Costing. CIPFA International Certificate in Public Financial Management. Management Accounting. Workbook 4 \ CIPFA EDUCATION AND TRAINING CENTRE

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1 \ CIPFA EDUCATION AND TRAINING CENTRE CIPFA International Certificate in Public Financial Management Management Accounting Costing Workbook 4 (Copyright)

2 Contents Topic Page 4.1 Costing methods Job and service costing Absorption, marginal and activity based costing Standard costing 10 Additional exercise Absorption costing Absorption costing introduction Service departments Overhead absorption rates (OARs) Under/over absorption Service level agreements 41 Additional exercises Activity based costing (ABC) Study focus Activity based costing introduction ABC process Absorption costing vs. ABC 55 Additional exercises Marginal costing and absorption costing Marginal costing introduction Differences between absorption and marginal costing Introduction to costing statements Profit comparisons When to use each method 92 Additional exercises Cost volume profit analysis (CVP) Introduction to cost volume profit analysis (CVP) Cost behaviour assumptions CVP - mathematical model CVP - graphical analysis CVP - assumptions and limitations Two CVP models 115 Additional exercises 121 Costing 2

3 Costing 4.1 Costing methods Learning objectives Explain various costing methods: o Job costing o Service costing o Absorption costing o Marginal costing o Activity based costing o Standard costing Costing 3

4 4.1.1 Job and service costing Costing is all about establishing the cost of producing a product or service delivery therefore costing methods used within an organisation must reflect the type of output that is produced by the organisation. Job costing and service costing both require costs to be established by measuring the resources consumed in delivering the output and recording the cost of those resources. Job costing Job costing is establishing how much it will cost to deliver the requirements of a customer. For example Bob s tables is approached by a school and asked to quote a price for delivering 150 tables that all have the school s logo on them. The starting point for assessing the price that should be charged is to assess how much it will cost to produce the tables. This is job costing. Establishing the cost of specific jobs for specific clients. Service costing Service costing is very similar to job costing. Service costing is when the final output is intangible. For example a local council may provide visits to the elderly to help them with tasks around the home. There is still a requirement to understand the cost of providing this service by measuring the resources used and consumed however there isn t an actual product as with the tables in the example of job costing. The main difference with service costing is that the resources consumed in delivering a service are more likely to be staff costs. Unlike the tables where the majority of the costs are likely to be the materials used in making the tables. Service costing tends to be more difficult. As the output is intangible it can be difficult to measure how much of a particular service is going to be received. The resources consumed are also harder to measure because they tend to be intangible also. There are two types of service costing: services provided by a company operating in a service industry such as the delivery of public sector services to the public. Costing 4

5 services provided by a company s service departments, that is those departments that support the production and delivery of the organisation s outputs but aren t directly involved in that production or delivery. For example finance, human resources and administration departments allow Bob s tables to function but are not actually involved in the building or distribution of tables. We will return to the idea of service departments that support production and delivery when we look at absorption costing later in this workbook. Costing 5

6 4.1.2 Absorption, marginal and activity based costing There are various ways of establishing the cost of the products or services that make up an organisation s outputs. We are going to look at each in more detail later in this workbook. The aim of this section is to introduce the key concepts. Absorption costing Absorption costing is the method of establishing the full cost of products or services, that is to include all costs, fixed and variable, within the cost of each unit produced. Exercise Requirement State the reasons why establishing full cost is important. Costing 6

7 Cost units Organisations require cost information for particular units of each product or service provided. The cost unit chosen is that which is most relevant to the circumstances of the organisation. For example: - a hospital s cost unit may be a patient day, or a consultant episode - a school s cost unit may be a student hour - a manufacturing firm s cost unit may be a particular job, contract, or product. Cost centres When a costing system is designed, it is important to divide the business into various cost centres so that costs can be accumulated for each cost centre. A cost centre can be a location or department (e.g. machine shop, canteen, hospital ward) or sometimes a person (e.g. managing director) or perhaps function (e.g. sales). For each cost centre, the costs relevant to it are collected, as discussed later. International Accounting Standard (IAS) 2 One of the key reasons for absorbing overheads is given in IAS 2, Inventories. Inventories shall be measured at the lower of cost and net realisable value. Net realisable value is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale. The cost of inventories shall comprise all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition. The cost of inventories shall be assigned by using the first-in, first-out (FIFO) or weighted average cost formula. All accounts subject to IAS 2 must use absorption costing to ensure all costs are included for inventory valuation and therefore profit reporting purposes. Costing 7

8 Marginal costing Marginal costing does not include the full cost of products and services with the cost of individual units as absorption costing does. Rather marginal costing only recognises those costs that are variable in relation to the number of units produced within the cost of individual units. Under marginal costing fixed costs are not treated as part of the cost of producing output because they aren t generated from producing the units. An example would be rent. The rent is required in order for the organisation to have a building and be able to function. However, rent is paid for the month and not paid as individual units of a product or service are produced/delivered. This method of costing is useful for short term decision making scenarios and for cost volume profit analysis. Both of these will be studied in more detail later on. Costing 8

9 Activity based costing Activity based costing (ABC) is a form of absorption costing. The aim is to establish the full cost of any outputs however activity based costing is a more sophisticated method of achieving this than traditional absorption costing. In ABC, budgets are set for activities instead of functional departments. The drivers, that is the causes of the costs, are also examined. This then leads to activity based budgets as seen in workbook 2. Acitivities will include those involved in both direct delivery of the products/services and the indirect support services. Products/service costs will include the cost of all of the activities involved in the delivery of the final output and hence is a measure of full cost. We will see this in more detail below. Benefits of ABC Budgets are based on cost drivers, the actual causes of the costs and therefore should be more accurate and have a greater focus on overhead and support costs. Problems with ABC It can be time consuming and costly to set up. There is also a requirement for a culture change in organisations to focus on support services and to produce timesheets. Costing 9

10 4.1.3 Standard costing Standard costing is a tool for budgetary control. Standard costing is a technique that evolved from the manufacturing sector. It is based upon the premise that when the same product or service is produced consistently, then standards can be set in relation to that product or service. Ultimately a review is made of the actual costs incurred and incomes earned in order to compare with the standards set. Definition A cost control system in which the standard costs of a product or service is compared with the actual cost and variances ascertained and examined, i.e.: what it should cost vs. what it did cost Exercise Requirement List the four steps required in a control system Costing 10

11 Types of standard cost Standards are set for inputs such as material, labour and overheads, as well as incomes. The setting of standards should not be taken lightly, as poor standards will result in large variances between expected and actual results. It is sometimes said that there are four types of standard (cost): Basic Standard The original specification, the first standard produced, the yardstick/benchmark against which later/updated standards can be compared. Ideal Standard An ideal standard assumes 100% efficiency 100% of the time and does not allow for all aspects of the production process, e.g. unavoidable delays or waste materials as a result of the process. Attainable Standard What should happen under normal operating conditions allowing for unavoidable in-efficiencies. Current Standard An attainable standard that has been updated for any changes during the period (this is usually price changes.) Which standard? The standard that should be used is often referred to as currently attainable. That is it allows for unavoidable inefficiencies and is also up to date. Care must be taken when allowing for inefficiencies in the standard. One of the key purposes of having budgets or standards is motivation. A standard that is set too high and is unattainable will not generate motivation to try and achieve it because it s impossible. A standard that is too easy to achieve also will not generate motivation to become more efficient. Therefore the standard set needs to be challenging but not impossible to achieve. Costing 11

