Paper 1.2 Financial Information for Management

Chapter 01        The purpose of cost accounting       Chapter 02        Cost Behaviour        Chapter 03           Understanding the Correlation between Total Costs and the Volume of OutputChapter 04        Direct and Indirect Materials: Part 1 - The control of stock itemsChapter 05        Direct & Indirect Materials: Part 2 – Stock Reorder Levels        Chapter 06        Overheads and Absorption Costing: Part 1 - ApportionmentsChapter 07        Overheads and Absorption Costing: Part 2 - Absorption

Paper 1.2Chapter 1

The Purpose of Cost Accounting

Cost accounting is part of management accounting, and its purpose arises due to the management’s need for specific or more detailed information as oppose to that provided by financial statements. Hence cost accounting will provide information to assist the management with planning, control and decision making as well as accumulating historical costs to establish stock valuations, profits and balance sheet items. All of this is done with the help of a Management Information System, which is simply a general term for the computer systems in an enterprise that provide information for management.

Therefore the key points of cost accounting are:

•        The recording and analysis of actual costs•        The forecast of future costs•        Cost control

Cost Classifications

As such, it is necessary to be able to understand the basic cost classifications and

behaviour to manage a cost accounting system.

Costs may be classified as either of the following:

1.        Direct or Indirect Costs2.        Function Costs3.        Fixed or Variable Costs4.        Product Costs or Period Costs5.        Available or Unavailable6.        Controllable, Uncontrollable, or Discretionary Costs

Direct or Indirect CostsA direct cost is a cost that can be traced in full to the product, service or department that is being costed. These costs consist of direct labour, direct materials, and any other direct costs.

Whereas an indirect cost 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. These costs consist of the following:

a)        Production overheads: indirect materials, indirect wages and indirect expensesb)        Administration overheads: e.g. depreciation and office salariesc)        Selling Overheads: e.g. commissions, advertising, market research, sales promotiond)        Distribution Overheads: e.g. cost of packing cases, insurance charges.

The two definitions mean that every product, service or department will incur a direct and indirect cost. Furthermore the total cost of every product, service or department is the sum of the relative direct and indirect costs.

Total Cost = Direct Cost + Indirect Cost

Function CostsCosts may also be classified by their function, i.e. what kind of service was the cost incurred to do? The answer to this question may be categorized in any one of these

classifications:

a)        Production Costsb)        Administration Costsc)        Selling Costsd)        Distribution Costse)        Research & Development Costsf)        Financing Costs

Fixed or Variable CostsA fixed cost is a cost which is incurred for a particular period of time and which, within certain activity levels, is unaffected by changes in the level of activity. A variable cost however is a cost which tends to vary with the level of activity.

Product Costs or Period CostsProduct costs are those identified with a finished product, as a part of the value of stock. They become expenses in the form of cost of goods sold. Whereas period costs are costs that are deducted as expenses during the current period without ever being included in the value of stock held.

Avoidable or UnavoidableSimply costs are avoidable, if the company could avoid them, and similarly for unavoidable costs.

Controllable or UncontrollableControllable costs are those that can be controlled by the company whereas uncontrollable costs are those outside the scope of the business.

Discretionary CostsThese costs are likely to arise from decisions made during the budgeting process. They are likely to be fixed amounts of money over fixed periods of time. E.g. Advertising, R&D, training budgets.

Cost UnitsOnce costs are recorded, i.e. the total costs of department ‘A’ are $100,000; one may prefer to analyze the cost per each unit. This is referred to as a cost unit, and it could be cost per kg, cost per machine hour, etc.

Cost ObjectsWhat if the manager comes up to you and says, what’s the cost of operating department ‘A’? This cost is referred to as a cost object, or objective, and it is any activity for which a separate measurement of costs is required, e.g. the cost of a product or the cost of a service, etc.

