Dr.

Zulfiqar
Shah

Warwick Business
School
 Learning Objectives
After this lecture, the associated readings and seminar
work you should be able to understand:

Why we need to calculate product costs?

How is full cost arrived at?
Describe the building block concept of costing
systems
Distinguish between job costing and process
costing
Distinguish between cause-and-effect and
arbitrary allocations
Calculate and explain Under- and Over
recovery of overheads
Distinguish between direct allocation, step-down and
reciprocal methods of allocating support costs
Produce profit statements in Marginal and Absorption
costing formats and reconcile the difference in profits
Warwick Business
School
Suggested Reading:
Drury, C., (2016), Management Accounting for Business, (6th
edition), Cengage Learning, Hampshire. Chapter 7

Go through EQL UMA 1,2 (Web Link available on the

module web site)

Other Useful Readings:

Drury, C., (2015) Management and Cost Accounting, (9th edition),
Cengage Learning, Hampshire. Chapters 3, 4, 7

Bhimani, A, Horngren, C.T., Datar, S.M., and Rajan, M., (2015),

Management and Cost Accounting, 6/E, Pearson. Chapters 3, 5, 7

Warwick Business
School
 Why Does Your Cappuccino Cost
Such a Lot?

Profit 8p
VAT 35 P
Other ingredients/pack 10 p
Head office 16 p
General operational costs 33 p

Rent and rates 50 p

Staff 41 p
Coffee 6 p

Cost of drink
1.99
Warwick Business
School
 Why Do We Need Product
Costs?
1. 3.
Stock Product Mix
Valuatio Decisions
n
2. 4.
Pricing Cost
Decisions Control

How do we arrive at
full cost for a
Warwick Business School
Determination of Unit
M
Manufacturing Cost
P
R
A
DIRECT MATERIALS I
N
DIRECT LABOUR
M
E
T
U
C
DIRECT EXPENSES
O
F O
S A

T C T
INDIRECT T
EXPENSES
(FACTORY U
A
OVERHEADS)
R
SELLING AND I L
ADMINISTRATION COSTS
N
Warwick Business C
School
Job Costing and
Process
There are twoCosting
basic systems used to
assign costs to products or services:

Job order costing, and

Process costing.
It is also possible to have a hybrid method

In a job-costing system, the cost object is an

individual unit, batch or lot of a distinct
product or service called a job.
In process costing, the cost object is masses of
identical or similar units or a product or
service.
Process costing allocates costs among all
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School
General approach to job
costing
The following six-step approach is used to assign
actual costs to individual jobs:
1. Identify the chosen cost object(s).
2. Identify the direct costs of the job.
3. Select the cost-allocation base(s).
4. Identify the indirect costs associated with each
cost-allocation base.
5. Compute the rate per unit of each cost-allocation
base used to allocate indirect costs to the job.
6. Compute the cost of the job by adding all direct
and indirect costs assigned to it.

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Costing a Widget:
Illustration
Direct Costs:
Direct materials
Direct labour
Direct expenses
Prime Cost
Factory
Overheads:
Welding
Machining
Assembly
Total factory
overheads
Manufacturin
g cost
Selling
and admin
Warwick Business
School
 Standard Cost Card: Direct Cost of one
Unit
Direct of Widget
Materials:
1kg wood @1.50 per kg 1.50
1.5kg steel plate at 5.00 per kg 7.50
1 brush (bought out) 2.00
11.00
Direct Labour:
Welding* 0.5 hours at 5.00 /hour 2.50
Machinin 0.5 hours at 8.60 /hour 4.30
g*
Assembly 2.0 hours at 5.50 /hour 11.00
*
17.80
Royalties at 1.70 per 1.7
Direct
widget expenses: 0
Prime Cost of one unit 30.50
of Widget
Notes:
* Time spent on automatic welders = 1
hour
* Time
Warwick Businessspend
School on machining cell = 1.5 hours
 Costing a Unit of
Widget
Direct Costs:
Direct 11.00
materials 17.80
Direct
1.70
labour
Direct
30.50
expenses
Prime Cost
Factory
Overheads:
?
Welding
Machini
ng
Assembl
y
Total
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School
 Three Cost Assignment
MethodsCost of Resources

Direct Costs Indirect Costs

Direct Driver Arbitrary

Tracin Tracin Allocation
g g

Physical Causal Assumed

Observation Relationship Relationship

Cost Objects

(Drury, 2013)
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 Identifying Cost Centers

Organisations distinguish between

operating departments and
support departments.

