Management Accounting:

Decisions and Control

Chapter 1 and 9
Costing Techniques and Activity
Based Costing
What is Management Accounting?

• Concerns with resource usage to meet targets of

the company
• Deals with short term timescales
• Accounts for transactions that relates to the day-
to day running of the business
 Information needed by the
Manufacturing Organisation
• Set selling price
• Determine quantities for production
• Continue of discontinue a product
• Control cost
• Control production process
• Appraise the performance
• Understand the type and nature of cost
 The Purpose of Costing
• Enables managers to know the cost of output and be able to set
up a selling price

• Collect information about costs and use it for decision making,

planning and control

• The managers of an organisation can use this cost to:

 determine a SELLING PRICE

 VALUE INVENTORY/ stock held in the company
 PROVIDE INFORMATION for Financial Statements
 Make MANAGEMENT DECISIONS
 Usefulness of Costing
Decision-making Planning Control

• How much to charge • Once a decision has been • After budget is put into
taken to make a new product action, the actual figures
in the coming period, or to can be recorded
• How much profit will be
continue making an existing
made • The actual results are
one, a plan or BUDGET will be
drawn up. monitored and compared to
budgeted, which will result
• Decide whether the in variance
product will be • The budget will contain:
profitable based on •
− Details of the quantities and Some minor variances are
market competition bound to occur, but the
costs
− business will investigate
A timetable for production
• Is it worth making the those which exceed pre-set
− Quantity that can be
product? tolerance limits
produced and sold,
established by market
research or past experience
 Cost Behaviour and output

General rule:
• Production increases- cost increases, thereby
increases the output

In real life:
• There are different types of cost, that behave
differently
 Types of Cost Behaviours

There are 4 types of cost:

1. Variable Cost
2. Fixed cost
3. Stepped fixed cost
4. Semi- variable cost
 Breakdown of Cost
• All businesses and organisations incur costs whether they
manufacture products or provide services.

• These can be broken down into 3 elements:

Materials Labour Expenses

 Cost Behaviour
• DEFINITION: Cost Behaviour is the way in which cost alters
with the changes in the level of output or activity. For Example:
 For manufacturing organization- the quantity of items produced
 For service organization- the volume of services produced

Why is it important to understand how cost behaves?

• Not all costs increase or decrease directly in line with increases

or decreases in output.​
• ​The four ways in which costs behave are:​
 Variable​
 Fixed​
 Step-fixed​
 Semi-variable
 Variable Costs
Cost changes with the change in activity

• For e.g. Materials, labour, etc.)

• FORMULA: VC = No. of units x cost per unit

Costs increases directly with changes Cost per unit remains unchanged,
in output levels regardless of changes in activity
 Fixed Costs
• Fixed cost does not vary with output and is often referred to as FIXED
OVERHEADS
• Eg. Rent and rates, insurance, staff salaries, etc

Cost remains the same regardless of the level of activity

This graph represents that the costs This graph represents that cost per
remain the same, irrespective of the unit decreases with the increase in the
number of units produced output level as the cost is spread over
more units
 Step-Fixed Costs
Fixed in nature within a certain level of activity

• For e.g. Supervisor cost, factory storage cost

 Semi- Variable Costs
• Cost will remain part fixed and part variable, therefore partly affected by the
changes in the level of activity
• E.g. Telephone – monthly fixed plan but if calls or data used over the set limit, you
will get charged depending on the level of usage
• HIGH AND LOW METHOD is used to find the semi- variable cost
• FORMULA: Total cost = FC + (No. of units x VC per unit)

Cost includes Fixed cost and Variable cost element

High- Low Method for Semi- variable Cost

This is a four- step method:

• Step 1 - Select the highest and the lowest activity level and their cost

• Step 2 - find the difference in the output and the cost

• Step 3 - divide the cost by output to get the Variable cost

cost/ output = VC per Unit

• Step 4 – calculate the Fixed Cost

VC per unit x no. of units = VC
Total production cost- VC = FC
Activity: Classification of Costs by Behaviour
Cameron Ltd produces one product, which requires the following inputs, in
the forthcoming quarter:
Direct Materials 1kg @ £3.50 per Kg
Direct Labour 1 hour @ £6.00 per hour
Rent £4,000 per quarter
Leased Machinery £1500 for every 4000 units of production

Required:
Classify the following costs incurred by their behaviour. Also,
calculate the total cost of production and the cost per unit for
different level of productions
(a) 4,000 units
(b) 10,000 units
 Activity: Classification of Costs by Behaviour
Solution:
Cost Classification
Costs By Behaviour Production Level- units

£ Workings 4,000 Workings 10,000

Direct Variable Cost - cost 1kg x £3.50 x £ 14,000 1kg x £3.50 x £35,000
Materials increases with the 4,000 units 10,000 units
increase in output
Direct Labour 1 hr x £6 x £ 24,000 1 hr x £6 x £ 60,000
4,000 units 10,000 units
Rent Fixed Cost No change £ 4,000 No change £ 4,000

Leased Stepped Cost - cost £1,500 for £ 1,500 Will require 3 £ 4,500
Machinery changes after a every 4,000 machines,
certain level of units therefore
production £1,500 x 3

Total Cost Add all costs £ 43,500 Add all costs £ 103,500

Cost per unit Total cost/ £10.88 £103,500/ £10.35

total units 10,000 units
i.e. £43,500/
4,000 units
 Activity: High- Low Method for Semi-
Variable Cost
The total costs of a business for different level of output are as follows:

Output- units Total Costs

£
10,000 £ 27,000
12,000 £ 31,000
14,000 £ 35,000
Required:
Calculate the following for the production level of 30,000 units
(a) Variable Cost per unit
(b) Total Fixed Cost
(c) Total Cost of Production
Activity: High- Low Method for Semi- Variable Cost
Solution:
(a) Variable cost (VC) per unit- Calculated by Cost / Output
Output Cost
Highest 14,000 £ 35,000
Lowest 10,000 £ 27,000
Difference 4,000 £ 8,000
VC per Unit = £8,000 / 4,000 units = £2 per unit

(b) & (c) Therefore, Fixed Cost (FC) = Total Cost- VC Fixed cost will not
Cost Units 10,000 12,000 14,000 30,000
change with the
change in level of
VC per Using High- £2 £2 £2 £2
unit Low Method activity. Therefore,
above (a) will be £7,000 at
the activity level of
Total VC/unit x £20,000 £24,000 £28,000 £60,000 30,000 units
Variable total units
Cost

Total VC + FC £27,000 £31,000 £35,000 £67,000

Cost (given) (given) (given)
Fixed Total Cost- VC £7,000 £7,000 £7,000 £7,000
Cost
Activity: Fixed Cost per Unit
Activity: Fixed Cost per Unit- Solution
Activity: Fixed or Variable Cost
Activity: Fixed or Variable Cost- Solution
Activity: Fixed, Variable or Semi- Variable Cost
Activity: Fixed, Variable or Semi-
Variable Cost- Solution
Activity: Cost at Different
Levels of Production
 Activity: Cost at Different
Levels of Production- Solution
Activity: Unit Cost
Activity: Unit Cost- Solution
Activity: High– Low Method
Activity: High– Low Method- Solution
Activity: High– Low Method
Activity: High– Low Method- Solution
Activity: High– Low Method
Activity: High– Low Method- Solution
 Cost Classification

Cost can be classified by:

• Type (capital or revenue expenditure)

• Function (production or non- production)
• Nature (materials, labour wages, expenses)
 Cost Classification by Type
Important to understand the type of expenditure, whether it is capital
or revenue
• Capital expenditure includes:
- Purchase of NCA
- Improvement of the earning capability of NCA by replacing
parts
- Shown in the Statement of Financial Position