Responsibility CentresA responsibility centre basically involves analyzing costs, profits or revenues and attributing them to specific managers or ‘centres’. In other words, the costs of department ‘A’ are the responsibility of Manager ‘A’, whereas the costs of Machine ‘A’ is attributed to the operator of Machine ‘A’. Basically, responsibility centres maybe categorized as follows:

a)        Cost Centresb)        Profit Centres, where profit centre managers should normally have control of how revenue is raised and how costs are incurred.c)        Revenue centres, whose responsibility is revenue only.d)        Investment centres, whose responsibility is that of a profit centre with additional responsibilities for capital investment and possibly for financing, and whose performance is measured by its return on investment.

Conclusion

1.        We know what information is, why it is needed and that it is managed within a Management Information System.2.        We said that an MIS is needed to enable the management to have sufficient information to do their job.3.        Cost Accounting is a part of MIS and it basically helps us witha)        The classification of actual costs incurredb)        The preparation of budgets of planned costsc)        The comparison of actual costs and budgeted costs

4.        This system involves the classification of costs into several categories such as direct and indirect costs, function costs or fixed and variable costs.

5.        Costs are based on cost units and cost incurred is allocated to a cost centre such as a department or a machine.

Paper 1.2Chapter 2

Cost Behaviour

The knowledge of cost behavior is essential for the tasks of budgeting, decision makingand control accounting, whose importance was established in the previous article. Costbehavior is the way in which costs are affected by changes in the volume of output. Inother words, this article will attempt to describe the behavior of various costs with thevolume of output.

The principle of cost behaviour is simple, as the level of activity rises, cost will usuallyrise, but the difficulty arises when one needs to determine the way in which cost rise and by how much as the level of activity increases.

A Cost Behaviour Pattern could be established for certain costs that ‘behave’ in a‘predefined’ or ‘usual’ way, which we may illustrate graphically. In the course of thisarticle we will discuss the cost behaviour of the following items:

1. Fixed costs2. Step costs3. Variable costs4. Semi-variable costs5. Total costs and unit costs

Fixed Costs

These costs are not generally related to the volume of output or to the level of activitywithin a firm, although they do increase with time. As such, they will not follow theprinciple of cost behaviour mentioned earlier (costs rising as level of activity rises), e.g.the salary of a managing director, or the straight line depreciation of a machine.

CostVolume of OutputAs you could see, fixedcosts are not affected by thevolume of outputFixed CostsStep Costs

These costs are fixed in nature but only within certain activity levels, e.g. if you employ100 employees their salaries would be a fixed amount of $100k per year, yet, if youincrease the number of employees to 150, the fixed amount of salaries would naturallyincrease.

Variable Costs

A variable cost tends to vary directly with the volume of output. As such it is natural toexpect that they have a ‘linear’ or uniform relationship with output.

Cost of raw materials, direct labour and sales commission may behave in this way subject to price per unit of materials or labour is constant.

CostVolume of OutputAs you can see, each extraunit of output causes aproportionate increase incost.VariableCosts

CostVolume of OutputNotice how costs remainfixed until a specific volumeof output is reached, whichcauses costs to immediatelyStep Costs rise.

Semi-Variable Costs

A semi-variable cost is a mixed cost, which consists of both a variable and a fixed cost,therefore they are partly affected by the volume of output. A typical example could be

electricity, where a fixed fee is paid per month as well as a charge per unit of electricityconsumed. Semi-variable costs could behave in either of the following two ways:The Cost Behaviour of Unit Costs and the Volume of Output

The total fixed costs incurred by a business is constant with the level of output, whereasvariable costs behave in a ‘variable’ way, whereas the total costs (Sum of all costs),behave as semi-variable costs. Yet, what if we considered the fixed cost per unitproduced, or the variable cost per unit produced, what would the cost behaviour pattern

As you could see, the variable cost per unit remains constant because it will always costthe same to produce one unit. Fixed costs per unit will gradually decrease with outputbecause fixed costs remain constant regardless of output, yet as output increases theFC/unit which is FC/volume of Output, becomes smaller. Total costs are the sum of theVC and FC graphs.

