COST C O S T COST. Cost is not a simple concept. It is important to distinguish between four different types - fixed,, variable, average and marginal.

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1 Ir. Haery Sihombing/IP Pensyarah Fakulti Kejuruteraan Pembuatan Universiti Teknologi Malaysia Melaka Chapter 3 DIRECT COST Chapter 4 INDIRECT COSTS C O S T COST Cost is not a simple concept. It is important to distinguish between four different types - fixed,, variable, average and marginal. Monetary measure of resources given up to attain an objective (such as acquiring a good or delivering a service) COST A cost may be defined as a sacrifice or giving up of resources for a particular purpose. Costs are frequently measured by the monetary units that must be paid for goods and services. Cost and Cost Terminology Cost is a resource sacrificed or forgone to achieve a specific objective. An actual cost is the cost incurred (a historical cost) as distinguished from budgeted costs. A cost object is anything for which a separate measurement of costs is desired.

2 Cost and Cost Terminology Cost Classifications Cost Assignment is both Tracing Direct Costs Allocating Indirect Costs Cost Object Association with cost object Cost object is anything for which management wants to collect or accumulate costs Direct - traceable to a cost object Indirect - not conveniently or practically traceable to a cost object treated as overhead allocated Cost Classifications Categories Cost Object Costing System anything for which a separate measurement of costs is desired Direct Cost costs that are related to a particular cost object in an economically feasible (Cost-effective) manner Cost Pool a grouping of individual cost items Cost Allocation Base a factor that is the common denominator for systematically linking an indirect cost or group of indirect costs to a cost object

3 Cost Categories Association with cost object Reaction to changes in activity Variable Fixed Mixed Step Cost Allocation Same issue exists for merchandising firms Easier for merchandising, purchase price (major) shipping cost (minor) taxes (minor) Relevant Range normal operating range Classification of Costs This section concentrates on the big picture of how manufacturing costs are accumulated and classified. Cost Objective A cost objective or cost object is defined as anything for which a separate measurement of costs is desired. Examples include departments, products, activities, and territories. Accounts could be type of cost, to which product, department?

4 Categories of Manufacturing Costs All costs which are eventually allocated to products are classified as either 1. direct materials, 2. direct labour,, or 3. indirect manufacturing. Direct-Material Costs Direct-material costs include the acquisition costs of all materials that are physically identified as a part of the manufactured goods and that may be traced to the manufactured goods in an economically feasible way. Direct-Material Costs Direct Materials Materials that are clearly and easily identified with a particular product. Example: Steel used to manufacture the automobile. Direct-Labour Costs Direct-labour costs include the wages of all labour that can be traced specifically and exclusively to the manufactured goods in an economically feasible way.

5 Direct-Labour Costs Direct Labor Labor costs that are clearly traceable to, or readily identifiable with, the finished product. Example: Wages paid to an automobile assembly worker. Indirect Manufacturing Costs Indirect manufacturing costs or factory overhead include all costs associated with the manufacturing process that cannot be traced to the manufactured goods in an economically feasible way. Indirect Manufacturing Costs Factory Overhead All factory costs except direct material and direct labor. Factory costs that cannot be traced directly to specific units produced. Examples: Indirect labor maintenance Indirect material cleaning supplies Factory utility costs Supervisory costs Prime Costs, Conversion Costs, and Direct-Labour Costs Prime Costs 1. Direct Materials 2. Direct Labour Conversion 3. Factory Overhead Costs

6 Product Costs Product Costs Product costs are costs identified with goods produced or purchased for resale. Direct material Measurable part of a product Direct labor Labor used to manufacture a product or perform a service Overhead Indirect production cost Product Costs Period Costs Product costs are initially identified as part of the inventory on hand. These product costs (inventoriable costs) become expenses (in the form of cost of goods sold) only when the inventory is sold. First appear on the balance sheet in inventory accounts Transferred to the income statement when product is sold Period costs are costs that are deducted as expenses during the current period without going through an inventory stage

7 Period Costs Period Costs Selling and administrative costs Distribution costs Cost to warehouse, transport, and/or deliver a product or service Major impact on managerial decision making Appear on the income statement when incurred Expensed when incurred Classification By Function Period and Products Cost Period costs are expenses not charged to the product. Period Costs (Expenses) 2005 Income Statement Operating Expenses Selling Costs Costs incurred to obtain customer orders and to deliver finished goods to customers advertising and shipping. Administrative Costs Non-manufacturing costs of staff support and administrative functions accounting, data processing, personnel, research and development Costs Incurred Product Costs (Inventory) Inventory Sold in 2005 Inventory Not Sold in 2005 Cost of Goods Sold 2005 Balance Sheet Inventory Raw Materials Work in Process Finished Goods 2006 Income Statement Cost of Goods Sold

8 Product Cost - Direct Direct Material Conveniently and economically traced to cost object Direct Labor to manufacture a product or perform a service includes wages paid to direct labor employees, production bonuses, payroll taxes may include holiday and vacation pay, insurance, retirement benefits Product Cost - Indirect Overhead - indirect production costs Fringe benefits, if cannot be easily traced to product Overtime, if due to random scheduling Cost of quality Prevention costs Appraisal costs Failure costs Product Cost vs. Period Cost Product cost All costs incurred in getting product to saleable condition Three main elements: Raw Materials Labour Factory overheads Period cost All costs incurred for a period of time regardless of production Sometimes classified into: Marketing expenses General (administrative) expenses Financial expenses Direct Costs Direct costs can be identified specifically and exclusively with a given cost objective in an economically feasible way.

9 Indirect Costs Indirect costs cannot be identified specifically and exclusively with a given cost objective in an economically feasible way. Direct vs. Indirect Costs Direct Costs Major costs that can be directly attributable to the final product or service. Includes: Direct materials Direct labour Other: subcontractors, tender document preparation Indirect Costs All other costs that cannot be directly attributable to the final product or service. Includes Indirect materials: factory supplies, small items of material Indirect labour: admin, cleaning or security staff Factory overheads; rates, rent, insurance, telephone, stationery Classification by Traceability Fixed Cost vs. Variable Cost Direct costs Costs incurred for the benefit of one specific cost object. Examples: material and labor cost for a product. Indirect costs Costs incurred for the benefit of more than one cost object. Example: maintenance expenditures benefiting two or more departments. Fixed costs Those costs that in total will remain the same for a period of time and over a relevant range or output. Includes: Rent, rates, insurance, depreciation Variable costs Those costs that in total will tend to increase as output level increase. Includes: Direct Materials and Direct Labour

10 Overhead Cost Allocation Allocating Overhead Actual Cost System Assign indirect costs to one or more cost objects To determine full absorption cost (GAAP) To motivate management To compare alternative courses of action for planning, controlling, and decision making Allocation process should be rational and systematic Product Cost Direct Materials Direct Labor Overhead Cost Used Actual Actual Actual Allocating Overhead Actual Cost System Allocating Overhead Actual vs. Normal The Actual Cost System is not timely All costs must be known before calculating product cost Product Cost Direct Materials Direct Labor Actual Cost System Actual Actual Normal Cost System Actual Actual Overhead Actual Predetermined Overhead Rate

