COST

C
O “Cost” is not a simple concept. It is
S important to distinguish between
T four different types - fixed,
fixed, variable,
average and marginal.
marginal.
Ir. Haery Sihombing/IP
Sihombing/IP
Pensyarah
Fakulti Kejuruteraan Pembuatan
Universiti Teknologi Malaysia Melaka Monetary measure of resources given up to
attain an objective (such as acquiring a good
Chapter 3 DIRECT COST or delivering a service)
Chapter 4 INDIRECT COSTS

COST Cost and Cost Terminology

Cost is a resource sacrificed or forgone to achieve

™ A cost may be defined as a sacrifice or a specific objective.
giving up of resources for a particular
purpose. An actual cost is the cost incurred (a historical cost)
as distinguished from budgeted costs.
A cost object is anything for which a separate
™ Costs are frequently measured by the
measurement of costs is desired.
monetary units that must be paid for
goods and services.
 Cost and Cost Terminology Cost Classifications

Association with cost object

Cost object is anything for which management wants to
Cost Assignment
collect or accumulate costs
is both
„ Direct- traceable to a cost object
„ Indirect- not conveniently or practically traceable
Tracing to a cost object
Direct Costs
Cost Object ¾ treated as overhead
¾ allocated
Allocating
Indirect Costs

Cost Classifications Categories Costing System

„ Cost Object
anything for which a separate measurement of costs is
desired
„ Direct Cost
costs that are related to a particular cost object in an
economically feasible (Cost-
(Cost-effective) manner
„ Cost Pool
a grouping of individual cost items
„ Cost Allocation Base
a factor that is the common denominator for systematically
linking an indirect cost or group of indirect costs to a cost
object
 Cost Categories Cost Allocation

„ Same issue exists for merchandising firms

„ Association with cost object
„ Reaction to changes in activity „ Easier for merchandising,
ƒ Variable „ purchase price (major)
ƒ Fixed „ shipping cost (minor)
ƒ Mixed „ taxes (minor)
ƒ Step

Relevant Range – normal operating range

Classification of Costs Cost Objective

This section concentrates on the big „ A cost objective or cost object is

picture of how manufacturing costs defined as anything for which a separate
are accumulated and classified. measurement of costs is desired.

Examples include departments, products, activities,

and territories.
Accounts could be type of cost, to which product,
department?
Categories of Manufacturing Costs Direct-Material Costs

All costs which are eventually „ Direct-

Direct-material costs include the
allocated to products are classified acquisition costs of all materials that are
as either physically identified as a part of the
manufactured goods and that may be
1. direct materials,
traced to the manufactured goods in an
2. direct labour, or economically feasible way.
3. indirect manufacturing.

Direct-Material Costs Direct-Labour Costs

Direct Materials „ Direct-

Direct-labour costs include the
Materials that are clearly and easily wages of all labour that can be traced
identified with a particular product. specifically and exclusively to the
manufactured goods in an economically
Example: feasible way.
Steel used to
manufacture
the automobile.
 Direct-Labour Costs Indirect Manufacturing Costs

Direct Labor
„ Indirect manufacturing costs or
Labor costs that are clearly traceable
to, or readily identifiable with, the factory overhead include all costs
finished product. associated with the manufacturing
process that cannot be traced to the
manufactured goods in an economically
Example:
feasible way.
Wages paid to an
automobile assembly
worker.

Prime Costs, Conversion Costs,

Indirect Manufacturing Costs and Direct-
Direct-Labour Costs
Factory Overhead
All factory costs except 1. Direct Materials
direct material and direct labor.
Prime
Factory costs that cannot be
traced directly to specific units produced. Costs 2. Direct Labour
Conversion
Examples: 3. Factory Overhead Costs
Indirect labor – maintenance
Indirect material – cleaning supplies
Factory utility costs
Supervisory costs
 Product Costs Product Costs

„ Product costs are costs identified with „ Direct material

goods produced or purchased for resale. „ Measurable part of a product
„ Direct labor
„ Laborused to manufacture a product or
perform a service
„ Overhead
„ Indirect production cost

Product Costs Period Costs

„ Product costs are initially identified as part of „ Period costs are costs
the inventory on hand.
that are deducted as
„ These product costs (inventoriable costs) expenses during the 1 2 3

become expenses (in the form of cost of goods current period without 4 5 6 7 8 9 10

sold) only when the inventory is sold. going through an inventory 11 12 13 14 15 16 17

„ First appear on the balance sheet in inventory stage. 18 19 20 21 22 23 24

accounts 25 26 27 28 29 30 31

„ Transferred to the income statement when

product is sold
 Period Costs Period Costs

„ Selling and administrative costs

„ Distribution costs
„ Appear on the income statement when
incurred
• Cost to warehouse, transport, and/or deliver
a product or service „ Expensed when incurred
• Major impact on managerial decision making

Classification By Function Period and Products Cost

2005 Income
Period costs are expenses Statement
not charged to the product. Period Costs Operating
(Expenses) Expenses

Administrative Costs 2005 Costs Cost of

Selling Costs Incurred Goods Sold
Non-manufacturing costs Inventory
Costs incurred to obtain Sold in 2005
of staff support and
customer orders and to 2005 Balance 2006 Income
administrative functions – Product Costs
deliver finished goods Sheet Inventory Statement
accounting, data processing, (Inventory)
to customers – Raw Materials
personnel, research Inventory Not Cost of
advertising and shipping. Work in Process
and development. Sold in 2005 Goods Sold
Finished Goods
 Product Cost - Direct Product Cost - Indirect
„ Direct Material „ Overhead - indirect production costs
„ Conveniently and economically traced „ Fringe benefits, if cannot be easily traced
to cost object to product
„ Direct Labor „ Overtime, if due to random scheduling
„ to manufacture a product or perform a service „ Cost of quality
„ includes wages paid to direct labor employees, ƒ Prevention costs
production bonuses, payroll taxes ƒ Appraisal costs
„ may include holiday and vacation pay, ƒ Failure costs
insurance, retirement benefits

Product Cost vs. Period Cost Direct Costs

„ Product cost „ Direct costs can be
„ All costs incurred in getting product to saleable condition identified specifically and
„ Three main elements:
exclusively with a given cost
„ Raw Materials
„ Labour objective in an economically
„ Factory overheads feasible way.
„ Period cost
„ All costs incurred for a period of time regardless of production
„ Sometimes classified into:
„ Marketing expenses
„ General (administrative) expenses
„ Financial expenses

Indirect Costs
„ Indirect costs cannot be
identified specifically and
exclusively with a given cost
objective in an economically
feasible way.
Classification by Traceability
Direct costs
z Costs incurred for the
benefit of one specific
cost object.
z Examples: material
and labor cost for a
product.
„ Direct Costs
„ Indirect Costs
Indirect costs
z Costs incurred for the
benefit of more than
one cost object.
z Example: maintenance
expenditures benefiting
two or more
departments.
Direct vs. Indirect Costs
„ Major costs that can be directly attributable to the final
product or service. Includes:
„ Direct materials
„ Direct labour
„ Other: subcontractors, tender document preparation
„ All other costs that cannot be directly attributable to the final
final
product or service. Includes
„ Indirect materials: factory supplies, small items of material
„ Indirect labour: admin, cleaning or security staff
„ Factory overheads; rates, rent, insurance, telephone,
stationery
Fixed Cost vs. Variable Cost
„ Fixed costs
„ Those costs that in total will remain the same for a period
of time and over a relevant range or output. Includes:
„ Rent, rates, insurance, depreciation
„ Variable costs
„ Those costs that in total will tend to increase as output
level increase. Includes:
„ Direct Materials and Direct Labour
 Overhead Cost Allocation Allocating Overhead
Actual Cost System
Assign indirect costs to one or more cost objects
Product Cost Cost Used
„ To determine full absorption cost (GAAP)
„ To motivate management
Direct Materials Actual
„ To compare alternative courses of action for
planning, controlling, and decision making Direct Labor Actual
Allocation process should be
rational and systematic
Overhead Actual

Allocating Overhead Allocating Overhead

Actual Cost System Actual vs. Normal

„ The Actual Cost System is not timely Product Cost Actual Cost Normal Cost
System System
„ All costs must be known before Direct Materials Actual Actual
calculating product cost
Direct Labor Actual Actual

Overhead Actual Predetermined

Overhead Rate
 Classification By Behavior Classification By Behavior

Cost behavior means

how a cost will react to Cost behavior means
changes in the level of how a cost will react to

Cost
business activity. changes in the level of
z Total fixed costs do business activity.
not change when activity Activity z Total fixed costs do
changes. not change when
z Total variable costs activity changes.