CostVolume of OutputEach extra unit in A causesa less than proportionateincrease in cost whereas inB, each extra unit of output causes a more thanproportionate increase in cost.Semi-VariableCost ASemi-VariableCost BVariable CostFixed Cost Total Cost

Assumptions and Conclusions

1. Within the normal or relevant range of output, costs are often assumed to be eitherfixed, variable or semi-variable.2. Variable costs have a linear relationships with the volume of output3. Fixed costs are constant4. Semi-variable costs have a curvilinear relationship5. When activity levels rise, variable costs per unit remain constant, the fixed costsper unit falls and the total cost per unit falls.

Paper 1.2Chapter 3

Understanding the Correlation between Total Costs and the Volume of Output

Although the cost behavior pattern of fixed, variable and semi-variable costs seem to be straightforward, the mere cost behavior pattern isn’t sufficient enough to enable us to control or anticipate future costs in order for us to set budgets, or to base management decisions on them. It is necessary, to determine the correlation between total costs and volume of output.

This article will focus on the various methods available, how to use them for forecasting purposes and their limitations. It is important however to realize that each of the following methods is only an estimate and each of them will produce different, but rather similar results. The following methods are available:

1.        High-low method (with or without inflation)2.        Scattergraph method and the line of best fit3.        Regressoin analysis4.        Least squares method

The High-Low Method

The high-low method may be used to determine and differentiate betw

Paper 1.2Chapter 4

Direct and Indirect Materials: Part 1 - The control of stock items.

The purpose of this article is to develop an understanding of how cost accountants deal with stocks, how they are valued and most importantly, how they are controlled.

Remember that costs may either be an expense, which would be written off in the profit and loss account, or a cost may be an asset, which would be carried

forward in the balance sheet. This is due to the application of the accruals concept. It is therefore necessary to classify costs in the most appropriate manner, so that they are valued, accounted for, and controlled as efficiently as possible.

As such, this article would answer the following questions:

1.        How are items of stock, such as materials, controlled within a cost accounting system?2.        What are the reasons for holding stock and what are the limitations of doing so?3.        What are the appropriate methods of establishing reorder levels whilst minimizing the cost of holding stock trough the interpretation of optimal reorder quantities?

How are items of stock, such as materials, controlled within a cost accounting system?

1.        Stocks are controlled using what is known as a stock control system. This system should cover the following functions:

a)        The ordering of stockb)        The purchase of stockc)        The receipt of goods into stored)        Storagee)        The issue of stock and maintenance of stock at the most appropriate level.

The reasons are due to the following points:a)        Holding costs of stock may be expensiveb)        Production will be disrupted if we run out of raw materialsc)        Unused stock with a short shelf life may incur unnecessary expenses.

2.        Furthermore, proper records must be kept regarding the ordering, receipt and issue of stock using the following process:

a)        When stocks reach the reorder level, the stores department issues a purchase requisition to the purchase department to order further stock.b)        The purchase department then issues a purchase order to the

supplierc)        Once the stock is delivered, the storekeeper signs a delivery note. The stocks are then further inspected for deficiencies. If all is okay, the store keeper prepares a goods received note (GRN) to the accounts department that check it with the purchase order. The supplier is paid.

The reasons are to ensure that:a)        Enough stock is heldb)        There is no duplication of orderingc)        Quality is maintainedd)        There is adequate record keeping for accounts purposes.

