PAT COLLEGE

P7 Planning, Control & Performance Management

Cost Accumulation
1.

INTRODUCTION TO COST ACCOUNTING

1.1 Cost accounting Cost accounting is 'the establishment of budgets, standard costs and actual costs of operations, processes, activities or products and the analysis of variances, profitability or social use of funds. 1.2 Classification of costs (a) Direct/indirect (b) Fixed/variable/semi-variable Also important for techniques such as break-even analysis; decision making, etc: Controllable/non-controllable Avoidable/unavoidable Standard/actual 1.3 Costing methods Can be analyzed into two basic categories: (a) Specific order costing: Job, Batch and Contract Costing

(b) Operation costing: Process costing, Services costing,

1.4 Costing principles Two basic principles are fundamental: (a) Marginal costing - overheads treated as period cost. Mainly use for decision-making. (b) Absorption costing -overhead included in stock valuation and written off in period that goods are sold. Mainly used is stock valuation.

2.

OVERHEADS AND ABSORPTION COSTING

2.1 Analysis of overheads: conventional approach Traditional absorption systems are used to absorb fixed production overheads into product units. This is achieved in stages: (a) Stage 1 Direct overheads are allocated to cost centres. For example, the salary of a maintenance foreman who works entirely in the maintenance department is a direct overhead to that department and the cost is allocated to the centre.

(b) Stage 2 Indirect common or joint costs are then apportioned to cost centres using a variety of arbitrary bases, on principles of benefit given, ability to bear or even simplicity. (c) Stage 3 Overheads then accumulated under service cost centres are re-apportioned to production cost centres again using arbitrary basis. (d) Stage 4 Finally, absorption takes place as the units pass through the cost centres. The most popular absorption bases are labour hours or machine hours. Other bases include: material cost %, labour cost %, prime cost % , and the single volume of units. 2.2 Over/under recovery of overheads For planning and control reasons absorption rates are normally pre-determined, i.e. calculations are based on budgeted overheads and normal or budgeted activity levels. Unlikely those actual overheads will equal overheads absorbed. Any over- or under-recovery of overheads should be written off to the profit or loss account in that accounting period. Exam pointers Common exam mistakes are: (a) Using actual rather than budgeted / normal figures to calculate absorption rates. (b) Failing to adjust for over- or under-recovery of overheads. Exercise 1.1 A company is preparing its production overhead budgets and determining the apportionment of those overheads to products. Cost centre expenses and related information have been budgeted as follows: Machine Total shop A 78,560 8,586 16,900 6,400 16,700 2,400 8,600 3,400 40,200 402,000 201,000 Machine shop B 9,190 8,700 Assembly 15,674 1,200 Canteen 29,650 600 Maintenance 15,460

Indirect wages Consumable materials Rent and rates Buildings insurance Power Heat and light Depreciation -machinery Value of machinery Other information Power usage - technical, Estimates (%) Direct labour (hours) Machine usage (hours) Area (sq. ft.) Direct materials cost () Labour cost ()

179,000

22,000

100 35,000 25,200 45,000 224,000 280,000

55 8,000 7,200 10,000 51,200 64,000

40 6,200 18,000 12,000 39,680 49,600

3 20,800 15,000 133,120 166,400

6,000 -

2 2,000 -

Required: (a) Using the direct apportionment to production departments method and bases of apportionment, which you consider most appropriate from the information provided, calculate overhead totals for the three production departments. (Assume that the two service departments do not work for each other.) (b) Using your answer for (a) calculate for each production department the following overhead absorption rates: (i) Direct materials cost percentage rate (ii) Direct labour wages cost percentage rate (iii) Prime cost percentage rate (iv) Machine hour rate (v) Direct labour hour rate (10 marks) (c) Standard data per unit of product X recorded by the cost accounting system are as follows: Machine shop A: Material: 10.00 Labour: 2 hours at 8.00 per hour Machine shop B: Machine hours: 2 Labour: 2 hours at 9.00 per hour Assembly: Labour: 4 hours at 6.00

Overhead costs for each department are presently each absorbed by product X using the following absorption rates: Machine shop A: Machine shop B: Assembly: Material cost percentage rate. Machine hour rate. Labour cost percentage rate.

