What is the purpose of costing?

In paper F2 we learnt how to determine the cost per unit for a

product. We might need to know this cost in order to :

• Value inventory the cost per unit can be used to value

inventory in the statement of financial position (balance
sheet).
• Record costs the costs associated with the product
need to be recorded in the income statement.
• Price products the business will use the cost per unit to
assist in pricing the product. For example, if the cost per unit
is $0.30, the business may decide to price the product at
$0.50 per unit in order to make the required profit of $0.20
per unit.
• Make decisions the business will use the cost information to
make important decisions regarding which products should
be made and in what quantities.

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 Overheads Review
Direct and indirect expenses

Direct expenses are expenses that can be directly traceable into the product cost. There are few
examples of direct expenses but royalties paid to a designer or fees paid to a subcontractor for a
specific job could be classed as direct expenses.
• Direct expenses are part of the prime cost of a product.

Indirect expenses cannot be directly traceable into the product cost.

• For example, the cost of renting a factory where shirts are manufactured is classified as an indirect
cost because it would be impossible to relate such costs to shirts only, if other clothes, such as
dresses and suits were also made in the same factory.
• Indirect expenses are also known as overheads.

The difference between absorption and marginal costing is the actually the treatment of Fixed
Production cost.
Two ways of treating the Fixed Production cost

a) For external reporting purpose, the cost of the product must include all the costs of
manufacturing it; direct materials, direct labor and all Factory overhead (both fixed and
variable). This method is commonly known as absorption costing.
b) For internal purpose, decision making is improved by treating fixed cost as period cost so
that the cost that are only variable in the short run are included in the cost of the product.
This is termed as marginal costing. Marginal costing is preferred because it describes exactly
what is happening- namely those product costs are based upon only on variable cost.

Absorption Costing:
• The main aim of absorption costing is to recover overheads in a way that fairly reflects the amount
of time and effort that has gone into making a product or service.

Step1: Allocation is the charging of overheads directly to specific departments where they can be
identified directly with a cost centre or cost unit.
Apportionment is the sharing of overheads which relate to more than one department on a
fair basis.
Step 2: Service department costs need to be reapportioned to the production departments, using a
suitable basis linked to usage of the service.
Step 3: Costs within production cost centres are charged to a cost unit, using Overhead absorption
rates (OAR) based on:
• Labour or machine hours (traditional/volume based drivers)
• % of direct labour cost.

• OAR = Budgeted overheads / Budgeted level of activity

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Example 1:

Reasons for under-/over-absorbed overhead:

The overhead absorption rate is predetermined from budget estimates of overhead cost and activity
level.
Under or over recovery of overhead will occur in the following circumstances.
1) Actual overhead costs are different from budgeted overheads.
2) The actual activity level is different from the budgeted activity level.
3) Actual overhead costs and actual activity level differ from those budgeted.

Example 2:
A production department has budgeted production overheads of $180,000 and budgeted activity
of45,000 machine hours. Overheads are absorbed on a machine hour basis.
Required:
Calculate the under-/over-absorbed overhead, and note the reasons for the under-/over-
absorption in the following circumstances.
(a) Actual overheads cost $170,000 and 45,000 machine hours were worked.
(b) Actual overheads cost $180,000 and 40,000 machine hours were worked.
(c) Actual overheads cost $170,000 and 40,000 machine hours were worked.

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 Marginal costing:
It is an alternative to absorption costing. Only variable costs (marginal costs) are charged as a cost of
sales. Fixed costs are treated as period costs and are charged in full against the profit of the period in
which they are incurred.
Knowledge brought forward from earlier studies
 In marginal costing, closing inventories are valued at marginal (variable) production cost
whereas, in absorption costing, inventories are valued at their full production cost which
includes absorbed fixed production overhead.
 If the opening and closing inventory levels differ in an accounting period, the profit reported
for the period will differ between absorption costing and marginal costing.
 But in the long run, total profit for a company will be the same whichever costing method
is used, because in the long run total costs will be the same by either method of accounting.
The different costing methods merely affect the reported profit for individual accounting
periods.

Example 3:
A company makes and sells a single product. At the beginning of period 1, there are no opening
inventories of the product, for which the variable production cost is $4 and the selling price is $6 per
unit.
There are no variable selling costs. Fixed costs are $2,000 per period, of which $1,500 are fixed
production costs. Normal output is 1,500 units per period. In period 1, sales were 1,200 units,
production was 1,500 units. In period 2, sales were 1,700 units, production was 1,400 units.
Required:
Prepare profit statements for each period and for the two periods in total using both absorption
costing and marginal costing.
The difference in profits reported under the two costing systems is due to the different inventory
valuation methods used.