3.        Storage of Raw Materials; Storekeeping involves storing materials to achieve the following objectives:a)        Speedy issue and receipt of materialsb)        Full identification of all materials at all timesc)        Correct location of all materials at all timesd)        Protection of materialse)        Efficient use of storage spacef)        Maintenance of correct stock levelsg)        Keeping up to date records

This is done through the use of:a)        Bin Cards – kept with the actual stock and updated whenever items are issued or received.b)        Stores Ledger Accountsc)        Stock Codes – materials held in stores are coded and classified

4.        Stocktaking – this process involves counting the physical stock on hand at a certain date and matching it with the balance shown in the stock records. This process should enable us to avoid discrepancies, check our records, and make sure that we know the free stock balance, which is actual stock that is available for future use. Stocktaking may be periodic or continuous, in which the later involves using a perpetual inventory system.

Remember that:•        Materials in stock plus Order from Suppliers less materials

requisitioned equals free stock balance.

5.        An Order Cycling Method may be used, where quantities on hand of each stores item are reviewed periodically.6.        A Two-bin system may also be used whereby each stores item is kept in two storage bins. When the first bin is emptied, an order must be placed for re-supply.7.        Materials may be classified as expensive, inexpensive or middle-cost range. Whilst the last two items are stored in large quantities, the expense items are subject to careful stores control procedures.8.        Computerization, whereby stock masters file is maintained concerning all the transactions and details of stock movement. This will ensure the following:

a)        Easier processb)        Better maintenance of recordsc)        Backup copies could be made.

What are the reasons for holding stock and what are the limitations of doing so?

The main reasons for holding stock are:

1.        To ensure that sufficient goods are available to meet expected demand.2.        To provide a buffer between process (in cases where output stock is the input stock for another process.3.        To meet any future shortages4.        To take advantage of any bulk purchasing discounts5.        To absorb seasonal fluctuations and any variations in usage and demand.6.        To allow production process to flow smoothly and efficiently.7.        Holding stock is necessary due to fermentation, e.g. wine.8.        As a deliberate investment policy, e.g. in times of inflation or shortages.

There are two kinds of limitations arising due to stock holding

A)        If stocks are held at a high level:

1.        Cost of storage and stores operations increase

2.        Insurance costs arise3.        Risk of obsolescence – stock being damaged or going out of fashion4.        Opportunity costs – instead of purchasing stock and holding them you could have invested the money elsewhere.

B)        If stocks are held at a low level:

1.        Cost of obtaining stock may increase – if stocks are kept too low, every time a new order is needed, the firm must incur cost of obtaining stock, such telephone calls, transportation, etc.2.        Stock out costs- whereby items of stocks run out. This may result in a lost contribution from sales, or a loss of future sales from disappointed customers, or worse, cost of production stoppages.

Paper 1.2Chapter 5

Direct & Indirect Materials: Part 2 – Stock Reorder Levels

What are the appropriate methods of establishing reorder levels whilst minimizing the cost of holding stock?

Step 1An analysis should be made regarding past stock usage and delivery times, whereby a series of control levels can be calculated and used to maintain stock at their optimal level.

Step 2Basically, stock control levels are established, such as:

a) Reorder levelsb) Reorder quantityc) Maximum leveld) Minimum levele) Average stock level

a) When stocks reach the reorder level, an order should be placed to

replenish stocks.The level is determined by the following formula:Reorder level = Maximum level x Maximum Lead timeWhere maximum lead-time refers to the time between placing an order with a supplierand the stock becoming available for use.b) The reorder quantity is the quantity of stock to be ordered when stocks reach thereorder levels.c) Maximum levels could lead to unnecessary holding costs, and this level may beestablished by the following formula:Maximum level = Reorder level + Reorder Qty – (Minimum level x Maximum lead time)d) When stocks reach the minimum level, stockouts may occur, and the level may beestablished by applying the following formula:Minimum level = reorder level – (Avg. Stock Level x Average Lead Time)e) The average stock level refers to the average stock held within an accounting period.The following formula assumes that stock levels fluctuate evenly between theminimum stock level and the highest possible stock level.

Average Stock = Minimum Stock + ½ Reorder Quantity

Step 3: Economic Order Quantity

Now it is necessary to calculate the Economic Order Quantity. This is the order quantitythat minimizes the total costs of holding and ordering stock.

