BMFP 3582-Chapter 3456 Cost (Direct-Indirect-Marginal-Standard)

Chapter 3Chapter 3 DIRECT COSTDIRECT COST

Chapter 4 INDIRECT COSTS

Ir. Haery Ir. Haery SihombingSihombing/IP/IPPensyarah

Fakulti Kejuruteraan PembuatanUniversiti Teknologi Malaysia Melaka

C

O

S

T

COST

““CostCost”” is not a simple concept. It is is not a simple concept. It is

important to distinguish between important to distinguish between

four different types four different types -- fixedfixed, variable, , variable,

averageaverage andand marginalmarginal..

Monetary measure of resources given up to Monetary measure of resources given up to

attain an objective (such as acquiring a good attain an objective (such as acquiring a good

or delivering a service)or delivering a service)

AA costcost may be defined as a sacrifice or may be defined as a sacrifice or

giving up of resources for a particular giving up of resources for a particular

purpose.purpose.

Costs are frequently measured by the Costs are frequently measured by the

monetary units that must be paid for monetary units that must be paid for

goods and services.goods and services.

COST Cost and Cost TerminologyCost and Cost Terminology

Cost is a resource sacrificed or forgone to achieve

a specific objective.

An actual cost is the cost incurred (a historical cost)

as distinguished from budgeted costs.

A cost object is anything for which a separate

measurement of costs is desired.

Cost AssignmentCost Assignmentis both

Cost Object

TracingDirect CostsDirect Costs

AllocatingIndirect CostsIndirect Costs

Cost and Cost TerminologyCost and Cost Terminology Cost ClassificationsCost Classifications

Association with cost objectAssociation with cost objectCost objectCost object is anything for which management wants to is anything for which management wants to

collect or accumulate costscollect or accumulate costs

Direct Direct -- traceable to a cost objecttraceable to a cost object

Indirect Indirect -- not conveniently or practically traceable not conveniently or practically traceable

to a cost objectto a cost object

treated as overhead treated as overhead

allocatedallocated

Cost Classifications CategoriesCost Classifications Categories Costing SystemCosting System

Cost ObjectCost Object

anything for which a separate measurement of costs is anything for which a separate measurement of costs is

desireddesired

Direct CostDirect Cost

costs that are related to a particular cost object in an costs that are related to a particular cost object in an

economically feasible (Costeconomically feasible (Cost--effective) mannereffective) manner

Cost PoolCost Pool

a grouping of individual cost itemsa grouping of individual cost items

Cost Allocation BaseCost Allocation Base

a factor that is the common denominator for systematically a factor that is the common denominator for systematically

linking an indirect cost or group of indirect costs to a cost linking an indirect cost or group of indirect costs to a cost

objectobject

Cost CategoriesCost Categories

Association with cost objectAssociation with cost object

Reaction to changes in activityReaction to changes in activity

VariableVariable

FixedFixed

MixedMixed

StepStep

Relevant RangeRelevant Range – normal operating range

Cost AllocationCost Allocation

Same issue exists for merchandising firmsSame issue exists for merchandising firms

Easier for merchandising,Easier for merchandising,

purchase price (major)purchase price (major)

shipping cost (minor)shipping cost (minor)

taxes (minor)taxes (minor)

Classification of CostsClassification of Costs

This section concentrates on the big This section concentrates on the big

picture of how manufacturing costs picture of how manufacturing costs

are accumulated and classified.are accumulated and classified.

Cost ObjectiveCost Objective

AA cost objective cost objective oror cost objectcost object isis

defined as anything for which a separate defined as anything for which a separate

measurement of costs is desired.measurement of costs is desired.

Examples include departments, products, activities, Examples include departments, products, activities,

and territories.and territories.

Accounts could be type of cost, to which product, Accounts could be type of cost, to which product,

department?department?

Categories of Manufacturing CostsCategories of Manufacturing Costs

All costs which are eventually All costs which are eventually

allocated to products are classified allocated to products are classified

as eitheras either

1.1. direct materialsdirect materials,,

2.2. direct labourdirect labour, or, or

3.3. indirect manufacturingindirect manufacturing..

DirectDirect--Material CostsMaterial Costs

DirectDirect--material costs material costs include the include the

acquisition costs of all materials that are acquisition costs of all materials that are

physically identified as a part of the physically identified as a part of the

manufactured goods and that may be manufactured goods and that may be

traced to the manufactured goods in an traced to the manufactured goods in an

economically feasible way.economically feasible way.

Example:Steel used tomanufacture

the automobile.

Direct Materials

Materials that are clearly and easilyidentified with a particular product.

DirectDirect--Material CostsMaterial Costs DirectDirect--Labour CostsLabour Costs

DirectDirect--labour costs labour costs include the include the

wages of all labour that can be traced wages of all labour that can be traced

specifically and exclusively to the specifically and exclusively to the

manufactured goods in an economically manufactured goods in an economically

feasible way.feasible way.

Direct Labor

Labor costs that are clearly traceable to, or readily identifiable with, the

finished product.

Example:Wages paid to an

automobile assemblyworker.

DirectDirect--Labour CostsLabour Costs Indirect Manufacturing CostsIndirect Manufacturing Costs

Indirect manufacturing costs Indirect manufacturing costs oror

factory overheadfactory overhead include all costs include all costs

associated with the manufacturing associated with the manufacturing

process that cannot be traced to the process that cannot be traced to the

manufactured goods in an economically manufactured goods in an economically


Factory Overhead

All factory costs exceptdirect material and direct labor.

Factory costs that cannot betraced directly to specific units produced.

Examples:Indirect labor – maintenance

Indirect material – cleaning suppliesFactory utility costsSupervisory costs

Indirect Manufacturing CostsIndirect Manufacturing Costs

1. Direct Materials1. Direct Materials

PrimePrime

CostsCosts 2. Direct Labour2. Direct Labour

ConversionConversion

3. Factory Overhead Costs3. Factory Overhead Costs

Prime Costs, Conversion Costs, Prime Costs, Conversion Costs,

and Directand Direct--Labour CostsLabour Costs

Product CostsProduct Costs

Product costs Product costs are costs identified with are costs identified with

goods produced or purchased for resale.goods produced or purchased for resale.


Direct materialDirect material

Measurable part of a productMeasurable part of a product

Direct laborDirect labor

Labor used to manufacture a product or Labor used to manufacture a product or

perform a serviceperform a service

OverheadOverhead

Indirect production costIndirect production cost


Product costs are initially identified as part of Product costs are initially identified as part of the inventory on hand.the inventory on hand.

These product costs (inventoriable costs) These product costs (inventoriable costs) become expenses (in the form of cost of goods become expenses (in the form of cost of goods sold) only when the inventory is sold.sold) only when the inventory is sold.

First appear on the balance sheet in inventory First appear on the balance sheet in inventory accountsaccounts

Transferred to the income statement when Transferred to the income statement when product is soldproduct is sold

Period CostsPeriod Costs

Period costs Period costs are costs are costs

that are deducted as that are deducted as

expenses during the expenses during the

current period without current period without

going through an inventory going through an inventory

stage.stage.

1 2 3

4 5 6 7 8 9 10

11 12 13 14 15 16 17

18 19 20 21 22 23 24

25 26 28 29 30 3127

Selling and administrative costsSelling and administrative costs

Distribution costsDistribution costs

•• Cost to warehouse, transport, and/or deliver Cost to warehouse, transport, and/or deliver

a product or servicea product or service

•• Major impact on managerial decision makingMajor impact on managerial decision making

Period CostsPeriod Costs Period CostsPeriod Costs

Appear on the income statement when Appear on the income statement when

incurredincurred

Expensed when incurredExpensed when incurred

Classification By FunctionClassification By Function

Period costs are expensesPeriod costs are expenses

not charged to the product.not charged to the product.

Administrative Costs

Non-manufacturing costsof staff support and

administrative functions –accounting, data processing,

personnel, researchand development.

Selling Costs

Costs incurred to obtain customer orders and todeliver finished goods

to customers –advertising and shipping.

Period and Products CostPeriod and Products Cost

Raw MaterialsWork in ProcessFinished Goods

2005 BalanceSheet Inventory

Period Costs(Expenses)(Expenses)

Product Costs(Inventory)(Inventory)

Inventory NotSold in 2005

OperatingExpenses

Cost ofGoods Sold

Cost ofGoods Sold

2005 CostsIncurredIncurred

2005 IncomeStatement

2006 IncomeStatement

InventorySold in 2005

Product Cost Product Cost -- DirectDirect

Direct MaterialDirect Material

Conveniently and economically traced Conveniently and economically traced

to cost objectto cost object

Direct LaborDirect Labor

to manufacture a product or perform a service to manufacture a product or perform a service

includes wages paid to direct labor employees, includes wages paid to direct labor employees,

production bonuses, payroll taxesproduction bonuses, payroll taxes

may include holiday and vacation pay, may include holiday and vacation pay,

insurance, retirement benefitsinsurance, retirement benefits

Product Cost Product Cost -- IndirectIndirect

Overhead Overhead -- indirect production costsindirect production costs

Fringe benefits, if cannot be easily traced Fringe benefits, if cannot be easily traced

to productto product

Overtime, if due to random schedulingOvertime, if due to random scheduling

Cost of qualityCost of quality

Prevention costsPrevention costs

Appraisal costsAppraisal costs

Failure costsFailure costs

Product Cost vs. Period CostProduct Cost vs. Period Cost

Product costProduct costAll costs incurred in getting product to saleable conditionAll costs incurred in getting product to saleable condition

Three main elements:Three main elements:

Raw MaterialsRaw Materials

LabourLabour

Factory overheadsFactory overheads

Period costPeriod costAll costs incurred for a period of time regardless of productionAll costs incurred for a period of time regardless of production

Sometimes classified into:Sometimes classified into:

Marketing expensesMarketing expenses

General (administrative) expensesGeneral (administrative) expenses

Financial expensesFinancial expenses

Direct CostsDirect Costs

Direct costs Direct costs can be can be

identified specifically and identified specifically and

exclusively with a given cost exclusively with a given cost

objective in an economically objective in an economically


Indirect CostsIndirect Costs

Indirect costs Indirect costs cannot be cannot be

identified specifically and identified specifically and

exclusively with a given cost exclusively with a given cost

objective in an economically objective in an economically


Direct vs. Indirect CostsDirect vs. Indirect Costs

Direct CostsDirect CostsMajor costs that can be directly attributable to the final Major costs that can be directly attributable to the final

product or service. Includes:product or service. Includes:

Direct materialsDirect materials

Direct labourDirect labour

Other: subcontractors, tender document preparationOther: subcontractors, tender document preparation

Indirect CostsIndirect CostsAll other costs that cannot be directly attributable to the finaAll other costs that cannot be directly attributable to the finall

product or service. Includesproduct or service. Includes

Indirect materials: factory supplies, small items of materialIndirect materials: factory supplies, small items of material

Indirect labour: admin, cleaning or security staffIndirect labour: admin, cleaning or security staff

Factory overheads; rates, rent, insurance, telephone, Factory overheads; rates, rent, insurance, telephone,

stationerystationery

Classification by TraceabilityClassification by Traceability

Direct costs

Costs incurred for the benefit of one specific cost object.

