output costing framework by tarun das

8/14/2019 Output Costing Framework by Tarun Das

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Output Budgeting Session-3 by Tarun Das 1

Output Costing and OutputBudgeting

Session-3: Output Costing

FrameworkProfessor Tarun Das


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Contents of thispresentation

Costing Framework- Basic Conceptsand Principles:

1. What is output budgeting?2. What is output costing?

3. Benefits of output budgeting4. General Ledger (GL) Costing5. Cost objects6. Cost classification

7. Total costs8. Cost drivers9. Costing Methods10.Activity Based Costing (ABC)


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1.1 What is Output Budgeting? Under output budgeting the cost and budget

estimates are provided for each output (costs of

inputs like man, materials, machines etc.,although estimated, may not be shownseparately in the budget).

The basic purpose is that given the budgetedcost, one is interested in the achievement ofoutput and outcome (and not in costs for labor,goods and other services).

Once one monitors output costs, the input costsare automatically monitored.

But, if one simply monitors input costs, one

would not know what happened to outputs.Thus, under output budgeting, there are outputheads for accounting and auditing.


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1.2 What is Output Budgeting?

Under output costing and output budgeting,

an identified output becomes a cost centreas well as a budget centre, so that the costof that output can be estimated,budgeted, monitored, and evaluated.

If single output cannot be budgeted, thenrelated outputs can form an output groupand the corresponding cost and budgetcentre.

The Departments and Agencies who areresponsible for delivering the outputs areidentified and specified in the Budget.


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1.3 What is Output Budgeting?

For operational purpose, it is more

convenient to realign outputs withdepartments/ divisions or to make aone-to-one correspondence betweenoutputs and departments/ divisions.

Because, if more than one Division is

responsible to deliver the output, thenmonitoring and fixing responsibility andaccountability becomes difficult.

In other words, at the first phase, eachdepartment/ division can become a costand budget centre.

At a later stage, when the system isdeveloped properly, the specific outputscan also become cost centres.


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2.1 What is output costing?

Costing is the way by which an agencyfinancially measures the resourcesconsumed in transforming inputs intooutputs.

Costing is completed through twobroad phases:

1. Cost collection - gathering of costsin an organised way using anaccounting system.

2. Cost assignment- the assignmentof a cost or group of costs to one ormore outputs.


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2.2 What is output costing? Whilst there are many

costing methods, allare designed todescribe the twoprimary functions ofcost collection & costassignment.

In its simplest form,this diagramillustrates the basicprocess or genericmethod of costing.


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2.3 Total CostThe total cost includes all direct and overhead

cash costs and accrued costs for the period.

Direct costs- the cost of resources consumedthat can be traced directly to the Cost Object. Direct costs are generally made up of direct

materials and direct labour. For example, officers and staff of a department

are directly responsible for the output of thedepartment, whereas the salary of the statesecretary is an indirect cost and needs to beallocated to all departments.

All costs that are not direct costs areoverhead/indirect costs. Common costs for

water, electricity, maintenance, security,library etc. are indirect costs.


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3.1 Objectives, purpose andbenefits of output budgeting

More information is available for optimalallocation of resources; A broader range of information is available for

better decision-making, for example: Comparison and benchmarking of the total

costof outputs with alternative suppliers; Identification of inefficiencies which allows to

take appropriate steps for cost reduction; A better understanding of the cost drivers;

Agencies have a more appropriate basis forpreparation of internal budgets.


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3.2 Objectives, purpose andbenefits of output budgeting

Access to more accurate informationassists agencies to determine the sellingprices of goods and services provided tothe third parties on a cost-plus principle.

Cross-subsidies become moretransparent.

Accurate costing identifies cases wheresome outputs are being over-funded atthe expense of other outputs.


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4.2 Cost accumulation andGeneral Ledger (GL) Costing

The complexity of cost modules ingovernment departments varies fromsimple stand-alone spread sheet to anintegrated system that links the costschedules to the general ledger andvarious output groups.

Chart of the accounts should be consistentwith cost classifications.

Chart of Accounts should include codes fordepartmental heads, cost centres, outputheads, and expense heads.


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5.1 Cost objects Cost objects are the elements which need to be

costed for the purpose of output budgeting. Cost objects could be outputs, group of outputsor activities.

Choice of cost objects depends on the degree ofcomplexity and the operational cost of the

costing system and methodology. It also depends on availability, accuracy andtimeliness of information.

For external reporting, agencies report costinformation at the output level.

For internal purposes, agencies may like toreport costs at sub-output, activity levels, basiccost centres and major geographic regions.


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5.2 Cost Objects- An Example The Economics Department of the

National University of Mongolia hasdecided to undertake Output Costing.

Management has decided to cost itssubjects as cost objects, being:

1. Accounting;

2. Economics;3. Econometrics;4. Applied mathematics. The Departments Cost Pools are

identified as:1. Library;2. Lecturers;3. Information Technology (IT);4. Enrolments.


