MANAGEMENT

ACCOUNTING
PREPARED BY:
SYAZLIANA KASIM
FACULTY OF ACCOUNTANCY
UITM SHAH ALAM
 CLASSIFICATION OF COSTS
PRODUCT VS.
PERIOD BEHAVIOUR

FUNCTIONS DIRECT VS.

INDIRECT

NATURE COSTS CONTROLLABLE VS.

UNCONTROLLABLE

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COSTS ACCORDING TO NATURE

LABOUR

MATERIAL EXPENSES

NATURE

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COSTS ACCORDING TO FUNCTION

PRODUCTION

RESEARCH &
ADMINISTRATION DEVELOPMENT

DISTRIBUTION &
SELLING FUNCTION TRANSPORTATION

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 PRODUCT VS PERIOD COST

PRODUCT • Cost of making or buying an inventory

for the purpose of resale
• Costs that are included on a stock
COST valuation

• Costs that are being charged to the Income Statement

PERIOD for the period which are not directly related to the
production of a product or services.
• It relates to the passage of time rather than output of
individual goods or services.

COST • Costs that will not be included in the stock valuation and
calculation of gross profit

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 COST BEHAVIOUR

FIXED COSTS SEMI-VARIABLE COSTS

Costs that are not affected in
Costs that have both fixed
total by the changes in
element and variable element
activity level

VARIABLE COSTS
Costs that change in total in
direct proportion to the level
of activity
STEPPED COSTS
Costs that are constant for a
range of activity levels and
then change and then remain
constant again for another
range

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 FIXED COST

TOTAL FIXED COST FIXED COST PER UNIT

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 VARIABLE COST

TOTAL VARIABLE COST VARIABLE COST PER UNIT

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SEMI-VARIABLE COST

TOTAL SEMI-VARIABLE COST

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STEPPED FIXED COST

TOTAL STEPPED FIXED COST

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DIRECT COST VS. INDIRECT COST

INDIRECT COSTS
DIRECT COSTS
Costs that cannot be directly
Costs that can be directly
attributed to any cost
attributed to any cost
centre/cost unit and thus must
centre/cost unit
be shared on equitable basis.

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CONTROLLABLE VS. UNCONTROLLABLE
CONTROLLABLE COSTS
Costs that are influenced by the decisions
or actions of a manager
Example: shut down cost such as
retrenchment benefits

UNCONTROLLABLE COSTS
Costs that cannot be influenced by the
decisions or actions of a manager
Example: increased cost of raw materials
due to inflation

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MATERIAL

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 DIRECT MATERIALS
• Materials that can be directly attributed to a unit of
production, or a specific job, or a service provided directly to
a customer.
• In a manufacturing business, direct materials are therefore
the raw materials and components that are directly input
into the products that the organisation makes.
• Example: Flour to make bread; steel to make spoon

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 INDIRECT MATERIALS
• Other materials that cannot be directly attributed to a unit
of production.
• An example of indirect materials might be the oil used for
the lubrication of production machinery. This is a material
that is used in the production process but it cannot be
directly attributed to each unit of finished product.

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 PRICING ISSUES OF MATERIALS
• When materials are purchased, the process of giving them a
value is fairly straightforward.
• The purchase cost of the items is the price charged by the
supplier plus any carriage inwards costs.
• The cost should be net of any trade discount given.
• When materials are issued from store, a cost or price has to be
attached to them.
• When a quantity of materials is purchased in its entirety for a
specific job, the purchase cost can be charged directly to the job.
• However, in common situation, materials are purchased in fairly
large quantities (but at different prices each time) and later
issued to cost centres in smaller quantities.
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 PRICING ISSUES OF MATERIALS
• It would be extremely difficult (almost impossible) to
identify specific units of materials that have been
purchased with units issued to cost centres.
• Consequently, when issues of materials from store are
being valued/priced, we do not try to identify what the
specific units actually did cost.
• Instead, materials issued from store are valued/priced
on the basis of a valuation method.
• For that valuation purposes, there are a few valuation
methods available, namely First-in First-out, Last-in,
First-out and Weighted Average Cost.
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 INVENTORY VALUATION METHODS
METHOD DESCRIPTION

It is assumed that materials are issued from store

First-in First-out (FIFO) in the order in which they were received.

It is assumed that materials issued from stores

Last-in, First-out (LIFO) are the units that were acquired the most
recently of those still remaining in inventory.

All quantities of an item of inventory are valued

at a weighted average cost. A new weighted
Weighted Average Cost average cost is calculated each time that there is
a new delivery into stores. Alternatively, an
(AVCO) average price can be calculates at the end of the
period which is then used to price all issues
(periodic weighted average cost method).

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 MATERIAL INVENTORY CONTROL
• Inventory control is the regulation of inventory
levels, which includes putting a value to the
amounts of inventory issued and remaining.
• Inventory control also includes ordering,
purchasing, receiving and storing goods.

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 STOCKTAKING
• Stocktaking involves counting the physical inventory on hand at a
certain date and then checking this against the balance in the
clerical records.
• Two methods of stocktaking process:-
 Periodic stocktaking
 Carried out annually and the objective is to count all items of inventory on a
specific date.
 Could be disruptive to production as it may involve closing the stores for several
days.
 There would be long periods between inventory checks and substantial
discrepancies may build up.
 Continuous stocktaking
 Involves counting and checking a number of inventory items on a regular basis so
that each item is checked at least once a year.
 Valuable items can be checked more frequently.
 Less disruptive method, less prone to error and achieves greater control.
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 INVENTORY DISCREPANCIES
• Sometimes, the physical amount of an item in inventory and
the amount shown in the inventory records are not the same.
• Reasons for these discrepancies should be investigated and
actions need to be taken.
• Possible causes of discrepancies:-
 Suppliers deliver a different quantity of goods than is shown on goods
received note (GRN).
 Quantity of inventory issued to production is different from that
shown on the materials requisition note (MRN).
 Excess inventory is returned from production without documentation.
 Clerical errors may occur in the inventory records.
 Inventory items may be wasted (due to breakage, spillage).
 Employees may steal inventory.
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 ACTIONS TO BE TAKEN
• If errors have been made when writing up the bin card or
items omitted then the bin card must be corrected.
• If items of inventory were stored in the wrong place then
they must be moved and a new total of actual inventory
held should be calculated.
• If items have been stolen, the security arrangements must
be reviewed and the cost of items stolen accounted for as
an expense.
• If inventory is being lost because it has deteriorated and
has to be thrown away, measures for improving storage
conditions should be considered, in order to reduce future
losses.
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 INVENTORY COSTS
• Purchase costs
– The purchase price of an inventory quoted by the supplier
• Inventory holding costs
– Holding inventory is expensive – keep a minimum level of
inventory
• Inventory ordering costs
– Incurred every time inventory is purchased from a
supplier
• Stockouts (the cost of being without inventory when
it is needed)
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 REASONS FOR HOLDING INVENTORY
• To ensure sufficient goods are available to meet expected
demand.
• To provide a buffer between processes.
• To meet any future shortages.
• To take advantage of bulk purchasing discounts.
• To absorb seasonal fluctuations and any variations in usage
and demand.
• To allow production processes to flow smoothly and efficiently.
• As a necessary part of the production process.
• As a deliberate investment policy, especially in times of
inflation or possible shortages.