Examples: material and labor cost for a product.

Indirect costs

Costs incurred for the benefit of more than one cost object.

Example: maintenance expenditures benefiting two or more departments.

Fixed Cost vs. Variable CostFixed Cost vs. Variable Cost

Fixed costsFixed costsThose costs that in total will remain the same for a period Those costs that in total will remain the same for a period

of time and over a relevant range or output. Includes:of time and over a relevant range or output. Includes:

Rent, rates, insurance, depreciationRent, rates, insurance, depreciation

Variable costsVariable costsThose costs that in total will tend to increase as output Those costs that in total will tend to increase as output

level increase. Includes:level increase. Includes:

Direct Materials and Direct LabourDirect Materials and Direct Labour

Overhead Cost AllocationOverhead Cost Allocation

Assign indirect costs to one or more cost objectsAssign indirect costs to one or more cost objects

To determine full absorption cost (GAAP)To determine full absorption cost (GAAP)

To motivate managementTo motivate management

To compare alternative courses of action for To compare alternative courses of action for

planning, controlling, and decision makingplanning, controlling, and decision making

Allocation process should be Allocation process should be

rationalrational andand systematicsystematic

Allocating OverheadAllocating Overhead

ActualActual Cost SystemCost System

Product CostProduct Cost

Direct MaterialsDirect Materials

Direct LaborDirect Labor

OverheadOverhead

Cost UsedCost Used

ActualActual

ActualActual

ActualActual

Allocating OverheadAllocating Overhead

Actual Cost SystemActual Cost System

The Actual Cost System is not timelyThe Actual Cost System is not timely

All costs must be known before All costs must be known before calculating product costcalculating product cost

Allocating OverheadAllocating OverheadActual vs. NormalActual vs. Normal

Product CostProduct Cost

Direct Materials

Direct Labor

Overhead

Actual Cost Actual Cost

SystemSystem

Actual

Actual

Actual

Normal Cost Normal Cost

SystemSystem

Actual

Actual

PredeterminedPredetermined

Overhead RateOverhead Rate

Cost behavior means how a cost will react to changes in the level of business activity.

Total fixed costs donot change when activity changes.

Total variable costschange in proportionto activity changes.

Classification By BehaviorClassification By Behavior

Activity

Co

st

Activity

Co

st

Cost behavior means how a cost will react to changes in the level of business activity.

Total fixed costs donot change when activity changes.

Total variable costschange in proportionto activity changes.

Classification By BehaviorClassification By Behavior

Product Cost BehaviorProduct Cost Behavior

Direct MaterialDirect Material VariableVariable

Direct LaborDirect Labor VariableVariable

OverheadOverhead Variable, Fixed, or MixedVariable, Fixed, or Mixed

Cost Item Behavior Traceability Function

Material Variable Direct Product

Assembly Wages Variable Direct Product

Advertising Fixed Indirect Period

Production Manager's Salary Fixed Indirect Product

Office Depreciation Fixed Indirect Period

Cost Item Behavior Traceability Function

Material Variable Direct Product

Assembly Wages Variable Direct Product

Advertising Fixed Indirect Period

Production Manager's Salary Fixed Indirect Product

Office Depreciation Fixed Indirect Period

Potential Multiple Cost Classifications

EXERCISEEXERCISE

Direct and Indirect CostsDirect and Indirect Costs

Direct Costs

Example: Oak wood used

in Mfg. of chairs.

Indirect Costs

Example: salary of the

Plant night watchperson.

COST OBJECT

Example: 50 Oak

Chairs produced in

May.

Direct and Indirect CostsDirect and Indirect CostsExampleExample

Direct Costs:

Maintenance Department $40,000

Personnel Department $20,600

Assembly Department $75,000

Finishing Department $55,000

Assume that Maintenance Department costs are

allocated equally among the production departments.

How much is allocated to each department?

Direct and Indirect CostsDirect and Indirect CostsExampleExample

Allocated$20,000

Maintenance

$40,000

AssemblyDirect Costs

$75,000

FinishingDirect Costs

$55,000

$20,000

Cost Behavior PatternsCost Behavior PatternsExampleExample

Bicycles by the Sea buys a handlebar

at $52 for each of its bicycles.

What is the total handlebar cost when

1,000 bicycles are assembled?


1,000 units × $52 = $52,000

What is the total handlebar cost

when 3,500 bicycles are assembled?

3,500 units × $52 = $182,000


Bicycles by the Sea incurred $94,500 in

a given year for the leasing of its plant.

This is an example of fixed costs with

respect to the number of bicycles assembled.


What is the leasing (fixed) cost per bicycle

when Bicycles assembles 1,000 bicycles?

$94,500 ÷ 1,000 = $94.50

What is the leasing (fixed) cost per bicycle


$94,500 ÷ 3,500 = $27

Cost DriversCost Drivers

The cost driver of variable costs is the level

of activity or volume whose change causes

the (variable) costs to change proportionately.

The number of bicycles assembled is a

cost driver of the cost of handlebars.

Relevant RangeRelevant RangeExampleExample

Assume that fixed (leasing) costs are $94,500

for a year and that they remain the same for a

certain volume range (1,000 to 5,000 bicycles).

1,000 to 5,000 bicycles is the relevant range.

Relevant RangeRelevant RangeExampleExample

0

20000

40000

60000

80000

100000

120000

0 1000 2000 3000 4000 5000 6000

Volume

Fix

ed C

ost

s

$94,500

Relationships of Types of CostsRelationships of Types of Costs

Direct

Indirect

Variable Fixed

Total Costs and Unit CostsTotal Costs and Unit CostsExampleExample

What is the unit cost (leasing and handlebars)


Total fixed cost $94,500

+ Total variable cost $52,000 = $146,500

$146,500 ÷ 1,000 = $146.50

Total Costs and Unit CostsTotal Costs and Unit CostsExampleExample

0

50000

100000

150000

200000

0 500 1000 1500

Volume

Tota

l C

ost

s

$94,500

$94,500 + $52x

$146,500

Use Unit Costs CautiouslyUse Unit Costs Cautiously

Assume that Bicycles management uses a

unit cost of $146.50 (leasing and wheels).

Management is budgeting costs for

different levels of production.

What is their budgeted cost for an

estimated production of 600 bicycles?

600 × $146.50 = $87,900


What is their budgeted cost for an estimated

production of 3,500 bicycles?

3,500 × $146.50 = $512,750

What should the budgeted cost be for an

estimated production of 600 bicycles?


Total fixed cost $ 94,500

Total variable cost ($52 × 600) 31,200

Total $125,700

$125,700 ÷ 600 = $209.50

Using a cost of $146.50 per unit would

underestimate actual total costs if output

is below 1,000 units.


What should the budgeted cost be for an

estimated production of 3,500 bicycles?

Total fixed cost $ 94,500

Total variable cost (52 × 3,500) 182,000

Total $276,500

$276,500 ÷ 3,500 = $79.00

MerchandisingMerchandising

Merchandising companiesMerchandising companies

purchase and then sell tangible productspurchase and then sell tangible products

without changing their basic formwithout changing their basic form.

ServiceService

Service companies

provide services or intangible

products to their customers.

Labor is the most significant cost category.

Types of InventoryTypes of Inventory

Manufacturing-sector companies

typically have one or more of the

following three types of inventories:

1. Direct materials inventory

2. Work in process inventory (work

in progress)

3. Finished goods inventory

Types of InventoryTypes of Inventory

Merchandising-sector companies hold

only one type of inventory – the

product in its original purchased form.

Service-sector companies do not

hold inventories of tangible products.

Classification ofClassification of

Manufacturing CostsManufacturing Costs

Direct materials costs

Direct manufacturing labor costs

Indirect manufacturing costs

Inventoriable CostsInventoriable Costs

Inventoriable costs (assets)…

become cost of goods sold…

after a sale takes place.

Period CostsPeriod Costs

Period costs are all costs in the income

statement other than cost of goods sold.

Period costs are recorded as expenses of the

accounting period in which they are incurred.

Flow of Costs Flow of Costs ExampleExample

Bicycles by the Sea had $50,000 of direct

materials inventory at the beginning of the period.

Purchases during the period amounted to

$180,000 and ending inventory was $30,000.

How much direct materials were used?

$50,000 + $180,000 – $30,000 = $200,000

Flow of CostsFlow of CostsExampleExample

Direct labor costs incurred were $105,500.

Indirect manufacturing costs were $194,500.

What are the total manufacturing costs incurred?

Direct materials used $200,000

Direct labor 105,500

Indirect manufacturing costs 194,500

Total manufacturing costs $500,000


Assume that the work in process inventory

at the beginning of the period was $30,000,

and $35,000 at the end of the period.

What is the cost of goods manufactured?

Beginning work in process $ 30,000

Total manufacturing costs 500,000

Ending work in process 35,000

Cost of goods manufactured $495,000


Assume that the finished goods inventory

at the beginning of the period was $10,000,

and $15,000 at the end of the period.

What is the cost of goods sold?

Beginning finished goods $ 10,000

Cost of goods manufactured 495,000

Ending finished goods 15,000

Cost of goods sold $490,000


Work in Process

Beg. Balance 30,000 495,000

Direct mtls. used 200,000

Direct labor 105,500

Indirect mfg. costs 194,500

Ending Balance 35,000


Work in Process

495,000

Finished Goods

10,000 490,000

495,000

15,000

Cost of Goods Sold

490,000

Manufacturing CompanyManufacturing Company

MaterialsInventory

FinishedGoods

Inventory

Revenues

Cost ofGoods Sold

INCOME STATEMENT

PeriodCosts

InventoriableCosts

BALANCE SHEET

Equals Operating Income

whensalesoccur

deduct

Equals Gross Margindeduct

Work inProcess

Inventory

Merchandising CompanyMerchandising Company

INCOME STATEMENTBALANCE SHEET

whensalesoccur

InventoriableCosts

MerchandisePurchases

Inventory

Revenuesdeduct

Cost ofGoods Sold

Equals Gross Margindeduct

PeriodCosts

Equals Operating Income

PrimePrime CostsCosts——allall direct mfg. costsdirect mfg. costs

Direct

Materials

Direct

Labor

Prime

Costs+ =

Prime CostsPrime Costs

What are the prime costs for Bicycles by the Sea?

Direct materials used $200,000

+ Direct labor 105,500

= $305,000

Conversion CostsConversion Costs

Direct

Labor

Manufacturing

Overhead+ =Conversion

Costs

IndirectLabor

IndirectMaterials Other

Conversion CostsConversion Costs

What are the conversion costs for

Bicycles by the Sea?

Direct labor $105,500

+ Indirect manufacturing costs 194,500

= $300,000

Conversion cost = all mfg. cost except direct materials

Measuring CostsMeasuring Costs

Requires JudgmentRequires Judgment

Manufacturing labor-cost classifications

vary among companies.

