Fundamentals of Management Accounting

Certificate in Business Accounting Paper C1 Course Notes (INMA21)

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C1 Fundamentals of Management Accounting Study Programme

1 2 3 4

Page Introduction to the paper and the course................................................................................................................. 4 Introduction to management accounting ...................................................................................................... 11 Introduction to costing and performance measurement ............................................................................... 19 Cost behaviour ............................................................................................................................................. 27 Overhead costs absorption costing ........................................................................................................... 35 Additional Study Guidance 53

Checkpoint 1 (including Course Test 1) 5 6 7 8

Marginal costing and pricing decisions......................................................................................................... 57 Breakeven and limiting factor analysis ......................................................................................................... 65 Standard costing .......................................................................................................................................... 77 Variance analysis ......................................................................................................................................... 83 Additional Study Guidance 93

Checkpoint 2 (including Course Test 2) 9 10 11 12a

Budget preparation....................................................................................................................................... 97 Flexible budgeting ...................................................................................................................................... 111 Cost bookkeeping ...................................................................................................................................... 117 Process costing basic.............................................................................................................................. 133 Additional Study Guidance 141

Checkpoint 3 (including Course Test 3) 12b 13 14 15

Process costing Work-in-progress (WIP) and joint and by-products ....................................................... 145 Job and batch costing ................................................................................................................................ 155 Service costing ........................................................................................................................................... 161 Decision making and investment appraisal ................................................................................................ 167 Additional Study Guidance 181

Checkpoint 4 (including Course Test 4) 16 17

Answers to lecture examples...................................................................................................................... 185 Appendix A : Maths tables.......................................................................................................................... 213

Prepare for and book your CBA!

You should plan to sit your CBA within the next couple of weeks while the knowledge from this course is still fresh in your mind. In preparation use the Learning Media P&R Kit and i-Pass to test yourself on as many questions as you can, revising from the Course Notes and Passcards any areas of the syllabus that cause you problems. Contact your local BPP centre as early as you can to book your CBA and good luck!

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INTRODUCTION

Introduction to Paper C1 Fundamentals of Management Accounting

Overall aims of the syllabus
The aims of the paper, as stated in the CIMA syllabus, are to test the student's ability to:

Explain the purpose of management accounting. Explain the role of the management accountant and CIMA as a professional body for management accountants. Apply methods for identifying cost. Demonstrate cost behaviour. Prepare budgetary control statements and statements of variance analysis. Prepare integrated accounts in a costing environment and financial statements for managers. Demonstrate the use of break-even analysis in making short-term decisions. Apply basic approaches for use in decision making. Demonstrate the use of investment appraisal techniques in making long-term decisions.

The syllabus
The broad syllabus headings and their relative weightings are: Topic A B C D E The context of management accounting Cost identification and behaviour Planning within organisations Accounting control systems Decision making Study weighting 10% 25% 30% 20% 15%

Links with other papers

The areas covered in C1 will be covered further and developed in Paper P1 Performance Operations and Paper P2 Performance Management in the CIMA professional qualification.

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INTRODUCTION

Assessment methods and format of the paper

The paper is tested by computer-based assessment. It is a two-hour assessment comprising 50 compulsory questions each with one or more parts. The pass mark is 50%. Objective test questions are used. There are a variety of objective test question types that can be used. These include multiple choice, true/false and numeric entry.

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INTRODUCTION

Learning Phase Aims

Achieving CIMA's Learning Outcomes
A
1a 1b 1c 1d 2a 2b 2c 3a 3b

The context of management accounting (10%)

Define management accounting. Explain the importance of cost control and planning within organisations. Describe how information can be used to identify performance within an organisation. Explain the differences between financial information requirements for companies, public bodies and society. Explain the role of the management accountant and activities undertaken. Explain the relationship between the management accountant and the managers being served. Explain the difference between placing management accounting within the finance function and a business partnering role within an organisation. Explain the background to the formation of CIMA. Explain the role of CIMA in developing the practice of management accounting. Chapter 1 Chapter 2 Chapter 1 & 2 Chapter 1 & 2 Chapter 1 Chapter 1 Chapter 1 Chapter 1 Chapter 1

B
1a 1b 1c 1d 1e 1f 2a 2b 2c 2d

Cost identification and behaviour (25%)