Usually the economic order quantity is found at the point where holding costs equalordering costs, which will be demonstrated by the following graph:

As you could see, as the average stock level or the order quantity increases, the holding costs increases proportionately or variably, yet the cost of ordering stock gradually decreases. The total cost curve is the sum of both the ordering and holding costs. As one could obviously see, the point where holding costs equal ordering costs, is the same point where the total costs are at the lowest level. This is referred to as the economic order quantity, i.e. the point where it is most efficient to order

stock items.

This could also be demonstrated, or calculated using the following formula(Refer to Mathytpe)

Step 4: Economic Batch Quantity

In step 3, we assumed that the re-supply of stocks is instantaneous, i.e. whenever we need the stock we order that amount exactly. Yet, what if re-supply is gradual rather than instantaneous, i.e. an order of units is received gradually in batches?

This situation requires an amendment to the economic order quantity, to what is known as the Economic Batch Quantity.

Where:If you compare this formula to that for the EOQ, you would notice that the amendmentinvolved replacing ….Ordering CostsHolding CostsTotal CostsActual Costs ($)Order Quantity (Units)Average Stock Level (Units)

So if the annual demand per year is 100 units, and the annual rate of production is 200units, then we are selling half of what we’re producing. As such the costs of holding willdrop by one half because we aren’t storing all of our productions, get it?

As you could see … is used because total stocks held per annum aren’t ‘Q’ but …. This is due to batch productions and as such there is a gradual resupply.

Step 5: Economic Order Quantity and Discounts

Obviously the EOQ must be modified if bulk discounts are available. This is done todecide whether it would be worthwhile to take a discount and ordering large quantities, or not.

Obviously the deciding factor will be the lower of total costs whena) Discounts are taken (minimum order size needed to take the discount)

b) Pre-discount EOQ level.This is simply calculated as follows:Total Costs of a) =PurchasesLess: DiscountsAdd: Holding CostsAdd: Ordering Costs

Total Costs of b) are found using the EOQ formula. The lower of a) or b) wins the vote!

Paper 1.2Chapter 6

Overheads and Absorption Costing: Part 1 - Apportionments

In accounting, there are various methods in dealing with direct and indirect costs,some of which have been explained in previous articles, such as direct/indirectmaterials and labour costs. The following series of articles aim to define and explainthe different methods of dealing with overheads.

Overheads are by nature, indirect costs. They are defined as a cost incurred in makinga product or a service, but cannot be traced directly and in full to the product orservice.

Overheads may be classified as manufacturing or non-manufacturing overheads forthe purpose of this article.

Manufacturing overheads being those costs related to the product or service as definedabove, and non-manufacturing overheads are those that cannot be directly allocated toparticular units of output.

Absorption Costing

In absorption costing, overheads will be added to each unit of output of productsmanufactured and sold. It is a method for sharing overheads between different

products on a fair basis.

In other words, it says, look at all those manufacturing overheads incurred, and letsadd them to the cost of sales!

SSAP 9 recommends this method because cost of all stocks should consist of all costsincurred in the normal course of business in bringing the product to its ‘presentlocation and condition.’ Overhead costs are incurred to produce the finishedproduct(s) including administration and directors’ wages, without them the productswouldn’t exist! Therefore it is justifiable to charge each unit of output with some ofthe overhead costs.

There are also various practical reasons for using absorption costing:

1. Stock Valuations – Closing and Opening Stock would consist of manufacturing overheads, as such, increasing the value of gross profit, by carrying forward the cost in the balance sheet as a current asset, rather than writing it off as an expense in the profit and loss account.2. Pricing Decisions – If you were to provide a service or a product for a customer, you would like to know the full cost to be incurred, including nonmanufacturing costs as well. This will enable you to determine how much of this cost should be bared by the customer. Kapiche?3. Profitability of different products – Since overheads are shared on a fair basis and charged to the cost of sales of each product/department/service, one could ascertain the profitability of each product/department/service.

