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CHAPTER 3
Calculating unit costs

ABSORPTION

MATERIAL
COSTING
HOW TO ESTIMATE
INVENTORY

VALUATION?

WORK IN PROCESS

PRODUCT
MARGINAL
COSTING

GOODS, …

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Absorption costing
• Absorption costing – Inventory is valued at full production
cost i.e. including both variable and fixed elements of
production cost.

Direct material costs

UNIT
Direct labour costs
COSTS

Overhead

Absorption costing
Absorption costing values a cost unit at prime cost plus
variable production overheads plus an estimate of the fair share
of fixed production overheads. This is the same as marginal
cost plus an estimate of the fair share of fixed production
overheads.
Absorption costing is also called full costing.
How can you determine the share of overhead need to be
attributed to a cost unit?

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Apportionment
• Whole cost items • All costs are
are charged added into unit
directly to a cost • Indirect costs are costs using
objects (centre). shared fairly calculated
• Service cost centre absorption rates.
costs are also
reapportioned
Allocation Absorption

• Allocation
Whole cost items are charged directly to a cost centres

E.g. Wages of foreman, indirect materials, indirect labour

costs only incurre in Department A can be allocated for this
department.

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• Overhead Apportionment
Process by which Indirect Costs are shared fairly between
cost centres
Requires application of appropriate basis of apportionment to
ensure that the distribution between the cost centres is fair
• Floor area
E.g. Rent, Rates, Heating, Light, Repairs,
• Equipment cost
E.g. Depreciation, Equipment Insurance
• Number of employees /Labour hours worked etc
E.g. Personnel Office, Canteen, Wages Dept, Welfare

Test your understanding 1

Sofa Universe operates its entire business from Galaxy Way. Sofa
Universe has 3 cost centres:
Warehouse
Showroom and shop
Head office
Would the following costs be allocated or apportioned to each
cost centre?
(a) Salary of the warehouse security guard
(b) Rates for Galaxy Way
(c) Rental of POS machine
(d) Insurance of inventory

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Test your understanding 1

Sofa Universe operates its entire business from Galaxy Way. Sofa
Universe has 3 cost centres:
Warehouse
Showroom and shop
Head office
Would the following costs be allocated or apportioned to each
cost centre?
(a) Salary of the warehouse security guard
(b) Rates for Galaxy Way
(c) Rental of POS machine
(d) Insurance of inventory

Test your understanding 2

LS Ltd has two production departments (Assembly and Finishing)
and two service departments (Maintenance and Canteen). The following
are budgeted costs for the next period:
Indirect materials £20,000
Rent £15,000
Electricity £10,000
Machine depreciation £5,000
Indirect labour £16,520

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Test your understanding 2

The following information is available:

Assembly Finishing Maintenance Canteen

Area (sq. metres) 1,000 2,000 500 500
kW hours consumed 2,750 4,500 1,975 775
Machine value £45,000 £35,000 £11,000 £9,000
Number staff 20 30 10 2
Direct labour hours 3,175 3,800
Indirect materials budget(£) 7,000 8,000 3,000 2,000
Indirect labour budget (£) 1,600 2,220 11,200 1,500

(a) which costs will be allocated or apportioned?

(b) Calculate the total budgeted overheads for each department.

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• Overhead Absorption
Process whereby overhead costs allocated and apportioned to
production cost centres are added to unit costs.
• Overhead absorption usually uses a predetermined absorption rate,
calculated from budgeted figures

• Choice of rate should reflect the characteristics of the cost centre.

Eg. % direct materials, % direct labour, Rate per labour hour, Rate
per machine hour etc

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Test your understanding 3

Natalia produces 2 products, paintbrushes and easels, with the following

budgeted costs:

Paintbrush Easel
Direct labour 0.1 hrs @ £5ph = £0.50 1 hr @ £9 = £9
Direct materials 0.5 m @ £8 perm = £4 2 m @ £4 per m = £8
Direct expenses £0 £0
Variable production costs £0.10 £2

Natalia produces and sells 350 paintbrushes and 50 easels per month.
Budgeted fixed production overheads are: £4,000.

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Test your understanding 3

Which is the fairest basis to absorb overheads?
 What is the budgeted absorption cost per product if overheads are
absorbed based on number of units?
 What is the budgeted absorption cost per product if overheads are
absorbed based on prime cost?
 What is the budgeted absorption cost per product if overheads are
absorbed based on direct labour cost?
 What is the budgeted absorption cost per product if overheads are
absorbed based on direct labour hour?

Absorption using an hourly rate is most common in the exam.