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 ORDERING COSTS
• Ordering costs are associated with low inventory levels
because if low inventories are maintained, it will be necessary
to place more frequent orders.
• To reduce ordering costs, need to order at infrequent intervals.
• Quantities orders need to be large enough to avoid stockouts.
• These costs are included in ordering costs:-
 Clerical and administrative costs associated with purchasing,
accounting for and receiving goods.
 Time spent contacting the supplier, storekeeper’s time spent checking goods
received
 Transportation costs.
 Production run costs (if an organisation manufactures its own
components).
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 HOLDING COSTS
Holding costs are associated with high inventory
levels.
 Costs of storage and stores operations
 Interest charges
 Insurance costs
 Risk of obsolescence
 Deterioration
 Theft

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 STOCKOUT COSTS
• Stockout costs are the additional cost incurred as a
result of the situation running out of inventories due
to keeping them at a level which is too low.
• Causes of stockout costs:-
 Loss of contribution from lost of sales
 Loss of future sales due to disgruntled customers
 Loss of customer goodwill
 Cost of production stoppages
 Labour frustration over stoppages
 Extra costs of urgent, small quantity, replenishment orders

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 REORDERING INVENTORY
• The ideal situation would be for business not to have any
inventories on the premises unless they are about to be used in
production.
• This situation is regarded as very risky and not practical as it is
difficult to predict the demand as well as the reliability of suppliers.
• Therefore, control levels are set to ensure:-
 business does not run out of inventory and suffer disruption to
production.
 business does not carry an excessive amount of inventories which take up
space, incur storage costs and possibly deteriorate with age.
• The problem is:-
 when to reorder?
 how much to reorder?

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 ECONOMIC ORDER QUANTITY (EOQ)
• EOQ is the order quantity for an item of inventory that
will minimise the combined costs of ordering and
holding inventory over a given period of time.
• Assumptions of EOQ:-
 There should be no stockout of the item.
 There is no buffer inventory (buffer stock).
 A new delivery of the inventory item is received from the
supplier at the exact time that existing inventory runs out.
 The inventory item is used up at an even and predictable rate
over time.
 The delivery lead time from supplier is predictable and
reliable.
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 ECONOMIC ORDER QUANTITY (EOQ)

EOQ = 2COD
CO Cost of placing an order of

CH
the inventory item

CH Annual cost of holding one

unit of the inventory for one
year

D Annual demand for the

inventory item
Order quantity
Q
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 EOQ & BULK PURCHASE DISCOUNTS

• Discounts will normally be offered if order in

large quantities.
• However, EOQ is said to be the order quantity
which will minimise the cost of ordering and
holding inventory.
• Which one should be chosen? EOQ or quantity
with bulk discounts?

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 EOQ & BULK PURCHASE DISCOUNTS
• Problem can be solved by doing these procedures:-
1. Calculate EOQ by ignoring the discounts.
2. If EOQ is smaller than the minimum purchase quantity to obtain a
bulk discount, calculate the total of annual inventory holding
costs, inventory ordering costs and inventory purchase costs.
3. Recalculate the annual inventory holding costs, inventory
ordering costs and inventory purchase costs for a purchase order
size that is only just enough to qualify for the bulk discount.
4. Compare the total costs of No. 2 and No. 3. Select the one which
gives the least cost.
5. If there is a further discount available for an even larger order
size, repeat the same calculations for the higher discount level.

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 REORDER LEVEL
• Reorder level is the level of inventory at which a fresh order is placed
with a supplier.
• Lead time is the time gap that arises between an order being placed
and its eventual delivery.
• If the demand and lead time are known with certainty, an exact re-
order level may be calculated.
• In real world, supply lead time and demand for the inventory will
vary.
• To avoid stockout, the order must be placed in order to leave some
buffer stock (safety stock).
• Buffer stock (safety stock) is a basic level of inventory held to cover
unexpected demand or uncertainty of lead time for the item of
inventory.
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 REORDER LEVEL TO AVOID STOCKOUTS, WITH
UNCERTAIN DEMAND AND LEAD TIME
Reorder Level = Max supply lead time (days or
weeks) X Max daily or weekly demand for the
item

If there is a safety stock requirement:–

Reorder Level = Safety stock + Max supply lead
time (days or weeks) X Max daily or weekly
demand for the item

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 CONTROL LEVELS OF INVENTORY
• Minimum Inventory Control Level
 It is a warning of low inventory level.
 If the quantity falls to its minimum control level, it will alert the
management to check any new delivery item will be received
before stockout occurs.

• Maximum Inventory Control Level

 This is the maximum quantity of an inventory item that should
ever be held in store.
 If inventory held exceeds maximum inventory level, it could be
due to reordering before reaching reorder level, consumption
of inventory is lower than usual or lead time is shorter than
expected.
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 CONTROL LEVELS OF INVENTORY
• Minimum Inventory Control Level
Reorder Level – Average expected demand for the
inventory during the average lead time
Reorder Level – (Average demand for the item X
Average length of lead time)

• Maximum Inventory Control Level

Reorder Quantity + Reorder Level – (Minimum
demand X Minimum lead time)

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LABOUR

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 DIRECT LABOUR
• Labour costs incurred in producing a
good/service that could directly be attributed
to a unit of production.
• These are the costs paid to the employees
who are directly involved in producing goods
or services for customers.
• Example: the salary of a chef who works at a
restaurant

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 INDIRECT LABOUR
• Employees who are not directly involved in
producing goods or services for customers.
• Example: factory supervisor’s salaries,
storeman’s wages, maintenance workers’
wages

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 Need to work Employees are paid for Rate of pay will be set Payments to employees on
with minimum the actual number of top of basic pay and any
A salary is a fixed working hours hours of attendance in Need to keep accurate
overtime
basic amount of a period record on actual number
pay, payable every of hours of attendance
month • Collective
Some org. do scheme for
not pay extra Time-based Bonus all
if work more Remuneration Bonuses • Collective
schemes
scheme for
Fixed Basic limited
Salaries or Wages group
• Individual
Flat rate bonus
bonus schemes
All paid the
Piece-rate with Payment by LABOUR
LABOUR same amount
guarantee results / output- of bonus
REMUNERATION
REMUNERATION Percentage
related pay
bonus
If an employee’s earnings for
units produced are lower than
the guaranteed amount, then Overtime Productivity-
the guaranteed amount is Additional hours Bonus is a set
Piecework related bonus
paid instead worked more than of % of the
the set working annual salary Bonus paid if able
hours to achieve higher
Differential
than expected
piecework system productivity
Overtime and fixed Employees working
overtime are paid
pay employees
Piece rate increases as additional amount Overtime
successive targets for a A fixed amount is per hour for those
paid per unit of premium
period are achieved and extra hours
exceeded output achieved Additional pay
regardless of time If employee’s pay is fixed, overtime per hour
spent payment will be expressed in terms Need to convert the
of a % of the basic hourly rate. salary into effective 40
hourly rate
 LABOUR COST
• There are two types of labour costing that can
be applied in any organisation:
– TIME RELATED PAY
– OUTPUT RELATED PAY
• PIECERATE WITH GUARANTEE
• DIFFERENTIAL PIECEWORK

