Costing

Chapter 1 Costing

LEARNING OBJECTIVES

1.      Explain the general concepts of costs.
2       Explain the computation of overhead allocation and apportionment.
3.      Explain the concept of over and under absorption of overheads.
4.      Explain and compare the difference between absorption costing and marginal costing.

costing

1. Introduction

1.1 Costing is the process of determining the costs of products, services or activities.
1.2 Cost accounting is used to determine the cost of products, jobs or services. Such costs have to be built up using a process known as cost accumulation.

costing

2. Overheads => indirect

2.1 Meanings of overhead

2.1.1    If a company manufactures a product, the cost of the product will include the cost of the raw materials and components used in it and cost of the labour effort required to make it. These are direct costs of the product. The company would, however, incur many other costs in making the product, which are not directly attributable to a single product, but which are incurred generally in the process of manufacturing a large number of product units. These are indirect costs or overheads. Such costs include the following, for example:
(a)        Factory rent and rates;
(b)       Supervision costs;
(c)        Machine depreciation;
(d)       Heating and lighting, etc.

2.1.2

Key Terms

(a)      A direct cost is a cost that can be traced in full to the product, service or department that is being costed.
(b)      An indirect cost or overhead is a cost that is incurred in the course of making a product, providing a service or running a department, but which cannot be traced directly and in full to the product, service or department.
(c)      Cost allocation is the process of allocating the whole overhead to a cost centre where this cost can be identified with a particular cost centre.
(d)      Cost apportionment – When an overhead is common to more than one cost centre, it must be shared out or split on an equitable basis.

2.2       Overhead cost allocation and apportionment
(Jun 15)
2.2.1    This section we focus in more detail on the two-stage overhead process of assigning overhead to products. The procedure is as follows:
(a)     Assign all factory overheads to production and service cost centres.
(b)     Reallocate service centre costs to production cost centres.
(c)     Calculate separate overhead rates for each cost centre.
(d)     Assign cost centre overhead to products.
Items (a) and (b) comprise stage one while (c) and (d) relate to stage two of the overhead assignment procedure.

costing

2.2.2 Also, the item (a) is called the primary apportionment which is the distribution of overheads basing on the data from source documents, such as utilities bills, to respective cost centers. The item (b) is called the secondary apportionment which is the further re-distribution of overhead costs from service cost centres to the production costs centres. Costs of goods manufactured can then be calculated basing on the overhead costs per unit after secondary apportionment.

Example 1

A company is preparing its production overhead budgets and determining the apportionment of those overheads to products. Cost centre expenses and related information have been budgeted as follows.

	Total	Machine Dept A	Machine Dept B	Assembly	Canteen	Maint.
	$	$	$	$	$	$
Indirect wages	78,560	8,586	9,190	15,674	29,650	15,460
Consumable materials	16,900	6,400	8,700	1,200	600	-
Rent & rates	16,700
Buildings insurance	2,400
Power	8,600
Heat and light	3,400
Depn. (machinery)	40,200
Value of machinery	402,000	201,000	179,000	22,000

Power usage (%)	100	55	40	3		2
Direct labour (hours)	35,000	8,000	6,200	20,800	-	-
Machine usage (hours)	25,200	7,200	18,000	-	-	-
Area (sq. ft.)	45,000	10,000	12,000	15,000	6,000	2,000

Required:

Using the direct apportionment to production department method and bases of apportionment which you consider most appropriate from the information provided, calculate overhead totals for the three production departments.