Cost
change in proportion z Total variable costs
to activity changes. change in proportion
to activity changes.
Activity

Product Cost Behavior Potential Multiple Cost Classifications

Cost
CostItem
Item Behavior
Behavior Traceability
Traceability Function
Function
¾ Direct Material Variable
Material
Material Variable
Variable Direct
Direct Product
Product
¾ Direct Labor Variable Assembly
AssemblyWages
Wages Variable
Variable Direct
Direct Product
Product
Advertising
Advertising Fixed
Fixed Indirect
Indirect Period
Period
¾ Overhead Variable, Fixed, or Mixed
Production
ProductionManager's
Manager'sSalary
Salary Fixed
Fixed Indirect
Indirect Product
Product
Office
OfficeDepreciation
Depreciation Fixed
Fixed Indirect
Indirect Period
Period
 Direct and Indirect Costs

COST OBJECT
Direct Costs
„EXERCISE Example: Oak wood used
Example: 50 Oak
in Mfg. of chairs.
Chairs produced in
May.
Indirect Costs
Example: salary of the
Plant night watchperson.

Direct and Indirect Costs Direct and Indirect Costs

Example Example

Direct Costs: Maintenance

Maintenance Department $40,000 $40,000
Personnel Department $20,600
Assembly Department $75,000
Finishing Department $55,000 Assembly Finishing
Direct Costs Direct Costs
Assume that Maintenance Department costs are $75,000 $55,000
allocated equally among the production departments.
How much is allocated to each department? $20,000 $20,000
Allocated
 Cost Behavior Patterns
Example
Bicycles by the Sea buys a handlebar
at $52 for each of its bicycles.
What is the total handlebar cost when
1,000 bicycles are assembled?
Cost Behavior Patterns
Example
Bicycles by the Sea incurred $94,500 in
a given year for the leasing of its plant.
This is an example of fixed costs with
respect to the number of bicycles assembled.
Cost Behavior Patterns
Example
1,000 units × $52 = $52,000
What is the total handlebar cost
when 3,500 bicycles are assembled?
3,500 units × $52 = $182,000
Cost Behavior Patterns
Example
What is the leasing (fixed) cost per bicycle
when Bicycles assembles 1,000 bicycles?
$94,500 ÷ 1,000 = $94.50
What is the leasing (fixed) cost per bicycle
when Bicycles assembles 3,500 bicycles?
$94,500 ÷ 3,500 = $27
 Cost Drivers Relevant Range
Example

The cost driver of variable costs is the level
of activity or volume whose change causes
the (variable) costs to change proportionately.
The number of bicycles assembled is a
cost driver of the cost of handlebars.
Assume that fixed (leasing) costs are $94,500
for a year and that they remain the same for a
certain volume range (1,000 to 5,000 bicycles).
1,000 to 5,000 bicycles is the relevant range.

Relevant Range
Example Relationships of Types of Costs

120000
Direct
100000
Fixed Costs

80000
60000
40000 $94,500 Variable Fixed
20000
0
0 1000 2000 3000 4000 5000 6000
Volume Indirect
 Total Costs and Unit Costs Total Costs and Unit Costs
Example Example

$146,500
200000
What is the unit cost (leasing and handlebars) 52x
00 + $
$94,5
when Bicycles assembles 1,000 bicycles? 150000

Total Costs
Total fixed cost $94,500 100000 $94,500
+ Total variable cost $52,000 = $146,500
50000
$146,500 ÷ 1,000 = $146.50
0
0 500 1000 1500
Volume

Use Unit Costs Cautiously Use Unit Costs Cautiously

Assume that Bicycles management uses a
unit cost of $146.50 (leasing and wheels).
Management is budgeting costs for
different levels of production.
What is their budgeted cost for an
estimated production of 600 bicycles?
600 × $146.50 = $87,900
What is their budgeted cost for an estimated
production of 3,500 bicycles?
3,500 × $146.50 = $512,750
What should the budgeted cost be for an
estimated production of 600 bicycles?
 Use Unit Costs Cautiously Use Unit Costs Cautiously

Total fixed cost $ 94,500 What should the budgeted cost be for an
Total variable cost ($52 × 600) 31,200 estimated production of 3,500 bicycles?
Total $125,700 Total fixed cost $ 94,500
$125,700 ÷ 600 = $209.50 Total variable cost (52 × 3,500) 182,000
Total $276,500
Using a cost of $146.50 per unit would
underestimate actual total costs if output $276,500 ÷ 3,500 = $79.00
is below 1,000 units.

Merchandising Service

Merchandising companies Service companies

purchase and then sell tangible products provide services or intangible
without changing their basic form.
form products to their customers.

Labor is the most significant cost category.

 Types of Inventory
Manufacturing-sector companies
typically have one or more of the
following three types of inventories:
1. Direct materials inventory
2. Work in process inventory (work
in progress)
3. Finished goods inventory
Classification of
Manufacturing Costs
Direct materials costs
Direct manufacturing labor costs
Indirect manufacturing costs
Types of Inventory
Merchandising-sector companies hold
only one type of inventory – the
product in its original purchased form.
Service-sector companies do not
hold inventories of tangible products.
Inventoriable Costs
Inventoriable costs (assets)…
become cost of goods sold…
after a sale takes place.
 Period Costs Flow of Costs
Example

Period costs are all costs in the income
statement other than cost of goods sold.
Period costs are recorded as expenses of the
accounting period in which they are incurred.
Bicycles by the Sea had $50,000 of direct
materials inventory at the beginning of the period.
Purchases during the period amounted to
$180,000 and ending inventory was $30,000.
How much direct materials were used?
$50,000 + $180,000 – $30,000 = $200,000

Flow of Costs Flow of Costs

Example Example

Direct labor costs incurred were $105,500. Assume that the work in process inventory
at the beginning of the period was $30,000,
Indirect manufacturing costs were $194,500. and $35,000 at the end of the period.
What are the total manufacturing costs incurred? What is the cost of goods manufactured?
Direct materials used $200,000 Beginning work in process $ 30,000
Direct labor 105,500 Total manufacturing costs 500,000
Indirect manufacturing costs 194,500 Ending work in process 35,000
Total manufacturing costs $500,000 Cost of goods manufactured $495,000
 Flow of Costs Flow of Costs
Example Example

Assume that the finished goods inventory

at the beginning of the period was $10,000, Work in Process
and $15,000 at the end of the period. Beg. Balance 30,000 495,000
Direct mtls. used 200,000
What is the cost of goods sold? Direct labor 105,500
Beginning finished goods $ 10,000 Indirect mfg. costs 194,500
Cost of goods manufactured 495,000 Ending Balance 35,000
Ending finished goods 15,000
Cost of goods sold $490,000

Flow of Costs Manufacturing Company

Example

BALANCE SHEET INCOME STATEMENT

Finished Goods Inventoriable
Costs Revenues
Work in Process 10,000 490,000 when deduct
495,000 495,000 Materials
Finished sales
Goods occur Cost of
15,000 Inventory Goods Sold
Inventory
Equals Gross Margin
deduct
Cost of Goods Sold Work in
Process Period
490,000 Costs
Inventory
Equals Operating Income
 Merchandising Company Prime Costs—all direct mfg. costs

BALANCE SHEET INCOME STATEMENT

Inventoriable
Costs Revenues
when deduct Direct Direct Prime
Merchandise
sales
occur Materials + Labor = Costs
Inventory Cost of
Purchases Goods Sold
Equals Gross Margin
deduct
Period
Costs
Equals Operating Income

Prime Costs Conversion Costs

What are the prime costs for Bicycles by the Sea?