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 TIME RELATED PAY
• Under this scheme, employees will be paid for
the hours they spent at work regardless of the
output of production or output they achieve
within that time frame.
– Salaried employees – salary will be fixed for each
month
– Hourly rate employees – will be paid based on a
set hourly rate for each hour worked

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 OUTPUT RELATED PAY
• Employees will be paid according to results or
piecework whereby a fixed amount will be paid per unit
or output achieved irrespective of the time spent.
• Piece rate with guarantee
– If an employee’s earnings for the amount of units produced in
the period are lower than the guaranteed amount, the
employee will be paid with the guaranteed amount.
– It provides some sense of security if employer does not
provide enough work in a particular time.
• Differential piecework
– Piece rate will increase as successive targets for a period are
achieved and exceeded.
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 OVERTIME
• Overtime is the number of hours worked greater than the
number of hours set by the organisation as the normal
working week.

• Overtime premium is the amount over and above normal

hourly rate that employees are paid for overtime hours.

• Overtime premium will be considered as direct cost if the

overtime is incurred to satisfy specific request for a
customer.

• Overtime premium will be considered as indirect cost if the

overtime is incurred just because of a general increased
level of activity.

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 IDLE TIME
• Also known as “down time” is the time paid for that is
non-productive.
• It represents the wasted hours.
• If there is an idle time, the production will be less than the
expected.
• The cost of idle time is treated as INDIRECT COST even
though it relates to direct labour.
– Included in production overhead costs
• Idle time can be either avoidable or non-avoidable.
– The main causes of avoidable idle time:-
• Production disruption
• Policy decisions
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 LABOUR TURNOVER
• Labour turnover is a measure of the speed at which
employees leave an organisation and are replaced.
• Costs of labour turnover:-
– Cost of replacing the employee
• Cost of advertising the replacement
• Cost of paying employment agency
• Cost of time spent on interviewing, choosing and taking new employee
• Cost of training new employee
• Loss of efficiency whilst new employee learn the job
• Loss of efficiency due to lowered morale of existing employee
– Preventative costs
• Improving employee remuneration or benefits
• Improving the working environment
• Training existing employees and offering career progression
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 CAUSES OF LABOUR TURNOVER
• Got a new job offer somewhere else which
offers better remuneration.
• Dissatisfied with current job scope.
• Unpleasant working conditions.
• Poor relationships with superiors or
colleagues.
• Dissatisfied with current employment policies.
• Discrimination.
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EXPENSES

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 DIRECT EXPENSES
• These are all business costs that are not
classified as materials or labour cost.
• These are the costs that are incurred
specifically for a particular product, job, batch
or service.
• For example, royalties paid per unit for
copyright design, plant or tool hire charges for
a particular job or batch.

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 INDIRECT EXPENSES
Majority of expenses cannot be traced to a specific cost unit and
therefore are classified as indirect expenses or better known as
overheads.

A. Manufacturing expenses
 Power for machinery, lighting and heating for factory, insurance of
machinery, depreciation of machinery
B. Selling expenses
 Advertising, depreciation of packing machine, cost of delivering goods to
customers, costs of after-sales service, warehouse rental for storage of
goods, commission paid to sales representative
C. Administration expenses
 Rent of building, business rates, insurance, telephone and utilities
charges, stationery, auditors’ fees
D. Finance expenses
 Loan interest, lease charges on any equipment or buildings which are
being leased rather than being purchased

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 TYPES OF EXPENSES
• Directly attributable expenses
– These are the expenses that can be directly attributed to a
single cost centre.
– The process of allotting a whole item of overhead cost to a
cost centre is called allocation.
• Apportioned expenses
– These are the expenses that need to be shared between a
number of cost centres.
– For example, rental of building, utilities, insurance etc.

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 OVERHEAD APPORTIONMENT BASIS
• Need to ensure that the basis is suitable for different
types of expenses
– Rent & rates, heating & lighting – floor area/space
occupied
– Supervision, welfare of employees, canteen expenses –
number of employees
– Depreciation, insurance of asset – asset values
– Power consumed – technical estimates
– Materials handlings – number of material requisitions

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 REAPPORTIONMENT OF
SERVICE COST CENTRE OVERHEADS
• Once the overheads have been allocated and apportioned
to the cost centres, it is necessary to re-apportion all
service cost centres’ overheads to production cost centres.
• Only the production cost centres are directly involved in the
manufacturing of a product.
• The basis for reapportionment will have to depend upon
the type of services being provided by these service cost
centres.

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 ABSORPTION OF OVERHEAD COSTS
• A method of including a fair proportion of the total overheads
costs in the cost of each cost unit.
• It is part of the process of building up a full product cost which
adds direct costs and a proportion of production overhead costs
by means of one or a number of overhead absorption rates.
• Absorption basis:-
– Based on units produced – only suitable if the products are
identical (single product line)
– Based on time – depending on time spent to produce one
unit of product
• Labour hour basis – suitable for labour intensive
production cost centres
• Machine hour basis – suitable for machine intensive
production cost centres
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COSTING
METHOD

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ABSORPTION
COSTING

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 ABSORPTION COSTING
• Absorption costing is a method of costing in which the costs of an item
(product or service or activity) are built up as the sum of direct costs
and a fair share of overhead costs, to obtain a full cost or a fully-
absorbed cost.
• The main reasons for wanting to calculate full costs are mainly to value
inventories of manufactured goods and possibly also to calculate a
selling price based on full costs.
• In absorption costing, products, services or activities are charged with a
fair share of indirect costs.
• Using absorption costing, all costs are absorbed into production and
thus operating statements do not distinguish between fixed and
variable costs.
• The valuation of stocks and WIP contain both fixed and variable
elements.
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 REASONS FOR ABSORPTION COSTING

Inventory Pricing at a
valuation mark-up
over full cost

ABSORPTION
COSTING

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 REASONS FOR ABSORPTION COSTING
• Inventory valuation
 The costs of making a product include the costs of
direct materials, direct labour and direct expenses.
 Overheads incurred by the production departments
are costs that are ALSO necessary to make those
products.
 Production overheads (although indirect costs) are
as much a cost of the product as the direct costs.
 Therefore, to value the full cost of producing each
product or cost unit, the cost unit incurred must
include a share of the overheads in the product cost.
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 REASONS FOR ABSORPTION COSTING
• Pricing at a mark-up over full cost
The pricing of the finished product could be
decided on different basis.
One of the basis is a mark-up on the full cost.
Under the mark-up on full cost of production basis,
the price set must be sufficient to cover all of the
costs of the product plus some margin to give a
profit.
Therefore, the production overheads must be
added to the prime costs of a product in deriving
at the full cost.
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TREATMENT OF OVERHEADS IN ABSORPTION COSTING

