4 Full Costing - n.a PDF

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Management Accounting – Full Costing 1 Concept of Full Cost Definition

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Full cost is the total amount of resources, usually measured in monetary terms sacrificed to achieve an objective. It takes into account of all resources sacrificed to achieve that objective. For example, if the objective was to supply a customer with a product or service, the cost of all aspects relating to making the product or provision of the service would be included as part of the full cost. To derive the full cost figure, we must accumulate the elements of cost incurred and then assign them to the particular product or service. Full Costing is the general approach for deducing the cost of a unit output which takes into account of all the costs. For example, the rent of a factory must be taken into account when calculating the full cost of a component that is produced in that factory. Cost Accounting Systems are techniques, forms and accounting records used to provide timely information about the cost of manufacturing specific products (or providing specific services) and of performing certain functions. For example, jobcosting systems and process-costing systems.

Usefulness of Full Costing

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The full cost of a unit is influential in Pricing and Output Decisions as it can help managers make decisions on the price to charge customers for the business’s products or services. Full cost information along with relevant information concerning prices can also be used to determine the number of units of products or services to be produced. Exercising Control – Determining the full cost of a product or service is often a good point for exercising control. Where the full cost figure is considered too high for example, individual elements of full cost may be examined to see whether there are opportunities for reduction. This could lead to re-engineering the production process or finding other sources of supply. Assessing relative efficiency – Full cost can help managers compare the cost of carrying out an activity in a particular way or particular place with its cost if carried out in a different way or place. For example, a car manufacturer may want to compare the cost of building a particular model of car in one manufacturing plant rather than in another. This could help determine a future production location. Assessing Performance – Profit is an important measure of business performance. To measure the profit arising from providing a particular product or service, the sales that it generates should be compared with the costs consumed in generating that revenue. This can help in assessing past decisions. It can also help in guiding future decisions, such as continuing with or abandoning the particular product or service.

2 Cost Accounting Systems Job-Process Systems  These are used for one-off products or batches. Costs are accumulated separately for each job such as building contracts, motion pictures, and consultancy projects  Costs are collected by some systematic method  Allocation of overheads includes rent or depreciation  It allows calculation of profit/loss on any individual job  Here, we accumulate costs for each individual unit of output  Examples: - Bushmills Irish Whiskey Process- Costing Systems  This is used when production involves steady stream of similar products passing through a number of processes. We track the production of identical and nearidentical items.

2 Cost Accounting Systems

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Costs are accumulated within each process over a period of time and then allocated over the equivalent full units of production. Total of all processes is equal to the cost of finished production. Issues do arise with this process: - For example, with depreciation which is an estimate therefore reliability is open to question - Also cost of raw materials is questionable as although historical cost is used, replacement cost is seen as more relevant but is less used Average total manufacturing costs are put over the number of units produced to determine full cost per unit. Examples: - A chartered accounts firm – PWC - A custom furniture factory

Direct Costs  Those cost that can be fully attributed to a service or product. Costs that can be identified with specific cost units. This is to say that costs can be traced to a particular cost unit and measured reliably. For example, direct materials or direct labour. Indirect Costs (overheads)  Those costs that cannot be fully attributed to a service or product. It is all other elements of cost that is those items that cannot be identified with each particular cost unit For example royalties or rent 3 Absorption Costing The key is that all overheads are absorbed into individual units. Therefore all costs are considered and included when calculating the cost of producing a particular unit. The main issue with this sort of costing is deciding the basis on how we should apportion overheads to each cost centre. For example, apportioning rent to floor space. Stages 1. Allocation – of those indirect costs that are directly incurred by just one cost centre. For example, canteen costs would be solely allocated to the Canteen, 2. Apportion – dividing all shared indirect overheads to more than one cost centre. For example, apportioning rent to Assembly, Polishing, Maintenance and Canteen. 3. Reapportion – all the service cost centre overheads were apportioned to production centres. For example, reapportioning, Canteen to Assembly, Polishing and Maintenance cost centres. 4. Absorb – overheads belonging to each production cost centre into individual units. Use OARs – the number of hours the product spends in the departments. For example, Assembly cost centre is absorbed by machine hours for example which would be capital intensive (or labour hours in which case it would be labour intensive). 5. Add any direct/variable costs per unit to the indirect costs per unit which gives you the FULL cost per unit. 6. Add on a mark-up (%) to set the selling price based on the FULL cost per unit. Examples of Basis on Apportionment  Rent – apportion to the floor area of each cost centre  Personnel Costs – number of employees within each cost centre  Depreciation of Computers – number of employees within each cost centre Worked Example:  Jo ltd. provides household service to its customers. It has £10000 each overhead each month. In each month 2500 hours are worked. A particular repair job that took place in the middle of the month used direct materials of £15. Direct labour worked on the job for 15 hours and the wage rate is £5 each. Overheads are charged to the job on a direct labour hour basis.  Direct Materials (£15) + Direct Labour (£5 × 15 hours) + Overheads (£4 × 15) =

