W3 Lecture Power Point

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Accounting for Decision Making

Week 3 Lecture

(Seminar 4 – The Nature of Costs)



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Classification of production costs

Element Nature

Materials = Direct materials + Indirect materials

+

Labour = Direct labour + Indirect labour+

Expenses = Direct expenses + Indirect expenses

=Total cost = Prime cost + Overheads

(Production Overheads)



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Indirect Costs (Overheads)Direct Costs (Prime Cost)

• Costs that can beeasily and

conveniently traced toa unit of product or other cost object.

• Examples: directmaterial, direct labour,and direct expenses

• Costs cannot beeasily and

conveniently traced toa unit of product or other cost object.

• Example: indirect

material, indirectlabour, and indirectexpenses




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Direct Materials

Those materials that become an integral part of the

product and that can be conveniently traced to it.

Example: A radio installed in an automobile

Example: A radio installed in an automobile




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Direct Labour

Those labor costs that can be easily and conveniently

traced to individual units of product.

Example: Wages paid to automobile assembly workers

Example: Wages paid to automobile assembly workers




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Direct expenses

Those production related costs that can be easily andconveniently traced to individual units of product.

Example: Cost of machinery used specially for

production the automobile

Example: Cost of machinery used specially forproduction the automobile




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Manufacturing costs that cannot be traced directly tospecific units produced.

Overheads

IndirectMaterials

IndirectLabour

IndirectExpenses

Overheads




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Materials used to support theproduction process

Examples: lubricants and cleaningsupplies used in the automobile

assembly plant.

IndirectMaterials

Wages paid to employees who arenot directly involved in production

work.Examples: maintenance workers,

supervisor, and security guards.

IndirectLabour

Costs related to the manufacturingfacility but cannot be traceddirectly to the cost object.

Examples: utilities, machinery

depreciation, insurance, repairs.

IndirectExpenses




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Seminar Question 1

How would you classify the following items using those six categoriesof the nature of cost?

1. Glue used by a furniture manufacturer toreinforce joints?

2. Charge for specialist colour work subcontracted

to another printer?

3. Steel girders used in a crane manufacturing

company?

4. Hairdresser’s wages in a hairdressing salon?

5. Forklift driver’s wages in handling and moving

factory materials?

6. Payment to firm of accountants in respect of the



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Cost Classifications of a Manufacturer

Selling andadministrativeexpenses

Direct Labour

Production Overheads('Overheads')

Direct Materials

Manufacturing Costs

Non-manufacturing Costs

Indirect Labour

Indirect Expenses

Indirect Materials

Direct Expenses

(Popular Classification)



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Selling andadministrativeexpenses

Direct Labour

Production Overheads('Overheads')

Direct Materials

Manufacturing Costs


Indirect Labour

Indirect Expenses

Indirect Materials Direct Expenses

(An alternative Classification)

Prime Cost



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Marketing and selling costs . . .

– Costs necessary to get the order and deliver

the product.

Administrative costs . . .

– All executive, organizational, and clerical costs.

– Depreciation (for facilities not related tomanufacturing)

– General office expenses.




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Cost Behaviour



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The basic types of cost behaviour are illustratedas follows:

Cost Behaviour

Variable



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•“Driven” by time = FIXED COSTS

•“Driven” by activity = VARIABLE COSTS

•“Driven” by both time & activity = MIXED COSTS

(step or semi-variable)

Cost Behaviour



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13,000 units

15,000 units

+ 5,000 £138,800

£150,800

+£25,000

High-Low method

To separate fixed and variable elements Output

10,000 units

Total costs

£125,800

5,000 MORE UNITS COST £25,000 MORE TO MAKE



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High-Low method

Since only VARIABLE costs vary with activity, the variable cost of producing 5,000 more units is

£25,000 or £25,000/5,000 = £5 per unit.

The fixed cost must be:

£125,800 – £50,000 (10,000 x £5) = £75,80



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Records have been kept for ten months of the total costs of aproduct at various levels of output:

Output (units) Total cost (£)

502 2,591

471 2,208

563 2,411

542 2,316593 2,405

494 2,280

601 2,663

585 2,602567 2,398

480 2,300

Calculate the variable cost per unit and the fixed cost per month

using the high-low method.