The Process of Absorption Costing

Simply, there are three stages:1. Allocation2. Apportionment3. Absorption

Allocation involves allocating manufacturing and non-manufacturing

overheads tovarious cost units or cost centers. Apportionment is the process by which generaloverheads are shared out on a fair basis between each cost center. In other words, it’sa process of taking all the non-manufacturing overheads and distributing them tothose involved in production. Absorption is the process by which the costs calculatedfor each cost center is finally added to unit, job or batch costs. Thus, establishing thecost per each unit produced, which would enable us to value both opening and closingstocks, the cost of sales, and the gross profit of the business.

Allocation

This step is very simple. First we establish the various cost centers within thebusiness, e.g. Production Department A and B, Services Department C and D. Wethen allocate all relative costs to each of these departments.

Apportionment

The process of apportioning overheads is based on what is called Basis of Apportionment. This means that overhead costs are shared out on a fair basis whichcould be the floor area occupied by each cost center, when rent, rates heating and lightrepairs are concerned, or cost or book value of equipment when depreciation ofequipment is concerned, etc.

Once a basis for apportionment for each service or non-manufacturing cost isestablished, the overheads should be apportioned in either one of the following ways:

1. Direct Apportionment2. Reciprocal method of apportionment3. Step Method of ApportionmentDirect Method of Apportionment

Suppose that we have four departments within an organization, two of which areproduction departments, whereas the other two are non-manufacturing departments,

they provide a service for example, such as repairs, etc. Production department Arequisitioned materials from department C to the value 12,000 and B requisitionedmaterials worth 8000. Service department D provided 500 hours of work todepartment A and 750 hours to department B. The following costs are incurred:

Production Departments Service Departments A B C DAllocated Costs 6000 4000 1000 2000Apportioned Costs 2000 1000 1000 500Total Overheads 8000 5000 2000 2500

The process of apportionment means that we should distribute the total costs ofservice departments C and D on a FAIR basis to production departments A and B.

The first step would be to establish the apportionment basis for each overhead.Obviously, the costs incurred by department C would be apportioned on the basis ofrequisitions that it provided to departments A and B. The costs incurred bydepartment D would be apportioned on the basis of the hours of service provided toboth department A and B.

Therefore, the costs of departments C and D would be apportioned in the followingway:Production Departments Service Departments TotalA B C DValue of Requisitions 12000 8000 20000 % Of requisitions 60% 40%Work Hours 500 750 1250 % Of work hours 40% 60%Overhead Costs 8000 5000 2000 2500 17500Apportionment of C 1200 800Apportionment of D 1000 1500Total Overheads 10200 7300 17500Did you see what happened?To apportion the costs of C, its overheads are apportioned to each departmentdepending on the percentage of requisitions supplied, and the overheads ofdepartment D have been apportioned to each department depending on the percentage of work hours received.

The Reciprocal Method of Apportionment

The reciprocal method of apportionment is useful when services are not only providedto manufacturing departments, but to service departments as well. Therefore, costs areapportioned between all departments, rather than just the manufacturing ones.

Let us suppose that, in the previous example, department D requisitioned materialsand provided hours of service to department C. The following table summarizes thetransactions and the solution:

Production Departments Service Departments TotalA B C DValue of Requisitions 12000 6000 2000 20000 % Of requisitions 60% 30% 10%Work Hours 500 650 100 1250 % Of work hours 40% 52% 8%Overhead Costs 8000 5000 2000 2500 17500Apportionment of C 1200 600 (2000) 200Apportionment of D 1080 1404 216 (2700)Apportionment of C 129.6 64.8 (216) 21.6Apportionment of D 8.64 11.232 1.728 (21.6)Apportionment of C 1.728 0 (1.728) 0Total Overheads 10420 7080 0 0 17500

As you could see, using the reciprocal method, overheads are repeatedly apportioneduntil the final cost to be apportioned becomes so small and immaterial in value.

