ACCA F5 Performance Management - 2010 - Study text - Emile Woolf Publishing
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Chapter 1: Costing systems
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Answer
$
Overheads absorbed into production costs: 5,400 hours × $24 per hour
129,600
Actual overhead expenditure 148,000
Under- absorbed overheads (18,400)
The under-absorption of overheads can be explained by a combination of two
factors.
Actual overhead expenditure was different from the budgeted expenditure on
which the absorption rate was based. There is an ‘expenditure variance’.
Actual volume of activity was different from the budgeted volume of activity on
which the absorption rate was based. There is an ‘volume variance’.
$
Budgeted overhead expenditure 120,000
Actual overhead expenditure 148,000
Expenditure variance – adverse, since spending more than budgeted (28,000)
hours
Budgeted production volume (labour hours) 5,000
Actual production volume (labour hours) 5,400
Volume variance in direct labour hours (favourable) 400
Absorption rate per direct labour hour $24
Volume variance in $ (favourable) $9,600
The volume variance is favourable because actual production volume was more
than the budgeted volume, and as a consequence there should have been some
over-absorption.
Summary
$
Expenditure variance (28,000)
Volume variance 9,600
Under- absorbed overheads (18,400)
1.4 Criticisms of absorption costing
Traditional absorption costing is still in use with some companies.
Its main advantage is that it provides a rational method of charging overhead
costs to production costs, so that a full cost of production can be calculated for
closing inventories.
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It may also be argued that absorption costing is useful for some pricing
decisions. Pricing is the subject of a later chapter.
However traditional absorption costing has many weaknesses, especially in a
‘modern’ manufacturing environment.
Production overhead costs are often high relative to direct production costs. A
system of adding overhead costs to product costs by using time spent in
production (direct labour hours or machine hours) is therefore difficult to justify.
A full cost of production has only restricted value as management information.
Managers use accounting information to help them make decisions for the
future, but most of the information they need cannot be provided by traditional
absorption costing methods.
Marginal costing has been suggested as an alternative to absorption costing, because
it can provide more useful management information.
1.5 Brief revision of marginal costing
You should be reasonably familiar with marginal costing from your previous
studies, but a brief revision is provided here.
The key element in marginal costing is the distinction between fixed costs and
variable costs. Fixed cost expenditure during any period of time is the same
amount in total regardless of the volume of activity (the volume of production
and sales) whereas variable costs rise or fall in direct proportion to increases or
falls in the activity level.
It is normally assumed that direct costs of production are also variable costs.
This is usually ‘true’ for direct materials. However, direct labour costs might be
treated as a variable cost in marginal costing even when direct labour employees
are paid a fixed wage or salary and so are actually a fixed cost.
A distinction could be made between variable and fixed overheads, so that some
overhead costs are recognised as a variable cost and included in the marginal
cost of production or sales. Marginal cost is therefore direct cost plus variable
overhead cost.
Inventory of finished goods and work-in-progress is valued at marginal
(variable) production cost, not at full absorbed production cost.
Profit is measured as follows:
$
Sales revenue X
Variable cost of sales (X)
Total contribution X
Fixed cost expenditure (X)
Profit or loss X or (X)
Fixed costs are therefore given less emphasis or attention in marginal costing than
variable costs and contribution.
Chapter 1: Costing systems
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Marginal costing is used for some aspects of planning or decision-making. For
example cost-volume-profit analysis (CVP analysis) can be used to calculate the
breakeven point for sales (where total contribution equals total fixed costs, and there
is neither profit nor loss).
Similarly, CVP analysis can be used to calculate the volume of sales required to
achieve a target figure for profit.
Weaknesses of marginal costing
Marginal costing is more useful than absorption costing as a technique for
providing some information to management for the purpose of planning or short-
term decision making. For example it is used with decision-making techniques such
as breakeven analysis and linear programming, which is the subject of a later
chapter.
However, marginal costing does not help management with the monitoring and
controlling of fixed costs. As production systems have become more automated, the
proportion of fixed costs in the total costs of production has risen, and the
proportion of direct costs (particularly direct labour costs) has fallen.
Another problem with marginal costing is the valuation of closing inventory.
Companies are required by international financial reporting standards (or by local
GAAP) to include some production overhead costs in inventory valuation. This
means that if a manufacturing company uses a system of marginal costing, it also
needs an additional system for adding overhead costs to inventory values for the
purpose of financial reporting.
1.6 Alternative costing systems
Both traditional absorption costing and marginal costing have weaknesses as a
costing system for manufacturing companies, and neither of these costing systems is
well-suited to costing in a modern manufacturing environment.
A number of alternative costing methods have been developed with a view to
replacing the traditional methods. These include activity based costing, backflush
accounting and throughput accounting.
