Paper 1.

2 Financial Information for Management

Chapter 01 The purpose of cost accounting

Chapter 02 Cost Behaviour
Chapter 03 Understanding the Correlation between Total Costs and the
Volume of Output
Chapter 04 Direct and Indirect Materials: Part 1 - The control of
stock items
Chapter 05 Direct & Indirect Materials: Part 2 – Stock Reorder
Levels
Chapter 06 Overheads and Absorption Costing: Part 1 -
Apportionments
Chapter 07 Overheads and Absorption Costing: Part 2 -
Absorption

Paper 1.2
Chapter 1

The Purpose of Cost Accounting

Cost accounting is part of management accounting, and its purpose arises

due to
the management’s need for specific or more detailed information as
oppose to that
provided by financial statements. Hence cost accounting will provide
information to
assist the management with planning, control and decision making as well
as
accumulating historical costs to establish stock valuations, profits and
balance sheet
items. All of this is done with the help of a Management Information
System, which is
simply a general term for the computer systems in an enterprise that
provide
information for management.

Therefore the key points of cost accounting are:

• The recording and analysis of actual costs

• The forecast of future costs
• Cost control

Cost Classifications

As such, it is necessary to be able to understand the basic cost

classifications and
behaviour to manage a cost accounting system.

Costs may be classified as either of the following:

1. Direct or Indirect Costs

2. Function Costs
3. Fixed or Variable Costs
4. Product Costs or Period Costs
5. Available or Unavailable
6. Controllable, Uncontrollable, or Discretionary Costs

Direct or Indirect Costs

A direct cost is a cost that can be traced in full to the product, service or
department
that is being costed. These costs consist of direct labour, direct materials,
and any
other direct costs.

Whereas an indirect cost is a cost that is incurred in the course of making

a product,
providing a service or running a department, but which cannot be traced
directly
and in full to the product, service or department. These costs consist of the
following:

a) Production overheads: indirect materials, indirect wages and

indirect
expenses
b) Administration overheads: e.g. depreciation and office salaries
c) Selling Overheads: e.g. commissions, advertising, market research,
sales
promotion
d) Distribution Overheads: e.g. cost of packing cases, insurance
charges.

The two definitions mean that every product, service or department will
incur a direct
and indirect cost. Furthermore the total cost of every product, service or
department
is the sum of the relative direct and indirect costs.

Total Cost = Direct Cost + Indirect Cost

Function Costs
Costs may also be classified by their function, i.e. what kind of service was
the cost
incurred to do? The answer to this question may be categorized in any one
of these
classifications:

a) Production Costs
b) Administration Costs
c) Selling Costs
d) Distribution Costs
e) Research & Development Costs
f) Financing Costs

Fixed or Variable Costs

A fixed cost is a cost which is incurred for a particular period of time and
which, within
certain activity levels, is unaffected by changes in the level of activity. A
variable cost
however is a cost which tends to vary with the level of activity.

Product Costs or Period Costs

Product costs are those identified with a finished product, as a part of the
value of
stock. They become expenses in the form of cost of goods sold. Whereas
period
costs are costs that are deducted as expenses during the current period
without
ever being included in the value of stock held.

Avoidable or Unavoidable
Simply costs are avoidable, if the company could avoid them, and similarly
for
unavoidable costs.

Controllable or Uncontrollable
Controllable costs are those that can be controlled by the company
whereas
uncontrollable costs are those outside the scope of the business.

Discretionary Costs
These costs are likely to arise from decisions made during the budgeting
process.
They are likely to be fixed amounts of money over fixed periods of time.
E.g.
Advertising, R&D, training budgets.

Cost Units
Once costs are recorded, i.e. the total costs of department ‘A’ are
$100,000; one
may prefer to analyze the cost per each unit. This is referred to as a cost
unit, and it
could be cost per kg, cost per machine hour, etc.
Cost Objects
What if the manager comes up to you and says, what’s the cost of
operating
department ‘A’? This cost is referred to as a cost object, or objective, and it
is any
activity for which a separate measurement of costs is required, e.g. the
cost of a
product or the cost of a service, etc.