Seminar Question 3



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The Elite Manufacturing Company has the following cost structure:

Variable costs £1 per unit

Fixed costs £100,000 per month

1) Calculate the unit cost achieved at the following levels of activity:

100,000 units per month200,000 units per month

400,000 units per month

2) What important principle have you learned from your calculations?

Seminar Question 4



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Fixed CostsVariable Costs

Variable cost is constant ifexpressed on per unitbasis

Units ofOutput

Va

riab

le

Co

sts

per

units

Per unit fixed cost decreasesas output increases

Units ofOutput

Fix

ed

Costs

per

unit



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Summary

Three cost classifications

Form Basic cost elements Direct & indirect Fixed, variable, semi-

variable & step

Purpose Basic records forsimple profit

statements

Relating costs toproducts &

departments for

cost control

Showing response tochanges in activity

levels for planning &

controlAnalysis of

total cost

Direct materials +

direct labour +production overhead

Direct (prime)

cost + indirect(overheads)

Variable, semi-

variable, step, fixed



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Absorption of Production Overheads



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Absorption of Production Overhead

ProductionOverheads

DirectMaterials

+

DirectLabor

Cost Object

It is anything forwhich cost data aredesired – includingproduct, product lines,

customers, jobs, andorganizationalsubunits.

Cost Tracing

Cost absorption/application

+

Manufacturing Costs



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Job No. 1Job No. 1

Job No. 2Job No. 2

Job No. 3Job No. 3

Charge directmaterials toeach job as

work is

performed.

Charge directmaterials toeach job as

work is

performed.

Direct MaterialsDirect Materials



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Job No. 1Job No. 1

Job No. 2Job No. 2

Job No. 3Job No. 3

Direct MaterialsDirect MaterialsChargedirectlabourcosts to

each job aswork isperformed.

Charge

directlabourcosts to

each job aswork is

performed.

Direct Labour Direct Labour



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Direct Labor $32,000at $100/hr

Inventory

$25,000

Job No. 1

$12,000

Job No. 2

$8,000

Job No. 3

$5,000

$32,000

$16,000

$12,000

$4,000

Based on 160actual directlabor-hours

120 actual directlabor-hours

40 actual directlabor-hours



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Absorb

overheadsto each job

using an

absorptionrate.

Absorb

overheadsto each job

using an

absorptionrate.

Direct MaterialsDirect Materials

Direct Labor Direct Labor

Job No. 1Job No. 1

Job No. 2Job No. 2

Job No. 3Job No. 3Production

Overheads

Production

Overheads



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Step 1: Estimate total production overheads for thecoming period

Note that the estimate total productionoverheads rather than the actual overheads is used. This is because weneed to apply overheads to jobs from thebeginning and throughout a period rather

than wait until the end of a period.

The actual overheads for the period is notknown until the end of the period.



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Step 2: Select Absorption (/allocation) baseThe allocation base used should be the cost driver of the overheads. A cost driver is a factor, such asmachine-hours, direct labor-hours, direct materials

cost, or floor space that causes the overheads.

If direct materials cost are used to absorb overheads,but in reality overheads has little to do with directmaterials cost, then products with high directmaterials cost will shoulder an unrealistic burden of overheads.



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Step 3: Compute the Absorption Rate

Absorption Rate

=Estimated total production overheads

Estimated total units in the absorption base



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Absorption Rate

=$60,000

300 direct labour-hours

Assuming the estimated total productionoverheads for the coming period is $60,000, the

absorption base selected is direct labour-hours,and the estimated total direct labour to be usedfor the coming period is 300 hours.

= $200 per direct labour-hour



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Step 4: Absorb overheads to jobs based on actualabsorption base incurred.

Overheads absorb to a particular job

=

Absorptionrate x

Actual amount of absorption base

incurred by the job



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Step 5: Determine under or over absorption (/recovery)

ActualProduction

Overheadsincurred

>

AppliedProduction

Overheads

=Under

absorption

$65,000 $64,000 $ 1,000

Under absorption of overheads reflects the actual overheads is morethan originally planned, it give rise to a lower profit than expected.



