Cost concepts
A cost object is any activity for which a separate measurement of costs is desired. In other
words, if the users of accounting information want to know the cost of something, this
something is called a cost object. Examples of cost objects include the cost of a product, the
cost of rendering a service to a bank customer or hospital patient, the cost of operating a
particular department or sales territory, or indeed anything for which one wants to measure
the cost of resources used (Drury, 2004).
Direct and indirect costs
Costs that are assigned to cost objects can be divided into two categories:

Direct costs – are those costs that can be specifically and exclusively identified with a
particular cost object; e.g. direct materials and labour – inputs can be traced to outputs.

Indirect cost – cannot be identified specifically and exclusively with a given cost object;
e.g. supervisor salary or factory rent cannot be traced to specific output (Drury, 2004).
Manufacturing costs
Prime costs refer to the direct costs of the product and consist of direct labour costs plus
direct material costs plus any direct expenses. Conversions costs refer to the cost incurred in
converting inputs (raw materials) into outputs (finished goods) and consist of direct labour
cost and manufacturing overheads. Manufacturing overheads consists of all manufacturing
costs other than direct labour, direct materials and direct expenses. It therefore includes all
indirect manufacturing labour and materials costs plus indirect manufacturing expenses (Drury,
2004).
Manufacturing overheads cannot be directly traced to products
(Drury, 2004).
Instead they
are assigned to products using cost allocations.
A cost allocation is the process of estimating the cost of resources consumed by products that
involve the use of surrogate, rather than direct measures.
Some of the cost allocation
techniques include (Drury, 2004):

Traditional overheads allocation

Activity-based costing
Period and product costs

Product costs are those costs that are identified with goods purchased or produced for
resale. In a manufacturing organization, they are costs of manufacturing the product.

Period costs are those costs that are not included in the inventory valuation and as a result
are treated as expenses in the period in which they are incurred; e.g. selling and
administrative expenses. Hence no attempt is made to attach period costs to products for
inventory valuation purposes (Drury, 2004).
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Cost behaviour
Costs can behave in three ways (Drury, 2004):
1. Variable costs – they vary in direct proportion to the volume of activity
2. Fixed costs - remain constant over wide ranges of activity for a specified time period
3. Mixed costs – these costs include both a fixed and a variable component (also known
as semi-variable costs or step-fixed costs)
Cost assignment
A cost allocation is the process of estimating the cost of resources consumed by products that
involve the use of surrogate, rather than direct measures.
Some of the cost allocation
techniques include (Drury, 2004):

Traditional costing system (arbitrary allocation)

Activity-based costing (cause-and-effect allocation)
The basis that is used to allocate costs to cost objects is called an allocation base or cost
driver. Where allocation bases are significant determinants of the costs, we shall describe
them as cause-and-effect allocations. Whereas, where a cost allocation base is used that is not
a significant determinant of its cost the term arbitrary allocation will be used (Drury, 2004).
Traditional costing system
For decision-making purposes and budgeting, actual overheads costs cannot be used because
the actual data is not available yet. As a result, budgeted overhead rates are used to assign
overheads to products. Budgeted overhead rate = budgeted fixed cost / budgeted cost driver.
Management committed itself to a specified level of fixed costs in the light of foreseeable
needs, thus an annualized rate based on the relationship of total annual overhead to total
annual activity is more representative of typical relationships between total costs and volume
(Drury, 2004).
The effect of calculating overhead rates based on budgeted annual overhead expenditure and
activity is that it will be most unlikely that the overhead allocated to products manufactured
during the period will be the same as the actual overhead incurred (Drury, 2004). Thus there will
most likely be under- or over-recovery of overheads (also called volume variance for standard
costing purposes). The under- or over-recovery of overheads can be written off in the
statement of comprehensive income as a period cost (preferred method) or allocated to
manufacturing costs (i.e. allocated to cost of sales, work-in-progress and finished goods
account) (Drury, 2004).
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Activity-based costing system
During the 1980s the limitations of traditional product costing systems began to be widely
publicized. These systems were designed decades ago when most companies manufactured a
narrow range of products, and direct labour and materials were the dominant factory costs.
Overhead costs were relatively small, and the distortions arising from inappropriate overhead
allocations were not significant. Information processing costs were high, and it was therefore
difficult to justify more sophisticated overhead allocation methods (Drury, 2004).
Today companies produce a wide range of products; direct labour represents only a small
fraction of total costs, and overhead costs are of considerable importance.
Simplistic
overheads allocations using a declining direct labour base cannot be justified, particularly
when information processing costs are no longer a barrier to introducing more sophisticated
cost systems. Furthermore, the intense global competition of 1980s has made decision errors
due to poor cost information more probable and more costly – hence the emergence of
activity-based costing (ABC) (Drury, 2004).
Our comparison of ABC systems with traditional costing systems indicated that 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 while traditional costing system used volume-based cost drivers only (Drury, 2004):