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In case, company has more than one production department we can

use multiple department OAR’s or Blanket absorption rate.
• Blanket absorption rate
A blanket absorption rate uses the same absorption rate for all cost
units irrespective of the department in which they were produced.
A blanket absorption rate is only appropriate if individual departmental
OARs would be similar to an overall company OAR.
This method is not appropriate if there are a number of departments
and different cost units do not spend an equal amount of time in each
department.
Blanket absorption rates are also called a single factory absorption rate.

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Test your understanding 4

Products alpha and beta are made in a factory that has two production cost
centres: production and finishing. Budgeted production is 8,000 units of alpha
and 10,000 units of beta. Fixed overheads are absorbed on a labour hour basis.
The following budgeted information is available:

Production Finishing
Allocated and apportioned fixed costs £55,000 £63,000
Direct labour hours per unit:
Product Alpha 1.5 hrs 2 hrs
Product Beta 1 hr 0.5 hrs
What is the budgeted fixed cost per unit for product Beta if company
applied blanket absorption rate?
A £4.116 B £4.00 C £9.75 D £10.425

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Test your understanding 5

A company manufactures two products, E and F, in a factory divided into
two production cost centres, Primary and Finishing. Inorder to determine a
budgeted fixed overhead cost per unit ofproduct, the following budgeted data
are relevant.
Primary Finishing
Allocated and apportioned fixed costs £84,000 £93,000
Direct labour hours per unit:
E 36 25
F 30 40
Budgeted production is 9,000 units of E and 6,000 units of F. Fixed
overheads are to be absorbed on a direct labour hour basis and multiple
absorption rate is used.
What is the budgeted fixed overheadcost of a unit of product E?
A £10 B £11 C £12 D £13

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Test your understanding 6

Lydia sells jodhpurs and breeches. There are 2 production departments,

assembly and finishing.
Assembly Finishing
Departmental overheads £31,370 £35,150
Departmental labour hours 3,175 3,800
Jodhpurs labour time per department 15 minutes 30 minutes
Breeches labour time per department 20 minutes 25 minutes

Calculate the absorption cost per pair of jodhpurs using

(a) labour hours OAR
(b) company-wide OAR
Comment whether the company wide methodology is appropriate.

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• Standard vs Actual
A standard cost is the expected, or budgeted, cost per unit of output.
A standard cost card is drawn up in advance of a period and shows the
expected usage of resources and price of resources for each cost unit.

E.g. Standard material cost per cup of coffee is £ 0.25 (50 gr @ £

0.05 per gr)

Standard costs are always different from actual.

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• Over and Under absorption

Because predetermined overhead absorption rates are based on
estimates, actual resultant rates usually differ from the rates applied and
charged to cost of sales.
Overheads inccured − Overheads absorbed
= Over or under absorbed overheads

If actual overheads < absorbed overhead (Negative = over)

If actual overheads > absorbed overhead (Positive = under)

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• Over and Under absorption

Over absorption means overheads charged to cost of sales are
greater than actually incurred

Eg. Sunshie Ltd has Actual overhead £45,000. Absorbed say 0.50p
x 100,000 dlh = £50,000 Over absorbed = £5,000

Under absorption occurs when insufficient overheads are charged

to cost of sales

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• Reasons for Over/Under Absorption

• Actual overhead costs are different from budgeted overheads
• Actual activity level is different from budgeted
• Actual overhead costs and actual activity level differ from
budgeted

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• Accounting for Over/under-absorbed Overhead

Cost of
Overhead is Adjustment will
sales is

Actual overhead >

Underabsorbed Too low Increase Cost of sales
absorbed overhead

Actual overhead <

absorbed overhead Overabsorbed Too high Decrease Cost of sales

Under or over absorbed overhead is written off as an adjustment in

the preparation of the period income statement.

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Test your understanding 7

Hill Ltd has budgeted for fixed production overheads to be

£240,000 for the period and production of 60,000 units.

Actual fixed production overheads were £242,400

Actual production was 61,000 units.

How much were overheads over or under absorbed by?

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Test your understanding 8

Over-absorbed overheads occur when:

A absorbed overheads exceed actual overheads.

B absorbed overheads exceed budgeted overheads.

C actual overheads exceed budgeted overheads.

D budgeted overheads exceed absorbed overheads.

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Test your understanding 9

A business absorbs its production overheads on the basis of labour hours.

There were 250,000 budgeted labour hours for the next period and the overhead
absorption rate was £3 per labour hour.
During the period the actual results were:
Actual labour hours 240,000
Actual production overhead £710,000
Which of the following statements is correct?
A Overhead was over-absorbed by £10,000.
B Overhead was under-absorbed by £10,000.
C Overhead was over-absorbed by £40,000.
D Overhead was under-absorbed by £40,000.

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Test your understanding 10

A business absorbs its fixed production overhead on the basis of
direct labour hours. The budgeted direct labour hours for week 24 were
4,200. During that week 4,050 direct labour hours were worked and the
production overhead incurred was £16,700. The overhead was under-
absorbed by £1,310.