Solution:

	Total	Machine Dept A	Machine Dept B	Assembly	Canteen	Maint.	Basis of apportion.
	$	$	$	$	$	$
Indirect wages	78,560	8,586	9,190	15,674	29,650	15,460	Actual
Consumable materials	16,900	6,400	8,700	1,200	600	-	Actual
Rent & rates	16,700	3,711	4,453	5,567	2,227	745	Area
Buildings insurance	2,400	533	640	800	320	107	Area
Power	8,600	4,730	3,440	258	-	172	Usage
Heat and light	3,400	756	907	1,133	453	151	Area/usage
Depn. (machinery)	40,200	20,100	17,900	2,200	-	-	Value of machine
	166,760	44,816	45,230	26,832	33,250	16,632
Reallocate	-	7,600	5,890	19,760	(33,250)	-	Direct labour
Reallocate	-	4,752	11,880	-	-	(16,632)	Machine usage
Total	166,760	57,168	63,000	46,592	-	-

OH absorb. basis		Machine hour	Machine hour	Labour hour
OAR		57,168	63,000	46,592
		7,200	18,000	20,800
		= $7.94	$3.50	$2.24

2.2.3 The choice of an absorption basis is a matter of judgement and common sense. There are no strict rules or formulae involved. But the basis should realistically reflect the characteristics of a given cost centre, avoid undue anomalies and be fair.

2.3 Over and under absorption of overheads

2.3.1	Over- or Under-absorbed Overhead
	(a) Over-/under-absorbed overhead occurs when overheads incurred do not equal overheads absorbed. (b) Over absorption means that the overheads charged to the cost of sales are greater than the overheads actually incurred. (c) Under absorption means that insufficient overheads have been included in the cost of sales.

2.3.2 The rate of overhead absorption is based on estimates (of both numerator and denominator) and it is quite likely that either one or both of the estimates will not agree with what actually occurs.

Example 2

Suppose that the budgeted overhead in a production department is $80,000 and the budgeted activity is 40,000 direct labour hours, the overhead recovery rate (using a direct labour hour basis) would be $2 per direct labour hour. Actual overheads in the period are, say $84,000 and 45,000 direct labour hours are worked.

	$
Overhead incurred (actual)	84,000
Overhead absorbed (45,000 x $2)	90,000
Over-absorption of overhead	6,000

In this example, the cost of production has been charged with $6,000 more than was actually spent and so the cost that is recorded will be too high. The over-absorbed overhead will be an adjustment to the profit and loss account at the end of accounting period to reconcile the overheads charged to the actual overhead.

Question 1

The total production overhead expenditure of the company in Example 1 was $176,533 and its actual activity was as follows.

	Machine shop A	Machine shop B	Assembly
Direct labour hours	8,200	6,500	21,900
Machine usage hours	7,300	18,700	-

Required:

Using the information above and the results of Example 1, calculate the under- or over-absorption of overheads.

2.3.3    The overhead absorption rate is predetermined from budget estimates of overhead cost and activity level. Under or over recovery of overhead will occur in the following circumstances.
(a)        Actual overhead costs are different from budgeted overheads.
(b)       The actual activity level is different from the budgeted activity level.
(c)        Actual overhead costs and actual activity level differ from those budgeted.

Question 2
In management accounting, allocation of overheads is a key issue.

There are five hotels in a hotel chain and their particulars are as follows:

Hotel	Location	No. of rooms	Annual revenue (HK$)
A	East	300	149,600,000
B	South	195	88,400,000
C	West	225	136,000,000
D	North	255	88,400,000
E	Central	525	217,600,000

There are two corporate positions who oversee the operations of these hotels; they are director of operations and corporate sales director. The annual salaries of these two positions are HK$2,000,000 and HK$1,500,000 respectively.

Required:

(a)     If the total salaries of these directors are shared equally among the five hotels, how much is the cost allocated to each hotel? Assume the two administrative positions are fixed overheads from the hotel chain’s perspective.                              (3 marks)
(b)     If the total salaries of these directors are allocated based on the number of rooms, how much is the respective overhead charged to each hotel? Present your result in tabular form.                                                                                                    (3 marks)
(c)     If the total salaries of these directors are allocated based on the percentage of total revenues earned, how much is the respective overhead charged to each hotel? Present your result in tabular form.                                                              (3 marks)
(d)     Which allocation method is best for hotel C? Explain briefly.                    (2 marks)
(e)     Some management argued that floor area or number of staff should be used in determining the amount of overheads allocated to the hotels. Do you agree (or disagree) that floor area is an appropriate cost driver? Explain briefly.   (4 marks)
(f)      “Higher cost allocated to a department/unit is not necessarily a bad thing.” What are the reasons behind this statement from (i) a cost centre perspective, and (ii) a profit centre perspective?                                                                               (5 marks)
(HKIAAT PBE Paper II Management Accounting and Finance June 2015 Q5)

