Presentation on theme: "Absorption Costing and Activity Based Costing"— Presentation transcript:
1 Absorption Costing and Activity Based Costing Week 7
2 Methods of Costing The cost of a unit of production = variable costs Direct MaterialsDirect Labour(Labour specifically related to the unit)Other Direct CostsEg patents, royaltiesFixed costs (overheads) are covered by contribution to profitThereafter each unit made and sold contributes “pure” profit ofSelling price – variable cost
3 Full or Absorption costing Treats overheads as resources consumed during manufactureEach unit consists ofDirect resources consumed (direct costs)Proportion of OverheadsDistinction betweenProduction related overheadsNon-production related overheads
4 Allocation of overhead costs Two stage processRelate overheads to production departmentsAllocationDirectly ascribing a cost or class of costs to a distinct departmentEg Assembly department supervisor’s salaryIs Allocable overhead of Assembly department
5 ApportionmentWhere costs or class of costs cannot be directly linked to distinct departmentNeed to devise method of apportioning the cost to all relevant departmentsApportionment base must beRelated to type of costEquitableEg costs of rentApportionment base could be Floor areaTherefore department with greatest use of space is attributed with greatest proportion of rent costs
6 Methodology Establish production and non-production departments Allocate costsEstablish apportionment bases for other overheadsApportion costsGives TOTAL overhead costs for each departmentABSORB costs into units of production by appropriate baseEg labour hours/machine hoursFull product unit cost =Direct costs + Absorbed overhead cost
7 Benefits The benefits of full costing are that: All the costs are includedDuplication of costs can be avoidedDecisions are made with an awareness of all costs
8 Potential Disbenefits Absorption costing is often crudeParticularly if the proportion of indirect costs in the institution is high in relation to direct costsThe method is simple to administer and easy to understandMay be appropriate when direct costs are of most significance
9 Worked Example Marmoset Ltd 1. Allocate costs to departments 2. Apportion costs on appropriate basesRent – Floor AreaLight & Heat – Power UsageDepreciation – Machine ValueInsurance – Floor Area
10 Worked Example Apportionment of Rent Total Floor Area = 2,600 Floor Area of Machining = 1,000Apportionment =1,000 / 2,600 X Overhead (600,000) =230,769, etc….
11 Worked Example Phase 2 Full costs of both Production and Non-Production service departmentsHave been establishedRe-apportionment Service Costs to Production DepartmentsThe FULL OVERHEAD COST of production depts now known
12 Worked Example Phase 2There needs to be a link between the costs of the production depts and the productUse Labour Hours (that’s all we’ve got)Calculate Labour Hours for each dept.Machining =50,000 X ,000 X 2 = 100,000 hoursAssembly =50,000 X ,000 X 2 = 125,000 hours
13 Worked Example Phase 2 Calculate OVERHEAD ABSORPTION rate Machining = Total Overhead / Total labour hours =967,714 / 100,000 = £9.68 per labour hourAssembly =722,286 / 125,000 = £5.78 per labour hour
14 Worked Example Phase 3 For each unit of Gibbon or Baboon made Absorb proportion of overheads into it in proportion to the number of labour hours worked on it in each department
15 Unit Costs Cost Card Gibbon Baboon Raw materials 18.00 £15.00 Labour - M£5.80£11.60Labour - A£9.75£13.00Overhead M£9.68£19.36Overhead A£8.67£11.56Total£51.90£70.52
16 Activity Based Costing (ABC) Cost objects consume activitiesActivities consume resourcesThe consumption of resources is what DRIVES costsIf you can understand the relationship you can control the costs
17 The steps to ABC Identify activities Determine costs for each activity Determine cost driversCollect activity dataCalculate product cost
18 Activity Based Costing Worked Example Osprey Ltd
19 Disadvantages of ABC Needs a lot of work to establish “cost “drivers” Expensive and time consumingWhat if cost drivers are wrong?How to deal with (say) Rent?What if product mix changes?
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