Professional Documents
Culture Documents
Assignment 2 Select and Apply Costing Systems and Techniques
Assignment 2 Select and Apply Costing Systems and Techniques
Assignment 2
Select and Apply Costing
Systems and Techniques
1 of 15
By Steve Goddard
Acknowledgements
3 of 15
Table of Contents
Section
1
2
-
Description
Executive Summary
Task 1
Task 2
References
Page
6
7
13
16
4 of 15
Executive Summary
This report is written as two parts the first part of my findings identifies and describes the appropriate
costing systems and techniques for a new product in a specific market so that an estimated selling price
can be decided.
Seeing as the product is entering an untapped market the market uptake is unknown. Therefore I have
been asked to assess the resources needed to manage an unknown market. I will do this by measuring
and evaluating the impact of changing activity levels on engineering business performance.
5 of 15
Quantity
1 days
4m x 3m
25sq m
8m
50
2
10sq m
8 hours
Price/unit
55/day
2/sq m
1.60/sq m
1/m
0.03/ea
1.50/ea
2/sq m
18/hour
Cost ()
Charge ()
55.00
24.00
40.00
8.00
1.50
3.00
20.00
144.00
60.50
26.40
44.00
8.80
1.65
3.30
22.00
144.00
6 of 15
310.65
Contract Costing
Contract costing is very similar to job costing but is used for larger jobs. As contract costing is used for larger
more complicated jobs that often last for longer durations there are more costs to be accounted for. For example
the cost of money due to inflation, interest to be paid on borrowed money. Overheads can often include
accountancy and legal fees, general admin costs, bank charges etc. Sub costs that have already been incurred
cannot be charged for.
Process Costing
Process costing is a type of costing system that is used for uniform, or homogeneous, products. Process costing
averages the costs over all units to come to the per unit cost. This is in contrast to other types of costing systems,
such as job-order costing that is used for products that are in differentiated batches. Unlike job-order costing,
process costing is tracked using a work-in-process account for each department, rather than through subsidiary
ledgers.
Process Costing Procedures
Process costing systems follow specific procedures, and while exact procedures may vary by company or by
industry, they will generally follow these steps:
While other types of costing start with a sales order, a sales order is not needed for process costing as it
is a continuous process
The work-in-process accounts are divided by department and are named as such for example: Work-in-
department account
Direct labour costs are recorded by period
Actual overhead costs are recorded; no contra-account is needed because there is no over- or under-
Direct materials
Direct Labour
Production Overheads
6,000.00
4,250.00
3,950.00
7 of 15
Direct materials
Direct Labour
Production Overheads
Total cost of process 2
Total cost of production
14,200.00
1,000.00
4,400.00
5,700.00
11,100.00
25,300.00
Fixed Costs
Fixed costs are those business costs that are not directly related to the level of production or output. In other
words, even if the business has a zero output or high output, the level of fixed costs will remain broadly the same.
In the long term fixed costs can alter - perhaps as a result of investment in production capacity (e.g. adding a new
factory unit) or through the growth in overheads required to support a larger, more complex business.
Examples of fixed costs:
- Rent and rates
- Depreciation
- Research and development
- Marketing costs (non- revenue related)
- Administration costs
Variable Costs
Variable costs are those costs which vary directly with the level of output. They represent payment output-related
inputs such as raw materials, direct labour, fuel and revenue-related costs such as commission.
A distinction is often made between "Direct" variable costs and "Indirect" variable costs.
Direct variable costs are those which can be directly attributable to the production of a particular product or
service and allocated to a particular cost centre. Raw materials and the wages those working on the production
line are good examples.
Indirect variable costs cannot be directly attributable to production but they do vary with output. These include
depreciation (where it is calculated related to output - e.g. machine hours), maintenance and certain labour costs.
Semi-Variable Costs
Whilst the distinction between fixed and variable costs is a convenient way of categorising business costs, in
reality there are some costs which are fixed in nature but which increase when output reaches certain levels.
These are largely related to the overall "scale" and/or complexity of the business. For example, when a business
has relatively low levels of output or sales, it may not require costs associated with functions such as human
resource management or a fully-resourced finance department. However, as the scale of the business grows (e.g.
output, number people employed, number and complexity of transactions) then more resources are required. If
production rises suddenly then some short-term increase in warehousing and/or transport may be required. In
these circumstances, we say that part of the cost is variable and part fixed.