An operating department (a production

department in manufacturing companies)
adds value to a product or service.
(e.g., Welding shop, Machining centre, Assembly
department)

A support department (service

department) provides the services that
assist other operating and support
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 TWO-STAGE PROCESS
Factory Overheads
D
i
Productionr Service
cost e centre
Direct centres c costs
Tracin t Re-allocate
g c
Absorption
o
s
Manufacturing Cost
t
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School
 Basis of
Apportionment
What is the most appropriate basis of
apportionment for the following overheads?
Floor
Factory Rent and
Rates area
Depreciation of
Buildings
Floor
Production area
Supervisors No. of
Salary
Employees
Electricity
Stores Costs Power
Maintenance rating No. of
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 Apportionment
Example
Apportion Rent and Rates of 150,000
among the following six cost centres on
the basis of floor area.
Cost Floor
Centre Area
Welding 5,00
Machining 0
Assembly 10,0
Canteen 00
Maintenanc 8,00
e Stores 0
150,000
Total rent & 1,00
150,000
Total
rates foor 0
30,000
=
area 4,00
0 5
= Rent = 2,00
& Rates per
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School 0
 Absorption
The charging of total cost centre overheads to cost units by
means of rates separately calculated for each cost centre.

Overhead Absorption Rate (OAR)

= Total cost centre overheads
Total units of absorption base

Absorption base should reflect the burden the product puts

on factory overheads.
Alternative bases include:
Units of production Machine hours
Direct labour hours Materials cost
Direct wage cost Prime cost
Two-Stage Allocation Process:
Illustration
Step 1 Assigning all manufacturing overheads to the production and
service cost centres
(Note: the expenditure on indirect materials and indirect labour has already
been allocated to cost centres on the overhead analysis sheet on the following
slides. Although these items cannot be directly assigned to products they can
be directly assigned to the cost centres. In other words they are indirect
costs when products are the cost objects and direct costs when cost centres
are the cost object).

Step 2 Reallocating the costs assigned to service cost centres to

production cost centres
Step 3 Computing separate overhead rates for each production cost
centre by dividing the total costs of each production cost centre by
an absorption base which measures the activity in that cost centre.
Step 4 Assigning cost centre overheads to products or other chosen
cost objects
(Note: Steps 1 and 2 comprise Stage One, and Steps 3 and 4 relate to
the Second Stage of the Two Stage Allocation process).
 EXAMPLE: Wyco Wigets
andLimited
Wyco Wigets (WW) has manufactured and sold wigets for many years
nowadays has several other products in its portfolio.
To arrive at the selling price for wigets, WW wishes to add a mark-up of 25% to
total cost (including an appropriate share of selling and admin costs). The prime
cost of each wiget is 30.50 (see standard cost card), manufacturing overheads
total 451,000 and are to be traced to products using a two-stage apportionment
and absorption procedure with separate overhead absorption rates for each of the
three production cost centres. Selling and administrative expenses of 115,000 are
to be absorbed into product costs on the basis of total manufacturing costs which
are budgeted to be 1,150,000.
Full details of overhead costs and apportionment bases are given in the
overhead analysis sheet (below) which it is your task to complete.
1. Complete the overhead analysis sheet and calculate the overhead cost of
each wiget (following steps 1 to 4 above).
2. Calculate the Overhead Absorption Rate (OAR) for selling and
administrative expenses and complete the calculation of the full cost of
a wiget.
3. Calculate the appropriate price using a 25% mark-up on full cost.
4. State what profit margin on sales this will generate.
 EXAMPLE: Wyco
Wigets Limited
OverheadWeldin
Absorption Rate Supporting
Machinin Assemb Data:
Cante Maintenan Store Total
g g ly en ce

Floor Area 5,000 10,000 8,000 1,000 4,000 2,000 30,000

No of Emp. 6 12 14 3 8 2 45

Repair Hrs. 200 1500 400 --- --- 200 2,300

Requisition 500 2,500 2,000 --- 500 --- 5,500

s
Labour Hrs. 14,000 20,000 40,000 --- --- --- 74,000

Machine 27,000 38,000 5,000 --- --- --- 70,000

Hrs
 Total
Manufacturing 0
Overhead eet Overheads of
45100 are as
Allocation and apportionment of overheads to costfollows:
centres:
Analysis Sh
(in 000s) WELD M/C ASSY CAN MAINT STORE TOT
T AL
Indirect Mats 10 19 35 1 7 1 73
8
Indirect Lab 23 36 50 4 20 5 13
0
Rents & Rates 25 50 40 5 20 10 150
Works Mgmt 12 24 28 6 16 4 9
Sub-Totals 70 129 153 16 63 20 4 5
150,000 1
Apportion of Rent & Rates at: = 5/Sq.metre
30,000
90,000
Apportionment of Works Management: = 2,000/Emp
45
Supporting Data (from previous slide):
Floor Area 5,000 10,000 8,000 1,000 4,000 2,000 30,000
No. Employed 6 12 14 3 8 2 45
 Overhead Analysis Sheet
(continued)
Reapportionment of service centre costs*
(in 000s) WELD M/C ASSY CANT MAINT STORE TOTA
L
Sub-Total 70 129 153 16 63 20 451
Canteen 3 6 7 -16 0 0 0
Maintenance 6 45 12 -63
Stores 2 10 8 -20
TOTALS 190 180 0 0 0
81Re-apportionment Canteen:
Reapportion maintenance:
Based on No. of Emp. 451
Based on Repairs Hours
Reapportion stores:

