Block 5 Introduction To Costing S

5.
Introduction to Management
Accounting and Costing
Trefor McElroy
September/October 2017
Voettekst van presentatie

LEARNING OUTCOMES
(a) to (c) You should be able to:
Examine the nature of management accounting
Discuss the importance of costs (for

decision-making) including the concepts of
marginal and opportunity cost.
Distinguish between fixed cost and variable

cost and use this distinction to explain the
relationship between cost, volume and profit
Calculate break-even points and discuss their

usefulness
Introduction to Management Accounting
3
Management and financial accounting compared
Management accounting Financial accounting
Nature of the
reports produced Tend to be specific purpose Tend to be general purpose
Level of detail Often very detailed Usually broad overview
Regulations Subject to accounting

Unregulated
regulation
Reporting As short as required

interval Usually annual or bi-annual
by managers
Uses projected future

Time horizon information as well as past Almost always historical
information
Range and quality Contains financial and non- Focus on financial
of information financial information. Uses information. Emphasis on
information that cannot be objective, verifiable
verified evidence
Accounting information system.
Information identification
Information collection and recording
Information analysis (including risk)
Information reporting
Aspects of a management accounting system
Developing long- Performance

term plans and evaluation and
strategies control
Management
accounting
system
Determining
Allocating
costs and
resources
benefits
Source: Atrill and McLaney (2006)

The Goal of Good Management is to Create Value
• Cost Management is applying the value criteria to every

decision we make, every activity we perform, and every
process we complete.
• Modern accounting systems do not just evaluate good
stewardship but must provide managers with the
information managers need to improve value.
• Management accounting systems are used to enhance
both decision making and management control.
• Management accounting systems do not need to be
perfect, but should be support decisions which increase
value.
Definition of cost
The amount of resources, usually

measured in monetary terms, sacrificed
to achieve a particular objective
Future income streams for airlines?
Classifying costs to help in decision-making
1. Cost behaviour with activity – classify costs between fixed and

variable
2. Cost relationship with the activity

– classify costs between direct and indirect
Cost behaviour
Cost – volume – profit analysis and break-even
13
The behaviour of costs
Costs may be broadly

classified as:
Those that stay fixed (the

same) when changes occur
Fixed to the volume of activity
Those that vary according

Variable to the volume of activity
The relationship between fixed cost, variable cost and total cost
Fixed Variable
cost cost
Total (or full) costs

Graph of fixed cost against the volume of activity
Cost
(£)
0
Volume of activity (units of output)
Graph of rent cost against the volume of activity
Rent
cost
(£)
0 Volume of activity
Graph of variable cost against the volume of activity
Cost
(£)
0 Volume of activity
Graph of total cost against volume of activity
Cost
(£) Total cost
Variable
costs
F
Fixed costs
0
Break-even chart
Total sales
Cost revenue
(£)
Break even
point of it
Pr
Total cost
Variable
s costs
Los
F
Fixed costs
0
Break-even formulae
Contribution = Sales revenue – VC

(This can be calculated as a total, or per unit)
B/E point in units = FC .
Contribution per unit
Margin of safety = Actual output – B/E output

B/E output (although actual output is sometimes used
Contribution margin = Contribution

