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ACCOUNTING FOR DECISIOM MAKING

Week 4 Lecture

(Seminar 5 – Calculating the unit cost and pricing the

product or service )

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Blanket Overhead Rate

Blanket Overhead RateBlanket Overhead Rate

A single overhead rate used throughoutA single overhead rate used throughoutan entire factory. A simple method,an entire factory. A simple method,

but one that can distort unit product costs.but one that can distort unit product costs.

Blanket Overhead RateBlanket Overhead Rate

A single overhead rate used throughoutA single overhead rate used throughoutan entire factory. A simple method,an entire factory. A simple method,

but one that can distort unit product costs.but one that can distort unit product costs.

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Blanket Overhead Rate

Job AJob A Job BJob BJob 1Job 1 Job 2Job 2

Labor Intensive Jobs Capital Intensive Jobs

Production OverheadAbsorption Base

Direct Labor-Hours

The above procedure results in high overhead costs for labor intensive jobs with high direct labor-hour content and low overhead costs for capital intensive jobs with low direct labor-hour content.

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Blanket Overhead Rate

Job AJob A Job BJob BJob 1Job 1 Job 2Job 2

Labor Intensive Jobs Capital Intensive Jobs

The above procedure results in high overhead costs for capital intensive jobs which require heavy machine processing and low overhead costs for labor intensive jobs which require low machine processing.

Production OverheadAbsorption Base Machine-Hours

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Blanket Overhead Rate• Direct labor or machine-hours has often used as

the absorption base for calculating the blanket predetermined overhead rate.

• Such absorption bases used are based on time spent in production cost centres (the higher the output, the higher the labor-hours/machine-hours, the higher the overhead applied).

• They fail to reflect many overhead cost items are not driven by the time spent in production cost centres ( i.e. product design, product planning, processing production orders, supervisor’s salary).

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Activity-Based Costing (“ABC”)

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Activity-based costing is an attempt to more accurately assign manufacturing overhead costs to products based on the activities required to products and the resources consumed by those activities.

Activity-Based Costing (“ABC”)

ABC is based on the principle that:

Products cause Activities; Activities cause Costs

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Activity-Based Costing (“ABC”)1)Identify activities involved in the manufacture of the

product

Machine Processing

Machine Setup

Product Design

General FactoryAdmin.

Cost Pools

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Activity-Based Costing (“ABC”)

2) Calculate the total cost of each activity (the ‘cost pool’)

Machine Processing

$10,000

Machine Setup

$2,000

Product Design

$6,000

General FactoryAdmin.

$16,000

Cost Pools

Activity 1Activity 2

Activity 1Activity 2

Activity 1 Activity 2

Activity 1Activity 2

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Activity-Based Costing (“ABC”)

3)Determine what causes each activity (the ‘cost driver’)

Machine Processing

$10,000

(machine hours)

Machine Setup$2,000

(setups)

Product Design$6,000

(Hours of Design)

General FactoryAdmin.$16,000(LaborHours)

Cost Pools

(Cost Driver)

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Activity-Based Costing (“ABC”)

4. Calculate Cost Driver Rate (“Predetermined Overhead Calculate Cost Driver Rate (“Predetermined Overhead Rates ”).Rates ”).

Machine Processing

$10,000(1,000

machine hours)

Machine Setup$2,000

(10setups)

Product Design$6,000(200

designhours)

General FactoryAdmin.$16,000

(400 laborhours)

Cost Pools(Cost

Driver)

Cost Driver Rate $10/

machine hour

$200/setup

$30 /Designhour

$40/ laborhour

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Activity-Based Costing (“ABC”)

5)Assign costs to products on the use made of the activity (applying the ‘cost driver rate’).

Cost Driver Rate

$10/machine

hour

$200/setup

$30 /designhour

$40/ laborhour

Job 101 Job 102 Job 103

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Activity-Based Costing (“ABC”)

In practical terms, an ABC costing system consists of five steps:

1) Identify activities involved in the manufacture of the product

2) Calculate the total cost of each activity (the ‘cost pool’)

3) Determine what causes each activity (the ‘cost driver’)

4) Calculate the average cost per driver (the ‘cost driver rate’)

5) Assign costs to products on the use made of the activity (applying the ‘cost driver rate’).

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Two products, X and Y, are made using similar equipment and methods. The data for an accounting period is as follows:

X Y

Units produced 6,000 8,000

Machine hours per unit 4 2

Production set-ups 15 45

Orders handled 12 60

The production overheads for the period can be analysed as follows:

£

Production set-ups 179,000

Order handling 30,000

Machine running costs 55,000

264,000

Seminar Question 1

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1) Calculate the overheads to be absorbed by each product using a traditional machine hour rate:

Seminar Question 1

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Seminar Question 1

2) Calculate the overheads to be allocated to each product using the ABC method:

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ProductionOverheads

Direct Materials

+ Direct Labor Cost

Object

(Job)

Cost Tracing

Cost absorption /application

Total Absorption Costing (or Absorption Costing) is referring a costing method in which all manufacturing costs are absorbed or included into a finished unit of product.

