Cost Accounting

The Cost Object

TimCo manufactures Chairs, each chair consists of Materials (Wood), Labor (A Carpenter) and Overhead (Rent, Utilities and Manager’s Wages). The Chairs are sold onto a furniture shop.

TimCo’s Strategy is to make a profit on its operations

Planning

• The manager asks how many chairs can the company make in a week?

• The Manager asks you how much the chair needs to sell for to make a profit?

Costs

• Material costs per chair are $10 of wood and nails/glue

• It takes a carpenter one hour to make a chair Carpenters are paid $300 per week and there are 40 working hours in each week, the company employs 2 carpenters

• Manufacturing Overheads are $1000 per week, this includes rent, heat light and managerial wages

How Many Chairs can be made?

• One chair per hour, per carpenter, two carpenters

• 40 hours in a week

= 40 x 2 = 80

What are the cost of constructing a chair?

• Direct Materials $10• Direct Labour $7.5 ($300/40 hours)• Overhead $12.5 (£1000/80 Chairs constructed

in one week)

= $30 per chair

What should the company sell the chair for?

• Your manager suggests that the company needs to make a Margin of 30%

= $30 x 0.30 = $9• The selling price of the chair is therefore = $39

Review Question

ABC Plc manufactures Beds the following information is available

• Direct Materials $10• Direct Labour $5• Overheads $5• Units produced in one week 100• Sales Margin of 25%• What is the Total cost of production?• What is the selling price of one bed?• How much profit will the company make in one week?

Answer

• Total Cost of production is $20 (10+5+5)• Selling Price is $25 (20 x 0.25)• Profit for one week is $500 (5 x 100)

Fixed and Variable Costs

• Fixed costs are usually the indirect costs of producing a Cost Object

• Variable Costs are all direct costs which are assigned to the production of a Cost Object

• Fixed and variable costs behave in different ways

Fixed Costs

• Fixed costs do not change with the volume of production

• Usually fixed costs include all of the running costs of the business apart from the direct materials and labour involved in the physical aspects of the Cost Object

Variable Costs

• Variable costs increase as production increases

• Variable costs are usually the direct materials and labour of producing the Cost Object

Allocation of Fixed Costs

• It is unusual for a company to make only one product, but often many products will be made in the same environment, sharing some portion of Fixed Costs

• Often managers will want more information about the difference between Cost Objects and the cost of production

• We can do this by allocating overheads in some way

Example

• A company makes two products A and B

$ A BDirect Materials

3 7

Direct Labour

5 9

Further InformationFixed Costs $Utilities and Rent 400Machine Costs 200Managerial Wages 600

How can we allocate the fixed costs to the Products?

• We need more information, assume the following

• Product A utilises 30% of the Factory, Product B utilises 70%

• Product A utilises 4 Machine Hours per unit, Product B utilises 3 Machine Hours per unit, there are a total of 400 machine hours used per week

Allocation of Fixed Costs

• We need to make a choice on how we allocate these costs, given the information available we can assume the following

• Allocate the utilities according to the % of space used

• Allocate the Machine Costs according to the % total machine time each product uses

• Allocate managerial costs using either of these methods

Rent and Utilities

• Total Fixed cost $400• Product A utilises 30%, Product B utilises 70%• Total Fixed Cost allocated to Product A $120

(400 x 0.3)• Total Fixed Cost allocated to product B $280

(400 x 0.7)• Fixed cost per Unit – Product A $2.4 (120/50)– Product B $5.6 (280/50)

Machine Costs

• Find Total Machine Hours per Product• Product A Machine Hours Per Unit = 4, Total

Units Produced = 50, total machine hours used producing Product A = 200 (4 x 50)

• Product B Machine Hours per Unit 3, total units produced 50, Total Machine Hours used producing Product B = 150 (3 x 50)

Machine Costs (ctd)• Find % of cost to allocate to each product• Total Machine Hours= 350• Product A Machine Hours = 200• Product A Percentage = 57% (200/350 x 100)• Product B Percentage = 43% (150/350 x 100)• Product A = $114 ($200 x 0.57)• Product B = $86 ($200 x 0.43)• Product A Per Unit = $2.28 (114/50)• Product B Per Unit = $1.72 (86/50)

Managerial Costs

• Managerial costs are less clear, we could use either method because there is not enough information, but it is likely that more managerial oversight is required for a bigger area of the factory, so you should use the same methodology as the Rent and Utilities

Managerial Cost Ctd

• Total Managerial Costs = $600• Product A = $180 (600 x 0.3)• Product B = $420 (600 x 0.7)• Per Unit, Product A $3.6 (180/50)• Per Unit, Product B $8.4 (420/50)

Allocated Costing

Cost Product A Product BDirect Materials 3 7Direct Labour 5 9Utilities and Rent 2.4 5.6Machine Costs 2.28 1.72Managerial Overheads 3.6 8.4Total Costs 16.28 31.72

Cost Behaviour

Basic Cost Revision

• Direct or Variable Costs are generally the materials and direct labour which go into making a Cost Object (Product or Service)