11 Classification By Behavior Classification By Behavior Cost behavior means how a cost will react to changes in the level of business activity. Total fixed costs do not change when activity changes. Total variable costs change in proportion to activity changes. Cost Cost Activity Activity Cost behavior means how a cost will react to changes in the level of business activity. Total fixed costs do not change when activity changes. Total variable costs change in proportion to activity changes. Product Cost Behavior Potential Multiple Cost Classifications Direct Material Variable Direct Labor Overhead Variable Variable, Fixed, or Mixed Cost Item Behavior Traceability Function Material Variable Direct Product Assembly Wages Variable Direct Product Advertising Fixed Indirect Period Production Manager's Salary Fixed Indirect Product Office Depreciation Fixed Indirect Period

12 Direct and Indirect Costs EXERCISE Direct Costs Example: Oak wood used in Mfg. of chairs. Indirect Costs Example: salary of the Plant night watchperson. COST OBJECT Example: 50 Oak Chairs produced in May. Direct and Indirect Costs Example Direct and Indirect Costs Example Direct Costs: Maintenance Department $40,000 Personnel Department $20,600 Assembly Department $75,000 Finishing Department $55,000 Assume that Maintenance Department costs are allocated equally among the production departments. How much is allocated to each department? Assembly Direct Costs $75,000 $20,000 Maintenance $40,000 Allocated Finishing Direct Costs $55,000 $20,000

13 Cost Behavior Patterns Example Cost Behavior Patterns Example Bicycles by the Sea buys a handlebar at $52 for each of its bicycles. What is the total handlebar cost when 1,000 bicycles are assembled? 1,000 units $52 = $52,000 What is the total handlebar cost when 3,500 bicycles are assembled? 3,500 units $52 = $182,000 Cost Behavior Patterns Example Cost Behavior Patterns Example Bicycles by the Sea incurred $94,500 in a given year for the leasing of its plant. This is an example of fixed costs with respect to the number of bicycles assembled. What is the leasing (fixed) cost per bicycle when Bicycles assembles 1,000 bicycles? $94,500 1,000 = $94.50 What is the leasing (fixed) cost per bicycle when Bicycles assembles 3,500 bicycles? $94,500 3,500 = $27

14 Cost Drivers Relevant Range Example The cost driver of variable costs is the level of activity or volume whose change causes the (variable) costs to change proportionately. The number of bicycles assembled is a cost driver of the cost of handlebars. Assume that fixed (leasing) costs are $94,500 for a year and that they remain the same for a certain volume range (1,000 to 5,000 bicycles). 1,000 to 5,000 bicycles is the relevant range. Relevant Range Example Relationships of Types of Costs Fixed Costs $94, Volume Variable Direct Indirect Fixed

15 Total Costs and Unit Costs Example Total Costs and Unit Costs Example What is the unit cost (leasing and handlebars) when Bicycles assembles 1,000 bicycles? Total fixed cost $94,500 + Total variable cost $52,000 = $146,500 $146,500 1,000 = $ Total Costs $146,500 $94,500 + $52x $94, Volume Use Unit Costs Cautiously Use Unit Costs Cautiously Assume that Bicycles management uses a unit cost of $ (leasing and wheels). Management is budgeting costs for different levels of production. What is their budgeted cost for an estimated production of 600 bicycles? 600 $ = $87,900 What is their budgeted cost for an estimated production of 3,500 bicycles? 3,500 $ = $512,750 What should the budgeted cost be for an estimated production of 600 bicycles?

16 Use Unit Costs Cautiously Use Unit Costs Cautiously Total fixed cost $ 94,500 Total variable cost ($52 600) 31,200 Total $125,700 $125, = $ Using a cost of $ per unit would underestimate actual total costs if output is below 1,000 units. What should the budgeted cost be for an estimated production of 3,500 bicycles? Total fixed cost $ 94,500 Total variable cost (52 3,500) 182,000 Total $276,500 $276,500 3,500 = $79.00 Merchandising Service Merchandising companies purchase and then sell tangible products without changing their basic form. Service companies provide services or intangible products to their customers. Labor is the most significant cost category.

17 Types of Inventory Types of Inventory Manufacturing-sector companies typically have one or more of the following three types of inventories: 1. Direct materials inventory 2. Work in process inventory (work in progress) 3. Finished goods inventory Merchandising-sector companies hold only one type of inventory the product in its original purchased form. Service-sector companies do not hold inventories of tangible products. Classification of Manufacturing Costs Inventoriable Costs Direct materials costs Inventoriable costs (assets) Direct manufacturing labor costs become cost of goods sold Indirect manufacturing costs after a sale takes place.

18 Period Costs Flow of Costs Example Period costs are all costs in the income statement other than cost of goods sold. Period costs are recorded as expenses of the accounting period in which they are incurred. Bicycles by the Sea had $50,000 of direct materials inventory at the beginning of the period. Purchases during the period amounted to $180,000 and ending inventory was $30,000. How much direct materials were used? $50,000 + $180,000 $30,000 = $200,000 Flow of Costs Example Flow of Costs Example Direct labor costs incurred were $105,500. Indirect manufacturing costs were $194,500. What are the total manufacturing costs incurred? Direct materials used $200,000 Direct labor 105,500 Indirect manufacturing costs 194,500 Total manufacturing costs $500,000 Assume that the work in process inventory at the beginning of the period was $30,000, and $35,000 at the end of the period. What is the cost of goods manufactured? Beginning work in process $ 30,000 Total manufacturing costs 500,000 Ending work in process 35,000 Cost of goods manufactured $495,000

19 Flow of Costs Example Flow of Costs Example Assume that the finished goods inventory at the beginning of the period was $10,000, and $15,000 at the end of the period. What is the cost of goods sold? Beginning finished goods $ 10,000 Cost of goods manufactured 495,000 Ending finished goods 15,000 Cost of goods sold $490,000 Work in Process Beg. Balance 30, ,000 Direct mtls. used 200,000 Direct labor 105,500 Indirect mfg. costs 194,500 Ending Balance 35,000 Flow of Costs Example Manufacturing Company Work in Process 495,000 Finished Goods 10, , ,000 15,000 Cost of Goods Sold 490,000 BALANCE SHEET Inventoriable Costs Materials Inventory Work in Process Inventory Finished Goods Inventory INCOME STATEMENT when sales occur Revenues deduct Cost of Goods Sold Equals Gross Margin deduct Period Costs Equals Operating Income