12 Drawbacks of Ideal Standards Because they assume optimum efficiency, ideal standards may lack credibility, as it is possible to take the view that optimum efficiency is simply not attainable in reality. And, if the standards lack credibility, then so will any budget which is constructed from them. A 1993 survey by Drury et al. indicated that only 4 per cent of the respondent UK manufacturing companies used standards based on maximum efficiency, the remainder employing either currently attainable standards or standards derived from past performance. However, the impact of total quality management, with its get it right first time all of the time approach, coupled with organisations desire to achieve world-class status, may mean that ideal standards will be more widely used in future. If, for example, current expectation is that performance will be, say, 75 percent of ideal, then an actual which betters this could indicate a move towards improved quality (although quality might also suffer in a push to exceed standard). Conversely, standards with an inbuilt allowance for waste imply that such waste is acceptable and improvement is not necessary, which could possibly become a selfperpetuating misconception. Costing 12

13 Advantages and problems Standard costing advantages The formality of a standard costing system will vary from organisation to organisation. There are considerable differences between manufacturing and service organisations. For tactical budgets to be effective, some degree of estimation at cost unit (i.e. operational) level is necessary, and can offer a number of advantages: accuracy of budgets is improved cost consciousness is instilled methods may be improved permits detailed control analysis provides a better costing and pricing basis than actual costs. Standard costing problems Despite the advantages, standard costing may also present some difficulties in operation: Setting an acceptable standard Where direct labour is a significant element in the output process, setting an appropriate standard for efficiency is important. Not too easily achieved but certainly attainable with effort. How do you measure unavoidable inefficiency? Inapplicability to varied output Standard costing is well suited to situations where output procedures consist of repetitive processes and where the output itself is fairly standardised. If the output is not standard then there can not be a single standard cost. Incorporating inflation Even where inflation rates are low, this may still be troublesome as it is a subjective estimate that if incorrect will create variances. Frequent changes in pay and/or prices will require standards to be updated. Cost Standard costing systems can be costly to introduce and maintain Overemphasise operations There may be a danger that development of workable standards may overshadow the link between operational, tactical and strategic factors, or even entirely mask the need for strategic planning. Costing 13

14 How does standard costing operate? Standard costing uses a concept called variance analysis. As the name implies, variance analysis looks at variances between standard and actual costs, that is, between what it should have cost and what it actually cost. Variance analysis will act as a means of focusing management attention on operations but especially on those areas (the biggest variances) which merit attention first (Remember exception reporting mentioned earlier.) Standard costing and variance analysis are focused towards the private sector. The main headings for variance analysis are: materials labour variable overheads fixed overheads sales. Manufacturing organisations would hold a standard cost card, (usually computerised,) for each product in their portfolio and will use it to monitor costs and levels of stock. It contains details on each of the resources consumed in production, in both amounts and cost. The following is an example of a standard cost card for a product called a stub joint. It shows that the standard cost of a stub joint is in other words it should cost precisely that to make one. The amount of detail at the top gives an idea of the time/trouble/effort used to derive the standard cost, (work study has been involved measuring and timing production, revisions are made and signed off when required.). Certainly more than a guess is the impression given. There is also a detailed breakdown of costs/amounts/timings/pay rates etc split between the different departments involved in the production of stub joints. Variance analysis will match actuals against these details and be able to pinpoint areas where things are not going according to plan. Costing 14

15 Standard Cost Card Example PART NO: X291 DESCRIPTION: Stub Joint TOOL REF: T5983 WORK STUDY REF: WS255 DRAWING NO: D59215 REVISION DATE: Cost Type and Quantity Direct Materials 2.5kg P units A359 Standard Price or Rate kg 3.75/100 REVISED BY Dept 7 Dept 19 Dept 15 Total Direct Labour Machine Operation Grade hrs 9.2 hrs Assembly Grade hrs 2.50 hr 2.50 hr 1.75 hr Production Overhead Machine hour rate Labour hour rate 11 hr 6 hr Standard Cost Summary DIRECT MATERIALS DIRECT LABOUR PRODUCTION OVERHEADS STANDARD COST Costing 15

16 Standard vs budget In the section on flexible budgeting we looked at how budgets needed to be flexible in order to allow a meaningful comparison of performance. As standard costing is comparing budgeted and actual costs we need to bear in mind the need to be flexible with the budgets so as to ensure that any volume variances are kept separate and to allow the variances between the flexed budget and the actual costs to be established. In standard costing the flexed budget is called the standard and the original budget remains the budget, for example: A Ltd has a budget for April to make 1,000 units of its product each using 3kgs of materials at a cost of 2.50 per kilo At the end of April 1,200 units had actually been produced. The materials budget is : 1,000 x 3kgs x 2.50 = 7,500 However, the standard cost for materials to be compared to the actual costs needs to reflect the actual level of activity and so the standard cost of materials would be 1,200 x 3kgs x 2.50 = 9,000 It should have taken 3kgs of materials per unit and these should have cost 2.50 per kilo but what was actually produced was 1,200 units. Standard costs based on the standard amount of resources per unit but on the actual number of units. Other estimates Similar estimates will be prepared for direct labour of standard hours (labour hours per unit of output) and standard rate (labour rate per hour). Predetermined overhead absorption rates will be developed allowing a standard overhead cost per unit to be calculated. In addition to estimating the input resources necessary per unit of output, a standard selling price will be set and standard profit (or standard contribution) per unit determined. The detailed estimates which support standard costs (eg of materials usage or labour time per unit) often require considerable expertise to produce. Direct materials requirements, for example, may result from engineering analysis of inputs and outputs and a work study" as in example above. Costing 16

17 Standard costing is then the process of comparing the standard costs with the actual costs to identify any areas where differences have occurred. In general, there are two reasons why actual and standard material costs might differ. Actual and standard material cost may differ because either or both of the purchase cost and/or usage differ. It is important to note that variances (regardless of their level of detail) are merely indicative of possible problem areas, but without further investigation do not constitute conclusive evidence of personal responsibility or of anything else. Also, a budget system which is used (or thought to be used) as some form of managerial witch-hunt is unlikely to find much support amongst managers, and, as a consequence, is unlikely to work particularly well. Let us consider an example where the flexed budget/actual comparison reveals variances such as: Materials cost variance = 5000 Adverse, (A) This undoubtedly indicates that actual spending on materials was 5,000 higher than the budget based on an identical output volume, but does it tell us anything about what aspect of material cost may be causing problems, or about where, within a responsibility accounting system, the locus of managerial responsibility might lie? Suppose that, within a responsibility accounting system, purchase of materials is the responsibility of the Chief Buyer whereas usage is the responsibility of, say, the Operations Manager the subdivision of this Materials Cost variance into price and usage elements may help decide to whom the respective variances should be reported. This is not the same as suggesting that the Chief Buyer and Operations Manager are responsible, respectively, for the price and usage elements of the budget variance. This is an important point. Variances, without further investigation, do not constitute conclusive evidence of personal responsibility or of anything else. What we are suggesting is that reporting detailed variances may help identify the individual who is in the best position to investigate and perhaps to suggest or initiate corrective action. Costing 17

18 Standard costing in public services Standard costing developed in the manufacturing sector because of the tangible nature of the industry making an identical (standard) product in high volumes. Can standard costing be applied to public services and if so, how? Exercise Requirement (a) List the problems there may be when trying to operate a standard costing system for a public service. Costing 18

