetitive services such as routine
processing of cheques by banks, handling of licence
applications by government departments
Process Costing
Steps in determining product cost:
Estimate the cost of production processes
2. Calculate the average cost per unit by dividing the cost of
the process by the number of units produced
Where there are sequential processes or departments, costs
are transferred from one department to the next at an average
unit cost for the department

Finished goods
No work-in-process inventory
# units produced (i.e. number of boxes of cereal): 80,000
Cereal Manufacturer
Required: Calculate the product cost for June.
Simple Process Costing in a Manufacturer
Cleaning & Mixing cost / unit… $250,000 / 80,000 = $3.125
/unit
Packaging cost / unit .………….$150,000 / 80,000 = $1.875
/unit
Total product cost……………… $ 5.00 /unit
Note also: The value of completed units = 80,000 x $5 =
$400,000
June periodCleaning & mixingPackagingDirect materials $
130,000 $ 20,000Direct labour $ 40,000 $
250,000 $ 150,000

27
To Think About…2 Issues
What if there was work-in-process inventory? For example,
some units are 20% finished, some 70% finished
What would the product cost for June be given that not all
manufacturing processes (and therefore costs) have been
completed?
What if more than one type of cereal was produced?
What if some of the cereal products required complex
manufacturing processes in some of the production department
but not others?
How would we figure out how much cost should apply to
different production departments and hence, cereal products that
pass through them?
Hint: We have to come up with a better allocation method than
the one on the previous slide
Stay tuned over the next week to find out more!

28
Job Costing Systems
Manufacturing costs traced to individual jobs
Products produced are significantly different and may be
produced in distinct jobs/batches
Used by printers, furniture manufacturers, machinery
manufacturers
Use in service firms such as lawyers, accountants, consulting
engineers
29

Purchase of materials Debit Credit
Raw material inventoryxxxx
Account payable/Cashxxxx
Transferring direct material to jobs
Work in process inventoryxxxx
Raw material inventoryxxxx
Journal Entries (Job Costing)
If purchased on credit
Charging direct labour to jobsDebit Credit
Work in process inventoryxxxx
Wages payable/Cashxxxx
Accounting for indirect labour
Manufacturing overheadxxxx
Wages payablexxxx
Accounting for manufacturing costs
Manufacturing overheadxxxx
Prepaid rentxxxx
Depreciation on equipmentxxxx

etc.
34
Application of manufacturing overhead
Work in process inventory xxxx
Manufacturing overhead xxxx
Completion of production job
Finished goods inventory xxxx
Work in process inventory xxxx
Accumulated cost of the job (DM, DL + MOH)
Sale of goods
Accounts receivable xxxx
Sales revenue xxxx
Cost of goods sold xxxx
Finished goods inventory xxxx

Underapplied overheadDebit Credit
Cost of goods soldxxxx
Manufacturing overhead xxxx
Or the reverse entry if overhead is overapplied
Don’t forget!!!! Always THREE journal entries for
manufacturing overhead:
1) Actual amount
2) Applied amount
3) Underapplied/overapplied amounts
Illustration 2
Aberat Pty Ltd manufactures custom made furniture and uses a
job costing system. The following information relates to
February.
1. Manufacturing supplies opening inventory $1,000
2. Direct material (plastic) opening inventory $4,500
3. WIP inventory (Job 101 (Chairs), started on Jan 10):
Direct materials (plastic) $1,000
Direct labor: 50 DLHs x $8 400
Manufacturing overhead: 50 DLHs x $6

300 $1,700
4. Finished goods opening inventory $0
5. Feb, 4: Purchase of direct materials (plastic):
$2,000
6. During February, the following materials were issued to
production:
Direct materials (plastic)
Job 101 (Chairs, started on Jan 10) $1,000
Job 102 (50 coffee tables, started on Feb 5) 1,100
$2,100
Indirect materials 200 $2,300
38
Illustration 2 (Cont’d)
7. The payroll summary showed the following totals for
February:
Job 101 – 100 hrs @ $4.50$450
Job 102 – 45 hrs @ $8.00 360 $ 810
Indirect labour 400 $1,210