 If inventory levels increase between the beginning and end of a period, absorption costing
will report the higher profit.
 If inventory levels decrease, absorption costing will report the lower profit.

Absorption Costing Profit= Marginal Costing Profit + (Closing – Opening) inventory x Fixed Overhead rate per unit

Justification of using Absorption Costing:

FORWAR
As these overheads cost is incurred for the manufacturing of products thus supporters of absorption
costing classify it as a product cost and charge it into the cost of the product when calculating full
cost.

 Inventory valuations:
It is the requirement of the financial reporting standards to value the closing inventory at full
cost that is adding the share of the fixed overheads in it.
 Pricing:
Some companies sell their products by calculating the full cost of production and then
adding the required profit margin.

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 Justification of Marginal costing
Under Marginal costing, fixed overhead cost is considered a cost of maintaining capacity, not
a cost of producing a product.
1) To illustrate, a company has a fixed rental expense of $10,000 per month on its factory
building. That cost will be $10,000 regardless of whether there is any production.
If the company produces zero units, the cost will be $10,000; if the company produces
10,000 units, the cost will be $10,000.
2) Therefore the $10,000 is not viewed as a cost of production and is not added to the cost
of the inventories produced. That $10,000 was a cost of maintaining a certain level of
capacity.

Limitations of Marginal costing

 Reporting Requirement:
According to IAS inventory can’t be valued only at variable cost thus marginal costing is not
used for external reporting purpose because of tax calculation.
 Fixed cost impact:
Focusing exclusively on marginal costs may cause companies to overlook important savings
that might result from better controlled fixed costs.
 Pricing problems:
If cost of producing a unit consists of marginal costs only, it will understate the true cost of
production and this can lead to problems. For example, if the selling price is based on a
mark-up on cost, then the company needs to make sure that all production costs are
covered by the selling price

MARGINAL VERSUS ABSORPTION COSTING

With marginal costing, contribution varies in direct proportion to the volume of units sold. Profits
will increase as sales volume rises, by the amount of extra contribution earned. Since fixed cost
expenditure does not alter, marginal costing gives an accurate picture of how a firm's cash flows and
profits are affected by changes in sales volumes.

With absorption costing, in contrast, there is no clear relationship between profit and sales
volume, and as sales volume rises the total profit will rise by the sum of the gross profit per unit plus
the amount of overhead absorbed per unit. Arguably this is a confusing and unsatisfactory method
of monitoring profitability.

Using absorption costing there is therefore the possibility of manipulating profit, simply by
changing output and inventory levels.

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 Activity Based Costing
The conventional approach to dealing with fixed overhead production costs is to assume that the
various cost types can be dumped together and a single overhead absorption rate is derived. The
absorption rate is usually presented in terms of overhead cost per labour hour, or overhead rate per
machine hour. This approach is likely to be an over-simplification, but it has the merit of being
relatively quick and easy.

The conventional approach outlined above is satisfactory if the following conditions apply:
1. Fixed costs are relatively immaterial compared to material and labour costs. This is the case
in manufacturing environments which do not rely on sophisticated and expensive facilities and
machinery.
2. Most fixed costs accrue with time.
3. There are long production runs of identical products with little customization.

The need of Activity Based Costing

Manufacturing has become more machine intensive and, as a result, the proportion of
production overheads, compared to direct costs, has increased. Therefore, it is important that
an accurate estimate is made of the production overhead per unit.

Modern manufacturing relies on highly automated, expensive manufacturing plants – so much so

that some companies do not separately identify the cost of labour because there is so little used.
Instead, factory labour is simply regarded as a fixed overhead and added in to the fixed costs of
running the factory, its machinery, and the sophisticated information technology system which
coordinates production.
Additionally, many companies rely on customization of products to differentiate themselves and to
enable higher margins to be made. Dell, for example, a PC manufacturer, has a website which lets
customers specify their own PC in terms of memory size, capacity, processor speed etc. That
information is then fed into their automated production system and the specified computer is built,
more or less automatically.
Instead of offering customers the ability to specify products, many companies offer an extensive
range of products, hoping that one member of the range will match the requirements of a particular
market segment. In Example 1, the company offers two products: ordinary and deluxe. The company
knows that demand for the deluxe range will be low, but hopes that the price premium it can charge
will still allow it to make a good profit, even on a low volume item. However, the deluxe product
could consume resources which are not properly reflected by the time it takes to make those units.
These developments in manufacturing and marketing mean that the conventional way of treating
fixed overheads might not be good enough. Companies need to know the causes of overheads, and
need to realise that many of their ‘fixed costs’ might not be fixed at all. They need to try to assign
costs to products or services on the basis of the resources they consume.