19 Standard costing in service industries Unlike manufacturing organisations, detailed standard costing will therefore not always be possible at the cost unit level. Some of the issues are discussed here. Meaningful standards A bank could not meaningfully prepare a standard cost card for each personal current account in any great degree of detail. At best, standard costing can be only partially implemented. We may, for example, have a standard salary scale for employees at the bank s branches and, based on our expectations about the future volume of business, estimate the number of employees of each grade required during the budget period (along with the related cost). What we cannot readily do, however, is say that each current account in operation during the year requires a given number of staff hours to service. Defining the cost unit Definition of the cost unit may be problematic a composite cost unit, such as passenger/kilometre, may be necessary, or there may be some doubt about the most appropriate cost unit to use (eg number of personal bank clients versus number of personal accounts of each different category). Nature of service We should stress that it is the nature of the service provided, along with our understanding of its inputs, outputs and processes, which governs the extent to which we can employ standard costing. A landscape gardener may be well aware of the standard input times, quantities and costs for a particular job, but a firm of solicitors might find this less easy. Once it is established that standard costing is suitable for the service in question the process of calculating the variances is exactly the same and so in terms of exam questions there is no distinction between public and private sector settings. Costing 19

20 Summary In this session we have been introduced to various costing methods that can be used for setting and controlling budgets. Absorption costing and ABC both aim to calculate the full cost of individual units of output. Marginal costing on the other hand only includes variable costs within the cost of individual units and instead recognises fixed costs are being related to periods of time and not units themselves. Standard costing is a tool for budgetary control that allows managers to identify the areas where there has been variances from costs and incomes that should have occurred. This allows investigation of the variances and if necessary corrective action to be taken to bring costs back in-line with the budget. You should now be able to explain various costing methods: o o o o o o Job costing Service costing Absorption costing Marginal costing Activity based costing Standard costing Costing 20

21 Additional exercise Exercise Trainee accountant (Exam Standard) You are a trainee accountant at a local authority. To help you with your training your manager has given you the opportunity to give a short presentation to the rest of the finance team. Cost control has been a problem in the authority and so this has been designated as the key theme of your presentation. Your manager has also volunteered to look over the notes for your presentation in advance. Requirement: Prepare some notes that cover the following: a) Describe the reasons for measuring costs (3 marks) b) Define the terms job costing and service costing and state an example of each (4 marks) c) Briefly explain the objective of a standard costing system and state the steps required in the operation of such a system (4 marks) d) Explain the problems that can be encountered when using standard costing systems (9 marks) Costing 21

22 Costing 4.2 Absorption costing Learning objectives Explain and apply methods of allocating and apportioning overhead costs Analyse overheads to calculate separate departmental overhead absorption rates and calculate under-and-over-absorption of overheads Apply overhead absorption to the public sector, including service level agreements Costing 22

23 4.2.1 Absorption costing introduction Absorbing Overhead to Obtain Full Cost As we saw in workbook 1 the process of overhead absorption consists of a series of cost attributions, each moving closer to the ultimate cost It is important to distinguish between direct and indirect costs. Exercise Requirements (a) Define a direct cost. A direct cost is: (b) Define an indirect cost. An indirect cost is: Costing 23

24 INDIRECT costs Are those which cannot be identified with a particular product (cost unit), so that there is a need to apportion the costs between a number of products. It should be noted that in practice the terms indirect costs and overheads tend to be used interchangeably however as shown in workbook 1 there is a distinction between them. For now we too will use the terms interchangeably. Example: Construction of a table: To determine the total cost, costs are classified as follows: DIRECT materials - raw materials, nuts/bolts, etc. DIRECT labour - remuneration of production worker(s) DIRECT expenses - hire charge of any tools used for this job. The total of the above elements is called the Prime Cost of Production. INDIRECT materials - stationery (purchase orders), lubricating oil, etc. INDIRECT labour - salaries of supervisors, storekeepers, production control, etc. INDIRECT expenses - factory rent & rates, insurance, power, lighting, etc. The total of the above indirect costs represents the Overheads. Total cost build-up To ascertain the total cost of a product or service, the prime costs, by definition, are easily identified. However, it is also necessary to ensure that each product bears a reasonable proportion of the company s overheads. After being collected for the organisation as a whole, each item of overhead is distributed to a cost centre, either by means of ALLOCATION or APPORTIONMENT. Costing 24

25 There are 3 ways of distributing overheads that we saw in workbook 1. Exercise Requirements (a) Explain the 3 ways of distributing overheads. Costing 25

26 4.2.2 Service departments These are defined as cost centres which provide a support service to the production cost centres (maintenance and stores are examples of support departments ). Their costs are built up by the usual processes of overhead allocation and apportionment, as described earlier. However, the ultimate aim of absorption costing is to determine the total cost of a cost unit (product) therefore these service department costs also have to be apportioned over the production cost centres, so that the total cost of the production cost centre can be absorbed into the cost units. This involves the same apportionment and absorption procedures as discussed earlier, selecting the most reasonable bases available. Reciprocal services Before apportioning service department costs to production departments it is necessary to take account of any services provided between the service departments to determine the total cost of a service department before it is apportioned. If one service department provides a service to another, it is necessary to apportion the servicing department s costs before that of the serviced to ensure that the latter s costs fairly reflect the charge for work done for it by the former. A more common occurrence in organisations is that 2 or more service departments work for each other as well as for production departments. The total cost of one cannot be ascertained until the charge from the other is known, and vice versa. A way has to be found to break this circular problem to obtain each service department s true full costs. The ways in which this problem can be addressed are considered in the following example: Costing 26

27 Worked example allocating & apportioning A factory has 2 service departments (M and S) and 3 production departments (X, Y and Z). It has been determined that M s costs will be apportioned according to equipment values, and those of S by the number of requisitions. The overheads applicable to each department following primary allocation are: Department Overheads ( ) M 6,800 S 2,700 X 12,000 Y 19,500 Z 26,000 Other relevant data are: Equipment Values ( ) Proportions No. of Requisitions Proportions M S X Y Z 10,000 50,000 76,000 5% 25% 38% - 2,400 1,620-40% 27% % 64,000 32% 1,080 18% Using the above data, 3 alternative methods are shown to solve the problem of allocating and apportioning overheads to cost centres where the added complication of reciprocal service departments exists: Exam Tip: It is possible to ignore the reciprocal problem completely and simply charge the service departments costs to the production cost centres only. This is sometimes acceptable on materiality grounds in practice but is not to be recommended in an examination situation) Costing 27

28 Solution 1 Repeated Distribution (or Continuous Allotment) This method involves the appropriate proportion of M being apportioned to S (5%) (and the three production departments) and then the proportion of the new total cost of S is apportioned back to M (15%) (and the three production departments) and so on until the amounts being apportioned are negligible. This is shown below: Original Cost Apportion M Apportion S Apportion M Apportion S Apportion M M S X Y Z 6,800 2,700 12,000 19,500 26,000 (6,800) 340 1,700 2,584 2, (3,040) 1, (456) (23) (3) ,040 23,086 28,874 2 Algebraic Method (using Simultaneous Equations) This method utilises equations for the 2 service departments representing the total overheads for each, once the charge from the other has been allotted. Say M = Total overheads for M (including apportioned cost of S) And S = Total overheads for S (including apportioned cost of M) => M = 6, S (1) S = 2, M (2) Substitute equation (2) into equation (1): M = 6, (2, M) M = 7, M M = 7,205 => M = 7,259, S = 3,063 (by substitution) Costing 28