Sales revenue
B/E point in € = Fixed costs .
Contribution margin
Cottage industries – how to calculate break-even
FC £500 a month
VC per basket – materials £2
- labour 1 hour @ £10 /hour
Selling price £14
B/E units
Contribution per unit = SP – VC = 14 – (2+10) = 2
B/E = FC = £500
contribution per unit £2
= 250 baskets a month
B/E £
Contribution margin ratio = 2/14 = 14.3%
B/E = . FC . = £500 = £3,496 (= 250 x £14)
contribution margin 0.143
Break-even charts for Cottage Industries’ basket-making activities
5
Cost Break-even
(£000) point Total
4
costs
2
Total
1 revenue
Fixed costs
0
100 200 300 400 500
Volume of activity (number of baskets)
They have the option to rent a machine fixed rate
Cottage industries – new option
£2,500/month. This would reduce labour to ½ hour
per basket.
New B/E
New fixed £(500 + 2,500) = £3,000
New contribution £14 – (£2 + £5) = £7
B/E = £3000/£7 = 429 baskets per month
24
Break-even chart for Cottage Industries’ basket-making activities (b) with the
machine
Cost
(£000)
6 Total
costs
5
Break-even
4 point
3
Fixed costs
2
Total
1 revenue
0
100 200 300 400 500 600
Volume of activity (number of baskets)
Break-even points and load factors for Ryanair
100%
80 82 81 82 83 82 82
79
73 72
67 70 70
60
%
40
20
0 2008 2009 2010 2011 2012 2013
Break- Load
Source: Based on information contained in the Ryanair Holding plc Annual Report 2013.
even factor
Operational leverage
• What happens to profit if sales increase by 10% from 500 units sold
to 550 units sold under the two options?
• With the machine
b) Profit original 10% increase in sales
Sales (500 x £14) £7,000 £7,700 10% increase
Materials (500 x £2) (1,000) (1,100)
Labour (500 x £5) (2,500) (2,750)
Contribution 3,500 3,850
Fixed costs 3,000 3,000
Profit (EBIT) 500 850 70% increase
• Without the machine

b) Profit original 10% increase in sales
Sales (500 x £14) £7,000 £7,700 10% increase
Materials (500 x £2) (1,000) (1,100)
Labour (500 x £10) (5,000) (5,500)
Fixed costs 500 500
Profit (EBIT) 500 600 20% increase
With the machine
A 10% increase in sales produced a 70% increase in profit with the

extra fixed cost of renting the machine.
Without the machine

A 10% increase in sales produced a 20% increase in profit
This effect of fixed costs exaggerating changes in sales

revenue on profit is known as operating leverage.
Operating leverage
The higher the fixed costs, the greater profit will

change relative to any change in sales revenue.
The operating leverage can be calculated as follows:
Contribution
EBIT
With the machine this = 3500/500 = 7 times
Without the machine this = 1000/500 = 2 times
30
The problem of too much fixed cost.
• Shares in aerospace group Rolls-Royce sank 19.6% after it warned "sharply weaker
demand" would hit profits.
• Job losses among its 2,000 senior managers.
• It has previously announced 3,600 job cuts across the group.
• Announcement that dividend payments could be cut.
• Shares in Rolls-Royce were down 130.5p at 536.5p. The company's shares have now
nearly halved since April.
Mr East, who is carrying out a structural review of the business, added Rolls-Royce
carried "too much fixed cost" and was "inflexible in managing this in response to changes
in market conditions".
He is looking for annual cost savings of between £150 and £200m.
Keith Bowman, equity analyst at Hargreaves Lansdown stockbrokers, said yet another
profit warning from Rolls had "shocked investors", adding that the review of its
shareholder payments policy was "a major negative".
http://www.bbc.co.uk/news/business-34795769 November 2015

Airbus A380 still to break even
Airbus launched the project to build a new super-jumbo A380 in 2000.

The cost break-even point for the A380 is now believed to be standing
at as high as 420 units (from 270 initially) as a result of delays in
production and detrimental currency fluctuations between the euro and
the US dollar.
Development costs $25bn
Price per plane around $440m
May 2016 Current orders + deliveries 320
Margin of safety
There are a number of different definitions but this one is commonly

used.
Margin of safety (%) = (Output – B/E point) x 100

B/E point
Margin of safety for Cottage Industries
Cottage Industries are selling 500 baskets per month.

The B/E is 429 baskets renting the machine (see previous
calculation)
Using the formula, the margin of safety can be
calculated as follows:
(500 – 429)/ 429 = 16.6%
i.e the firm is selling 16.6% above b/e
Without the machine, FC are lower and b/e was calculated

at 250. This gives a margin of safety of
(500 – 250) / 250 = 100%
i.e the firm is selling 100% above b/e
Ryanair’s margin of safety
28 Margin of safety 720
Operating profit (in millions of euros)