• In absorption costing, products, services or

activities are charged with a fair share of indirect
costs.
• Three-stage process involved in charging
overhead costs to products or services:

Overhead Overhead Overhead

allocation apportionment absorption

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 THE THREE-STAGES PROCESS

Overhead A process of charging a whole item

Allocation of cost to a cost centre

Overhead A process of sharing out overhead

Apportionment costs on a fair basis

A process of adding overhead costs

Overhead to the cost of a product or service, in
Absorption order to build up a fully-absorbed
product cost or service cost

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OVER-ABSORPTION OR UNDER-ABSORPTION
OF OVERHEAD
• Overhead absorption rates are based on budgeted overhead costs and
the budgeted volume of activity, they are pre-determined.
• In practice, for each accounting period, it is often the case that:-
– Actual overhead expenditure will differ from budgeted overhead expenditure
– The actual volume of activity will differ from the budgeted volume of activity
• As a consequence, the amount of overheads charged to product costs
will differ from the actual overhead expenditure.
• The company might be charging more overhead costs to production
than the amount of overhead expenditure actually incurred.
• If so, there are over-absorbed overheads.
• The company might be charging less overhead costs to production than
the amount of overhead expenditure actually incurred.
• If so, there are under-absorbed overheads.
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 NON-PRODUCTION OVERHEADS
• In a system of absorption costing, it is quite usual for
administration overheads and sales and distribution
overheads to be treated as period costs and written as a
charge to the income statement, instead of being added to
the cost of cost units.
• However, it is also possible to calculate a full cost of sale
by absorbing non-production overheads into costs.
• Administration overheads might be absorbed into unit
costs as a percentage of full production cost.
• Sales and distribution overheads might be absorbed into
unit costs as either a percentage of sales value, or as a
percentage of full production cost.

64
Pro-forma Income Statement – Absorption
Costing
$ $ $
Sales XXX
Production cost of sales
Opening inventory (full production cost) X
ADD: Production costs
Direct materials X
Direct labour X
Production overheads absorbed X X
XX
LESS: Closing inventory (full production cost) (X) (XX)
XX
Over-absorbed/(under-absorbed) overheads X or (X)
Gross profit XX
Administration overheads incurred (X)
Selling and distribution overheads incurred (X)
Net profit XX

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MARGINAL
COSTING

66
 MARGINAL COSTING
• A costing principle whereby variable costs are charged to
cost units and the fixed cost attributable to the relevant
period is written-off in full against the contribution for
that period.

• Marginal costing distinguishes between fixed costs and

variable costs.

• The marginal cost of a product is its variable costs: direct

materials, direct labour and direct expenses and variable
overheads.

• Contribution is the difference between Sales Price and

Marginal Cost.
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 MARGINAL COSTING
• In marginal costing, fixed manufacturing
overheads are not absorbed into cost units.
• Inventory is valued at marginal or variable
production cost.
• All fixed overheads, including fixed
manufacturing overheads are treated as
period costs and are charged in the income
statement of the period in which the
overheads are incurred.
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 THE CONTRIBUTION CONCEPT
• It is an important concept in marginal costing where
contribution is defined as the selling price minus the
variable cost of sales.
• Changes in the volume of sales, sales price or variable
costs will all affect profit y altering the total
contribution.
• Marginal costing techniques can be used to help
management to assess the likely effect on profits of
higher or lower sales volume, or the likely consequences
of reducing the sales price of a product in order to
increase demand and so on.
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 USES OF MARGINAL COSTING
• As a basis for providing information to the
management for planning and decision-making. It is
particularly appropriate for short run decisions
involving changes in volume or activity and the
resulting cost changes.

• It can also be used in routine cost accounting system

for the calculation of cost and the valuation of stocks.

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 Pro-forma Income Statement – Marginal
Costing
$ $ $
Sales XXX
Variable cost of sales
Opening inventory (variable production cost) X
ADD: Variable production costs
Direct materials X
Direct labour X
Variable production overheads X X
XX
LESS: Closing inventory (variable production cost) (X)
Variable production cost of sales XX
Variable selling and distribution costs X
Total variable cost of sales (XX)
Contribution XX
Fixed costs (period costs) (X)
Fixed production overheads (X)

Fixed administration overheads (X)

Fixed selling and distribution overheads (X)
Net profit XX

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Reasons for the differences in profits between
Marginal Costing and Absorption Costing
• The difference in profit between the two costing methods is due to
the difference in inventory levels between the beginning and the
end of the period.
• If inventory levels are rising or falling, absorption costing will give a
different profit figure from marginal costing.
• If sales equal production, the fixed overheads absorbed into cost of
sales under absorption costing will be the same as the period costs
charged under marginal costing and thus the profit figure will be the
same.
• If the inventory levels are rising, AC profit > MC profit
• If the inventory levels are falling, AC profit < MC profit
• If the opening and closing inventory levels are the same, AC profit =
MC profit
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ACTIVITY-
BASED
COSTING
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 ACTIVITY-BASED COSTING (ABC)
• ABC is an approach to the costing and monitoring of activities
which involves identifying the activities that are responsible
for the generation of costs.

• ABC is invented due to known problems of treating the

overheads since the manufacturing processes have become
more automated and less labour intensive.

• The production overheads which are mostly fixed have

become a large proportion of the total costs.

• The traditional absorption method of overheads have been

rendered less useful since it will not provide accurate figures.

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 PRINCIPLES OF ABC
1. Activities (not products) generate costs.
2. Products consume activities.

• An activity is a process which adds value and consumes

resources.

• Cost driver is any factor which causes a change in the cost of

an activity. It represents the allocation bases in an ABC
system, instead of the traditional overhead apportionment
bases in the traditional absorption costing system.

• Cost pool will result from the pooling or accumulation of

overhead costs which relate to a specific activity.

75
 ADVANTAGES OF ABC
• The unit costs should more accurately reflect the activities
performed and therefore the resources used.

• An improved more accurate product cost may enable a company

to concentrate on a more profitable mix of products or
customers.

• It helps identify those activities that add more to value than to

cost, so that the non-value added items can be appraised
effectively with a view to elimination.

• By focusing attention on cost drivers, managers will have a

better understanding of the costs of production and the costs of
the activities performed by the company.

76
 DISADVANTAGES OF ABC
• The ability of one cost drives to explain all the items in
a cost pool is questionable.
• Some measure of cost apportionment may still be
required at the cost pooling stage for items like rent,
rates and building depreciation. If an ABC system has
many cost pools then the need for cost
apportionment may be greater.
• ABC is sometimes introduced because it is fashionable
and not because it will be used by the management.
In such cases, the traditional system can be followed
as it is simpler to operate.