29 Having obtained these values for total overhead costs of S and M, they can be fully apportioned direct to all departments. This will produce the same total cost figures for X, Y and Z as method 1 above (subject to rounding). Original Cost Apportion M Apportion S M S X Y Z 2,700 12,000 19, ,815 2,758 (3,063) 1, ,800 (7,259) ,000 2, ,040 23,085 28,875 3 Specified Order of Closure Simplest of the 3 methods Once apportioned, the department is eliminated from further apportionments The sequence in which departments are eliminated generally relates to the amounts involved Original Cost Apportion S Apportion M M S X Y Z 6,800 2,700 12,000 19,500 26, (2,700) 1, (7,205) - 1,896 2,882 2, ,976 23,111 28,913 Notes S is apportioned first as a larger amount is involved in the reciprocal charge (15% x 2700 = 405 is larger than 5% x 6800 = 340. With the first method Repeated Distribution you would get the same answer whichever of the 2 service departments is apportioned first) As S has been closed, the apportionments of M are in the proportions 25:38:32 (omitting the 5% relating to S) This method is less accurate than the other two, BUT: by its very nature overhead apportionment uses approximations simple and practical method, especially applicable in situations with many service departments Costing 29

30 Exam Tip: Which method to use? If asked to fully take account of reciprocal services o do not use specified order of closure o either repeated distribution or simultaneous equations permitted but beware of time for repeated distribution If 3 departments all giving & receiving services use specified order of closure Costing 30

31 4.2.3 Overhead absorption rates (OARs) The charging of production overhead to cost units is the process of overhead absorption. We calculate overhead absorption rates (OAR) for each cost centre and use that OAR for all products manufactured in that cost centre as seen above. As we shall see below there are alternative bases of absorption possible but each cost centre will choose and use only ONE method the one it deems most appropriate for its circumstances/the way it works. Methods of overhead absorption A number of methods are available, each using a different base. Most bases are related to activity within the cost centre (such as labour hours, machine hours, units produced), on the presumptions that the benefit that a particular product derives from the overheads associated with a department will tend to relate to the time spent in the department by the product. Some of the most commonly used are: Direct labour hour (DLH) rate = Total overheads of cost centre x direct labour Total direct labour hours hours per unit Machine hour rate (MHR) = Total overhead of cost centre x machine hours Total machine hours per unit Cost unit rate = Total overheads of cost centre Total units of product(s) made The DLH rate is generally most appropriate to use in a labour-intensive cost centre, but not so appropriate if heavily mechanised. It does require accurate reliable information on the booking of labour time. We can argue that many overheads fluctuate with time spent producing cost units, (e.g. supervision, lighting and heating), hence the use of the DLH rate. The MHR is the most appropriate in a mechanised cost centre as then most overheads would relate to machinery (e.g. power, depreciation, maintenance etc.). This does require records of machine hours, and some jobs may not use machines; if so, no overheads are charged to such jobs. The cost unit absorption rate is only appropriate where the product units produced in the cost centre are reasonably similar in terms of Costing 31

32 production processes, times, etc. For example making different coloured crockery. Whether a plate is blue or green it is probably made in a very similar process, taking about the same time, labour etc. The DWP rate (the only suitable cost based absorption rate in general) is likely to produce similar results to the DLH, unless there are substantial variations in pay rates between workers. In such cases, overheads are likely to be unfairly absorbed more heavily into jobs involving more highly paid workers, which will not necessarily reflect the benefit received from the overhead item. Once the particular OAR is chosen, the following method is used to absorb overheads into cost units: Number of Units of Absorption Base involved in Cost Unit x OAR Predetermined overhead absorption rates For a number of reasons the OAR used will be a predetermined or budgeted rate: a) It will be unacceptable to organisations to wait until the end of an accounting period to charge overheads to jobs. For pricing purposes, especially, it is necessary to calculate an estimated overhead rate in advance so that the full cost of a job is known at the budgeting stage. b) The number of units of the absorption base (e.g. labour hours) will fluctuate seasonally, and if the overhead were absorbed at the end of each month, the rate may fluctuate wildly, hence so would the cost charged to the cost unit. c) Also the amount of overhead itself will fluctuate seasonally (e.g. heating and lighting) having the same effect as above. So a predetermined rate based on annual budgets and applied to all cost units in the year is used. Hence the OAR becomes: Budgeted Overheads of Cost Centre Budgeted Units of Absorption base Costing 32

33 Worked example An organisation s cost centre has three outputs; X, Y and Z, with the following information: Product X Y Z Total Direct costs per unit ( ) Direct labour hrs per unit Machine hrs per unit Units produced Overheads 50,000 Determine the absorption rate and then the unit cost of each product using: a) a labour hour absorption rate b) a machine hour absorption rate c) a cost unit absorption rate d) a direct cost absorption rate Costing 33

34 Solution a) Absorption rate = 50,000 (10 x 40) + (16 x 50) + (24 x 60) = 50,000 = per labour hour 2,640 => Unit costs Direct costs Overheads X Y Z b) Absorption rate = 50,000 (6 x 40) + (16 x 50) + (14 x 60) = 50,000 = per machine hour 1,880 => Unit costs Direct costs Overheads X Y Z c) Absorption rate = 50,000 = per unit 150 => Unit costs Direct costs Overheads X Y Z Costing 34

35 d) Absorption rate = 50,000 (122 x 40) + ( x 50) + ( x 60) = 50,000 = 2.34 per 1 direct cost 21,337 => Unit costs Direct costs Overheads X Y Z Costing 35

36 4.2.4 Under/over absorption The consequence of using predetermined overhead absorption rates is that there will be an under-or-over absorption of overheads at the end of the accounting period as the forecasts of both overheads to be incurred and actual units of the absorption base are likely to be inaccurate. We have to compare actual overheads incurred with those absorbed. Under/over absorption occurs if: a) actual overheads differ from budgeted overheads and/or b) differences occur between actual and budgeted amount of the absorption base (e.g. labour hours in cost centre different to that budgeted) Significance of volume measure Why might the selection of a volume measure be significant to absorption of fixed overheads? The significance is that the cost being absorbed is fixed relative to volume of output. Let us take a look at an example. Absorption activity levels When the cost being absorbed is fixed relative to volume of output, there are three broad views of activity level. Normal volume This is a medium-term average volume, allowing for demand over, say, a five-year period and for seasonal and cyclical fluctuations. The argument in favour of using normal volume is that fluctuations in absorption rate caused by seasonal and cyclical factors are smoothed out, and that, by attempting to approximate longer-term costs in this way, there may be less danger of overemphasising short-term considerations at the expense of the longer term view. The difficulty with using normal volume lies in arriving at a credible estimate spanning the sort of time horizon involved a problem which may be exacerbated if an organisation s activities are subject to significant cyclical fluctuations. Practical capacity Practical capacity is effectively maximum operational capacity. It provides a reasonable measure of volume. It is also suggested that the under absorption of overhead which results from use of practical capacity provides management with some measure of the cost of Costing 36

37 failing to achieve maximum operational capacity. However, because it is based on maximum volume, practical capacity will yield a lower overhead cost per unit than other volume measures and this may result in understatement of unit costs. Annual budgeted volume This is the expected activity level during the upcoming year, and on which the organisation s annual budget is based. Unlike normal volume and practical capacity, it reflects current operating conditions and this is the main argument put forward in favour of its use. Worked example 1 Robinson s PLC have set an overhead absorption rate for their product in advance of the financial year based on estimated expected overheads of 100,000 and expected utilised capacity of 100,000 labour hours. The overhead absorption rate has therefore been set at 1 per labour hour. At the end of the year the overheads are reviewed and it is noted that 100,000 hours were indeed worked but that overheads were actually 120,000 due to a larger rent increase than was expected. Question: Has there been over/under absorption of overheads and if so by how much? Answer: There has been under absorption: The overhead absorption rate was applied to each hour worked so (100,000hrs x 1) = 100,000 of overheads were absorbed into cost units (or charged to cost units.) However, actual overhead incurred was 120,000 so under absorption of ( 120, ,000) = 20,000 was incurred. Question: If actual overheads were lower than budgeted and all else remains constant would there be under or over absorption? Answer: There would be over absorption. 100,000 of overheads would be absorbed over 100,000 hours but less overhead would actually be incurred. Costing 37