8. Other indirect manufacturing costs incurred during February:
$400
9. On 20 February, Job 101 was completed, and all of the 100
chairs were transferred to finished goods inventory. The
manufacturing overhead costs were added to the job cost sheet
using the predetermined manufacturing overhead rate of $6.00
per direct labour hour.
10. Fifty (50) of the 100 chairs completed on Job 101 were
shipped to the customer. The chairs were sold for $80 per unit.
11. Job 102 remained incomplete at the end of February.
Manufacturing overhead costs were applied to Job 102.
Required: Complete the following ledger accounts to reflect the
transactions for February.
39
Ledger TransactionsManufacturing Supplies InventoryWork in

progress InventoryFinished Goods InventoryDirect Materials
InventoryCost of Goods SoldManufacturing OverheadWages
PayableSales RevenueAccounts payableAccounts
receivable(various accounts)
40
Calculations
Presentation title
41
Journal Entries: Job vs. Process Costing
The journal entries in process costing are basically similar to
those made in job costing systems
The main difference is that, in process costing, there is often
more than one work-in-process account –– one for each process
In contrast, job costing has just one work-in-process account

42
Acknowledgement
Some slides contained in this presentation were adapted from:
43
Chapter 3
Cost Behaviour, Cost Drivers and Cost Estimation
Economics.
MONASH

BUSINESS
SCHOOL
Explain the relationship between cost estimation, cost behaviour
and cost prediction
Understand the concept of cost drivers, including volume-based
and non-volume based cost drivers, and the hierarchy of cost
drivers – unit, batch, product, facility
Identify and analyse different cost behaviours, including
variable, fixed, step-fixed, semivariable & curvlinear
Use different approaches to cost estimation, including
managerial judgement, the engineering approach and
quantitative analysis
Explain the difficulties of estimating costs in practice and think
of ways to overcome them
□
□
□
□
□

The Relationship between Cost Behaviour, Estimation, and
Prediction
COST
BEHAVIOUR
COST
PREDICTION
COST
ESTIMATION
The process of determining cost behaviour
The relationship between a cost and the level of activity
Using knowledge of cost behaviour to forecast the level of cost
at a particular level of activity
How do We Estimate Cost Behaviour?
…by using cost drivers
What is a cost driver?
An activity or factor that drives a cost to be incurred
In choosing appropriate cost drivers, consideration needs to be
given about the underlying causes of the costs

What drives it to go up or down?
3-4
The cost of paint goes up
Why? What drives the increase?
There is an increase in the number of cars sprayed
Cost driver = number of
cars
A volume-based cost driver
Example 1: A Spray-Painting Business
Administration costs in the corporate headquarters has gone
down. Why?
Senior managers decided to hold less face-to-face meetings and
communicate electronically instead
Cost driver = number of face-to- face senior management

meetings
A non volume-based cost driver
Example 2: A Large Bank
Conventional vs. Contemporary Cost Drivers
Conventional approach:
Uses volume-based cost drivers (e.g., Units produced, DLH,
DL$, MH)
Assumes that all costs are driven by the organisation’s level of
activity, for example production or sales volume
This will be accurate for direct product costs such as direct
material and labour….but not for other types of costs
Contemporary approach:
Recognises that there are a range of possible cost drivers other
than production volume that explain cost behaviour
Uses both volume and non-volume based cost drivers
Activity-based Approach to Cost Drivers
Classifies costs and cost drivers into four levels:

Unit level
Batch level
Product (or product-sustaining) level
Facility level
Unit level costs:
Relate to activities performed for each unit produced
Use conventional volume-based cost drivers
Example: Direct material
Batch level costs:
Relate to activities performed for a group of product units
Examples include a batch or a delivery load
Example: Delivery costs
Product level costs:
Also called product sustaining costs
Relates to activities performed for specific products or product
groups
Example: Research & design costs
Facility level costs:
Also called facility- sustaining costs
Costs incurred to run the business, not caused by any particular
product
Example: Premises costs

3-10
Unit
Facility
Batch
Batch
Product/Facility
Selecting the Best Cost Drivers
How detailed should the analysis be?
As total costs of the organisation are split into smaller cost
categories and associated costs drivers, the accuracy of the
resulting information will increase
Cost-benefit criteria are important
Long or short term?