8 of 15
Costing Techniques
Absorption Costing/ Full Costing
Absorption Costing is a costing technique where all normal costs whether it is variable or fixed costs are charged
to cost units produced. Unlike marginal costing which take the fixed cost as period cost.
Advantages
Unlike marginal costing where fixed costs are agreed to change into variable cost, it is cost into the stock value
hence distorting stock valuation.
Disadvantages
As absorption costing emphasized on total cost namely both variable and fixed, it is not so useful for
management to use to make decision, planning and control;
As the managers emphasis is on total cost, the cost volume profit relationship is ignored. The manager
needs to use his intuition to make the decision.
Marginal costing involves ascertaining marginal costs. Since marginal costs are direct cost, this costing
technique is also known as direct costing;
In marginal costing, fixed costs are never charged to production. They are treated as period charge and is
written off to the profit and loss account in the period incurred;
Once marginal cost is ascertained contribution can be computed. Contribution is the excess of revenue
over marginal costs.
The marginal cost statement is the basic document/format to capture the marginal costs.
Features
Advantages
9 of 15
Disadvantages
Marginal cost has its limitation since it makes use of historical data while decisions by management
relates to future events;
It ignores fixed costs to products as if they are not important to production;
It fails to recognize that in the long run, fixed costs may become variable;
Its oversimplified costs into fixed and variable as if it is so simply to demarcate them;
Its not a good costing technique in the long run for pricing decision as it ignores fixed cost. In the long
run, management must consider the total costs not only the variable portion;
Difficulty to classify properly variable and fixed cost perfectly, hence stock valuation can be distorted if fixed cost is
classified as variable.
Activity Based Costing
Activity based costing (ABC) assigns manufacturing overhead costs to products in a more logical manner than the
traditional approach of simply allocating costs on the basis of machine hours. Activity based costing first assigns
costs to the activities that are the real cause of the overhead. It then assigns the cost of those activities only to the
products that are actually demanding the activities.
Let's discuss activity based costing by looking at two products manufactured by the same company. Product 124
is a low volume item which requires certain activities such as special engineering, additional testing, and many
machine setups because it is ordered in small quantities. A similar product, Product 366, is a high volume product
running continuouslyand requires little attention and no special activities. If this company used traditional
costing, it might allocate or "spread" all of its overhead to products based on the number of machine hours. This
will result in little overhead cost allocated to Product 124, because it did not have many machine hours. However,
it did demand lots of engineering, testing, and setup activities. In contrast, Product 366 will be allocated an
enormous amount of overhead (due to all those machine hours), but it demanded little overhead activity. The
result will be a miscalculation of each product's true cost of manufacturing overhead. Activity based costing will
overcome this shortcoming by assigning overhead on more than the one activity, running the machine.
Activity based costing recognizes that the special engineering, special testing, machine setups, and others are
activities that cause coststhey cause the company to consume resources. Under ABC, the company will
calculate the cost of the resources used in each of these activities. Next, the cost of each of these activities will be
assigned only to the products that demanded the activities. In our example, Product 124 will be assigned some of
the company's costs of special engineering, special testing, and machine setup. Other products that use any of
these activities will also be assigned some of their costs. Product 366 will not be assigned any cost of special
engineering or special testing, and it will be assigned only a small amount of machine setup.
Activity based costing has grown in importance in recent decades because (1) manufacturing overhead costs
have increased significantly, (2) the manufacturing overhead costs no longer correlate with the productive
machine hours or direct labor hours, (3) the diversity of products and the diversity in customers' demands have
grown, and (4) some products are produced in large batches, while others are produced in small batches.
10 of 15
Standard Costing
Standard costs are usually associated with a manufacturing company's costs of direct material, direct labor, and
manufacturing overhead.
Rather than assigning the actual costs of direct material, direct labor, and manufacturing overhead to a product,
many manufacturers assign the expected or standard cost. This means that a manufacturer's inventories and cost
of goods sold will begin with amounts reflecting the standard costs, not the actual costs, of a product.
Manufacturers, of course, still have to pay the actual costs. As a result there are almost always differences
between the actual costs and the standard costs, and those differences are known as variances.
Standard costing and the related variances is a valuable management tool. If a variance arises, management
becomes aware that manufacturing costs have differed from the standard (planned, expected) costs.
If actual costs are greater than standard costs the variance is unfavorable. An unfavorable variance tells
management that if everything else stays constant the company's actual profit will be less than planned.