77
 COST FORMULAE
DIRECT DIRECT DIRECT PRIME
MATERIAL LABOUR EXPENSES COST

INDIRECT INDIRECT INDIRECT PRODUCTION

MATERIAL LABOUR EXPENSES OVERHEADS

PRODUCTION PRODUCTION
PRIME COST
OVERHEADS COST

78
COST-VOLUME-
PROFIT
ANALYSIS
79
COST-VOLUME-PROFIT (CVP) ANALYSIS
• Cost-volume-profit (CVP) analysis is a technique which analyses cost behaviour
to assess the effect of different activity level on costs, revenues and profits.

• In particular, it will identify the activity level at which there is neither a profit
nor a loss (the breakeven activity level).

• The breakeven point is the level of output at which neither a profit nor a loss is
realised. It is the point at which total costs equal total revenues, or the point
where contribution is equal to fixed costs.

• The management needs to analyse the relationship between cost, volume and
profit especially for the purpose of planning and controlling their operations.

• This analysis would assist the management to determine the most profitable
combinations of the fixed and variable cost factors.

80
 USES OF CVP ANALYSIS
• Determine the level of operations necessary to
cover all operating expenses.
• Helps financial manager to determine the level
of output that must be produced and sold to
cover all operating costs.
• Measure the extent to which the firm uses
operating leverage.
• Assist the management in planning and
controlling such as profit determination, etc.
81
 ASSUMPTIONS IN CVP ANALYSIS
• The behaviour of both costs and revenues is linear
throughout the relevant range of the activity index.
• All costs can be classified with reasonable accuracy as
either variable or fixed.
• Changes in activity are the only factors that affect costs.
• All units produced are sold.
• When more than one type of product is sold, the sales mix
will remain constant. That is, the percentage that each
product represents of total sales will stay the same. Sales
mix complicates CVP analysis because different products
will have different cost relationships.
82
 BEP FORMULAE (SINGLE PRODUCT)
• Break-even point (in units)
= Total fixed costs/ contribution margin per unit
* Contribution margin per unit = Selling price per
unit - variable cost per unit

• Break-even point (in RM)

= Total fixed costs/ contribution sales ratio OR
= BEP in units x selling price per unit

83
 BEP FORMULAE (MULTIPLE PRODUCT)
• Break-even point (in units)
= Total fixed costs/ weighted average contribution
margin
* Weighted average contribution margin
= ∑ contribution margin X sales mix

• Break-even point (in RM)

= BEP in units x selling price per unit

84
 MARGIN OF SAFETY
• Margin of safety is the difference between actual or
expected sales and sales at the breakeven point.
• This relationship measures the “cushion” that
management has, allowing it to still break even if
expected sales fail to materialise.
• Margin of safety can be expressed either in RM or as
a ratio.

MOS (RM) = Actual (Expected ) Sales - Breakeven Sales

Actual
MOS Ratio = Margin of Safety (RM) ÷ (Expected ) Sales
85
 TARGET NET INCOME
• Management usually sets an income objective for
individual product lines.

• This objective is called target net income.

• It indicates the sales necessary to achieve a specified

level of income.

• The sales necessary to achieve target net income can

be determined from each of the approaches used to
determine break-even sales.
86
 TARGET NET INCOME
Required = Variable + Fixed costs + Target net
Sales costs income

Required Target Contribution

Sales =
(units)
( net
income
+ Fixed
costs ) ÷ margin per
unit

Required Target
Sales =
(RM)
( net
income
+
Fixed
costs ) ÷ Contribution
margin ratio

87
 LIMITATIONS OF CVP ANALYSIS
• A fixed cost is fixed only within a given time span and
over a given range of activity called the relevant range.
Fixed cost may change from the budget year to budget
year or when the activity level changes too greatly.
• Variable cost per unit is assumed to be constant.
However, variable cost may fall as volume increases
and trade discounts or economies of scale are
achieved. It will then rise when the demand for
resources exceed supply.
• Selling price may be reduced to achieve greater volume
of sales.
88
 LIMITATIONS OF CVP ANALYSIS

• In practice, it is not always feasible to resolve all

cost into their fixed and variable elements.
• Efficiency and productivity do change thus
affecting costs.
• Volume is not the only factor affecting costs.
Other factors such as efficiency, productivity, war,
government legislation would also affect costs.

89
CVP ANALYSIS – MULTIPLE PRODUCT
• Nearly all companies sell more than one
product.
• Thus, they must be concerned with the sales
mix, which is the relative proportions or
combinations of quantities of products that
comprise the total sales.
• If the proportions of the sales mix change, the
CVP relationship also change.

90
CVP ANALYSIS – MULTIPLE PRODUCT
• Suppose Infinity Co has two products, key chains
and fridge magnets. The income budget are as
follows:-
Key Chains Fridge Magnet Total
(KC) (FM)
Sales in units 300,000 75,000 375,000
Sales @$8 and $5 $2,400,000 $375,000 $2,775,000
Variable expenses @$7 and $3 $2,100,000 $225,000 $2,325,000
Contribution margins @$1 and $2 $300,000 $150,000 $450,000
Fixed expenses $180,000
Net income $270,000

91
CVP ANALYSIS – MULTIPLE PRODUCT
• What is the break-even point for each
product?
• The typical answer assumes a constant mix of
four units of KC for every unit of FM.
• Therefore, let FM = number of units of
product FM to break-even and 4FM = number
of units of products KC to break-even.

92
CVP ANALYSIS – MULTIPLE PRODUCT
Sales – variable expenses – fixed expenses = zero net income

[$8($FM) + $5(FM)] – [$7(4FM) + $3(FM)] - $180,000 = 0

$32FM + $5FM - $28FM -$3FM - $180,000 = 0
$6FM = $180,000
FM = $180,000 / $6
FM = 30,000 units

KC = 4FM = 4 X 30,000 = 120,000 units

93
CVP ANALYSIS – MULTIPLE PRODUCT
• Using formula BEP = Fixed Cost/WACM
Sales Mix
KC = 300,000/375,000 = 0.8
FM = 75,000/365,000 = 0.2

Key Chains Fridge Magnet

(KC) (FM)
BEP = $180,000/1.2 = 150,000 units
Selling price $8.00 $5.00
Variable $7.00 $3.00
KC = 150,000 X 0.8 = 120,000
expenses FM = 150,000 X 0.2 = 30,000
Contribution $1.00 $2.00
margins
Sales mix 0.8 0.2
0.8 0.4
WACM 0.8 + 0.4 = 1.2

94
CVP ANALYSIS – MULTIPLE PRODUCT
• The previous illustrations show that 150,000 is
the only break-even point for a sales mix of four
key chains for every unit of fridge magnet.
• Clearly, however, there are other break-even
points for other sales mixes.
• For instance, if Infinity Co sells only fridge
magnets and fixed expenses stay at $180,000,
the BEP would be 90,000 units of fridge magnets.
• If Infinity Co sells only key chains, the BEP would
be 180,000 units of key chains.