Margin of safety (as a percentage of BEP)
Operating profit 718
26 660
683
24
600
22
22 540
20
537
480
18
488
420
16 17 17
402
14 15 360
12
300
12
10
240
8
180
6
120
4
93 60
2 3
0 0
2008 2009 2010 2011 2012 2013
Source: Derived from information contained in Ryanair Holdings plc 2013 Annual Report.
Profit target
We can use the b/e formula to calculate the output required
to meet a target profit.
e.g how many baskets would give Cottage Industries a

monthly profit of £1,000 under the two options?
Target profit in units = FC + target profit .
Contribution per unit
With machine (FC = £3,000) :

(£3,000 + £1,000)/£7 per unit = 571 baskets per month
Without machine (FC = £250)

(£500 + £1,000)/£2 per unit = 750 baskets per month
• That fixed costs remain constant
B/Evariable
• That Assumptions
costs increase in a linear fashion with output
• NB: The above can only hold true within limits:
– range of output (relevant range)
– period of time
37
Marginal costing focuses on costs and revenues which:
Costing for decision-making : Marginal Analysis
1. Will occur in the future (i.e they are not sunk costs)
2. Are incremental i.e they will only occur if the decision is made
A marginal costing statement shows

Sales
- all VC (production + selling/distribution)
= contribution
- all FC (both inside and outside the factory)
= Profit
38
Identifying relevant costs for decision-making
Does the cost relate to
the objectives of the No
business?
Yes
Does the cost relate to No

the future?
Yes
Does the cost vary with No

the decision?
Yes
Relevant Irrelevant cost

cost
The four key areas of decision making using marginal analysis
Determining the
Pricing/assessing
most efficient
opportunities to
use of scarce
enter contracts
resources
Marginal
analysis
Closing or
Make-or-buy
continuation
decisions
decisions
Maximising profit when there is a scarce resource
• A scarce resource is when there is a shortage or a supply problem

for a particular item which at any time or over a period may limit the
activity of an entity:
e.g. labour, materials, manufacturing capacity, financial resources
• It is assumed in limiting factor accounting that management wishes

to maximise profit and that profit will be maximised when
contribution is maximised.
• Therefore, contribution maximised by earning the biggest possible

contribution per unit of scarce resource, and the decision involves
the determination of the contribution earned by each different
product per unit of scarce resource.
41
Limiting Factor Decisions
Company makes 2 products - for which unit variable
costs are:
B S
£ £
Direct materials 1 3
Direct labour (£5 per hour) 10 5
Variable overhead 1 1
12 9
Sales price £18 £13
42
• During July the available direct labour is
limited to 8,000 hours
• Sales demand is expected to be
B 3,000 units
S 5,000 units
• Fixed costs are £20,000 for the month
• What production budget will maximise
profit?
43
1. Establish limiting factor
B S Total
Labour hours per unit 2 1
Sales demand (units) 3000 5000
Labour hours needed 6000 5000 11,000
Labour hours available 8000
Shortfall 3000 hrs
N. B. in this example, labour is a limiting factor

44
2. Identify contribution earned
B S
£ £
Sales price 18 13
Variable cost 12 9
Unit contribution 6 4
Labour hours per unit 2hrs 1hrs
Contribution per labour
hour £3 £4
45
3. Calculate Budgeted Production to Maximise Profit
Product Demand Hours Hours Priority for

Required Available Manufacture
S 5000 5000 5000 1st
B 3000 6000 *3000 2nd
11,000 8,000
* Balance
46
3. Calculate Budgeted Production to Maximise Profit
Product Units Hours Contribution Total
needed per unit
£ £
S 5,000 5,000 4 20,000
B 1,500 3,000 6 9,000
Less: Fixed costs 20,000
Profit 9,000
47
Two types of cost
Historic cost A cost already incurred
The value of an
Opportunity
opportunity forgone
cost
Accepting or Rejecting Orders
• e.g. Single product sells for £40
Variable Costs per unit £
Direct material 8
Direct labour (2 hours) 12
Variable overhead 4
Variable cost 24
Contribution 16
Fixed costs 10
Profit 6
An overseas retailer has offered to buy at £30 each.