Responsibility Centres
A responsibility centre basically involves analyzing costs, profits or
revenues and
attributing them to specific managers or ‘centres’. In other words, the costs
of
department ‘A’ are the responsibility of Manager ‘A’, whereas the costs of
Machine
‘A’ is attributed to the operator of Machine ‘A’. Basically, responsibility
centres maybe
categorized as follows:

a) Cost Centres
b) Profit Centres, where profit centre managers should normally have
control of
how revenue is raised and how costs are incurred.
c) Revenue centres, whose responsibility is revenue only.
d) Investment centres, whose responsibility is that of a profit centre
with
additional responsibilities for capital investment and possibly for financing,
and
whose performance is measured by its return on investment.

Conclusion

1. We know what information is, why it is needed and that it is

managed within a
Management Information System.
2. We said that an MIS is needed to enable the management to have
sufficient
information to do their job.
3. Cost Accounting is a part of MIS and it basically helps us with
a) The classification of actual costs incurred
b) The preparation of budgets of planned costs
c) The comparison of actual costs and budgeted costs

4. This system involves the classification of costs into several

categories such
as direct and indirect costs, function costs or fixed and variable costs.
5. Costs are based on cost units and cost incurred is allocated to a
cost centre
such as a department or a machine.

Paper 1.2
Chapter 2

Cost Behaviour

The knowledge of cost behavior is essential for the tasks of budgeting, decision
making
and control accounting, whose importance was established in the previous article.
Cost
behavior is the way in which costs are affected by changes in the volume of
output. In
other words, this article will attempt to describe the behavior of various costs with
the
volume of output.

The principle of cost behaviour is simple, as the level of activity rises, cost will
usually
rise, but the difficulty arises when one needs to determine the way in which cost
rise
and by how much as the level of activity increases.

A Cost Behaviour Pattern could be established for certain costs that ‘behave’ in a
‘predefined’ or ‘usual’ way, which we may illustrate graphically. In the course of
this
article we will discuss the cost behaviour of the following items:

1. Fixed costs
2. Step costs
3. Variable costs
4. Semi-variable costs
5. Total costs and unit costs

Fixed Costs

These costs are not generally related to the volume of output or to the level of
activity
within a firm, although they do increase with time. As such, they will not follow
the
principle of cost behaviour mentioned earlier (costs rising as level of activity
rises), e.g.
the salary of a managing director, or the straight line depreciation of a machine.
Cost
Volume of Output
As you could see, fixed
costs are not affected by the
volume of output
Fixed Costs
Step Costs

These costs are fixed in nature but only within certain activity levels, e.g. if you
employ
100 employees their salaries would be a fixed amount of $100k per year, yet, if
you
increase the number of employees to 150, the fixed amount of salaries would
naturally
increase.

Variable Costs

A variable cost tends to vary directly with the volume of output. As such it is
natural to
expect that they have a ‘linear’ or uniform relationship with output.

Cost of raw materials, direct labour and sales commission may behave in this way
subject to price per unit of materials or labour is constant.

Cost
Volume of Output
As you can see, each extra
unit of output causes a
proportionate increase in
cost.
Variable
Costs

Cost
Volume of Output
Notice how costs remain
fixed until a specific volume
of output is reached, which
causes costs to immediately
Step Costs rise.

Semi-Variable Costs

A semi-variable cost is a mixed cost, which consists of both a variable and a fixed
cost,
therefore they are partly affected by the volume of output. A typical example could
be
electricity, where a fixed fee is paid per month as well as a charge per unit of
electricity
consumed. Semi-variable costs could behave in either of the following two ways:
The Cost Behaviour of Unit Costs and the Volume of Output

The total fixed costs incurred by a business is constant with the level of output,
whereas
variable costs behave in a ‘variable’ way, whereas the total costs (Sum of all
costs),
behave as semi-variable costs. Yet, what if we considered the fixed cost per unit
produced, or the variable cost per unit produced, what would the cost behaviour
pattern

As you could see, the variable cost per unit remains constant because it will
always cost
the same to produce one unit. Fixed costs per unit will gradually decrease with
output
because fixed costs remain constant regardless of output, yet as output increases
the
FC/unit which is FC/volume of Output, becomes smaller. Total costs are the sum
of the
VC and FC graphs.