95
CVP ANALYSIS – MULTIPLE PRODUCT
• Managers are not interested in the break-even point
for its own sake.
• Instead, they want to know how changes in a planned
sales mix will affect net income.
• When the sales mix changes, the BEP and the
expected net income at various sales levels change as
well.
• For example, suppose overall actual total sales were
equal to the budget of 375,000 but Infinity sold only
50,000 fridge magnets only, the actual net income will
be different from the budgeted figures.
96
CVP ANALYSIS – MULTIPLE PRODUCT
Key Chains Fridge Magnet Total
(KC) (FM)
Sales in units 325,000 50,000 375,000
Sales @$8 and $5 $2,600,000 $250,000 $2,850,000
Variable expenses @$7 and $3 $2,275,000 $150,000 $2,425,000
Contribution margins @$1 and $2 $325,000 $100,000 $425,000
Fixed expenses $180,000
Net income $245,000

• The change in sales mix has resulted in a $245,000 actual

net income rather than $270,000 budgeted net income, an
unfavourable difference of $25,000.
• The budgeted and actual sales in number of units were
identical, but the proportion of sales of product bearing the
higher unit contribution margin has declined.
97
GRAPHING THE BREAK-EVEN POINT
1) Draw the axis. The horizontal axis is the sales volume and
the vertical axis is dollars of cost and revenue.
2) Plot sales revenue. Select a convenient sales volume and
mark it as point A. Draw the sales line from point A to the
origin, point 0.
3) Plot fixed expenses. It should be a horizontal line
intersecting the vertical axis at the fixed expenses amount
and mark it as point B.
4) Plot total expenses. Determine the variable portion of
expenses at a convenient level of activity and add to the
fixed expenses. Mark it as point C. Draw the total expenses
line from point C to the origin, point 0.
5) Locate the break-even point where the total expenses line
crosses the sales line.
98
BREAK-EVEN CHART

99
BUDGETING

100
 PLANNING & BUDGETING
• In a management accounting context, the budgeting process is
part of the overall planning process.

• A plan is a series of actions to be carried out if objectives and

goals are to be met.

• Corporate planning is a long-run, on-going activity which seeks to

determine the direction in which the firm should be moving in
the future.

• A budget is a plan in monetary terms.

101
 OVERALL PLANNING PROCESS
SEARCH FOR
IDENTIFY ALTERNATIVE
SET MISSION
OBJECTIVES COURSES OF
ACTION

IMPLEMENT SHORT-
GATHER DATA
TERM PLAN IN SELECT COURSE OF
ABOUT
FORM OF ANNUAL ACTION
ALTERNATIVES
BUDGETS

RESPOND TO
MONITOR ACTUAL
DIVERGENCES
RESULTS
FROM PLAN

102
STAGES IN THE BUDGETARY PROCESS
Communicate
Determine the Prepare budget
policy guidelines to
factor which using the principal
preparers of
restricts output budgetary factor
budgets

Final acceptance of Co-ordinate and Initial preparation

budgets review of budgets of budgets

Budget review

103
BENEFITS OF A BUDGETING SYSTEM
 Planning and co-ordination
 Budget serves a formal planning framework
 Authorisation and delegation
 Need not to continuously ask for top management’s decision and responsibility is
being delegates to respective managers
 Performance evaluation
 Budget is benchmark to assess performance
 Trend identification
 Early detection of future trends
 Communication and motivation
 Budget is to be used by everyone and act as a source of motivation in the sense
that everyone is working on achieving the budget
 Control
 Budget acts as a yardstick which actual performance can be measured and
variances being analysed. Actions could be taken to adjust performance or
targets.
104
 BUILDING UP THE BUDGET
SALES BUDGET

PRODUCTION BUDGET

RAW MATERIALS LABOUR FACTORY OVERHEAD

COST OF GOODS SOLD BUDGET

SELLING AND DISTRIBUTION GENERAL AND ADMINISTRATION

EXPENSES BUDGET EXPENSES BUDGET

BUDGETED I/S

CAPITAL
BUDGETED BALANCE SHEET
EXPENDITURE
BUDGET
CASH BUDGET

105
STANDARD
COSTING

106
 STANDARD COSTING
• Standard costing is an accounting control system which uses the
concept of pre-determined measures which can be used as
benchmarks and the feedback features for correcting
performance and plans.

• Standard costing compares standard costs and revenues with

actual results, in order to report variances for the purposes of
performance measurement and control.

• A standard cost is the planned unit cost of the products,

components or services produced in a period.
– It is built up from an assessment of the value of cost elements.
– Its main uses are providing bases for performance measurement, control
by exception reporting, valuing inventory and establishing prices.

107
 STANDARD COSTING
• Standard costing is most suited to an organisation whose
activities consist of a series of common or repetitive operations
and the input required to produce each unit of output can be
specified.
• It is therefore relevant in manufacturing companies, since the
processes involved are often of a repetitive nature.
• Standard costing procedures can also be applied in service
industries such as units within banks, where output can be
measured in terms of the number of cheques or the number of
loan applications processed.
• Standard costing cannot, however, be applied to activities of a
non-repetitive nature, since there is no basis for observing
repetitive operations and consequently standards cannot be
set.

108
HOW STANDARD COSTING WORKS?

Production costs Actual costs

There is a are recorded in incurred and
standard unit the costing Budgets are actual profits are
cost for each system at prepared with compared with
type of product standard cost standard costs. standard costs
(or service). rather than at and budgeted
actual cost. profits.

DIFFERENCES ARE
REPORTED TO
MANAGEMENT AS
VARIANCES

109
 PURPOSES OF STANDARD COSTING
Standard costing systems are widely used because they provide
cost information for many different purposes such as the
following:

 Providing a prediction of future costs that can be used for

decision-making purposes.
 Providing a challenging target which individuals are motivated
to achieve.
 Assisting in setting budgets and evaluating managerial
performance.
 Acting as a control device by highlighting those activities which
do not conform to plan and thus alerting managers to those
situations that may be out of control and in need of corrective
action.
 Simplifying the task of tracing costs to products for profit
measurement and inventory valuation purposes.
110
BENEFITS OF STANDARD COSTING
Standard costing has certain benefits:

 The valuation of all output at a standard cost means that

there are no minor variations in unit costs due to small
differences in actual expenditure.

 It can be useful for preparing budgets.

 It provides a system for performance measurement and

control using variance analysis. Variances indicate the
reasons for differences between expected and actual results,
as well as measuring the size of the difference.

111
 TYPES OF STANDARD
• Basic standard
– A standard cost per unit that is established for use over a
long period of time.
• Current standard
– A standard that represents costs and efficiencies that are
currently being achieved.
• Expected/attainable standard
– A standard which can be attained if a standard unit of work is
carried out efficiently, a machine properly operated or
material properly used. Allowances are made for normal
losses, waste and machine downtime.
• Ideal standard
– A standard that can be attained under the most favourable
conditions, with no allowance for normal losses, waste and
machine downtime.
112
 VARIANCE ANALYSIS
• A variance is the difference between an actual cost
and an expected (standard) cost.
• Variances indicate that actual results are either better
or worse than the standard.
• When performance is better than standard, the
variance is favourable.
• When performance is worse than standard, the
variance is unfavourable or adverse.

