2013 John Wiley Sons, Ltd, Accounting for Managers, 1Ce, Ch 11 1.

© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 11 1

CHAPTER 11

AccountingDecisions


Learning Objectives How do I distinguish between various types of costs,

including product, period, direct, indirect, prime, conversion, and overhead costs?

What risks are present when arbitrary methods of overhead allocation are used?

How does activity-based costing create more accurate product costs?

What is the difference between absorption and variable costing?

What are two methods of writing off an overallocation or underallocation of overhead?



Product and Period Costs Period costs relate to the accounting period (year,

month) in which a cost was incurred Product costs relate to the cost of goods or services

produced The calculation of profit is based on the separation

of product and period costs Revenues - Cost of goods sold = Gross profit

– Selling and Administrative costs and other period costs = Operating profit


Product and Period Costs Cost of goods sold (product cost)

The cost of providing a service The cost of buying goods sold by a retailer The cost of raw materials and production costs

for a manufacturer For a retailer

Cost of goods sold = Opening inventory + Purchases - Closing inventory

For a manufacturer Cost of goods sold = Opening inventory + Cost of

production - Closing inventory


Calculation of Operating Profit


Direct and Indirect Costs Production costs

Direct Indirect

Direct costs Traceable to product/ services

Direct materials or labour Other direct costs

Indirect costs (Overhead costs) Necessary, but not readily traceable to particular

product/ services Indirect materials Indirect labour Other indirect costs

Other Cost Terms Prime cost refers to the total of all direct costs

Includes the total of direct materials and direct labour. Production overhead is all production costs

other than direct costs The total of all indirect material, indirect labour, and

other indirect costs Conversion costs are the production costs, other

than direct materials, used to make a product or provide a service. Includes direct labour and production overhead


Calculating Product/Service Costs Company-wide overhead rate

An overhead rate calculated using the total of the overhead costs for the company, divided by the total of the allocation base for the overhead


Calculating Product/Service Costs Divisional-based overhead rate

Calculates the overhead for each division within the company and then uses an allocation base to assign the divisional overhead to jobs



Activity-Based Costing (ABC)

Uses cost pools to accumulate the indirect costs of significant business activities and then assigns the costs from the cost pools to products based on cost drivers , which measure each product’s demand for activities

Cost Pools Cost pools accumulate the indirect cost of

business processes Business process

A sales order from customer to delivery and invoicing

A purchase order on a supplier to receipt of goods and payment

Collects the purchasing costs in all of the departments into a cost pool

12© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 11

Cost Drivers The most significant cause of activity in a

cost pool, e.g. Enable the cost of activities to be assigned

from cost pools to cost objects



Activity-Based Costing (ABC) Three stage process

Trace costs for business processes to cost pools Identify cost drivers for each cost pool Determine number of activities for each cost

driver Transaction, frequency, intensity

Cost driver rateCost pool / Number of cost drivers Apply cost driver rate to product/services based

on number of cost drivers for each business process


Activity-Based Costing (ABC) In order to identify a cost driver, categorize

costs as follows Unit-level activities Batch-related activities Product-sustaining activities Customer-sustaining activities Facility-sustaining activities

Example of ABC


Accumulated overhead costs

Cost drivers identified

Example of ABC


Calculation of Cost per Activity

Allocation of Overhead to Products

Example of ABC


Overhead per Product Based on ABC

Total Product Cost under ABC

Difference between Traditional Approach and ABC


Total Product Cost under Traditional Approach

Difference between Traditional Approach and ABC

Absorption and Variable Costing Variable costing

A method of reporting in which only variable costs are treated as inventoriable

Direct materials, direct labour, and variable overhead costs are assigned to each product made during the period

Fixed overhead costs are treated as period expenses


Absorption and Variable Costing Absorption costing

A system where all production overhead costs (fixed and variable) are inventoriable

Variable costs (direct materials, direct labour, and variable overhead) are assigned directly to each unit made

Fixed overhead costs are assigned to each product/service based on an allocation base

Fixed production overhead is estimated and divided by the allocation base to calculate a budgeted overhead rate

Each and every product that is made at the plant is then assigned fixed production overhead costs based on this budgeted overhead rate


Absorption and Variable Costing Budgeted fixed overhead rate


Absorption and Variable Costing Compared


Company Data

Absorption and Variable Costing Compared


Overallocation or Underallocationof Overhead

The overhead rate is normally established prior to the production year

At the end of the year when actual cost and actual activity volumes are known, there is going to be a difference between the actual overhead and the budgeted overhead that was allocated throughout the period

This is underallocation or overallocation of overhead


In order to adjust the records of the company, two approaches can be used

1. Assign overallocation or underallocation to cost of goods sold

2. Prorate overallocation or underallocation to cost of goods sold, work in progress inventory, and finished goods inventory


Overallocation or Underallocationof Overhead

Conclusions Cost terminology

Product/period Direct/indirect Other costs Activity-based costing Variable costing Absorption costing Comparison of approaches Overallocation or underallocation of overhead


2013 John Wiley Sons, Ltd, Accounting for Managers, 1Ce, Ch 11 1.

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