(7) Costing - Traditional Absorption Costing and ABC PDF

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Lecture 7, Semester 1...

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Costing - Traditional Absorption Costing and ABC ABC = Activity Based Costing ! Overheads Overheads are dealt with in three stages: ! 1. Cost allocation! 2. Cost apportionment ! 3. Cost absorption !

Activity

Basis of Apportionment

Supervision, welfare, personnel

Relative number of employees

Rent, heating, lighting building insurance

Relative floor area occupied

Depreciation and insurance of plant and machinery

Book value of machinery

Power consumption

Power use per hour

First identify the different activities that generate overhead costs and then generate a basis that you can link this activities - have to have something quantifiable. ! All have in common the knowledge that fixed costs aren’t always costs and may change over time - assumption that fixed costs long term are variable costs. ! Absorption Costing “A cost accounting method that assigns direct costs and all or part of overhead to cost units using one or more overhead absorption rates” (CIMA OT, 2005)!

Full Costing in Single and Multi Product Businesses Single product businesses - process costing: ! Cost per unit =. total costs of output ! #

#

number of units produced !

Bach costing:! Cost per unit = cost of the batch (direct + indirect) ! #

#

number of units in batch!

Mutli product businesses - job costing: ! Full (absorption) cost = Direct + indirect costs !

Full Costing in a Single Product Firm - Example: For a single output, all production costs can be accumulated. ! McKing Ltd produces the infamous “Big King”. Cost and production detail for 180,000 burgers are (£): Ingredients #

#

#

=#

30,000!

Labour##

#

#

=#

40,000!

#

=#

70,000!

Variable Overheads# #

=#

5,000!

Rent of Factory #

=#

8,000!

Other Fixed Overheads#

=#

7,000!

Total Costs#

=#

90,000!

Total Direct Costs #

#

# #

REQUIRED: Find the cost of one burger ! Production: # #

180,000 burgers!

Total Costs # #

£90,000!

Cost per burger: #

50p!

If there are 15,000 burgers in the fridge at the end of the period, what is (i) the cost of sales; and (ii) the closing inventory value?! #

#

#

#

Cost of Sales# #

Number of Burgers:# #

#

Inventory !

165,000#

#

#

15,000!

Cost per Burger:#

#

50p#

#

#

50p!

#

#

£82,500#

#

#

£7,500!

#

#

This is the number of burgers left multiplied by the cost of one burger.

Also shown as:! Cost of Sales:##

#

#

!

Opening Inventory #

#

#

=#

!

Plus purchases#

#

#

=#

30,000!

Plus all other production expenses! = !

60,000 #

Less closing inventory #

#

=#

(7,500)!

= Cost of Sales#

#

=#

82,500!

#

Job Costing CARBS Car Repairs Ltd. - Example : A customer brings a broken car for repair ! The repair will take 2 mechanics 4 hours each ! Parts and materials will cost £80!

This is just the price of one burger multiplied by how many were sold which is 180,000 burgers minus 15,000 burgers left in stock.

(Labour, Variable, Fixed and Rent)

Wages #

#

=#

4 mechanics @ £20 per hour!

Planned Hours#

=#

30 hours per week!

Weeks Worked#

=#

50 weeks per year!

Total Hours # #

=#

50 x 30 x 4 = 6,000 hours !

Total overhead costs for the company are £24,000 per year. ! REQUIRED: What will the repair cost, and, if CARBS charges a gross mark up of 25%, what price should it charge for the job?! Solution:! A logical way of “spreading” the overheads over CARBS’ output, in which every job may be different, is to apportion them in line with hours worked. ! Total Overheads #

=#

£24,000!

Total Hours # #

=#

6,000# #

= £4 per hour!

! Total Cost of the Job: #

#

#

Parts and materials# #

#

=#

80.00 !

2 Mechanics x 4 hours x £20##

=#

160.00!

Overheads @ £4 per hour x 8 hours# = #

32.00# #

Total cost of job#

#

Add: 25% gross mark up #

£!

#

=#

272.00!

#

=#

68.00!

=

£340.00!

Price charged to customer# #

#

This figure comes from the generated overheads per # hour,!multiplied by 8 hours (4 hours for each mechanic and there are 2) This is 25% of £272.00

Overhead Absorption Rate OAR is a means of attributing overhead to a product or service based for example on direct labour hours, direct labour cost or machine hours. ! OAR =. Budgeted overhead ! #

Budgeted level of activity !

Some firms use a single overhead rate (i.e. blanket or plant-wide) for the organisation as a whole. ! Example:! Total Overheads #

=#

£24,000!