113
JOB COSTING
 INTRODUCTION
• Job costing relates to a costing system that is
required in organisations where each unit or
batch of output of a product is unique.
• This creates the need for the cost of each unit
to be calculated separately.
• Under job costing system, each cost unit is
separately identifiable.
• Job costing systems are used in industries that
provide customized products or services.
115
 AIM OF JOB COSTING
• The aim of job costing is simply to collect the
cost information consist of the followings:
 Direct materials  Total production cost
 Direct labour  Administration overhead
 Direct expenses  Selling overhead
 Prime cost  Cost of sales
 Production overhead

• To the final figure is added a profit ‘mark-up’

and the total is the selling price of the job.

116
 WHAT IS A JOB?
• A job is an individual product designed and produced as a single
order for an individual customer.
• Simply, a job is a cost unit which consists of a single order or
contract.
• A job will normally be requested by a customer and that customer’s
individual requirements and specifications considered.
• Each job will tend to be a specific individual order and as such will
normally differ in some respects from other jobs that the
organisation performs.
• The costs for each individual job must therefore be determined.
• Example of organisations that perform jobbing work are printing
company, painting and decorating company, interior designers etc.

117
PROCEDURE FOR THE PERFORMANCE OF JOBS
The normal procedure in jobbing concerns involves the following:

a) The prospective customer approaches the supplied and indicates the

requirements of the job.
b) A responsible official sees the prospective customer and agrees the precise
details of the items to be supplies, for example, the quantity, quality and colour
of the goods, the date of delivery and any special requirements.
c) The estimating department of the organisation then prepares an estimate for
the job. The total of these items will represent the quoted selling price.
d) If the customer accepts that quote the job will proceed according to the
timetable agreed between customer and supplier.
e) At the appropriate time, the job will be ‘loaded’ on to the factory floor. This
means that as soon as all materials, labour and equipment are available and
subject to the scheduling of other orders, the job will be started.

118
 COLLECTION OF JOB COSTS
• Each job will be given a number to identify it. A
separate record must be maintained to show the
details of individual jobs. The process of
collecting job costs may be outlined as follows.
a) Materials requisitions are sent to stores.
b) The materials requisition note will be used to cost
the materials issued to the job concerned, and this
cost may then be recorded on a job cost sheet.
c) The job ticket is passed to the worker who is to
perform the first operation.

119
COLLECTION OF JOB COSTS (ctd.)
d) When the job is completed by the worker who performs
the final operation, the job ticket is sent to the cost
office, where the time spent will be costed and recorded
on the job cost sheet.
e) The relevant costs of materials issued, direct labour
performed and direct expenses incurred as recorded on
the job cost sheet are charged to the job account in the
work-in-progress ledger.
f) The job account is debited with the job’s share of the
factory overhead, bases on the absorption rate(s) in
operation.
g) The difference between the agreed selling price and the
total actual cost will be the supplier’s profit or loss.
120
 JOB ACCOUNT
Here is a pro-forma job account, which will be
one of the accounts in the work-in-progress
control account.
JOB ACCOUNT
RM RM
Materials issued X Finished jobs XX
Direct labour X
Direct expenses X
Production overhead at
X
predetermined rate
Other overheads X
XX XX

121
 JOB COST SHEET (CARD)
• When jobs are
completed, job cost
sheets are transferred
from the work-in-
progress category to
finished goods.

• When delivery is
made to the customer,
the costs become a
cost of sale.

122
 JOB COST SHEET (CARD)
The normal items recorded would include:
Job number
Description of the job; specification, etc.
Customer details
Estimated cost, analysed by cost element
Selling price and estimated profit
Delivery date promised
Actual costs to date, analysed by cost element
Actual delivery date, once the job is completed
Sales details (delivery note no., invoice no.)
123
 EXAMPLE OF JOB COSTING
Pansy Co is a company that carried out jobbing
work. One of the jobs carried out in May was
job 2409, to which the following information
relates.
Direct material Y 400 kilos were issued from stores at a cost of $5.00 per kilo.
Direct material Z 800 kilos were issued from stores at a cost of $6.00 per kilo. 60
kilos were returned to stores.
Department P 300 labour hours were worked, of which 100 hours were
overtime.
Department Q 200 labour hours were worked, of which 100 hours were
overtime.

124
 EXAMPLE OF JOB COSTING (ctd.)
Overtime work is not normal in Department P, where
basic pay is $6 per hour plus an overtime premium
of $1 per hour. Overtime work was done in
Department Q in May because of a request by the
customer of another job to complete his job quickly.

Basic pay in Department Q is $8 per hour and

overtime premium is $1.50 per hour. Overhead is
absorbed at the rate of $3 per direct labour hour in
both departments.
125
 EXAMPLE OF JOB COSTING (ctd.)
Required:

a) Calculate the direct material cost of job 2409.

b) Calculate the direct labour cost of job 2409.
c) Calculate the full production cost of job 2409
using absorption costing.

126
 SOLUTION
a) Direct material Y (400 kilos X $5) $2,000
Direct material Z (800 – 60 kilos X $6) $4,400
Total direct material cost $6,440

b) Department P (300 hours X $6) $1,800

Department P (200 hours X $8) $1,600
Total direct labour cost $3,400
Overtime premium will be charged to overhead in the case of Department P,
and to the job of the customer who asked for overtime to be worked in the
case of Department Q.

c) Total direct material cost $6,440

Total direct labour cost $3,400
Production overhead (500 hours X $3) $1,500
$11,430

127
 COST PLUS PRICING
• Many organisations base the price of a product on simple
cost plus rules which involves estimating costs and then
adding a profit margin in order to set the price.

• Cost plus pricing is a method of determining the sales

price by calculating the full cost of a product and adding a
percentage mark-up for profit.

• The full cost may be a fully absorbed production cost only,

or it may include some absorbed administration, selling
and distribution overhead (non-production overheads).

128
 MARK-UP VS. MARGIN
• A profit mark-up is when you add the profit to
the cost as a standard percentage of the total
cost.
• A profit margin is when you add the profit to
the cost as a standard percentage of sales
price.