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ActualProduction

Overheadincurred

<

AppliedProduction

Overhead

=Over

Absorption

Step 5: Determine under or over absorption (/recovery)

$63,000 $64,000 $ 1,000

Over absorption of overheads reflects the actual overheads is lessthan originally planned, it give rise to a higher profit than expected.



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Why do we calculate the absorption rate at thebeginning of a period?

Instead of using an absorption rate which is determined at thebeginning of a period, a company could wait until the end of the

accounting period to compute an actual overhead rate based on theactual total production overhead costs and the actual total units inthe absorption base for the period. It could then not have anyunder or over absorption.

This is not preferred. Managers would like to know the accountingsystem’s valuation of the completed jobs before the end of theaccounting period. Suppose, for example, the a company waitsuntil the end of the year to compute its absorption rate. Then therewould be no way for managers to know the cost of goods sold for aparticular job until the close of the year, even though the job was

completed and shipped to the customer during the year.



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Step 6: Close out under or over absorption overheads

The simplest method is to close out the under or over absorption overheads to the Cost of Goods

Sold. Deducting the C/G/S if it is over absorbed.Adding back the under absorbed amount to C/G/Sif it is under absorbed. (in the U.K. accountingsystem, under or over absorption overhead

balance is closed out to the Selling andAdministrative expenses) .

More complicated methods are sometimes used,but they are beyond the scope of this course.



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Step 6: Close out under or over absorption overheads

Step 5: Determine under or over absorption

Step 4: Absorb overheads to jobs based on actualabsorption base incurred


Step 2: Select absorption base

Step 1: Estimate total production overheads for thecoming period



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Estimated totalproductionoverheads

At the beginning of the period

/Estimated total

units in theabsorption base

=Absorption

rate

Absorptionrate

During the period

xActual total units of the

absorption baseincurred during the

period

=Total production

overheadsabsorbed

Actual totalproductionOverheads

At the end of the period

-Total

productionoverheads

absorbed

=Under (over)

absorption



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Seminar Question 6

During the year the actual number of cycles producedwas 31,428 and the actual overhead incurred totalled£249,392

1) Calculate the under/over absorption for the company

2) What will be the effect on the reported profit?



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Overhead Attachment Procedure

h d h P d



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Allocate

&Apportion

Re-apportion

Re-apportion

Overhead Cost Accounts

ProductionCost Centre 1



ServiceCost Centre 1

ServiceCost Centre 2

Production

Cost Centre 1

Production

Cost Centre 2

Production

Cost Centre 3

Service

Cost Centre 2




ProductA

ProductB

ProductC

Absorption



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1. ESTABLISH COST CENTRE: Cost Centres (or

departments) are established for collecting costs and can either be Production (Assembly Dept.,Machining Dept. etc) or Service (Canteen,Maintenance Dept., Stores Dept. etc).

2. ALLOCATE : Overhead costs that can easily beidentified with the Cost Centre are allocateddirectly to each of the departments.

3. APPORTION : Costs of a general nature such asrents, rates, insurance and depreciation areapportioned to each of the departments using alogical base such as area for rents and rates, fixed

asset values for insurance and depreciation etc.




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4. RE-APPORTION : The total costs of the ServiceDepartments are then re-apportioned to theProduction Departments by again using a logical basesuch as no. of employees for the canteen, no. ofrequisitions from the Stores Department etc.

service centres e.g. canteen

5. ABSORPTION : The total costs of each of theProduction Departments are then absorbed into the

product by using an absorption rate such asOverhead per Direct Labour Hour or Overhead perMachine Hour.




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Blanket Overhead Rate

Blanket Overhead RateBlanket Overhead Rate

A single overhead rate used throughoutA single overhead rate used throughout

an entire factory. A simple method,an entire factory. A simple method,but one that can distort unit product costs.but one that can distort unit product costs.

Blanket Overhead RateBlanket Overhead Rate

A single overhead rate used throughoutA single overhead rate used throughoutan entire factory. A simple method,an entire factory. A simple method,

but one that can distort unit product costs.but one that can distort unit product costs.



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Seminar 4: Questions 1 – 4

Students are required to hand inhandwritten solutions to the assigned

exercises at the beginning of the

tutorial sessions.

Tutorial Exercise



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End ofWeek 3

Lecture

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