University of the Gambia
BSc. In Accounting – Management accounging 3
Lecture 1: Cost and Management Accounting – New developments
Lecturer: Mr. Lamin Fofana FCCA, MSc., BSc. (Hons.), MAAT -
(Director of Finance and admin – Social
Development Fund (SDF)
Absorption and Marginal Costing
_ In Absorption Costing fixed manufacturing
overheads are absorbed into cost units.
_ Stock is valued at absorption cost and fixed
manufacturing overheads are charged in the P&L
account of the period in which units are sold
_ In Marginal costing fixed manufacturing
overheads are NOT absorbed into cost units.
_ All fixed overheads, including fixed manufacturing
overheads are treated as period costs and charged in
the P&L account of the period.
UTG
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ABSORPTION COSTING
Absorption costing – a reminder
The linking of all production costs to the cost unit to prepare a full cost per unit.
Uses
1.
Stock Valuation
2.
Pricing decisions
3.
Budgeting
Traditional overhead analysis
Cost
Centres
Overhead
cost item
Cost
Units
Steps using absorption costing
The steps using absorption costing are:
1
Overhead costs are collected in various cost centres
Allocation: Specific overhead costs directly relating to individual cost centres,
for example, supervision, indirect materials.
Apportionment: General or common overhead costs like rent, heating,
electricity are incurred as a whole item by the company and therefore have to
be distributed to cost centres on some sharing bases like floor area, machine
hours, number of staff etc
2
Overhead absorption is achieved by means of a predetermined Overhead
Absorption Rate.
a.
Overhead Absorption Rate =
Budgeted Overheads
Budgeted Level of Activity *
* Activity levels generally used by examiners are number of units,
labour hours or machine hours, which means overheads are
charged to units on these bases.
b.
2
Number of Units:
Single product environment
Labour Hours:
Manual manufacturing operations
Machine Hours:
Mechanical manufacturing operations
Absorbed overheads
=
OAR x Actual Activity
Lecture 1: Cost and Management Accounting – New developments
Example 1 2P2D Ltd
2P2D Ltd produces 2 products in 2 departments. Relevant product information is:
Direct material cost (£)
Direct labour cost in Department X (£)
Time per unit in Department X (Hours)
Direct labour cost in Department Y (£)
Time per unit in Department Y (Hours)
Budgeted number of units
Product A
20
20
4
25
5
2,000
Product B
35
30
6
35
7
1,000
The labour rate is £5 per hour in each department.
The Budgeted Departmental Overheads are:
Department X
Department Y
£18,000
£6,500
Required:
Calculate the cost/unit using:
(a)
Separate OARs for each department, based on labour hours.
(b)
An overall OAR, based on labour hours.
(c)
Discuss the differences.
Criticisms of absorption costing
Criticisms of absorption costing are:
●
A big amount of guess work in relating overhead costs to the products.
●
Inappropriate bases to link overheads to products
●
Can only work in single product and simple manufacturing environments
Recent changes in manufacturing
The reason for the increasing inaccuracy of absorption costing is due to two basic
issues:
1.
Increased production complexity.
2.
Increased proportion of overhead costs.
Production complexity
A wide variety of production processes have become more complex in recent years
in a number of ways:
1.
Flexible manufacturing systems allow for a number of widely differing
products to be produced on the same machinery. Absorbing overhead on a
simple volume base is unlikely to reflect the differing overhead costs incurred
by each product.
3
2.
Fast product development may mean that a number of differing iterations
of the same product may be produced in quick order.
With such products
having differing production volumes again a volume base is unlikely to work.
3.
Wider product ranges lead to a more complex cost analysis.
Increased proportion of overhead costs
Overheads have
the substitution
greater degree.
rise to increased
increased in importance as a percentage of total costs due to both
of direct labour with indirect labour as companies mechanise to a
Also the increased production complexity outlined above has given
costs for such disciplines as production planning and logistics.
Increased proportion of support services’ costs
Activity based costing also introduces the important aspect that cost are incurred in
selling and distributing a product and the cost of servicing customers are often
more important
than production
therefore
an
accurate
cause
effect
relationship should be established as to what generates the cost and what is the
real impact of
this cost on the volume of units sold.
See supplementary notes on Lecture 1b on ABC before proceeding
A revised analysis – ABC
Overhead
Cost Item
Cost
Pool
Cost
Unit
Steps using ABC
The steps involved in ABC are:
1.
Identify an organisation’s activities.
2.
Collect the cost of each activity into what is called cost pool (equivalent to
cost centre under traditional costing).
3.
Identify the factors which determine the size of the costs of an activity. These
are called cost drivers.
Activity
Ordering
Material handling
Production scheduling
Despatching
4.