Direct Manufacturing Conversion
Direct materials used $200,000
Labor + Overhead = Costs
+ Direct labor 105,500
= $305,000

Indirect Indirect
Labor Materials Other
 Measuring Costs
Conversion Costs
Requires Judgment

What are the conversion costs for Manufacturing labor-cost classifications

Bicycles by the Sea? vary among companies.
Direct labor $105,500 The following distinctions are generally found:
+ Indirect manufacturing costs 194,500
= $300,000 Direct manufacturing labor
Manufacturing overhead
Conversion cost = all mfg. cost except direct materials

Measuring Costs Measuring Costs

Requires Judgment Requires Judgment

Manufacturing overhead Overtime premium is usually

considered part of overhead.
Indirect labor Managers’ salaries Payroll fringe costs
Assume that a worker gets $18/hour
Forklift truck operators (internal handling of materials) for straight time and gets
Janitors Rework labor time and one-half for overtime.
Overtime premium Idle time
 Measuring Costs
Many Meanings of Product Cost
Requires Judgment

How much is the overtime premium? A product cost is the sum of the costs
$18 × 50% = $9 per overtime hour assigned to a product for a specific purpose.
If this worker works 44 hours on a given 1. Pricing and product emphasis decisions
week, how much are his gross earnings? 2. Contracting with government agencies
Direct labor 44 hours × $18 = $792 3. Preparing financial statements for external
Overtime premium 4 hours × $ 9 = 36 reporting under generally accepted
Total gross earnings $828 accounting principles

Balance Sheet of a Manufacturer Balance Sheet of a Manufacturer

Work in Work in
Raw Process Finished Raw Process Finished
Materials Goods Materials Goods

Partially complete
Materials products. Completed
Manufacturing waiting to be products
Inventory processed. Material to which for sale.
some labor and/or
Classifications overhead have
been added.
Income Statement of a Manufacturer Income Statement of a Manufacturer
Merchandiser Manufacturer Cost of goods sold for manufacturers differs only
Beginning Beginning slightly from cost of goods sold for merchandisers.
Merchandise Finished Goods
Merchandising Company Manufacturing Company
Inventory Inventory
Cost of goods sold: Cost of goods sold:
+ + Beg. merchandise Beg. finished
Cost of Goods The major Cost of Goods inventory $ 14,200 goods inv. $ 14,200
Manufactured + Purchases 234,150 + Cost of goods
Purchased difference
_ _ = Goods available
for sale $ 248,350
manufactured
= Goods available
234,150

Ending Ending - Ending for sale $ 248,350

merchandise - Ending
Merchandise Finished Goods inventory (12,100) finished goods
Inventory Inventory = Cost of goods inventory (12,100)
sold $ 236,250 = Cost of goods
Cost of Goods
= Sold = sold $ 236,250

Income Statement of a Manufacturer Question

Manufacturing costs are often What type of account is the manufacturing

combined as follows: goods in process account?
Direct Direct Manufacturing
Material Labor Overhead a. Income statement expense account.
b. Balance sheet inventory account.
c. Temporary clearing account for direct
material and direct labor.
Prime Conversion
d. Holding account for manufacturing
Cost Cost
overhead and direct labor.
 Question Flow of Manufacturing Activities
Materials Production activity Sales activity
The primary distinction between product activity
Work in Process Finished Goods
and period costs is . . . Raw Beginning Inventory Beginning Inventory
Materials
Beginning Cost of Goods
Inventory Direct Labor
a. Product costs are expensed in the period Manufactured
incurred. Raw Factory
b. Product costs are directly traceable to Materials Overhead Finished Cost
Purchases Goods of
product units. Raw Materials
Ending Goods
Used
c. Product costs are inventoriable. Inventory Sold
d. Period costs are inventoriable. Raw Materials Work in Process
Ending Inventory Ending Inventory

Statement of Cost of Goods Manufactured Statement of Cost of Goods Manufactured

Cost of all goods completed and transferred

from work in process to finished goods
during a reporting period.

Direct Materials Used

Let’s take a look
+ Direct Labor
at Rocky
+ Factory Overhead Mountain Bikes’
= Total Manufacturing Costs Statement of Cost
+ Beginning Work in Process of Goods
– Ending Work in Process Manufactured.
= Cost of Goods Manufactured
Statement of Cost of Goods Manufactured Statement of Cost ofof
Computation CostGoods Manufactured
of Direct Material Used
Exh.
Beginning raw materials inventory $ 8,00018-16
Add: Purchases of raw materials 86,500
Cost of raw materials available for use $ 94,500
Less: Ending raw materials inventory 9,000
ROCKY MOUNTAIN BIKES ROCKY MOUNTAIN BIKES
Cost of direct materials used in production $ 85,500
Statement of Cost of Goods Manufactured Statement of Cost of Goods Manufactured
For Year Ended 31 December 2005 For Year Ended 31 December 2005
Direct materials used in production $ 85,500 Direct materials used in production $ 85,500
Direct labor 60,000
Direct labor 60,000
Total factory overhead costs 30,000
Total factory overhead costs 30,000
Total manufacturing costs for the period $ 175,500
Total manufacturing costs for the period $ 175,500
Add: Beginning work in process inventory 2,500
Add: Beginning work in process inventory 2,500
Total cost of work in process $ 178,000
Less: Ending work in process inventory 7,500 Total cost of work in process $ 178,000
Cost of goods manufactured $ 170,500 Less: Ending work in process inventory 7,500
Cost of goods manufactured $ 170,500

Computation of Total Manufacturing Overhead

Statement of Cost of Goods Manufactured Statement
Indirect labor
of Cost of Goods
$
Manufactured
9,000
Factory supervision 6,000
Factory utilities 2,600
Include all direct labor Property taxes, factory building 1,900
costs
ROCKYincurred
MOUNTAINduring the
BIKES Factory supplies usedROCKY MOUNTAIN BIKES 600
current
Statement of Cost of period.
Goods Manufactured Factory insurance expired 1,100
Statement of Cost of Goods Manufactured
Depreciation, building and equipment 5,300
For Year Ended 31 December 2005 For Year Ended 31 December 2005
Other factory overhead 3,500
Direct materials used in production $ 85,500 Total factory
Direct overhead
materials usedcosts
in production $ 30,000 $ 85,500
Direct labor 60,000 Direct labor 60,000
Total factory overhead costs 30,000 Total factory overhead costs 30,000
Total manufacturing costs for the period $ 175,500 Total manufacturing costs for the period $ 175,500
Add: Beginning work in process inventory 2,500 Add: Beginning work in process inventory 2,500
Total cost of work in process $ 178,000 Total cost of work in process $ 178,000
Less: Ending work in process inventory 7,500 Less: Ending work in process inventory 7,500
Cost of goods manufactured $ 170,500 Cost of goods manufactured $ 170,500
Statement of Cost of Goods Manufactured Statement of Cost of Goods Manufactured

Beginning work in Ending work in process inventory

process
ROCKY MOUNTAIN BIKES inventory is contains
ROCKY the cost
MOUNTAIN of unfinished
BIKES
carried over from the
Statement of Cost of Goods Manufactured goods,
Statement andofisGoods
of Cost reported in the current
Manufactured
prior period.
For Year Ended 31 December 2005 Forassets section
Year Ended of the balance
31 December 2005 sheet.

Direct materials used in production $ 85,500 Direct materials used in production $ 85,500
Direct labor 60,000 Direct labor 60,000
Total factory overhead costs 30,000 Total factory overhead costs 30,000
Total manufacturing costs for the period $ 175,500 Total manufacturing costs for the period $ 175,500
Add: Beginning work in process inventory 2,500 Add: Beginning work in process inventory 2,500
Total cost of work in process $ 178,000 Total cost of work in process $ 178,000
Less: Ending work in process inventory 7,500 Less: Ending work in process inventory 7,500
Cost of goods manufactured $ 170,500 Cost of goods manufactured $ 170,500
 Direct Costing

„ Alternative method of costing

CHAPTER 3 ¾ Relatively new
¾ More useful costing method for management

DIRECT COST planning and decision making

¾ Also know as variable costing as most direct costs
are variable with respect to level activities
„ Main difference between ‘absorption’
absorption’
costing and direct costing is in the
treatment of fixed manufacturing overhead

ST 10.1
Mts Manufactured 9000
Treatment of Fixed Manufacturing Mts Sold 8600

Overhead Direct Materials $ 42,300.00 $ 4.70

Direct Labour $ 54,000.00 $ 6.00
Fixed Factory overhead $ 72,000.00 $ 8.00

„ Fixed manufacturing costs is not treated as a Variable factory overhead $

$
36,000.00
204,300.00
$
$
4.00
22.70

product cost instead it is treated as a period cost $ 22.70

„ That is, it is written off (expensed) in the period in which Manufacturing cost per metre
it is incurred rather than included as a cost when Total costs $ 204,300.00
Number of Metres produced 9,000
determining the cost of inventory Manufacturing cost per metre $ 22.70