As the total cost is £34 (VC£24 + FC£10), it looks like this offer
should be rejected.
What do you think?
49
Accepting or Rejecting Orders
If there is spare capacity, this offer should be accepted. Even though
total costs are £34, £10 of this is fixed, which have to be paid anyway.
As long as price covers the extra (variable) cost, profit will increase i.e
the decision depends on whether the order provides a contribution.
This one does : SP £30 – VC £24 = £6 per unit
Qualifications
• Will other customers be happy that you have sold at £30 to
overseas, but £40 to them?
• Could you have found another customer who would pay the full
£40?
• If there is no spare capacity, you must also take into account the
contribution you lose by transferring production to meet this order
50
Pricing Decisions
A garage buys a lorry for £10,000.
It requires a new engine costing £2,500 that will take 20 hrs to fit.
The technicians will be paid £15 per hour to fit the engine.
The technicians are short of work but the garage wishes to
retain
their services.
The lorry could be sold immediately for £9,000.
What is the minimum price the garage should charge

for the lorry after the engine has been fitted?
£
Opportunity cost of lorry 9,000
Cost of new engine 2,500
11,500
A garage buys a lorry for £10,000.
It requires a new engine costing £2,500 that will take 20 hrs to fit.
The technicians will be paid £15 per hour to fit the engine.
The technicians are busy and are charged out at £50 per hour.
The lorry could be sold immediately for £9,000.
What is the minimum price the garage should charge

for the lorry after the engine has been fitted?
£
Opportunity cost of lorry 9,000
Opportunity cost of technicians’ time 1,000
Cost of new engine 2,500
12,500
Shutdown Decisions - Illustration
•May relate to the problem of closing down a department or
factory, or of ceasing to make and sell an item of product
e.g. Company makes 4 products, A,B,C and D.
Budget for forthcoming year:
A B C D Total
£ £ £ £ £
Direct materials 5000 6000 4000 8000 23,000
Direct labour 4000 8000 6000 4000 22,000
Variable overheads 1000 2000 1500 1000 5500
10,000 16,000 11,500 13,000 50,500
Sales 20,000 15,000 14,000 20,000 69,000
Contribution 10,000 (1000) 2500 7000 18,500
Share of fixed costs 6000 4000 4000 2000 16,000
Profit/ (Loss) 4000 (5000) (1500) 5000 2500
53
•Any department that does not make a contribution should be closed
•e.g Close B and allocate B’s share of fixed costs between A,C and D in
the same proportion as their current share i.e 6:4:2
A C D Total
£ £ £ £
Direct materials 5000 4000 8000 17,000
Direct labour 4000 6000 4000 14,000
Variable overheads 1000 1500 1000 3,500
10,000 11,500 13,000 34,500
Sales 20,000 14,000 20,000 54,000
Contribution 10,000 2500 7000 19,500
Share of fixed costs 8000 5333 2667 16,000
Profit/ (Loss) 2000 (2833) 4333 3,500
54
Do not close down C even though it is making an accounting loss.
The important thing is that C is making a contribution. If it is closed, C’s
share of fixed costs will have to be redistributed between A and D. In
this case what is left of the business will make £2,500 less profit .
The example below splits C’s share of fixed costs A:D = 3:1
A D Total
£ £ £
Direct materials 5000 8000 13,000
Direct labour 4000 4000 8,000
Variable overheads 1000 1000 2,000
10,000 13,000 23,000
Sales 20,000 20,000 40,000
Contribution 10,000 7000 17,000
Share of fixed costs 12,000 4000 16,000
Profit/ (Loss) (2000) 3000 1,000
55
Make or buy
Shah needs a component for it’s machines.
It can buy from an outside supplier for £20, or make the component
itself for £15 variable cost.
Decision It’s cheaper for Shah to make the component itself.
After a while, Shah no longer has spare capacity to make this

component. If it does use resources to make it, it will have to stop other
production which provides a contribution of £12 per component.
Decision There is now an opportunity cost of £12 per unit in addition to

the other variable costs of £15 = £27. It is now cheaper to buy from a
supplier
56
Summary
• Management accounting is used to assist decision-
making
• Costs can be split into fixed and variable – according to

their behaviour
• Break-even points are a risk factor
• Fixed costs exaggerate the effect on profit of changes in

revenue
• Marginal costing techniques can improve decisions
57
Absorption and Variable (Marginal) Costing
Preparation of Income Statements
58
Absorption and Variable Costing
The only cost of driving my car

on a 200 mile trip today is
$12 for gasoline.
Variable
Costing
No! You must consider these costs too!