20 Merchandising Company Prime Costs all all direct mfg. costs BALANCE SHEET Inventoriable Costs Merchandise Purchases Inventory INCOME STATEMENT when sales occur Revenues deduct Cost of Goods Sold Equals Gross Margin deduct Direct Materials Direct Labor + = Prime Costs Period Costs Equals Operating Income Prime Costs Conversion Costs What are the prime costs for Bicycles by the Sea? Direct materials used $200,000 + Direct labor 105,500 = $305,000 Direct Labor Manufacturing + Overhead = Conversion Costs Indirect Labor Indirect Materials Other

21 Conversion Costs Measuring Costs Requires Judgment What are the conversion costs for Bicycles by the Sea? Direct labor $105,500 + Indirect manufacturing costs 194,500 = $300,000 Conversion cost = all mfg. cost except direct materials Manufacturing labor-cost classifications vary among companies. The following distinctions are generally found: Direct manufacturing labor Manufacturing overhead Measuring Costs Requires Judgment Measuring Costs Requires Judgment Manufacturing overhead Indirect labor Managers salaries Payroll fringe costs Forklift truck operators (internal handling of materials) Janitors Rework labor Overtime premium Idle time Overtime premium is usually considered part of overhead. Assume that a worker gets $18/hour for straight time and gets time and one-half for overtime.

22 Measuring Costs Requires Judgment Many Meanings of Product Cost How much is the overtime premium? $18 50% = $9 per overtime hour If this worker works 44 hours on a given week, how much are his gross earnings? Direct labor 44 hours $18 = $792 Overtime premium 4 hours $ 9 = 36 Total gross earnings $828 A product cost is the sum of the costs assigned to a product for a specific purpose. 1. Pricing and product emphasis decisions 2. Contracting with government agencies 3. Preparing financial statements for external reporting under generally accepted accounting principles Balance Sheet of a Manufacturer Balance Sheet of a Manufacturer Raw Materials Work in Process Finished Goods Raw Materials Work in Process Finished Goods Manufacturing Inventory Classifications Materials waiting to be processed. Partially complete products. Material to which some labor and/or overhead have been added. Completed products for sale.

23 Income Statement of a Manufacturer Income Statement of a Manufacturer Merchandiser Beginning Merchandise Inventory + Cost of Goods Purchased _ Ending Merchandise Inventory = The major difference Cost of Goods Sold Manufacturer Beginning Finished Goods Inventory + Cost of Goods Manufactured _ Ending Finished Goods Inventory = Cost of goods sold for manufacturers differs only slightly from cost of goods sold for merchandisers. Merchandising Company Cost of goods sold: Beg. merchandise inventory $ 14,200 + Purchases 234,150 = Goods available for sale $ 248,350 - Ending merchandise inventory (12,100) = Cost of goods sold $ 236,250 Manufacturing Company Cost of goods sold: Beg. finished goods inv. $ 14,200 + Cost of goods manufactured 234,150 = Goods available for sale $ 248,350 - Ending finished goods inventory (12,100) = Cost of goods sold $ 236,250 Income Statement of a Manufacturer Manufacturing costs are often combined as follows: Question What type of account is the manufacturing goods in process account? Direct Material Prime Cost Direct Labor Conversion Cost Manufacturing Overhead a. Income statement expense account. b. Balance sheet inventory account. c. Temporary clearing account for direct material and direct labor. d. Holding account for manufacturing overhead and direct labor.

24 Question The primary distinction between product and period costs is... a. Product costs are expensed in the period incurred. b. Product costs are directly traceable to product units. c. Product costs are inventoriable. d. Period costs are inventoriable. Flow of Manufacturing Activities Materials activity Raw Materials Beginning Inventory Raw Materials Purchases Raw Materials Ending Inventory Production activity Work in Process Beginning Inventory Direct Labor Factory Overhead Raw Materials Used Work in Process Ending Inventory Sales activity Finished Goods Beginning Inventory Cost of Goods Manufactured Finished Goods Ending Inventory Cost of Goods Sold Statement of Cost of Goods Manufactured Statement of Cost of Goods Manufactured Cost of all goods completed and transferred from work in process to finished goods during a reporting period. Direct Materials Used + Direct Labor + Factory Overhead = Total Manufacturing Costs + Beginning Work in Process Ending Work in Process = Cost of Goods Manufactured Let s take a look at Rocky Mountain Bikes Statement of Cost of Goods Manufactured.

25 Statement of Cost of Goods Manufactured ROCKY MOUNTAIN BIKES Statement of Cost of Goods Manufactured For Year Ended 31 December 2005 Direct materials used in production $ 85,500 Direct labor 60,000 Total factory overhead costs 30,000 Total manufacturing costs for the period $ 175,500 Add: Beginning work in process inventory 2,500 Total cost of work in process $ 178,000 Less: Ending work in process inventory 7,500 Cost of goods manufactured $ 170,500 Statement of Cost of Goods Manufactured Statement Computation of Cost of of Cost Goods of Direct Material Manufactured Used Beginning raw materials inventory $ Exh. 8, Add: Purchases of raw materials 86,500 Cost of raw materials available for use $ 94,500 Less: Ending raw materials inventory 9,000 ROCKY MOUNTAIN BIKES Cost of direct materials used in production $ 85,500 Statement of Cost of Goods Manufactured For Year Ended 31 December 2005 Direct materials used in production $ 85,500 Direct labor 60,000 Total factory overhead costs 30,000 Total manufacturing costs for the period $ 175,500 Add: Beginning work in process inventory 2,500 Total cost of work in process $ 178,000 Less: Ending work in process inventory 7,500 Cost of goods manufactured $ 170,500 Statement of Cost of Goods Manufactured Include all direct labor costs ROCKY incurred MOUNTAIN during BIKES the Statement of current Cost of period. Goods Manufactured For Year Ended 31 December 2005 Direct materials used in production $ 85,500 Direct labor 60,000 Total factory overhead costs 30,000 Total manufacturing costs for the period $ 175,500 Add: Beginning work in process inventory 2,500 Total cost of work in process $ 178,000 Less: Ending work in process inventory 7,500 Cost of goods manufactured $ 170,500 Statement of Cost of Goods Manufactured Computation of Total Manufacturing Overhead Indirect labor $ 9,000 Factory supervision 6,000 Factory utilities 2,600 Property taxes, factory building 1,900 Factory supplies usedrocky MOUNTAIN BIKES 600 Factory insurance expired 1,100 Statement of Cost of Goods Manufactured Depreciation, building and equipment 5,300 For Year Ended 31 December 2005 Other factory overhead 3,500 Direct Total factory materials overhead used costs in production $ 30,000 $ 85,500 Direct labor 60,000 Total factory overhead costs 30,000 Total manufacturing costs for the period $ 175,500 Add: Beginning work in process inventory 2,500 Total cost of work in process $ 178,000 Less: Ending work in process inventory 7,500 Cost of goods manufactured $ 170,500