What was the budgeted fixed overhead for the week?

A £14,840 B £15,960

C £17,320 D £18,680

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Stages in overhead absorption

1 2 3

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• Apportionment and Reapportionment

Beside production cost centres, company also has service cost centres
Production cost centres physically work on the cost unit. Service
cost centres support the production activities but do not physically work
on the cost unit.
If there is more than one service centre for which costs need to be
reapportioned, either:
1. Firstly reapportion service cost centre with the biggest costs,
2. Secondly reapportion the service cost centre which gives the
biggest proportion of its services to other service cost centres.

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• Stage 1:
Allocation is the process by which whole cost items are charged
direct to a cost unit or a cost centre.

Indirect materials, Indirect labors, Security

guard, Depreciation, Rent, etc.

Service Service Production Production

center center center center
Canteen Maintenance Machining Assembly

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• Stage 2:
Apportionment is a process whereby indirect costs are spread fairly
between cost centres.
Service cost centre costs may be reapportioned to production cost
centres by using one of the following methods:
• Direct method
• Step-down method
• Reciprocal method

Service Production
Center Center
(Canteen) (Machining)

Service Production
center Center
(Maintenance) (Assembly)

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Service cost reapportionment methods

• Direct
• Service Costs apportioned to production depts. only
• Step-down
• Service Costs apportioned to only some (not all) of other service
centres
• Repeated distribution (reciprocal)
• Service costs apportioned to both production and other service
centres. Service centres use each other’s services
• The results of the reciprocal method may also be obtained using
algebra and simultaneous equations.

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Service Production
Center Center
Interactions
(Canteen) (Machining)
between service
centers are
ignored and all Ignore
costs are Interraction
apportioned
directly
to production Service Production
centers. Center Center
(Maintenance) (Assembly)

Direct Method
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Service Production
Center Center
Once a service
(Canteen) (Machining)
center’s costs
are apportioned,
other service
center costs
are not
apportioned
back to it. Service Production
Center Center
(Maintenance) (Assembly)

Step-down Method
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Service Production
Center Center
Maintenance will
(Canteen) (Machining)
have a new
total to apportion
to production
centers; its
own costs plus
those costs
apportioned from Service Production
the Canteen. Center Center
(Maintenance) (Assembly)

Step-down Method
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Service Production
Center Center
(Canteen) (Machining)
Interdepartmental
services are given
full recognition
rather than partial
recognition as with
the step method. Service Production
Center Center
(Maintenance) (Assembly)

Because of its mathematical complexity,

the reciprocal method is rarely used.

Reciprocal Method
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Test your understanding 11

Service center Production center
Canteen Maintenance Machining Assembly
Dept cost before $360,000 $90,000 $400,000 $700,000
apportionment
No of employees 15 10 20 30
Maintenance hours 5,000 2,000 25,000 50,000

Service center Apportionment base

Canteen No of employees
Maintenance Time using

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Activity based costing

• A significant feature of many modern businesses is the
relatively high level of overhead costs in relation to total
costs. In this situation, the traditional absorption costing
system can create a problem for management seeking to
accurately identify unit costs and exert control over these
costs.
• ABC is a development of traditional absorption costing
which aims to establish a better way of relating overheads
to output. This should assist managers with cost control and
the analysis of profitability.

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Activity based costing

COST COST OF
CENTER ACTIVITY

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Test your understanding 12

Weaver Ltd prints weekly newspapers:

- The Crystal Courier: 40,000 copies in one production run per week

- The Palace Bugle: 25,000 copies in two production runs per week

Production run set-up costs = £2,150 per week

(a) Calculate overheads absorbed per newspaper using traditional

absorption costing. OAR is based on units produced.

(b) What do you think about the basis which was used to absorb
production run set-up costs?

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The following information relates to Brunti plc:

Products
XYI YZT ABW
Sales and production (units) 50,000 40,000 30,000
£ £ £
selling price per unit 45 95 73
Prime cost per unit 32 84 65
hours hours hours
machine department (machine hours per unit 2 5 4
assembly department (direct labour hours per unit) 7 3 2

Overheads allocated and apportioned to production departments (including service cost

centre costs) are expected to be recovered in product costs as follows:

Machine department at £1.20 per machine hour

Assembly department at £0.825 DLh

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The management accountant suggests that the overheads could be analysed into 'cost pools'
as follows:

Cost Pool £ Cost Driver quantity

machining services 357,000 machine hours 420,000
assembly services 318,000 direct labour hours 530,000
set up costs 26,000 set ups 520
order processing 156,000 customer orders 32,000
purchasing 84,000 supplier orders 11,200
941,000
The following estimates have also been provided;
XYI YZT ABW
number of set ups 120 200 200
customer orders 8,000 8,000 16,000
supplier orders 3,000 4,000 4,200

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Activity based costing

• Cost driver: Something which causes costs to change eg,
volume of output, number of production runs etc.
• Cost pool: A grouping of costs relating to a particular
activity in an activity-based costing system.