The following distinctions are generally found:

Direct manufacturing labor

Manufacturing overhead



Manufacturing overhead

Indirect labor Managers’ salaries Payroll fringe costs

Forklift truck operators (internal handling of materials)

Janitors Rework labor

Overtime premium Idle time



Overtime premium is usually

considered part of overhead.

Assume that a worker gets $18/hour

for straight time and gets

time and one-half for overtime.



How much is the overtime premium?

$18 × 50% = $9 per overtime hour

If this worker works 44 hours on a given

week, how much are his gross earnings?

Direct labor 44 hours × $18 = $792

Overtime premium 4 hours × $ 9 = 36

Total gross earnings $828

Many Meanings of Product CostMany Meanings of Product Cost

A product cost is the sum of the costs

assigned to a product for a specific purpose.

1. Pricing and product emphasis decisions

2. Contracting with government agencies

3. Preparing financial statements for external

reporting under generally accepted

accounting principles

ManufacturingInventory

Classifications

Balance Sheet of a ManufacturerBalance Sheet of a Manufacturer

RawMaterials

FinishedGoods

Work inProcess

Completedproductsfor sale.

Materialswaiting to beprocessed.

Partially completeproducts.

Material to whichsome labor and/or

overhead havebeen added.

Balance Sheet of a ManufacturerBalance Sheet of a Manufacturer

RawMaterials

FinishedGoods

Work inProcess

BeginningMerchandise

Inventory

BeginningFinished Goods

Inventory

Cost of GoodsPurchased

Cost of GoodsManufactured

EndingMerchandise

Inventory

EndingFinished Goods

Inventory

Cost of GoodsSold

Merchandiser Manufacturer

+

_

+

==

_

The major difference

Income Statement of a ManufacturerIncome Statement of a Manufacturer

Manufacturing Company

Cost of goods sold:

Beg. finished

goods inv. 14,200$

+ Cost of goods

manufactured 234,150

= Goods available

for sale 248,350$

- Ending

finished goods

inventory (12,100)

= Cost of goods

sold 236,250$

Merchandising Company

Cost of goods sold:

Beg. merchandise

inventory 14,200$

+ Purchases 234,150

= Goods available

for sale 248,350$

- Ending

merchandise

inventory (12,100)

= Cost of goods

sold 236,250$

Cost of goods sold for manufacturers differs only Cost of goods sold for manufacturers differs only

slightly from cost of goods sold for merchandisers.slightly from cost of goods sold for merchandisers.


DirectMaterial

DirectLabor

ManufacturingOverhead

PrimeCost

ConversionCost

Manufacturing costs are oftencombined as follows:


What type of account is the manufacturing goods in process account?

a. Income statement expense account.

b. Balance sheet inventory account.

c. Temporary clearing account for directmaterial and direct labor.

d. Holding account for manufacturingoverhead and direct labor.

QuestionQuestion

The primary distinction between product and period costs is . . .

a. Product costs are expensed in the periodincurred.

b. Product costs are directly traceable toproduct units.

c. Product costs are inventoriable.

d. Period costs are inventoriable.

QuestionQuestion

Finished GoodsBeginning Inventory

Cost of GoodsManufactured

FinishedGoodsEnding

Inventory

RawMaterialsBeginningInventory

RawMaterials

Purchases

Raw MaterialsEnding Inventory

Costof

GoodsSold

Work in ProcessBeginning Inventory

Direct Labor

FactoryOverhead

Raw MaterialsUsed

Sales activityProduction activityMaterialsactivity

Flow of Manufacturing ActivitiesFlow of Manufacturing Activities

Work in ProcessEnding Inventory

Cost of all goods completed and transferred Cost of all goods completed and transferred from work in process to finished goods from work in process to finished goods

during a reporting period.during a reporting period.

Direct Materials UsedDirect Materials Used++ Direct LaborDirect Labor++ Factory OverheadFactory Overhead== Total Manufacturing CostsTotal Manufacturing Costs++ Beginning Work in ProcessBeginning Work in Process–– Ending Work in ProcessEnding Work in Process== Cost of Goods ManufacturedCost of Goods Manufactured

Statement of Cost of Goods ManufacturedStatement of Cost of Goods Manufactured

Let’s take a look at Rocky

Mountain Bikes’Statement of Cost

of Goods Manufactured.


ROCKY MOUNTAIN BIKES

Statement of Cost of Goods Manufactured

For Year Ended 31 December 2005

Direct materials used in production 85,500$

Direct labor 60,000

Total factory overhead costs 30,000

Total manufacturing costs for the period 175,500$

Add: Beginning work in process inventory 2,500

Total cost of work in process 178,000$

Less: Ending work in process inventory 7,500

Cost of goods manufactured 170,500$






Direct labor 60,000







Exh.

18-16

Computation of Cost of Direct Material Used

Beginning raw materials inventory 8,000$

Add: Purchases of raw materials 86,500

Cost of raw materials available for use 94,500$

Less: Ending raw materials inventory 9,000

Cost of direct materials used in production 85,500$






Direct labor 60,000







Include all direct labor costs incurred during the

current period.






Direct labor 60,000







Computation of Total Manufacturing Overhead

Indirect labor 9,000$

Factory supervision 6,000

Factory utilities 2,600

Property taxes, factory building 1,900

Factory supplies used 600

Factory insurance expired 1,100

Depreciation, building and equipment 5,300

Other factory overhead 3,500

Total factory overhead costs 30,000$






Direct labor 60,000







Beginning work in process inventory is carried over from the

prior period.






Direct labor 60,000







Ending work in process inventory contains the cost of unfinished

goods, and is reported in the current assets section of the balance sheet.


CHAPTER 3CHAPTER 3

DIRECT COSTDIRECT COST

Direct CostingDirect Costing

Alternative method of costingAlternative method of costing

Relatively newRelatively new

More useful costing method for management More useful costing method for management

planning and decision makingplanning and decision making

Also know as variable costing as most direct costs Also know as variable costing as most direct costs

are variable with respect to level activitiesare variable with respect to level activities

Main difference between Main difference between ‘‘absorptionabsorption’’

costing and direct costing is in the costing and direct costing is in the

treatment of fixed manufacturing overheadtreatment of fixed manufacturing overhead

Treatment of Fixed Manufacturing Treatment of Fixed Manufacturing

OverheadOverhead

Fixed manufacturing costs is not treated as a Fixed manufacturing costs is not treated as a product cost instead it is treated as a period costproduct cost instead it is treated as a period cost

That is, it is written off (expensed) in the period in which That is, it is written off (expensed) in the period in which

it is incurred rather than included as a cost when it is incurred rather than included as a cost when determining the cost of inventory determining the cost of inventory

If fixed manufacturing costs are excluded from the cost of If fixed manufacturing costs are excluded from the cost of inventory when using direct costing then inventory @ end inventory when using direct costing then inventory @ end of an accounting period will be lower than the value is of an accounting period will be lower than the value is

using absorption costing this will effect both the balance using absorption costing this will effect both the balance sheet and profits sheet and profits

ST 10.1ST 10.1Mts Manufactured 9000

Mts Sold 8600

Direct Materials 42,300.00$ 4.70$

Direct Labour 54,000.00$ 6.00$

Fixed Factory overhead 72,000.00$ 8.00$

Variable factory overhead 36,000.00$ 4.00$

204,300.00$ 22.70$

22.70$

Manufacturing cost per metre

Total costs 204,300.00$

Number of Metres produced 9,000

Manufacturing cost per metre 22.70$

Product cost using absorption costing

Direct material costs 42,300.00$

Direct labour costs 54,000.00$

Fixed Factory overhead 72,000.00$

Variable factory costs 36,000.00$

Product cost using absorption costing 204,300.00$

Product cost using direct costing

Direct material costs 42,300.00$

Direct labour costs 54,000.00$

Variable factory costs 36,000.00$

Product cost using direct costing 132,300.00$

ST 1ST 1

Value of closing inventory using absorption costing

Metres Produced 9,000

less Metres sold 8,600

Closing Stock 400

Product cost/no of metres produced 22.70$ cost per metre

Value of closing inventory using absorption costing 9,080.00$

Value of closing inventory using direct costing

Metres Produced 9,000

less Metres sold 8,600

Closing Stock 400

Product cost/no of metres produced 14.70$ cost per metre

Value of closing inventory using direct costing 5,880.00$

St.2St.2Sales 462,500

Less COGS

Opening Inventory -

Cost of production

Direct materials Used 97,000

Direct labour used 64,020

Variable factory overhead incurred 54,320

Fixed factory overhead 106,700

322,040

Less Closing inventory 14,940 307,100

Gross profit 155,400

Less Operating expenses

Marketing Expenses 45,325

Administrative Expense 92,500

Financial Expense 9,460 147,285

Net profit 8,115

Closing inventory

Production 19400 units

Sale 18500 units

Closing inventory 900 units

Costof production/# of production units 16.60$ per unit

322040/19400

Closing inventory 14,940.00$

ST.3ST.3

Sales 462,500

Less Variable Costs

Opening Inventory -

Cost of production

Direct materials Used 97,000

Direct labour used 64,020

Variable factory overhead incurred 54,320

215,340

Less Closing inventory 9,990 205,350

Contribution Margin 257,150

Less Fixed Costs

Manufacturing 106,700

Marketing Expenses 45,325

Administrative Expense 92,500

Financial Expense 9,460 253,985

Net profit 3,165

Closing inventory

Production 19400 units

Sale 18500 units

Closing inventory 900 units

Costof production/# of production units 11.10$ per unit

215340/19400

Closing inventory 9,990.00$

Reconciliation of reported profits Reconciliation of reported profits

–– absorption and direct costingabsorption and direct costing

The difference in profits between the absorption The difference in profits between the absorption and direct costing is caused by the amount of and direct costing is caused by the amount of fixed overhead in the opening and closing fixed overhead in the opening and closing inventories because they are excluded when using inventories because they are excluded when using direct costingdirect costing

To reconcile profits using absorption costing to To reconcile profits using absorption costing to profits using direct costing you add back fixed profits using direct costing you add back fixed costs in opening inventory using absorption costs in opening inventory using absorption costing and deduct fixed costs in closing inventory costing and deduct fixed costs in closing inventory using absorption costingusing absorption costing

Self test problem 4Self test problem 4

Part aPart a

Absorption Costing

August September

Product Costs

Directy materials 5000 5500

Direct labour 25000 27500

Variable manufacturing overheads 5000 5500

Fixed manufacturing overheads 44000 44000

79000 82500

no of litres produced 100000 110000

cost per litre 0.79$ 0.75$


Part bPart bRevenue Statement using the Absorption Costing Method

August September Total

Sales (sale price * # of litres sold) 117,600 117,600.00$ 235200

0

Less COGS 0

Opening Inventory 15,800 17,380 15,800

Cost of production 0

Direct materials Used 5000 5500 10500

Direct labour used 25000 27500 52500

Variable factory overhead incurred 5000 5500 10500

Fixed factory overhead 44000 44000 88000

94,800 99,880 177,300

Less Closing inventory 17,380 25,500 25,500

77,420 74,380 151800

Gross profit 40,180 43,220 83400

Less Operating expenses 0

Selling & Administrative expenses 30,000 30,000 60000

Net profit 10,180 13,220 23400

3,040

Closing inventory

Opening Stock 20,000 22,000

add Production 100000 110000

less Sale 98000 98000

Closing inventory 22,000 ltrs 34,000 ltrs

Cost of production/# of production units 0.79$ 0.75$

79000/100000 84080/110000

Closing inventory 17,380.00$ 25,500.00$


Part CPart C

Variance in Profit b/w August & September

Variance is due to the amount of fixed factory overhead component of cost of goods sold