26 Statement of Cost of Goods Manufactured Statement of Cost of Goods Manufactured Beginning work in ROCKY MOUNTAIN process BIKES inventory is carried over from the Statement of Cost of Goods Manufactured prior period. For Year Ended 31 December 2005 Direct materials used in production $ 85,500 Direct labor 60,000 Total factory overhead costs 30,000 Total manufacturing costs for the period $ 175,500 Add: Beginning work in process inventory 2,500 Total cost of work in process $ 178,000 Less: Ending work in process inventory 7,500 Cost of goods manufactured $ 170,500 Ending work in process inventory ROCKY contains MOUNTAIN the cost BIKES of unfinished Statement goods, of Cost and of is Goods reported Manufactured in the current For assets Year Ended section 31 December of the balance 2005 sheet. Direct materials used in production $ 85,500 Direct labor 60,000 Total factory overhead costs 30,000 Total manufacturing costs for the period $ 175,500 Add: Beginning work in process inventory 2,500 Total cost of work in process $ 178,000 Less: Ending work in process inventory 7,500 Cost of goods manufactured $ 170,500

27 Direct Costing CHAPTER 3 DIRECT COST Alternative method of costing Relatively new More useful costing method for management planning and decision making Also know as variable costing as most direct costs are variable with respect to level activities Main difference between absorption costing and direct costing is in the treatment of fixed manufacturing overhead Treatment of Fixed Manufacturing Overhead Fixed manufacturing costs is not treated as a product cost instead it is treated as a period cost That is, it is written off (expensed) in the period in which it is incurred rather than included as a cost when determining the cost of inventory If fixed manufacturing costs are excluded from the cost of inventory when using direct costing then end of an accounting period will be lower than the value is using absorption costing this will effect both the balance sheet and profits ST 10.1 Mts Manufactured 9000 Mts Sold 8600 Direct Materials $ 42, $ 4.70 Direct Labour $ 54, $ 6.00 Fixed Factory overhead $ 72, $ 8.00 Variable factory overhead $ 36, $ 4.00 $ 204, $ $ Manufacturing cost per metre Total costs $ 204, Number of Metres produced 9,000 Manufacturing cost per metre $ Product cost using absorption costing Direct material costs $ 42, Direct labour costs $ 54, Fixed Factory overhead $ 72, Variable factory costs $ 36, Product cost using absorption costing $ 204, Product cost using direct costing Direct material costs $ 42, Direct labour costs $ 54, Variable factory costs $ 36, Product cost using direct costing $ 132,300.00

28 ST 1 Value of closing inventory using absorption costing Metres Produced 9,000 less Metres sold 8,600 Closing Stock 400 Product cost/no of metres produced $ cost per metre Value of closing inventory using absorption costing $ 9, Value of closing inventory using direct costing Metres Produced 9,000 less Metres sold 8,600 Closing Stock 400 Product cost/no of metres produced $ cost per metre Value of closing inventory using direct costing $ 5, Sales 462,500 St.2 Less COGS Opening Inventory - Cost of production Direct materials Used 97,000 Direct labour used 64,020 Variable factory overhead incurred 54,320 Fixed factory overhead 106, ,040 Less Closing inventory 14, ,100 Gross profit 155,400 Less Operating expenses Marketing Expenses 45,325 Administrative Expense 92,500 Financial Expense 9, ,285 Net profit 8,115 Closing inventory Production Sale Closing inventory units units 900 units Costof production/# of production units $ per unit /19400 Closing inventory $ 14, Sales 462,500 Less Variable Costs ST.3 Opening Inventory - Cost of production Direct materials Used 97,000 Direct labour used 64,020 Variable factory overhead incurred 54, ,340 Less Closing inventory 9, ,350 Contribution Margin 257,150 Less Fixed Costs Manufacturing 106,700 Marketing Expenses 45,325 Administrative Expense 92,500 Financial Expense 9, ,985 Net profit 3,165 Closing inventory Production Sale Closing inventory units units 900 units Reconciliation of reported profits absorption and direct costing The difference in profits between the absorption and direct costing is caused by the amount of fixed overhead in the opening and closing inventories because they are excluded when using direct costing To reconcile profits using absorption costing to profits using direct costing you add back fixed costs in opening inventory using absorption costing and deduct fixed costs in closing inventory using absorption costing Costof production/# of production units $ per unit /19400 Closing inventory $ 9,990.00

29 Self test problem 4 Part a Absorption Costing August September Product Costs Directy materials Direct labour Variable manufacturing overheads Fixed manufacturing overheads no of litres produced cost per litre $ 0.79 $ 0.75 Self test problem 4 Part b Revenue Statement using the Absorption Costing Method August September Total Sales (sale price * # of litres sold) 117,600 $ 117, Less COGS 0 Opening Inventory 15,800 17,380 15,800 Cost of production 0 Direct materials Used Direct labour used Variable factory overhead incurred Fixed factory overhead ,800 99, ,300 Less Closing inventory 17,380 25,500 25,500 77,420 74, Gross profit 40,180 43, Less Operating expenses 0 Selling & Administrative expenses 30,000 30, Net profit 10,180 13, ,040 Closing inventory Opening Stock 20,000 22,000 add Production less Sale Closing inventory 22,000 ltrs 34,000 ltrs Cost of production/# of production units $ 0.79 $ / / Closing inventory $ 17, $ 25, Variance in Profit b/w August & September Self test problem 4 Part C Variance is due to the amount of fixed factory overhead component of cost of goods sold August September Fixed production costs Production in ltrs Fixed costs per litre $ 0.44 $ 0.40 Fixed costs in opening inventory opening inventory (ltrs)* fixed cost per ltr $ 8, ( Aug closing balance) Fixed costs incurred Less fixed cost in closing inventory closing inventory (ltrs)* fixed cost per ltr $ 43, difference b/w sept & Aug 3040 equals defference in net profit Revenue Statement using the Direct Costing Method ST 4 Part D August September Total Sales (sale price * # of litres sold) 117, , Less Variable Costs Opening Inventory (variable component only) 7,000 7, Cost of production Direct materials Used 5, Direct labour used 25, Variable factory overhead incurred 5, ,000 46, Less Closing inventory 7,700 11, , $ $ $ 34,300 34,300 68, Contribution margin 83,300 83, Less Fixed Costs 0 Manufacturing 44,000 44, Selling & Admin Exp 30,000 30, , Net profit 9,300 9, Closing inventory Opening Stock 20,000 22,000 add Production less Sale Closing inventory 22,000 ltrs 34,000 ltrs Cost of production/# of production units $ 0.35 $ /100000) (38500)/ Closing inventory $ 7, $ 11,900.00