Cost behaviour and cost drivers can change over time
Choice depends on the intended purpose of the cost analysis, for
example short-term budgeting or long-term strategic decision
making?
Selecting the Best Cost Drivers…. (cont’d)
Cost estimation or cost management?
Cost estimation: understand cost
behaviour so that we can estimate cost
functions or predict future costs
Cost management: analysing costs to reduce costs and manage
resources more effectively
Effective cost management requires the identification of root
cause cost drivers – the basic factors that cause a cost to be
incurred
Cost drivers that are used to predict costs may differ from those
used to manage costs

The research department sends out blood samples for
examination to an external pathology lab.
What is the cost driver of this activity?
For cost estimation purposes: Number of blood samples sent
For cost management purposes: Skill level of staff
Research Cost - $1.5 million – Pharmaceutical Company
Remember last week?!
Cost-benefit Considerations
To predict costs accurately, there is a trade-off between:
Having a strong correlation between the cost and cost driver,
therefore increasing the accuracy of the cost information and
Having a cost driver that is easy to measure
Many organisations select cost drivers for convenience reasons,
not for their ability to predict costs accurately
Also, with more cost drivers, the costs of gathering and
analysing information about costs and cost drivers will also

increase
Need to consider cost vs. benefits
A matter of managerial judgement
Therefore….
When choosing cost drivers, the costs and benefits of each
driver must be assessed, taking into account:
Reasons for analysing cost behaviour
Timeframe for analysing the cost behaviour
Availability of data on cost drivers
Cost Behaviour Patterns
Cost behaviour
The relationship between a cost and the level of activity (or cost
driver)
Cost behaviour patterns
Variable costs
Fixed costs

Step-fixed costs
Semivariable costs
Curvilinear costs
Variable Costs
Variable costs change in total, in direct proportion to changes in
the level of activity, but the variable cost per unit remains
constant
Constant
Changes
Fixed Costs
Fixed costs remain unchanged in total despite changes in the
level of activity, but fixed cost per unit changes
Fixed cost per unit is often calculated for use in product costs
but is of limited use in management decision making as it does

not reflect the way that fixed costs actually behave
Modern approaches to cost analysis recognise that there are cost
drivers for some of these fixed costs and very few costs actually
remain fixed
Activity based costing in Week 7
3-19
Changes
Constant (compare with variable
costs!)
Lecture Illustration 1
The following table shows the costs during a month if 600 cars
are spray-painted

Required: Fill in the values labelled (a) to (p) in the table
Number of spray-painted cars500600700 Fixed Costs(a)$84
000(b) Variable costs(c) (d)(e) Total costs(f)$144 000(g) Cost
per spray-painted car: Fixed cost (h)(i)(j) Variable
cost(k)(l)(m) Total cost per car:(n)(o)(p)
Lecture Illustration 1
The following table shows the costs during a month if 600 cars
are spray-painted

Required: Fill in the values labelled (a) to (p) in the table
Number of spray-painted cars500600700 Fixed Costs$84
000 Variable costs Total costs$144 000Cost per spray-painted
car: Fixed cost Variable cost Total cost per car:
Variations in Cost Behaviour Patterns
Step-fixed costs
Remain fixed over a wide range of activity levels but jump to a
different amount for levels outside that range
Semi-variable (or mixed) cost
Has both fixed and variable components
Curvilinear cost
At lower levels of activity there is decreasing marginal cost
At higher levels of activity there is increasing marginal cost

Marginal cost: the cost of producing one additional unit
As opening hours increase, more managers are employed
Mixed Costs
Most costs are mixed or semi-variable
This means they have both a fixed and variable cost component
They can be represented using the following cost function:
Y = a + bX
Where Y = total cost
a = fixed cost component (the intercept on the vertical
axis)
b = variable cost per unit of activity (the slope of the
line)
X = the level of activity

Petrol, oil and maintenance costs – vary proportionately with
number of deliveries made
Lease, insurance, and delivery staff salary costs – remain
constant irrespective of number of deliveries
For up to 1000 batches, marginal electricity costs decrease as
economies of scale are achieved.
Above 1000 batches, older machinery needs to be used so
marginal electricity costs increase.
Cost Behaviour and the Relevant Range
The relevant range is the range of activity over which a
particular cost behaviour pattern is assumed to be valid
For example:
The direct material cost per unit may only hold for production
up to 1000 units per day, and for higher volumes the cost per
unit may decrease due to cheaper cost of buying material in
larger quantities