Explain the concept of a direct cost and an indirect cost. Explain why the concept of cost needs to be defined, in order to be meaningful. Distinguish between the historical cost of an asset and the economic value of an asset to an organisation. Prepare cost statements for allocation and apportionment of overheads, including reciprocal service departments. Calculate direct, variable and full costs of products, services and activities using overhead absorption rates to trace indirect costs to cost units. Apply cost information in pricing decisions. Explain how costs behave as product, service or activity levels increase or decrease. Distinguish between fixed, variable and semi-variable costs. Explain step costs and the importance of timescales in their treatment as either variable or fixed. Calculate the fixed and variable elements of a semi-variable cost. Chapter 2 Chapter 2 Chapter 2 Chapter 4 Chapter 4 & 5 Chapter 5 Chapter 3 Chapter 3 Chapter 3 Chapter 3

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INTRODUCTION

C
1a 1b 1c 1d 1e 1f 1g 1h 1i 2a 2b 2c 2d 2e 2f

Planning within organisations (30%)

Explain why organisations set out financial plans in the form of budgets, typically for a financial year. Prepare functional budgets and budgets for capital expenditure and depreciation. Prepare a master budget based on functional budgets. Explain budget statements. Identify the impact of budgeted cash surpluses and shortfalls on business operations. Prepare a flexible budget. Calculate budget variances. Distinguish between fixed and flexible budgets. Prepare a statement that reconciles budgeted contribution with actual contribution. Explain the difference between ascertaining costs after the event and establishing standard costs in advance. Explain why planned standard costs, prices and volumes are useful in setting a benchmark. Calculate standard costs for the material, labour and variable overhead elements of the cost of a product or service. Calculate variances for materials, labour, variable overhead, sales prices and sales volumes. Prepare a statement that reconciles budgeted contribution with actual contribution. Prepare variance statements. Chapter 9 Chapter 9 Chapter 9 Chapter 10 Chapter 9 Chapter 10 Chapter 10 Chapter 10 Chapter 10 Chapter 7 Chapter 7 Chapter 7 Chapter 8 Chapter 8 Chapter 8

D
1a 1b 1c 1d 2a 2b

Accounting control systems (20%)

Explain the principles of manufacturing accounts and the integration of the cost accounts with the financial accounting system. Prepare a set of integrated accounts, showing standard cost variances. Explain job, batch, and process costing. Prepare ledger accounts for job, batch and process costing systems. Prepare financial statements that inform management. Distinguish between managerial reports in a range of organisations, including commercial enterprises, charities and public sector undertakings. Chapter 11 Chapter 11 Chapter 12 & 13 Chapter 12 & 13 Chapter 4 & 5 Chapter 14

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INTRODUCTION

E
1a 1b 1c 2a 2b 2c 3a 3b

Decision making (15%)

Explain the contribution concept and its use in cost-volume-profit (CVP) analysis. Calculate the break-even point, profit target, margin of safety and profit/volume ratio for a single product or service. Prepare break-even charts and profit/volume graphs for a single product or service. Explain relevant costs and cash flows. Explain make or buy decisions. Calculate the profit maximising product sales mix using limiting factor analysis. Explain the process of valuing long-term investments. Calculate the net present value, internal rate of return and payback for an investment. Chapter 6 Chapter 6 Chapter 6 Chapter 15 Chapter 15 Chapter 6 Chapter 15 Chapter 15

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INTRODUCTION

Certificate in Business Accounting

On successful completion of all five of the Certificate level computer-based assessments (or those for which you have not been granted exemptions) you will be awarded the CIMA Certificate in Business Accounting. The Certificate is considered by CIMA to be a qualification in its own right for those who do not wish to qualify fully as a management accountant but who require a broad grounding in basic management accounting and financial accounting issues. However, it is also the principal entry requirement for students aiming to attain the Chartered Management Accountant qualification. The knowledge content of the Certificate ensures that you understand: the fundamental underlying concepts of management accounting (FMA); the regulatory framework for financial accounting and reporting (FFA); quantitative statistical methods used in management accounting (FBM); the economic environment in which organisations operate (FBE); and how formal business relationships between organisations are established (FBLW).

The Certificate in Business Accounting clearly demonstrates to an employer that you have a thorough knowledge of the basics of business accounting, and is a milestone in your career development!

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INTRODUCTION

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Introduction to management accounting

Syllabus Guide Learning Outcomes

Having studied this chapter you will be able to: define management accounting. describe how information can be used to identify performance within an organisation. explain the differences between financial information requirements for companies, public bodies and society. explain the role of the management accountant and activities undertaken. explain the relationship between the management accountant and the managers being served. explain the difference between placing management accounting within the finance function and a business partnering role within an organisation. explain the background to the formation of CIMA. explain the role of CIMA in developing the practice of management accounting.