„ If fixed manufacturing costs are excluded from the cost of

Product cost using absorption costing
inventory when using direct costing then inventory @ end Direct material costs $ 42,300.00
of an accounting period will be lower than the value is Direct labour costs
Fixed Factory overhead
$
$
54,000.00
72,000.00
using absorption costing this will effect both the balance Variable factory costs $ 36,000.00
Product cost using absorption costing $ 204,300.00
sheet and profits

Product cost using direct costing

Direct material costs $ 42,300.00
Direct labour costs $ 54,000.00
Variable factory costs $ 36,000.00
Product cost using direct costing $ 132,300.00
 ST 1
Sales 462,500
St.2
Value of closing inventory using absorption costing Less COGS
Opening Inventory -
Metres Produced 9,000 Cost of production
Direct materials Used 97,000
less Metres sold 8,600 Direct labour used 64,020
Closing Stock 400 Variable factory overhead incurred 54,320
Fixed factory overhead 106,700
Product cost/no of metres produced $ 22.70 cost per metre 322,040
Less Closing inventory 14,940 307,100
Value of closing inventory using absorption costing $ 9,080.00
Gross profit 155,400
Less Operating expenses
Marketing Expenses 45,325
Administrative Expense 92,500
Value of closing inventory using direct costing Financial Expense 9,460 147,285

Net profit 8,115

Metres Produced 9,000

Closing inventory
less Metres sold 8,600 Production 19400 units
Sale 18500 units
Closing Stock 400 Closing inventory 900 units
Product cost/no of metres produced $ 14.70 cost per metre
Costof production/# of production units $ 16.60 per unit
Value of closing inventory using direct costing $ 5,880.00 322040/19400

Closing inventory $ 14,940.00

Sales

Less Variable Costs ST.3

462,500
Reconciliation of reported profits
Opening Inventory
Cost of production
Direct materials Used 97,000
-
– absorption and direct costing
Direct labour used 64,020
Variable factory overhead incurred 54,320 „ The difference in profits between the absorption
Less Closing inventory
215,340
9,990 205,350 and direct costing is caused by the amount of
Contribution Margin 257,150
fixed overhead in the opening and closing
Less Fixed Costs
Manufacturing 106,700
inventories because they are excluded when using
Marketing Expenses
Administrative Expense
45,325
92,500
direct costing
Financial Expense 9,460 253,985
„ To reconcile profits using absorption costing to
Net profit 3,165 profits using direct costing you add back fixed
Closing inventory
costs in opening inventory using absorption
Production 19400 units costing and deduct fixed costs in closing inventory
Sale 18500 units
Closing inventory 900 units using absorption costing
Costof production/# of production units $ 11.10 per unit
215340/19400

Closing inventory $ 9,990.00

 Self test problem 4
Self test problem 4
Part a Revenue Statement using the Absorption Costing Method
Part b
August September Total
Sales (sale price * # of litres sold) 117,600 $ 117,600.00 235200
0
Less COGS 0
Opening Inventory 15,800 17,380 15,800
Cost of production 0
Absorption Costing Direct materials Used 5000 5500 10500
Direct labour used 25000 27500 52500
August September Variable factory overhead incurred 5000 5500 10500
Product Costs Fixed factory overhead 44000 44000 88000
94,800 99,880 177,300
Directy materials 5000 5500 Less Closing inventory 17,380 25,500 25,500
77,420 74,380 151800
Direct labour 25000 27500 Gross profit 40,180 43,220 83400
Variable manufacturing overheads 5000 5500 Less Operating expenses 0
Selling & Administrative expenses 30,000 30,000 60000
Fixed manufacturing overheads 44000 44000 Net profit 10,180 13,220 23400
3,040
79000 82500
no of litres produced 100000 110000 Closing inventory
Opening Stock 20,000 22,000
add Production 100000 110000
less Sale 98000 98000
cost per litre $ 0.79 $ 0.75
Closing inventory 22,000 ltrs 34,000 ltrs

Cost of production/# of production units $ 0.79 $ 0.75

79000/100000 84080/110000

Closing inventory $ 17,380.00 $ 25,500.00

Variance in Profit b/w August & September Self test problem 4

Revenue Statement using the Direct Costing Method
ST 4 August
Part D September Total
Part C Sales (sale price * # of litres sold) 117,600 117,600 - 235200
Variance is due to the amount of fixed factory overhead component of cost of goods sold
August September Less Variable Costs
Fixed production costs 44000 44000 Opening Inventory (variable component only) 7,000 7,700 7000
Production in ltrs 100000 110000 Cost of production
Fixed costs per litre $ 0.44 $ 0.40 Direct materials Used 5,000 5500 10500
Direct labour used 25,000 27500 52500
Fixed costs in opening inventory Variable factory overhead incurred 5,000 5500 10500
opening inventory (ltrs)* fixed cost per ltr $ 8,800.00 9680 ( Aug closing balance) 42,000 46,200 80500
Less Closing inventory 7,700 $ 11,900.00 $ 11,900.00
Fixed costs incurred 44000 44000
34,300 34,300 $ 68,600.00
Contribution margin 83,300 83,300 166600
Less fixed cost in closing inventory
Less Fixed Costs 0
closing inventory (ltrs)* fixed cost per ltr 9680 13600 Manufacturing 44,000 44,000 88000
$ 43,120.00 40080 Selling & Admin Exp 30,000 30,000 60000
74,000 74000 148000
difference b/w sept & Aug 3040 Net profit 9,300 9,300 18600
equals defference in net profit

Closing inventory
Opening Stock 20,000 22,000
add Production 100000 110000
less Sale 98000 98000
Closing inventory 22,000 ltrs 34,000 ltrs

Cost of production/# of production units $ 0.35 $ 0.35

35000/100000) (38500)/110000

Closing inventory $ 7,700.00 $ 11,900.00

 ST4 part (e) Reporting variable marketing and
administrative expense – direct costing
„ Revenue statement using direct costing:
„ Is divided into 2 main areas
Net profit using absorption costing 10,180 13,220 „ Variable costs and fixed expenses
add Fixed costs in opening inventory „ Shows Variable non-
non- manufacturing expenses
using absorption costing $ 8,800.00 9680 and fixed non manufacturing expenses
18,980 22,900 separately
Less Fixed costs in closing inventory
using absorption costing 9680 13600 „ Shows the variable non-
non- manufacturing
Net Profit using direct costing 9,300 9,300 expenses after the variable COGS
(manufacturing exp) but before the net
contribution margin line

ST.5 $ $ $
Revenue Statements with applied
Sales 274,543
factory overheads
Less Variable costs
Cost of goods sold
Inventory 1 July 26,485
„ There may be a variance between factory
Variable costs of production overheads applied and actual factory overheads
Diect materials 45,965 incurred
Direct labour 46,980
Variable factory overheads 22,698 115,643 „ Any under-
under-or-
or-over-
over-applied overhead may be
142,128 added or subtracted from the COGS
Less Inventory 30 June 25,660 116,468
„ In absorption costing the under-
under-or-
or-over-
over-applied
Gross contribution Margin 158,075 overhead may include both variable and fixed
less variable marketing expense 16,258 elements
Net Contribution Margin 141,817
„ However in direct costing under-
under- or-
or- over applied
less Fixed Costs overhead will only include variable fixed overhead
Factory Overhead 72,458 as the fixed overhead is not applied but written
Mark eting & Admin Exp
Net Profit
57,632 130,090
11,727
off as a period cost
 ST 6 Part A ST 6 Part B Calculations

Calculations July August

Value of Opening & Closing inventory using absorption costing
Product cost using direct costing Opening Stock In Units 4,000.00 6,000.00
Direct material costs $ 2.00 Unit Cost $ 7.00 $ 7.00
Direct labour costs $ 1.50 $ 28,000.00 $ 42,000.00

Variable factory costs $ 1.00 Closing Stock 6,000.00 3,000.00

Product cost using direct costing
Product cost using absorption costing
Direct material costs
Direct labour costs
Variable factory overheads
Fixed factory overhead
Product cost using absorption costing
$ 4.50 Unit Cost $ 7.00 $ 7.00
$ 42,000.00 $ 21,000.00
Value of Opening & Closing inventory using direct costing
Opening Stock In Units 4,000.00 6,000.00
$ 2.00 Unit Cost $ 4.50 $ 4.50
$ 18,000.00 $ 27,000.00
$ 1.50
$ 1.00 Closing Stock 6,000.00 3,000.00
$ 2.50 75000/30000(normal capacity) Unit Cost $ 4.50 $ 4.50
$ 27,000.00 $ 13,500.00
$ 7.00