Direct Labour (or machine hours)#

=#

6,000!

Overhead rate #

=#

£4 per hour!

# #

# #

A blanket overhead rate can only be justified id all products consume departmental overheads in approximately the same proportions:! 1. Allocation and Apportionment !

- Allocation - to assign a whole item of cost to a single cost unit or cost centre ! - Apportionment - to spread indirect costs over two or more cost units or cost centres ! #

1. Apportioning in general overheads !

#

2. Service cost centre cost apportionment !

2. Absorption - add overheads into product costs by applying a predetermined overhead absorption rate!

AB Co - Lecture Example: AB Co has two production departments:! Department 1

Department 2

Total

Budgeted overheads

£360,000

£200,000

£560,000

Budgeted direct labour hours

200,000 hrs

40,000 hrs

240,000 hrs

Ab Co makes two products: !

- Product A has a prime cost of £100, takes 30 hours in department 2 only ! - Product B also has a prime cost of £100, takes 28 hours in department 1 and 2 hours in department 2.!

- What is the factory cost of each product?! Need to allocate overheads for product A in department 2 only. ! Need to allocate overheads for product B in department 1 and 2. ! OAR

Department 1

Department 2

Budgeted Overheads

360,000

200,000

Budgeted activity

200,000

40,000

£1.8

£5

OAR

After calculating the OAR you are able to determine the factory overheads. ! Factory Cost

Product A

Prime Cost

Product B 100

100

0

50.4

Department 2

150

10

Factory Cost

£150

£60.40

Total Factory Cost

£250

£160.40

Factory Overhead:! Department 1

Limitations of Traditional Absorption Costing •

Assumes products consume resources in relation to volume measures!

•

It can give a distorted product cost where a diverse range of products with a high and low volume exists !

•

Hence, it provides inadequate information for managers to make informed decisions about: !

- Accurate cost of producing a product and therefore whether or not it is profitable ! - Whether the existing cost attribution practices reflect the resource consumption of a companies different product lines!

Traditional Absorption Costing Systems

Today’s Business Environment

Small product ranges

Wider product ranges

Most of the costs related to direct labour and materials

Lower labour costs

A relatively low proportion of non-volume related overheads

Higher proportion of fixed costs

Results in practice: under absorption and over absorption! Activity Based Costing (ABC) developed as a response !

Activity Based Costing (ABC) Key names: Johnson, Kaplan, Cooper! Key reading: How Cost Accounting Systematically Distorts Product Costs (Cooper & Kaplan, 1986); Relevance Lost: the Rise and Fall of Management Accounting (Johnson & Kaplan, 1987)! Key idea: ABC is a more relevant method for product costing because it sets out to associate costs with products more accurately than traditional methods. Simplistic volume-related bases of overhead apportionment assume that all such costs are volume-related and may link overheads to products in a way that does not reflect the resources those products consume.!

Categories of Cost for ABC Purposes:! Short-term variable costs:!

- Direct costs such as materials or productivity-based wages, which vary directly with volumes of activity and output. ! Long-term variable costs:!

- Many overheads vary in line with an activity measure, but may not be directly related to changes in volume. ! Examples of Long-Term Variable Costs:! •

Setting up an automated production line !

•

“First - item” inspection of production output !

•

Buying materials and components!

•

Delivery inspections !

•

Transfers from stock !

ABC’s View of Activities:! Unit - Level Activities - Performed each time a unit of the product or service is produced ! Batch - Related Activities - Performed each time a batch of goods is produced! Product - Sustaining Activities - Enable production or sale of individual product / services ! Facility - Sustaining Activities - General support activities such as plant management and property! Benefits of ABC:! Despite early criticism about the costs and complexities of implementing ABC evidence is emerging about steady recognition of benefits: ! •

Cost reduction through better understanding of the causes of costs !

•

Ability to build in low-cost production through new product design and process re-engineering!

•

More accurate product / service pricing !

•

More management focus on potentially unprofitable products / services / customers !

•

More focused product marketing!

ABC Process:! 1. Identify the activities performed! 2. Identify the “COST POOL” - the total associated cost of each activity ! 3. Identify the activity’s cost driver - the factor that influences the activity! 4. Calculate the cost driver rate ! 5. Measure how much of each activity product consumes ! 6. Assign part of the cost of each activity to different product based the proportion of activity caused by those products!

Pens Ltd - ABC Example:!

- Two lines of pens, multi and blue! - Both sold in boxes of 100 pens! - Sales volume of 1,000 boxes each ! #

£!

