COSTING METHOD

CHAPTER 2

ACC466

LEARNING OBJECTIVES

• Able to understand the material control system (EOQ and stock levels) and material pricing (FIFO and WAM)
• Able to understand two remuneration schemes for labour.
• Able to understand overhead cost.
• Able to calculate overhead absorption rate using both methods, traditional and ABC method
• Able to explain the advantages and disadvantages of traditional and modern (ABC) approaches.

COSTING FOR MATERIAL

Material Control System

• Materials are supplies purchased from outside sources which are used to manufacture products for sale.
• Material control is a system that ensures the provision of materials at the required quantity, quality and time with the minimum capital investment.
• Material control is important because:
1. Material forms the largest cost of production, so success or failure may be influenced by efficient material purchasing, storage and utilization.
2. Without proper control excess stocks, obsolescence and deterioration of stocks are likely to occur.

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Objectives of Material Control System

1. To ensure proper standard and quality of materials purchased.
2. To ensure funds for material investment is properly utilized.
3. To ensure that supply of materials is available as and when they are needed.
4. To ensure proper utilization of materials in order to avoid any wastage.
5. To avoid over-stocking of materials.
6. To ensure proper storage of materials.

Material control system

• Economic Order Quantity (EOQ)
• An EOQ is an order quantity which minimizes the total of carrying costs and ordering costs.
• EOQ is used to determine how much material should be ordered and what quantity is the most economic to order.
• The EOQ can be determined by:
1. Tabulation method,
2. Graphical method, or
3. Formula method

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Stock Level

Reorder level: the amount at which new stock is ordered. 300 items are ordered and it takes two weeks lead time for ordered stock to arrive. There is always a buffer stock of 100 items held in case deliveries are held up or there is an unexpected large order.

Maximum stock level: the largest amount of items to be stored on site (500).

Minimum stock level: the lowest amount of items to be stored on site (100).

Stock Valuation

FIFO

WAM

COSTING FOR LABOUR

Methods of Remuneration

TIME BASED-SCHEME

• Wages paid on the basis of time spent at work.
• The rate is predetermined.

OUTPUT BASED-SCHEME

• Employees are paid based on output produced. Thus, workers have incentive to put more effort on work.

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TIME BASED-SCHEME

OUTPUT BASED-SCHEME

COSTING FOR OVERHEAD

COSTING FOR OVERHEAD (OH)/�INDIRECT COSTS

• Not easily and conveniently traceable to cost objects
• Cost element is shared among cost objects
• Physically impossible to trace
• Not cost effective to trace
• Eg. Supervisors and cashers’ salary, rental, depreciation.

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CLASSIFICATION OF OVERHEAD

• Production (factory) OH
• Costs incurred related to the production activities. Eg. depreciation of machine, factory rent, insurance of plant
• Administrative OH
• Costs incurred in the administration of the organization. Eg; clerical salary, depreciation of office equipment, audit fees
• Selling and distribution
• Costs involve in selling and delivering the products to customers the products/services. Eg; commission expense, advertising/marketing expense, salesman salary, fuel of delivery van
• Research and development
• Costs relate to any improvement or innovation of existing/new products. Eg: cost conducting a survey, laboratory cost

COST DEPARTMENTS IN OH

• Production department
• Department where the production activities are carried out
• For a company that manufactures computer production centers will be assembly department, finishing department, and etc.
• Service department
• Department which provides services to the production departments.
• Eg; canteen, maintenance department, store

COST ALLOCATION & �COST APPORTIONMENT

• Cost allocation and cost apportionment are the two procedures which describe the identification and allotment of costs to cost centers or cost units.

COST ALLOCATION

• Cost allocation occurs when overheads and expenses are charged directly to the cost centre.
• Allocation of overheads/expenses is more specific, and exact cost amounts can be charged directly to each cost centre.
• Eg; a special machine is only used in Department A. Thus depreciation on the machinery will be allocated to Department A. The exact value of the depreciation is RM 5,000

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COST APPORTIONMENT

• Cost apportionment occurs when a specific cost cannot be directly identified with one specific cost centre.
• Any cost that does not belong to one department and is shared by a number of departments will be divided among these departments using apportionment.
• Expenses such as rent, water and utilities can be fairly shared among departments by using a basis such as square feet per department space.

