This document discusses cost measurement and different costing methods, including absorption costing and variable/direct costing. It provides examples to illustrate the calculation of product costs under absorption costing and variable costing. Absorption costing includes both variable and fixed manufacturing costs in product costs, while variable costing treats fixed costs as period costs not included in product costs. The document compares the two methods and discusses their treatment of inventory costs and reported profit.

1. Unit 9 Management Accounting
COST MEASUREMENT

2. LEARNING OUTCOME
Calculate costs using
appropriate techniques

3. TOPICS
Review
of Last session
Group Reporting
Different Costing
Methods

4. REVIEW OF LAST SESSION
Costing methods
Group Works

5. COST TERMS

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. ABSORPTION COSTING

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. 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. 
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. VARIABLE/ DIRECT COSTING

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. 
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. COMPARING ABSORPTION & DIRECT COSTING

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. 
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. SOLUTION
Absorption
Costing
Variable
Costing
Materials
$150
$150
Labor
$45
$45
Variable
overhead
$25
$25
Fixed overhead
$20*
–
——-
——-
240
220

18. DIFFERENCE BETWEEN ABSORPTION
AND MARGINAL COSTING
18

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
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
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. ARGUMENT FOR ABSORPTION
COSTING
22

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. ARGUMENTS FOR MARGINAL COSTING
24

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

26. TRADITIONAL COSTING

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. 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. 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. 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. TWO-STAGE COST ALLOCATION (2 OF 2)

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. PATIENTAID EXAMPLE
Step 1 of Stage 1 cost allocations (given)

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. ALLOCATION BASES VALUES

36. ALLOCATION RATIOS
Based on relative allocation basis value
300,000 / 1,200,000 = 0.250

37. ALLOCATION OF
SERVICE DEPARTMENT COSTS

Multiply service department cost by the allocation ratios
$160,000 x 0.250 = $40,000

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. 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. 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. ACTIVITY BASED COSTING

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. 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. 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. 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. 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. 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. 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. A COMPARISON
ABSORPTION
COSTING VS.
ACTIVITY BASED
COSTING

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. 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. 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. 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. 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. 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. THE CALCULATION IS:

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. 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. REAPPORTION MAINTENANCE BASED ON
MACHINE USAGE.

60. STEP 2
Step 3
Calculate separate overhead absorption rates for each
production cost centre.

61. ABSORPTION RATES ARE:

X = 58672/ 10000
= £5.87

Y = 67502/ 10000
= £6.75

Z = 49786/ 10000
= £2.49

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. ABC AND TRADITIONAL COMPUTATION

64. REQUIRED
Calculate
costs for traditional
Absorption Costing
Calculate costs for Activity
Based Costing.

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. CALCULATIONS

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. ACTIVITY BASED COST METHOD

69. CALCULATIONS

70. SUMMARY
43.97
221.4
8

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

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. 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. 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. TOPICS FOR RESEARCH
Inventory Valuation
o FIFO
o LIFO
o AVCO
o Standard Costing
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77. REQUIRED
Calculate costs using
appropriate techniques
Go Top

78. END OF SESSION