If actual costs are less than standard costs the variance is favorable. A favorable variance tells
management that if everything else stays constant the actual profit will likely exceed the planned profit.
The sooner that the accounting system reports a variance, the sooner that management can direct its
attention to the difference from the planned amounts.
Cost Units
As well as using cost centres another important way of costing is to determine the cost per unit of production or
sales. For example, in a printing firm producing books, each book can be counted as a cost unit.
The purpose of a costing exercise is to determine the cost of a cost unit, therefore all costs should be allocated to
cost units whenever possible. Only when costs cannot be attributed to a specific product are they to be charged to
a cost centre - for example, take two costs incurred in a workshop of a garage, the wages of a mechanic working
on customers' cars and the cost of electricity used for powering workshop tools and lighting. The wages of the
mechanic can be identified with cost units provided a record is kept of how time has been spent, e.g. by each
11 of 15
repair or service job, but it is not practical to record the electricity attributable to specific jobs. This cost should be
allocated to the cost of running the workshop (i.e. it is a cost centre cost).
If we can break up an organisation into cost centres to see how much machines, departments, or other
components cost to operate we can also divide the organisation into profit centres.
In a profit centre we will need to look at the costs associated with running that centre and the revenues to
calculate the profit. For example, an organisation like the BBC can be split into profit centres and each can be set
profit targets to work towards. Dividing an organisation into profit centres makes it possible to identify the parts of
the organisation that generate the profits and the parts that do not.
12 of 15
In the diagram above, the line OA represents the variation of income at varying levels of production activity
("output"). OB represents the total fixed costs in the business. As output increases, variable costs are incurred,
meaning that total costs (fixed + variable) also increase. At low levels of output, Costs are greater than Income. At
the point of intersection, P, costs are exactly equal to income, and hence neither profit nor loss is made.
The formula: To conduct breakeven analysis, take the fixed costs, divided by the price, minus the variable costs.
As an equation, this is defined as:
Breakeven Point = Fixed Costs/(Unit Selling Price - Variable Costs)
This calculation will show how many units of a product need to sell to break even. Once youve reached that point,
youve recovered all costs associated with producing your product (both variable and fixed).
Above the breakeven point, every additional unit sold increases profit by the amount of the unit contribution
margin, which is defined as the amount each unit contributes to covering fixed costs and increasing profits. As an
equation, this is defined as:
Unit Contribution Margin = Sales Price - Variable Costs
Here is how to work out the breakeven point, using the example of a firm manufacturing compact discs. You can
assume the firm has the following costs:
Fixed costs: 10,000
Variable costs: 2.00 per unit
You first construct a chart with output (units) on the horizontal (x) axis, and costs and revenue on the vertical (y)
axis. On to this, you plot a horizontal fixed costs line (it is horizontal because fixed costs don't changewith output).
Then you plot a variable cost line from this point, which will, in effect, be the total costs line. This is because the
fixed cost added to the variable cost gives the total cost. To do this, you multiply:
Variable cost per unit number of units
In this example of the CD manufacturing firm, you can assume that the variable cost per unit is 2 and there are 2
000 units = 4,000
13 of 15
Once you have done this, you are ready to plot the total revenue line. To do this, you multiply:
Sales price number of units (output)
If the sales price is 6.00 and 2.000 items were to be manufactured, the calculation is:
6.00 2,000 = 12,000 total revenue
Where the total revenue line crosses the total costs line is the breakeven point (ie costs and revenue are the
same). Everything below this point is produced at a loss, and everything above it is produced at a profit.
Fixed costs: 10,000, Variable costs: 2 per unit, Sales price: 6 per unit
If you read downwards, it tells you how many units you need to produce and sell at this price to breakeven: 2,500
CDs
If you read across, it tells you how much money you must spend before you recover your outlay: 15,000
14 of 15
References
Books
Tooley & Dingle HNC Engineering
Internet Pages
http://www.businesslink.gov.uk/bdotg/action/detail?
r.l1=1073858790&r.l3=1074416511&r.lc=en&type=RESOURCES&itemId=1074416965&r.l2=1073858944&r.s=
sc
http://www.equiworld.net/internet.htm
http://en.wikipedia.org/wiki/New_product_development
http://blog.livemygoals.com/EntrepreneursChampion/archive/2008/05/18/ideas-pt-3-how-to-decide-if-anidea-is.aspx
15 of 15