• Cost apportionment refers to the allotment of proportions of items of cost to cost centers or cost units.
• This happens when OHs are not possible to be allocated directly to a specific cost centre. The costs must be apportioned to the various cost centres on some equitable basis (basis of apportionment).
• These OHs are referred as command cost. Eg; rent, insurance and utility bills.

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METHODS OF OVERHEAD ALLOCATION/APPORTIONMENT

TRADITIONAL COSTING METHOD (TCM)

ACTIVITY-BASED COSTING METHOD (ABC)

TRADITIONAL COSTING METHOD

• Typically used one rate to allocate overhead to products.
• This rate was often based on direct labor hours or direct labor cost.
• This made sense, as direct labor was a major cost driver in early manufacturing plants.

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TRADITIONAL COSTING METHOD

• STEPS
1. Calculate Overhead absorption rate (OAR), by dividing total budgeted production OH with total budgeted basis

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• Calculate production OH by multiplying OAR with the basis for the particular product.

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OAR = Total budgeted production OH

Total budgeted basis

Production OH = OAR x basis for the product

• 3. Calculate production cost.

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Direct material RM XX

Direct Labor RM XX

Production OH RM XX

PRODUCTION COST RM XX

ACTIVITY BASED COSTING (ABC)

• ABC is a process of identifying the costs of all activities and allocating, applying, assigning or tracing costs to product.
• The assumption of this method is that products cause activities, activities cause costs and therefore activity is related to product cost.
• This type of costing/ technique is highly debated to be used in determining OH as traditional costing is perceived is inadequate and unsophisticated to charge OH.

STAGES IN ABC

1. Identify the major activities that take place in an organization
2. Determining the cost driver to each major activity
3. Compute OH/ cost driver rate by dividing activities with cost driver
4. Assigning the cost of activities to products according to the product’s demand for activities

Production OH: A

Inspection = RM 2500 X 50

= RM 125,000

Assembly = RM 100 X 600

= RM 60,000

Mat.handling = RM 200 X 100

= RM 20,000

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Production OH: B

Inspection = RM 2500 X 20

= RM 50,000

Assembly = RM 100 X 300

= RM 30,000

Mat.handling = RM 200 X 250

= RM 50,000

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Production OH: C

Inspection = RM 2500 X 30

= RM 75,000

Assembly = RM 100 X 700

= RM 70,000

Mat.handling = RM 200 X 150

= RM 30,000

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Production OH:

A = RM 250,000

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B = RM 130,000

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C = RM 175,000

RM 510,000

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Assume that the volume of each product are as follows:

A = 48,000

B = 35,000

C = 17,000

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Thus, production OH cost per unit for each product is:

A = RM 205,000 / 48000 = RM 4.27

B = RM 130,000 / 35,000 = RM 3.71

C = RM 175,000 / 17,000 = RM 10.29

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TRADITIONAL VS ABC

TRADITIONAL

ABC

TRADITIONAL

• Advantage
• Easy to implement- just need a space and a good filing system
• Disadvantage
• Not as accurate as ABC systems-this system results in significant under-costing and over-costing when costs of performing all of the diverse activities will be contained in one cost pool and will be divided by single basis.
• Outdated costing system in many companies because manufacturing companies now use machines and computers for much of their production, instead of labour.
• lead to bad management decisions because it excludes certain nonmanufacturing costs.

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ABC

• Advantages
• Applies multiple cost drivers to ascertain a more reliable product cost
• Provides an opportunity to trace the costs to the activities that cause the costs.
• This method eliminates allocating irrelevant costs to a product.
• include an easy interpretation of cost for internal management, the ability to enable benchmarking and a greater understanding of overhead costs. 
• Criticism
• Difficult to determine the most appropriate cost driver
• Implementation involves high expertise and high costs
• Uses large amount of historic data and may restrict future decision

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COST STATEMENT

• Cost statement refers to a report showing the various cost involved in producing, manufacturing or providing goods or services.
• Generally, a cost statement consists of prime cost (direct material, direct labour and direct expenses), production overhead or indirect cost and non production/manufacturing cost.
• However, the presentation of cost statement is different according to the nature of business or operations.
• Cost statement prepared by servicing companies is different compared to cost statement prepared by manufacturing companies or retailing companies.

Illustration of Cost Statement