Unit 3

Costing and
accounting systems
Process Costing
Session 4
Introduction
 Process costing is used in those industries where the
end products are more or less identical. With this type
of costing, no attempt is made to allocate the cost to a
specific job or batch. Instead, the cost of an
individual order for a single unit of product can be
obtained by dividing the costs of production for a
particular period by the number of units produced
during that period.

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4.1 Process costing
 Process costing is used where production moves from one process to the
next until final completion. Process costing is applicable where it is not
easy to identify separate units of production, for example, food
manufacturing and oil refining.
 Process costing is a ‘form of costing applicable to continuous processes
where costs are attributed to the number of units produced. This may
involve estimating the number of equivalent units in stock at the start and
end of the period under consideration.’
 In comparison, job costing is used in cases where production is carried out
against specific orders, mainly to a particular customer’s specification. The
job acts as the cost unit charged. Under process costing, the procedure for
direct costs is the same as for job costing, but with materials and labor
being charged to the appropriate process. Process costing is easier to
operate than job costing because the detailed work of allocating costs to
many individual jobs or batches is unnecessary.

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4.1 Process costing (Cont’d)

 As you can see from Figure 7, as production moves from process to

process, costs are transferred with it. The costs of process A are transferred
to process B; process B costs are then added to this cost, and the resulting
total cost is transferred to process C; and finally, process C costs are then
added to the combined A and B costs. Therefore, the cost becomes
cumulative as production proceeds and the addition of the costs from
successive processes determines the total cost.

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4.1 Process losses
 In many processes, there is wastage from shrinkage, evaporation and
scrap.

 Normal and abnormal losses require a different treatment. The cost of

normal losses is absorbed by the units of output produced. Abnormal
losses are not included in the process costs but are treated as a general
overhead cost for the period.

 Abnormal losses arise as a result of factors that management ought to be

able to control and must be identified and investigated so that effective
management action is taken to prevent their recurrence.

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4.1 Process losses (Cont’d)
 Example – Page 43 & 44

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4.1 Joint products and by-products
 A joint product is a separate product resulting from the production of
another product manufactured simultaneously by a common series of
processing operations. For example, fuel, oil and synthetic rubber are the
joint products produced from processing crude oil.
Joint products are ‘two or more products produced by the same process
and separated in processing, each having a sufficiently high saleable value
to merit recognition as a main product.’

 A by-product is produced under the same conditions, but is essentially a

secondary result of the process, both in terms of quantity and value of
output. In furniture making, for example, by-products include sawdust and
wood shavings. A by-product is an ‘output of some value produced
incidentally while manufacturing the main product.’

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4.1 Joint products and by-products (Cont’d)

 A by-product has comparatively low value and is not

treated as a product in its own right. A joint product
is a separate product, of significant value, resulting
from the production of another product.

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4.1 Joint products and by-products (Cont’d)
 The physical measure method apportions process cost between products in
proportion to their volume, for example, weight. Each product is assumed
to consume similar amounts of the costs and is therefore charged with its
proportionate share of the total cost. This method assumes that the cost per
unit is the same for each of the products.

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4.1 Joint products and by-products (Cont’d)
 The net realisable value method apportions process costs between products
in proportion to their sales value (minus any further processing costs
necessary to enable them to be sold). Process costs are allocated to
products in proportion to their sales value, on the assumption that higher
sales value indicates higher costs.

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4.1 Joint products and by-products (Cont’d)
 A joint product is a separate product resulting from the production of
another product manufactured simultaneously by a common series of
processing operations. For example, fuel, oil and synthetic rubber are the
joint products produced from processing crude oil.
Joint products are ‘two or more products produced by the same process
and separated in processing, each having a sufficiently high saleable value
to merit recognition as a main product.’

 A by-product is produced under the same conditions, but is essentially a

secondary result of the process, both in terms of quantity and value of
output. In furniture making, for example, by-products include sawdust and
wood shavings. A by-product is an ‘output of some value produced
incidentally while manufacturing the main product.’

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4.2 Equivalent units
 Equivalent units are the result of expressing partly completed units in
terms of the stage of completion. To calculate equivalent units for a
process at the end of an accounting period, the number of incomplete units
is multiplied by the stage of completion at the end of the accounting
period.
 If the 2,000 partly completed units were 50 per cent complete, we could
express this as an equivalent production of 1,000 fully completed units.

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Activity 4.1
 On board, Page 46 & 47

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Activity based costing
Session 5
Introduction
 Activity based costing is a system that traces indirect
costs to products by allocating indirect costs to
activities and then to products based on each
product’s usage of the activities. Non-volume related
activities may include materials handling, materials
procurement, machine set-ups, production scheduling
and quality inspections.

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5.1 Activity based costing
 Knowing how different activities interact to create products
allows managers more accurately to trace indirect costs to
products. To simplify the analysis of the different
organisational activities, indirect product costs are divided
into four types as outlined below.

 Unit level costs are costs that vary with the number of units
produced. Certain activities and their associated costs increase
with the number of units produced. For example, the cost of
operating a machine increases with the number of units
produced owing to wear on the machine parts. These indirect
costs could be translated into direct labour hours or machine
hours.

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5.1 Activity based costing (Cont’d)
 Batch level costs are associated with batches. A batch consists
of multiple units of the same product that are processed
together. As a batch moves through a manufacturing process,
machinery must be set up and adjusted to produce the
particular product in the batch.
The resulting down-time and associated work can be costly.
Smaller batch sizes and production of dissimilar items means
more set-ups and higher set-up costs. Batch level costs are
fixed with respect to the number of units in the batch, but vary
with the number of batches.