Chapter Context
This chapter introduces the paper by looking at what management accounting is and the role of both management accountants within organisations and CIMA itself. There are a couple of relatively lengthy definitions in the middle of the chapter but the key thing at this stage is to be comfortable with the main areas of management accountancy in section 1.

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1: INTRODUCTION TO MANAGEMENT ACCOUNTING

Overview
Management Accounting

Position in Organisation

Definitions

The role of CIMA

Main areas

Decision-making

Control

Costing

Planning

Performance evaluation

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1: INTRODUCTION TO MANAGEMENT ACCOUNTING

1
1.1

Management accounting
It is useful to start by looking at a definition: CIMAs definition of management accounting CIMA define management accounting as the application of the principles of accounting and financial management to create, protect, preserve and increase value for the stakeholders of for-profit and not-for-profit enterprises in the public and private sectors. Management accounting is an integral part of management. It requires the identification, generation, presentation, interpretation and use of relevant information...

1.2

The main areas of management accountancy Following on from the above definition we could break down management accounting into five main areas: (a) COSTING What is the cost of goods or services? We need to know this for the income statement, to help set prices and to value inventory in the balance sheet. (b) DECISION-MAKING There are many decisions managers may have to make such as:

What should we produce? How should we finance the business? Is a project worthwhile?

(c)

PLANNING Planning involves defining objectives and assessing future costs and revenues to set up a budget. Planning is essential to help assess purchasing/production requirements of the business.

(d)

CONTROL Once plans have been made, the company must ensure they are being followed and assess any inefficiencies in the business.

(e)

PERFORMANCE EVALUATION Employees and divisions can be assessed by comparing their performance against targets or budgets.

2
2.1

The role of the management accountant

The management accountant assists in the management of an organisation by providing relevant information to help it achieve its objectives, and also by improving the systems that produce that information. Although it is important to appreciate that businesses will have many objectives in order to satisfy various different groups (e.g. employees, customers, suppliers, the government) the
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1: INTRODUCTION TO MANAGEMENT ACCOUNTING assumption that will usually be made in your studies is that companies wish to maximise the wealth of their shareholders. Usually this will be achieved by maximising profit. It should however be noted that the role of the management accountant isnt solely restricted to producing information in monetary terms. For a more detailed description of the role of a management accountant it is worthwhile to refer to some definitions: 2.2 CIMAs definition Chartered Management Accountants help organisations establish viable strategies and convert them into profit (in a commercial context) or into value for money (in a not-forprofit context). To achieve this they work as an integral part of multi-skilled management teams in carrying out the: Formulation of policy and setting of corporate objectives; Formulation of strategic plans derived from corporate objectives; Formulation of shorter-term operational plans; Acquisition and use of finance; Design of systems, recording of events and transactions and management of information systems; Generation, communication and interpretation of financial and operating information for management and other stakeholders; Provision of specific information and analysis on which decisions are based; Monitoring of outcomes against plans and benchmarks, financial and nonfinancial, quantitative and qualitative, for monitoring and control; and Improvement of business systems and processes through risk management and internal audit review. Through these forward-looking roles and by application of their expert skills management accountants help organisations improve their performance, security, growth and competitiveness in an ever more demanding environment. 2.3 IFAC definition of the role and domain of the Professional Accountant in Business IFAC (The International Federation of Accountants) recognise that the roles of professional accountants who work in business are extraordinarily varied in terms of work, experience and responsibilities. IFAC have defined the domain of the Professional Accountant in Business as: The generation or creation of value through the effective use of resources (financial and otherwise) through the understanding of the drivers of stakeholder value (which may include shareholders, customers, employees, suppliers, communities, and government) and organisational innovation The provision, analysis and interpretation of information to management for formulation of strategy, planning, decision making and control Performance measurement and communication to stakeholders, including the financial recording of transactions and subsequent reporting to stakeholders typically under national or international Generally Accepted Accounting Principles (GAAP)

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1: INTRODUCTION TO MANAGEMENT ACCOUNTING Cost determination and financial control, through the use of cost accounting techniques, budgeting and forecasting The reduction of waste in resources used in business processes through the use of process analysis and cost management Risk management and business assurance

3
3.1

The management accountants position

Given that traditionally management accountants focussed on producing cost information they could use the same basic data as financial accountants and it therefore made sense for them to be based in the finance function. However, over time their role has widened to encompass the production of both financial and non-financial information. This, coupled with the fact that much of the basic information production can now be automated, has led to the argument that the management accountant should be based outside the finance function acting as a business advisor and working in cross-functional teams.