August September

Fixed production costs 44000 44000

Production in ltrs 100000 110000

Fixed costs per litre 0.44$ 0.40$

Fixed costs in opening inventory

opening inventory (ltrs)* fixed cost per ltr 8,800.00$ 9680 ( Aug closing balance)

Fixed costs incurred 44000 44000

Less fixed cost in closing inventory

closing inventory (ltrs)* fixed cost per ltr 9680 13600

43,120.00$ 40080

difference b/w sept & Aug 3040

equals defference in net profit

ST 4 Part DST 4 Part DRevenue Statement using the Direct Costing Method

August September Total

Sales (sale price * # of litres sold) 117,600 117,600 - 235200

Less Variable Costs

Opening Inventory (variable component only) 7,000 7,700 7000

Cost of production

Direct materials Used 5,000 5500 10500

Direct labour used 25,000 27500 52500

Variable factory overhead incurred 5,000 5500 10500

42,000 46,200 80500

Less Closing inventory 7,700 11,900.00$ 11,900.00$

34,300 34,300 68,600.00$

Contribution margin 83,300 83,300 166600

Less Fixed Costs 0

Manufacturing 44,000 44,000 88000

Selling & Admin Exp 30,000 30,000 60000

74,000 74000 148000

Net profit 9,300 9,300 18600

Closing inventory

Opening Stock 20,000 22,000

add Production 100000 110000

less Sale 98000 98000

Closing inventory 22,000 ltrs 34,000 ltrs

Cost of production/# of production units 0.35$ 0.35$

35000/100000) (38500)/110000

Closing inventory 7,700.00$ 11,900.00$

ST4 part (e)ST4 part (e)

Net profit using absorption costing 10,180 13,220 add Fixed costs in opening inventory

using absorption costing 8,800.00$ 9680

18,980 22,900 Less Fixed costs in closing inventory

using absorption costing 9680 13600

Net Profit using direct costing 9,300 9,300

Reporting variable marketing and Reporting variable marketing and

administrative expenseadministrative expense –– direct costingdirect costing

Revenue statement using direct costing:Revenue statement using direct costing:

Is divided into 2 main areasIs divided into 2 main areas

Variable costs and fixed expensesVariable costs and fixed expenses

Shows Variable Shows Variable nonnon-- manufacturingmanufacturing expenses expenses

and fixed non manufacturing expenses and fixed non manufacturing expenses

separately separately

Shows the variable Shows the variable nonnon-- manufacturingmanufacturing

expenses after the variable COGS expenses after the variable COGS

(manufacturing exp) but before the net (manufacturing exp) but before the net

contribution margin linecontribution margin line

ST.5ST.5 $ $ $

Sales 274,543

Less Variable costs

Cost of goods sold

Inventory 1 July 26,485

Variable costs of production

Diect materials 45,965

Direct labour 46,980

Variable factory overheads 22,698 115,643

142,128

Less Inventory 30 June 25,660 116,468

Gross contribution Margin 158,075

less variable marketing expense 16,258

Net Contribution Margin 141,817

less Fixed Costs

Factory Overhead 72,458

Marketing & Admin Exp 57,632 130,090

Net Profit 11,727

Revenue Statements with applied Revenue Statements with applied

factory overheadsfactory overheads

There may be a variance between factory There may be a variance between factory overheads applied and actual factory overheads overheads applied and actual factory overheads incurredincurred

Any underAny under--oror--overover--applied overhead may be applied overhead may be added or subtracted from the COGSadded or subtracted from the COGS

In absorption costing the underIn absorption costing the under--oror--overover--appliedappliedoverhead may include both variable and fixed overhead may include both variable and fixed elementselements

However in direct costing However in direct costing underunder-- oror-- over applied over applied overhead will only include variable fixed overhead overhead will only include variable fixed overhead as the fixed overhead is not applied but written as the fixed overhead is not applied but written off as a period cost off as a period cost

ST 6 Part AST 6 Part A


Direct material costs 2.00$

Direct labour costs 1.50$

Variable factory costs 1.00$

Product cost using direct costing 4.50$




Variable factory overheads 1.00$

Fixed factory overhead 2.50$ 75000/30000(normal capacity)

Product cost using absorption costing 7.00$

ST 6 Part B Calculations ST 6 Part B Calculations

Calculations July August

Value of Opening & Closing inventory using absorption costing

Opening Stock In Units 4,000.00 6,000.00

Unit Cost 7.00$ 7.00$

28,000.00$ 42,000.00$

Closing Stock 6,000.00 3,000.00

Unit Cost 7.00$ 7.00$

42,000.00$ 21,000.00$

Value of Opening & Closing inventory using direct costing

Opening Stock In Units 4,000.00 6,000.00

Unit Cost 4.50$ 4.50$

18,000.00$ 27,000.00$

Closing Stock 6,000.00 3,000.00

Unit Cost 4.50$ 4.50$

27,000.00$ 13,500.00$

Under- or over-applied fixed factory overhead

Budgeted & Actual fixed overhead 75,000.00$ 75000

Fixed overhead applied (32000*$2.50) 80,000.00$ 72500 29000*$2.50

Under- or (over) applied fixed overhead 5,000.00-$ 2500

overapplied underapplied

ST 6 Part BST 6 Part B

Revenue statements using absorption costing

Sales (Sales in Quantity * $9) 270,000.00$ 288000

Less COGC

Inventory @ Beginning (@ $7) 28,000.00$ 42,000.00$

Cost of production (units produced *$7) 224,000.00$ 203,000.00$

252,000.00$ 245,000.00$

Less Closing inventory 42,000.00$ 21,000.00$

210,000.00$ 224,000.00$

Add Under/ over applied Overhead 5,000.00-$ 2500

205,000.00$ 226,500.00$

Gross profit 65,000.00$ 61,500.00$

Less Marketing & Admin costs

Variable ( Units sold *.3) 9,000.00$ 9,600.00$ Fixed 36,000.00$ 36,000.00$

45,000.00$ 45,600.00$

Net profit 20,000.00$ 15,900.00$

ST 6 Part CST 6 Part C

Revenue statements using direct costing

Sales (Sales in Quantity * $9) 270,000.00$ 288000

Less COGC

Inventory @ Beinginning @ $4.5 18,000.00$ 27,000.00$

Cost of production (units produced *$4.5) 144,000.00$ 130,500.00$

162,000.00$ 157,500.00$

Less Closing inventory 27,000.00$ 13,500.00$

135,000.00$ 144,000.00$

Gross contribution margin 135,000.00$ 144,000.00$

Less Variable Costs

VariableMarketing Costs ( Units sold *.3) 9,000.00$ 9,600.00$

Contribution Margin 126,000.00$ 134,400.00$

Less Fixed Costs

Manufacturing Costs 75,000.00$ 75,000.00$

Fixed marketing, admin & finance 36,000.00$ 36,000.00$

111,000.00$ 111,000.00$

Net profit 15,000.00$ 23,400.00$

ST 6 Part DST 6 Part D

Net profit using absorption costing 20,000 15,900

add Fixed costs in opening inventory using absorption

costing4000 units @ $2.5 10000 15000 6000 units @ $2.5

30,000 30,900

Less Fixed costs in closing inventory using absorption

costing6000 units @ $2.5 15,000.00$ 7,500.00$ 3000 units @ $2.5Net Profit Using Direct costing 15,000.00$ 23,400.00$

ST 6 Part dST 6 Part d

Sales is only one component of ProfitsSales is only one component of Profits

Profits is also affected by the difference Profits is also affected by the difference between Quantity produced and between Quantity produced and Quantity sold.Quantity sold.

Under the absorption method the Under the absorption method the opening stocks of each accounting opening stocks of each accounting period contain a fixed manufacturing period contain a fixed manufacturing component carried forward from the component carried forward from the previous periodprevious period

ST problem 7 (a)ST problem 7 (a)Fixed Factory Overhead Recovery Rate

Budgeted Fixed factory Overhead 150,000$

Budgeted Direct labour Hours 15000

10$ per direct labour hour

Variable Factory Overhead Recovery Rate

Budgeted Variable factory Overhead 45,000$



Combined Factory overhead rate

Budgeted Fixed factory Overhead 150,000$

Budgeted Variable factory Overhead 45,000$

195,000$



7(b)7(b)Under- or over-applied combined factory overhead

Actual fixed overhead 154,000.00$

Actual Variable Overhead 48,000.00$

Combined Factory Overhead 202,000.00$

Combined overhead applied (15,000 direct labour

hrs *$13/hr) 195,000.00$

Under-applied fixed overhead 7,000.00$

Under- or over-applied Fixed factory overhead

Actual fixed overhead $154,000.00

Fixed overhead applied (15,000 direct labour hrs

*$10/hr) $150,000.00

Under-applied fixed overhead $4,000.00

Under- or over-applied Variable factory overhead

Actual Variable overhead $48,000.00

Actual variable overhead applied (15,000 direct

labour hrs *$3/hr) $45,000.00

Under-applied fixed overhead $3,000.00

7 c7 c

Calculations




Fixed Factory overhead 5.00$ $10/direct labour hour*15000hours/30000units

Variable factory overheads 1.50$ $3/direct labour hour*15000hours/30000units

Product cost using absorption costing 9.50$




Variable factory costs 1.50$

Product cost using direct costing 4.50$

7 c7 c calculations contcalculations cont

WIP Finished goods Total

Value of Opening & Closing inventory using absorption costing

Opening Stock In Units - 4,000.00

Unit Cost 9.50$ 9.50$

-$ 38,000.00$ 38,000.00$

Closing Stock - 8,000.00

Unit Cost 9.50$ 9.50$

-$ 76,000.00$ 76,000.00$

Value of Opening & Closing inventory using direct costing

Opening Stock In Units - 4,000.00

Unit Cost 4.50$ 4.50$

-$ 18,000.00$ 18,000.00$

Closing Stock - 8,000.00

Unit Cost 4.50$ 4.50$

-$ 36,000.00$ 36,000.00$

7 c7 cRevenue statements using absorption costing

Sales 338,000.00$

Less COGC

Inventory @ Beginning 38,000.00$

Cost of production (units produced *$9.5) 285,000.00$

323,000.00$

Less Closing inventory 76,000.00$

247,000.00$

Add Under/ over applied Overhead 7,000.00$

254,000.00$

Gross profit 84,000.00$

Less Marketing & Admin costs 51,380.00$ (18100+33280)

