5. Costing system, standard cost and variance analysis
5.1 costing systems
5.1.1 basic definition
(1) cost unit: a unit of product or service in relation to which costs are ascertained.
(2) direct cost: cost which are incurred for, and can be conveniently identified with, a particular cost unit.
(3) indirect cost: cost which can not be associated with a particular unit of output.
(4) prime cost: the aggregate of direct materials, direct wages and direct expenses.
(5) overheads: indirect materials, indirect wages and indirect expenses represents overheads.
(6) cost centre: a cost centre is a production or service location, function, activity or item of equipment whose costs may be attributed to cost units.
(7) variable cost: cost that varies in accordance with the output.
(8) fixed cost: cost that is constant irrelevant to the output.
5.1.2 Absorption costing
(1) Definition: in addition to direct costs, a share of indirect production costs( overheads) is attributed to cost units by means of overhead absorption rates.
(2) Absorption rates:
•single product absorption rate= cost centre overhead in $/ cost centre volume in units
•more than one product, overhead may be absorbed in cost units by any of the following means:
* rate per unit
* percentage of prime cost
* percentage of direct wages
* direct labor hour rate
* machine hour rate
(3) over/under absorption of overheads
•Absorption rate= Budgeted overhead/ Budget volume
Generally, the rate is derived from the annual budget to avoid distortion caused by seasonal fluctuation and to provide a consistent basis for measuring variations.
Actually, overhead and/or volume will rarely coincide exactly with budget and therefore a difference between overhead absorbed and overhead incurred will arise, which leads to over/under absorption.
Case This year the budget for a machine shop shows:
Overhead $ 100,000
Volume 20,000 machine hours
At the end of this year, the machine shop incurred $90,000 of overhead and 21,000machine hours were worked.
Calculate the predetermined absorption rate and the overhead under-or- over absorbed.
Absorption rate= Budgeted overhead/ Budget volume
= $ 100,000/ 20,000=$ 5/ hour (complete rate required)
Overhead incurred $90,000
Overhead absorbed(w1) $105,000
Over absorption $15,000
W1: overhead absorbed= Actual production (machine hour)ｘPredetermined rate per unit
= 21000ｘ$5 = $ 105,000
The over absorption arises from a combination of two factors.
* Overhead costs were lower than budget: $100,000-$90,000=$10,000
* volume were greater than budget: (21,000-20,000)ｘ$ 5/ hour=$5,000
Note: a relatively simple relationship shows below;
Budget actual over/under
Overhead cost > Overhead cost over
Overhead cost < Overhead cost under
Volume > Volume under
Volume < Volume over
However, analysis of over/under absorbed overhead is perhaps covered more appropriately under standard costing.
(4) Appraisal of total absorption costing
Argument for:
•It is necessary to include fixed overhead in stock values for financial statement. Using absorption costing to produce stock can make sure a share of fixed overhead contained.
•For a small business, overhead allotment is the only practical way to obtain job costs for estimating and analyzing profit.
•Analysis of over/under absorption is useful to identify inefficient utilization of production resources.
•absorption costing complies with requirement of SAAP 9 for financial statement.
Argument against:
•allocation, apportionment and absorption methods are arbitrary.
•it treats what are predominantly fixed costs as if they varied per unit.
•under/over absorption will almost certainly need adjustment at the end of each year. Only if both expenditure and activity level coincide exactly with budget will the correct amount of overheads be absorbed into production. This is very unlikely.
5.1.3 Marginal costing
(1) Definition: Marginal costing is a system of cost accounting which values stock at direct cost plus variable overhead costs. In other words, only variable costs are charged to cost units, fixed costs for a period are utterly written off against contribution.
(2) Case
company A produce 10,000 identical products with the following cost
direct material $30,000
direct wages $20,000
variable overhead $10,000
fixed overhead $10,000
cost per unit=($30,000+$20,000+$10,000)/10,000=$6 per unit
(3) Appraisal of marginal costing
Argument for:
•contribution per unit is a direct measure of how profit and volume relate, and does not change with the level of production. Profit per unit is a somewhat misleading figure.
•build-up or run-down of stocks of finished goods will not distort comparison of period operating statements.
•There is no arbitrary apportionment of fixed costs that may give misleading product cost comparisons.
Argument against:
•Marginal treats fixed costs as a period cost, on the assumption that fixed cost do not change in the short term, and thus is irrelevant to short-term decision making. However, a change in fixed cost may ultimately be the result of short-term decision.
•It is possible for a fixed cost to be relevant where incremental fixed cost arisen while it is also possible for a variable cost to be irrelevant. Consequently, reliance on marginal costing for making short-term decisions may lead to a sub-optimal one.