Cost
Volume of Output
Each extra unit in A causes
a less than proportionate
increase in cost whereas in
B, each extra unit of output causes a more than
proportionate increase in cost.
Semi-Variable
Cost A
Semi-Variable
Cost B
Variable Cost
Fixed Cost Total Cost

Assumptions and Conclusions

1. Within the normal or relevant range of output, costs are often assumed to be
either
fixed, variable or semi-variable.
2. Variable costs have a linear relationships with the volume of output
3. Fixed costs are constant
4. Semi-variable costs have a curvilinear relationship
5. When activity levels rise, variable costs per unit remain constant, the fixed costs
per unit falls and the total cost per unit falls.
Paper 1.2
Chapter 3

Understanding the Correlation between Total Costs and the Volume of

Output

Although the cost behavior pattern of fixed, variable and semi-variable costs seem
to
be straightforward, the mere cost behavior pattern isn’t sufficient enough to enable
us
to control or anticipate future costs in order for us to set budgets, or to base
management decisions on them. It is necessary, to determine the correlation
between
total costs and volume of output.

This article will focus on the various methods available, how to use them for
forecasting purposes and their limitations. It is important however to realize that
each
of the following methods is only an estimate and each of them will produce
different,
but rather similar results. The following methods are available:

1. High-low method (with or without inflation)

2. Scattergraph method and the line of best fit
3. Regressoin analysis
4. Least squares method

The High-Low Method

The high-low method may be used to determine and differentiate betw

Paper 1.2
Chapter 4

Direct and Indirect Materials: Part 1 - The control of stock items.

The purpose of this article is to develop an understanding of how cost

accountants deal
with stocks, how they are valued and most importantly, how they are
controlled.

Remember that costs may either be an expense, which would be written

off in the profit
and loss account, or a cost may be an asset, which would be carried
forward in the
balance sheet. This is due to the application of the accruals concept. It is
therefore
necessary to classify costs in the most appropriate manner, so that they
are valued,
accounted for, and controlled as efficiently as possible.

As such, this article would answer the following questions:

1. How are items of stock, such as materials, controlled within a cost

accounting
system?
2. What are the reasons for holding stock and what are the limitations
of doing so?
3. What are the appropriate methods of establishing reorder levels
whilst
minimizing the cost of holding stock trough the interpretation of optimal
reorder
quantities?

How are items of stock, such as materials, controlled within a cost

accounting system?

1. Stocks are controlled using what is known as a stock control

system. This
system should cover the following functions:

a) The ordering of stock

b) The purchase of stock
c) The receipt of goods into store
d) Storage
e) The issue of stock and maintenance of stock at the most
appropriate level.

The reasons are due to the following points:

a) Holding costs of stock may be expensive
b) Production will be disrupted if we run out of raw materials
c) Unused stock with a short shelf life may incur unnecessary
expenses.

2. Furthermore, proper records must be kept regarding the ordering,

receipt and
issue of stock using the following process:

a) When stocks reach the reorder level, the stores department issues
a purchase
requisition to the purchase department to order further stock.
b) The purchase department then issues a purchase order to the
supplier
c) Once the stock is delivered, the storekeeper signs a delivery note.
The stocks
are then further inspected for deficiencies. If all is okay, the store keeper
prepares a
goods received note (GRN) to the accounts department that check it with
the purchase
order. The supplier is paid.

The reasons are to ensure that:

a) Enough stock is held
b) There is no duplication of ordering
c) Quality is maintained
d) There is adequate record keeping for accounts purposes.