Net profit 32,620.00$

7 d7 dRevenue statements using direct costing

Sales 338,000.00$

Less COGC

Inventory @ Beinginning 18,000.00$

Cost of production (units produced *$4.5) 135,000.00$

153,000.00$

Less Closing inventory 36,000.00$

117,000.00$

Add Underapplied Variable o/head $3,000.00

120,000.00$

Gross contribution margin 218,000.00$

Less Variable Costs

Variable Marketing & Admin Exp 33,280.00$

Contribution Margin 184,720.00$

Less Fixed Costs

Manufacturing Costs (fixed factory o/head) 154,000.00$ actual not budgeted

Fixed- Marketing & admin 18,100.00$

172,100.00$

Net profit 12,620.00$

7 (e)7 (e)Statement of Reconciliation

Net profit using absorption costing 32,620

add Fixed costs in opening inventory using

absorption costing

4000 units @ $5 20000

52,620

Less Fixed costs in closing inventory using

absorption costing

8000 @ $5 40000

12,620.00$

Alternatively

Increase in inventory of 4000 units * fixed Factoy o/h $5 = 20000

(32620-12620) = 20000

Job Costing & Direct CostingJob Costing & Direct Costing

Direct costing can be:Direct costing can be:integrated with job, process or operation integrated with job, process or operation costingcosting

Used together with standard costing and Used together with standard costing and activity based costingactivity based costing

Fixed manufacturing overhead is debited Fixed manufacturing overhead is debited to the general ledger to an account to the general ledger to an account called fixed factory overheadcalled fixed factory overhead

CHAPTER 4CHAPTER 4

INDIRECT COSTINDIRECT COST

Costing for indirect costsCosting for indirect costs

On completion of this topic you should be able On completion of this topic you should be able

toto

Calculate the total cost of a cost unit using Calculate the total cost of a cost unit using

absorption costing methodsabsorption costing methods

Describe the problems associated with Describe the problems associated with

apportioning and absorbing indirect costsapportioning and absorbing indirect costs

Independent studyIndependent study

Progress test and practice question(s) as setProgress test and practice question(s) as set

The Story So Far The Story So Far ……

Absorption costingAbsorption costing isis ‘‘a method of costing that, in a method of costing that, in

addition to direct costs, assigns a proportion or all the addition to direct costs, assigns a proportion or all the

production overheads to the cost units. Costs are first production overheads to the cost units. Costs are first

allocated or apportioned to the cost centres, where allocated or apportioned to the cost centres, where

they are absorbed into the cost unit using one or more they are absorbed into the cost unit using one or more

absorption ratesabsorption rates’’ (Collis and Hussey, 2007, p. 241)(Collis and Hussey, 2007, p. 241)

The purpose of absorption costing is to find the The purpose of absorption costing is to find the total total

costcost of a cost unit for valuing stock, planning and of a cost unit for valuing stock, planning and

controlling production costs and determining the controlling production costs and determining the

selling priceselling price

TheThe absorption approachabsorption approach is used by is used by

many firms and is a costing approach many firms and is a costing approach

that considers all factory overhead (both that considers all factory overhead (both

variable and fixed) to be product variable and fixed) to be product

((inventoriableinventoriable) costs that become an ) costs that become an

expense in the form of manufacturing expense in the form of manufacturing

cost of goods sold only as sales occur.cost of goods sold only as sales occur.

The Story So Far The Story So Far ……

Main stages in absorption costing Main stages in absorption costing

Identify cost centres according to their function

(eg production department)

Collect indirect costs in cost centres

on the basis of allocation or apportionment

Determine overhead absorption rate (OAR)

for each production cost centre (eg cost per machine hour)

Charge indirect costs to products using OAR and a measure

of the product’s consumption of the cost centre’s cost

Overhead analysisOverhead analysis

The first stage in absorption costing is to prepare The first stage in absorption costing is to prepare

anan overhead analysis overhead analysis which shows the allocation which shows the allocation

or apportionment of the production overheads to or apportionment of the production overheads to

the production cost centresthe production cost centres

In the previous lecture we carried out an overhead In the previous lecture we carried out an overhead

analysis for Cotswold Coolers, which allocated analysis for Cotswold Coolers, which allocated

and apportioned the total production overheads of and apportioned the total production overheads of

££97,400 between the bottling department and the 97,400 between the bottling department and the

warehouse on what was considered to be a fair warehouse on what was considered to be a fair

basisbasis ……

Cotswold CoolersCotswold Coolers

Overhead analysisOverhead analysis

Overhead Total £

Basis Bottling £

Warehouse£

Indirect materials 1,500 Allocated 900 600Indirect labour 45,000 No. of employees 30,000 15,000Rent and rates 27,000 Area 9,000 18,000Electricity 6,000 Area 4,000 2,000Depreciation 8,000 Value of machinery 6,000 2,000Supervision 21,000 No. of employees 14,000 7,000Stock insurance 500 Value of stock 100 400Total 109,000 64,000 45,000

Production Overhead AbsorptionProduction Overhead Absorption

The next stage is to find a means of absorbing the The next stage is to find a means of absorbing the

production overheads for each cost centre into the production overheads for each cost centre into the

cost units passing through themcost units passing through them

An overhead absorption rate (OAR) is An overhead absorption rate (OAR) is ‘‘a means of a means of

attributing production overheads to a product or attributing production overheads to a product or

serviceservice’’ (Collis and Hussey, 2007, p. 241)(Collis and Hussey, 2007, p. 241)

The three most commonly used OARs areThe three most commonly used OARs are

The cost unit overhead absorption rateThe cost unit overhead absorption rate

The direct labour hour overhead absorption rateThe direct labour hour overhead absorption rate

The machine hour overhead absorption rateThe machine hour overhead absorption rate

Exercise 1Exercise 1

Cost unit OARCost unit OAR

TheThe cost unit cost unit OAROAR is the simplest to use and the is the simplest to use and the

formula isformula is

Cost centre overheadsCost centre overheads

Number of cost units passing throughNumber of cost units passing through

104,000 units were produced during the period104,000 units were produced during the period

Production overheads were Production overheads were ££64,000 for the 64,000 for the

bottling department and bottling department and ££45,000 for the 45,000 for the

warehousewarehouse

RequiredRequired

Using the formula, calculate the cost unit OAR Using the formula, calculate the cost unit OAR

for each cost centrefor each cost centre

Solution 1Solution 1

Cost unit OARCost unit OAR

££0.43 per 0.43 per

unitunit££0.62 per 0.62 per

unitunitCost unit OARCost unit OAR

104,000104,000104,000104,000Number of cost Number of cost

unitsunits

££45,00045,000££64,00064,000Cost centre Cost centre

overheadoverhead

WarehouseWarehouseBottlingBottlingFormulaFormula

Ros has decided to use the cost unit OAR to absorb thewarehouse production overheads into the cost of a bottle of water (the cost unit)

Direct Labour Hour OARDirect Labour Hour OAR

An alternative is the An alternative is the labour hour labour hour OAROAR

Cost centre overhead costsCost centre overhead costs

Total direct labour hoursTotal direct labour hours

Cotswold Coolers cannot use this OAR because the Cotswold Coolers cannot use this OAR because the

firm does not use a pay scheme that is linked firm does not use a pay scheme that is linked

directly to the productdirectly to the product

The labour hour OAR is typically used to absorb The labour hour OAR is typically used to absorb

production overheads where the firm operates a production overheads where the firm operates a

timetime--based pay scheme and the level of direct based pay scheme and the level of direct

labour hours in production cost centre is highlabour hours in production cost centre is high


Machine hour OARMachine hour OAR

An alternative is the An alternative is the machine hour machine hour OAROAR

Cost centre overhead costsCost centre overhead costs

Total machine hoursTotal machine hours

104,000 units were produced during the period104,000 units were produced during the period

Production overheads were Production overheads were ££64,000 for the 64,000 for the bottling department and bottling department and ££45,000 for the 45,000 for the warehousewarehouse

Total machine hours were 16,000 for the bottling Total machine hours were 16,000 for the bottling department and 2,000 for the warehousedepartment and 2,000 for the warehouse

RequiredRequired

Using the formula, calculate the machine hour Using the formula, calculate the machine hour OAR for each cost centreOAR for each cost centre


Machine hour overhead absorption rateMachine hour overhead absorption rate

££22.50 per 22.50 per

m/hourm/hour££4.00 per 4.00 per

m/hourm/hourMachine hour Machine hour

OAROAR

2,0002,00016,00016,000Total machine Total machine

hourshours

££45,00045,000££64,00064,000Cost centre Cost centre

overheadoverhead

WarehouseWarehouseBottlingBottlingFormulaFormula

To reflect the high number of machine hours in the bottlingdepartment, Ros has decided to use the machine hour OAR for absorbing the production overheads into the cost of a bottle of water (the cost unit)


Production cost per unitProduction cost per unit

Direct costs per unit areDirect costs per unit are

Mineral water Mineral water ££0.30; bottle, lid and label 0.30; bottle, lid and label ££0.750.75

The OAR in the bottling department will be The OAR in the bottling department will be

££4.00 per machine hour (from Exercise 2)4.00 per machine hour (from Exercise 2)

The OAR in the warehouse will be The OAR in the warehouse will be ££0.430.43

per unit (from Exercise 1)per unit (from Exercise 1)

RequiredRequired

Complete the production cost statement and Complete the production cost statement and

calculate the production cost per unitcalculate the production cost per unit

Pro formaPro forma Cotswold CoolersCotswold Coolers

Production cost statement (1 unit)Production cost statement (1 unit)

£ £Direct materials Mineral water 0.30 Bottle, lid and label 0.75

Prime cost ?Production overheads Bottling dept ? Warehouse ? ?

Production cost ?