•when making short-term decision, a detailed analysis of cost behavior is therefore needed in order to ensure not only variable costs and fixed costs but also all other relevant costs are totally included.
5.1.4 Comparison between absorption costing and marginal costing.
(1) The fundamental difference between marginal and absorption costing is one of timing. Under marginal costing fixed production overheads are charged in the period incurred. Under absorption costing fixed production overheads are absorbed into units made and charged in the period of sale.
In general, absorption costing is preferred for reporting purposes, while marginal costing is preferred for decision making purposes. Marginal costing has normally been used for short-term decisions such as whether to cease production of a product, whether to make a product or buy it from a supplier, as well as how to allocate scarce resources in order to maximize contribution.
Examiners stress repeatedly the need for students to discuss pros and cons of each other, as well as getting the right numerical answers.
(2) Case: A company produces a single product with the following budget:
selling price $10
direct material $3
direct wages $2
variable overhead $1
fixed overhead $10,000
The fixed overhead absorption is based on a volume of $5,000 units per month.
Show the operating statement for the month when 4,800 units were produced and 4,500 were sold under:
(a) absorption costing
(b) marginal costing
(c) reconcile the difference in reported profit.
Solution:
(a) absorption costing
$ $
Sales(4,500ｘ$10) 45,000
Cost of sales
Opening stock -
Production cost(w1) 38,400
Closing stock(w2) (2,400)
(36,000)
Operating margin 9,000
Under-absorbed overhead(w3) (400)
Operating profit 8,600

W1= overhead absorbed= Actual productionｘPredetermined rate per unit
=[$3+$2+$1+($10,000/5,000)]ｘ4800=$8ｘ4800=$38,400
W2= Closing stockｘPredetermined rate per unit
=4800-4500=300ｘ$8 = $2,400
W3: output are less than budget, and therefore under absorption of fixed overhead should be deducted in the operating statement.
Under-absorbed overhead= (5,000-4,800)ｘ$2 =$400

(b) Marginal costing
$ $
Sales(4,500ｘ$10) 45,000
Cost of sales
Opening stock -
Production cost(w1) 28,800
Closing stock(w2) (1,800)
(27,000)
Contribution 18,000
Fixed costs 10,000
Operating costs 8,000
W1= variable cost per unitｘactual production
= $6ｘ4800 =$28,800
W2= variable cost per unitｘproduction unsold
= $6ｘ300=$1,800
(c) Reconciliation
$ $
Profit under marginal costing 8,000
Closing stock valuation under
absorption costing 2,400
Closing stock valuation under
marginal costing 1,800
Fixed cost absorbed into closing
stock in absorption costing 600
Profit under absorption costing 8,600
5.1.5 Activity based costing
(1) Definition: Activity based costing (ABC) is the process of cost attribution to cost units on the basis of benefit received from indirect activities, such as ordering, setting up and assuring quality.
ABC recognizes that:
•activities consume resources and products consume activities
•volume related drivers such as direct labor and machine hours are not meaningful cost drivers for many overheads in modern manufacturing environments.
(2) Basic terms:
•cost driver: The event or factors which cause a cost to occur.
•cost pool: All the costs incurred when an activity takes places.
(3) Steps in ABC
•step 1 The collection of overhead costs in the same way as traditional overhead control accounts would operates.
•step 2 The pooling of costs based on the activities which have consumed resource rather than on the basis of working hours or employee wages.
•step 3 The cost pooled then allocated to the products based on a series of cost drivers which indicate how the product has made demands on the various activities.
(4) Comparison between ABC and absorption costing
•ABC is preferred for management performance appraisal. ABC rests on a more
accurate information base than absorption costing, and hence the impact of management decision is potentially more easily identified under ABC than it is under traditional volume-related absorption methods.
•ABC absorbs costs into products in a wider variety of ways than traditional absorption costing, which rely mostly on labor or machine hours. In extending the range of absorption bases, ABC is able to more closely track costs to the causes of the costs which then links to management decisions.
(4) Case
Riley Ltd has the following budgeted overhead costs for next year:
Set-up costs $120,000
Order processing costs $85,000
Quality control costs $75,000
During the year there are expected to be 1,000 set-ups of the production
machinery, 17,000 orders received and 2,500 quality inspections. What is the
standard overhead cost for each unit of product X for which the following
information applies:
Total production for the year 50,000 units
Number of set-ups 200
Number of orders received 3,000
Number of quality inspections 500
Solution:
Products of 50,000 of product X absorbs:
Set-up costs 200ｘ($120,000/1,000) $24,000
Order processing costs 3,000ｘ($85,000/17,000) $15,000
Quality control costs 500ｘ($75,000/2,500) $15,000
$ 54,000
each unit absorbs $54,000/50,000=$1.08 overhead
(5) Appraisals of ABC
Argument for:
•an improved, more accurate product cost may enable a company to concentrate on a more profitable mix of products or customers. It is argued that traditional overhead apportionment leads to incorrect commitment of resources to products.