Cost Per month Per day
Car payment $ 300.00 $ 10.00
Insurance 60.00 2.00
Absorption
Costing
You are wrong. I have the car

payment and the
insurance payment even if
I do not make the trip.
Variable
Costing
Who’s right?
How should we treat the car
payment and the insurance?
Direct and indirect cost
Categories
of cost
Cost that can be identified with

specific cost units – the effect of
Direct cost the cost can be measured in
respect of each particular output
All other elements of cost: that

Indirect cost is, those that cannot be directly
or measured in respect of each
overheads particular unit of output
The relationship between direct cost and indirect cost
Direct cost Fair share of

indirect cost
of the job
(overheads)
Full cost of the job

Full cost
Direct Material (steel, aluminium, chemicals etc.)
plus
Direct Labour (machinists, painters etc.)
plus
Direct Expense (energy, consumables, dep’n(?))
and
Overheads (supervision, factory rent, cleaners etc.)
e.g. indirect materials & indirect labour
Overheads have to be allocated to units produced

Variable and fixed manufacturing overhead
Overheads are costs that apply to a range of output, not just a

specific item of production.
Variable manufacturing overhead includes the cost of utilities

(such as electricity), maintenance of machinery, depreciation,
office supplies, packaging, printing, advertising etc
(N.B some of these of course can have an element of fixed
expense i.e they will occur regardless of the level of production
output)
Fixed manufacturing overhead includes rent, lease payments,

insurance, supervisor salaries
66
Absorption Variable
Costing Costing
Direct Materials (variable)
Direct Labour (variable)

Product
Product Costs
Costs Variable Manufacturing Overhead
Fixed Manufacturing Overhead
Variable Selling and Administrative Expenses

Period
Period Costs
Costs Fixed Selling and Administrative Expenses
Note: Manufacturing Cost Flows
Balance Sheet Income
Costs Inventories Statement
Material Purchases Raw Materials Expenses
Direct Labor
Work in
Variable i ng Process
Manufacturing c o st
n
Overhead
r p ti o
bs o Cost of
Fixed A Finished
Goods
Manufacturing Goods
Overhead Variable Sold
c osting
Selling and Selling and
Administrative Period Costs Administrative
Before, an example, a reminder of the difference between marginal and absorption
costing
•Marginal costing
•Fixed production/manufacturing overhead is taken directly to the

P&L a/c. These costs do not form part of the cost per unit for stock
valuation purposes
•Absorption costing
•Fixed production/manufacturing overhead is apportioned across all

production units and included in stock values
•There will therefore be a difference in profit between the two

systems due to the way stock is valued
Absorption and marginal costing – an example
• Direct variable cost per unit = £7
• Selling price per unit = £20
•
• Opening stock = 1000 units
• Budgeted production = 8000 units per month
• Fixed production overhead = £40,000
• Budgeted production overhead per unit = ?

•
• Actual sales and production (units)
•
• Month 1Month 2 Month 3
• Opening stock 1000
• Production 9000 8000 7000
• Sales 6000 8000 8000
• Closing stock ? ? ?
•
• During this period all costs and revenues were in line with budget
• Requirements
• Produce P&L a/cs for each of months 1-3 using total absorption costing and
• marginal costing
Example
•Calculation of Budgeted fixed production overhead per unit
•= (£40,000/ 8000)
•= £5
•Calculation of closing stock

•Actual sales and production (units)
•
• Month 1 Month 2 Month 3
•
•Opening stock1000 4000 4000
•Production 9000 8000 7000
•Sales 6000 8000 8000
•Closing stock4000 4000 3000
•
• During this period all costs and revenues were in line with budget
•Requirements
•Produce P&L a/cs for each of months 1-3 using total absorption costing and
•marginal costing
Solution – total absorption costing
• Month 1 Month2 Month3