129
 EXAMPLE OF MARK-UP
• A company carries out small building work for
domestic customers. A customer has asked the
company to quote a price for building an extension
at the back of his house. The company’s estimator
has come up with the following estimated costs:
Direct materials $2,500
Direct labour $4,000
Direct expenses $500
Production overhead 100% of labour cost
Other overheads 20% of total production cost
Profit mark-up 25% of total cost

130
 EXAMPLE OF MARK-UP (ctd.)
Required:
Calculate the price to quote for the job.

$
Solution:
Direct materials 2,500
Direct labour 4,000
Direct expenses 500
Production overhead 4,000
Full production cost 11,000
Other overheads 2,200
Total cost 13,200
Profit mark-up (25%) 3,300
Job price 16,500

131
 EXAMPLE OF MARGIN
• A company carries out small building work for
domestic customers. A customer has asked the
company to quote a price for building an extension
at the back of his house. The company’s estimator
has come up with the following estimated costs:
Direct materials $2,500
Direct labour $4,000
Direct expenses $500
Production overhead 100% of labour cost
Other overheads 20% of total production cost
Profit margin 20% of sales price

132
 EXAMPLE OF MARGIN (ctd.)
Required:
Calculate the price to quote for the job.

$
Solution:
Direct materials 2,500
Direct labour 4,000
Direct expenses 500
Production overhead 4,000
Full production cost 11,000
Other overheads 2,200
Total cost (80%) 13,200
Profit margin (20%) 3,300
Job price (100%) 16,500

133
 EXAMPLE OF COST PLUS PRICING
A company budgets to make 20,000 units which
have a variable cost of production of $4 per
unit. Fixed production costs are $60,000 per
annum. The selling price is to be 40% higher
than full cost.

Required:
Calculate the selling price of the product using
the cost plus pricing method.
134
 SOLUTION
Full cost per unit = variable cost + fixed cost
Variable cost = $4 per unit
Fixed cost = $60,000/20,000 = $3 per unit
Full cost per unit = $4 + $3 = $7

SELLING PRICE = 140/100 X $7 = $9.80

135
BATCH COSTING
 INTRODUCTION
• A batch is a cost unit which consists of a
separate, readily identifiable group of product
units which maintains its separate identity
throughout the production process.
• Batch costing is similar to job costing in that each
batch of similar articles is separately identifiable.
• The cost per unit manufactured in a batch is the
total batch cost divided by the number of units in
the batch.
137
 EXAMPLE OF BATCH COSTING
A company manufactures model cars to order and has the following
budgeted overheads for the year, based on normal activity levels.
DEPARTMENT BUDGETED OVERHEADS ($) BUDGETED ACTIVITY
Welding 6,000 1,500 labour hours
Assembly 10,000 1,000 labour hours

Selling and administrative overheads are 20% of production cost. An order

for 250 model cars type XJS1, made as Batch 8638, incurred the following
costs.
Materials $12,000
Labour 100 hours welding shop at $8 per hour
200 hours assembly shop at $9 per hour
$500 was paid for the hire of special X-ray equipment for testing the welds.

Required:

Calculate the cost per unit for Batch 8638.

138
 SOLUTION
Step 1: Calculate the OAR for the production
departments.

Welding = $6,000 ÷ 1,500 = $4 per labour hour

Assembly = $10,000 ÷ 1,000 = $10 per labour hour

139
 SOLUTION
Step 2: Calculate the Total Cost for Batch 8638
$
Direct material 12,000
Direct expense 500
Direct labour {(100 X $8) + (200 X $9)} 2,600
Prime cost 15,100
Overheads {(100 X $4) + (200 X $10)} 2,400
Production cost 17,500
Selling and administrative cost (20% of production cost) 3,500
Total cost 21,000

Cost per unit = $21,000 ÷ 250 = $84

140
SERVICE
COSTING
 INTRODUCTION
• Service costing is a method of accounting for
services provided to internal customers (eg.
canteens, maintenance, personnel) and/or external
customers (eg. law firms, hospitals, schools). These
may be referred to as service centres, service
departments or service organisations.
• Service costing can be used by companies
operating in a service industry or by companies
wishing to establish the cost of services carried out
by different departments.
142
 WHAT ARE SERVICE ORGANISATIONS?

• Service organisations do not make or sell

tangible products.
• Profit-seeking service organisations include
accountancy firms, law firms, transport
companies, banks and hotels.
• Almost all not-for-profit organisations –
hospitals, schools, libraries and so on – are
also service organisations.

143
 WHAT ARE SERVICE ORGANISATIONS?
• Service costing differs from the other costing
methods in the following ways:
 In general, with service costing, the cost of direct
materials consumed will be relatively small compared
to the labour, direct expenses and overhead cost.
 Indirect costs tend to represent a higher proportion of
total cost compared with product costing.
 The output of most service organisations is often
intangible and it is therefore difficult to establish a
measureable unit cost.

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 UNIT COST MEASURES
• A particular problem with service costing is the difficulty
in defining a realistic cost unit that represents a suitable
measure of the service provided.
• Frequently, a composite cost unit may be deemed more
appropriate if the service is a function of two activity
variables.
• Typical composite cost units used by companies operating
in a service industry are shown below.
SERVICE COST UNIT
Road, rail and air transport services Passenger-kilometre, tonne-kilometre
Hotels Occupied room-night
Hospitals Patient day

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 EXAMPLE OF COMPOSITE COST UNITS
The following information is available for the Whiteley Hotel for the
latest thirty day period.

Number of rooms available per night 40

Percentage occupancy achieved 65%
Room servicing cost incurred $3,900

Required:

a) Calculate the number of occupied room-nights.

b) Calculate the room servicing cost per occupied room-night (to the nearest
cent).

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 SOLUTION
a) Number of occupied room-nights
= 40 rooms X 30 nights X 65%
= 780
b) Room servicing cost per occupied room-night
= Total room servicing costs ÷ number of
occupied room-nights
= $3,900 ÷ 780
= $5

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 SERVICE VS. MANUFACTURING
SERVICE MANUFACTURING
BUSINESS BUSINESS
OUTPUT Service - intangible Product - tangible
PRODUCTION Service is produced Inventory is produced,
AND and delivered at the stored and delivered in
DELIVERY same time some other times
STORAGE Service cannot be Inventory can be stored
stored
QUALITY Difficult to control the Easier to control the
CONTROL quality quality
COSTS Higher proportion of Normally higher
overheads proportion of direct costs

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DECISION
MAKING

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 THE CONCEPT OF RELEVANCE
• Often than not, owner or manager of a business
organisation has to make decisions in conducting
their business transactions.
• When making a decision, information is required so
that the decision made is considered as the ‘right’
one.
• The information must be RELEVANT to the decision
making.
• But, how do we determine which information is
relevant?
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 THE CONCEPT OF RELEVANCE
• Making business decisions requires managers to
compare two or more alternative courses of action.
• Two criteria determine whether information is
relevant:
1. Information must be an expected future revenue or
cost
2. It must have an element of difference among the
alternatives.
• Thus RELEVANT INFORMATION is the predicted
future costs and revenues that will differ among
the alternatives.
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 THE CONCEPT OF RELEVANCE
• Relevant information is a prediction of the future,
not a summary of the past.
• Historical information has no direct bearing on a
decision.
• Such information can have an indirect bearing on a
decision because it may help in predicting the
future.
• But past figures are irrelevant to the decision itself
because decision cannot change the past.
• Decisions can only affect the future.
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