38 Worked example 2 Continuing from example 1 above, at the end of the year the overheads are reviewed and it is noted that 110,000 hours were worked and that overheads were 100,000 as budgeted. Question: Has there been over/under absorption of overheads and if so by how much? Answer: There has been over absorption. As the overhead absorption rate is applied to each and every hour worked 110,000 has been absorbed but actual overhead incurred is 100, ,000 has been over absorbed, (again it can be thought of as overcharged by 10,000) Question: If actual hours worked were lower than had been budgeted, all else remaining equal, would there be under or over absorption? Answer: There would be under absorption. There would not be enough hours to collect the full 100,000 at the rate of 1 per hour. The issue of under and over absorption will be revisited later in this workbook in the comparison between absorption and marginal costing. Costing 38

39 Exercise Health Authority (Exam Standard) A Health Authority has developed a business using spare accommodation that was previously nurses apartments. The business provides residential accommodation for visitors to the area who wish to stay for a few weeks and also accommodation for conferences. It has four cost centres; which are known as Residents (R) and Conferences (C) (which deal with paying customers) whilst Hotel (H) and Maintenance (M) are internal service cost centres. Overhead details for the next accounting period have been estimated as:- Total R Consumable 82,000 16,000 26,000 29,000 11,000 materials Indirect staff 52,500 17,500 14,000 11,200 9,800 costs Rent & rates 37,500 Insurance of contents 14,000 Heat & light 18,500 Depreciation of equipment 37, ,000 C H M The following information is also available: R C H M Floor area (m 2 ) 2,750 1, Equipment 350, ,000 75,000 75,000 value ( ) Number of employees In the period it is estimated there will be 2,950 guest-nights for residents and 12,000 conference delegate days. Work carried out by the service cost centres is estimated as: Costing 39

40 Hotel % Maintenance % Residents Conferences Maintenance 10 - Hotel Requirement: a) Calculate overhead absorption rates for the residents and conferences cost centres fully taking account of reciprocal services and making clear the basis of any apportionments. (15 marks) b) Calculate the total under/over recovery of overheads for both centres if actual results were: Residential 3,500 guest nights with overheads of 144,000 Conference 11,600 delegate days with overheads of 98,600 (5 marks) Total 20 marks Costing 40

41 4.2.5 Service level agreements Practicalities of support department recharges As we read in workbook 1, traditionally the costs from support departments in public service organisations were made at the year end to move the costs from the support departments to frontline services. This lead to problems with accountability and control of budgets for those managing the frontline services. How could they manage and control their budgets if charges were unknown until the end of the year? This led to the introduction of charges that are set in advance and formalised with a service level agreement (SLA) or a trading agreement that details the support and services that front line services can expect from support departments and the charges that will be levied. Service level agreements Service level agreements (SLAs) specify the level of and charge for the service in the form of a contract covering: 1. the provision of a certain amount of the service 2. the standards to be expected in that service regarding quality and performance 3. a predetermined cost 4. the duration of the agreement. A successful SLA should allow users to control: the standard of service the cost of the service the volume and type of service. Setting the charges in SLAs A number of issues will affect setting charges, which will require central policy decisions in interdepartmental matters: Are departments free to negotiate charges or opt for in-house provision? Can service departments set differential prices? Must service providers break even as they recharge their input costs? Costing 41

42 Implications of SLAs There are a number of implications to consider: Cost benefit - Time and effort is spent on arriving at suitable recharge rates so the benefit of doing so must outweigh the cost Costs need be known in advance to allow the department in receipt of the services to budget for them. Consumers may reject a service on a price basis if the costs are not competitive with external suppliers. This could have organisational wide implications as the support department may not be fully utilised and could close. This may or may not ultimately result in better value. As the charges are predetermined, balances may result if the actual costs of the support department are higher/lower then anticipated or indeed if the level of support required in the year differs from that included in the budget. Within the accounts of users, support service charges replace apportioned support department costs. Trading accounts (TAC) Trading accounts otherwise known as operating accounts are preferred by CIPFA as a way of recording the activities of support departments. As the name operating account suggests it records the costs and incomes of support departments as if they were a separate commercial area of the organisation although they only operate within the internal market of public service organisations. TACs show the charges for work undertaken at the agreed rates and the costs incurred and so will show: whether the service is breaking even or achieving set targets to have a surplus. whether the recharge rates are appropriate or if costs are out of line with recharges, requiring efforts at cost control. Overall TACs for each activity within a service department should aid good management. Costing 42

43 Summary In this session we have underpinned the establishment of the full cost of cost units (ABSORPTION COSTING). Organisations will tend to be organised into a number of cost centres, some involved in producing the final outputs, and some supporting this process (the service departments). All of the costs attributable through primary apportionment to these cost centres must be recovered from final outputs. Hence, service departments full costs must be apportioned to production cost centres too. Finally appropriate methods of overhead absorption (or recovery) are determined to establish the amount of departmental overhead to be borne by individual cost units. The public sector has applied the commercially developed absorption costing rates method to its own specific requirements. Service level agreements and trading accounts have been advocated within this sector to make for greater accountability. You should now be able to: Explain and apply the concept and calculation of full cost Explain and apply methods of allocating and apportioning overhead costs Analyse overheads to calculate separate departmental overhead absorption rates and calculate under-and-overabsorption of overheads Apply overhead absorption to the public sector, including service level agreements Costing 43

44 Additional exercises Exercise Bloggs UK. Bloggs UK Ltd is a manufacturing company consisting of two production departments (processing and assembly) and two service departments (finance and maintenance). The expenditure budgets of the service departments are shown in Table 1. Both service departments have provided details of the amount of work that they do for the other departments, shown in Table 2: Table 1 Finance 67,500 Maintenance 180,000 Table 2 Department Finance Maintenance Processing Assembly Finance (hours) Maintenance (call-outs) Requirement: a) Calculate the overheads to be allocated to the two production departments using the following methods: specified order of closure reciprocal using repeated distribution/continuous allotment reciprocal using simultaneous equations. b) Comment on the results and the stengths and weaknesses of each method. Costing 44

45 Exercise Local Authority Care Homes (Exam standard) A local authority runs two care homes for the elderly. The two homes share administration and finance services in order to save costs. The following budgeted overhead costs for two care homes (Home 1 and Home 2) and two service departments (admin and finance) for the next financial year are: Indirect materials Home 1 100,000 Home 2 100,000 Finance 45,000 Admin 9, ,000 Indirect wages Home 1 100,000 Home 2 98,500 Finance 92,500 Admin 46, ,000 Managers salaries 80,000 Depreciation of machinery 150,000 Heating and lighting 50,000 Building insurance 25,000 Insurance of machinery 15,000 Rent and rates 100,000 1,011,000 The following additional information is also available: Home 1 Home 2 Finance Admin Number of Employees Area Occupied (Sq m) 5,000 7,500 7,500 5,000 Value of Machines ( ) 2,000, ,000 Invoices Received 50,000 25,000-25,000 Care Hours 50,000 75, Admin Hours 4,000 4,000 2,000 - Requirement: (a) Allocate and apportion all costs to the 4 departments; home 1, home 2, finance and admin, making clear the basis by which costs have been apportioned. (8 marks) (b) (c) Calculate the full cost per care hour for each of the homes to be applied during the year. You should fully take account of reciprocal services between the service departments. (7 marks) Explain why it is more usual for the homes to calculate overhead recovery rates using budgeted figures rather than wait for actual figures at the end of the year and describe any problems this may cause. (5 marks) Total 20 marks Costing 45