•ABC extends the variable cost rationale to both short and long term costs by quantitatively addressing the cost behavior patterns in terms of both short-run volume changes as well as long-term cost trends.
•it can identify non-value added costs from value added cost so that non-value added costs can be appraised effectively with a view to eliminate.
Argument against:
•It is unlikely to relate all overheads to specific activities, some costs do not vary with either volume-related drivers or any cost driver as there is no cause and effect relationship, such as the depreciation on the factory building.
•It ignores the potential conflicts where more than one potential cost driver identified.
•ABC assumes that the cost per activity is constant over the entire range. In practice the cost per activity does not always remain unchanged, such as the function of learning curve.
5.1.6 Service costing
(1) Definition: service costing is the cost accounting method used in a business which provides a service, or in a service activity within any business to ascertain the cost of providing each unit of service.
(2) Usefulness:
Management needs to ascertain the cost per unit is important for pricing decision, such as choice in providing the service in-house or buying-out, and for evaluation and cost control, such as compare cost per unit in different locations or years and actual cost per unit with expected or budgeted cost per unit.
5.1.7 Value analysis
5.1.8 Throughput accounting
(1) Basic points:
•Throughput accounting is a method of accounting that focuses on throughput, and relates costs of production to throughput.
•Throughput is a rate of production of a defined process over a stated period of time. Rates may be expressed in terms of products, batches produced, turnover, or other meaningful measurement.
•Throughput accounting is similar to marginal costing with only direct materials treated as variable costs. Direct labor and production overheads are fixed and are combined as total factory costs.
With its emphasis on direct material, throughput accounting is treated as an ideal complement to ABC.
Throughput accounting considers stocks to be desirable when they can increase throughput. In this respect, the principles of throughput accounting are consistent with the principles of just in time production.
(2) Influence on throughput
•factors affecting the value of throughput:
* the selling price of items sold
* the purchase cost of direct materials
* efficiency in the usage of direct materials
* the volume of throughput
•constraints on throughput:
*selling prices are too high thereby limiting sales demand, or selling prices are too low thereby restricting sales revenue.
*unreliable product quality results in scarped items or items returned by customers.
*unreliable suppliers of key material results to the production can not be operated in an optimal way.
* a shortage of production resource leads to bottlenecks.
•bottleneck. A bottleneck is an activity within an organization which has a low
capacity than activity in precedence or subsequence, thereby limiting throughput.
Simply put, it is the shortage of resources. Management should eliminate
bottlenecks as well as other constraints in order to increase throughput further.
(3) Throughput accounting performance measurements
•return per factory hour= (sales-direct materials cost)/usage of the bottleneck resource
•throughput accounting ratio= return per factory hour/ total cost per factory hour
(4) Case
X limited manufactures a product that requires 1.5 hours of machining. Machine time is a bottleneck resource, for sufficient machines unavailable. There are 10 machines, and each machine can be used up to 40 hours per week. The product is sold for $85 per unit and the direct material cost per unit is $ 42.50. Total factory costs are $8,000 each week.
Require to calculate:
(a) the return per factory hour; (b) the throughput accounting ratio.
Solution:
(a) the return per factory hour=($85-$42.50)/1.5 hours =$ 28.33
(b) cost per factory hour= $8,000/(10ｘ40hours)=$20
throughput accounting ratio=$ 28.33/$20=1.42
Management should try to achieve a high throughput ratio
5.1.9 Life cycle costing
(1) Definition: life cycle costing is the allocation of cost over a product’s life, including the pre-production stage, and it tracks and accumulates the actual costs and revenues attributable to each product from inception to abandonment.
The final profitability of a given product is determined at the end of its life, further the accumulated costs at any stage can be compared with life cycle budgeted costs, product by product, for the purpose of planning and control.
(2) Relevance to today’s manufacturing environment.
•a very high proportion of the total cost over the product’s life cycle is in the form of initial development, design and production set-up costs, and ongoing fixed costs that are committed to at this stage.
•in an advanced manufacturing environment where products have low labor content and are designed to make use of standard component and minimize wastage, the direct unit cost is relatively low.
•in a globally competitive market, product life cycles are decreasing, making initial costs even more disproportionate in the early stages.
(3) Compare to traditional accounting system.
review FTC book P283