One could also determine that the total costs of department C consists of a proportionof the total costs of department D, and vice versa.

Therefore, as an alternative to using repeating the appropriations of each of theservice departments, simultaneous equations may be used to establish the total cost ofC and the total cost of D, which we could then directly apportion to departments Aand B.

Total Cost of C = 2000 + 8% of department D overheadsHence C = 2000 + 0.08*DTotal Cost of D = 2500 + 10% of department C overheadsHence D= 2500 + 0.1*C

Apply C to DC = 2000 + 0.08(2500 + 0.1C)Hence, C= 2000 + 200 + 0.008CHence, 0.992C = 2200Therefore C=2217.7419Hence, D= 2500 + 0.1*2217.7419 = 2721.7741Therefore the solution would now beProduction Departments Service Departments TotalA B C DValue of Requisitions 12000 6000 2000 20000 % Of requisitions 60% 30% 10%Work Hours 500 650 100 1250 % Of work hours 40% 52% 8%Overhead Costs 8000 5000 2000 2500 17500Apportionment of C 1330.6451 665.3225 (2217.7419) 221.7741Apportionment of D 1088.7096 1415.3225 217.7419 (2721.7741)Total Overheads 10419 7081 0 0 17500

Notice what happened? Instead of apportioning the 2000 and 2500 overhead costs, theoverhead costs apportioned where those found in the simultaneous equations above.

The same result is obtained either way; the slight difference shown is due to roundingoff only.

The Step Method

The step method is very similar to the reciprocal method but the apportionmentsaren’t repeated since costs are not reapportioned to the service departments again.Thus, whatever is apportioned first will affect the results obtained. If we apply it tothe above example, the following results are obtained:

Production Departments Service Departments TotalA B C DValue of Requisitions 12000 6000 2000 20000 % Of requisitions 60% 30% 10%Work Hours 500 650 100 1250 % Of work hours 40% 52% 8%Overhead Costs 8000 5000 2000 2500 17500Apportionment of C 1200 600 (2000) 2009200 5600 0 2700

Now the 2700 will be distributed to A and B only, based on work hours.Apportionment of D 1173.69 1526.04Total Overheads 10374 7126 17500

Please notice how the apportionment basis percentages were recalculated to distributethe overheads to A and B only, similarly if D was apportioned first. Yet in the latercase, the results would differ. Try it yourself.

Paper 1.2Chapter 7

Overheads and Absorption Costing: Part 2 - Absorption

After allocating and apportioning overheads to cost units or cost centers, we need toadd the costs calculated for each cost center to unit, job or batch costs. This is calledoverhead absorption or overhead recovery. Therefore, the production overheadscalculated using absorption costing would be included in the following formula:

Direct MaterialsPlus: Direct LabourPlus: Direct ExpensesPlus: Overheads (based on recovery rate)Equals: Actual Costs of Production

The previous formula is known as normal costing. The actual costs of production arenecessary to calculate the cost of sales, hence, the profits of the organization.

Opening StockPlus: Production CostsLess: Closing StockEquals: Cost of Sales

Yet, the final process of absorbing the overhead costs into unit and batch costs aren’tbased on actual costs incurred during the course of the business. Absorption costing is based on a predetermined absorption rate, which is established from a budget for aforthcoming period.

This could be illustrated using the following example. Suppose that a

company makestwo products, A and B, each respectively taking 2 and 5 hours to make. If the totalestimated overheads are $50,000 and the estimated labour hours would be 100,000hours, what would the absorption rate be?

Calculation ResultAbsorption Rate 50/100 $0.5 per labour hourOverhead absorbed per unit A 2 x 0.5 $1 per unitOverhead absorbed per unit B 5 x 0.5 $2.50 per unit

The results obtained above mean that whatever the cost of producing one unit of A orB is, the overhead absorbed per unit should be added to it. Suppose further that thedirect labour, materials and expenses are $12 per unit, and we produce 1000 units ofA and 2000 units of B during a the year. We have no opening stock, and no closingstock, we simply sold all the stock of A and B produced during the year for $30 perunit. What would the Profit and loss account look like?