3. Storage of Raw Materials; Storekeeping involves storing materials

to achieve the
following objectives:
a) Speedy issue and receipt of materials
b) Full identification of all materials at all times
c) Correct location of all materials at all times
d) Protection of materials
e) Efficient use of storage space
f) Maintenance of correct stock levels
g) Keeping up to date records

This is done through the use of:

a) Bin Cards – kept with the actual stock and updated whenever items
are issued
or received.
b) Stores Ledger Accounts
c) Stock Codes – materials held in stores are coded and classified

4. Stocktaking – this process involves counting the physical stock on

hand at a
certain date and matching it with the balance shown in the stock records.
This process
should enable us to avoid discrepancies, check our records, and make
sure that we
know the free stock balance, which is actual stock that is available for
future use.
Stocktaking may be periodic or continuous, in which the later involves
using a perpetual
inventory system.

Remember that:
• Materials in stock plus Order from Suppliers less materials
requisitioned equals
free stock balance.

5. An Order Cycling Method may be used, where quantities on hand of

each stores
item are reviewed periodically.
6. A Two-bin system may also be used whereby each stores item is
kept in two
storage bins. When the first bin is emptied, an order must be placed for re-
supply.
7. Materials may be classified as expensive, inexpensive or middle-
cost range.
Whilst the last two items are stored in large quantities, the expense items
are subject to
careful stores control procedures.
8. Computerization, whereby stock masters file is maintained
concerning all the
transactions and details of stock movement. This will ensure the following:

a) Easier process
b) Better maintenance of records
c) Backup copies could be made.

What are the reasons for holding stock and what are the limitations of
doing so?

The main reasons for holding stock are:

1. To ensure that sufficient goods are available to meet expected

demand.
2. To provide a buffer between process (in cases where output stock is
the input
stock for another process.
3. To meet any future shortages
4. To take advantage of any bulk purchasing discounts
5. To absorb seasonal fluctuations and any variations in usage and
demand.
6. To allow production process to flow smoothly and efficiently.
7. Holding stock is necessary due to fermentation, e.g. wine.
8. As a deliberate investment policy, e.g. in times of inflation or
shortages.

There are two kinds of limitations arising due to stock holding

A) If stocks are held at a high level:

1. Cost of storage and stores operations increase

2. Insurance costs arise
3. Risk of obsolescence – stock being damaged or going out of
fashion
4. Opportunity costs – instead of purchasing stock and holding them
you could
have invested the money elsewhere.

B) If stocks are held at a low level:

1. Cost of obtaining stock may increase – if stocks are kept too low,
every time a
new order is needed, the firm must incur cost of obtaining stock, such
telephone calls,
transportation, etc.
2. Stock out costs- whereby items of stocks run out. This may result in
a lost
contribution from sales, or a loss of future sales from disappointed
customers, or worse,
cost of production stoppages.

Paper 1.2
Chapter 5

Direct & Indirect Materials: Part 2 – Stock Reorder Levels

What are the appropriate methods of establishing reorder levels whilst

minimizing the
cost of holding stock?

Step 1
An analysis should be made regarding past stock usage and delivery
times, whereby a
series of control levels can be calculated and used to maintain stock at
their optimal
level.

Step 2
Basically, stock control levels are established, such as:

a) Reorder levels
b) Reorder quantity
c) Maximum level
d) Minimum level
e) Average stock level

a) When stocks reach the reorder level, an order should be placed to

replenish stocks.
The level is determined by the following formula:
Reorder level = Maximum level x Maximum Lead time
Where maximum lead-time refers to the time between placing an order
with a supplier
and the stock becoming available for use.
b) The reorder quantity is the quantity of stock to be ordered when stocks
reach the
reorder levels.
c) Maximum levels could lead to unnecessary holding costs, and this level
may be
established by the following formula:
Maximum level = Reorder level + Reorder Qty – (Minimum level x
Maximum lead time)
d) When stocks reach the minimum level, stockouts may occur, and the
level may be
established by applying the following formula:
Minimum level = reorder level – (Avg. Stock Level x Average Lead Time)
e) The average stock level refers to the average stock held within an
accounting
period.
The following formula assumes that stock levels fluctuate evenly between
the
minimum stock level and the highest possible stock level.

Average Stock = Minimum Stock + ½ Reorder Quantity

Step 3: Economic Order Quantity

Now it is necessary to calculate the Economic Order Quantity. This is the

order quantity
that minimizes the total costs of holding and ordering stock.