30 ST4 part (e) Net profit using absorption costing 10,180 13,220 add Fixed costs in opening inventory using absorption costing $ 8, ,980 22,900 Less Fixed costs in closing inventory using absorption costing Net Profit using direct costing 9,300 9,300 Reporting variable marketing and administrative expense direct costing Revenue statement using direct costing: Is divided into 2 main areas Variable costs and fixed expenses Shows Variable non- manufacturing expenses and fixed non manufacturing expenses separately Shows the variable non- manufacturing expenses after the variable COGS (manufacturing exp) but before the net contribution margin line ST.5 $ $ $ Sales 274,543 Less Variable costs Cost of goods sold Inventory 1 July 26,485 Variable costs of production Diect materials 45,965 Direct labour 46,980 Variable factory overheads 22, , ,128 Less Inventory 30 June 25, ,468 Gross contribution Margin 158,075 less variable marketing expense 16,258 Net Contribution Margin 141,817 less Fixed Costs Factory Overhead 72,458 Marketing & Admin Exp 57, ,090 Net Profit 11,727 Revenue Statements with applied factory overheads There may be a variance between factory overheads applied and actual factory overheads incurred Any under-or or-over-applied overhead may be added or subtracted from the COGS In absorption costing the under-or or-over-applied overhead may include both variable and fixed elements However in direct costing under- or- over applied overhead will only include variable fixed overhead as the fixed overhead is not applied but written off as a period cost

31 ST 6 Part A ST 6 Part B Calculations Product cost using direct costing Direct material costs $ 2.00 Direct labour costs $ 1.50 Variable factory costs $ 1.00 Product cost using direct costing $ 4.50 Product cost using absorption costing Direct material costs $ 2.00 Direct labour costs $ 1.50 Variable factory overheads $ 1.00 Fixed factory overhead $ /30000(normal capacity) Product cost using absorption costing $ 7.00 Calculations July August Value of Opening & Closing inventory using absorption costing Opening Stock In Units 4, , Unit Cost $ $ 28, $ $ 42, , Closing Stock 6, Unit Cost $ $ 42, $ $ 21, Value of Opening & Closing inventory using direct costing Opening Stock In Units 4, , Unit Cost $ $ 18, $ $ 27, , Closing Stock 6, Unit Cost $ $ 27, $ $ 13, Under- or over-applied fixed factory overhead Budgeted & Actual fixed overhead $ 75, Fixed overhead applied (32000*$2.50) $ 80, *$2.50 Under- or (over) applied fixed overhead -$ 5, overapplied underapplied ST 6 Part B Revenue statements using absorption costing Sales (Sales in Quantity * $9) $ 270, Less COGC Beginning $7) $ 28, $ 42, Cost of production (units produced *$7) $ 224, $ 203, $ 252, $ 245, Less Closing inventory $ 42, $ 21, $ 210, $ 224, Add Under/ over applied Overhead -$ 5, $ 205, $ 226, Gross profit $ 65, $ 61, Less Marketing & Admin costs Variable ( Units sold *.3) $ 9, $ 9, Fixed $ 36, $ 36, $ 45, $ 45, Net profit $ 20, $ 15, Revenue statements using direct costing ST 6 Part C Sales (Sales in Quantity * $9) $ 270, Less COGC $4.5 $ 18, $ 27, Cost of production (units produced *$4.5) $ 144, $ 130, $ 162, $ 157, Less Closing inventory $ 27, $ 13, $ 135, $ 144, Gross contribution margin $ 135, $ 144, Less Variable Costs VariableMarketing Costs ( Units sold *.3) $ 9, $ 9, Contribution Margin $ 126, $ 134, Less Fixed Costs Manufacturing Costs $ 75, $ 75, Fixed marketing, admin & finance $ 36, $ 36, $ 111, $ 111, Net profit $ 15, $ 23,400.00

32 ST 6 Part D ST 6 Part d Net profit using absorption costing 20,000 15,900 add Fixed costs in opening inventory using absorption costing 4000 $ $2.5 30,000 30,900 Less Fixed costs in closing inventory using absorption costing 6000 $2.5 $ 15, $ 7, $2.5 Net Profit Using Direct costing $ 15, $ 23, Sales is only one component of Profits Profits is also affected by the difference between Quantity produced and Quantity sold. Under the absorption method the opening stocks of each accounting period contain a fixed manufacturing component carried forward from the previous period ST problem 7 (a) Fixed Factory Overhead Recovery Rate Budgeted Fixed factory Overhead $ 150,000 Budgeted Direct labour Hours $ per direct labour hour 7(b) Under- or over-applied combined factory overhead Actual fixed overhead $ 154, Actual Variable Overhead $ 48, Combined Factory Overhead $ 202, Combined overhead applied (15,000 direct labour hrs *$13/hr) $ 195, Under-applied fixed overhead $ 7, Variable Factory Overhead Recovery Rate Budgeted Variable factory Overhead $ 45,000 Budgeted Direct labour Hours $ per direct labour hour Combined Factory overhead rate Budgeted Fixed factory Overhead $ 150,000 Budgeted Variable factory Overhead $ 45,000 $ 195,000 Budgeted Direct labour Hours $ per direct labour hour Under- or over-applied Fixed factory overhead Actual fixed overhead $154, Fixed overhead applied (15,000 direct labour hrs *$10/hr) $150, Under-applied fixed overhead $4, Under- or over-applied Variable factory overhead Actual Variable overhead $48, Actual variable overhead applied (15,000 direct labour hrs *$3/hr) $45, Under-applied fixed overhead $3,000.00

33 7 c 7 c calculations cont Calculations Product cost using absorption costing Direct material costs $ 2.00 Direct labour costs $ 1.00 Fixed Factory overhead $ 5.00 $10/direct labour hour*15000hours/30000units Variable factory overheads $ 1.50 $3/direct labour hour*15000hours/30000units Product cost using absorption costing $ 9.50 Product cost using direct costing Direct material costs $ 2.00 Direct labour costs $ 1.00 Variable factory costs $ 1.50 Product cost using direct costing $ 4.50 WIP Finished goods Total Value of Opening & Closing inventory using absorption costing Opening Stock In Units - 4, Unit Cost $ 9.50 $ 9.50 $ - $ 38, $ 38, Closing Stock - 8, Unit Cost $ 9.50 $ 9.50 $ - $ 76, $ 76, Value of Opening & Closing inventory using direct costing Opening Stock In Units - 4, Unit Cost $ 4.50 $ 4.50 $ - $ 18, $ 18, Closing Stock - 8, Unit Cost $ 4.50 $ 4.50 $ - $ 36, $ 36, Revenue statements using absorption costing 7 c Sales $ 338, Less COGC Beginning $ 38, Cost of production (units produced *$9.5) $ 285, $ 323, Less Closing inventory $ 76, $ 247, Add Under/ over applied Overhead $ 7, $ 254, Gross profit $ 84, Less Marketing & Admin costs $ 51, ( ) Revenue statements using direct costing 7 d Sales $ 338, Less COGC Beinginning $ 18, Cost of production (units produced *$4.5) $ 135, $ 153, Less Closing inventory $ 36, $ 117, Add Underapplied Variable o/head $ $3, , Gross contribution margin $ 218, Less Variable Costs Variable Marketing & Admin Exp $ 33, Contribution Margin $ 184, Less Fixed Costs Manufacturing Costs (fixed factory o/head) $ 154, actual not budgeted Fixed- Marketing & admin $ 18, $ 172, Net profit $ 12, Net profit $ 32,620.00