3.2

It is important that management accountants recognise that the information needs of managers will vary depending on their level within the organisation. Decision-making operates at three levels: Level Strategic Nature of tasks Developing long term organisational goals and objectives Management Implementing the strategy set efficiently and effectively Operational Ensuring that specific tasks are being carried out in an efficient and effective way Nature of information Unstructured, forward looking and externally focussed, qualitative and quantitative Routine reports for example showing budget v actual Detailed, structured, numerical and internally focussed

CIMA and its role in management accounting

CIMA is global accounting body based in the UK. It is the worlds largest professional body of management accountants. It has over 183,000 members and students in 168 countries.

4.1

The history of CIMA

CIMA was founded in 1919 as The Institute of Cost and Works Accountants (ICWA). It specialised in the development of accounting techniques for use in the internal control of manufacturing, service and public sector operations. It changed its name from ICWA to the Institute of Cost and Management Accountants (ICMA) in 1972 It changed its name again in 1986 to the Chartered Institute of Management Accountants (CIMA) after the granting of a Royal Charter in 1975.

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1: INTRODUCTION TO MANAGEMENT ACCOUNTING 4.2 CIMA and the profession of management accounting

CIMA are committed to upholding the ethical and professional standards and to maintain public confidence in management accounting. CIMA regulates the activities of its members by a code of practice, a discipline committee and a continuing education scheme. It is the responsibility of each student and member to ensure they comply with both CIMA's regulations and any specific regulations and legislation as required by their country of residence. Members and students must uphold the Code of Ethics and refrain from any conduct which might discredit the profession.

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1: INTRODUCTION TO MANAGEMENT ACCOUNTING

Overview
Management Accounting

Position in Organisation

Definitions

The role of CIMA

Main areas

Decision-making

Control

Costing

Planning

Performance evaluation

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1: INTRODUCTION TO MANAGEMENT ACCOUNTING

END OF CHAPTER
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Introduction to costing and performance measurement

Syllabus Guide Learning Outcomes

Having studied this chapter you will be able to: explain the importance of cost control and planning within organisations. describe how information can be used to identify performance within an organisation. explain the differences between financial information requirements for companies, public bodies and society. explain the concept of a direct cost and an indirect cost. explain why the concept of cost needs to be defined, in order to be meaningful. distinguish between the historical cost of an asset and the economic value of an asset to an organisation.

Chapter Context
This chapter introduces some important concepts and terms that are fundamental for this paper including the benefit of splitting total costs into different categories to help us run the organisation effectively. It also looks at how we might assess the financial performance of a company and the performance of a not-for-profit organisation.

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2: INTRODUCTION TO COSTING AND PERFORMANCE MEASUREMENT

Overview

Costing and Performance

Costing

Performance

Financial measures

Value for money

Definitions

Classifications

Direct v indirect

Production v nonproduction

Environmental

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Costing definitions
1.1 Cost object A cost object anything for which cost data is desired. e.g. products, product lines, jobs, customers or departments and divisions of a company 1.2 Cost unit A cost unit is a unit of product or service in relation to which costs may be ascertained. The cost unit should be appropriate to the type of business. For example: Business Car manufacturer Ball bearing manufacturer Builder Management consultant 1.3 Cost centre A cost centre is a function or location for which costs are ascertained (and related to costs units for control purposes). Production cost centre Service cost centre Appropriate cost unit

(E.g. Assembly, processing, finishing)

(Eg Canteen, maintenance, stores)

Introduction to cost classification

Cost classification is the arrangement of cost items into logical groups. For example:

classification by nature (e.g. materials, wages etc.) classification by function (e.g. administration, production)

One of the eventual aims is to determine the cost of making a product or providing a service. 2.1 Classification by function Production costs Non-production costs Administration costs Selling and distribution costs TOTAL COST
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$ X

Direct Prod'n cost Indirect Prod'n cost

X X X

2: INTRODUCTION TO COSTING AND PERFORMANCE MEASUREMENT The management accounting techniques in this paper are mostly concerned with production costs. 2.2 Direct production costs Direct costs are those costs which can be specifically identified with and allocated to a particular cost object. Usually the cost object will be a cost unit and therefore direct costs can be attributed in full to a particular unit of production. Examples of direct production costs:

TOTAL DIRECT COSTS = PRIME COST 2.3 Indirect production costs (production overheads) Indirect production costs are those costs which are incurred in the course of making a product/service but which cannot be identified with a particular cost object (which is usually a cost unit) Examples of indirect production costs:

TOTAL PRODUCTION COST = PRIME COST + PRODUCTION OVERHEADS 2.4 Non-production costs All other costs required to run the business are non-production costs. Examples of non-production costs:

TOTAL COSTS = PRODUCTION COSTS + NON-PRODUCTION COSTS

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3.1 3.2 3.3 3.4

Historical cost v economic value of an asset

In practice most organisations record assets at historical cost. Historical cost of an asset is the original cost to the organisation. However, assets can also be measured at their economic value. Economic value of an asset is the most someone is willing to give up in order to obtain the asset. How much a person is willing to pay for the asset tells us the economic value.
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4
4.1

Environmental costing
Increasingly, businesses need to be aware of the environmental costs associated with business activities. In the past, environmental costs such as energy costs were treated as production overheads and effectively hidden from management scrutiny. Classification of environmental costs. In order to manage environmental costs it can be useful to classify them into 4 categories Environmental prevention costs costs incurred to prevent the production of waste that could cause damage to the environment. Environmental appraisal costs costs incurred to assess whether a firms activities comply with environmental laws and standards. Environmental internal failure costs costs incurred after waste has been produced but not discharged into the environment. Environmental external failure costs costs incurred after waste has been produced and discharged into the environment. Some of these costs may be paid by society as a whole.

4.2

Lecture Example 1
MBash Ltd produces catalytic convertors that are purchased by a wide range of motor manufacturers. Required Identify possible environmental costs that MBash may incur in each of the four categories.

Solution

Performance measurement
One of the main roles of the management accountant is the evaluation of performance. To assist in this a number of financial performance measures can be calculated.

5.1

The gross profit margin is calculated as (gross profit sales) 100%.

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2: INTRODUCTION TO COSTING AND PERFORMANCE MEASUREMENT 5.2 The net profit margin is calculated as (net profit sales) 100%. 5.3 Return on capital employed (ROCE) (also called Return on investment (ROI)) is calculated as (net profit/capital employed) 100% 5.4 Asset turnover is calculated as sales capital employed 5.5 Note that ROCE = net profit margin x Asset turnover

Lecture Example 2
MPRUV plcs summarised results for the last two years are shown below. 20X1 $000 40,000 11,000 6,000 30,000 20X2 $000 50,000 15,000 8,000 40,000

Sales Gross profit Net profit Capital employed Required

Calculate the ratios shown in section 5 for both 20X1 and 20X2

Solution

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Value for money

Many organisations are run on a notforprofit basis, in this case the performance measures in the previous section are less valid. It is more important to assess whether the organisation is getting good value for money by measuring economy, efficiency, and effectiveness. (a) (b) (c) Economy purchase of inputs of appropriate quality at minimum cost Efficiency use of these inputs to maximise output Effectiveness use of these inputs to achieves it goals (quality, speed of response)

Lecture Example 3
Birmington University is a public sector higher education institution with 27,000 students, 500 staff and an annual budget of $243m. Required Identify possible performance measures for Birmington University that would give an indication of its economy, efficiency and effectiveness.

Solution

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2: INTRODUCTION TO COSTING AND PERFORMANCE MEASUREMENT

Overview

Costing and Performance

Costing

Performance

Financial measures

Value for money

Definitions

Classifications

Gross profit margin Net profit margin ROCE Asset turnover

Economy Efficiency Effectiveness

Cost object Cost unit Cost centre

Direct v indirect

Production v non-production

Environmental

Prevention Appraisal Internal failure External failure

END OF CHAPTER
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Cost behaviour

Syllabus Guide Learning Outcomes

Having studied this chapter you will be able to: explain how costs behave as product, service or activity levels increase or decrease. distinguish between fixed, variable and semi-variable costs. explain step costs and the importance of timescales in their treatment as fixed or variable. calculate the fixed and variable elements of a semi-variable cost.

Chapter Context
This chapter firstly covers an important way of classifying costs based on what happens when we increase or decrease output. We can split them between those that stay the same (fixed costs) and those that change (variable costs). It then moves on to look at how we can calculate the fixed and variable elements of an organisations total costs.

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3: COST BEHAVIOUR

Overview

Cost behaviour

Fixed

Variable

Stepped

Mixed

High-low method

Line of best fit method

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3: COST BEHAVIOUR

Cost behaviour and output

A business needs to know how costs behave with output so that predictions of costs can be made. It is expected that costs will increase as production increases (i.e. as output increases) but, the exact way costs behave with output may vary.