Usually the economic order quantity is found at the point where holding
costs equal
ordering costs, which will be demonstrated by the following graph:

As you could see, as the average stock level or the order quantity
increases, the
holding costs increases proportionately or variably, yet the cost of ordering
stock
gradually decreases. The total cost curve is the sum of both the ordering
and holding
costs. As one could obviously see, the point where holding costs equal
ordering costs,
is the same point where the total costs are at the lowest level. This is
referred to as the
economic order quantity, i.e. the point where it is most efficient to order
stock items.

This could also be demonstrated, or calculated using the following formula

(Refer to Mathytpe)

Step 4: Economic Batch Quantity

In step 3, we assumed that the re-supply of stocks is instantaneous, i.e.

whenever we
need the stock we order that amount exactly. Yet, what if re-supply is
gradual rather
than instantaneous, i.e. an order of units is received gradually in batches?

This situation requires an amendment to the economic order quantity, to

what is known
as the Economic Batch Quantity.

Where:
If you compare this formula to that for the EOQ, you would notice that the
amendment
involved replacing ….
Ordering Costs
Holding Costs
Total Costs
Actual Costs ($)
Order Quantity (Units)
Average Stock Level (Units)

So if the annual demand per year is 100 units, and the annual rate of
production is 200
units, then we are selling half of what we’re producing. As such the costs of
holding will
drop by one half because we aren’t storing all of our productions, get it?

As you could see … is used because total stocks held per annum aren’t ‘Q’
but ….
This is due to batch productions and as such there is a gradual resupply.

Step 5: Economic Order Quantity and Discounts

Obviously the EOQ must be modified if bulk discounts are available. This is
done to
decide whether it would be worthwhile to take a discount and ordering
large quantities,
or not.

Obviously the deciding factor will be the lower of total costs when
a) Discounts are taken (minimum order size needed to take the discount)
b) Pre-discount EOQ level.
This is simply calculated as follows:
Total Costs of a) =
Purchases
Less: Discounts
Add: Holding Costs
Add: Ordering Costs

Total Costs of b) are found using the EOQ formula. The lower of a) or b)
wins the vote!

Paper 1.2
Chapter 6

Overheads and Absorption Costing: Part 1 - Apportionments

In accounting, there are various methods in dealing with direct and indirect
costs,
some of which have been explained in previous articles, such as
direct/indirect
materials and labour costs. The following series of articles aim to define
and explain
the different methods of dealing with overheads.

Overheads are by nature, indirect costs. They are defined as a cost

incurred in making
a product or a service, but cannot be traced directly and in full to the
product or
service.

Overheads may be classified as manufacturing or non-manufacturing

overheads for
the purpose of this article.

Manufacturing overheads being those costs related to the product or

service as defined
above, and non-manufacturing overheads are those that cannot be directly
allocated to
particular units of output.

Absorption Costing

In absorption costing, overheads will be added to each unit of output of

products
manufactured and sold. It is a method for sharing overheads between
different
products on a fair basis.

In other words, it says, look at all those manufacturing overheads incurred,

and lets
add them to the cost of sales!

SSAP 9 recommends this method because cost of all stocks should

consist of all costs
incurred in the normal course of business in bringing the product to its
‘present
location and condition.’ Overhead costs are incurred to produce the
finished
product(s) including administration and directors’ wages, without them the
products
wouldn’t exist! Therefore it is justifiable to charge each unit of output with
some of
the overhead costs.

There are also various practical reasons for using absorption costing:

1. Stock Valuations – Closing and Opening Stock would consist of

manufacturing
overheads, as such, increasing the value of gross profit, by carrying
forward the cost in
the balance sheet as a current asset, rather than writing it off as an
expense in the
profit and loss account.
2. Pricing Decisions – If you were to provide a service or a product for a
customer, you
would like to know the full cost to be incurred, including nonmanufacturing
costs as
well. This will enable you to determine how much of this cost should be
bared by the
customer. Kapiche?
3. Profitability of different products – Since overheads are shared on a fair
basis and
charged to the cost of sales of each product/department/service, one could
ascertain
the profitability of each product/department/service.