• Revenue Expenditure is the day-to-day expenses incurred, they

include:
- Purchase of goods for resale
- Maintenance of NCA
- Charged as cost in the Statement of Profit and Loss
 Cost Classification by Function
• Important to understand which part of the
business the cost relates to:
• Cost associated with the production of
Production goods and services
Costs • Eg. From raw material to finished goods

Non • All other cost incurred in the business

Production
Costs
 Cost Classification by Nature
Production Cost

Labour
Materials Overheads
Cost of workforce
Cost incurred in making Cost required to support
involved in making the
the product / service production
product

Non- Production
Cost

Administration
Marketing Distribution Finance
Cost incurred in
Cost of Promoting and Cost of despatching Cost of financing
manging the
retaining customer and delivery business
organisation
Further Classification of Costs

Direct • Specifically identified with and

Cost allocated to a single cost unit
• Incurred in the course of
Indirect making a product or service but
Cost cannot be identified with a
particular cost unit
 Further Classification of Costs
Direct Also called Indirect
Cost PRIME COST Cost

Materials Labour Materials Labour Expenses

Eg. To make Need staff to
cake we need: make cakes Oil for supervisors Rent
• Milk machinery, Rates
• Sugar Parts for Insurance
• Eggs the oven
• Cocoa
• Flour
• butter
Illustration: Classifying Costs
Activity: Classification by Function
Activity: Classification by Function- Solution
Activity: Cost Classification by Function
Activity: Cost Classification by Function- Solution
 Responsibility Centres

Within a business different managers have

responsibilities at different levels:

• A responsibility for controlling costs

• To achieve a particular level of output
• To achieve a particular return on money invested
• To achieve a level of sales revenue
• Typical examples may be cutting, assembling, finishing,
packing, warehouse, stores, maintenance,
administration, selling and distribution, finance
 Responsibility Centres
-Different centres in the organisation having
different responsibilities. These can be:
• cost centres- e.g. Production Cost centre
(assembly dept.) and service cost centres
(canteen)
• Profit centres- Accountable for cost and
revenues
• Investment centres- responsible for capital
investments
 Cost Centre
Each cost centre is responsible for costs!!
• Cost centres are areas of a business for which costs are incurred, such
as the factory or canteen
• Collecting costs together in cost centres helps with control of the
business
• The manager of each cost centre can be held responsible for its costs
• Helps to compare budgets against what has actually been spent
• Can be split into:
• Production Cost Centres- factory cost centre through which units of
production actually flow
• Service Cost Centres- these support or service the production cost
centres
 Profit centres
• Profit centres are parts of the organisation where costs
are incurred, but income is generated as well. This
means that profit can be calculated

• The manager responsible would be accountable for the

amount of profit based on both income and the
expenditure in that responsibility centre.
 Profit centre

Responsible for cost and revenues

Revenue Costs

Individual cost
centre

Profit
 Investment Centres

• Investment centres are sections of a business or

organisation where profit can be compared with the
amount of money invested in the centre.

• The manager is still responsible for income and

expenditure (as in a profit centre), but also for the level of
investment.

• An investment centre is in effect a mini business within

the main organisation
 Investment centre

Responsible for costs, revenues and investment

of the profit

Individual cost
Revenue Costs
centre

Investment Profit
 Revenue centre

Responsible for revenue only

Individual cost
Revenue Costs
centre

Investment Profit
Activity: Classifying factory Cost Centres
Activity: Classifying factory Cost Centres- Solution
Activity: Classifying Centres
Activity: Classifying Centres- Solution
 Methods of Costing
Absorption Costing
• All production cost are included in the costing of a cost per unit
• Distinguishes between production and non- production costs
• AC = VC + FC

Marginal Costing

• Only variable cost per unit is included in the cost per unit
• Fixed overheads are not part of the cost per unit and is treated as a period cost
• Charged as an expense to the SOPL
• MC= ALL VC added together

Activity Based Costing

• Method of absorbing cost by allocating overheads to cost units- (Chapter – 9)