Under- or over-applied fixed factory overhead

Budgeted & Actual fixed overhead $ 75,000.00 75000
Fixed overhead applied (32000*$2.50) $ 80,000.00 72500 29000*$2.50
Under- or (over) applied fixed overhead -$ 5,000.00 2500
overapplied underapplied

ST 6 Part B ST 6 Part C

Revenue statements using absorption costing Revenue statements using direct costing

Sales (Sales in Quantity * $9) $ 270,000.00 288000

Sales (Sales in Quantity * $9) $ 270,000.00 288000
Less COGC
Less COGC Inventory @ Beinginning @ $4.5 $ 18,000.00 $ 27,000.00
Inventory @ Beginning (@ $7) $ 28,000.00 $ 42,000.00 Cost of production (units produced *$4.5) $ 144,000.00 $ 130,500.00
Cost of production (units produced *$7) $ 224,000.00 $ 203,000.00 $ 162,000.00 $ 157,500.00
$ 252,000.00 $ 245,000.00 Less Closing inventory $ 27,000.00 $ 13,500.00
Less Closing inventory $ 42,000.00 $ 21,000.00 $ 135,000.00 $ 144,000.00
$ 210,000.00 $ 224,000.00 Gross contribution margin $ 135,000.00 $ 144,000.00
Add Under/ over applied Overhead -$ 5,000.00 2500
$ 205,000.00 $ 226,500.00 Less Variable Costs
VariableMarketing Costs ( Units sold *.3) $ 9,000.00 $ 9,600.00
Gross profit $ 65,000.00 $ 61,500.00 Contribution Margin $ 126,000.00 $ 134,400.00

Less Marketing & Admin costs Less Fixed Costs

Variable ( Units sold *.3) $ 9,000.00 $ 9,600.00 Manufacturing Costs $ 75,000.00 $ 75,000.00
Fixed marketing, admin & finance $ 36,000.00 $ 36,000.00
Fixed $ 36,000.00 $ 36,000.00
$ 111,000.00 $ 111,000.00
$ 45,000.00 $ 45,600.00
Net profit $ 15,000.00 $ 23,400.00

Net profit $ 20,000.00 $ 15,900.00

 ST 6 Part D ST 6 Part d
Net profit using absorption costing 20,000 15,900
„ Sales is only one component of Profits
add Fixed costs in opening inventory using absorption „ Profits is also affected by the difference
costing
4000 units @ $2.5 10000 15000 6000 units @ $2.5 between Quantity produced and
30,000 30,900 Quantity sold.
Less Fixed costs in closing inventory using absorption „ Under the absorption method the
costing opening stocks of each accounting
6000 units @ $2.5 $ 15,000.00 $ 7,500.00 3000 units @ $2.5
Net Profit Using Direct costing $ 15,000.00 $ 23,400.00 period contain a fixed manufacturing
component carried forward from the
previous period

ST problem 7 (a) 7(b)

Under- or over-applied combined factory overhead
Actual fixed overhead $ 154,000.00
Actual Variable Overhead $ 48,000.00
Fixed Factory Overhead Recovery Rate Combined Factory Overhead $ 202,000.00
Budgeted Fixed factory Overhead $ 150,000 Combined overhead applied (15,000 direct labour
Budgeted Direct labour Hours 15000
hrs *$13/hr) $ 195,000.00
$ 10 per direct labour hour
Under-applied fixed overhead $ 7,000.00

Variable Factory Overhead Recovery Rate

Budgeted Variable factory Overhead $ 45,000 Under- or over-applied Fixed factory overhead
Budgeted Direct labour Hours 15000
Actual fixed overhead $154,000.00
$ 3 per direct labour hour
Fixed overhead applied (15,000 direct labour hrs
*$10/hr) $150,000.00
Combined Factory overhead rate Under-applied fixed overhead $4,000.00
Budgeted Fixed factory Overhead $ 150,000
Budgeted Variable factory Overhead $ 45,000
$ 195,000
Under- or over-applied Variable factory overhead
Budgeted Direct labour Hours 15000
Actual Variable overhead $48,000.00
$ 13 per direct labour hour
Actual variable overhead applied (15,000 direct
labour hrs *$3/hr) $45,000.00
Under-applied fixed overhead $3,000.00
 7c 7c calculations cont

Calculations WIP Finished goods Total

Product cost using absorption costing Value of Opening & Closing inventory using absorption costing
Direct material costs $ 2.00 Opening Stock In Units - 4,000.00
Direct labour costs $ 1.00 Unit Cost $ 9.50 $ 9.50
Fixed Factory overhead $ 5.00 $10/direct labour hour*15000hours/30000units $ - $ 38,000.00 $ 38,000.00
Variable factory overheads $ 1.50 $3/direct labour hour*15000hours/30000units
Product cost using absorption costing $ 9.50 Closing Stock - 8,000.00
Unit Cost $ 9.50 $ 9.50
$ - $ 76,000.00 $ 76,000.00
Value of Opening & Closing inventory using direct costing
Opening Stock In Units - 4,000.00
Product cost using direct costing
Unit Cost $ 4.50 $ 4.50
Direct material costs $ 2.00
$ - $ 18,000.00 $ 18,000.00
Direct labour costs $ 1.00
Variable factory costs $ 1.50
Closing Stock - 8,000.00
Product cost using direct costing $ 4.50
Unit Cost $ 4.50 $ 4.50
$ - $ 36,000.00 $ 36,000.00

7c Revenue statements using direct costing

Sales
7d $ 338,000.00

Revenue statements using absorption costing Less COGC

Inventory @ Beinginning $ 18,000.00
Sales $ 338,000.00 Cost of production (units produced *$4.5) $ 135,000.00
$ 153,000.00
Less Closing inventory $ 36,000.00
Less COGC $ 117,000.00
Inventory @ Beginning $ 38,000.00 Add Underapplied Variable o/head $3,000.00
$ 120,000.00
Cost of production (units produced *$9.5) $ 285,000.00 Gross contribution margin $ 218,000.00
$ 323,000.00
Less Closing inventory $ 76,000.00 Less Variable Costs
Variable Marketing & Admin Exp $ 33,280.00
$ 247,000.00 Contribution Margin $ 184,720.00
Add Under/ over applied Overhead $ 7,000.00
Less Fixed Costs
$ 254,000.00
Manufacturing Costs (fixed factory o/head) $ 154,000.00 actual not budgeted
Gross profit $ 84,000.00 Fixed- Marketing & admin $ 18,100.00
$ 172,100.00
Net profit $ 12,620.00
Less Marketing & Admin costs $ 51,380.00 (18100+33280)

Net profit $ 32,620.00

 7 (e)
Statement of Reconciliation
Job Costing & Direct Costing
Net profit using absorption costing 32,620

add Fixed costs in opening inventory using „ Direct costing can be:
absorption costing
4000 units @ $5 20000
„ integrated with job, process or operation
52,620 costing
„ Used together with standard costing and
Less Fixed costs in closing inventory using
absorption costing activity based costing
8000 @ $5 40000
$ 12,620.00
„ Fixed manufacturing overhead is debited
to the general ledger to an account
Alternatively
Increase in inventory of 4000 units * fixed Factoy o/h $5 = 20000
called fixed factory overhead
(32620-12620) = 20000