46 Exercise The ISIS Engineering Co. (Exam standard) The ISIS Engineering Co. operates a job order costing system, which includes the use of predetermined overhead absorption rates. The Company has two support service and two production cost centres. The production cost centres, A and B, have overheads charged to jobs via direct labour hour rates, which are for the current year 3.10 per hour and per hour respectively. These calculated rates exclude any analysis of services provided by each support service cost centre to the other. The methodology and bases currently used to charge factory overheads and service cost centre expenses to the production cost centres are as follows:- i) General factory overhead - relative floor area used by production and service cost centres, then; ii) iii) Support service cost centre 1 s expenses - number of personnel in each production cost centre, then; Support service cost centre 2 s expenses - usage of its services by each production cost centre. The Company s plans for the forthcoming year are to be based on the following data: Budgeted overhead before secondary allocation ( ) % of factory floor area % of factory personnel General Factory Support Service Cost Centres Production Cost Centres Overhead 1 2 A B 210, , , , , Estimated usage of services of Cost Centre 2 (hrs) Budgeted Direct Labour Hrs for next year Budgeted Direct Labour Hrs for current year , , , ,000 25,000 20,000 30,000 Costing 46

47 Requirement: a) Without accounting for services provided to each other by the two support service cost centres, calculate overhead absorption rates for next year for the production cost centres using the Company s current costing methods. Comment briefly on the reasons for the differences with the current year s absorption rates. (7 marks) b) Recalculate next year s overhead absorption rates, this time recognising fully the existence of reciprocal service charges assuming that they can be measured on the same bases as those used to apportion costs to the production cost centres in (a). (7 marks) c) Given the further information below: (i) (ii) (iii) (iv) (v) General factory overhead is a fixed cost. Service cost centre 1 is concerned with quality control with its budgeted expenses (before reallocation) being 10% fixed and 90% variable. Service cost centre 2 is the maintenance section with its budgeted expenses (before reallocation) being 90% fixed and 10% variable. Production cost centre A is labour intensive with its budgeted overhead (before reallocation) being 90% fixed and 10% variable. Production cost centre B is highly mechanised with its budgeted overhead (before reallocation) being 20% fixed and 80% variable. Comment critically on the cost apportionment and absorption methodologies used, and information produced, in (a) and (b), and suggest appropriate improvements, giving your reasons. No calculations are required. (6 marks) Total 20 marks Costing 47

48 Exercise Tradeline LTD (Exam standard) Tradeline Ltd manufactures three products, the P1, P2 and P3. The following budgeted information is available for the current financial year: Cost of materials per unit ( ) Machine shop Finishing shop Labour hours per unit: Machine shop Finishing shop Machine hours per unit: Machine shop Finishing shop Budgeted weekly production (units) Products P1 P2 P The factory works a 48 week year. It consists of four departments. The following information is provided about each department: Budget for current year Number of employees Cost of labour per hour ( ) Floor area (m 2 ) WDV of machinery ( ) % of stores usage Allocated overheads ( ) Machine shop , , ,500 Finishing shop , ,750 Stores , ,350 Maintenance , ,420 There are also overheads that remain to be apportioned to the above departments, as follows: Management Rent Cleaning Heating and Lighting 278,778 28, ,806 48,859 The cost of the Stores and Maintenance departments are to be apportioned to other departments using a specified order of closure, namely Stores and then Maintenance. Requirement: (a) Calculate overhead recovery rates per machine hour for the machine shop and per labour hour for the finishing shop. (7 marks) (b) Calculate the full unit cost of each of the three products. (7 marks) (c) Recalculate the total cost of the two production departments, and comment briefly on the results, using the repeated distribution or simultaneous equation method of apportioning support service costs. (6 marks) Total 20 marks Costing 48

49 Costing 4.3 Activity based costing (ABC) Learning objectives Explain the limitations of traditional absorption costing systems Calculate product & service costs using ABC Discuss the differences between ABC and traditional absorption costing systems Describe the factors to be considered when designing an ABC system Costing 49

50 4.3.1 Study focus The following material deals with the topic of Activity based costing (ABC). From an examination point of view a number of possible questions could be asked. One possibility is for a 100% discursive question asking such things as how to set up an ABC system, reasons for doing so, advantages and disadvantages of ABC etc. Another possibility is for a mainly computational question asking (say) for product costs to be derived using an ABC approach and perhaps comparing with costings using an absorption cost based approach. You must read the theory in this workbook with the intention of ensuring that you are able to answer any discursive parts of a computational question and if necessary a full 20 mark discursive question. Costing 50

51 4.3.2 Activity based costing introduction Limitations of traditional absorption costing systems The traditional treatment of overheads, with its (sometimes) arbitrary allocations and apportionment of costs across functions and departments, has caused unrest among accountants for many years. ABC has arisen from the apparent limitations found in the traditional absorption costing systems. ABC s focus is on calculating the costs of the activities and processes of an organisation with attention being centred on the causal factors for overheads being incurred (cost drivers). Why Traditional systems are inadequate today Traditional absorption costing systems evolved from: small product ranges a relatively low proportion of non-volume related overheads direct labour and materials costs predominant. In today s business environment the above is less true. The business environment has changed over time: wider product ranges low labour costs higher fixed costs Managers find cost information useful in making many types of decisions: What should the selling price of a product/service be relative to the costs incurred? Does the market price allow a profit to be made? How far do existing cost allocation practices reflect the resource consumption of a company s different product lines? Such questions point to a need for refining costing systems. One significant factor underlying the belief that many accounting systems miscost products is that substantial changes have generally been made within production environments. Costing 51

52 Investment in capital-intensive technology Investment in capital-intensive technology can alter the material/labour/overhead cost mix of an organisation s products. Operational knowledge of how resources are consumed may not tally with information reported by the costing system. Consequently, a difficult-to-make product may attract very little cost allocation under the prevailing accounting systems. Shorter product life The life of a product type may be getting shorter because of more intensive competition by technologically driven companies. Under such situations, managers may find themselves with cost information provided by an accounting system relying on product-life assumptions which are rapidly becoming inappropriate. Managers may even reduce the selling price of a loss-making product based on the mistaken cost information-based belief that the product is in fact very profitable. The limitations of absorption costing have led to the development of ABC. Limitations of absorption costing include: it assumes products consume resources in relation to volume measures (direct labour or machine hours for example) it can give a distorted product cost (e.g. where a diverse range of products exists, and with a mix of high and low volumes of products. For example we might make thousands of Product A which is comparatively easy to make and just a few Product B s which are hand made, complex and fiddly! There will probably be economies of scale associated with A, whereas B actually causes a lot of the overheads to be incurred. BUT traditional overhead absorption systems especially using time based methods of absorption such as Labour Hours will tend to charge or absorb most overhead into Product A. It was because of this kind of argument that ABC was developed.) ABC views overhead costs as arising because certain activities are undertaken activities cause costs ABC terminology Activities series of related tasks that are carried out repeatedly Cost drivers Cost pool the factors which cause the activity to occur costs of the activity grouped together Costing 52