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Activity based costing (ABC)
Introduction to activity based costing
Activities
Cost drivers and cost pools
ABC and traditional absorption costing
When using ABC might be appropriate
Advantages and disadvantages of ABC
Implications of switching to ABC
Problems with switching to ABC
Activity-based costing and costs of services
2 Activity based costing (ABC)
2.1 Introduction to activity based costing
Activity based costing (ABC) is a form of absorption costing. However, it differs
from traditional absorption costing, because it takes a different approach to the
apportionment and absorption of production overhead costs.
Activity-based costing is based on the following assumptions:
In a modern manufacturing environment, a large proportion of total costs are
overhead costs, and direct labour costs are relatively small.
Because overhead costs are large, it is appropriate to trace these costs as
accurately as possible to the products that create the cost.
In traditional absorption costing, production overheads are allocated or
apportioned to production departments, and are then absorbed on the basis of
the volume of production work, using a rate per direct labour hour or rate per
machine hour.
However many production overhead costs are not directly related to the
production work that is carried out. For example:
− The costs of quality control and inspection depend on the quality standards
and inspection methods that are used: these do not necessarily relate to the
number of hours worked in production.
− The costs of processing and chasing customer orders through the factory
relate more to the volume of customer orders rather than the hours worked
on each job in production.
− Costs of managing the raw materials inventories (storage costs) relate more
to the volume of materials handled rather than hours worked on the
material in production.
− The costs of production planning relate more to the volume and complexity
of customer orders or the number of batch production runs, rather than
hours worked in production.
Chapter 1: Costing systems
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The traditional methods of absorbing production overhead costs on the basis of
direct labour hours or machine hours do not have any rational justification and a
better method is needed for charging overheads to different products or jobs.
2.2 Activities
Activity based costing (ABC) takes the view that many production overhead costs
can be associated with particular activities that are not direct production work.
It is therefore appropriate to identify these activities and allocate overhead costs to
them. Overhead costs can then be added to product costs by using a separate
absorption rate for each activity. The costing of overheads and full production costs
is therefore based on activities, rather than hours worked in production.
Identifying activities
A problem with introducing activity-based costing is deciding which activities
create or ‘drive’ overhead costs.
They should be activities that use up a large amount of resources, such as labour
time. However, there are many different activities within a manufacturing
company, and it is not always clear which activities should be used for costing.
Activities might include, for example:
Materials handling and storage
Customer order processing and chasing
Materials purchasing
Quality control and inspection
Production planning
Repairs and maintenance.
These activities are not necessarily confined to single functional departments within
the production department.
Although ABC is often concerned with production costs, it can also be applied to
activities outside production, such as sales and distribution. Sales and distribution
activities might include:
selling activities
warehousing and despatch
after-sales service.
In a system of activity-based costing, it is preferable to select a fairly small number
of activities. If a large number of activities are selected, the costing system could
become too complex and time-consuming to operate.
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The activities are selected on the basis of management judgement and experience,
and their knowledge of the activities within manufacturing.
If only a small number of activities are identified and selected for use in the ABC
system, it is likely that some overhead costs will not relate to those activities. An
example might be the costs of rental of a factory and the running costs of the factory
(heating and lighting costs, security costs and so on). These overhead costs not
related to the selected activities might therefore be recorded as ‘general overheads’
and absorbed into product costs separately.
2.3 Cost drivers and cost pools
Cost drivers
For each activity, there should be a cost driver. (An activity might have more than
one cost driver, but if an activity does have more than one cost driver the costing
system becomes more complex. Just one cost driver per activity is desirable.)
A cost driver for an activity can be defined as a factor that determines the cost of the
activity. It is something that will cause the costs for an activity to increase as more of
the activity is performed.
It is not always obvious what the cost driver for an activity might be. A cost driver
might be unique to the activity. Here are some examples.
Activity Possible cost driver
Materials handling and storage Raw materials: purchases of materials
Finished goods: volume of products made
Customer order processing Number of customer orders
Materials purchasing Number of purchase orders
Quality control and inspection Number of inspections
Production planning Number of production runs or batches
Repairs and maintenance
Number of machines, or machine hours
operated
Selling Number of sales orders
Warehousing and despatch Number of deliveries made
Each cost driver must be a factor that can be measured, so that the number of units
of the cost driver that have occurred during each period can be established.
Activity Possible cost driver and measure of activity level
Materials handling and storage Raw materials: purchases of materials
Finished goods: volume of products made
Customer order processing Number of customer orders
Chapter 1: Costing systems
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Activity Possible cost driver and measure of activity level
Materials purchasing Number of purchase orders
Quality control and inspection Number of inspections
Production planning Number of production runs or batches
Repairs and maintenance Number of machines, or machine hours operated
Selling Number of sales orders
Warehousing and despatch Number of deliveries made
Overhead costs are therefore caused by activities, and the costs of activities are
driven by factors other than production volume.