The Process of Absorption Costing

Simply, there are three stages:

1. Allocation
2. Apportionment
3. Absorption

Allocation involves allocating manufacturing and non-manufacturing

overheads to
various cost units or cost centers. Apportionment is the process by which
general
overheads are shared out on a fair basis between each cost center. In
other words, it’s
a process of taking all the non-manufacturing overheads and distributing
them to
those involved in production. Absorption is the process by which the costs
calculated
for each cost center is finally added to unit, job or batch costs. Thus,
establishing the
cost per each unit produced, which would enable us to value both opening
and closing
stocks, the cost of sales, and the gross profit of the business.

Allocation

This step is very simple. First we establish the various cost centers within
the
business, e.g. Production Department A and B, Services Department C
and D. We
then allocate all relative costs to each of these departments.

Apportionment

The process of apportioning overheads is based on what is called Basis of

Apportionment. This means that overhead costs are shared out on a fair
basis which
could be the floor area occupied by each cost center, when rent, rates
heating and light
repairs are concerned, or cost or book value of equipment when
depreciation of
equipment is concerned, etc.

Once a basis for apportionment for each service or non-manufacturing cost

is
established, the overheads should be apportioned in either one of the
following ways:

1. Direct Apportionment
2. Reciprocal method of apportionment
3. Step Method of Apportionment
Direct Method of Apportionment

Suppose that we have four departments within an organization, two of

which are
production departments, whereas the other two are non-manufacturing
departments,
they provide a service for example, such as repairs, etc. Production
department A
requisitioned materials from department C to the value 12,000 and B
requisitioned
materials worth 8000. Service department D provided 500 hours of work to
department A and 750 hours to department B. The following costs are
incurred:

Production Departments Service Departments A B C D

Allocated Costs 6000 4000 1000 2000
Apportioned Costs 2000 1000 1000 500
Total Overheads 8000 5000 2000 2500

The process of apportionment means that we should distribute the total

costs of
service departments C and D on a FAIR basis to production departments A
and B.

The first step would be to establish the apportionment basis for each
overhead.
Obviously, the costs incurred by department C would be apportioned on
the basis of
requisitions that it provided to departments A and B. The costs incurred by
department D would be apportioned on the basis of the hours of service
provided to
both department A and B.

Therefore, the costs of departments C and D would be apportioned in the

following
way:
Production Departments Service Departments Total
ABCD
Value of Requisitions 12000 8000 20000 % Of requisitions 60% 40%
Work Hours 500 750 1250 % Of work hours 40% 60%
Overhead Costs 8000 5000 2000 2500 17500
Apportionment of C 1200 800
Apportionment of D 1000 1500
Total Overheads 10200 7300 17500
Did you see what happened?
To apportion the costs of C, its overheads are apportioned to each
department
depending on the percentage of requisitions supplied, and the overheads
of
department D have been apportioned to each department depending on
the
percentage of work hours received.

The Reciprocal Method of Apportionment

The reciprocal method of apportionment is useful when services are not
only provided
to manufacturing departments, but to service departments as well.
Therefore, costs are
apportioned between all departments, rather than just the manufacturing
ones.

Let us suppose that, in the previous example, department D requisitioned

materials
and provided hours of service to department C. The following table
summarizes the
transactions and the solution:

Production Departments Service Departments Total

ABCD
Value of Requisitions 12000 6000 2000 20000 % Of requisitions 60% 30%
10%
Work Hours 500 650 100 1250 % Of work hours 40% 52% 8%
Overhead Costs 8000 5000 2000 2500 17500
Apportionment of C 1200 600 (2000) 200
Apportionment of D 1080 1404 216 (2700)
Apportionment of C 129.6 64.8 (216) 21.6
Apportionment of D 8.64 11.232 1.728 (21.6)
Apportionment of C 1.728 0 (1.728) 0
Total Overheads 10420 7080 0 0 17500

As you could see, using the reciprocal method, overheads are repeatedly
apportioned
until the final cost to be apportioned becomes so small and immaterial in
value.