34 Statement of Reconciliation 7 (e) Net profit using absorption costing 32,620 add Fixed costs in opening inventory using absorption costing 4000 $ ,620 Less Fixed costs in closing inventory using absorption costing $ $ 12, Alternatively Increase in inventory of 4000 units * fixed Factoy o/h $5 = ( ) = Job Costing & Direct Costing Direct costing can be: integrated with job, process or operation costing Used together with standard costing and activity based costing Fixed manufacturing overhead is debited to the general ledger to an account called fixed factory overhead Costing for indirect costs CHAPTER 4 INDIRECT COST On completion of this topic you should be able to Calculate the total cost of a cost unit using absorption costing methods Describe the problems associated with apportioning and absorbing indirect costs Independent study Progress test and practice question(s) as set

35 The Story So Far Absorption costing is a a method of costing that, in addition to direct costs, assigns a proportion or all the production overheads to the cost units. Costs are first allocated or apportioned to the cost centres, where they are absorbed into the cost unit using one or more absorption rates (Collis and Hussey, 2007, p. 241) The purpose of absorption costing is to find the total cost of a cost unit for valuing stock, planning and controlling production costs and determining the selling price The Story So Far The absorption approach is used by many firms and is a costing approach that considers all factory overhead (both variable and fixed) to be product (inventoriable)) costs that become an expense in the form of manufacturing cost of goods sold only as sales occur. Main stages in absorption costing Identify cost centres according to their function (eg production department) Collect indirect costs in cost centres on the basis of allocation or apportionment Determine overhead absorption rate (OAR) for each production cost centre (eg cost per machine hour) Charge indirect costs to products using OAR and a measure of the product s consumption of the cost centre s cost Overhead analysis The first stage in absorption costing is to prepare an overhead analysis which shows the allocation or apportionment of the production overheads to the production cost centres In the previous lecture we carried out an overhead analysis for Cotswold Coolers, which allocated and apportioned the total production overheads of 97,400 between the bottling department and the warehouse on what was considered to be a fair basis

36 Cotswold Coolers Overhead analysis Overhead Total Basis Bottling Warehouse Indirect materials 1,500 Allocated Indirect labour 45,000 No. of employees 30,000 15,000 Rent and rates 27,000 Area 9,000 18,000 Electricity 6,000 Area 4,000 2,000 Depreciation 8,000 Value of machinery 6,000 2,000 Supervision 21,000 No. of employees 14,000 7,000 Stock insurance 500 Value of stock Total 109,000 64,000 45,000 Production Overhead Absorption The next stage is to find a means of absorbing the production overheads for each cost centre into the cost units passing through them An overhead absorption rate (OAR) is a a means of attributing production overheads to a product or service (Collis and Hussey, 2007, p. 241) The three most commonly used OARs are The cost unit overhead absorption rate The direct labour hour overhead absorption rate The machine hour overhead absorption rate Exercise 1 Cost unit OAR The cost unit OAR is the simplest to use and the formula is Cost centre overheads Number of cost units passing through 104,000 units were produced during the period Production overheads were 64,000 for the bottling department and 45,000 for the warehouse Required Using the formula, calculate the cost unit OAR for each cost centre Formula Cost centre overhead Number of cost units Solution 1 Cost unit OAR Bottling 64, ,000 Warehouse 45, ,000 Cost Ros has unit decided OAR to use the 0.62 cost unit per OAR to 0.43 absorb per the warehouse production overheads into the cost of a bottle unit unit of water (the cost unit)

37 Direct Labour Hour OAR An alternative is the labour hour OAR Cost centre overhead costs Total direct labour hours Cotswold Coolers cannot use this OAR because the firm does not use a pay scheme that is linked directly to the product The labour hour OAR is typically used to absorb production overheads where the firm operates a time-based pay scheme and the level of direct labour hours in production cost centre is high Exercise 2 Machine hour OAR An alternative is the machine hour OAR Cost centre overhead costs Total machine hours 104,000 units were produced during the period Production overheads were 64,000 for the bottling department and 45,000 for the warehouse Total machine hours were 16,000 for the bottling department and 2,000 for the warehouse Required Using the formula, calculate the machine hour OAR for each cost centre Solution 2 Machine hour overhead absorption rate Formula Cost centre overhead Total machine hours Machine hour OAR Bottling 64,000 16, per m/hour Warehouse 45,000 2, per m/hour To reflect the high number of machine hours in the bottling department, Ros has decided to use the machine hour OAR for absorbing the production overheads into the cost of a bottle of water (the cost unit) Exercise 3 Production cost per unit Direct costs per unit are Mineral water 0.30; bottle, lid and label 0.75 The OAR in the bottling department will be 4.00 per machine hour (from Exercise 2) The OAR in the warehouse will be 0.43 per unit (from Exercise 1) Required Complete the production cost statement and calculate the production cost per unit

38 Pro forma Cotswold Coolers Production cost statement (1 unit) Direct materials Mineral water 0.30 Bottle, lid and label 0.75 Prime cost? Production overheads Bottling dept? Warehouse?? Production cost? Solution 3 Cotswold Coolers Production cost statement (1 unit) Direct materials Mineral water 0.30 Bottle, lid and label 0.75 Prime cost 1.05 Production overheads Bottling dept (0.15 machine hour x 4.00) 0.60 Warehouse (cost unit OAR) Production cost 2.08 Exercise 4 Apportioning non-production overheads The final step is to apportion the non-production overheads (eg administration, selling and distribution, research and development costs) A simple method is to add a percentage based on the following formula Non-production overheads x 100 Production cost Required Using the formula, calculate the percentage if non-production overheads are 43,250 and the production cost is 216,320 Solution 4 Apportioning non-production overheads Non-production overheads are 43,250 and the production cost is 216,320 Non-production overheads x 100 Production cost = 43,250 x ,320 = 20% of production cost If we also add a gross profit mark up of 50% of the production cost, we can calculate the selling price