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 Comparing ABC with traditional methods

Traditional systems measure accurately volume related resources that are consumed in
proportion to the number of units produced of the individual products. Such resources include
direct materials, direct labor, energy, and machine related costs.

However, many organisational resources exist for activities that are unrelated to physical
volume. Nonvolume related activities consist of support activities such as materials
handling, material procurement, setups, production scheduling and first item inspection
activities.
Traditional productcost systems, which assume that products consume all activities in
proportion to their production volumes, thus report distorted product costs.

Steps involved in Activity Based Costing

1) Group production overheads into activities, according to

how they are driven.
2) Identify cost drivers for each activity, i.e. what causes
these activity costs to be incurred.
3) A cost driver is a factor that influences (or drives) the level
of cost.
4) Calculate an OAR for each activity.

The OAR is calculated in the same way as the absorption

costing OAR. However, a separate OAR will be calculated for
each activity, by taking the activity cost and dividing by the
total cost driver volume.

5) Absorb the activity costs into the product.

The activity costs should be absorbed back into the individual products.

6) Calculate the full production cost.

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Page 8
 Advantages and Disadvantages of ABC
ABC has a number of advantages:

 It provides much better insight in to what drives overhead costs.

 ABC recognizes that overhead costs are not all related to production and sales volume.
 Overheads cost is charged to the products in a more realistic way, hence the pricing of the
product can be done more accurately as product cost cross subsidization is avoided.
 Individual product profitability is better understood because of ABC implementation that aids
in decision making process.
 It can be used as a tool for cost control as it focuses on cause and effect relationship by
identifying cost drivers.

Disadvantages of ABC:

 ABC benefits will be limited benefit if the overhead costs are primarily volume related or if
the overhead is a small proportion of the overall cost.
 It is impossible to allocate all overhead costs to specific activities.
 The choice of both activities and cost drivers might be inappropriate.
 The benefits obtained from ABC might not justify the costs.
 At times there are more than one cost driver for an activity.
 Organizations producing single product can’t yield benefits from ABC.
 Information processing can be an issue when it comes to implementing ABC.

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Example No. 1:
Duff Co manufactures three products, X, Y and Z. Demand for products X and Y is relatively elastic
whilst demand for product Z is relatively inelastic. Each product uses the same materials and the
same type of direct labour but in different quantities. For many years, the company has been using
full absorption costing and absorbing overheads on the basis of direct labour hours. Selling prices are
then determined using cost plus pricing. This is common within this industry, with most competitors
applying a standard mark-up.
Budgeted production and sales volumes for X, Y and Z for the next year are 20,000 units, 16,000
units and 22,000 units respectively.
The budgeted direct costs of the three products are shown below:
Product X Y Z
$ per unit $ per unit $ per unit
Direct materials 25 28 22
Direct labour ($12 per hour) 30 36 24
In the next year, Duff Co also expects to incur indirect production costs of $1,377,400, which are
analyzed as follows:
Cost pools $ Cost drivers
Machine set up costs 280,000 Number of batches
Material ordering costs 316,000 Number of purchase orders
Machine running costs 420,000 Number of machine hours
General facility costs 361,400 Number of machine hours
––––––––––
1,377,400
––––––––––
The following additional data relate to each product:
Product X Y Z
Batch size (units) 500 800 400
No of purchase orders per batch 4 5 4
Machine hours per unit 1·5 1·25 1·4

Duff Co wants to boost sales revenue in order to increase profits but its capacity to do this is limited
because of its use of cost plus pricing and the application of the standard mark-up. The finance
director has suggested using activity based costing (ABC) instead of full absorption costing, since this
will alter the cost of the products and may therefore enable a different price to be charged.

Required:
(a) Calculate the budgeted full production cost per unit of each product using Duff Co.’s current
method of absorption costing. All workings should be to two decimal places.
(b) Calculate the budgeted full production cost per unit of each product using activity based
costing. All workings should be to two decimal places.
(c) Discuss the impact on the selling prices and the sales volumes OF EACH PRODUCT which a
change to activity based costing would be expected to bring about.