 Absorption Costing
• Only absorb the production overheads and
service cost centres
• Exclude Administrative overheads
• Calculate- Overhead Absorption Rate (OAR)

What is an OAR?
• OAR is an estimated amount of fixed
overheads used to produce one cost per unit
 How to calculate Overhead
Absorption Rate (OAR)?
OAR = Total Production Overheads Cost/ Total Activity Level

Most commonly used activity levels are:

- Machine hours- if the production process is machine
intensive
- Labour hours- if the production process is labour
intensive
- Budgeted cost units- activity level is used, only if one
type of product is manufactured by the organisation
Illustration: Absorption Costing
 Over and Under- Absorption of
Overheads
Over- Absorption
• More budgeted overheads absorbed in comparison to Actual overheads
incurred
• Adjust profits by adding the difference between budgeted and actual
overheads
Under- Absorption
• Less budgeted overheads absorbed in comparison to Actual overheads
incurred
• Adjust profits by deducting the difference between budgeted and actual
overheads
Illustration: Over and Under Absorption of Overheads
 Marginal Costing and Contribution
• Contribution- amount of money generated by a
cost unit to contribute towards fixed cost
incurred in a period in order to make profit
• Contribution calculated as:

Contribution= Sales Revenue- All Variable Cost

Illustration: Marginal Costing
Comparing Marginal and Absorption
Costing- Inventory levels and profits
Inventory levels Rising
• AC will give higher profits
• Reason: more fixed OH being carried forward into the next accounting period
through cost of closing inventory

Inventory Levels Falling

• AC will give lower profits
• Reason: less fixed OH being carried forward into the next accounting period through
cost of closing inventory

Constant Inventory Levels

• AC and MC will give the same level of profit
Illustration: Inventory levels and Profits
Illustration: Inventory levels and Profits (Contd.)
 Advantages of AC and MC
ABSORPTION COSTING MARGINAL COSTING
• Fair to charge fixed overhead
• Fixed cost are same regardless
to each unit of product, as they
of the level of output, so makes
are incurred to produce output
more sense to charge FC in full
• Using full absorption cost to
as period cost to the SOPL
value inventory is consistent
• MC does not require
with the closing inventory
apportionment of FC
value that is required by
• There is no under or over
accounting standards (IAS 2) in
absorption of FC as it charged
the production of Financial
as a period cost
Statements
• Focuses on variable costs and
• Full production cost helps in
contribution which is more
setting the selling prices in
useful for decision making
order to make profit in the long
run
 Activity Based Costing
• This is a more sophisticated method of allocating
overheads to cost per unit than the normal methods
•

• It involves identifying the activities that causes the

overheads to be incurred and the factors that give rise
to the costs (cost drivers)
• Apportionment of overheads are done based on the
activity level
• OAR is calculated per cost pool rather than taking total
overheads into account (as in Absorption Costing)
• Results in fair allocation of resources.
Steps to calculate CPU under ABC

Steps to take to calculate Cost per unit under ABC

This is a six-step method:

• Step 1 – Identify Cost Pools

• Step 2 – Identify Cost drivers that give rise to the cost pool
• Step 3 – Calculate OAR per unit of cost driver for each individual cost pool

• Step 4 – Calculate total activity costs for each unit, based on the total
usage of cost drivers

• Step 5 – Absorb activity into cost units by dividing the total activity cost by
the total number of units

• Step 6 – Allocate Overhead cost per unit to calculate total production cost
per unit
Illustration: Activity Based Costing
Illustration: Activity Based Costing
Activity: Absorption Vs Marginal Costing
Activity: Absorption Vs Marginal Costing- Solution
Activity: Acitvity Based Costing
Activity: Activity Based Costing
Activity: Actvity Based Costing- Solution
Test your knowledge
 Ask question if you
got any concern in
relation to the topic

How to test
Do all the activities Do all the text book
in the Question
your activities on this
Bank Knowledge? topic

Do the activities
given out in class
Thank You