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Activity based costing

(2) (4)
(3)
Identify Calculate
Collect the
(1) the cost an activity
costs
Identify a drivers absorption
associated
business’ (the rate and
with each
major factors absorb
activity
activities causing overheads
into cost
activity into cost
pools
costs) units.

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Test your understanding 12

Weaver Ltd prints weekly newspapers:

- The Crystal Courier: 40,000 copies in one production run per week

- The Palace Bugle: 25,000 copies in two production runs per week

Production run set-up costs = £2,150 per week

Calculate overheads absorbed per newspaper using ABC costing.

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A costing method is designed to suit the way goods are

processed or manufactured or the way services are provided.

Chapter 3 looks at:

• Job costing

• Batch costing

• Contract costing

• Process costing

• Other approaches to cost management

Costing methods
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Jobs costing
A job is a cost unit which consists of a single order or contract.
• Job costing has the following features:
• Work is undertaken to customers' special requirements.
• Each order is of short duration.
• Jobs are usually individual and separate records should be
maintained on an individual job costing sheet.

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Examples of businesses that use job costing

• Plumbers
• Builders
• Engineering company
Also used in the service industry
• Accountancy firms
• Law firms

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Test your understanding 1

Which of the following companies would be likely to use job-
order costing?
a. Scott Paper Company for Watersilk.
b. Architects.
c. Heinz for ketchup.
d. Queen Bee for a wedding reception.
e. Bason (Builder of commercial fishing vessels.)

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Direct material issues

Direct labour cost
LIFO, FIFO, WAC

Job costing sheet

Production overhead
costs
Absorbed

Procedure of Job costing

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Batch costing
A batch can be defined as a cost unit which consists of a separate,
readily identifiable group of product units which maintain their separate
identity throughout the production process.
• Example: Footwear, Baked goods and clothing manufacturing
industries.
• For costing purposes, each batch can be looked at as a separate job
where the selling price of a batch is calculated by adding a profit to the
cost of the batch.
Total batch costs
Cost per = -------------------------------------------------
unit Number of units made in the batch

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Contract costing
Contract costing is appropriate for specific one-off jobs of relatively
long duration e.g. building a hospital.
Contract cost includes prime cost, allocated overheads and absorbed
overheads.

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Test your understanding 2

Select the costing method which would be most appropriate in each of
the following industries:
Paint manufacture Baking bread
A Job I Job
B Batch J Batch
C Contract K Contract
D Other L Other
Garden design Bridge construction
E Job M Job
F Batch N Batch
G Contract O Contract
H Other P Other

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Process costing
Process costing is used in businesses where identical items are
produced continuously and therefore costs cannot be traced to individual
units of production or batches.
Fearture of process costing:
All costs, direct or indirect, incurred during the period are charged to
each process so that a total process cost for each is obtained.
The total process cost of each process is then shared equally among all
cost units processed in that process

Total process cost incurred during period

Cost per unit = ----------------------------------------------------------
Total units processed during the period

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Direct material cost

Process Finished
Direct labour cost Process 1
N output

Overhead

Additional cost
(Material, Labour, Overhead)

Procedure of Process costing

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Test your understanding 3

Which of the following companies would be likely to use
process costing?
a. Scott Paper Company for Watersilk.
b. Architects.
c. Heinz for ketchup.
d. Queen Bee for a wedding reception.
e. Bason (Builder of commercial fishing vessels.)

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Test your understanding 4

Select the costing method which would be most appropriate in each of
the following industries:
Paint manufacture Baking bread
A Job I Job
B Batch J Batch
C Contract K Contract
D Process L Process
Garden design Bridge construction
E Job M Job
F Batch N Batch
G Contract O Contract
H Process P Process

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Other approaches to cost management

• Life cycle costing
Life cycle costing tracks and accumulates actual costs and revenues
attributable to each product over its entire life cycle. The life cycle runs
from research and development through to withdrawal from the market.
Analysing the life cycle cost avoids decisions being made solely on
initial costs.

• Target costing
Market research is conducted to estimate the price customers would
be willing to pay to allow the business to achieve the required market share.
The required profit is deducted from this price to generate the target cost.

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• Just in time (JIT )

Just in time is an approach to operations planning which aims
for goods and services to be produced exactly when they are needed.
Therefore zero inventory is held, but the customer does not have
to wait. This is desirable because holding inventory is expensive
(storage costs, insurance, risk of obsolescence).
Operational requirements for the JIT system include:
High Quality Speed
Reliability Efficient production planning
Reliable sales forecasting

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