Possible Cost Drivers
number of orders
number of production run
number of production run
number of despatches
Assign the cost of activities to products according to the product’s demand for
activities.
Cost Pool is an activity that consumes resources and for which overhead
costs are identified and allocated. For each cost pool there should be a cost
driver.
Cost Driver is any factor which causes a change in the cost of an activity.
4
Example 2 Hensau Ltd
Hensau Ltd has a single production process for which the following costs have
been estimated for the period ending 31 December 2010:
£
Material receipt and inspection costs
Power costs
Material handling costs
15,600
19,500
13,650
Three products - X, Y, and Z are produced by workers who perform a number of
operations on material blanks using hand held electrically powered drills. The
workers are paid £4 per hour.
The following budgeted information has been obtained for the period ending 31
December 2009:
Production quantity (units)
Batches of Material
Data per product unit:
Direct material (square metres)
Direct material cost (£)
Direct labour (minutes)
No. of power drill operations
Product X
Product Y
Product Z
2,000
10
1,500
5
800
16
4
5
24
6
6
3
40
3
3
6
60
2
Overhead costs for material receipt and inspection, process power and material
handling are presently each absorbed by product units using rates per
direct labour hour.
An activity based costing investigation has revealed that the cost drivers for the
overhead costs are as follows:
Material receipt and inspection:
Process power:
Material handling:
Number of batches of material
Number of power drill operations
Quantity of material (square metres)
handled
Required
(a)
Prepare a summary which shows the budgeted product cost per unit
for each product of X, Y, and Z for the period ending 31 December
2010 detailing the unit costs for each cost element using:
(i)
the existing method for the absorption of overhead costs and
(ii) an approach which recognises the cost drivers revealed in the
activity based costing investigation.
(13 marks)
(b)
Explain the relevance of cost drivers in activity based costing. Make
use of figures from the summary statement prepared in (a)
to illustrate your answer.
(7 marks)
(20 marks)
5
Conditions under which ABC is most appropriate
The usefulness of ABC techniques will depend on
organisation, in particular the following:
(1)
Cost structure
(2)
Product mix or diversity
(3)
Information
(4)
the characteristics of the
Environment.
Benefits and limitations
Benefits
1.
More accurate product costing.
2.
Is flexible enough to analyse costs by activity providing more useful costing
data.
3.
Provides a reliable indication of long-run variable product cost.
4.
Helps understanding of cost.
5.
Provides a more logical basis for costing of overhead.
Limitations
1.
Cost vs benefit.
2.
ABC information is historic and internally.
3.
Difficult to apply in practice.
4.
Focuses on the allocation of cost rather than minimizing the cost incurred.
6
Example 3 Brunti plc
The following budgeted information relates to Brunti plc for the forthcoming period.
Products
XYI
(000s)
YZT
(000s)
ABW
(000s)
50
40
30
£
£
£
45
32
Hours
95
84
Hours
73
65
Hours
2
7
5
3
4
2
Sales and production (units)
Selling Price (per unit)
Prime cost (per units)
Machine department (machine hours per unit)
Assembly department (direct labour hours per
unit)
Overheads allocated and apportioned to production departments (including service
cost centre costs) were to be recovered in product costs as follows.
●
Machine department at £1.20 per machine hour
●
Assembly department at £0.825 per direct labour hour
You ascertain that the above overheads could be re-analysed into 'cost pools' as
follows:
Cost pool
£000
Machining services
Assembly services
357
318
Set-up costs
Order processing
Purchasing
26
156
84
941
Quantity for the
period
Cost driver
Machine hours
Direct labour
hours
Set-ups
Customer orders
Suppliers' orders
420,000
530,000
520
32,000
11,200
You have also been provided with the following estimates for the period:
Number of set-ups
Customer orders
Suppliers' orders
XYI
Products
YZT
ABW
120
8,000
3,000
200
8,000
4,000
200
16,000
4,200
Required:
(a)
Prepare and present profit statements using:
(i)
conventional absorption costing, and
(5 marks)
(ii)
activity based costing.
(9 marks)
(b) Comment on why activity based costing is considered to present a
fairer valuation of the product cost per unit.
(6 marks)
(20 marks)
ACCA June 1995 Amended
7
ACTIVITY BASED BUDGETING (ABB)
●
Activity based budgeting extends the use of ABC from individual product
costing, for pricing and output decisions, to the overall planning and control
systems of the business.
●
The basic principle of ABB is that the work of each department for which a
budget is to be prepared is analysed by its major activities, for which
cost drivers may be identified.
The budgeted cost of resources used by
each activity is determined (from recent historical data) and, where
appropriate, cost per unit of activity is calculated.
●
Future cost can then be budgeted by d e c i d i n g on
working back to the required resource input.
future activity levels and