Production cost statement (1 unit)Production cost statement (1 unit)

£ £Direct materials Mineral water 0.30 Bottle, lid and label 0.75Prime cost 1.05Production overheads Bottling dept (0.15 machine hour x £4.00) 0.60 Warehouse (cost unit OAR) 0.43 1.03Production cost 2.08


Apportioning nonApportioning non--production overheadsproduction overheads

The final step is to apportion the nonThe final step is to apportion the non--production production overheads (eg administration, selling and overheads (eg administration, selling and distribution, research and development costs)distribution, research and development costs)

A simple method is to add a percentage based on A simple method is to add a percentage based on the following formulathe following formula

NonNon--production overheadsproduction overheads x 100x 100

Production costProduction cost

RequiredRequired

Using the formula, calculate the percentage if Using the formula, calculate the percentage if nonnon--production overheads are production overheads are ££43,250 and the 43,250 and the production cost is production cost is ££216,320216,320


Apportioning nonApportioning non--production overheadsproduction overheads

NonNon--production overheads are production overheads are ££43,250 and the 43,250 and the

production cost is production cost is ££216,320216,320

NonNon--production overheadsproduction overheads x 100x 100

Production costProduction cost

== ££43,25043,250 x 100x 100

££216,320216,320

= 20% of production cost= 20% of production cost

If we also add a If we also add a gross profit mark upgross profit mark up of 50% of the of 50% of the

production cost, we can production cost, we can calculate the selling price calculate the selling price ……


Total cost (1 unit)Total cost (1 unit)

£ £Direct materials

Mineral water 0.30Bottle, lid and label 0.75

Prime cost 1.05Production overheads

Bottling dept (0.15 machine hour x £4.00) 0.60Warehouse (cost unit OAR) 0.43 1.03

Production cost 2.08Non-production overheads (£2.08 x 20%) 0.42Total cost 2.50Profit (£2.08 x 50%) 1.04Selling price 3.54

Using predetermined absorption ratesUsing predetermined absorption rates

NormallyNormally predetermined overhead absorption rates predetermined overhead absorption rates (based on estimates) are used because the actual (based on estimates) are used because the actual

figures are not available until the end of the periodfigures are not available until the end of the period

Where the predetermined overheadWhere the predetermined overhead that has beenthat has been

absorbed is higher than the actual overhead, the absorbed is higher than the actual overhead, the

variance is known as variance is known as overabsorptionoverabsorption and this and this

reduces expenses in the profit and loss accountreduces expenses in the profit and loss account

Where the predetermined overhead that has beenWhere the predetermined overhead that has been

absorbed is lower than the actual overhead, the absorbed is lower than the actual overhead, the

variance is known as variance is known as underabsorptionunderabsorption and this and this

increases expenses in the profit and loss accountincreases expenses in the profit and loss account

INCOME STATEMENTINCOME STATEMENT

TheThe income statementincome statement oror profit and loss profit and loss

statementstatement summarizes the firmsummarizes the firm’’s revenues and s revenues and

expenses over a period of time (a month, a expenses over a period of time (a month, a

quarter, or a year)quarter, or a year)

The income statement is used to evaluate The income statement is used to evaluate

revenue and expenses that occur in the interval revenue and expenses that occur in the interval

between consecutive balance sheet statements.between consecutive balance sheet statements.

RevenuesRevenues –– Expenses = Net Profit (Loss)Expenses = Net Profit (Loss)

Here is an example of an Income StatementHere is an example of an Income Statement10,78010,780Total operating incomeTotal operating income

17,25017,250Total operating expenseTotal operating expense

510510Lease paymentsLease payments

900900General and administrativeGeneral and administrative

18501850DepreciationDepreciation

930930Selling and promotionSelling and promotion

22802280Indirect CostsIndirect Costs

46404640MaterialsMaterials

61406140LaborLabor

Cost of Goods and Services SoldCost of Goods and Services Sold

Operating ExpensesOperating Expenses

28,03028,030Total Operating RevenuesTotal Operating Revenues

--870870(minus) returns and (minus) returns and

allowancesallowances

$28,900$28,900

SalesSales

Operating RevenuesOperating Revenues

Operating Revenues and Operating Revenues and

ExpensesExpenses

$7,310$7,310Net Profit (loss) for year 2005Net Profit (loss) for year 2005

3,9303,930Income Taxes (35%)Income Taxes (35%)

11,24011,240Net Income Before TaxesNet Income Before Taxes

460460Total NonTotal Non--operating incomeoperating income

--120120(minus) Interest payments(minus) Interest payments

180180Interest Interest

receiptsreceipts

$400$400RentsRents

NonNon--operating Revenues and operating Revenues and

ExpensesExpenses

10,78010,780Total operating incomeTotal operating income

SOME FINANCIAL RATIOS DERIVED SOME FINANCIAL RATIOS DERIVED

FROM INCOME STATEMENTFROM INCOME STATEMENT

Interest Coverage = Total Income / Interest paymentsInterest Coverage = Total Income / Interest payments

(28,610 (28,610 --17,250) /120 = 94.717,250) /120 = 94.7

Net profit ratio = Net profit / Net sales revenueNet profit ratio = Net profit / Net sales revenue

7,310 / 28,030 = 0.261 = 26.1%7,310 / 28,030 = 0.261 = 26.1%

TRADITIONAL COST ACCOUNTINGTRADITIONAL COST ACCOUNTING

Direct Costs:Direct Costs:

Direct material :Direct material : all material that is used in all material that is used in manufacturing a productmanufacturing a product

Direct labor:Direct labor: wages of the direct touch labor needed wages of the direct touch labor needed to build one unit to build one unit

Indirect Costs:Indirect Costs: also known as overheadalso known as overhead

Shipping and receivingShipping and receiving

Quality controlQuality control

EngineeringEngineering

Rent, Insurance, etcRent, Insurance, etc

All other expenses which are not direct labor or direct All other expenses which are not direct labor or direct materialmaterial

ABSORPTION COSTINGABSORPTION COSTING

To allocate indirect cost (OH) to different To allocate indirect cost (OH) to different products accountants use quantities such as products accountants use quantities such as directdirect--labor hours, directlabor hours, direct--labor cost, material labor cost, material cost, or total direct cost as the metric.cost, or total direct cost as the metric.

For example, if direct laborFor example, if direct labor--hours is the metric hours is the metric to use, then overhead will be allocated based to use, then overhead will be allocated based on overhead dollar per directon overhead dollar per direct--labor hour.labor hour.

Then each product will Then each product will absorb absorb (or be (or be allocated) overhead costs, based on the direct allocated) overhead costs, based on the direct labor hours it consumes. labor hours it consumes.

ABSORPTION COSTINGABSORPTION COSTING

RRii*total direct *total direct

cost per unitcost per unit$OH/total $OH/total

Direct costDirect costTotal direct Total direct

costcost

RRii*DM cost per *DM cost per

unitunit$OH/total DM $OH/total DM

costcostDM costDM cost

RRii*DL cost per *DL cost per

unitunit$OH/total DL $OH/total DL

costcostDL costDL cost

RRii*DL hours *DL hours

per unitper unit$OH/total DL $OH/total DL

hourshoursDL hoursDL hours

Unit allocation Unit allocation

of OH costof OH costUnit allocation Unit allocation

rate rate RateRate,, RRii

Metric, iMetric, i

ExampleExampleTotal Overhead is $850,000Total Overhead is $850,000

$900$900$550$550Materials cost Materials cost

(each)(each)

$500$500$400$400Labor cost Labor cost

(each)(each)

400400750750Number of Number of

Units per yearUnits per year

PremiumPremiumStandardStandard


$900$900$550$550Materials cost Materials cost

(each)(each)

$500,000$500,000$200,000$200,000$300,000$300,000Total labor costTotal labor cost

$360,000$360,000

$500$500

400400

PremiumPremium

$772,500$772,500

TotalTotal

$412,500$412,500Total materials costTotal materials cost

$400$400Labor cost (each)Labor cost (each)

750750Number of Units Number of Units

per yearper year

StandardStandard


$1.100324$1.100324$1.100324$1.100324Overhead Overhead

materialmaterial

$850,000$850,000$340,000$340,000$510,000$510,000Allocation by laborAllocation by labor

$360,000$360,000$412,000$412,000Material costMaterial cost

$396,117$396,117

1.701.70

$200,000$200,000

PremiumPremium

$850,000$850,000

$500,000$500,000

TotalTotal

$453,884$453,884Allocation by Allocation by

materialmaterial

1.701.70Overhead/laborOverhead/labor

$300,000$300,000Labor costLabor cost

StandardStandard

Unit cost based on $DL allocation of OHUnit cost based on $DL allocation of OH

500*1.70 = 850500*1.70 = 850400*1.70 = 680400*1.70 = 680OH (DL cost.)OH (DL cost.)

2250225016301630Unit costUnit cost

500500400400DLDL

900900550550DMDM


Unit cost based on $DM allocation of OHUnit cost based on $DM allocation of OH

900*1.100 = 900*1.100 =

990990550*1.100 = 550*1.100 =

605605OH (DM cost.)OH (DM cost.)

2390239015551555Unit costUnit cost

500500400400DLDL

900900550550DMDM


CONCLUSIONSCONCLUSIONS

Direct costs are allocated to the cost unitDirect costs are allocated to the cost unit

Production overheads are allocated or apportioned Production overheads are allocated or apportioned to the cost centres on a fair basis and absorbed to the cost centres on a fair basis and absorbed into the cost unit using an appropriate OARinto the cost unit using an appropriate OAR

NonNon--production overheads can be absorbed into production overheads can be absorbed into the cost unit by adding a percentage based on the the cost unit by adding a percentage based on the proportion of nonproportion of non--production overheads to the production overheads to the total production costtotal production cost

But a limitation of absorption costing is that it is But a limitation of absorption costing is that it is based on arbitrary decisions about the basis for based on arbitrary decisions about the basis for apportionment and absorption of overheadsapportionment and absorption of overheads

CHAPTER 5CHAPTER 5

MARGINAL COSTMARGINAL COST

Using direct (marginal) costingUsing direct (marginal) costing

for decision makingfor decision making

The Direct Costing method (Marginal costing) is an The Direct Costing method (Marginal costing) is an inventory valuation / costing model that includes inventory valuation / costing model that includes only the variable manufacturing costs:only the variable manufacturing costs:

direct materials (those materials that become an direct materials (those materials that become an integral part of a finished product and can be integral part of a finished product and can be conveniently traced into it)conveniently traced into it)

direct labor (those factory labor costs that can be direct labor (those factory labor costs that can be easily traced to individual units of product. Also easily traced to individual units of product. Also called touch labor)called touch labor)

-- only variable manufacturing overhead in the cost only variable manufacturing overhead in the cost of a unit of product. The entire amount of fixed of a unit of product. The entire amount of fixed costs are expenses in the year incurred.costs are expenses in the year incurred.

What is Direct Costing?What is Direct Costing? The Principles of Marginal CostingThe Principles of Marginal Costing

1.1. For any given period of time, fixed costs will be the For any given period of time, fixed costs will be the

same, for any volume of sales and production same, for any volume of sales and production

(provided that the level of activity is within the (provided that the level of activity is within the ‘‘relevant relevant

rangerange’’). Therefore, selling an extra item of product or ). Therefore, selling an extra item of product or

service:service:

Revenue will increase by the sales value of the item soldRevenue will increase by the sales value of the item sold

Costs will increase by the variable cost per unitCosts will increase by the variable cost per unit

Profit will increase by the amount of contribution earned Profit will increase by the amount of contribution earned

from the extra itemfrom the extra item

2. 2. The volume of sales falls by one item The volume of sales falls by one item the profit will the profit will fall by the amount of contribution earned from the item.fall by the amount of contribution earned from the item.