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5.3 Cost Objects- AnExample


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6.1 Cost classification

Costs can be classifies as fixed and

variable costs. Fixed costs remainunchanged with variations of outputvolumes in the short run, while variablecosts change when quantity of output

changes. For decision making, costs may be

classified as controllable (avoidable)or uncontrollable (unavoidable).

For example, employers contributions tothe social insurance funds for theemployees are decided by existing lawsand are unavoidable.


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6.2 Cost classification

Costs can also be classified as incrementalcosts, sunk costs and opportunity costs.

Incremental costs (marginal costs) couldbe avoided if production plan is dropped.

Sunk costs are those costs, which havebeen either made or committed, cannot beavoided and are irrelevant for financialdecisions.

Opportunity cost is the cost that could besaved, from the next best alternative use ofany resource.


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6.3 Direct Costs For the purpose of output budgeting, costs are

classified into direct and indirect costs.

Direct costs are those costs which can bedirectly attributed to an output. They are mostlyvariable costs and vary in direct proportion tooutput.

In the public sector, labor is the dominant factor

for direct cost. Direct costs are divided intodirect staffing cost and other direct costs(e.g. direct material costs).

Direct staffing costs include not only wages andsalaries but also other compensation to labor

such as contributions to pensions, insurance,leave travel etc.


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6.4 Indirect costs or Overheads

For some costs, it may not be possible to

establish direct relationships with the costobjects, because they are common to morethan one output. These are called indirectcosts, and sometimes referred as overheads.

For example, indirect costs can include thesalary of the Agency Head, corporateoffice, general administration, the costs ofsecurity services, library, officeaccommodation and maintenance, etc.

These costs are assigned to different outputson the basis of their contributions to theoutput cost.


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6.5 Other expenses or non-outputcosts

An agency may incurcosts that areunrelated to outputs.

For example, costsdue to abnormalrestructuring,write-off of assets,

extra-ordinary costsetc. are regarded asnon-output costs andexcluded from theoutput cost.

Direct Costs-

Mostly variableand Little fixed

Indirect Costs-

Some variableand More fixed

Capital Costs-

Little variableand Mostly fixed


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6.6 Capital Costs

There are two aspects relating to the use

of assets which must be considered inany analysis of cost:

the determination of an appropriate

depreciation charge; and Capital charge on recognizing that the

funds invested in the assets havealternative uses and, therefore, some

allowance should be made for a rate ofreturn on those assets (also known as theopportunity cost of capital).


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6.7 Asset Depreciation

The prime cost or straight line method

which allocates the cost of the asset over thenumber of years of useful life; and

The diminishing value method whichallocates a higher proportion of the cost ofthe asset to the earlier years of its life.

A depreciation charge is not relevant in allcircumstances. For example, where agenciespurchase equipment, receive an input taxcredit, hold the equipment for a relativelyshort period of time and sell it at a priceclose to the original purchase price, there isno need for a depreciation charge.


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6.8 Capital Charge

As a thumb rule, the Australian Treasuryrecommends that the long term borrowing rate(around 2 per cent) be used as an estimate forthe cost of funds.

To calculate the required return on assets,Australian Treasury uses the following formula:

Cost of capital (%) multiplied by(Total estimated replacement value or currentcost equivalent of assets employed lessaccumulated depreciation)

less the interest portion of any relevant debtservicing cost.


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6.9 How relevant is the Capital Chargefor the Mongolian Budget entities?

The objective of a system of capitalcharges. is twofold:

1. To encourage the sale of excessgovernment assets, and

2. To assess the full cost of deliveringservices by budgetary bodies. For Mongolia, both these objectives can be

served by the depreciation cost, because

most the surplus assets had already beenprivatized, and agencies depend oncentral govt for new assets creation.


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6.10 Estimation of depreciation fund

Depreciation on the basis of book value of

assets can be used for the next five years, as itprovides reliable and inexpensiveapproximations to capital cost.

There are undesirable consequences to currentvalue and capital charges.

Danger inherent in the current value is that themanagement has no control over it.

So they may be discouraged from investing inthe future.

Capital charges and current value accounting arecomplicated, expensive, and may not providemuch benefit in return.


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7.1 Total Costs The full cost of an Output is the aggregation

of direct, indirect and capital costs.

Most of these costs are attributable toagencies. However, some costs may be metby other agencies.

Some costs are based on cash transactions,while others represent the future call on

expenditure (e.g. accrued pension benefits). The estimation of the output cost is the first

step in the analysis of costs.

At the end of an accounting period, actualresults should be compared with the costestimates to improve costing procedures.


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8.1 Cost Drivers

Cost drivers are those activities, eventsor factors that trigger or have a strongcorrelation to the total cost.

Identification of cost drivers makes theallocation of costs to outputs easier andmore accurate.

A simple example is the allocation ofrental and clearing costs to a range ofoutputs.