• Indirect or Fixed Costs are generally the Overheads which are Allocated to the Cost Object

• Together these make up the Total Cost of the Cost Object

Ctd

• Selling Price is the Total Cost plus a Contribution or Revenue from the Cost Object

• Revenue is often expressed as a Sales Margin or a percentage (%) of the Total Costs Plus Total Costs

Common Abbreviations

• Variable (Direct) Cost = VC• Fixed (Indirect) Cost = FC• Units of Production = U• Total Costs = TC• Revenue = R• Sales Margin = M (Expressed as a %)• Selling Price = SP• Total Profit = TP

Some Relationships

• TC = VC + FC (Total Costs = Direct + Indirect Costs)

• R = (TC x M%) + TC (Revenue = Total Costs x Margin as a percentage) + Total Cost

• SP = TC + M (Selling Price = Total Costs + Margin)

Assumptions of Cost Behaviour

• We assume that Variable Costs are Linear to Units Produced, as production increases so to does Variable Cost

• We Assume that Fixed Costs do not change with production, so as units produced increases Fixed cost remain even

True?

• Sometimes this is true, but only in very simple cases

• Fixed and Variable Costs are usually more complex

• There are a number of reasons for this– Economies or Dis-economies of scale– Step Effects– Mixed Costs

Variable Costs

• Most costs are variable, they change in relation to something else

• In our simple model the Variable Costs share a Linear Relationship with Units Produced, as units produced increase so too do Variable Costs

• In more complicated analysis Variable Costs change in relation to the Activity Base

Activity Base• The Activity Base is whatever causes the costs to

vary• In the simple model the Units Produced are the

Activity Base• The Activity Base can be anything• Common Activity Base’s can be:– Batches of Production– Changes to Direct Labour

• But there are many more, and often they are unique to the organisation

Example

• A good example of this is the Variable Cost of offering some Services

• We are an Electrical Repair Company• Our Allocation base is Number of Repair Jobs

Completed per day• We pay our Repairman a daily wage of $10• Our Repairman completes 5 Jobs per day

Ctd

• Our Allocation Base is therefore not the number of Jobs completed but how many Repairmen we need to employ to service the demand

• We can understand this cost by plotting a Graph of $ cost and Jobs completed assuming that each Repairman completes 5 Jobs per day

Linearity Assumptions

• Economics states that cost behave in a curvilinear way

• Accountants assume Linear Relationships (or as we have seen Step Variability)

• Who is right?

• Its the Economists

Why Curvilinear?

• There are economies and diseconomies of scale. For instance:– Price per unit of raw material will often fall as

larger numbers of units are orders– Prices are subject to discounts for minimum

orders– As Volume increases more problems can occur in

production or larger units of labour are required than in a strict linear relationship

Fixed Costs

• In the modern manufacturing environment there is a Trend to Fixed Costs

• The Manufacturing Environment has become dominated by Technology

• The Price of operating and maintaining highly technical equipment is very high

• This has meant that Overheads such as maintenance and depreciation of machinery has become the major cost, rather than Labour or Direct Materials

Committed Fixed Costs

• Types of Committed Fixed Costs– Investment in Facilities, Machinery and

Depreciation – Salaries of Managers and Costs of Sales

• Committed Fixed Costs generally– Remain relatively constant– Stay stable over fairly long periods of time

Discretionary Fixed Costs

• Types of Discretionary Fixed Costs– Advertising– Research and Development– Company Relations

• Discretionary Fixed Costs will generally– Have a short term planning horizon– Be relatively unique

Fixed Costs and the Relevant Range

• Fixed costs are subject to the same relevant range idea as Variable costs

• Fixed Costs tend to step in line with production

• Therefore we need to understand how relevant the range is to our cost assumptions

Cost Analysis

• So we need to ‘diagnose’ the costs involved and discover the ‘relevant range’ that applies to our production levels

• We can do this by plotting graphs of Dependant Variables and Independent Variables

Independent Variables

• Independent Variables are plotted on the X Axis

• Independent Variables are the Activity Base

Identifying the Relevant Range

• The Relevant Range can be identified by plotting a scatter graph and applying linearity where it is seen

• You run a hotel, it has enough room for a maximum of 60 Guests, and you have the following cost information

Hotel Stays (People) Cost $10 8015 8020 8025 8030 8035 8840 96.845 106.4850 117.12855 128.840860 141.7249

Cost Analysis1) You Have the following information:

Direct Materials $4 per unitDirect Labour $3 per unitIndirect Costs $3 per unitTotal Units Produced 20Sales Margin 25%

Provide the following informationTotal Indirect CostsTotal Costs per unitSelling PriceRevenue

Answers

• Total Indirect Costs $60 (20 x 3)• Total Cost per unit $10 (4+3+3)• Selling Price =$12.50 (10 x 25% + TC)• Revenue = $12.50 x 20 units = $250

Review Questions

• What is Cost Behaviour?• What is Linearity?• Is Linearity true?• What can cause Curvilinear Cost Behaviour?• What is the Relevant Range?• How can we identify the Relevant Range