3.3. Profit measurement should be based on an analysis of Profit measurement should be based on an analysis of

total contribution. Since fixed costs relate to a period of total contribution. Since fixed costs relate to a period of

time, and do not change with increases or decreases in time, and do not change with increases or decreases in

sales volume, it is misleading to charge units of sale sales volume, it is misleading to charge units of sale

with a share of fixed costswith a share of fixed costs

4.4. When a unit of product is made, the extra costs When a unit of product is made, the extra costs

incurred in its manufacture are the variable production incurred in its manufacture are the variable production

costs. Fixed costs are unaffected, and no extra fixed costs. Fixed costs are unaffected, and no extra fixed

costs are incurred when output is increasedcosts are incurred when output is increased

The principles of marginal costingThe principles of marginal costing Features of Marginal costingFeatures of Marginal costing

1. Cost Classification1. Cost Classification

TThe marginal costing technique makes a he marginal costing technique makes a

sharp distinction between variable costs and sharp distinction between variable costs and

fixed costs. It is the variable cost on the fixed costs. It is the variable cost on the

basis of which production and sales policies basis of which production and sales policies

are designed by a firm following the are designed by a firm following the

marginal costing techniquemarginal costing technique

2.2. StockStock//InventoryInventory ValuationValuation

Under marginal costing, inventory/stock for Under marginal costing, inventory/stock for

profit measurement is valued at marginal profit measurement is valued at marginal

cost. It is in sharp contrast to the total unit cost. It is in sharp contrast to the total unit

cost under absorption costing methodcost under absorption costing method

Features of Marginal costingFeatures of Marginal costing

3.3. MarginalMarginal ContributionContribution

Marginal costing technique makes use of Marginal costing technique makes use of

marginal contribution for marking various marginal contribution for marking various

decisions. Marginal contribution is the decisions. Marginal contribution is the

difference between sales and marginal cost. difference between sales and marginal cost.

It forms the basis for judging the It forms the basis for judging the

profitability of different products or profitability of different products or

departmentsdepartments

Features of Marginal costingFeatures of Marginal costing

CostCost--VolumeVolume--Profit AnalysisProfit Analysis

Systematic method of examining the relationship Systematic method of examining the relationship

between changes in activity and changes in total between changes in activity and changes in total

sales revenue, expenses and net profitsales revenue, expenses and net profit

CVP analysis is subject to a number of underlying CVP analysis is subject to a number of underlying

assumptions and limitationsassumptions and limitations

The objective of CVP analysis is to establish what The objective of CVP analysis is to establish what

will happen to the financial results if a specified will happen to the financial results if a specified

level of activity or volume fluctuateslevel of activity or volume fluctuates

CVP Analysis AssumptionsCVP Analysis Assumptions

All other variables remain constantAll other variables remain constant

A single product or constant sales mixA single product or constant sales mix

Total costs and total revenue are linear functions Total costs and total revenue are linear functions

of outputof output

The analysis applies to the relevant range onlyThe analysis applies to the relevant range only

Costs can be accurately divided into their fixed and Costs can be accurately divided into their fixed and

variable elementsvariable elements

The analysis applies only to a shortThe analysis applies only to a short--time horizon time horizon

ComplexityComplexity--related fixed costs do not changerelated fixed costs do not change

CVP DiagramCVP DiagramA Mathematical Approach to A Mathematical Approach to

CVP AnalysisCVP AnalysisNP=NP=PxPx--(a+bx(a+bx),),

NPNP –– net profitnet profit

xx –– units soldunits sold

PP –– selling priceselling price

bb –– unit variable costunit variable cost

aa –– total fixed coststotal fixed costs

BreakBreak--Even and Related FormulasEven and Related Formulas

TRTR ––Profit = FC + VCProfit = FC + VC

Contribution = TR Contribution = TR –– VCVC

Profit = Contribution Profit = Contribution –– FCFC

BreakBreak--eveneven (units)(units) = FC/Contribution per unit= FC/Contribution per unit

BreakBreak--eveneven (sales revenue)(sales revenue) =FC/PV ratio, =FC/PV ratio, wherewhere PVPV

(profit(profit -- volume) ratio = Contribution/Selling volume) ratio = Contribution/Selling

priceprice

Margin of SafetyMargin of Safety

Indicates by how much sales may decrease Indicates by how much sales may decrease

before a loss occursbefore a loss occurs

Margin of safety (units)= Profit/Contribution Margin of safety (units)= Profit/Contribution

per unitper unit

Margin of safety (sales revenue) = Profit/PV Margin of safety (sales revenue) = Profit/PV

ratioratio

RangeRange ofof GGoodsoods PPlanninglanning (1)(1)

40 49040 49014 49014 490101012 00012 000101014 00014 0001414ContributionContribution

4902 0422 04211--3 9343 934--332 3822 38222ProfitProfit

120 010120 01035 45835 458242451 93451 934434332 61832 6183333CostsCosts

40 00040 00012 44812 4486615 93415 934131311 61811 6181212FC (FC (allocatedallocated))

80 01023 01023 010151536 00036 000303021 00021 0002121VCVC

120 50037 50037 500252548 00048 000404035 00035 0003535PricePrice((salessales))

totaltotalperper unitunittotaltotalperper unitunittotaltotalperper unitunit

150015001200120010001000

CCBBAA

28 49028 49014 49014 4901010000014 00014 0001414ContributionContribution

-11 510--6 2006 200--440000--5 3105 310--55ProfitProfit

84 01084 01043 70043 7002929000040 31040 3104040CostsCosts

40 00040 00020 69020 69066000019 31019 3101919FC (FC (allocatedallocated))

44 01023 01023 0101515000021 00021 0002121VCVC

72 50037 50037 5002525000035 00035 0003535PricePrice((salessales))


150015000010001000

CCBBAA

Increases in Activity Level Increases in Activity Level (unlimited)(unlimited)


11 4902 0422 04211--3 9343 934--3323 38223 382+915022ProfitProfit

161 510161 51035 45835 458242451 93451 934434364 11864 1183333CostsCosts

50 00012 44812 4486615 93415 934131311 61811 618+100001212FC (FC (allocatedallocated))

111 510111 51023 01023 010151536 00036 000303052 50052 500+315002121VCVC

173 000173 00037 50037 500252548 00048 000404087 50087 500+525003535PricePrice((salessales))

totaltotalperper unitunittotaltotalperper unitunittotaltotalincrementincrementperper unitunit

150015001200120025002500

CCBBAA

Increases in Activity Level Increases in Activity Level (limited)(limited)

1200007000TotalTotal labourlabour demanddemand

19000600060007000700060006000DemandDemand inin unitsunits

maxmax hourshours113322RankRank

4,833,334,67ContributionContribution perper hourhour

223333NumberNumber ofof labourlabour hourshours usedused


4902 0422 04211--19 87119 871--17172 3822 38222ProfitProfit

120 01035 45835 458242467 87167 871575732 61832 6183333CostsCosts

40 00012 44812 4488831 87131 871272711 61811 6181212FC (FC (allocatedallocated))

80 01023 01023 010151536 00036 000303021 00021 0002121VCVC

120 50037 50037 500252548 00048 000404035 00035 0003535PricePrice((salessales))


150015001200120010001000

CCBBAA

PricingPricingPrice is 250 $ per unitPrice is 250 $ per unit

choice 1choice 1 better qualitybetter quality ((higher pricehigher price,,higher FChigher FC)) choice 2choice 2 lower pricelower price

25 00025 00025 00025 000CapacityCapacity

20 00020 00015 00015 000BEPBEP


1 437 6001201201 997 000200200ProfitProfit

962 400962 40080801 003 0001 003 000100100CostsCosts

2 4002 4003 0003 000FC (FC (allocatedallocated))

960 000960 00080801 000 0001 000 000100100VCVC

2 400 0002 400 0002002003 000 0003 000 000300300PricePrice((salessales))

totaltotalperper unitunittotaltotalperper unitunit

12 00012 00010 00010 000

2211

To PTo Produceroduce oror to Bto Buyuy

00002000020000100100ProfitProfit

1800001800001501501600005050CostsCosts

xxxx100000100000FC (FC (allocatedallocated))

xxxx60000600005050VCVC

180000150150180000180000150150PricePrice((salessales))


1200120012001200

BuyBuy ((unlimitedunlimited))ProduceProduce

000000100100ProfitProfit

1500001500001501501500005050CostsCosts

xxxx100000100000FC (FC (allocatedallocated))

xxxx50000500005050VCVC

150000150150150000150000150150PricePrice


1000100010001000

BuyBuy ((unlimitedunlimited))ProduceProduce

AdvantagesAdvantages

Direct costing is simple to understand Direct costing is simple to understand

It provides more useful information for decisionIt provides more useful information for decision--makingmaking

Direct costing removes from profit the effect of inventory Direct costing removes from profit the effect of inventory

changeschanges

Is effective in internal reporting for frequent profit Is effective in internal reporting for frequent profit

statements and measurement of managerial performancestatements and measurement of managerial performance

Direct costing avoids fixed overheads being capitalized in Direct costing avoids fixed overheads being capitalized in

unsaleableunsaleable stocksstocks

The effects of alternative sales or production policies can The effects of alternative sales or production policies can

be easier assessed thus the decisions yield the maximum be easier assessed thus the decisions yield the maximum

return to businessreturn to business

By concentration on maintaining a uniform and consistent By concentration on maintaining a uniform and consistent

marginal costmarginal cost practical cost control is greatly facilitatedpractical cost control is greatly facilitated

DisadvantagesDisadvantages

The separation of costs into fixed and variable is difficult The separation of costs into fixed and variable is difficult

and sometimes gives misleading results and sometimes gives misleading results

Direct costing underestimates the importance of fixed costsDirect costing underestimates the importance of fixed costs

Full costing systems also apply overhead under normal Full costing systems also apply overhead under normal

operating volume and this shows that no advantage is operating volume and this shows that no advantage is

gained by direct costinggained by direct costing

Under direct costing, stocks and work in progress are Under direct costing, stocks and work in progress are

understated. The exclusion of fixed costs from inventories understated. The exclusion of fixed costs from inventories

affect profit, and true and fair view of financial affairs of anaffect profit, and true and fair view of financial affairs of an

organization may not be clearly transparentorganization may not be clearly transparent

Volume variance in standard costing also discloses the Volume variance in standard costing also discloses the

effect of fluctuating output on fixed overhead. Marginal effect of fluctuating output on fixed overhead. Marginal

cost data becomes unrealistic in case of highly fluctuating cost data becomes unrealistic in case of highly fluctuating

levels of production, e.g., in case of seasonal factories. levels of production, e.g., in case of seasonal factories.