#

Sales Price # #

70.00 per box!

Direct Costs:! Labour #

#

10.00 per box# (0.25 hours @ £40 per hour)!

Materials #

#

20.00 per box!

Total Indirect Costs:#

£60,000 per annum!

How would traditional costing divide the overheads between multi and blue pens, based on direct labour hours? Product #

#

#

Mutli#

#

Blue!

Boxes#

#

#

1,000#

#

1,000!

Direct hours per box#

#

0.25#

#

0.25!

Total direct hours#

#

250#

#

250!

Total direct hours #

#

500 Hours!

OAR:! Total Overheads #

#

£60,000!

Total Direct Hours #

#

500 Hours!

Overhead Absorption Rate# #

£120 per labour hour!

Total O/H Assigned per box# #

(120 x 0.25)#

#

(120 x 0.25)!

#

#

£30#

#

£30!

Total O/H Assigned#

#

£30,000#

#

£30,000!

#

#

#

Multi#

#

Blue!

Labour#

#

#

10.00#

#

10.00!

Materials#

#

#

20.00#

#

20.00!

Overheads:#

#

#

30.00#

#

30.00!

Total Product Cost#

#

60.00#

#

60.00#

Selling Price:# #

#

70.00#

#

70.00!

Profit per Box:##

#

10.00#

#

10.00!

#

Direct Costs!

!

When the Quantities are Changed: ! Product #

#

#

Mutli#

#

Blue!

Boxes#

#

#

200#

#

1800!

Direct hours per box#

#

0.25#

#

0.25!

Total direct hours#

#

250#

#

250!

Total direct hours #

#

500 Hours!

OAR:! Total Overheads #

#

£60,000!

Total Direct Hours #

#

500 Hours!

Overhead Absorption Rate# #

£120 per labour hour!

Total O/H Assigned per box# #

(120 x 0.25)#

#

(120 x 0.25)!

#

#

£30#

#

£30!

#

£6,000#

#

£54,000!

#

Mutli Pens#

#

Blue Pens!

#

Total O/H Assigned#

ABC In Action - Example: Other Information:! #

#

Number of Production Runs# #

8#

#

2!

Number of Set Up Hours#

#

7#

#

3!

Number of Inspections#

#

3#

#

2!

Number of Suppliers #

#

1#

#

1!

Volume of Sales #

#

200 Boxes#

Production Scheduling#

#

£10,000 pa!

Set up Costs# #

#

£20,000 pa!

Inspection#

#

£10,000 pa!

Component Sourcing#

#

£20,000 pa!

Total Indirect Costs#

#

£60,000 pa!

Cost Driver Rate = #

Total Cost Pool!

#

Indirect Costs:!

#

#

Total Quantity of Cost Driver Consumed!

1800 Boxes!

How would traditional costing divide the overheads between multi and blue pens, based on ABC?

Activity

Cost pool

Activity cost driver

Cost driver rate

Quantity of cost driver consumed

Activity cost assigned

Multi

Blue

Multi

Blue

Scheduling

£10,000

Number of production runs

£10,000! 10! =1,000 per run

8

2

8,000

2,000

Set up #

£20,000

Number of set up hours

£20,000! 10! = 2,000 per set up hour

7

3

14,000

6,000

Inspection

£10,000

Number of inspections

£10,000! 5! =2,000 per inspection

3

2

6,000

4,000

Component sourcing

£20,000

Number of suppliers

£20,000! 2! =10,000 per supplier!

1

1

10,000

10,000

Overheads: # #

#

#

Multi

Scheduling(80:20 x £10,000) #

#

8,000#

2,000!

Set up(7:3 x £20,000)#

#

#

14,000#

6,000!

Inspection(3:2 x £10,000)#

#

#

6,000#

4,000!

#

10,000

10,000!

38,000#

22,000!

200 boxes

1,800 boxes!

190.00#

12.22#

Component sourcing(1:1 x £20,000) # Total overheads:#

#

Production:#

#

#

#

#

!

Blue!

Overheads per box:#

#

Add: direct costs#

#

#

30.00#

30.00!

Product cost:# #

#

#

220.00#

42.22!

Selling price:# #

#

#

70.00#

70.00!

Box profit#

#

#

(150.00)#

27.78!

#

#

Conclusion:! Gross profit per unit

Multi Pens

Blue pens

Traditional Costing

70 – 60 = 10

70 – 60 = 10

ABC

70-220 = (150)

70-42.22 = 27.78

!...