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5.1 Activity based costing (Cont’d)
 Product level costs arise from activities to support the
production of the product. For example, engineering support
costs (maintaining a bill of materials and a routing sheet) for
product production depend on the product line and do not vary
with the number of units or number of batches produced.

 Facility level costs cannot be identified with a particular unit,

batch or product. Facility level costs are fixed with respect to
the number of units, batches and products produced. For
example, the factory general manager’s salary is not
associated with any particular unit, batch or product so her/his
costs cannot be traced to products.

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5.1 Activity based costing (Cont’d)
 Activity based costing (also referred to commonly using the
acronym ABC) is an approach to absorption costing based on
the notion that it is activities that drive costs and, therefore,
activities should be the basis for allocating such costs.

 A single measure of volume is normally used for allocating

costs to each product or service in traditional indirect cost
absorption, for example:
machine hours - direct labour hours - direct material cost -
direct labour cost.

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5.1 Activity based costing (Cont’d)
 Cost drivers are the factors that cause costs to be incurred. A
cost driver is an activity that generates cost. It may be related
to, or example:
 A particular machine’s running costs – where the cost is

driven by production volume and the cost driver is volume

based, for example, machine hours.
 Quality inspection costs – where the cost is driven by the

number of times the relevant activity occurs and the cost

driver is transaction based, for example, the number of
inspections.

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5.1 Activity based costing (Cont’d)

 Activity based costing systems provide a more precise

analysis of indirect costs, which can potentially improve the
quality of management decision making and cost control.
However, ABC systems are more complex and hence costly to
implement and maintain.

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5.2 An example of activity based costing

 On Board, Page 52 & 53

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5.3 Customer account profitability analysis
 There appears to be a growing tendency for companies to seek
competitive advantage by applying customer focused
strategies.

 Customer profitability analysis uses the customer or market

segment as the unit of analysis (i.e., the cost object) rather
than the product, as many costs in an organisation are driven
by customers rather than products. Cost drivers include supply
and delivery patterns, customer locations, quality, after sales
service levels, sales and promotion effort and the level of
discounts allowed.

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5.3 Customer account profitability analysis
(Cont’d)
 Customer profitability can be defined as the difference
between the revenues earned from and the costs associated
with the customer relationship during a specific period.

 It is important to distinguish high profit customer relationships

from low or unprofitable relationships, for the company to
react appropriately and improve overall profitability.

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5.3 Customer account profitability analysis
(Cont’d)
 The aim is to pin-point unprofitable customers and either stop
doing business with them, modify the service provided to
them or re-negotiate prices charged to them. However, care
must be taken not to apportion non-avoidable fixed costs
among customer groups. If this is done, every time an
unprofitable customer is identified and dropped, the total costs
will simply be re-apportioned over fewer customers, which
may then indicate another loss maker, and so on until no
customers remain.

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5.3 Customer account profitability analysis
(Cont’d)
 Knowledge of potential customers is another important and
difficult aspect of management decision making.

 The concept of lifetime analysis extends the basic customer

profitability analysis approach to incorporate the future
profitability projected to accrue over the lifetime of the
customer relationships. The practice focuses on all anticipated
future revenue streams and costs involved in servicing a
particular customer.

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5.4 Benefits of activity based techniques
 Integration of ABC into a budgetary system provides
more detailed information about overhead costs and
reveals inefficiencies in spending for specific
overhead resources. Activity based budgeting
determines which activities incur costs within an
organisation and informs decisions as to how much of
the total budget should be allocated to each activity.

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5.4 Benefits of activity based techniques (Cont’d)
 The activity based approach recognises that it is not only the
number of units produced that can affect the costs incurred in
production.
Re-setting machines, be it for a single unit or for a long
production run, incurs similar costs. Re-designing products
leads to a chain reaction of additional costs, from having to re-
draw the product specification to sourcing and ordering new
parts into raw material inventories.

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5.4 Benefits of activity based techniques (Cont’d)
 Activity based costing relies on historical data and therefore
shares with many other aspects of accounting the
disadvantages of being a backward looking measure which
must be used with caution in forward looking decisions.
 Furthermore, activity based costing requires detailed
accounting records and a well structured cost coding system
so that costs are allocated correctly to activities and from there
to products.

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5.4 Benefits of activity based techniques -
Activity based budgeting (ABB)
 Activity based budgeting developed from the logic that, if the
business is being viewed as a collection of activities instead of
departments, then the budget should be adapted to reflect this.

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5.4 Benefits of activity based techniques -
Activity based management (ABM)
 Activity based management (ABM) describes the
management and control of organisational performance using
activity based costing information. The aim is to control
causes of costs directly. Managing cost drivers will manage
costs in the long term.
 ABM represents the set of actions that management can take

to increase profitability, using activity based costing

information. The actions can include:
 making operational improvements to high cost processes

 modifying product mix or prices

 restructuring customer relationships.

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5.4 Benefits of activity based techniques -
Activity based management (ABM) (Cont’d)
 ABM extends ABC by analysing the management of
activities, instead of simply analysing the costs of activities.
ABM connects ABC to the strategy of the organisation. ABM
achieves its double goals of customer and shareholder value
primarily though the analysis of activities along the value
chain.
 The value chain analysis identifies those activities that affect
the value received by a customer from purchasing the
organisation’s products or services. Those activities that add
value to the customer are called value added activities.
 The value added activities are described in the value chain
analysis of an organisation.

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5.4 Benefits of activity based techniques -
Activity based management (ABM) (Cont’d)
 Organisations also perform activities that do not add value.
These activities are called non-value added activities. Non-
value added activities do not have any effect on customer
value.

 Many administrative activities have no direct effect on

customer satisfaction. Therefore, the measurement of non-
value added activities may give some indication of where
costs for an organisation could be reduced.

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