One could also determine that the total costs of department C consists of a
proportion
of the total costs of department D, and vice versa.

Therefore, as an alternative to using repeating the appropriations of each

of the
service departments, simultaneous equations may be used to establish the
total cost of
C and the total cost of D, which we could then directly apportion to
departments A
and B.

Total Cost of C = 2000 + 8% of department D overheads

Hence C = 2000 + 0.08*D
Total Cost of D = 2500 + 10% of department C overheads
Hence D= 2500 + 0.1*C
Apply C to D
C = 2000 + 0.08(2500 + 0.1C)
Hence, C= 2000 + 200 + 0.008C
Hence, 0.992C = 2200
Therefore C=2217.7419
Hence, D= 2500 + 0.1*2217.7419 = 2721.7741
Therefore the solution would now be
Production Departments Service Departments Total
ABCD
Value of Requisitions 12000 6000 2000 20000 % Of requisitions 60% 30%
10%
Work Hours 500 650 100 1250 % Of work hours 40% 52% 8%
Overhead Costs 8000 5000 2000 2500 17500
Apportionment of C 1330.6451 665.3225 (2217.7419) 221.7741
Apportionment of D 1088.7096 1415.3225 217.7419 (2721.7741)
Total Overheads 10419 7081 0 0 17500

Notice what happened? Instead of apportioning the 2000 and 2500

overhead costs, the
overhead costs apportioned where those found in the simultaneous
equations above.

The same result is obtained either way; the slight difference shown is due
to rounding
off only.

The Step Method

The step method is very similar to the reciprocal method but the
apportionments
aren’t repeated since costs are not reapportioned to the service
departments again.
Thus, whatever is apportioned first will affect the results obtained. If we
apply it to
the above example, the following results are obtained:

Production Departments Service Departments Total

ABCD
Value of Requisitions 12000 6000 2000 20000 % Of requisitions 60% 30%
10%
Work Hours 500 650 100 1250 % Of work hours 40% 52% 8%
Overhead Costs 8000 5000 2000 2500 17500
Apportionment of C 1200 600 (2000) 200
9200 5600 0 2700

Now the 2700 will be distributed to A and B only, based on work hours.
Apportionment of D 1173.69 1526.04
Total Overheads 10374 7126 17500
Please notice how the apportionment basis percentages were recalculated
to distribute
the overheads to A and B only, similarly if D was apportioned first. Yet in
the later
case, the results would differ. Try it yourself.

Paper 1.2
Chapter 7

Overheads and Absorption Costing: Part 2 - Absorption

After allocating and apportioning overheads to cost units or cost centers,

we need to
add the costs calculated for each cost center to unit, job or batch costs.
This is called
overhead absorption or overhead recovery. Therefore, the production
overheads
calculated using absorption costing would be included in the following
formula:

Direct Materials
Plus: Direct Labour
Plus: Direct Expenses
Plus: Overheads (based on recovery rate)
Equals: Actual Costs of Production

The previous formula is known as normal costing. The actual costs of

production are
necessary to calculate the cost of sales, hence, the profits of the
organization.

Opening Stock
Plus: Production Costs
Less: Closing Stock
Equals: Cost of Sales

Yet, the final process of absorbing the overhead costs into unit and batch
costs aren’t
based on actual costs incurred during the course of the business.
Absorption costing
is based on a predetermined absorption rate, which is established from a
budget for a
forthcoming period.

This could be illustrated using the following example. Suppose that a

company makes
two products, A and B, each respectively taking 2 and 5 hours to make. If
the total
estimated overheads are $50,000 and the estimated labour hours would
be 100,000
hours, what would the absorption rate be?

Calculation Result
Absorption Rate 50/100 $0.5 per labour hour
Overhead absorbed per unit A 2 x 0.5 $1 per unit
Overhead absorbed per unit B 5 x 0.5 $2.50 per unit

The results obtained above mean that whatever the cost of producing one
unit of A or
B is, the overhead absorbed per unit should be added to it. Suppose
further that the
direct labour, materials and expenses are $12 per unit, and we produce
1000 units of
A and 2000 units of B during a the year. We have no opening stock, and no
closing
stock, we simply sold all the stock of A and B produced during the year for
$30 per
unit. What would the Profit and loss account look like?

