AF6010

COSTING
 Relevant Reading

• Essential Reading – Drury, C,. 2016, Management Accounting

for Business, Cengage Learning, Chapters 2, 5 & 7
• Useful Reading - Drury, C,. 2016, Management Accounting for
Business, Cengage Learning, Chapters 3 & 4
 What is Costing

“System of computing cost of production or of

running a business, by allocating expenditure to
various stages of production or to different
operations of a firm.”
www.businessdictionary.com
 For Example:
iPhone – Production Cost
 For Example
iPhone – Production Cost
$
Material - Chip, processors, battery,
Sony camera, housing unit 450
Labour - Assemply process, quality
control, etc. 100
Overheads - R&D, Sales, marketing 200
750
 QUIZ!

Why is COSTING
Strategically
Important to
Managers?
 The Purpose of Costing
• Inventory Valuation:­the cost per unit can be used to value inventory in
the statement of financial position (balance sheet).
• Record Costs: ­in the income statement to ascertain profit performance.
• Price products: ­the business will use the cost per unit to assist in pricing
the product.
• Make decisions­: cost information is used to make important product
decisions (e.g. which product) and quantities
Kaplan Publishing
 So, what is the
professional approach to
costing for business?
 1. Business Cost Classification
• DIRECT /VARIABLE COSTS – Costs exclusively relating to a
cost object.
– Direct Material: Material specifically identifiable in a cost object e.g.
iPhone screen, camera, battery, speakers, etc.
• You can see and identify the materials on the product /service
– Direct Labour: Labour costs of making & assembling the cost object
• We can see that the iPhone has been put together
– Variable Production Overheads: The indirect production costs that change
(increase/decrease) in proportion to production output.
• Variable production electricity, costs of purchasing, wholesale packaging, inward transport
cost
1. Business Cost Classification
• INDRECT /FIXED PRODUCTION OVERHEADS –
Production costs incurred generally and that cannot be specifically traced
to a cost unit.
– do not vary with modest increase or decrease in volume of production
e.g. the cost of running the iPhone factory.
• PERIOD COSTS – Selling and administration or other costs not
relating to production and may be fixed or variable.
– charged against sales revenue of the same period costs were incurred.
 2. Application of Costing Systems
• ABSORPTION OR FULL COSTING – This is a method of
calculating product/service cost by taking into account direct costs and indirect
costs (overheads) to establish full-cost of production.
• VARIABLE OR MARGINAL COSTING – In this costing method,
only variable production costs are allocated to product/service cost: i.e. direct
labour, direct materials and variable production overheads.
– All overheads (fixed costs) are charged against revenue in the period incurred
 2. Application of Costing Systems
ADSORPTION Vs. VARIABLE COSTING
Absorption costing Variable costing
approach approach

DIRECT MATERIAL COST

PRODUCT
DIRECT LABOUR COST COST
PRODUCT
COST VARIABLE OVERHEADS
INDIRECT/FIXED
PRODUCTION OVERHEADS
PERIOD
PERIOD SELLING & DISTRIBUTION COSTS COSTS
COSTS
2. Application of Costing Systems

PRODUCT
ABSORPTION
COSTING APPROACH
COST
 COST
PRODUCT
Absorption Costing

THE AIM – Determine the full

production cost
per unit.
2. Application of Costing Systems
ABSORPTION COSTING EXAMPLE USING iPhone
Data
DIRECT COSTS $
Direct Materials 210.00
Direct Labour 9.50
Variable Overheads 10.00
Total Variable Costs 229.50
Absorbed indirect
INDIRECT COSTS
Costs = $12.5
Fixed Overheads 12.50
Full Product Cost 242.00
2. Application of Costing Systems
UNDER ABSORPTION COSTING APPROACH
• Direct Costs are easily calculated:
– Direct Material Costs = Required quantity x cost per unit
– Direct labour cost = Required labours x Rate per her
– Variable Overhead = allocation basis
• But ..how is fixed overhead calculated to go into each cost
object?
2. Application of Costing Systems

WE USE OVERHEAD ABSORPTION RATE –

OAR
This is our attempt at coming up with an equitable way of sharing out the
overheads to products or services when computing total cost of production.
– Can be based on:
• Machine hour
• Labour hour
• Units produced
2. Application of Costing Systems
COMPUTATION:

OAR = Production Overhead Cost

Total Absorption Basis

Example:
So for the iPhone, using units produced as the absorption basis, Apple may
have a production overhead of $12,500,000 and sell 1million iPhone units.
OAR = $12.50 per unit i.e.
$12,500,000
1,000,000 units
2. Application of Costing Systems

PRODUCT VARIABLE OR MARGINAL

COST
COSTING APPROACH
2. Application of Costing Systems
Variable Costing Approach

$
Direct Materials 210.00
Direct Labour 9.50
Variable Overheads 10.00
Variable Product Cost 229.50
 Costing Question
Sounds Ltd produce high quality head sets for use with the iPhone.
• 10,000 units are produced in October.
• Sounds Ltd sell 8,000 units for £60 each
• Direct Materials are £10 per unit
• Direct Labour is £15 per unit
• Variable Production Overheads are £5 per unit
• Fixed Production Overheads are £120,000
• The absorption basis is the number of Units produced
• Selling and Administrative costs:
Variable - £1 per unit sold
Fixed £20,000