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Example 2:
Jola Publishing Co publishes two forms of book.
The company publishes a children’s book (CB), which is sold in large quantities to government
controlled schools. The book is produced in only four large production runs but goes through
frequent government inspections and quality assurance checks.
The paper used is strong, designed to resist the damage that can be caused by the young children it
is produced for. The book has only a few words and relies on pictures to convey meaning.
The second book is a comprehensive technical journal (TJ). It is produced in monthly production
runs, 12 times a year. The paper used is of relatively poor quality and is not subject to any
governmental controls and consequently only a small number of inspections are carried out. The TJ
uses far more machine hours than the CB in its production.
The directors are concerned about the performance of the two books and are wondering what the
impact would be of a switch to an activity based costing (ABC) approach to accounting for
overheads. They currently use absorption costing, based on machine hours for all overhead
calculations. They have accurately produced an analysis for the accounting year just completed as
follows:
CB TJ
$per unit $per unit $per unit $per unit
Direct production costs
Paper 0·75 0·08
Printing ink 1·45 4·47
Machine costs 1·15 1·95
3·35 6·50
Overheads 2·30 3·95
Total cost 5·65 10·45
Selling price 9·05 13·85
Margin 3·40 3·40

The main overheads involved are:

Overhead % of total overhead Activity driver
Property costs 75·0% Machine hours
Quality control 23·0% Number of inspections
Production set up costs 2·0% Number of set ups

If the overheads above were re-allocated under ABC principles then the results would be that the
overhead allocation to CB would be $0·05 higher and the overhead allocated to TJ would be $0·30
lower than previously.
Required:
(a) Explain why the overhead allocations have changed in the way indicated above. (8 marks)
(b) Briefly explain the implementation problems often experienced when ABC is first introduced.
(4 marks)

The directors are keen to introduce ABC for the coming year and have provided the following cost
and selling price data:
1) The paper used costs $2 per kg for a CB but the TJ paper costs only $1 per kg. The CB
uses 400g of paper for each book, four times as much as the TJ uses.
2) Printing ink costs $30 per litre. The CB uses one third of the printing ink of the larger
TJ. The TJ uses 150ml of printing ink per book.

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 3) The CB needs six minutes of machine time to produce each book, whereas the TJ
needs 10 minutes per book. The machines cost $12 per hour to run.
4) The sales prices are to be $9·30 for the CB and $14·00 for the TJ

As mentioned above there are three main overheads, the data for these are:
Overhead Annual cost for the coming year
$
Property costs 2,160,000
Quality control 668,000
Production set up costs 52,000
––––––––––
Total 2,880,000
––––––––––
The CB will be inspected on 180 occasions next year, whereas the TJ will be inspected just 20 times.
Jola Publishing will produce its annual output of 1,000,000 CBs in four production runs and
approximately 10,000TJs per month in each of 12 production runs.

Required:
(c) Calculate the cost per unit and the margin for the CB and the TJ using machine hours to absorb
the overheads. (5 marks)
(d) Calculate the cost per unit and the margin for the CB and the TJ using activity based costing
principles to absorb the overheads. (8 marks)

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Example 3:
The Gadget Co produces three products, A, B and C, all made from the same material. Until now, it
has used traditional absorption costing to allocate overheads to its products. The company is now
considering an activity based costing system in the hope that it will improve profitability. Information
for the three products for the last year is as follows:
A B C
Production and sales volumes (units) 15,000 12,000 18,000
Selling price per unit $7.50 $12 $13
Raw material usage (kg) per unit 2 3 4
Direct labour hours per unit 0·1 0·15 0·2
Machine hours per unit 0·5 0·7 0·9
Number of production runs per annum 16 12 8
Number of purchase orders per annum 24 28 42
Number of deliveries to retailers per annum 48 30 62

The price for raw materials remained constant throughout the year at $1·20 per kg. Similarly, the
direct labour cost for the whole workforce was $14·80 per hour. The annual overhead costs were as
follows:
$
Machine set up costs 26,550
Machine running costs 66,400
Procurement costs 48,000
Delivery costs 54,320

Required:
(a) Calculate the full cost per unit for products A, B and C under traditional absorption costing,
using direct labor hours as the basis for apportionment. (5 marks)
(b) Calculate the full cost per unit of each product using activity based costing. (9 marks)
(c) Using your calculation from (a) and (b) above, explain how activity based costing may help The
Gadget Co improve the profitability of each product. (6 marks)
(20 marks)

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