A cost driver for this will be the ratio of

floor space occupied by each work groupto the total floor area.


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8.2 Commonly Used Cost Drivers

Floor space used

Number of staff

Number of hours worked

Number of transactionsprocessed

Number of documents receivedand dispatched.


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8.3 Cost Drivers

General Ledger

(GL) Cost Items

Cost Grouping Allocation

MethodOfficeaccommodationrentals

Employees/ staff Resource usageanalysis (Floorarea used)

Salaries andwages Employees/ staff Activity analysis(Person hours)

Medical expensesEmployees/ staff Activity analysis(Time consumed)

Travel Employees/ staff Activity analysis(Time consumed)


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8.4 Cost Drivers

General Ledger

(GL) Cost Items


MethodTelephones, andcommunicationslines

Communications Resource usageanalysis

Stationary Consumables Resource usageanalysis

Equipmentmaintenance

Equipment Resource usageanalysis

Softwarelicenses Softwares Resource usageanalysis


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8.5 Cost Drivers

General Ledger

(GL) Cost Items


MethodDepreciation Depreciation Resource usage

analysis

Equipmentrental Equipment Resource usageanalysis

Motor vehiclesexpenses

Overhead Allocation tooverhead


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9.1 Costing Methods A costing method defines the process that is

used to trace all relevant costs and attribute

them to outputs. In order to determine the cost of its outputs,

an agency will establish a costing systemthat may use a variety of costing methods,techniques and tools.

There are two main types of costingmethods:(a)Job Costing;(b) Process Costing .

These main methods are often used inconjunction with refinements and othertechniques such as Activity Based Costing(ABC)or Standard Costing..


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9.2 Job Costing Job Costing is used by organisations that produce

unique products, where each product or service

consumes a different amount of direct labour,material and overhead costs.

Job Costing is also used on jobs that have distinctstart and finish times.

Examples of non-manufacturing entities that use

the Job Costing method are:1. Appliance repairers2. Auto repairers3. Main Roads engineering jobs4. Doctors and dentists

5. Accountants6. Universities.


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9.3 Process Costing Process Costing is used for mass production of like

units through a sequence of processes. Costs are

accumulated for a period of time. Individual unitsare not separately costed.

In order to obtain an average unit cost, the totalcost for the period is divided by the number of unitsproduced during that period.

Job Costing is generally used when the number ofunits is small, the units are not homogeneous andthe cost per unit is high.

Process Costing is generally used when thenumber of units is large, the units arehomogeneous and the cost per unit is low.

9 4 Which method should be


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9.4 Which method should beused?

The most important aspect of costing is the

understanding of cost behavior patterns. Factors that determines a particularcosting method include the following:

1. Size, structure and type of the agencysoperation;

2. Agencys outputs required to be costed;3. Existing costing or accounting systems;4. Availability of technology and resources to

support a costing system;5. Cost/benefit analysis of alternative

methods.

10 1 A ti it B d C ti


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10.1 Activity Based Costing(ABC)

ABC is a Process Costing technique that aims

to attribute overheads (or joint costs) to theCost Centres based on some norms ratherthan on some arbitrary allocation basis.

ABC assigns costs to activities on the basis ofresources consumed by the activities.

Activity costs are reassigned to outputs usingcost-drivers based on the amount of theactivity used by the outputs.

In many cases, ABC provides meaningful

costing data and information. So, its use byagencies should be encouraged.


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10.2 Potential Benefits of ABC More meaningful costing of outputs as

overheads are included in total costs;

More effective cost managementthrough improved information about thecost of activities undertaken to producean agencys outputs;

Process improvement throughbenchmarking the cost of activitiesagainst other providers and industrysBest Practices; and

Increased public accountability forresource consumption.


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10.3 Potential Benefits of ABC

Improved cost management due to

regular analysis and monitoring ofthe cost of activities;

Improved customer service byproviding activity information that

can contribute to improved servicelevels or quality;

Improved cost modeling by allowingchanges in activities;

Better ability to align activities toorganisational units and to assist ininternal budget allocation.


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10.4 ABC Process1. Identify the agencys activities.;

2. Identify the cost of input that will be consumedby the direct and indirect activities.

3. Assign cost elements to supporting activitiesusing resource-drivers.

4. Reassign the cost of supporting activities to

primary activities using resource-drivers.5. Assign costs from primary activities to Cost Key

Points using activity cost-drivers.

6. Assign to outputs the cost of relevant sub-

outputs consumed.


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10.5 An Example of ABC


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10.6 ABC and Standard Costing

Activity based costing (ABC)

ABC is useful for both Job Costing andProcess Costing. It examines the wayactivities consume resources and howthey relate to outputs.

Standard Costing Standard costing is not a costing method;

rather it is a technique to calculate abenchmark against which the actual cost

can be compared.


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Thank you

Have a Good Day

output costing framework by tarun das

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