Requirement:
– What is the value of 1 unit under Absorption Costing?
– What is the value of closing inventory under Absorption Costing?
– Prepare an income statement for the period using Absorption Costing.
Sounds Ltd Question
Using the Sound Limited task, lets
compare
Absorption Costing
Vs
Variable Costing
 Let’s Compare…
Abso rptio n Va ria ble
Co sting Co sting
Appro a c h Appro a c h
£ £
Dire c t m a te ria l 10 10
Dire c t la b o u r 15 15
Va ria b le o ve rh e a d 5 5
Prime Co st
Total Variable Cost 30 Va ria ble Co st 30 Unit Cost
*Ap p o rtio n e d Fixe d o ve rh e a d 12
Full c o st pe r unit 42 Unit Cost

* FO HD = £120,000/ 10,000 u n its = £12 p e r u n it

 Let’s Compare…
Inventory Valuation
Units produced 10,000
Units sold 8,000
Units left in warehouse 2,000

Abso rptio n Va ria ble

Co sting Co sting
Appro a c h Appro a c h

2,000 u n its x £42 £84,000 2,000 u n its x £30 £60,000

 Let’s Compare…
Income Statement
ABSORPTION COSTING BASED

Re ve nue (£60 x 8,000 units so ld) 480,000

Dire c t m a te ria l (£10 x 8,000 un its so ld ) 80,000

Dire c t la b o ur (£15 x 8,000 un its so ld ) 120,000
Va ria b le p ro d uc tio n o ve rh e a d (£5 x 8,000 un its so ld ) 40,000
Fixe d p ro d uc tio n o ve rh e a d (£12 x 8,000 un its so ld ) 96,000
Co st o f g o o ds so ld (COGS) 336,000
Gro ss pro fit 144,000

Se llin g a n d a d m in istra tio n c o sts (va ria b le ) (£1 x 8,000 un its so ld ) 8,000
Se llin g a n d a d m in istra tio n c o sts (Fixe d ) 20,000
Ne t pro fit 116,000
 Let’s Compare…
Income Statement
VARIABLE OR MARGINAL COSTING BASED

Re ve nue (£60 x 8,000 units so ld) 480,000

Dire c t m a te ria l (£10 x 8,000 un its so ld ) 80,000

Dire c t la b o ur (£15 x 8,000 un its so ld ) 120,000
Va ria b le p ro d uc tio n o ve rh e a d (£5 x 8,000 un its so ld ) 40,000
Se llin g a n d a d m in istra tio n o ve rh e a d (va ria b le ) (£1 x 8,000 so ld ) 8,000
Co st o f g o o d s so ld (COGS) 248,000
Co ntributio n 232,000

Fixe d p ro d uc tio n o ve rh e a d 120,000

Se llin g a n d a d m in istra tio n o ve rh e a d (Fixe d ) 20,000
Ne t p ro fit 92,000
 Let’s Compare…
Inventory Valuation & Income Statement

• Difference in inventory valuation = £84,000 - £60,000 = £24,000

• Difference in Income Statement = £116,000 - £92,000 = £24,000
• The difference in profit of £24,000 has gone to Inventory and is held on the balance
sheet.
Alternative Costing Method

ACTIVITY BASED COSTING

(ABC)
Video Support
 PRODUCT COSTING PROCESS
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Source: Duran and Duran (2018)

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Charge direct to Charge direct to

products products
 Traditional Costing Systems ..
PROBLEMS
• Modern manufacturing processes and products have become more complex
• Plants are automated + reduced proportion of direct labour + increased
proportion of overheads +multiple products
• Traditional systems allocate overheads on volume-related bases e.g. direct
labour hour, machine hour, and production units.
• However, in modern manufacturing plants, different resources are employed
in non-volume related support activities e.g. machinery set-up, production
scheduling, material ordering.
Traditional Costing Systems ..
PROBLEMS
• Consequences for product costing:
– Over and under-costing of products with marketing implications
• Advanced or complex products are under-costed through failure to
allocate adequate share of the overheads.
• Basic products with less complex manufacturing process get
allocated too much and with serious impact on market performance.
 ABC – What is it?
• “An approach to the costing and monitoring of activities which involves
tracing resource consumption and costing final outputs. Resources are
assigned to activities, and activities to cost objects based on consumption
estimates. The latter utilise cost drivers to attach activity costs to outputs.”
(CIMA Official Terminology, 2005)

• First developed in the USA during the 1970’s & 1980’s, the concept was
brought to light by Cooper & Kaplan in 1988.
• ABC seeks to improve the tracing of indirect costs to products by recognising
the different levels of activities that lead to indirect product costs (Mc Watters et al.,
2008)
 ABC – What is it?
• ABC - suited for various types of overhead costs, particularly indirect and
related to specific activities within the organization, including:
o Indirect labour costs
o Indirect materials costs
o Machine setup costs
o Maintenance and repair costs
o Quality control costs
o Facility-related costs: such as rent, utilities, and maintenance, to specific activities.
THE TRADITIONAL PROCESS
Overhead Costs: All collected together