Required: Prepare a summary, which shows the budgeted product cost per unit of product X detailing the unit costs for each cost element. ( 6 marks) (d) Recognition is now made of the fact that the canteen and maintenance departments do work for each other, and the following information about activity in the recent costing period is also available: Machine shop A Cost of food prepared 60,000 Maintenance Hrs. needed 6,000 Machine shop B 80,000 1,000 Assembly 20,000 2,000 Canteen 1,000 Maintenance 40,000 -

Required: Recalculate the overhead totals for the three production departments using the following two methods of reapportioning the service department costs: (i)

(ii)

The repeated distribution method; and The algebraic distribution method.

(11 marks)

Question (a) Discuss the advantages and disadvantages of using the full cost (absorption costing) method for
dealing with the costs of internal services. Include in your answer comments on the motivational aspects of this method of costing. (b) Describe the factors which affect the choice of bases of apportionment by which internal services are to be apportioned. (c) JR Limiteds budgeted overheads for the forthcoming period for the service departments are as follows: Department 1 Department 2 000 870 690

The budgeted total costs for the forthcoming period for the service departments are as follows: Production Department 1 2 G (%) H (%) Required: Apportion the service department costs to production departments: (i) (ii) (iii) Using the Step wise (elimination) method, starting with G, and The reciprocal (simultaneous equation) method, starting with G and Comment briefly on your figures 60 50 30 30 Service Department G H 20 10 -

(8 marks)

(Total 20 marks)

3.

ACTIVITY BASED COSTING (ABC)

3.1 The system A different approach for calculating product costs is activity based costing which emphasizes the need to obtain a better understanding of the behavior of overhead costs and in doing so ascertains what causes cost. (a) Stage 1 Identify the major activities in the organization. Examples include machine-related activities (such as machining cost centres), direct labour-related activities (like assembly departents) and various support activities such as ordering, receiving, materials handling, parts administration, production scheduling, packing and dispatching. (b ) Stage 2 Identify factors, which influence the cost of a particular activity. The term 'cost driver' is used to describe the events or forces that are the significant determinants of the cost of the activities. For example, if production scheduling cost is generated by the number of 'production runs each product generates, the number of set-ups would represent the cost driver for production scheduling. Use of cost drivers ABC recognizes that cost behavior is dictated by cost drivers and therefore the tracing of overhead costs to products requires that cost behavior must (be understood to identify appropriate cost drivers. Examples of some of the: cost drivers used by ABC systems include the number of receiving orders for the receiving department, the number of production runs undertaken for scheduling and set-up costs, the number of purchase orders for the Cost of operating the purchasing department and the number of dispatch orders for the dispatch department. For those costs, which are purely variable with output in the short term, ABC systems use volume-related cost drivers such as direct labour hours or machine hours. For example, power costs to products using machine hours as the cost driver, since machine hours drive the consumption of power. So if production increases by 10%, the consumption cost and the number of machine hours will increase by 10%. (c) Stage 3 A cost centre is created for each activity, e.g. total cost of all set-ups might constitute one cost centre for all costs related to them. ( d) Stage 4 The cost of each activity is traced to products according to the product's demand (using cost drivers as a measure of demand) for these activities during the production process. This is measured by the number of transactions, which the product generates for the cost driver. Assume, for example, that the total cost traced to the cost centre for set -up related costs was 100,000 and there were 100 set-ups during the period. The charging out rate would be 1, 000 per set -up. To determine the set -up costs for a particular product the number of set - ups for the product would be multiplied by 1 ,000 so the cost per unit for one batch of 20 units would be 50 (1,000/20 units). ABC would trace the costs of other activities to products using a similar approach.