Supporting Data: Based on Requisitions

No. Employed 6 12 14 3 8 2 45
Repair Hours 200 1,500 400 - - 200 2,300
Requisitions 500 2,500 2,000 - 500 - 5,500
* Reapportionment of service cost centre overheads to production cost
centres are made using the direct method (i.e. ignoring interdependent
 Note:
Calculating the OARs Assembly is labour intensive
So appropriate base to use
is Labour hour

Weldin Machining Assembly

g
Total Overheads (000s) 81 190 180
Absorption base (000s)
27 38 40
OAR (s)
3 5 4.50
Per Per Per
welding machine labour
machine hour hour hour
Supporting Data:
Labour Hours 14,000 20,000 40,000
Machine Hours 27,000 38,000 5,000
 Costing a Wiget -
Overheads
Direct Costs:
Direct 11.00
materials 17.80
Direct 1.70
labour 30.50
Direct
expenses
1 hour x 3.00 3.00
Prime Cost 1.5 hours x 5.00 7.50
Factory 2 hours x 4.50 9.00
Overheads:

TotalWelding
factory 19.50
overheads
Machini
Manufacturing 50.00
ng
cost Selling
Assembl ?
Totaland
y admin
 Non-Manufacturing

Overheads
Treated as a period costs for external
reporting
Need to be absorbed to get full
product cost
But is there a fair absorption base?
May be absorbed on ability to bear
basis
Common to use a fairly arbitrary base

E.g.OAR for non-manufacturing

overheads
= = 10%
115,000
= Total Non-Manufacturing
X Manufacturing Cost
Overheads 1,150,0
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School
 Completing the
Costings
Prime Cost
30.50
Factory 19.50
Overheads 10% of
50.00
Mfg. cost
Manufacturing 5.00
cost Selling
55.
and admin
00
Total cost
13.
Mark up of 25% = (55
75
x 0.25) Cost plus price
What is the profit margin on 68.
sales?
Warwick Business
75
School
Budgeted Indirect Costs and End of
Period Adjustments
Budgeted indirect-cost rates can be
assigned to individual jobs on an
ongoing and timely basis.

However, budgeted rates are based on

estimates made up to 12 months before
actual costs are incurred.

Adjustments may need to be made by year

end.

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Under and Over-Absorption of
Overhead Costs (under-absorbed) indirect
Under-allocated
costs occur when the allocated amount of
indirect costs in an accounting period is less
than the actual amount incurred.

Over-allocated (over-absorbed) indirect

costs occur when the allocated amount of
indirect costs is greater than the actual
amount incurred.

Under- or over-allocated indirect costs =

Indirect costs incurred Indirect costs

allocated.
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Over and Under-Absorption of
Predetermined
Overhead CostsOverhead
Absorption Rate (OAR):
Budgeted factory overhead
OAR = amount for the year
Expected level of cost
driver for the year
direct labour hours, machine hours etc.

Overhead applied = Actual activity

OAR
Based on estimates, and Actual amount of the allocation
determined before the period base, such as direct labor hours,
begins incurred during the period
Leads to either Over- or Under-absorption of overheads. For two reasons:

Actual overhead expenditure not as budgeted

Actual activity levels not as budgeted
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 Under- and Over-
Absorption
Budgeted Assembly 180,000
T1 Overheads Budgeted
Assembly Hours 40,000
T2 Actual Assembly 38,000
Hours
190,000
T3 Actual Assembly
Overheads
1.
180,000
Calculate the OAR.
= 4.50 per
40,000 hour
2. What overheads would be absorbed?
OAR x Actual 171,000
machine
Compare tohours =
actual overheads of 190,000

= Under-absorbed by 19,000
3. What is the under or over absorption?
Warwick Business Why?
School
 Departmental Allocations
Three methods are widely used to allocate
the costs of
support departments to operating
departments:

Direct method: Allocates support

department costs to operating
departments only.