1.1

Types of cost behaviour (a) Fixed cost Total cost $

Output (units) (b) Stepped cost Total cost $

Output (units) (c) Variable cost Total cost $

Output (units) (d) Mixed cost (semi-variable) Total cost $

Output (units)

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2
2.1

Behaviour of manufacturing costs

With the linear assumption all costs can be categorised as either fixed or variable. This fits together with previous definitions: Direct costs By their nature direct costs will be variable costs.

2.2

Indirect costs/overheads Overheads can be fixed (e.g. rent) or variable (e.g. tool hire) Fixed Direct costs X 9 Production overheads 9 Non-manufacturing costs Variable 9 9 9

2.3

The importance of timescale Whether a cost is classified as fixed or variable will depend on the timescale being considered. The longer the timescale the greater the proportion of costs that can be considered as variable. For example rent is fixed in the short run, but can be considered a stepped cost in the medium term, and even a variable cost in the long run.

Determining the fixed and variable elements of semivariable costs

Total Cost ($)

Variable cost (VC)

Fixed cost (FC) Output 3.1 3.2 Total cost = Fixed cost + (VC/unit x Output) How can we estimate fixed and variable costs if we only know total cost? High-low method Line of best fit method.

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High-low method
This is a four-step method.

Lecture Example 1
The total costs of a business for differing levels of output are as follows. Month January February March April Required (a) What is the fixed and variable elements of the total cost using the High-Low method? A C (b) Y = $30,000 + $100x Y = $30,000 + $110x B D Y = $10,000 + $110x Y = $10,000 + $100x Output (units) 500 200 800 1,000 Total Costs ($000) 70 30 90 110

What is the total cost if output is 400 units?

Solution

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3: COST BEHAVIOUR

Line of best fit method

A scattergraph with total cost on the vertical axis and output on the horizontal axis is prepared. A line of best fit, which is a line of judgement is drawn to pass through the middle of the points. A scattergraph of the cost and output in Lecture Example 1 is shown below. Total costs ($'000) 100 80 60 40 20 Output (units) 200 400 600 800 1,000 1,200 The point where the line cuts the vertical axis (approximately $10,000) is the fixed cost. If we take the value of one of the plotted points which lies close to the line and deduct the fixed cost from the total cost, we can calculate variable cost per unit. Example: Total cost for 1,000 unit = $110,000 Variable cost for 1,000 units = $110,000 $10,000 = $100,000 Variable cost per unit = $100,000/1,000 = $100 per unit Note: As C1 is examined by CBA you will not be required to draw a scattergraph; however you could be required to answer objective test questions about how the technique works. x x x x

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Overview

Cost behaviour

Fixed

Variable

Stepped

Mixed

High-low method

Line of best fit method

Used to split fixed and variable elements Find highest and lowest activity levels Subtract Low from High Use remainder to calculate VC Substitute VC back into High or Low total cost formula to calculate FC

Provides more accurate cost estimation than High-low method

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END OF CHAPTER
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Overhead costs absorption costing

Syllabus Guide Learning Outcomes

Having studied this chapter you will be able to: prepare cost statements for allocation and apportionment of overheads, including reciprocal service departments. calculate direct, variable and full costs of products, services and activities using overhead absorption rates to trace indirect costs to cost units. prepare financial statements that inform management.

Chapter Context
In this chapter we start to look at one of the key questions that management accountants have to answer: How much does it cost to produce each item of our product? Absorption costing is one method used to answer this question, and we will look at another approach in the following chapter. Absorption costing takes all of the production costs (both fixed and variable) and attributes them to individual units of production. By definition overheads are going to be the most difficult costs to deal with because they cant objectively be traced to an individual cost unit.

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4: OVERHEAD COSTS ABSORPTION COSTING

Overview

Absorption costing

Proforma income statement

Steps

(1) Allocate direct costs to units

(4) Absorb overheads into cost units

(2) Allocate and apportion overheads to cost centres

(3) Reapportion service cost centre overheads

Overhead absorption rates

Service cost centres

Production cost centres

Direct method

Reciprocal method

Step method

Prime cost

AC Cost card

Production overhead

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4: OVERHEAD COSTS ABSORPTION COSTING

1
1.1

Overview
Businesses need to put a cost on goods/services they produce (i.e. cost units) for many reasons. AIM To find the cost of making one unit Pricing Inventory valuation Profitability analysis Absorption costing (this chapter) OR Marginal costing (Chapter 5)

WHY?