3.2 Benefits of ABC (a) Improved buy or make

(b) (c) (d) (e) (f) (g) (h) Decisions Improved product pricing strategy Greater cost awareness of departmental managers Better product design strategy Improved management control Improved quality management Improved profitability

Question 1 The following budgeted information relates to Brunti pIc for the forthcoming period: XYI (000) 50 45 32 Products YZT (000) 40 95 84 ABW (000) 30 73 65

Sales and production (units) Selling price (per unit) Prime cost (per unit)

Hours Hours Hours Machine department (machine hours per unit) 2 5 4 Assembly department (direct labour hours per unit) 7 3 2 Overheads allocated and apportioned to production departments (including service cost centre costs) were to be recovered in product costs as follows: Machine department at 1.20 per machine hour Assembly department at 0.825 per direct labour hour

You ascertain that the above overheads could be re-analyzed into 'cost pools' as follows. Cost pool Machining services Assembly services Set-up costs Order processing Purchasing 000 357 318 26 156 84 941 Cost driver Machine hours Direct labour hours Set-ups Customer orders Suppliers' orders Quantity for the period 420,000 530,000 520 32,000 11,200

You have also been provided with the following estimates for the period. XYI 120 8,000 3,000 Products YZT 200 8,000 4,000 ABW 200 16,000 4,200

Number of set-ups Customer orders Suppliers' orders

Required
(a) Prepare and present profit statements using: (i) Conventional absorption costing; and (ii) Activity based costing. (5 marks) (10 marks)

(b) Comment on why activity based costing is considered to present a fairer valuation of the Product cost per unit. (5 marks) (Total: 20 marks) Question 2: Hensau Ltd has a single production process for which the following costs have been estimated for the period ending 31 December 2001. Material receipt and inspection cost 15,600 Power cost 19,500 Material handling cost 13,650 Three products -X, Y and Z -are produced by workers, who perform a number of operations on material blanks using hand-held electrically powered drills. The workers have a wage rate of 4 per hour. The following budgeted information has been obtained for the period ending 31 December 2001. Production quantity (units) Batches of material Data per product unit Direct material (square metres) Direct material () Direct labour (minutes) Number of power drill operations Product X 2,000 10 4 5 24 6 Product y 1,500 5 6 3 40 3 Product Z 800 16 3 6 60 2

Overhead costs for material receipt and inspection; process power and material handling are presently each absorbed by product units using rates per direct labour hour. Activity-based costing investigation has revealed that the cost drivers for the overhead costs re as follows: Material receipt and inspection Process power Material handling number of batches of material number of power drill operations quantity of material (square metres) handled

Required (i) Prepare a summary, which shows the budgeted product cost per unit for each of the products X, Y and Z for the period ending 31 December 2001, detailing the unit costs for each cost element: (i) Using the existing method for the absorption of overhead costs, and (ii) Using an approach, which recognizes the cost drivers revealed in the activity-based costing investigation. (10 marks)

ACTIVITY BASED COSTING: Summary Steps Estimate overhead costs. Determine the cost drivers for those overheads. Aggregate costs into cost pools where they have the same cost drivers. Calculate overhead cost per unit of activity for each cost pool and cost driver. Find a cost per unit by determining the amount of benefit that is derived by each unit from each activity.

Typical cost drivers

Quality control cost -number of inspections Production control -number of production runs Maintenance -machine hours or number of breakdowns Each set-up costs -number of runs

Deciding on cost drivers is clearly a problem; therefore ask departments how costs are incurred

(i.e. what do they do?). ADVANTAGES OF ACTIVITY BASED COSTING

Product costs closer to managers' perceptions -reflects 'hassle' of some products Helps managing resources and identifying profitable business -Kaplan's 50 per cent sold at ABC loss Improves control of overheads by making them a current issue and also by identifying what activities cause them -aids 'downsizing' and 'restructuring' Overhead cost per unit of activity from a cost-driver provides a useful measure of a department's performance -important to remember More reliable budgets produced since cost volume relationships are understood better (ABB) (provided less busy staff are made redundant)

DISADVANTAGES OF ACTIVITY BASED COSTING

Greater information needs -some information should exist to help traditional budgets Difficulty in tracing overheads to actual units of production .Not accepted by all managers -behavioral problems Cost of implementing an ABC system

Problem of selecting the most appropriate cost drivers 8