Calculation $000 $000

Sales 3000 x 30 90000
Cost of Sales
Opening Stock 0
Closing Stock 0
Production Costs: Direct Overheads 12 x 3000 36000
Overheads ‘A’ 1 x 1000 1000
Overheads ‘B’ 2.5 x 2000 5000 (42000)
Gross Profit 48,000

In the previous example we assumed that a separate absorption rate is

used for each
product, and this could be similarly applied to other cost centers and cost
units.
However, the predetermined absorption rate may not always be
distinguishable for
each product. Sometimes, a blanket absorption rate is used, in which a
single
absorption rate is used throughout a factory and for all job units of output
irrespective
of the department in which they were produced.

The result of using a blanket absorption rate may drastically affect the
costing of
products and units or services manufactured or offered to customers. This
can be
illustrated by slightly modifying the previous example:

Previously we said that the overhead absorption rate of A is $1 per unit,

and $2.5 per
unit of B. These are separate valuations. Suppose now, that we
alternatively use a
blanket absorption rate, calculated as follows:
Total Overheads: 50,000
Total Labour Hours: 100,000
Absorption Rate: 50/100 = $0.50 per labour hour.
Total Units Produced = 3000
Taking 7 hours to make a unit of both A and B, thus Total Labour Hours is
21000,
(7*3000).
Production Overheads = 21*0.5 = $10, 500
Therefore:
Calculation $000 $000
Sales 3000 x 30 90000
Cost of Sales
Opening Stock 0
Closing Stock 0
Production Costs: Direct Overheads 12 x 3000 36000
Production Overheads 21000 x 0.5 10500 46500
Gross Profit 43,500

As you could easily see, the gross profit changed dramatically, from 48,000
to a mere
43,500.

Furthermore, one may still be confused as I have whilst trying to

understand why I
have divided 50/100 to calculate the absorption rater per labour hour, and
then
multiply that with the total labour hours taken to produce 3000 units, which
resulted
in a total cost of 10,500. Especially since we didn’t do that when we used
separate
absorption rate, because we calculated the absorption rate per unit at the
time.

I have done what I have done because I believe the costs associated with
producing
unit of ‘A’ are different to those taken producing unit of ‘B’, because each
takes a
different number of hours to produce. Therefore, it is essential to absorb
the costs
the way I have.

Another reason for the discrepancy may be due to what is known as

over/under
absorption. The problem is that normal costing (refer to the formula on the
first page!)
is based on overheads absorbed at a predetermined rate, which is based
on budgets
and estimates, rather than what is actually incurred. This would lead to
either one of
the following:
1. Over Absorption – overheads charged to the cost of sales are greater
than the
overheads actually incurred.
2. Under Absorption – insufficient overheads have been included in the
cost of
sales.

To solve this problem, an adjustment to reconcile the overheads charged

to the actual
overheads incurred is necessary, in which the under/over absorbed
overheads will be
written as an adjustment to the profit and loss account, at the end of the
accounting
period.

At the moment, the budget for the previous example says that the
production
overheads should be 46,500, but what if at the end of the year, we find that
the actual
costs incurred, weren’t 46,500 but only $30,000. This means that we over-
charged our
cost of sales by $16,500. This is referred to as over-absorption.

To correct this problem we simply add the bold line below to the cost of
sales
account:
Calculation $000 $000
Sales 3000 x 30 90000
Cost of Sales
Opening Stock 0
Closing Stock 0
Production Costs: Direct Overheads 12 x 3000 36000
Production Overheads 21000 x 0.5 10500
Under / Over absorption 46500 - 30000 (16500) 30000
Gross Profit 43,500

Remember over-absorption is due to overcharging the cost of sales, as

such; we have
to deduct it from the cost of sales, whereas under-absorption is the
opposite.