• £000 £000 £000 £000 £000 £000
•
• Sales
•
• O stock
•
• V prod’n costs
• F prod’n costs
•
• C stock
• ____ ____ ____ ____ ____ ____
• Net profit
• ____ ____ ____
•

• £000 £000 £000 £000 £000 £000
•
• Sales (£20)
•
• O stock (£12)
•
• V prod’n costs (£7)
• F prod’n costs (£5)

•
• C stock (£12)
• ____ ____ ____ ____ ____ ____
• Net profit
• ____ ____ ____
•

• £000 £000 £000 £000 £000 £000
•
• Sales (£20) 120
•
• O stock (£12) 12
•
• V prod’n costs (£7) 63
• F prod’n costs (£5) 45

•
• C stock (£12) (48) (72)
• ____ ____ ____ ____ ____ ____
• Net profit 48
• + F prodn over absorbed
• (45 absorbed – actual 40) 5
• Profit for period 53

•
Solution using marginal costing
• £000 £000 £000 £000 £000 £000
•
• Sales
•
• O stock
•
• V prod’n costs
•
• C stock
• ____ ____ ____ ____ ____ ____
•
• Contribution
•
• ____ ____ ____ ____ ____ ____
•
• Net profit ____ ____ ____
• £000 £000 £000 £000 £000 £000
•
• Sales (£20)
•
• O stock (£7)
•
• V prod’n costs (£7)
•
• C stock (£7)
• ____ ____ ____ ____ ____ ____
•
• Contribution (£13)
•
• ____ ____ ____ ____ ____ ____
•
• Net profit ____ ____ ____
• £000 £000 £000 £000 £000 £000
•
• Sales (£20) 120
•
• O stock (£7) 7
•
• V prod’n costs (£7) 63
•
• C stock (£7) (28) (42)
• ____ ____ ____ ____ ____ ____
•
• Contribution (£13) 78
•
• F prod’n costs (40)
• ____ ___ ____ ____ ____ ___
•
• Net profit 38
• ____ ____ ____
Reconciliation

• £000 £000 £000
• MC profit 38 64 64
• TAC profit 53 64 59
• Difference 15 0 (5)
• = stock movement
• 3000 x £5 0 x £5 -1000 x £5
• @ £5 pu
Summary
• If production > sales then
• TAC profit > MC profit
•
• If production = sales then
• TAC profit = MC profit
•
• If production < sales then
• TAC profit < MC profit
Summary
Relation between Effect Relation between

production on variable and
and sales inventory absorption income
Inventory Absorption
Production > Sales increases >
Variable
Inventory Absorption
Production < Sales decreases <
Variable
Absorption
Production = Sales No change =
Variable
Comparison
• Absorption costing
•
• provides estimate of full unit cost useful for stock valuation (in line with
IAS 2)
•
• provides estimate of full unit cost for pricing purposes
•
• Marginal costing
•
• useful for decision making (capacity) decisions
•
•
• Therefore, DIFFERENT TECHNIQUES FOR DIFFERENT PURPOSES,
there is no right or wrong.
•
•
Uses of full cost by managers
Assessing
relative
efficiency
Pricing and Uses of full Exercising

output cost control
decisions
Assessing
performance
Deriving the full cost of the sail made by Marine Suppliers Ltd
in Activity 8.6
Overheads
Apply the
Ascertain the Derive a suitable overhead
total overheads overhead absorption rate
for Marine absorption rate (based on the
Suppliers Ltd for for the business specifics of the
the period as a whole job, for example,
direct labour
hours)
A particular
sail (job)
Direct costs
Direct labour Direct materials

Cost of direct labour Cost of the direct materials to
for the sail make the sail
A cost unit (Job A) passing through Autosparkle Ltd’s process
Preparation Paintshop Finishing Customers

department department department
Job A
Cost accumulated
* Direct
* Any further * Any further
materials
direct cost direct cost
* Direct
* A share of * A share of Full cost
labour
* A share of + the
Paintshop
+ the
Finishing
= of the job
the
department’s department’s
Preparation
overheads overheads
department’s
overheads
Traditional overhead cost absorption
Jasmine Ltd has a cost centre where 2 products are made – A and B
Total overhead for this cost centre is :
Machine set-up costs €800 + Inspection costs €200 = €1,000.
This overhead is absorbed on the basis of direct labour hours (DLH).
Total DLH = 150 for A + 50 for B = 200
How much overhead will be absorbed by each product?
Absorption rate = €1,000 total overhead / 200DLH = €5 per DLH
Thus product A is charged with 150 x €5 = €750 overhead