39 Cotswold Coolers Total cost (1 unit) Direct materials Mineral water 0.30 Bottle, lid and label 0.75 Prime cost 1.05 Production overheads Bottling dept (0.15 machine hour x 4.00) 0.60 Warehouse (cost unit OAR) Production cost 2.08 Non-production overheads ( 2.08 x 20%) 0.42 Total cost 2.50 Profit ( 2.08 x 50%) 1.04 Selling price 3.54 Using predetermined absorption rates Normally predetermined overhead absorption rates (based on estimates) are used because the actual figures are not available until the end of the period Where the predetermined overhead that has been absorbed is higher than the actual overhead, the variance is known as overabsorption and this reduces expenses in the profit and loss account Where the predetermined overhead that has been absorbed is lower than the actual overhead, the variance is known as underabsorption and this increases expenses in the profit and loss account INCOME STATEMENT The income statement or profit and loss statement summarizes the firm s s revenues and expenses over a period of time (a month, a quarter, or a year) The income statement is used to evaluate revenue and expenses that occur in the interval between consecutive balance sheet statements. Revenues Expenses = Net Profit (Loss) Here is an example of an Income Statement Operating Revenues and Expenses Operating Revenues Sales (minus) returns and allowances Total Operating Revenues Operating Expenses Cost of Goods and Services Sold Materials Indirect Costs Selling and promotion Depreciation General and administrative Lease payments Total operating expense Total operating income Labor $28, , ,250 10,780

40 SOME FINANCIAL RATIOS DERIVED FROM INCOME STATEMENT Total operating income Non-operating operating Revenues and Expenses Interest (minus) Interest payments receipts Total Non-operating operating income Net Income Before Taxes Income Taxes (35%) Rents Net Profit (loss) for year ,780 $ ,240 3,930 $7,310 Interest Coverage = Total Income / Interest payments (28,610-17,250) /120 = 94.7 Net profit ratio = Net profit / Net sales revenue 7,310 / 28,030 = = 26.1% TRADITIONAL COST ACCOUNTING Direct Costs: Direct material : all material that is used in manufacturing a product Direct labor: wages of the direct touch labor needed to build one unit Indirect Costs: also known as overhead Shipping and receiving Quality control Engineering Rent, Insurance, etc All other expenses which are not direct labor or direct material ABSORPTION COSTING To allocate indirect cost (OH) to different products accountants use quantities such as direct-labor hours, direct-labor cost, material cost, or total direct cost as the metric. For example, if direct labor-hours is the metric to use, then overhead will be allocated based on overhead dollar per direct-labor hour. Then each product will absorb (or be allocated) overhead costs, based on the direct labor hours it consumes.

41 ABSORPTION COSTING Metric, i Unit allocation rate Rate, R i Unit allocation of OH cost Example Total Overhead is $850,000 Standard Premium DL hours DL cost DM cost Total direct cost $OH/total DL hours $OH/total DL cost $OH/total DM cost $OH/total Direct cost R i *DL hours per unit R i *DL cost per unit R i *DM cost per unit R i *total direct cost per unit Number of Units per year Labor cost (each) Materials cost (each) 750 $400 $ $500 $900 Example Total Overhead is $850,000 Standard Premium Total Labor cost Example Total Overhead is $850,000 Standard $300,000 Premium $200,000 Total $500,000 Number of Units per year Labor cost (each) 750 $ $500 Overhead/labor Allocation by labor 1.70 $510, $340,000 $850,000 Materials cost (each) $550 $900 Material cost $412,000 $360,000 Total labor cost Total materials cost $300,000 $412,500 $200,000 $360,000 $500,000 $772,500 Overhead material Allocation by material $ $453,884 $ $396,117 $850,000

42 Unit cost based on $DL allocation of OH Unit cost based on $DM allocation of OH Standard Premium Standard Premium DM DM DL DL OH (DL cost.) Unit cost 400*1.70 = *1.70 = OH (DM cost.) Unit cost 550*1.100 = *1.100 = CONCLUSIONS Direct costs are allocated to the cost unit Production overheads are allocated or apportioned to the cost centres on a fair basis and absorbed into the cost unit using an appropriate OAR Non-production overheads can be absorbed into the cost unit by adding a percentage based on the proportion of non-production overheads to the total production cost But a limitation of absorption costing is that it is based on arbitrary decisions about the basis for apportionment and absorption of overheads CHAPTER 5 MARGINAL COST Using direct (marginal) costing for decision making

43 What is Direct Costing? The Direct Costing method (Marginal costing) is an inventory valuation / costing model that includes only the variable manufacturing costs: direct materials (those materials that become an integral part of a finished product and can be conveniently traced into it) direct labor (those factory labor costs that can be easily traced to individual units of product. Also called touch labor) - only variable manufacturing overhead in the cost of a unit of product. The entire amount of fixed costs are expenses in the year incurred. The Principles of Marginal Costing 1. For any given period of time, fixed costs will be the same, for any volume of sales and production (provided that the level of activity is within the relevant range ). Therefore, selling an extra item of product or service: Revenue will increase by the sales value of the item sold Costs will increase by the variable cost per unit Profit will increase by the amount of contribution earned from the extra item 2. The volume of sales falls by one item the profit will fall by the amount of contribution earned from the item. The principles of marginal costing 3. Profit measurement should be based on an analysis of total contribution. Since fixed costs relate to a period of time, and do not change with increases or decreases in sales volume, it is misleading to charge units of sale with a share of fixed costs 4. When a unit of product is made, the extra costs incurred in its manufacture are the variable production costs. Fixed costs are unaffected, and no extra fixed costs are incurred when output is increased Features of Marginal costing 1. Cost Classification The marginal costing technique makes a sharp distinction between variable costs and fixed costs. It is the variable cost on the basis of which production and sales policies are designed by a firm following the marginal costing technique

44 Features of Marginal costing 2. Stock/Inventory Valuation Under marginal costing, inventory/stock for profit measurement is valued at marginal cost. It is in sharp contrast to the total unit cost under absorption costing method Features of Marginal costing 3. Marginal Contribution Marginal costing technique makes use of marginal contribution for marking various decisions. Marginal contribution is the difference between sales and marginal cost. It forms the basis for judging the profitability of different products or departments Cost-Volume Volume-Profit Analysis Systematic method of examining the relationship between changes in activity and changes in total sales revenue, expenses and net profit CVP analysis is subject to a number of underlying assumptions and limitations The objective of CVP analysis is to establish what will happen to the financial results if a specified level of activity or volume fluctuates CVP Analysis Assumptions All other variables remain constant A single product or constant sales mix Total costs and total revenue are linear functions of output The analysis applies to the relevant range only Costs can be accurately divided into their fixed and variable elements The analysis applies only to a short-time time horizon Complexity-related fixed costs do not change

45 CVP Diagram A Mathematical Approach to CVP Analysis NP=Px Px-(a+bx), NP net profit x units sold P selling price b unit variable cost a total fixed costs Break-Even and Related Formulas TR Profit = FC + VC Contribution = TR VC Profit = Contribution FC Break-even even (units) = FC/Contribution per unit Break-even even (sales revenue) =FC/PV ratio, where PV (profit - volume) ratio = Contribution/Selling price Margin of Safety Indicates by how much sales may decrease before a loss occurs Margin of safety (units)= Profit/Contribution per unit Margin of safety (sales revenue) = Profit/PV ratio