3 Absorption Costing Advantages: 1) Smaller % mark up required than marginal costing when setting the selling price. It should be more accurate as two costs have already been covered (both direct and indirect) whereas marginal costing only covers direct costs. 2) It promotes cost recovery. Businesses should cover their costs (assuming actual costs are similar to budgeted costs). 3) Good overall strategy for setting selling prices unlike marginal costing which is really good for 'one off' decision making such as special orders or optimum production plans. 4) Suits 'old fashioned' production methods where time is an important factor rather than batch sizes like ABC costing. Disadvantages 1) Cannot be used for short term decision making (e.g. make or buy and special order decisions) unlike marginal costing. 2) It is based on budgeted figures, for example, estimations or future indirect costs such as insurance might prove inaccurate due to unexpected economic changes so it is still possible to make a loss. 3) Basis for apportionment of indirect costs is not always obvious or fair in reality. The basis might seem quite arbitrary so might lead to inaccurate results perhaps resulting in setting an inaccurate selling prices. It can be difficult to identify a ‘reasonable’ basis for allocating overheads. 4) More complex and time consuming compared to marginal costing. 5) Not as good at dealing with a wide product range with different levels of 4 ABC/Batch Costing Definition: Activity Based Costing is a method of costing which identifies the activity which influences each overhead. The cost per unit of output is then calculated based on its use of this activity. For example, producing a batch of products might require the activity of setting up machinery. The smaller the batch size, the more use of this activity (more machine set ups required) so the more expensive the batch and therefore the more expensive the products produced in that batch. Cost Pools: An organisation’s activities are analysed into groups of indirect costs. The collection of costs relating to that activity is called a cost pool. For example, the cost of setting up machinery. Cost Drivers: These relate to the use of the activity. They cause indirect costs to change. The cost of producing one unit of output can be calculated depending on that unit’s use of that activity. For example, the number of machine set ups required. If the cost driver doesn’t exist, it is presumed that the overhead wouldn’t happen. Steps

1. Define the activities – understand the organisational processes 2. Cost the activities – how much does it cost to perform an activity 3. Determine cost drivers – what causes costs to be incurred, for example – testing costs are driven by the number of machine hours use 4. Cost driver rate – if set up costs are £158 per production run, this gives you the cost of performing a specific activity 5. Apply the cost driver rate to cost products or services

Advantages of ABC Costing  ABC avoids the limitations associated with absorption costing such as - A subjective use of machine or labour hours to absorb overheads which might be irrelevant to modern businesses - Basis for apportionment of indirect costs is not always obvious or fair in reality

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ABC is accepting to IAS2 (Inventories) when valuing inventory as is absorption but marginal costing IS NOT. Batch sizes will influence costs which is ignored by absorption costing. Cost drivers focus on the activity which causes costs to be incurred. This is unlike absorption costing which focuses on cost behaviour.

Disadvantages of ABC Costing  Time consuming to set up and record costs.  If a business produces a small range of products that are relatively simple to produce ten it would probably me more appropriate to use Labour Hour OARs or Machine Hour OARs as per absorption costing.  Cannot be used for short term decision making in comparison with marginal costing.  Cost drivers and cost pools need to be kept up to date as they...