And product B is charged with 50 x €5 = €250 overhead
85
Overhead absorption using ABC
Jasmine Ltd has a cost centre where 2 products are made – A and B
Total overhead for this cost centre is :
Machine set-up costs €800 + Inspection costs €200 = €1,000.
ABC allocates according to the activities that caused the overhead costs – in
this case, machine set-ups and inspections (these are known as the cost
drivers)
Assume that the machine for product A only needs to be set up once, whereas
the machine for product B needs to be set up 9 times.
Both products require 2 inspections each.
There are a total of 10 machine set-ups = €80 each

There are a total of 4 machine inspections = €50 each
Total overhead charged for A = (1 x €80) + (2 x €50) = €180

Total overhead charged for B = (9 x €80) + (2 x €50) = €820
86
Activity-based costing (ABC) – what drives the costs
Identify:
Each support activity involved

in making products/services
The costs attributed to each

support activity
The factors that cause a change

in these costs (cost drivers)
Activity-based costing – attributing overheads
Establish an overhead cost pool for

each activity
Allocate the total cost of each support

activity to the relevant cost pool
Charge the total cost in each pool to

output using the relevant cost drivers
Example of ABC
Activity Cost Pools Activity Cost Drivers

Purchasing Department Number of Purchase Orders
Receiving Department Number of Purchase Orders
Materials Handling Number of Materials
Requisitions
Setup Number of Machine Setups
Required
Inspection Number of Inspections
Personnel Processing Number of Employees Hired
or laid off
Credit checks Number of credit checks
Customer service Number of service calls, or
warranties
Process customer orders Number of orders
Marketing No. of advertisements
Swann Ltd
a) i) Summary of unit costs using existing method
• Direct labour hours

•
• X 2000 x 24/60 = 800
• Y 1500 x 40/60 = 1000
• Z 800 x 60/60 = 800
• ____
• 2600 hrs
• ____
•
• Total overhead = £15600 + £19500 + £13650 = £48750
•
• Therefore Overhead rate per hr = £48750/ 2600 = £18.75
Summary Unit costs
• X Y Z
• £ £ £
•
• Direct material 5.00 3.00 6.00
• Direct labour 4.80 8.00 12.00
• Overhead
• (£18.75 per hr) 7.50 12.50 18.75
• ____ ____ ____
• 17.30 23.50 36.75
• ____ ____ ____
•
Summary of unit costs using ABC
X Y Z
• £ £ £
•
• Direct labour 4.80 8.00 12.00
• Overhead – MRI
• Power
• MH
• ____ ____ ____
•
•
• ____ ____ ____
•
a ii) Using ABC
• Material Receipt and Inspection
•
• No of batches = 31
•
• Cost per batch = £15600/ 31 = £503.23
•
• Unit cost
• X: 503.23 x 10 / 2000 = £2.52
• Y: 503.23 x 5 / 1500 = £1.68
• Z; 503.23 x 16 / 800 = £10.06
• Power
•
• Total drill operations = 12000 + 4500 + 1600 = 18100
•
• Cost per operation = £19500 / 18100 = £1.077
•
• Unit costs
• X: 6 x £1.077 = £6.46
• Y: 3 x £1.077 = £3.23
• Z: 2 x £1.077 = £2.15
• Material handling
•
• Total sq metres = 8000 + 9000 + 2400 = 19400
•
• Cost per sq metre = £13650 / 19400 = £0.704
•
• Unit cost
• X: 4 x £0.704 = £2.81
• Y: 6 x £0.704 = £4.22
• Z : 3 x £0.704 = £2.11
Summary of unit costs using ABC
• X Y Z
• £ £ £
•
• Direct labour 4.80 8.00 12.00
• Overhead – MRI 2.52 1.68 10.06
• Power 6.46 3.23 2.15
• MH 2.81 4.22 2.11
• ____ ____ ____
•
• 21.59 20.13 32.32
• ____ ___ ____
•
Advantages of ABC
• more accurate reflection of true effort put into each
product (ie less arbitrary than absorption costing)
• therefore better basis for pricing
• It can apply to both production overhead and support
service overhead, such as the marketing dept, finance,
IT, HR etc etc
• better basis for cost management (ie cost reduction)
•
• BUT
•
• Greater information needs means more time consuming
and expensive to apply
Activity Based Management
- Customer profitability models
• Rarely include costs beyond direct cost of sales

