Download - Lecture 6 - Full Costing
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PGBM01
Financial Management & Control
Lecture 6 Full Costing
Francis Kuagbela
Senior Lecturer of Accounting & Finance
The university of Sunderland
School of Business & Law 1
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Learning Outcomes
Distinguish between direct costs andindirect costs
Allocate indirect costs absorption (full)costing
Explain absorption (full) costing
overhead recovery rate
Limitations of absorption costing
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The Product
Direct
Materials
Direct
Labour
Manufacturing
Overhead
Manufacturing Costs
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Direct and Indirect costs
Direct costs those costs clearlyattributable to the production of a
particular item or service intervention. Indirect costs those costs that are not
attributable to a particular product,
instead they serve several products.
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Direct Materials
Those materials that become an integral partof the product and that can be conveniently
traced directly to it.
Example: A radio installed in a car
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Direct Labour
Those labour costs that can be easily traced toindividual units of product.
Example: Wages paid to car assembly workers
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Manufacturing costs that cannot be traceddirectly to specific units produced.
Manufacturing Overhead
Examples: Indirect labor, indirect materials and other
manufacturing expenses (light, heat insurance .)
Wages paid to employees
who are not directlyinvolved in production
work.Examples: maintenance
workers, cleaners and
security guards.
Materials used to supportthe production process.
Examples: lubricants andcleaning supplies used in the
car assembly plant.
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Classifications of Costs
DirectMaterials
DirectLabour
ManufacturingOverhead
Prime
Cost
Conversion
Cost
Manufacturing costs are oftencombined as follows:
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Nonmanufacturing Costs
Marketing and selling costs . . . Costs necessary to get the order and deliver
the product.
Administrative costs . . .All executive, organizational and clerical costs.
All these costs are considered indirect
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Profit & loss account
000
Sales (turnover) XXX
Cost of sales (XXX)
Gross profit XXX
Distribution and selling costs (XXX)
Administrative expenses (XXX)
Operating profit XXX
Net interest receivable and other income XXXProfit from ordinary activities before taxation XXX
Taxation on profit of ordinary activities (XXX)
Profit after tax XXX
Dividends proposed (XXX)
Retained profit for the financial year XXX
Direct costs + some indirect costs
Indirect costs
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Classification of costs
Cost of sales include
Direct materials (direct cost)
Direct labour (direct cost)
MFG overheads (indirect costs)
Distribution and selling costs (allindirect)
Administrative expenses (all indirect)
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Dealing with indirect costs
The key question is:
Whether or not indirect costs areto be considered as part of productcosts
There are two opinions:
1 They can be ignored marginal(variable) costing
2 They can be apportioned in some way-absorption costing
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Marginal (variable) Costing
In marginal costing overheads (indirectcosts) are not included in the cost ofgoods produced
Products make a contribution towardspaying for the overheads and thenmaking a profit
Danger in not having enough
contribution to cover the overheads
Unable to measure each products profit
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Cost profile
Product A B Combined
Units 1500 1500
Labour hours 2.5 2
Machine Hours 0.5 1.5
Labour cost per hour 5 5Material cost per unit 6.5 7.5
Selling price per unit 22 22
Total labour hours 3750 3000 6750
Total machine hours 750 2250 3000
Total overhead 10000
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Product contribution statements
Marginal CostingA B Combined
Sales ? ? ?
Direct labour ? ? ?
Direct Material ? ? ?
Contribution ? ? ?
Overhead 10000
Profit
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Product contribution statements
Marginal CostingA B Combined
Sales 33000 33000 66000
Direct labour 18750 15000 33750
Direct Material 9750 11250 21000
Contribution 4500 6750 11250
Overhead 10000
Profit 1250
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Product contribution statements
Marginal CostingA B Combined
Sales 33000 33000 66000
Direct labour 18750 15000 33750
Direct Material 9750 11250 21000
Contribution 4500 6750 11250
Overhead 10000Does A or B make more profit?
Profit ? ? 1250
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Absorption (Full) Costing
Seeks to allocate the overheads fairlybetween the different products
Knowing what the full cost of producinga product can be very useful in settingthe price
It can also help us assess theprofitability of different products
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Overhead allocation
But the question is:
How can we allocate the indirect costs
between products in a suitable and fairmanner?
There is no correct allocation method!