In addition, it must be possible to relate the cost drivers for each activity to the
products or services that the entity sells. For example:
Activity Possible cost driver Information needed for ABC
Customer order
processing
Number of customer
orders
Number of orders for each
product
Materials purchasing
Number of purchase
orders
Number of orders for
materials for each finished
product
Quality control and
inspection
Number of
inspections
Number of inspections of
output of each product
Production planning
Number of
production runs or
batches
Number of runs or batches of
each product
Repairs and maintenance
Number of machines,
or machine hours
operated
Number of machines or
machine hours worked for
each product
Selling
Number of sales
orders
Number of orders for each
product
Warehousing and
despatch
Number of deliveries
made
Number of deliveries for each
product
Cost pools
Overhead costs are allocated (or allocated and apportioned) to each activity, and for
each activity there is a ‘cost pool’. A cost pool is simply the overhead expenditure
allocated and apportioned to an activity.
In ABC, overheads are absorbed into the cost of products (or services) at a separate
rate for each cost pool (each activity). The total production cost for each product or
service is therefore direct production costs plus absorbed overheads for each
activity. In addition, as mentioned earlier, there might also be an absorbed amount
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for general overheads, which cannot be attributed to any specific activity and cost
pool.
Example
A manufacturing company has identified that a large part of its overhead costs are
incurred in handling customer orders, and that the same effort goes into handling a
small order as the effort required to deal with a large order. Order sizes differ
substantially. The company makes four products, and the estimated costs of order
handling are $250,000 per year.
The company uses ABC, and wants to establish an order-handling overhead cost for
each product, based on the following budget:
Product
Number of
orders
Total number of
units ordered
W 15
60,000
X 22
33,000
Y 4
40,000
Z 9
27,000
50
160,000
If the cost driver for order handling is the number of orders handled, the budgeted
order handling cost will be $250,000/50 = $5,000 per order. Overhead costs will be
charged to products as follows:
Product
Number of
orders
Cost
$
W 15
75,000
X 22
110,000
Y 4
20,000
Z 9
45,000
50
250,000
Example
Menia Co makes three products, X, Y and Z using the same direct labour employees
and the same machine for production. The company uses activity-based costing.
Production details for the three products for a typical period are as follows:
Hours per unit Materials Production
Labour
hours
Machine
hours
Cost per
unit
units
$
Product X 0.25 0.75 10.0 1,500
Product Y 0.75 0.50 6.0 2,500
Product Z 0.50 1.50 12.5 14,000
Chapter 1: Costing systems
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Direct labour costs $16 per hour and production overheads are absorbed on a
machine hour basis.
Total production overheads are $1,309,000 and further analysis shows that the total
production overheads can be divided as follows:
%
Costs relating to machinery 15
Costs relating to inspection 35
Costs relating to set-ups 30
Costs relating to materials handling 20
Total production overhead 100
The following total activity volumes are associated with each product for the period:
Number of
inspections
Number of
set-ups
Number of
movements of
materials
Product X 360 80 40
Product Y 80 120 80
Product Z 960
500 280
1,400
700 400
Required:
Calculate the cost per unit for each product using ABC principles.
Answer
Working: Machine hours per period = (1,500 × 0.75) + (2,500 × 0.5) + (14,000 × 1.5)
1,125 + 1,250 + 21,000 = 23,375 hours.
Activity
Cost
allocated
Cost
driver
Activity
per
period
Overhead
absorption rate
$
Machinery operations
(15%)
196,350
Machine
hrs
23,375
$8.40 per machine
hour
Inspection (35%) 458,150
Inspections 1,400
$327.25 per
inspection
Set-ups (30%) 392,700
Set-ups 700 $561 per set-up
Materials handling
(20%)
261,800
Movements
400
$654.50 per
movement
Total 1,309,000
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Overheads per cost pool and per unit X Y
Z
Production overheads: $ $ $
Machinery at $8.40 per machine hour 9,450
10,500 176,400
Inspection at $327.25 per inspection 117,810
26,180 314,160
Set-ups at $561 per set-up 44,880
67,320 280,500
Materials handling at $654.50 per
movement
26,180
52,360 183,260
Overhead costs per product 198,320
156,360 954,320
Number of units 1,500 2,500 14,000
Overhead cost per unit $132.21 $62.54 $68.17
Production cost per unit: ABC X Y
Z
$ $ $
Direct materials 10.00
6.00 12.50
Direct labour 4.00
12.00 8.00
Production overhead 132.21
62.54 68.17
Full production cost per unit 146.21
80.54 88.67