Costing for indirect costs

„ On completion of this topic you should be able
CHAPTER 4 to
ƒ Calculate the total cost of a cost unit using
absorption costing methods
INDIRECT COST ƒ Describe the problems associated with
apportioning and absorbing indirect costs
„ Independent study
ƒ Progress test and practice question(s) as set
 The Story So Far …
„ Absorption costing is ‘a method of costing that, in
addition to direct costs, assigns a proportion or all the
production overheads to the cost units. Costs are first
allocated or apportioned to the cost centres, where
they are absorbed into the cost unit using one or more
absorption rates’
rates’ (Collis and Hussey, 2007, p. 241)
„ The purpose of absorption costing is to find the total
cost of a cost unit for valuing stock, planning and
controlling production costs and determining the
selling price
Main stages in absorption costing
Identify cost centres according to their function
(eg production department)
Collect indirect costs in cost centres
on the basis of allocation or apportionment
Determine overhead absorption rate (OAR)
for each production cost centre (eg cost per machine hour)
Charge indirect costs to products using OAR and a measure
of the product’s consumption of the cost centre’s cost
The Story So Far …
„ The absorption approach is used by
many firms and is a costing approach
that considers all factory overhead (both
variable and fixed) to be product
(inventoriable)
inventoriable) costs that become an
expense in the form of manufacturing
cost of goods sold only as sales occur.
Overhead analysis
„ The first stage in absorption costing is to prepare
an overhead analysis which shows the allocation
or apportionment of the production overheads to
the production cost centres
„ In the previous lecture we carried out an overhead
analysis for Cotswold Coolers, which allocated
and apportioned the total production overheads of
£97,400 between the bottling department and the
warehouse on what was considered to be a fair
basis …
 Cotswold Coolers
Production Overhead Absorption
Overhead analysis
Overhead Total Basis Bottling Warehouse „ The next stage is to find a means of absorbing the
£ £ £ production overheads for each cost centre into the
Indirect materials 1,500 Allocated 900 600
Indirect labour 45,000 No. of employees 30,000 15,000 cost units passing through them
Rent and rates 27,000 Area 9,000 18,000 „ An overhead absorption rate (OAR) is ‘a means of
Electricity 6,000 Area 4,000 2,000
Depreciation 8,000 Value of machinery 6,000 2,000 attributing production overheads to a product or
Supervision 21,000 No. of employees 14,000 7,000 service’
service’ (Collis and Hussey, 2007, p. 241)
Stock insurance 500 Value of stock 100 400
Total 109,000 64,000 45,000 „ The three most commonly used OARs are
„ The cost unit overhead absorption rate
„ The direct labour hour overhead absorption rate
„ The machine hour overhead absorption rate

Exercise 1 Solution 1
Cost unit OAR Cost unit OAR
„ The cost unit OAR is the simplest to use and the
formula is Formula Bottling Warehouse
Cost centre overheads Cost centre £64,000 £45,000
Number of cost units passing through overhead
„ 104,000 units were produced during the period
Number of cost 104,000 104,000
„ Production overheads were £64,000 for the units
bottling department and £45,000 for the
Ros has
Cost decided
unit OAR to use the£cost
0.62unit
perOAR to£0.43
absorb the
per
warehouse warehouse production overheads into the cost of a bottle
unit unit
„ Required of water (the cost unit)
„ Using the formula, calculate the cost unit OAR
for each cost centre

Direct Labour Hour OAR
„ An alternative is the labour hour OAR
Cost centre overhead costs
Total direct labour hours
„ Cotswold Coolers cannot use this OAR because the
firm does not use a pay scheme that is linked
directly to the product
„ The labour hour OAR is typically used to absorb
production overheads where the firm operates a
time-
time-based pay scheme and the level of direct
labour hours in production cost centre is high
Exercise 2
Machine hour OAR
„ An alternative is the machine hour OAR
Cost centre overhead costs
Total machine hours
„ 104,000 units were produced during the period
„ Production overheads were £64,000 for the
bottling department and £45,000 for the
warehouse
„ Total machine hours were 16,000 for the bottling
department and 2,000 for the warehouse
„ Required
„ Using the formula, calculate the machine hour
OAR for each cost centre

Solution 2 Exercise 3
Machine hour overhead absorption rate Production cost per unit
„ Direct costs per unit are
Formula Bottling Warehouse
„ Mineral water £0.30; bottle, lid and label £0.75
Cost centre £64,000 £45,000
overhead „ The OAR in the bottling department will be
Total machine 16,000 2,000 £4.00 per machine hour (from Exercise 2)
hours „ The OAR in the warehouse will be £0.43
Machine
To hour
reflect the high number£of
4.00 per hours in
machine £22.50 per
the bottling per unit (from Exercise 1)
department,
OAR Ros has decided to use the machine
m/hour hour OAR
m/hour
for absorbing the production overheads into the cost of a
„ Required
bottle of water (the cost unit) „ Complete the production cost statement and
calculate the production cost per unit
Pro forma Cotswold Coolers Solution 3
Production cost statement (1 unit) Cotswold Coolers
Production cost statement (1 unit)
£ £
Direct materials £ £
Direct materials
Mineral water 0.30 Mineral water 0.30
Bottle, lid and label 0.75 Bottle, lid and label 0.75
Prime cost ? Prime cost 1.05
Production overheads Production overheads
Bottling dept (0.15 machine hour x £4.00) 0.60
Bottling dept ? Warehouse (cost unit OAR) 0.43 1.03
Warehouse ? ? Production cost 2.08
Production cost ?

Exercise 4 Solution 4
Apportioning non-production overheads Apportioning non-
non-production overheads
„ The final step is to apportion the non-
non-production „ Non-
Non-production overheads are £43,250 and the
overheads (eg administration, selling and production cost is £216,320
distribution, research and development costs) Non-
Non-production overheads x 100
„ A simple method is to add a percentage based on Production cost
the following formula
Non-
Non-production overheads x 100 = £43,250 x 100
Production cost £216,320
„ Required
„ Using the formula, calculate the percentage if = 20% of production cost
non-
non-production overheads are £43,250 and the „ If we also add a gross profit mark up of 50% of the
production cost is £216,320 production cost, we can calculate the selling price …
 Cotswold Coolers
Using predetermined absorption rates
Total cost (1 unit)
£ £ „ Normally predetermined overhead absorption rates
Direct materials (based on estimates) are used because the actual
Mineral water 0.30 figures are not available until the end of the period
Bottle, lid and label 0.75
„ Where the predetermined overhead that has been
Prime cost 1.05
Production overheads absorbed is higher than the actual overhead, the
Bottling dept (0.15 machine hour x £4.00) 0.60 variance is known as overabsorption and this
Warehouse (cost unit OAR) 0.43 1.03 reduces expenses in the profit and loss account
Production cost 2.08
„ Where the predetermined overhead that has been
Non-production overheads (£2.08 x 20%) 0.42
Total cost 2.50 absorbed is lower than the actual overhead, the
Profit (£2.08 x 50%) 1.04 variance is known as underabsorption and this
Selling price 3.54 increases expenses in the profit and loss account

Operating Revenues and

INCOME STATEMENT Expenses
Operating Revenues
$28,900
„ The income statement or profit and loss Sales (minus) returns and -870
statement summarizes the firm’
firm’s revenues and allowances
Total Operating Revenues 28,030
expenses over a period of time (a month, a Operating Expenses
quarter, or a year) Cost of Goods and Services Sold
Labor 6140
„ The income statement is used to evaluate Materials 4640
revenue and expenses that occur in the interval Indirect Costs 2280
between consecutive balance sheet statements. Selling and promotion 930
Depreciation 1850
General and administrative 900
„ Revenues – Expenses = Net Profit (Loss)
Lease payments 510
Total operating expense 17,250
Here is an example of an Income Statement
Total operating income 10,780
 SOME FINANCIAL RATIOS DERIVED
FROM INCOME STATEMENT

Total operating income 10,780 Interest Coverage = Total Income / Interest payments
Non-
Non-operating Revenues and
(28,610 -17,250) /120 = 94.7
Expenses
Rents $400
Interest 180
receipts
(minus) Interest payments -120 Net profit ratio = Net profit / Net sales revenue
Total Non-
Non-operating income 460
7,310 / 28,030 = 0.261 = 26.1%
Net Income Before Taxes 11,240
Income Taxes (35%) 3,930
Net Profit (loss) for year 2005 $7,310

TRADITIONAL COST ACCOUNTING ABSORPTION COSTING

Direct Costs: „ To allocate indirect cost (OH) to different
¾ Direct material : all material that is used in products accountants use quantities such as
manufacturing a product
¾ Direct labor: wages of the direct touch labor needed
direct-
direct-labor hours, direct-
direct-labor cost, material
to build one unit cost, or total direct cost as the metric.
„ For example, if direct labor-
labor-hours is the metric
Indirect Costs: also known as overhead to use, then overhead will be allocated based
¾ Shipping and receiving on overhead dollar per direct-
direct-labor hour.
¾ Quality control
„ Then each product will absorb (or be
¾ Engineering
allocated) overhead costs, based on the direct
¾ Rent, Insurance, etc
¾ All other expenses which are not direct labor or direct
labor hours it consumes.
material
 ABSORPTION COSTING Example
Total Overhead is $850,000
Metric, i Unit allocation Unit allocation Standard Premium
rate Rate,
Rate, Ri of OH cost

DL hours $OH/total DL Ri*DL hours

hours per unit
Number of 750 400
Units per year
DL cost $OH/total DL Ri*DL cost per
cost unit Labor cost $400 $500
DM cost $OH/total DM Ri*DM cost per (each)
cost unit
Materials cost $550 $900
Total direct $OH/total Ri*total direct (each)
cost Direct cost cost per unit