Calculation $000 $000Sales 3000 x 30 90000Cost of SalesOpening Stock 0Closing Stock 0Production Costs: Direct Overheads 12 x 3000 36000Overheads ‘A’ 1 x 1000 1000Overheads ‘B’ 2.5 x 2000 5000 (42000)Gross Profit 48,000

In the previous example we assumed that a separate absorption rate is used for eachproduct, and this could be similarly applied to other cost centers and cost units.However, the predetermined absorption rate may not always be distinguishable foreach product. Sometimes, a blanket absorption rate is used, in which a singleabsorption rate is used throughout a factory and for all job units of output irrespectiveof the department in which they were produced.

The result of using a blanket absorption rate may drastically affect the costing of

products and units or services manufactured or offered to customers. This can beillustrated by slightly modifying the previous example:

Previously we said that the overhead absorption rate of A is $1 per unit, and $2.5 perunit of B. These are separate valuations. Suppose now, that we alternatively use ablanket absorption rate, calculated as follows:Total Overheads: 50,000Total Labour Hours: 100,000Absorption Rate: 50/100 = $0.50 per labour hour.Total Units Produced = 3000Taking 7 hours to make a unit of both A and B, thus Total Labour Hours is 21000,(7*3000).Production Overheads = 21*0.5 = $10, 500Therefore:Calculation $000 $000Sales 3000 x 30 90000Cost of SalesOpening Stock 0Closing Stock 0Production Costs: Direct Overheads 12 x 3000 36000Production Overheads 21000 x 0.5 10500 46500Gross Profit 43,500

As you could easily see, the gross profit changed dramatically, from 48,000 to a mere43,500.

Furthermore, one may still be confused as I have whilst trying to understand why Ihave divided 50/100 to calculate the absorption rater per labour hour, and thenmultiply that with the total labour hours taken to produce 3000 units, which resultedin a total cost of 10,500. Especially since we didn’t do that when we used separateabsorption rate, because we calculated the absorption rate per unit at the time.

I have done what I have done because I believe the costs associated with producing unit of ‘A’ are different to those taken producing unit of ‘B’, because each takes a different number of hours to produce. Therefore, it is essential to absorb the costs

the way I have.

Another reason for the discrepancy may be due to what is known as over/underabsorption. The problem is that normal costing (refer to the formula on the first page!)is based on overheads absorbed at a predetermined rate, which is based on budgetsand estimates, rather than what is actually incurred. This would lead to either one ofthe following:1. Over Absorption – overheads charged to the cost of sales are greater than theoverheads actually incurred.2. Under Absorption – insufficient overheads have been included in the cost ofsales.

To solve this problem, an adjustment to reconcile the overheads charged to the actualoverheads incurred is necessary, in which the under/over absorbed overheads will bewritten as an adjustment to the profit and loss account, at the end of the accountingperiod.

At the moment, the budget for the previous example says that the productionoverheads should be 46,500, but what if at the end of the year, we find that the actualcosts incurred, weren’t 46,500 but only $30,000. This means that we over-charged ourcost of sales by $16,500. This is referred to as over-absorption.

To correct this problem we simply add the bold line below to the cost of salesaccount:Calculation $000 $000Sales 3000 x 30 90000Cost of SalesOpening Stock 0Closing Stock 0Production Costs: Direct Overheads 12 x 3000 36000Production Overheads 21000 x 0.5 10500Under / Over absorption 46500 - 30000 (16500) 30000Gross Profit 43,500

Remember over-absorption is due to overcharging the cost of sales, as

such; we haveto deduct it from the cost of sales, whereas under-absorption is the opposite.