46 Range of Goods Planning (1) A B C Increases in Activity Level (unlimited) per unit total per unit total per unit total A B C Price(sales sales) VC FC (allocated( allocated) Costs per unit increment total per unit total per unit total Profit Price(sales sales) Contribution A B C VC per unit 1000 total per unit 0 total per unit 1500 total FC (allocated( allocated) Price(sales sales) Costs VC FC (allocated( allocated) Profit Costs Profit Contribution Contribution Increases in Activity Level (limited) Pricing A 1000 B 1200 C 1500 Price is 250 $ per unit choice 1 better quality (higher price,higher FC higher FC) choice 2 lower price Price(sales sales) VC per unit total per unit total per unit total FC (allocated( allocated) per unit total per unit total Costs Price(sales sales) Profit VC Contribution Number of labour hours used Contribution per hour , , , FC (allocated( allocated) Costs Rank max hours Profit Demand in units Contribution Total labour demand BEP Capacity

47 Price VC FC (allocated( allocated) Costs Profit Price(sales sales) VC FC (allocated( allocated) Costs Profit To ProduceP or to BuyB per unit per unit Produce Produce total total x x per unit x x Buy (unlimited) per unit Buy (unlimited) x x total x x total Advantages Direct costing is simple to understand It provides more useful information for decision-making Direct costing removes from profit the effect of inventory changes Is effective in internal reporting for frequent profit statements and measurement of managerial performance Direct costing avoids fixed overheads being capitalized in unsaleable stocks The effects of alternative sales or production policies can be easier assessed thus the decisions yield the maximum return to business By concentration on maintaining a uniform and consistent marginal cost practical cost control is greatly facilitated Disadvantages The separation of costs into fixed and variable is difficult and sometimes gives misleading results Direct costing underestimates the importance of fixed costs Full costing systems also apply overhead under normal operating volume and this shows that no advantage is gained by direct costing Under direct costing, stocks and work in progress are understated. The exclusion of fixed costs from inventories affect profit, and true and fair view of financial affairs of an organization may not be clearly transparent Volume variance in standard costing also discloses the effect of fluctuating output on fixed overhead. Marginal cost data becomes unrealistic in case of highly fluctuating levels of production, e.g., in case of seasonal factories. Disadvantages (2) Application of fixed overhead depends on estimates and there may be under or over absorption of the same Control affected by means of budgetary control is also accepted by many. In order to know the net profit, we should not be satisfied with contribution and hence, fixed overhead is also a valuable item. A system which ignores fixed costs is less effective since a major portion of fixed cost is not taken care of under marginal costing In practice, sales price, fixed cost and variable cost per unit may vary. Thus, the assumptions underlying the theory of marginal costing sometimes becomes unrealistic. For long term profit planning, absorption costing is the only answer

48 Direct vs. Absorption (full) costing Direct vs. Absorption (full) costing Direct costing are regarded as period costs (written are allocated to the products (included in inventory valuation) as a lump sum to the profit and loss account) Variable manufacturing costs are assigned to the products are period costs are added to the variable manufacturing cost of sales to determine total manufacturing costs Fixed manufactured overheads Non-manufacturing overheads Absorption costing are assigned to the products are period costs Fixed manufacturing costs are assigned to the products Direct costing Profit is a function of sales Are recommended where indirect costs are a low proportion of an organization s s total costs is used for managerial decision-making and control used mainly for internal purposes Absorption costing Profit is a function of both sales and production Assigns indirect costs to cost objects is widely used for cost control purpose esp. in the long run consistent for external reporting THE END

49 STANDARD COSTS Ir. Haery Sihombing/IP Pensyarah Fakulti Kejuruteraan Pembuatan Universiti Teknologi Malaysia Melaka CHAPTER 6 STANDARD COST WHAT ARE STANDARD COST? Standard costs are the expected costs of manufacturing the product. WHAT ARE STANDARD COST SYSTEM? 1. A standard costs system is a method of setting cost targets and evaluating performance 2. Target or expected costs are set based on a variety of criteria, and actual performance relative to expected targets is measured STANDARD COSTS WHAT ARE STANDARD COST SYSTEM? 3. Significant difference between expectations and actual results are investigated 4. Consistent with the themes developed throughout this class, standard cost systems are means of helping managers with decision making and control STANDARD COSTS Standard Direct Labor costs = Expected Wage Rate X Expected Number of Hours Standard Direct Material Cost = Expected Cost of Raw Materials X Expected Number of Units of Raw Material Standard Overhead Costs = Expected Fixed OH + Expected Variable Overhead X Expected Number of Units to be Produced

50 TARGET COSTING 1. The market place determines the selling price of the future product 2. The company determines the profit margin they desire to achieve on his product 3. The difference between the selling price and the profit margin is the target cost TARGET COSTING WHY USE A STANDARD COST SYSTEM 1. Standard are important for decision making How we produce our product How we price our product Contract billing 2. Monitor Manufacturing Large variances may indicative of problems in production 3. Performance Measurement Deviations between actual and standards are often used as measure of a manager s s performance Who sets the standard? TARGET COSTING HOW DO WE SET THE STANDARDS? Theoretically the standard should be expected cost of producing the product General practices: Prior years performance Expected future performance under normal operating Optimistic (Motivator) TARGET COSTING Important considerations in setting standard 1. Why are senior managers using standard Pricing Performance measurement Production decisions 2. What happens if managers fail to meet the standards? 3. Standard are supposed to represent the opportunity cost of production

51 Example : 1 Example : 1 Example : 1 Example : 1

52 Example : 1 (Question) Direct Labor Wage Variance What do we do with the raw materials price variance? Who do we hold responsible? What do we do with the raw materials quantity variance? Who do we hold responsible? Direct Labor Efficiency Variances STANDARD COSTS BUDGETS are TOTAL amounts A STANDARD COST is a PER UNIT BUDGET amount

53 Ideal Vs. Normal Standards Analysis of Direct Material Variances An Ideal Standard is the theoretical best-cause which assumes 100% efficiency A Normal Standard should represent a level of efficiency that is attainable under normal operating conditions The setting of the standard is a management judgment call and must reflect expected and acceptable inefficiencies Analysis of Direct Material Variances Analysis of Direct Material Variances TOTAL VARIANCE for Direct Materials must be analyzed in terms of Quantity Variance Price Variance

54 Analysis of Direct Material Variances Analysis of Direct Labor Variances The Analysis of the Labor Variance works the same mechanically as the Analysis of Direct Materials Variances Direct Materials Quantity Price Direct Labor # of Hours Hourly Cost Analysis of Overhead Variances Analysis of Overhead Variances

55 Analysis of Overhead Variances Analysis of Overhead Variances Analysis of Overhead Variances Example : 2 Manufacturing Product Costs Direct costs-- --can be traced to units produced direct direct labor direct direct materials Overhead-- --can t t be traced to units indirect indirect labor-- --e.g., janitorial, supervisory indirect indirect materials-- --e.g., miscellaneous supplies other--e.g., depreciation, utilities, rent allocated to units based on drivers

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