• Rarely include cost to acquire the customer or cost to retain
and serve customer after transaction is complete
• Customer lifetime value = customer lifetime revenue –
customer lifetime costs
Costs of managing customers
Phone support
Visits
Delayed payments
Number of invoices to be sent to them … and reminders
Delivery costs
Customer Lifetime Costs
• Cost to Acquire – ABM identifies the cost of all major customer
(re)acquisition activities
• Cost to Provide – ABM identifies the costs of activities/support
services delivered to the customers
• Cost to Retain – ‘After sales’ costs
Value segmentation of customers
• Champions – high revenue/low cost – loyal, regular, high-
margin, relatively easy to serve.
• Demanders – high revenue/high cost – make heavy
uncompensated use of your resources.
• Acquaintances – low revenue/low cost – low profit but demand
little so hate to lose.
• Losers – low revenue/high cost – Drain valuable resources yet
from the organisation yet provide little return.
Summary of direct and indirect costs
• Costs can be split into direct or indirect (overhead)

• Overheads can be allocated or apportioned to cost centres
• Apportioning requires a basis of apportioning
• Activity based costing (ABC) focusses on the activity when
apportioning overhead.
10

Block 5 Introduction To Costing S

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Block 5 Introduction To Costing S

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5.

Voettekst van presentatie

Examine the nature of management accounting

Discuss the importance of costs (for

Distinguish between fixed cost and variable

Calculate break-even points and discuss their

Management accounting Financial accounting

Level of detail Often very detailed Usually broad overview

Regulations Subject to accounting

Reporting As short as required

Uses projected future

Information collection and recording

Information analysis (including risk)

Developing long- Performance

Source: Atrill and McLaney (2006)

• Cost Management is applying the value criteria to every

The amount of resources, usually

1. Cost behaviour with activity – classify costs between fixed and

2. Cost relationship with the activity

Cost – volume – profit analysis and break-even

Costs may be broadly

Those that stay fixed (the

Those that vary according

Total (or full) costs

Contribution = Sales revenue – VC

B/E point in units = FC .

Contribution per unit

Margin of safety = Actual output – B/E output

Contribution margin = Contribution

B/E point in € = Fixed costs .

0 2008 2009 2010 2011 2012 2013

• Without the machine

With the machine

A 10% increase in sales produced a 70% increase in profit with the

Without the machine

This effect of fixed costs exaggerating changes in sales

The higher the fixed costs, the greater profit will

With the machine this = 3500/500 = 7 times

Without the machine this = 1000/500 = 2 times

He is looking for annual cost savings of between £150 and £200m.

http://www.bbc.co.uk/news/business-34795769 November 2015

Airbus launched the project to build a new super-jumbo A380 in 2000.

There are a number of different definitions but this one is commonly

Margin of safety (%) = (Output – B/E point) x 100

Cottage Industries are selling 500 baskets per month.

Without the machine, FC are lower and b/e was calculated

Operating profit (in millions of euros)

e.g how many baskets would give Cottage Industries a

Target profit in units = FC + target profit .

Contribution per unit

With machine (FC = £3,000) :

Without machine (FC = £250)

A marginal costing statement shows

Does the cost relate to No

Does the cost vary with No

Relevant Irrelevant cost

• A scarce resource is when there is a shortage or a supply problem

• It is assumed in limiting factor accounting that management wishes

• Therefore, contribution maximised by earning the biggest possible

Labour hours per unit 2 1

Sales demand (units) 3000 5000

Labour hours needed 6000 5000 11,000

Labour hours available 8000