3. Absorption Costing and Marginal Costing

3.1

Key Terms

(a) Absorption costing (full costing) is a form of costing in which the costs of products are calculated by adding an amount for indirect costs (overheads) to the direct costs of production. => Fixed Overheads
(b) Marginal costing (variable costing) is an alternative to absorption costing. Only variable costs (marginal costs) are charged as a cost of sales. Fixed costs are treated as period costs and are charged in full against the profit of the period in which they are incurred.

Example 3

A company makes and sells a single product. At the beginning of period 1, there are no opening inventories of the product, for which the variable production cost is $4 and the sales price $6 per unit. Fixed costs are $2,000 per period, of which $1,500 are fixed production costs. Normal production is 1,500 units per period. In period 1, sales were 1,200 units, production was 1,500 units. In period 2, sales were 1,700 units, production was 1,400 units.

Required:

(a) Prepare profit statements for each period and for the two periods in total using both absorption costing and marginal costing.
(b) Reconcile the profits between absorption costing and marginal costing for period 1.

Solution:
(a)
Absorption costing
The absorption rate for fixed production overhead is $1,500/1,500 units = $1 per unit. The fully absorbed cost per unit = $(4 + 1) = $5.

	Period 1		Period 2		Total
	$	$	$	$	$	$
Sales		7,200		10,200		17,400
Production costs
Variable	6,000		5,600		11,600
Fixed	1,500		1,400		2,900
	7,500		7,000		14,500
Add: opening inventory b/f	-		1,500		1,500
	7,500		8,500		16,000
Less: closing inventory c/f	(1,500)		-		(1,500)
Production cost of sales	6,000		8,500		14,500
Under-absorbed OH	-		100		100
Total costs		6,000		8,600		14,600
Gross profit		1,200		1,600		2,800
Other costs		(500)		(500)		(1,000)
Net profit		700		1,100		1,800

Marginal costing
The marginal cost per unit = $4.

	Period 1		Period 2		Total
	$	$	$	$	$	$
Sales		7,200		10,200		17,400
Production costs
Variable	6,000		5,600		11,600
Add: opening inventory b/f	-		1,200		1,200
	6,000		6,800		12,800
Less: closing inventory c/f	(1,200)		-		(1,200)
Variable prod. cost of sales		4,800		6,800		11,600
Contribution		2,400		3,400		5,800
Fixed costs		(2,000)		(2,000)		(4,000)
Profit		400		1,400		1,800

(b)
The profits reported for period 1 would be reconciled as follows.

	$
Marginal costing profit	400
Adjusted for fixed overhead in inventory (inventory increase of 300 units x $1 per unit)	300
Absorption costing profit	700

3.2	Reconciliation of Profits between Two Methods
	(a) If opening inventory = closing inventory, MC profit = AC profit (b) If opening inventory > closing inventory, MC profit > AC profit (c) If opening inventory < closing inventory, MC profit < AC profit

Question 3 – Manipulating Profits

ABC Co budgeted to make and sell 10,000 units of its product in 2011. The selling price is $10 per unit and the variable cost $4 per unit. Fixed production costs were budgeted at $50,000 per year. The company uses absorption costing and budgeted an absorption rate of $5 per unit. During 2011, it became apparent that sales demand would only be 8,000 units. The management, concerned about the apparent effect of the low volume of sales on profits, decided to increase production for the year to 15,000 units. Actual fixed costs were still expected to be $50,000 in spite of the significant increase in production volume.

Required:

Calculate the profit at an actual sales volume of 8,000 units, using the following methods.
(a) Absorption costing
(b) Marginal costing
Explain the difference in profits calculated.

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Costing

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