HOW? 1.2

Absorption costing Absorption costing is a product costing/inventory valuation method which includes all production costs in the valuation and is required by IAS 2 for external reporting purposes. A cost card shows us the cost to make one unit Direct materials Direct labour Prime cost Production overheads Product cost $/unit X X X X X

1.3

Prime cost (direct cost) The direct costs of a cost unit are usually straightforward to ascertain since by definition they are identified with a cost unit. Direct materials: Direct labour: x kg of material at $y per kg a hrs of labour at $b per hour

This is step (1) in Method for absorption costing steps below. 1.4 Production overheads Since these are not identified with specific cost units, some method must be used to charge a share of the total production overhead to each cost unit. Steps (2) to (4) in the method below represent the traditional absorption costing method by which we achieve this.

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2
2.1

Absorption costing steps

Method Total Production Costs Direct Costs Indirect Costs (overheads) COST CENTRES 1. Allocate Production 1 Production 1 COST UNITS To get the full absorbed production cost there are four steps: (1) (2) (3) (4) Allocate direct costs to cost units Allocate and apportion production overheads to cost centres Reapportion overheads in service cost centres to production cost centres Absorb overheads into cost units Production 2 Production 2 4. Absorb Service 3. Reapportion

2. Allocate & Apportion

Allocation and apportionment of production overheads to cost centres Step (2) of method
The first stage in valuing the overhead cost of a cost unit is to allocate and apportion overheads between cost centres. A cost centre is a location, function or item of equipment in respect of which costs may be ascertained and related to cost units for control purposes. Each cost centre acts as a 'collecting place' for certain costs before they are analysed further. Note: (a) (b) Cost centres may be set up in any way the business thinks appropriate. Usually, only manufacturing costs are considered and hence we will focus on factory cost centres.

3.1 3.2

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4: OVERHEAD COSTS ABSORPTION COSTING 3.3 Service and production cost centres (a) (b) Production cost centres. Factory cost centres through which cost units actually flow; Service cost centres. Support/service the production cost centres.

Lecture Example 1
Split the following between two types of cost centres. assembly, canteen, maintenance, packing, stores, finishing. (a) (b) Production cost centres Service cost centres

Solution
(a) Production cost centres (b) Service cost centres

3.4

Terminology Allocation whole cost items are charged to a cost centre. Apportionment cost items are divided between several cost centres.

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Lecture Example 2
Overhead allocation and apportionment (Step 2 of method) Mars Ltd has the following overheads in the year ended 31 December 20X5: Overhead: Rent and rates Insurance of machinery and equipment Stores costs (wages and salaries) Heating costs Required Allocate and apportion overhead costs to mixing dept, stirring dept, stores and canteen using the following information: Mixing Stirring Stores Canteen Total Floor space (square ft) 9,000 3,000 1,000 2,000 15,000 NBV of machinery and equipment 2,000 1,000 600 400 4,000 $ 90,000 40,000 75,000 57,000 262,000

Solution

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4
4.1

Reapportionment of service cost centre overheads Step 3 of the method

All service cost centre overheads must be transferred to the production centres so that all production overheads for the period are shared between the production cost centres alone as it is through these cost centres that cost units flow. The reapportionment becomes a little more complicated where there is: more than one service cost centre, and the service centres do work for one another.

4.2

4.3

To reapportion service cost centre overheads to production cost centre there are three methods. Direct method Inter-service department work is ignored Service centre overheads reapportioned directly to production cost centres Mainly used when only have one service centre or service centres do not work for each other Step method Some inter-service department work is recognised Most widely used service centre's overheads are reapportioned to production and service cost centres. (Where not clear, reapportion the service centre with the largest overheads.) Used when more than one service centre, but don't work for each other Reciprocal method All inter-service department work is recognised Therefore, the most accurate method Two ways: (i) Repeated distribution method (ii) Algebraic method (not examinable at this stage.)