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Absorption Costing
Common allocation methods used in thepast have included:
Direct labour hours spent making a
product/delivering a service Machine hours the time spent using
special machinery in making a product
Find a standard (expected) cost perlabour or machine hour
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Overhead recovery rates
Total overhead/total labour hours =Overhead recovery rate per labour hour
OR
Total overhead/total machine hours =Overhead recovery rate per machine hour
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Cost profile
Product A B Combined
Units 1500 1500
Labour hours 2.5 2
Machine Hours 0.5 1.5
Labour cost per hour 5 5Material cost per unit 6.5 7.5
Selling price per unit 22 22
Total labour hours 3750 3000 6750
Total machine hours 750 2250 3000
Total overhead 10000
Overhead recovery rate per labour hour = ?
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Cost profile
Product A B Combined
Units 1500 1500
Labour hours 2.5 2
Machine Hours 0.5 1.5
Labour cost per hour 5 5Material cost per unit 6.5 7.5
Selling price per unit 22 22
Total labour hours 3750 3000 6750
Total machine hours 750 2250 3000
10000
Overhead recovery rate per labour hour
= 10000/6750hrs = 1.48/hr
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Full Cost Statements
Absorption Costing - labour hours
A B Combined
Sales 33000 33000 66000
Direct labour 18750 15000 33750
Direct Material 9750 11250 21000Contribution 4500 6750 11250
Overhead ? ? 10000
Profit ? ? 1250
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Full Cost Statements
Absorption Costing - labour hours
A B Combined
Sales 33000 33000 66000
Direct labour 18750 15000 33750
Direct Material 9750 11250 21000Contribution 4500 6750 11250
Overhead 5556 4444 10000
Profit -1056 2306 1250
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Full Cost Statements
Absorption Costing - machine hours
A B Combined
Sales 33000 33000 66000
Direct labour 18750 15000 33750
Direct Material 9750 11250 21000
Contribution 4500 6750 11250
Overhead ? ? 10000
Profit ? ? 1250
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Cost profile
Product A B Combined
Units 1500 1500
Labour hours 2.5 2
Machine Hours 0.5 1.5
Labour cost per hour 5 5Material cost per unit 6.5 7.5
Selling price per unit 22 22
Total labour hours 3750 3000 6750
Total machine hours 750 2250 3000
Total overhead 10000
Overhead recovery rate per machine hour = ?
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Cost profile
Product A B Combined
Units 1500 1500
Labour hours 2.5 2
Machine Hours 0.5 1.5
Labour cost per hour 5 5Material cost per unit 6.5 7.5
Selling price per unit 22 22
Total labour hours 3750 3000 6750
Total machine hours 750 2250 3000
10000
Overhead recovery rate per machine hour
= 10000/3000hrs = 3.333/hr
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Full Cost Statements
Absorption Costing - machine hours
A B Combined
Sales 33000 33000 66000
Direct labour 18750 15000 33750
Direct Material 9750 11250 21000
Contribution 4500 6750 11250
Overhead 2500 7500 10000
Profit 2000 -750 1250
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Absorption Costing Issues
Several cost allocation methods available- use can be arbitrary
Different types of cost can be allocatedusing different methods
No perfect method exists
The overhead absorbed into cost is the
budgeted overhead - not the actualoverhead incurred
Absorption costing can send out wrongsignals with regard to product profitability
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Full Cost Statements
Different allocation methods can give different
results!
A B Combined
Labour Hours
Profit -1056 2306 1250
Machine Hours
Profit 2000 -750 1250
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Product A B Combined
Units 30000 42000
Labour hours 0.25 0.6
Machine Hours 0.25 0.1
Labour cost per hour 12 12
Material cost per unit 3 4
Selling price per unit 7 12
Total labour hours 7500 25200 32700
Total machine hours 7500 4200 11700
Total overhead 28,000
Cost profile
Work out the full profit for A and B using both labour hour
and machine hour recovery rates
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Absorption costing
Overhead recovery rate (labour hours)= 28,000/32700 = 0.8563
Overhead recovery rate (machinehours) = 28,000/11,700 = 2.393
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Labour Hour
Absorption A B Combined
Sales 210,000 504,000 714,000
Labour
90,000
(30,000 x
0.25 x 12)
302,400
(42,000 x 0.6
x 12) 392,400
Materials
90,000
(30,000 x 3)
168,000
(42,000 x 4) 258,000
Contribution 30,000 33,600 63,600
Overheadrecovery
(0.8563/LH) 6,422 21,578 28,000
Full Profit 23,578 12,022 35,600
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Machine Hour Absorption A B Combined
Sales 210,000 504,000 714,000
Labour 90,000 302,400 392,400
Materials 90,000 168,000 258,000Contribution 30,000 33,600 63,600
Overhead recovery
(2.393/MH) 17,949 10,051 28,000
Full Profit 12,051 23,549 35,600
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End of session 6
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