Cost Estimation
Identifying the specific cost behaviour pattern for each cost
Approaches to cost estimation:
Managerial judgment
Engineering approach
Quantitative analysis
Visual fit method
High-low method
Regression analysis
Managerial Judgment
Using experience and knowledge rather than formal analysis to
classify costs behaviour
Future costs are estimated by examining past costs and
identifying other factors that might affect costs in the future
Reliability of cost estimates is dependent upon the ability of the

manager
Engineering Approach
Studying processes that result in the incurrence of a cost
Using time and motion studies - employees are observed as they
work to record the steps for each task and the times taken
Useful when there is no reliable past data on which to base cost
estimates
Most effective when there is a direct relationship between
inputs and outputs
However, expensive and time-consuming
Quantitative Analysis
Formal analysis of past data to identify the relationships
between costs and activities
Three approaches:
Visual fit method - a scatter plot diagram involves plotting the

data points to visualise the relationship between cost and level
of activity
High-low method - involves taking the two observations with
the highest and lowest level of activity to calculate the cost
function
Regression analysis - is a statistical technique that uses a range
of data points to estimate the relationship between cost and
cost drivers
Example: Dental ClinicMonthNo. of patientsMaterial
costs1160$3,4002120$3,0003150$3,2004100 $2,500580$2,10061
30$3,2007140$3,0008190$4,1009230$5,10010170$3,80011160$
3,20012180$3,900
32
Visual Method - Scatter Plot Diagram

Material
costs160120150100801301401902301701601803400300032002
50021003200300041005100380032003900
No. of patients
Material costs
Lecture Illustration 2: High-Low Method
Nature Clinic’s data for last year in relation to in-house
diagnostic blood tests are as follows:
Required: Use the high–low method to estimate the company’s
cost behaviour and express it in equation form.
MonthNo. of blood

testsCostJanuary6,100$63,500February5,300$50,500March4,900
$50,500April4,800$51,500May5,100$51,500June3,000$31,000J
uly4,500$44,500August7,100$72,000September6,200$57,000Oc
tober4,700$46,500November5,900$64,500December6,000$61,0
00
Illustration 2: High-Low method
Calculations:
35
35
Regression Analysis
A statistical technique used to estimate the relationship between
a dependent variable (cost) and independent variables (cost

driver)
The line of best fit makes deviations between the cost line and
the data points as small as possible
More accurate than high-low method as it makes use of all data
and has statistical properties that allows inferences to be drawn
between cost and activity levels
Simple regression involves estimating the relationship between
the dependent variable (Y) and one independent variable (X)
Y = a + bX
Multiple regression estimates a linear relationship between one
dependent variable and two or more independent variables
Y = a + b1X1 + b2X2
SUMMARY OUTPUTRegression StatisticsMultiple R0.973R
Square0.947Adjusted R Square0.942Standard

Error188.713Observations12ANOVAdfSSMSFSignif.
FRegression16,366,3726,366,372178.7670.0000Residual10356,
12835,613Total116,722,500CoefficientsStd. Errort StatP-
valueLower 95%Upper
95%Intercept561.05217.402.580.0376.651045.44No. of
patients18.661.4013.370.0015.5521.77
Regression Analysis
Ŷ = $561 + $18.66X
where
Y= Material cost
X = No. of patients
Dependent Variable
Independent Variable
R2 - measures the proportion of change in the dependent
variable that is explained by a change in the independent
variable
Adjusted R2 – an R2 adjusted to compensate for a small sample

size
Evaluating the Regression Line
Practical Issues in Cost Estimation Data
Cost estimates are only as good as the data upon which they are
based
40
40
Issues in
Cost
estimation
Missing
data

Outliers
Inflation
Mismatched
time periods
Trade-offs
Allocated
fixed costs
Data Collection Problems
Missing data
Outliers—extreme observations of activity/cost relationships
Mismatched time periods for dependent and independent

variables
Trade-offs in choosing the time period—the number of
observations vs the reliability of past data points as pr edictors
of future cost behaviour
Data Collection Problems
Allocation of fixed costs (on a per unit basis) may suggest cost
behaviours that are misleading
Inflation may cause historic cost data to be less relevant in
predicting future cost behaviours
Effect of learning – labour costs decrease over time
Other Issues in Cost Estimation

Activity-based approaches allow more complex cost behaviour
patterns to be considered.
The accuracy of cost functions.
Sometimes budgets and cost estimates capture
only approximations of cost behaviours
All cost functions are based on simplifying assumptions, such
as:
Cost behaviours depend on a single or only a few types of
activity.
Cost behaviours are linear within a relevant range.
Costs of producing more accurate cost estimates need to be
assessed against the likely benefits.
3-43

ME290 Global Engineering Professional Seminar Engineer

ME290 Global Engineering Professional Seminar Engineer

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