+

Manufacturing Costs

Absorption Costing vs. Marginal Costing

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Absorption Costing vs. Marginal Costing

Cost Object

(Job)

Marginal Costing is referring a costing method in which only variable costs are included into a finished unit of product.

Under marginal costing, fixed production overheads are considered to be period costs and treated as expenses for the period.

Manufacturing Costs

ProductionOverheads

+

Profit &Loss

Account

FixedOverheads

VariableOverheads

FixedCosts

Direct Materials

+ Direct Labor

VariableCosts

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The characteristics of businesses using the three methods are as follows:

Total absorption: Low production overheads compared with direct costs; fairly limited product range; used extensively in smaller businesses where there is some variation to the main product line e.g. printing

Marginal costing: Direct costs a high proportion of the production cost; used by businesses involved in fast moving consumer goods (fmcg) where pricing decisions are critical e.g. food industry

ABC: High production overheads; diverse product range; products using very different amounts of overheads e.g. medical equipment manufacturers

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Costing System of a Manufacturer

FinishedGoods

Inventory

Revenues

=

Net Profit

Cost of Goods Sold

(an expense)

Gross Profit

Marketing, selling and administrative

expenses

_

_

whensalesoccur

BALANCE SHEET INCOME STATEMENT

Marketing, selling and administrative

expenses

Work inProcessInventory

Direct LaborProductionOverhead

Direct Materials

ManufacturingCosts

Non-manufacturingCosts

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Non-Manufacturing Overheads (Costs)

1. Research and development2. Selling and distribution3. Administration4. Finance

Non-manufacturing overheads are usually added to the manufacturing cost on a % basis.

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Unit Cost

As output increase so the UNIT cost decreases

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Process and Job-Order Costing

ProcessCosting

Job-OrderCosting

• Many different products are produced each period. • Products are manufactured to order.• Cost are traced or allocated to jobs.• Cost records must be maintained for each distinct

product or job.

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Process and Job-Order CostingJob-Order Costing

DirectMaterials

DirectLabor

ManufacturingOverhead

Job 1

FinishedGoods

Cost of Goods Sold

Job 2

FinishedGoods

Cost of Goods Sold

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Process and Job-Order Costing

• Produces many units of a single product for long periods.

• Products are homogeneous.• Cost are accumulated in a process unit and then

evenly allocated to each product.• Products flow through the production process on a

continuous basis.

ProcessCosting

Job-OrderCosting

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Process and Job-Order CostingProcess Costing

DirectMaterials

DirectLabor

ManufacturingOverhead

Process1

Process2

FinishedGoods

Cost of Goods Sold

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Process and Job-Order Costing

Examples

Manufacturing

Sector

ServiceSector

Merchandising Sector

Job-OrderCosting

- Aircraft assembly

- House construction

- Auditing- Consulting- Advertising - Auto-repair

- Special mail order

Not Common

ProcessCosting

- Oil refining- Beverage

production

- Bank-check clearing

- Postal service

Not Common

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SALES MARGIN

&

MARK-UP COSTING

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SALES MARGIN

The product is priced to achieve a standard margin based on the SELLING PRICE

For example:Cost £1.60

Sales margin required 20%Selling price = £1.60 x 100 = £2.00

80to get back to cost = £2.00 x 80% = £1.60

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COST PLUS (MARK-UP)

Where the product is priced to achieve a standard mark-up on COST

For example:Cost £1.20

Mark-up required 25%Selling price = £1.20 x 125 = £1.50

100to get back to cost = £1.50 x 100/125 =

£1.20

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PREFERRED METHOD?

As a general rule:

Sales margin method is used by manufacturers

Cost plus method is used by retailers

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What costs are covered?

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SEMINAR QUESTION 2

(a) Calculate the total unit cost. (b) Calculate the selling price to the cycle shop if the company

wishes to achieve a sales margin of 10%

(c) On the basis of the answer arrived at in (b), calculate the retail price to the general public if the cycle shop’s policy is to mark-up 25% on cost to cover overheads and profit.

The unit production cost of a Crusader Mountain Bike is £232 and the company has budgeted £400,000 for selling, distribution and

administration costs, based on annual sales of 40,000 cycles per year.

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SEMINAR QUESTION 3 Try the following……….

If sales are £280 and the sales margin is 30%, calculate the cost of sales:

If sales are £390 and the mark-up is 30%, calculate the cost of sales:

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DEMAND BASED PRICING

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DEMAND BASED PRICING

SEMINAR QUESTION 4

Demand for product A has been established as follows:

Demand (units) Selling price 20,000 £30 18,000 £35 15,000 £40 11,000 £45

If the variable cost per unit of product A is £20, calculate the optimum selling price

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Seminar 5: Questions 1 – 2

Students are required to hand in handwritten solutions to the assigned exercises at the beginning of the tutorial sessions.

Tutorial Exercise

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End of Week 4Lecture