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Lecture Example 3
Service Cost reapportionment Production Depts. Mixing Stirring $ $ Allocated and apportioned overheads From Lecture example 2 Estimated work done by the service centres for other departments Stores Canteen Required (a) After the apportionment of the service departments to the production department, what will the total overhead costs for the production departments be? Mixing Direct Step Reciprocal (b) $ $ $ $ $ $ method. Stirring 108,200 39,400 Service Centres Stores Canteen $ $ 90,800 23,600

50% 45%

30% 40%

15%

20% -

The most appropriate method to use would be the This is because

Solution
Workings

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5
5.1

Absorption of overheads into production (cost units) Step (4) of the method
Bases All of the production overhead costs have now been apportioned to the production cost centres. We now need to charge these to the cost units passing through the production cost centres. This is termed absorption. We are going to absorb an element of total production overhead into each cost unit. OAR (overhead absorption rate) = Production overhead Activity level

5.2

Choosing bases Ideally, the basis chosen should be the one which most accurately reflects the way in which the overheads are in fact being incurred. For example: Basis (a) (b) (c) (d) (e) (f) Per unit Per labour hour Per machine hour % of direct labour cost % of direct materials cost % of prime cost

Lecture Example 4
Calculating absorption rates Mars Ltd has decided to use the step method to re-apportion service centre costs to its two production departments, mixing and stirring. As calculated in Lecture Example 3, this resulted in allocated overheads of $175,708 and $86,292 to the mixing and stirring departments respectively. During the year the following data has been collected. Direct labour hours Direct machine hours Number of units Required (a) (b) The overhead absorption rate for the mixing department was $ The overhead absorption rate for the stirring department was $ per per Mixing 20,000 2,000 10,000 Stirring 5,000 60,000 10,000

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Solution
Workings (a)

(b)

Cost units (c) Mars Ltd has one particular product, the 'Venus', for which you obtain the following information. Direct materials per unit Direct labour hours Mixing Stirring Direct machine hours Mixing Stirring Labour is paid $10 per hour Required What is the total cost of this product? A $40 B $58.30 C $66.22 D $77.33 $15 2 hours 0.5 hours 0.2 hours 6 hours

Solution
Workings (c)

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Pre-determined overhead absorption rates

Businesses need to cost their production throughout the year, not at the end of an accounting period. Therefore, they predetermine or estimate their absorption rates for the year. Budgeted overhead Budgeted activity level

Pre-determined OAR =

Note: activity level refers to production activity not sales. 6.1 Budget (or normal) activity level IAS 2 states that the activity level used for absorption of overheads should always be the budgeted (normal) activity, i.e. the expected long-term average. This is to stop fluctuations in OARs due to fluctuations in activity. 6.2 Absorption into production Businesses will record overheads regularly during the year. Overhead = Actual Activity Predetermined Absorbed OAR At the end of the year actual overheads will be known Under/(over)-absorption = Actual Overhead less Overhead Absorbed

If overheads absorbed are less than actual overheads = under-absorption If overheads absorbed are greater than actual overheads = over-absorption Overheads absorbed may differ from actual overhead costs incurred for either or both of the following two reasons: (a) (b) Actual expenditure was more or less than budget. Actual units produced (ie. volume) were more or less than budget.

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Lecture Example 5
Pre-determined overhead absorption rates Gurney Halleck Limited had the following budgeted and actual figures for units of production and overheads. Budget Actual Units of production 20,000 24,000 Overheads $100,000 $117,000 Required Complete the following calculations. Pre-determined absorption rate =

Overhead absorbed for period

Under-/over-absorption

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7
7.1

Proforma absorption costing

INCOME STATEMENT $ Sales Less: Cost of sales Opening inventory (@ full cost) Production costs: Variable costs materials labour variable overheads Fixed overhead absorbed Less: Closing inventory (@ full cost) Production cost of sales Adjustment for over-/underabsorbed overhead Total cost of sales GROSS PROFIT Less: sales and distribution costs NET PROFIT Notes: (a) (b) Inventory is valued at full production cost. The method of costing by which 'actual production costs' include a figure based on a predetermined estimate is called normal costing. X X X X X X (X) X X (X) X (X) X $ X

Lecture Example 6
Selling price $25. Cost card per unit: Direct materials Direct wages Variable production overheads Fixed production overheads $ 7 8 5 0.90 20.90

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4: OVERHEAD COSTS ABSORPTION COSTING There is a variable selling cost/unit of $0.50. Normal/Budgeted production Actual production Actual sales Actual fixed production overheads Actual fixed selling costs Required (i) The total budgeted fixed production overhead was Year 1 units 12,000 14,000 13,000 $11,000 $5,000 Year 2 Units 12,000 11,500 12,500 $11,000 $5,000

There is no opening inventory. All variable costs were as budgeted for the two years.

(ii)

The overheads absorbed in Year 1 were

(iii)

The net profit in Year 1 was

(iv) (v)

The overheads in Year 2 were The net profit in Year 2 was

absorbed by

Solution
Workings (i)

(ii)

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