Example Example
Total Overhead is $850,000 Total Overhead is $850,000
Standard Premium Total Standard Premium Total
Labor cost $300,000 $200,000 $500,000

Number of Units 750 400 Overhead/labor 1.70 1.70

per year
Allocation by labor $510,000 $340,000 $850,000
Labor cost (each) $400 $500

Materials cost $550 $900 Material cost $412,000 $360,000

(each)
Overhead $1.100324 $1.100324
Total labor cost $300,000 $200,000 $500,000
material
Total materials cost $412,500 $360,000 $772,500
Allocation by $453,884 $396,117 $850,000
material
 Unit cost based on $DL allocation of OH Unit cost based on $DM allocation of OH

Standard Premium Standard Premium

DM 550 900 DM 550 900

DL 400 500 DL 400 500

OH (DL cost.) 400*1.70 = 680 500*1.70 = 850 OH (DM cost.) 550*1.100 = 900*1.100 =
605 990
Unit cost 1630 2250 Unit cost 1555 2390

CONCLUSIONS
„ Direct costs are allocated to the cost unit
Production overheads are allocated or apportioned
„
to the cost centres on a fair basis and absorbed CHAPTER 5
into the cost unit using an appropriate OAR
„ Non-
Non-production overheads can be absorbed into
the cost unit by adding a percentage based on the
MARGINAL COST
proportion of non-
non-production overheads to the
total production cost Using direct (marginal) costing
„ But a limitation of absorption costing is that it is for decision making
based on arbitrary decisions about the basis for
apportionment and absorption of overheads
 What is Direct Costing?
The Direct Costing method (Marginal costing) is an
inventory valuation / costing model that includes
only the variable manufacturing costs:
„ direct materials (those materials that become an
integral part of a finished product and can be
conveniently traced into it)
„ direct labor (those factory labor costs that can be
easily traced to individual units of product. Also
called touch labor)
„ - only variable manufacturing overhead in the cost
of a unit of product. The entire amount of fixed
costs are expenses in the year incurred.
The principles of marginal costing
3. Profit measurement should be based on an analysis of
total contribution. Since fixed costs relate to a period of
time, and do not change with increases or decreases in
sales volume, it is misleading to charge units of sale
with a share of fixed costs
4. When a unit of product is made, the extra costs
incurred in its manufacture are the variable production
costs. Fixed costs are unaffected, and no extra fixed
costs are incurred when output is increased
The Principles of Marginal Costing
1. For any given period of time, fixed costs will be the
same, for any volume of sales and production
(provided that the level of activity is within the ‘relevant
range’
range’). Therefore, selling an extra item of product or
service:
Î Revenue will increase by the sales value of the item sold
Î Costs will increase by the variable cost per unit
Î Profit will increase by the amount of contribution earned
from the extra item
2. The volume of sales falls by one item Î the profit will
fall by the amount of contribution earned from the item.
Features of Marginal costing
1. Cost Classification
The marginal costing technique makes a
sharp distinction between variable costs and
fixed costs. It is the variable cost on the
basis of which production and sales policies
are designed by a firm following the
marginal costing technique
 Features of Marginal costing
2. Stock/
Stock/Inventory Valuation
Under marginal costing, inventory/stock for
profit measurement is valued at marginal
cost. It is in sharp contrast to the total unit
cost under absorption costing method
Cost-Volume-Profit Analysis
„ Systematic method of examining the relationship
between changes in activity and changes in total
sales revenue, expenses and net profit
„ CVP analysis is subject to a number of underlying
assumptions and limitations
„ The objective of CVP analysis is to establish what
will happen to the financial results if a specified
level of activity or volume fluctuates
Features of Marginal costing
3. Marginal Contribution
Marginal costing technique makes use of
marginal contribution for marking various
decisions. Marginal contribution is the
difference between sales and marginal cost.
It forms the basis for judging the
profitability of different products or
departments
CVP Analysis Assumptions
„ All other variables remain constant
„ A single product or constant sales mix
„ Total costs and total revenue are linear functions
of output
„ The analysis applies to the relevant range only
„ Costs can be accurately divided into their fixed and
variable elements
„ The analysis applies only to a short-
short-time horizon
„ Complexity-
Complexity-related fixed costs do not change
 A Mathematical Approach to
CVP Diagram
CVP Analysis
NP=Px
NP=Px--(a+bx),
(a+bx),
NP – net profit
x – units sold
P – selling price
b – unit variable cost
a – total fixed costs

Break-
Break-Even and Related Formulas Margin of Safety
„ TR –Profit = FC + VC Indicates by how much sales may decrease
before a loss occurs
„ Contribution = TR – VC
„ Profit = Contribution – FC
Margin of safety (units)= Profit/Contribution
„ Break-
Break-even (units) = FC/Contribution per unit
per unit
„ Break-
Break-even (sales revenue) =FC/PV ratio, where PV
(profit - volume) ratio = Contribution/Selling
price Margin of safety (sales revenue) = Profit/PV
ratio
 Range of Goods Planning (1)
Increases in Activity Level (unlimited)
A B C
1000 1200 1500
per unit total per unit total per unit total
A B C
Price(
Price(sales)
sales) 35 35 000 40 48 000 25 37 500 120 500

VC 21 21 000 30 36 000 15 23 010 80 010 2500 1200 1500

FC (allocated
(allocated)) 12 11 618 13 15 934 6 12 448 40 000
per unit increment total per unit total per unit total
Costs 33 32 618 43 51 934 24 35 458 120 010

Profit 2 2 382 -3 -3 934 1 2 042 490

Price(
Price(sales)
sales) 35 +52500 87 500 40 48 000 25 37 500 173 000
Contribution 14 14 000 10 12 000 10 14 490 40 490

A B C VC 21 +31500 52 500 30 36 000 15 23 010 111 510

1000 0 1500
FC (allocated
(allocated)) 12 +10000 11 618 13 15 934 6 12 448 50 000
per unit total per unit total per unit total

Price(
Price(sales)
sales) 35 35 000 0 0 25 37 500 72 500
Costs 33 64 118 43 51 934 24 35 458 161 510
VC 21 21 000 0 0 15 23 010 44 010

FC (allocated
(allocated)) 19 19 310 0 0 6 20 690 40 000 Profit 2 +9150 23 382 -3 -3 934 1 2 042 11 490
Costs 40 40 310 0 0 29 43 700 84 010

Profit -5 -5 310 0 0 -4 -6 200 -11 510 Contribution 14 35 000 10 12 000 10 14 490 61 490
Contribution 14 14 000 0 0 10 14 490 28 490

Increases in Activity Level (limited) Pricing

Price is 250 $ per unit
A B C
choice 1 better quality (higher price,
price,higher FC)
FC) choice 2 lower price
1000 1200 1500
per unit total per unit total per unit total
1 2
Price(
Price(sales)
sales) 35 35 000 40 48 000 25 37 500 120 500
10 000 12 000
VC 21 21 000 30 36 000 15 23 010 80 010

FC (allocated
(allocated)) 12 11 618 27 31 871 8 12 448 40 000 per unit total per unit total

Costs 33 32 618 57 67 871 24 35 458 120 010 Price(

Price(sales)
sales) 300 3 000 000 200 2 400 000
Profit 2 2 382 -17 -19 871 1 2 042 490
VC 100 1 000 000 80 960 000
Contribution 14 14 000 10 12 000 10 14 490 40 490
FC (allocated
(allocated)) 3 000 2 400
Number of labour hours used 3 3 2
Costs 100 1 003 000 80 962 400
Contribution per hour 4,67 3,33 4,83
Profit 200 1 997 000 120 1 437 600
Rank 2 3 1 max hours