First Stage Allocation

Cost Cost Cost

Adapted from DrurY (2015)

Centre Centre Centre
(Department) (Department) (Department)

Second Stage Allocation: Labour Hours,

Machine Hours, etc

Cost Cost Cost

Objects Objects Objects
 THE ABC PROCESS
Overhead Costs: Collected by Activity
Cost Pool:
Grouping of costs relating to First Stage Allocation
particular activity: e.g.
• Purchasing materials
• Setting up a machine Cost Driver:
Factor influencing the cost
Activity Activity Activity level e.g.

Adapted from DrurY (2015)

Cost Pool Cost Pool Cost Pool • No. of purchase orders
• No. of machine set ups

Second Stage Allocation: Allocated by how

different products use different Cost Drivers

Cost Cost
Cost Objects Objects Objects
 ABC Process
2. Assigning
1. Identify major activitiescosts to cost
involved pools
in the for each activity
4. Compute activity:rates and assign
involving
production process: 3. Determining
tracking
setup, machine the actual
operation, the cost
costs fordriver
each for each major
cost of activities to products based
activity,
material handling, activity:
control,i.e.
including
quality factors
labour, that cause or influence the
materials,
on product’s demand/usage for
equipment,
maintenance, etc. and overhead costs of activities
expenses. activities

infoDiagram.com
 ABC - ADVANTAGES
1. Management gains deeper insights into the costs of production activities and better
understand the cost drivers.
2. More accurate cost allocation and informed decision-making related to pricing,
process improvement, and resource allocation.
3. Most beneficial in firms where products or services use overheads in differing
ways – engineering vs. machine set costs. High and low volume products will tend to
use overheads in different ways
4. Assists managers in finding opportunities to reduce costs
5. Provides Information to assist managers to analyse the value chain
– Value-Added vs Non-Value-Added Activities
6. Increased Control – more measurement
7. Helps to set better Selling Prices – must recover overhead!
McWatters et al 2008, Drury (2015)
 ABC - DISADVANTAGES
1. Implementing ABC system requires management support and a big budget
initially and maintenance can be costly too.
2. Reports from ABC system do not conform to Generally Accepted Accounting
Principles (GAAP). Organisation using ABC should consider having two
systems for internal and external reporting.
3. Ignores the difference between fixed and variable indirect costs, therefore
additional use of the activity may result in higher costs
4. Interpretation – improved costing system does not mean dealing with
underlying causes of high cost.
5. Design/ implementation of ABC system requires a cross-functional team –
Accounting, finance, IT, marketing, engineering, production. Time consuming.
 ABC - SURVEYS
1. A UK survey by Drury and Tayles (2005) reported that 51 per cent of the
financial and service organizations and 15 per cent of manufacturing
organizations had implemented ABC.
2. International Survey by The Chartered Institute of Management (2009) reported
that approximately 28 per cent of the respondents used ABC.
3. Both surveys report a higher rate of adoption in larger companies compared with
smaller companies
4. Developing countries are lagging in the adoption of ABC + adoption rates are
generally lower compared to developed countries (Alsayegh, 2020).
5. Firms that adopt ABC system are larger in size, involved in complex production
and operate in strong competitive environment. (Alsayegh, 2020).
ACTIVITY BASED COSTING

Example:

In class activity – Waterproof Ltd

(See the BB)
 Any
Questions
Please?
• Giampiero Favato and Roger Mills (2007) Identifying best practices in cost management, Henley Manager Update Vol. 18 No. 3 Spring 2007
• CIMA Activity Based Costing Topic Gateway Series No. 1
• Armstrong, G.M., Kotler, P., 2013, Marketing: An Introduction, Boston, Mass Pearson
• Cooper, R., Kaplan, S., Measure Costs Right: Make the Right Decisions, Harvard Business Review Sept:Oct 1986, p96 - 103
• Drury, C., 2015, Management and Cost Accounting 9 th Edition, Cengage Learning
• Drury, C., 2016, Management Accounting for Business 6 th Edition, Cengage Learning
• McWatters, 2008, Management Accounting Analysis and Interpretation, FT Prentice Hall
• A. Cemkut Bade, Emre Ergin & Colin Drury (2013) Is Standard Costing Still Used? Evidence from Turkish Automotive Industry, International
Business Research; Vol. 6, No. 7; 2013
• Is Standard Costing Still Relevant? Evidence from Dubai, dubai, m a n a g e m e n t a c c o u n t i n g q u a r t e r l y 1 w i n t e r 2 0 1 0 , v o l . 1
1,no.2
• Alsayegh, M (202) Activity Based Costing around the World: Adoption, Implementation, Outcomes and Criticism. Journal of Accounting and
Finance in Emerging Economies 6(1):251-262. DOI:10.26710/jafee.v6i1.1074