Volume-based cost drivers assume that a product’s consumption of overhead resources is
directly related to units produced.
In other words, they assume that the overhead
consumed by products is highly correlated with the number of units produced. Typical
examples are units of output, direct labour hours and machine hours.

Non-volume-based cost drivers such as number of set-ups and engineering orders which
have nothing to do with the number of units produced
Using only volume-based cost drivers to assign non-volume related overheads costs can result
in the reporting of distorted product costs.
The extent of distortion depends on what
proportion of total overheads costs the non-volume-based overheads represent and the level of
product diversity (i.e. products consuming different overhead activities in dissimilar
proportions) (Drury, 2004). Four steps are involved in designing ABC system:
1. identifying the major activities that take place in an organization;
2. assigning costs to cost pools/cost centres for each activity;
3. determining the cost driver for each major activity;
4. assigning the cost of activities to products according to the product’s demand for
activities
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Early ABC systems were subject to a number of criticisms, particularly relating to theoretical
aspects. As a response to these criticisms a number of theoretical developments emerged
during the 1990s. The first theoretical development was reported by Cooper (1990a) who
classified manufacturing activities along a cost hierarchy dimension consisting of (Drury, 2004):
1. Unit-level activities;
2. Batch-level activities;
3. Product-sustaining activities; and
4. Facility-sustaining activities
Unit-level activities
Unit-level activities (also known as volume-related activities) are performed each time a unit
of the product or service is produced. Expenses in this category include direct labour, direct
materials, energy costs and expenses that are consumed in proportion to machine processing
time (such as maintenance). Unit-level activities consume resources in proportion to the
number of units of production and sales volume (Drury, 2004). Typical cost drivers for unit level
activities include labour hours, machine hours and the quantity of materials processed. These
cost drivers are also used by traditional costing systems. Traditional systems are therefore
also appropriate for assigning the costs of unit-level activities to cost objects (Drury, 2004).
Batch-related activities
Batch-related activities, such as setting up a machine or processing a purchase order, are
performed each time a batch of goods is produced. The cost of batch-related activities varies
with the number of batches made, but is common (or fixed) for all units within the batch.
ABC system assume that batch-related expenses vary with the number of batches processed
and provide a mechanism for assigning some of the costs of complexity (such as set-ups or
ordering) to the products or services that cause the activity while traditional costing systems
treat batch-related expenses as fixed costs (Drury, 2004).
Product (or service) sustaining activities
Product-sustaining activities are performed to enable the production and sale of individual
products. Examples of product-sustaining activities provided by Kaplan and Cooper (1998)
include maintaining and updating product specifications and the technical support provided
for individual products and services. The costs of product-sustaining activities are incurred
irrespective of the number of units of output or the number of batches processed and their
expenses will tend to increase as the number of different products manufactured increase.
Kaplan and Cooper (1998) have extended their ideas to situations where customers are the
cost objects with the equivalent term for product-sustaining being customer-sustaining
activities. Customer market research and support for an individual customer, or groups of
customers if they represent the cost object, are examples of customer-sustaining activities.
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Facility-sustaining activities
These are performed to support the facility’s general manufacturing process and include
general administrative staff, plant management and property costs. They are incurred to
support the organization as a whole and are common and joint to all products manufactured in
the plant. There would have to be a dramatic change in activity, resulting in an expansion or
contraction in the size of the plant, for facility-sustaining costs to change. ABC literature
advocates that these costs should not be assigned to products since they are unavoidable and
irrelevant for most decisions (Drury, 2004).
Example 1
Scenario
Having attended a CIMA course on activity-based costing (ABC), you decide to experiment
by applying the principles of ABC to the four products currently made and sold by your
company. Details of the four products and relevant information are given below for one
period:
Product
A
B
C
D
Output in units
120
100
80
120
Cost per unit (in Rands):