Step-down (sequential allocation)

method: Allocates support department
costs to other support departments and to
operating departments.
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 Absorption and Marginal Costing:
Classifying Costs
Marginal Absorption

Direct Material
Product
Direct Labour
Cost Product
Variable O/H
Cost
Fixed Mfg. Period
O/H Cost
S&A O/H Period
(Fixed+Var.
Warwick Business School Cost
 Example: AC and MC
Cheeky Limited commenced business on 1 March,
2010 making one product only, the cost of which is
as follows:
Direct Labour
5
Direct Material 8
Variable Production Overhead 2
Fixed Production Overhead 5
Allocated
Standard Production Cost 2
The fixed production overhead figure has been 0 calculated on
the basis of a budgeted normal output of 36,000 units per
annum.
Monthly production is budgeted to be 3,000 units per month.
March and April are to be taken as equal period months.
Selling, distribution and administration expenses are:
Fixed 120,000 per annum. These are to be treated as Period
 Example: AC and MC
The selling price per unit is 35 and the number of
units produced and sold was:
March April
Units Units
Productio 2,000 3,200
n
Sales
Required: 1,500 3,400
a) Prepare profit statements for each of the months of
March and April using:
(i)Marginal Costing; and
(ii)Absorption Costing (showing any
under-absorption or over- absorption of
fixed costs).
b) Present a reconciliation of the profit or loss figure for
each
Warwick month given in your answers to (a) (i) and (a)
Business
School
Marginal Costing
Example: AC
March and MC
Sales: (1500 units x 52,5
VC of 35) (2,000 30,0 00
production units x 15) 00 22,5
Closing stock (500 units x (7,50 00
15) 0) 30,0
Contribution
Less: Monthly fixed costs Monthly fixed cost
00
Production: (36,000 units x 5 15,00
12) Selling + Distribution Cost 0 25000
(120,000 12) 10,00
0
Profit
5,00
Absorption Costing March 52,5
0
Cost
Sales:of (2,000 units x 40,00 00
production: 20) (500 0 30,00
Closing stock units x 20) (10,00 0
GrossSelling
Less profit & Distribution Cost 0) 22,50
(120,000 12) Profit 0
Underabsorbed fixed costs: (1,000 10,00
units x 5) 0
 Example: AC and MC
Marginal Costing April

Sales: 119,000
VC of
production: 7,50
Opening 0
Stock 48,00
Production 0
Less: Closing 51,000
Stock 55,50
0
Contribution 68,000
(4,50
Less: Fixed costs (as calculated
0) 25,000
for March) Profit 43,000
Warwick Business
School
 Example: AC and MC
Absorption Costing April
Sales 119,00
0

Opening Stock 10,000

Production 64,000
74,000
Less: Closing Stock (6,000) 68,000

51,000
Less: Selling and Distribution 10,000
Costs

41,000
Profi 42,000
Overabsorbed
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t Fixed costs 1,000
School
 Example: AC and MC
Reconcilia
tion
Absorption
Period 1 cost 7,50
profit: Remove 0
fixed costs: ---
Add Fixed costs in (500 x 2,50
opening stock: 5) 0
Less Fixed costs in 5,00
Period
closing stock: 2 Marginal 0
Absorption
cost profit cost profit 42,0
Add Fixed costs in op, 2,50 00
stock: Less Fixed costs in 0 1,00
closing stock: 1,50 0
Marginal cost profit 0 43,0
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 Comparison of MC and
AC
MC AC
Simple Recognises
No arbitrary importance of fixed
apportionme costs
nts Inclusion of fixed
Avoids costs necessary
over/under where stock is
absorption building up
Logical to write fixed More accurate cost
costs off as occur plus pricing
Closer to cash Complies with
flow position
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IAS2 for external
School
 Product Costing in
Services
Many services have high
proportion of overheads.

Different service types have

different cost structures.

Full costs or marginal costing

approach?

Consider costs v benefits!

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School
 What the Researchers
have
Drury found?
and Tayles (1994)
A flexible approach in using product costs
Questionable overhead allocations

Abdel-Kader and Luther (2006) (on Food and Drink

Industry)
Use of plant-wide rate or departmental or
multiple plant- wide rate: 50% suggest not
important and never use that
Overhead allocation is important but not worth
implementing frequently

Dugdale an etusedal. (2005)

d
Old methods have not died: they are still taught,
Warwick Business
School
Suggested Reading:
Drury, C., (2016), Management Accounting for Business, (6th
edition), Cengage Learning, Hampshire. Chapter 7

Go through EQL UMA 1,2 (Web Link available on the

module web site)

Other Useful Readings:

Drury, C., (2015) Management and Cost Accounting, (9th edition),
Cengage Learning, Hampshire. Chapters 3, 4, 7

Bhimani, A, Horngren, C.T., Datar, S.M., and Rajan, M., (2015),

Management and Cost Accounting, 6/E, Pearson. Chapters 3, 5, 7

Warwick Business
School