Absorption Costing and Activity Based Costing Week 7

Methods of Costing The cost of a unit of production = variable costs Direct Materials Direct Labour (Labour specifically related to the unit) Other Direct Costs Eg patents, royalties Fixed costs (overheads) are covered by contribution to profit Thereafter each unit made and sold contributes “pure” profit of Selling price – variable cost

Full or Absorption costing Treats overheads as resources consumed during manufacture Each unit consists of Direct resources consumed (direct costs) Proportion of Overheads Distinction between Production related overheads Non-production related overheads

Allocation of overhead costs Two stage process Relate overheads to production departments Allocation Directly ascribing a cost or class of costs to a distinct department Eg Assembly department supervisor’s salary Is Allocable overhead of Assembly department

Apportionment Where costs or class of costs cannot be directly linked to distinct department Need to devise method of apportioning the cost to all relevant departments Apportionment base must be Related to type of cost Equitable Eg costs of rent Apportionment base could be Floor area Therefore department with greatest use of space is attributed with greatest proportion of rent costs

Methodology Establish production and non-production departments Allocate costs Establish apportionment bases for other overheads Apportion costs Gives TOTAL overhead costs for each department ABSORB costs into units of production by appropriate base Eg labour hours/machine hours Full product unit cost = Direct costs + Absorbed overhead cost

Benefits The benefits of full costing are that: All the costs are included Duplication of costs can be avoided Decisions are made with an awareness of all costs

Potential Disbenefits Absorption costing is often crude Particularly if the proportion of indirect costs in the institution is high in relation to direct costs The method is simple to administer and easy to understand May be appropriate when direct costs are of most significance

Worked Example Marmoset Ltd 1. Allocate costs to departments 2. Apportion costs on appropriate bases Rent – Floor Area Light & Heat – Power Usage Depreciation – Machine Value Insurance – Floor Area

Worked Example Apportionment of Rent Total Floor Area = 2,600 Floor Area of Machining = 1,000 Apportionment = 1,000 / 2,600 X Overhead (600,000) = 230,769, etc….

Worked Example Phase 2 Full costs of both Production and Non-Production service departments Have been established Re-apportionment Service Costs to Production Departments The FULL OVERHEAD COST of production depts now known

Worked Example Phase 2 There needs to be a link between the costs of the production depts and the product Use Labour Hours (that’s all we’ve got) Calculate Labour Hours for each dept. Machining = 50,000 X 1 + 25,000 X 2 = 100,000 hours Assembly = 50,000 X 1.5 + 25,000 X 2 = 125,000 hours

Worked Example Phase 2 Calculate OVERHEAD ABSORPTION rate Machining = Total Overhead / Total labour hours = 967,714 / 100,000 = £9.68 per labour hour Assembly = 722,286 / 125,000 = £5.78 per labour hour

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

Unit Costs Cost Card Gibbon Baboon Raw materials 18.00 £15.00 Labour - M £5.80 £11.60 Labour - A £9.75 £13.00 Overhead M £9.68 £19.36 Overhead A £8.67 £11.56 Total £51.90 £70.52

Activity Based Costing (ABC) Cost objects consume activities Activities consume resources The consumption of resources is what DRIVES costs If you can understand the relationship you can control the costs

The steps to ABC Identify activities Determine costs for each activity Determine cost drivers Collect activity data Calculate product cost

Activity Based Costing Worked Example Osprey Ltd

Disadvantages of ABC Needs a lot of work to establish “cost “drivers” Expensive and time consuming What if cost drivers are wrong? How to deal with (say) Rent? What if product mix changes?