53 4.3.3 ABC process Exercise Requirements (a) Thinking back to workbook 2, state the five stages of preparing activity based budgets Activity based costing needs: careful choice of activities / cost pools means of distributing indirect costs and overheads to cost pools choice of cost driver for each cost pool Activity-based costing (ABC) systems refine costing systems by focusing on individual activities as the fundamental cost objects. An activity is an event, task, or unit of work with a specified purpose, for example designing products, setting up machines, operating machines and distributing products. ABC systems calculate the costs of individual activities and assign costs to cost objects such as products and services on the basis of the activities undertaken to produce each product or service. ABC systems focus on indirect costs because direct costs can be traced to products and jobs relatively easily. Costing 53

54 Direct-cost tracing Classify as many of the total costs as direct costs as is economically feasible. This guideline reduces the amount of costs classified as indirect. Indirect-cost pools Expand the number of indirect-cost pools until each of these pools is homogeneous (in other words the cost pool contains costs for reasonably similar things such as the production cost pool, the marketing cost pool, the set-up related cost pool etc etc. We are grouping things together into cost pools which are generally speaking being caused, we call it driven by the same thing.. In a homogeneous cost pool, all of the costs have the same or a similar cause-and-effect (or benefits-received) relationship with the costallocation base. Cost-allocation bases usually called the cost driver Identify the preferred cost-allocation base for each indirect-cost pool. In this session we focus on the cause-and-effect criterion for choosing allocation bases. Application of ABC While ABC has been predominantly developed for the manufacturing sector it is now being increasingly applied within a service context. The costs of the public sector are predominantly overhead costs and therefore regarded as difficult to control and influence. Often in the past internal services were charged to clients by a year-end allocation of costs on a simplistic basis, for example based on the number of employees. Thus ABC has been welcomed, in that the potential for cost management has been extended. Particular interest has been shown in the application of ABC by the National Health Service and Police Authorities in the United Kingdom. The application of ABC to the public sector is very close to that of the manufacturing sector. The work of an organisation can be broken down into activities, with costs allocated and apportioned to activity cost pools. Cost drivers can then be identified and an activity-based cost calculated for each activity. The users of an organisation s activities can then be charged, based on their consumption of the different cost drivers. The use of ABC costing systems in public sector organisations also allows for cost comparisons between organisations. The comparison between organisations may highlight areas where efficiencies could be made to reduce costs. Costing 54

55 4.3.4 Absorption costing vs. ABC Similarities both have direct costs which go straight to the product both have overheads that are allocated to production cost centres/cost pools Ultimately ABC is a form of absorption costing that results in full costs being apportioned and absorbed into the products and services being delivered. Differences absorption costing generally uses 2 bases to charge overheads to products (DLH and MH ) ABC uses many cost drivers as absorption bases to charge overheads to products (e.g. number of orders, number of set ups, number of despatches etc.) ABC is similar to Absorption Costing but the pooling of overheads is by activities rather than by departmental level cost centres. Advantages and problems of ABC Advantages better understanding of overhead behaviour recognises that overheads are not always volume related cost drivers are independent of volume avoid inequitable overhead absorption greater accuracy of costs & improved product costing greater understanding of the cost complexity useful for performance evaluation improves control of costs by identifying factors that cause costs improves management information ABC information should improve pricing and product range decisions Costing 55

56 encourages better interaction between management accountants & operational managers; helps management accountants have better understanding of the business encourages an understanding of the processes in a business no need to worry about reciprocal service allocations Criticisms common costs may still require some arbitrary cost apportionment (e.g. rent, depreciation) a true cost driver is not always easy to measure problem of how to treat costs which have no measurable cost driver do we fall back on apportionment? ability of a single cost driver to fully explain cost behaviour of cost pool is doubtful potential for too large a number of cost pools accuracy & cost trade off to have a useable cost driver it must be measurable not always possible costly to set up time recording essential ABC does not solve all problems! Costing 56

57 ABC vs traditional absorption costing systems in more detail There are several areas where comparison of the two systems is worthwhile, and we shall discuss these below. Reflection of resource inputs Reflection of resource inputs to support outputs: We have already said that absorption rates based on simple activity measures such as direct labour or machine hours may be unrepresentative of complex relationships between support activities and outputs. Assuming tolerable accuracy in identification and quantification of activities, cost drivers and overhead costs, the very calculation of a greater range of absorption rates should allow ABC to more accurately reflect consumption of support resources by output. The subjectivity problem We described the potential subjectivity of apportionment bases in the context of the traditional absorption methodology. In most circumstances, ABC is unlikely to improve this aspect of overhead absorption, the effect being, to alter which costs need to be apportioned to what cost objectives. For example, under the traditional methodology, supervisory costs may be allocated to cost centres; using ABC, these costs may need to be apportioned to the overhead cost pools, bearing in mind that the cost pools cross departmental boundaries. Conversely, under the traditional approach, some costs may be required to be apportioned to cost centres; whereas under ABC, these costs are allocated to the activity cost pool. Cost drivers as absorption rates Where possible, using the cost driver as absorption rate makes sense, given that it is the underlying cause of the cost being absorbed, which is preferable to employing a more general activity measure, such as machine hours. Costing 57

58 Using cost drivers in this way may pose problems: 1. It may be difficult to identify the cost driver. For example, the cost driver for communication cost in an education establishment may be the number of students, number of courses, relative complexity of courses, or a combination of all three. 2. It may be difficult to quantify the cost driver once identified: for example, relative complexity of courses. 3. Where there are problems identifying/quantifying cost drivers, any related absorption rate must be open to question. 4. Once identified, quantified and related to output, it will almost certainly be true that the cost driver is, at best, the main underlying cause of the costs within a particular pool. However, what we have just said does not mean that cost drivers cannot or should not be used as absorption rates, but that complete causal accuracy may need to be traded off against practicality and the cost/benefit criterion (just as it was with the traditional approach). Identifying activities Traditional absorption costing systems tend, on the whole, to attribute overheads to departments, which at least has the merit of simplicity, but which may result in a rather inflexible approach in the context of a dynamic environment. But although there is greater potential flexibility in an activity basis, this may itself create a difficulty. Many activities (such as computing) cross departmental boundaries, and this may make them difficult to define with reasonable precision, especially where there are differences in the exact nature of apparently identical activities being carried on in (or on behalf of) several departments. This could, in turn, affect the cost driver: for instance, communication costs in one department may be driven by the complexity of courses provided, whereas for another department the same cost might be driven by the number of assignments. In such circumstances, we may need either to develop a cost driver rate for each department, which raises the problem of apportioning computing costs between departments, or to revert to a traditional departmental absorption rate. Costing 58

59 Cost of setting up Cost of setting up and operating absorption systems Whether it be traditional or ABC, there are costs involved in installing and operating an absorption costing system: estimates of costs and activity/volume measure(s) need to be made; actual costs and activity/volume measure(s) must be recorded; and data for apportionment (and possibly reapportionment) bases must be found. Some of this information will be available as a matter of routine (eg budgeted and actual costs) and some may be readily obtained. It must nevertheless be recognised that there is a cost involved, and the significance of the cost/benefit criterion should be borne in mind. It might be that the more complex analysis required by ABC could impose additional costs for information gathering and updating such that the associated benefit is outweighed. In many cases, adoption of ABC necessitates the use of external consultants to identify activities/cost drivers, which could be prohibitively expensive. ABC as a control aid One important argument advanced in support of ABC is its use as an aid to cost control: that is, if the major activities and related cost drivers can be identified, then any action to reduce the incidence of either or both should have the effect of reducing the related costs. However, it may also be argued that, where some doubt attaches to the definition of activities and/or cost drivers, this is a questionable benefit of ABC. Costing 59