Direct materials
40
50
30
60

Direct labour
28
21
14
21

Machine hours (per unit)
4
3
2
3
The four products are similar and are usually produced in production runs of 20 units and sold
in batches of 10 units.
The production overhead is currently absorbed by using a machine hour rate, and the total of
the production overhead (in Rands) for the period has been analysed as follows:

Machine department costs (rent, business rates,
depreciation, and supervision)
10 430

Set-up costs
5 250

Stores receiving
3 600

Inspection/Quality control
2 100

Materials handling and despatch
4 620
You have ascertained that the cost drivers to be used are listed below for the overhead costs
shown:
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Cost
Cost Driver
Set up
Number of production runs
Stores receiving
Requisitions raised
Inspection/Quality control
Number of production runs
Materials handling and despatch
Orders executed
The number of requisitions raised on the store was 20 for each product and the number of
orders executed was 42, each order being for a batch of 10 of a product.
Required
a) Calculate the total costs for each product if all overhead costs are absorbed on a machine
hour basis;
b) Calculate the total costs for each product, using activity based- costing; and
c) Calculate and list the unit product costs from your figures in (a) and (b) above, to show
the difference and to comment briefly on any conclusions which may be drawn which
could have a pricing and profit implications.
Solution
Part (a) - Total Costs: TCS
A
B
C
D
Direct materials
Direct labour
Overheads
*rate (R26 000/1 300) = R20 per MH
*Machine hours per unit
Total costs
40.00
28.00
80.00
20.00
4.00
148.00
50.00
21.00
60.00
20.00
3.00
131.00
30.00
14.00
40.00
20.00
2.00
84.00
60.00
21.00
60.00
20.00
3.00
141.00
Number of units
Total costs
120.00
17 760
100.00
13 100
80.00
6 720
120.00
16 920
Traditional costing system
*Overhead costs
(10 430 + 5 250 + 3 600 + 2 100 + 4 620) = R26 000
*Overhead driver
A (120*4)
480
B (100*3)
300
C (80*2)
160
D (120*3)
360
1 300
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Part (b) - Total Costs: ABC
A
B
C
D
Direct materials
Direct labour
Overheads
*Machine costs - facility costs
Rate is R8.02 (R10 430/1 300)
per MH
*Set-up costs - 20 units in 1 run
Runs (6 + 5 + 4 + 6) = 21 runs
Rate is R250 per run (R5 250/21)
4 800
3 360
8 170
5 000
2 100
6 156
2 400
1 120
4 463
7 200
2 520
7 207
3 850
2 406
1 283
2 887
1 500
1 250
1 000
1 500
900
900
900
900
600
500
400
600
1 320
16 330
1 100
13 256
880
7 983
1 320
16 927
*Stores receiving:
R45 per requisition (R3 600/80)
*Inspection/Quality control
R100 per run (R2 100/21 runs)
*Materials handling & despatch
R110 per order (R4 620/42)
Total unit costs
Part (c) - Comparison
Cost from (a) - TCS
Cost from (b) - ABC
A
B
148.00
136.08
11.92
131.00
132.56
(1.56)
C
84.00
99.79
(15.79)
D
141.00
141.06
(0.06)
Product A is over-costed with the traditional system. Product B and C are under-costed
and similar costs are reported with Product D. It is claimed that ABC more accurately
measures resources consumed by products. Thus ABC will result in more accurate prices
and avoid under- or over-pricing situations (where it could mislead demand).
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Absorption costing
Absorption costing is a costing method where all the costs of manufacturing are included in
the cost of inventory. In other words, inventory is valued at direct materials, direct labour,
direct production expenses and allocated fixed manufacturing overheads.
When absorption costing systems are used, estimated fixed overhead rates must be calculated.
These rates will be significantly influenced by the choice of the activity level; that is the
denominator activity level that is used to calculate the overhead rate. This problem applies
only to fixed overheads, and the greater the proportion of fixed overheads in an organization’s
cost structure the more acute is the problem
(Drury, 2004).
Four choices are available for
determining the denominator activity level when calculating overhead rates:
1. Theoretical maximum capacity – is a measure of maximum operating capacity based
on 100% efficiency with no interruptions for maintenance or other factors. This
measure is not encouraged on the grounds that it represents an activity level that in