Disadvantages (2)Disadvantages (2)

Application of fixed overhead depends on estimates and Application of fixed overhead depends on estimates and

there may be under or over absorption of the same there may be under or over absorption of the same

Control affected by means of budgetary control is also Control affected by means of budgetary control is also

accepted by many. In order to know the net profit, we should accepted by many. In order to know the net profit, we should

not be satisfied with contribution and hence, fixed overhead not be satisfied with contribution and hence, fixed overhead

is also a valuable item. A system which ignores fixed costs is is also a valuable item. A system which ignores fixed costs is

less effective since a major portion of fixed cost is not taken less effective since a major portion of fixed cost is not taken

care of under marginal costing care of under marginal costing

In practice, sales price, fixed cost and variable cost per unit In practice, sales price, fixed cost and variable cost per unit

may vary. Thus, the assumptions underlying the theory of may vary. Thus, the assumptions underlying the theory of

marginal costing sometimes becomes unrealistic. For long marginal costing sometimes becomes unrealistic. For long

term profit planning, absorption costing is the only answerterm profit planning, absorption costing is the only answer

Direct vs. Absorption (full) costingDirect vs. Absorption (full) costing

Direct costingDirect costing

are regarded as period costs (writtenare regarded as period costs (written

as a lump sum to the profit and lossas a lump sum to the profit and loss

account)account)

are assigned to the productsare assigned to the products

are period costsare period costs

are added to the variableare added to the variable

manufacturing cost of sales tomanufacturing cost of sales to

determine total manufacturing costsdetermine total manufacturing costs

Absorption costingAbsorption costing

are allocated to the products are allocated to the products

(included in inventory valuation)(included in inventory valuation)


are period costsare period costs


Fixed manufactured overheads

Variable manufacturing costs

Non-manufacturing overheads

Fixed manufacturing costs

Direct vs. Absorption (full) costingDirect vs. Absorption (full) costing

Direct costingDirect costing

Profit is a function of Profit is a function of

salessales

Are recommended where Are recommended where

indirect costs are a low indirect costs are a low

proportion of an proportion of an

organizationorganization’’s total costss total costs

is used for managerial is used for managerial

decisiondecision--making and making and

controlcontrol

used mainly for internal used mainly for internal

purposespurposes

Absorption costingAbsorption costing

Profit is a function of both Profit is a function of both

sales and productionsales and production

Assigns indirect costs to Assigns indirect costs to

cost objectscost objects

is widely used for cost is widely used for cost

control purpose esp. in control purpose esp. in

the long runthe long run

consistent for external consistent for external

reportingreporting

THE ENDTHE END

CHAPTER 6 STANDARD COSTCHAPTER 6 STANDARD COST

Ir. Haery Ir. Haery SihombingSihombing/IP/IPPensyarah

Fakulti Kejuruteraan PembuatanUniversiti Teknologi Malaysia Melaka

STANDARD COSTSSTANDARD COSTS

WHAT ARE STANDARD COST ?WHAT ARE STANDARD COST ?Standard costs are the expected costs of manufacturing Standard costs are the expected costs of manufacturing

the productthe product..

WHAT ARE STANDARD COST SYSTEM?WHAT ARE STANDARD COST SYSTEM?

1. A standard costs system is a method of setting cost 1. A standard costs system is a method of setting cost

targets and evaluating performancetargets and evaluating performance

2. Target or expected costs are set based on a variety of 2. Target or expected costs are set based on a variety of

criteria, and actual performance relative to expected criteria, and actual performance relative to expected

targets is measuredtargets is measured


WHAT ARE STANDARD COST SYSTEM?WHAT ARE STANDARD COST SYSTEM?

3. Significant difference between expectations and 3. Significant difference between expectations and

actual results are investigatedactual results are investigated

4. Consistent with the themes developed throughout 4. Consistent with the themes developed throughout

this class, standard cost systems are means of helping this class, standard cost systems are means of helping

managers with decision making and controlmanagers with decision making and control

Standard Direct Labor costsStandard Direct Labor costs ==

Expected Wage Rate Expected Wage Rate XX Expected Number of HoursExpected Number of Hours

Standard Direct Material CostStandard Direct Material Cost ==

Expected Cost of Raw Materials Expected Cost of Raw Materials XX Expected Number of Units ofExpected Number of Units of

Raw MaterialRaw Material

Standard Overhead CostsStandard Overhead Costs ==

Expected Fixed OH Expected Fixed OH ++ Expected Variable Overhead Expected Variable Overhead XX Expected Expected

NumNumber of Units to be Producedber of Units to be Produced


TARGET COSTINGTARGET COSTING

1. The market place determines the selling 1. The market place determines the selling

price of the future productprice of the future product

2. The company determines the profit margin 2. The company determines the profit margin

they desire to achieve on his productthey desire to achieve on his product

3. The difference between the selling price 3. The difference between the selling price

and the profit margin is the target costand the profit margin is the target cost

WHY USE A STANDARD COST SYSTEMWHY USE A STANDARD COST SYSTEM


1. Standard are important for decision making1. Standard are important for decision making•• How we produce our productHow we produce our product

•• How we price our productHow we price our product

•• Contract billingContract billing

2. Monitor Manufacturing2. Monitor Manufacturing•• Large variances may indicative of problems in Large variances may indicative of problems in

productionproduction

3. Performance Measurement3. Performance Measurement•• Deviations between actual and standards are often Deviations between actual and standards are often

used as measure of a managerused as measure of a manager’’s performances performance

•• Who sets the standard ?Who sets the standard ?


HOW DO WE SET THE STANDARDS ?HOW DO WE SET THE STANDARDS ?

Theoretically the standard should be expected cost Theoretically the standard should be expected cost

of producing the productof producing the product

General practices:General practices:•• Prior years performancePrior years performance

•• Expected future performance under normal operatingExpected future performance under normal operating

•• Optimistic (Motivator)Optimistic (Motivator)


Important considerations in setting standardImportant considerations in setting standard

1. Why are senior managers using standard•• PricingPricing

•• Performance measurementPerformance measurement

•• Production decisionsProduction decisions

2. What happens if managers fail to meet the

standards ?

3. Standard are supposed to represent the

opportunity cost of production

Example : 1Example : 1 Example : 1Example : 1

Example : 1Example : 1 Example : 1Example : 1

• What do we do with the raw materials price

variance ?

• Who do we hold responsible ?

• What do we do with the raw materials

quantity variance?

• Who do we hold responsible ?

Example : 1 Example : 1 (Question)(Question) Direct Labor Wage VarianceDirect Labor Wage Variance

Direct Labor Efficiency VariancesDirect Labor Efficiency Variances STANDARD COSTSSTANDARD COSTS

BUDGETSBUDGETS areare TOTALTOTAL amountsamounts

A STANDARD COSTA STANDARD COST isis

aa PER UNIT BUDGETPER UNIT BUDGET amountamount

Ideal Vs. Normal StandardsIdeal Vs. Normal Standards

AnAn Ideal StandardIdeal Standard is the theoretical bestis the theoretical best--causecause

which assumes 100% efficiencywhich assumes 100% efficiency

AA Normal StandardNormal Standard should represent a level of should represent a level of

efficiency that is attainable under normal efficiency that is attainable under normal

operating conditionsoperating conditions

The setting of the standard is a management The setting of the standard is a management

judgment call and must reflect expected and judgment call and must reflect expected and

acceptable inefficienciesacceptable inefficiencies

Analysis of Direct Material VariancesAnalysis of Direct Material Variances


TOTAL VARIANCETOTAL VARIANCE for Direct Materials for Direct Materials

must be analyzed in terms ofmust be analyzed in terms of

Quantity VarianceQuantity Variance

Price VariancePrice Variance



The Analysis of the Labor VarianceThe Analysis of the Labor Variance worksworks

the same mechanically as the the same mechanically as the Analysis of Analysis of

Direct Materials VariancesDirect Materials Variances

Analysis of Direct Labor VariancesAnalysis of Direct Labor Variances

Direct Materials Direct LaborDirect Materials Direct Labor

Quantity # of HoursQuantity # of Hours

Price Hourly CostPrice Hourly Cost

Analysis of Overhead VariancesAnalysis of Overhead Variances Analysis of Overhead VariancesAnalysis of Overhead Variances

Analysis of Overhead VariancesAnalysis of Overhead Variances Analysis of Overhead VariancesAnalysis of Overhead Variances

Analysis of Overhead VariancesAnalysis of Overhead Variances Example : 2Example : 2 Manufacturing Product CostsManufacturing Product Costs

Direct costsDirect costs----can be traced to units can be traced to units

producedproduceddirect labordirect labor

direct materialsdirect materials

OverheadOverhead----cancan’’t be traced to unitst be traced to unitsindirect laborindirect labor----e.g., janitorial, supervisorye.g., janitorial, supervisory

indirect materialsindirect materials----e.g., miscellaneous suppliese.g., miscellaneous supplies

otherother----e.g., depreciation, utilities, rente.g., depreciation, utilities, rent

allocated to units based on allocated to units based on ““driversdrivers””

Steps in recordingSteps in recording

Place purchases in raw materials inventoryPlace purchases in raw materials inventory

Transfer raw materials inventory to workTransfer raw materials inventory to work--

inin--process inventory when production startsprocess inventory when production starts

Add in direct labor and overhead to WIPAdd in direct labor and overhead to WIP

Transfer costs of completed units to finished Transfer costs of completed units to finished

goods inventorygoods inventory


Transfer costs associated with sold goods to Transfer costs associated with sold goods to

CGSCGS

Steps in recordingSteps in recording Steps in recordingSteps in recording


EXAMPLE: 3 EXAMPLE: 3 Statement of Cost of Goods ManufacturedStatement of Cost of Goods Manufactured

Beginning work in processBeginning work in process $ 145,000$ 145,000

Raw materials usedRaw materials used $284,000$284,000

Direct laborDirect labor 436,000436,000

Variable overheadVariable overhead 115,200115,200

Fixed overheadFixed overhead 98,88098,880

Current period manufacturing costsCurrent period manufacturing costs 934,080934,080

Total costs to account forTotal costs to account for $1,079,080$1,079,080

Ending work in processEnding work in process 20,88020,880

Cost of goods manufacturedCost of goods manufactured $1,058,200$1,058,200

Statement of Cost of Goods ManufacturedStatement of Cost of Goods ManufacturedRaw Materials UsedRaw Materials Used

Beginning balanceBeginning balance $ 73,000$ 73,000

Purchases of materialsPurchases of materials 280,000280,000

Raw materials availableRaw materials available $353,000$353,000

Ending balance Ending balance 69,00069,000

Total raw materials used Total raw materials used $284,000$284,000

To Statement of Cost of Goods ManufacturedTo Statement of Cost of Goods Manufactured

Schedule of Cost of Goods SoldSchedule of Cost of Goods Sold

Beginning Finished GoodBeginning Finished Good $ 87,400$ 87,400

Cost of Goods ManufacturedCost of Goods Manufactured 1,058,2001,058,200

Cost of Goods Available for SaleCost of Goods Available for Sale $1,145,600$1,145,600

Ending Finished GoodsEnding Finished Goods 91,60091,600

Cost of Goods SoldCost of Goods Sold $1,054,000$1,054,000

From Schedule of Cost of Goods Manufactured

Income StatementIncome Statement

RevenueRevenue xxxxxxxx

Cost of Goods Sold Cost of Goods Sold <<1,054,0001,054,000>>

Gross Profit Gross Profit xxxxxxxx

Operating Expenses Operating Expenses <xxxx> <xxxx>

Operating Income Operating Income xxxxxxxx

From Schedule of Cost of Goods Sold

QuestionsQuestions

What is the difference between a fixed and What is the difference between a fixed and

variable cost? variable cost?

What are the three components of product What are the three components of product

cost?cost?

What are the three inventory accounts for What are the three inventory accounts for

a manufacturing company?a manufacturing company?

BMFP 3582-Chapter 3456 Cost (Direct-Indirect-Marginal-Standard)

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