Demand in units 6000 7000 6000 19000 Contribution 200 2 000 000 120 1 440 000

Total labour demand 7000 0 12000 BEP 15 000 20 000

Capacity 25 000 25 000

 To Produce or to Buy Advantages
Produce Buy (unlimited)
unlimited) „ Direct costing is simple to understand
1000 1000
per unit total per unit total
„ It provides more useful information for decision-
decision-making
Price 150 150000 150 150000 „ Direct costing removes from profit the effect of inventory
VC 50 50000 x x
changes
FC (allocated
(allocated)) 100000 x x
Costs 50 150000 150 150000 „ Is effective in internal reporting for frequent profit
Profit 100 0 0 0
statements and measurement of managerial performance
„ Direct costing avoids fixed overheads being capitalized in
Produce Buy (unlimited)
unlimited) unsaleable stocks
1200 1200
per unit total per unit total „ The effects of alternative sales or production policies can
Price(
Price(sales)
sales) 150 180000 150 180000 be easier assessed thus the decisions yield the maximum
VC 50 60000 x x
return to business
FC (allocated
(allocated)) 100000 x x
Costs 50 160000 150 180000 „ By concentration on maintaining a uniform and consistent
Profit 100 20000 0 0
marginal cost practical cost control is greatly facilitated

Disadvantages Disadvantages (2)

„ The separation of costs into fixed and variable is difficult
and sometimes gives misleading results
„ Direct costing underestimates the importance of fixed costs
„ Full costing systems also apply overhead under normal
operating volume and this shows that no advantage is
gained by direct costing
„ Under direct costing, stocks and work in progress are
understated. The exclusion of fixed costs from inventories
affect profit, and true and fair view of financial affairs of an
organization may not be clearly transparent
„ Volume variance in standard costing also discloses the
effect of fluctuating output on fixed overhead. Marginal
cost data becomes unrealistic in case of highly fluctuating
levels of production, e.g., in case of seasonal factories.
„ Application of fixed overhead depends on estimates and
there may be under or over absorption of the same
„ Control affected by means of budgetary control is also
accepted by many. In order to know the net profit, we should
not be satisfied with contribution and hence, fixed overhead
is also a valuable item. A system which ignores fixed costs is
less effective since a major portion of fixed cost is not taken
care of under marginal costing
„ In practice, sales price, fixed cost and variable cost per unit
may vary. Thus, the assumptions underlying the theory of
marginal costing sometimes becomes unrealistic. For long
term profit planning, absorption costing is the only answer
 Direct vs. Absorption (full) costing Direct vs. Absorption (full) costing
Direct costing Absorption costing Direct costing Absorption costing
Fixed manufactured overheads „ Profit is a function of „ Profit is a function of both
are regarded as period costs (written are allocated to the products sales sales and production
(included in inventory valuation)
as a lump sum to the profit and loss „ Are recommended where „ Assigns indirect costs to
account) indirect costs are a low
Variable manufacturing costs cost objects
proportion of an „ is widely used for cost
are assigned to the products are assigned to the products
organization’
organization’s total costs control purpose esp. in
Non-manufacturing overheads „ is used for managerial the long run
are period costs are period costs decision-
decision-making and „ consistent for external
control reporting
Fixed manufacturing costs
„ used mainly for internal
are added to the variable are assigned to the products
purposes
manufacturing cost of sales to
determine total manufacturing costs

THE END
 STANDARD COSTS
WHAT ARE STANDARD COST ?
Standard costs are the expected costs of manufacturing
the product.

WHAT ARE STANDARD COST SYSTEM?

1. A standard costs system is a method of setting cost
Ir. Haery Sihombing/IP
Sihombing/IP
Pensyarah targets and evaluating performance
Fakulti Kejuruteraan Pembuatan
Universiti Teknologi Malaysia Melaka 2. Target or expected costs are set based on a variety of
criteria, and actual performance relative to expected
targets is measured
CHAPTER 6 STANDARD COST

STANDARD COSTS STANDARD COSTS

WHAT ARE STANDARD COST SYSTEM? ™ Standard Direct Labor costs =

3. Significant difference between expectations and Expected Wage Rate X Expected Number of Hours
actual results are investigated
™ Standard Direct Material Cost =
4. Consistent with the themes developed throughout
Expected Cost of Raw Materials X Expected Number of Units of
this class, standard cost systems are means of helping
Raw Material
managers with decision making and control

™ Standard Overhead Costs =

Expected Fixed OH + Expected Variable Overhead X Expected
Number
Number of Units to be Produced
 TARGET COSTING TARGET COSTING
„ 1. The market place determines the selling WHY USE A STANDARD COST SYSTEM
price of the future product 1. Standard are important for decision making
• How we produce our product
• How we price our product
„ 2. The company determines the profit margin • Contract billing
they desire to achieve on his product
2. Monitor Manufacturing
• Large variances may indicative of problems in
„ 3. The difference between the selling price production
and the profit margin is the target cost
3. Performance Measurement
• Deviations between actual and standards are often
used as measure of a manager’
manager’s performance
• Who sets the standard ?

TARGET COSTING TARGET COSTING

HOW DO WE SET THE STANDARDS ?
Important considerations in setting standard
Theoretically the standard should be expected cost
of producing the product 1. Why are senior managers using standard
• Pricing
• Performance measurement
General practices:
• Production decisions
• Prior years performance
• Expected future performance under normal operating 2. What happens if managers fail to meet the
• Optimistic (Motivator)
standards ?
3. Standard are supposed to represent the
opportunity cost of production
Example : 1 Example : 1

Example : 1 Example : 1
 Example : 1 (Question) Direct Labor Wage Variance

• What do we do with the raw materials price

variance ?
• Who do we hold responsible ?
• What do we do with the raw materials
quantity variance?
• Who do we hold responsible ?

Direct Labor Efficiency Variances STANDARD COSTS

BUDGETS are TOTAL amounts

A STANDARD COST is
a PER UNIT BUDGET amount
 Ideal Vs. Normal Standards Analysis of Direct Material Variances

„ An Ideal Standard is the theoretical best-

best-cause
which assumes 100% efficiency
„ A Normal Standard should represent a level of
efficiency that is attainable under normal
operating conditions

„ The setting of the standard is a management

judgment call and must reflect expected and
acceptable inefficiencies

Analysis of Direct Material Variances Analysis of Direct Material Variances

TOTAL VARIANCE for Direct Materials

must be analyzed in terms of
ƒ Quantity Variance
ƒ Price Variance
Analysis of Direct Material Variances Analysis of Direct Labor Variances

The Analysis of the Labor Variance works

the same mechanically as the Analysis of
Direct Materials Variances

Direct Materials Direct Labor

Quantity # of Hours
Price Hourly Cost

Analysis of Overhead Variances Analysis of Overhead Variances

Analysis of Overhead Variances Analysis of Overhead Variances

Analysis of Overhead Variances Example : 2 Manufacturing Product Costs

„ Direct costs--
costs--can
can be traced to units
produced
™ direct labor
™ direct materials

„ Overhead--
Overhead--can
can’’t be traced to units
™ indirectlabor--
labor--e.g.,
e.g., janitorial, supervisory
™ indirectmaterials--
materials--e.g.,
e.g., miscellaneous supplies
™ other--
other--e.g.,
e.g., depreciation, utilities, rent
™ allocated to units based on “drivers”
drivers”
 Steps in recording Steps in recording
¾ Place purchases in raw materials inventory ¾ Add in direct labor and overhead to WIP

¾ Transfer raw materials inventory to work-

work-
in-
in-process inventory when production starts
¾ Transfer costs of completed units to finished
goods inventory

Steps in recording Steps in recording

¾ Transfer costs associated with sold goods to

CGS
 Steps in recording

EXAMPLE: 3 Statement of Cost of Goods Manufactured

Statement of Cost of Goods Manufactured Raw Materials Used

„ Beginning work in process $ 145,000 Beginning balance $ 73,000

„ Raw materials used $284,000
„ Direct labor 436,000
Purchases of materials 280,000
„ Variable overhead 115,200 Raw materials available $353,000
„ Fixed overhead 98,880 Ending balance 69,000
„ Current period manufacturing costs 934,080 Total raw materials used $284,000
„ Total costs to account for $1,079,080
„ Ending work in process 20,880 To Statement of Cost of Goods Manufactured
„ Cost of goods manufactured $1,058,200
 Schedule of Cost of Goods Sold Income Statement

Beginning Finished Good $ 87,400 „ Revenue xxxx

Cost of Goods Manufactured 1,058,200 „ Cost of Goods Sold <1,054,000>
1,054,000>
Cost of Goods Available for Sale $1,145,600 „ Gross Profit xxxx
Ending Finished Goods 91,600 „ Operating Expenses <xxxx>
Cost of Goods Sold $1,054,000 „ Operating Income xxxx

From Schedule of Cost of Goods Manufactured From Schedule of Cost of Goods Sold

Questions
„ What is the difference between a fixed and
variable cost?
„ What are the three components of product
cost?
„ What are the three inventory accounts for
a manufacturing company?