most unlikely to be achieved.
2. Practical capacity – represents the maximum capacity that is likely to be supplied by
the infrastructure after taking into account unavoidable interruptions arising from
maintenances and plant holiday closures.
3. Normal activity – is a measure of capacity required to satisfy average customer
demand over a longer term period of, say, approximately three years after taking into
account seasonal and cyclical fluctuations.
4. Budgeted activity – is the activity level based on the capacity utilization required for
the next budget period
Budgeted activity is the most widely used rate as firms prefer to allocate fixed manufacturing
overheads incurred during a period to products rather than writing off some cost as an excess
capacity period cost. Also budgeted annual activity is readily available, being determined as
part of the annual budgeting process. In contrast, normal activity and practical capacity are
not readily available and cannot be precisely determined (Drury, 2004).
Variable costing
Under this alternative system, only variable manufacturing costs are assigned to products and
included in the inventory valuation. Fixed manufacturing overheads are not allocated to the
product, but are considered period costs and charged directly to the income statement
2004).
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(Drury,
Absorption vs. Variable costing
Whenever, sales are equal to production, the profits will be the same for both the absorption
costing and variable costing system
(Drury, 2004).
This is because all the fixed manufacturing
overheads are expensed under the variable costing and all the allocated fixed overheads would
be cost of sales (no inventory movement) and the over- or under-recovery fully expensed
under the absorption costing system.
However, if production is in excess of sales, the absorption costing system will show a higher
profit than the variable costing system (Drury, 2004). This is because some of the allocated fixed
overheads will be deferred with unsold inventory under the absorption costing system while
the fixed overheads are expensed in full under the variable costing system. In contrast, if
sales are in excess of production, the variable costing system will show a higher profit than
the absorption costing system
(Drury, 2004).
This is due to the fact that some of that deferred
fixed overheads which was capitalized to inventory is now released when the opening
inventory turns into cost of sales.
As a result, the profit calculations for an absorption costing system can produce some strange
results. In periods where the sales volume has increased, profits may decline, in spite of the
fact that both the selling price and the cost structure have remained unchanged
(Drury, 2004).
This may impact negatively on the manager’s confidence of the system if managerial
performance is measured on profits
(Drury, 2004).
In contrast, the variable costing profit
calculations show that when sales volume increases, profit also increases
(Drury, 2004).
These
relationships continue as long as the selling price and cost structure remain unchanged.
Example 2
Scenario
The following data have been extracted from the budgets and standard costs of ABC Limited,
a company which manufactures and sells a single product
R per unit
Selling price
45.00
Direct material cost
10.00
Direct wages cost
4.00
Variable overhead cost
2.50
Fixed production overhead costs are budgeted at R400 000 per annum. Normal production
levels are thought to be 320 000 units per annum.
Budgeted selling and distribution costs are as follows:
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Variable
R1.50 per unit sold
Fixed
R80 000 per annum
Budgeted administration costs are R120 000 per annum.
The following pattern of sales and production is expected during the first six months of the
year:
Jan – March
April – June
Sales (units)
60 000
90 000
Production (units)
70 000
100 000
There is to be no stock on 1 January.
Required
a) Prepare profit statements for each of the two quarters, in a columnar format, using
marginal costing, and absorption costing.
b) Reconcile the profits reported for the two quarters in your answer to (a) above.
c) Write up the production overhead control account for the quarter to 31 March, using
absorption costing principles. Assume that the production overhead costs (fixed) incurred
amounted to R102 400 and the actual production was 74 000 units;
d) State and explain briefly the benefits of using marginal costing as the basis of
management reporting.
Solution
Part (a) - Absorption costing
Sales revenue
Cost of sales
*Direct material costs
*Direct wages costs
*Variable overhead costs
*Fixed overhead costs
Rate is R1.25 per unit (R400 000/320 000)
Cost of manufactured goods
Add: opening inventory
Less: closing inventory (1 242 500*10/70)
Quarter 1
2 700 000
1 065 000
700 000
280 000
175 000
Gross profit
Operating expenses
Variable selling and distribution costs
Add : over-absorption of overheads
Less : under-absorption of overheads
Fixed selling and distribution costs
Administration costs
Profit
87 500
1 242 500
(177 500)
125 000
1 775 000
177 500
(355 000)
1 635 000
152 500
90 000
2 452 500
160 000
135 000
(25 000)
12 500
20 000
30 000
1 482 500
10
Quarter 2
4 050 000
1 597 500
1 000 000
400 000
250 000
20 000
30 000
2 292 500
Part (a) - Variable costing
Sales revenue
Variable production costs
*Direct material costs
*Direct wages costs
*Variable overhead costs
Cost of manufactured goods
Add: opening inventory
Less: closing inventory (1 155 000*10/70)
Quarter 1
2 700 000
990 000
700 000
280 000
175 000
1 155 000
(165 000)
Quarter 2
4 050 000
1 485 000
1 000 000
400 000
250 000
1 650 000
165 000
(330 000)
Variable selling and distribution costs
Contribution margin
90 000
1 620 000
135 000
2 430 000
Fixed costs
Fixed overhead costs
Fixed selling and distribution costs
Administration costs
Profit
150 000
100 000
20 000
30 000
1 470 000
150 000
100 000
20 000
30 000
2 280 000
Part (b) - Reconciliation
Quarter 1
Variable costing profit
Fixed costs deferred with inventory
*Quarter 1 (R1.25*10 000)
*Quarter 2 (R1.25*20 000)
Fixed costs released with inventory
Absorption costing profit
1 470 000
Quarter 2
2 280 000
12 500
1 482 500
25 000
(12 500)
2 292 500
Part © - Write ups
R
Absorbed fixed costs (R1.25*74 000)
Actual fixed costs
Under-absorption (Volume variance)
92 500
102 400
9 900
Some arguments in support of variable costing
1
The separation of fixed and variable costs helps to provide relevant information about
costs for making decisions. In addition, the estimation of costs for different levels of
activities requires that costs be split into fixed and variable.
Even though the cost
differentiation can be performed under absorption costing, it is not mandatory while it is
readily available under variable costing system (Drury, 2004).
2
Variable costing removes from profit the effect of inventory changes especially when
such valuations occur frequently and the effects of seasonal variations are included
3
Managers may deliberately alter their inventory levels to influence profit when an
absorption costing system is used (Drury, 2004).
4
Stock will be overvalued under absorption costing and result in inventory write downs in
the period in which the cost of inventory was not incurred (Drury, 2004).
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Some arguments in support of absorption costing
1
Absorption costing does not understate the importance of fixed costs while variable
costing ignore the fact that fixed costs must be met in the long-run – this argument is false
because if a manager ignores fixed costs under variable costing it will be due to faulty
management not to a faulty accounting system (Drury, 2004).
2
In a business that relies on seasonal sales and in which production is built up outside the
sales season to meet demand, the full fixed costs will be charged under variable costing
system. This will mean fictitious losses in off-seasons while absorption costing would
match the fixed costs with the sales during sales seasons (Drury, 2004).
3
The proponents of absorption costing argue that the production of goods is not possible if
fixed manufacturing costs are not incurred.
Consequently, fixed manufacturing
overheads should be allocated to units produced and included in the inventory valuation.
4
Top management may prefer their internal profit reporting systems to be consistent with
the external financial accounting absorption costing systems so that they will be
congruent with the measures used by financial markets to appraise company performance.
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