60 Worked example - Activity based costing 3 outputs: Product A = 70,000 units per annum Product B = 50,000 units per annum Product C = 30,000 units per annum Given the following information: A B C Total Sales price Direct labour Direct materials Direct labour hrs ,000 Machine hours ,000 Overhead costs: Machine-related 1,540,000 Labour-related 2,220,000 What would be the unit cost and profit and profit margin under a traditional absorption costing system? Costing 60

61 Solution Determine absorption rates: Machine overhead = 1,540,000 = 3.50 per machine hour 440,000 hrs Labour overhead = 2,220,000 = 3 per labour hour 740,000 hrs i.e. overheads are attributed to products based on a measurable volume attribute of products such as direct labour hours or machine hours. Unit costs are therefore: A B C Direct cost Machine overhead Labour overhead Unit cost Price Profit Profit margin 8% 42.5% 23.3% i.e. product volumes cause costs Costing 61

62 Worked example An activity based approach Traditional functional cost Activity costs might be: Machine related 1,540,000 Machining 1,540,000 Labour related 2,220,000 Processing orders 800,000 Materials handling 520,000 Setting up 900,000 We now have the labour related overhead costs analysed into 3 separate areas technically grouped into cost pools and the question then is what are the causes of these three activities and how therefore can the activity costs be traced to outputs? Given the following information: A B C Production runs Production orders Material movements Cost driver rates could be as follows: Machine costs = 1,540,000 = 3.50 per machine hour 440,000 hrs (as before) Processing orders = 800,000 = 5,000 per order 160 orders Materials handling = 520,000 = 2,000 per material movement 260 mat. movements Setting up = 900,000 = 7,500 per production run 120 production runs Costing 62

63 Solution A B C Direct cost Machine overheads Processing orders Materials handling Set-ups Unit cost Price Profit/(loss) (3.25) Profit margin 18.8% 42% (3.6%) NB: Unit costs are derived as follows: Cost driver rate x product s consumption of cost driver Product s volume Compare with traditional/absorption system Profit Profit margin 8% 42.5% 23.3% Activity based costing gives quite different results. This is due to the fact that the activities undertaken are what cause the costs. Traditional absorption costing, where there are a mix of products that have differing volumes and levels of complexity, will over cost those products that are produced in high volumes but are relatively simple. This is the case with product A, it is made in high volumes but consumes relatively small amounts of the cost drivers. The converse is true of those products made in small volumes but are more complex to produce. This is the case with product C where it is produced in much lower volumes but has high consumption of the activities that cause costs. Product C is under-costed when using traditional absorption costing. Costing 63

64 Product-cost cross-subsidisation Product-cost cross-subsidisation means that at least one miscosted product is resulting in the miscosting of other products in the organisation. A classic example arises when a cost is uniformly spread across multiple users without recognition of their different resource demands. Let s look at a simple example of a restaurant. Simple example Consider the costing of a restaurant bill for four colleagues who meet once a month to discuss business developments. Each diner orders separate entrees, desserts and drinks. The restaurant bill for the most recent meeting is as follows: Entree Dessert Drinks Total Emmanuelle Jean-Paul Nathalie Christophe Total Average Analysis The 540 total restaurant bill produces a 135 average cost per dinner. This broad-average costing approach treats each diner the same. Emmanuelle would probably object to paying 135 because her actual cost is only 75. Indeed, she ordered the lowest-cost entree, had no dessert, and had the lowest drink bill. When costs are averaged across all four diners, both Emmanuelle and Christophe are over-costed, Jean- Paul is under costed and Nathalie is accurately costed. The restaurant example is both simple and intuitive. The amount of cost cross-subsidisation of each diner can be readily calculated given that all cost items can be traced as direct costs to each diner. More complex costing issues arise, however, when there are indirect costs. Then resources are used by two or more individual diners. By definition, indirect costs require allocation for example, the cost of a bottle of wine shared by two or more diners. Costing 64

65 4.3.5 Practicalities of designing and implementing an ABC system Managers choose the level of detail required by costing systems by carrying out cost-benefit analysis. ABC systems would be of benefit where: 1. Significant proportions of the organisations costs are indirect costs. 2. Products have differences in volumes produced, processes required, batch size or complexity and as such require significantly different levels of support activities. 3. Complex products appear to be very profitable, and simple products appear to be losing money. 4. Operations staff and finance staff have significant disagreements regarding the costs of producing and marketing products or services. Designing and implementing an ABC system Setting up an ABC system is costly and time consuming. For example staff costs will require that staff fill in time sheets so as to record their salary costs into the appropriate cost pools to reflect the activities that they undertake. Even basic ABC systems require many calculations to determine costs of products and services. These measurements are costly. The cost pools and the rates at which activities are recharged then need to be reviewed and updated on a regular basis. Detailed ABC systems are even more costly to operate and difficult to understand. At times, organisations will be forced to use substitute allocation bases where data is readily available whereas the preferred allocation bases might require further and costly information. For example, a company might be forced to use the number of loads moved, instead of the complexity and distance of different loads moved as the allocation base for material handling costs because the former is easier to measure. But of course simply using number of loads then implies that each load is reasonably similar to the next one. Costing 65

66 ABC and the organisational context It is often the case that relations between management accountants and operational managers improve significantly following the implementation of activity-based costing. Perhaps this is due partly to ABC systems requiring the management accountant to integrate operational information based on first-hand observation and discussions with individuals across different departments, functions and activities within the enterprise. Nevertheless, resistance to accounting systems change is often present. The cure is not always management education. You saw when looking at the differences between the two approaches that another important consideration when deciding to set up an ABC system is the cost. The absorption and ABC approaches will invariably have initial set-up and ongoing maintenance costs, however the ABC system is likely to be more costly. ABC on the face of it may seem straightforward as a conceptual model, but the real-world mechanics can be extremely complex. Imagine a large industrial engineering firm producing hundreds of products. The systems to practically implement and maintain an ABC system will be expensive so it is important that the organisation decides whether the costs outweigh the benefits. However it should be noted that examination of activities and in particular of the cost drivers behind those activities can lead to efficiency savings even if a full ABC system isn t ultimately adopted. Costing 66

67 4.3.6 ABC as a management tool The emphasis so far has been on the role of ABC systems in obtaining altered activity and product costs. Companies use ABC information for pricing, product mix, and cost management decisions. Activity-based management (ABM) describes management decisions that use activitybased costing information to satisfy customers and manage profitability. Although ABM has many definitions, we define it broadly to include pricing and product-mix decisions, cost reduction and process improvement decisions, and product design decisions. Pricing and product-mix decisions An ABC system gives management particular insights into the cost structures for making and selling diverse products. As a result, management can make pricing and product-mix decisions. Cost reduction and process improvement decisions ABC information can be used as a way of controlling costs. It allows management to understand the underlying causes of costs and therefore to take action to control those costs. If ordering is one of the activities undertaken in an organisation and it has been identified that the number of purchase orders is the cost driver then managers can actively take action to manage the number of orders raised and therefore reduce costs by placing orders on a weekly rather than daily basis for example. Design decisions Management can identify and evaluate new designs to improve performance by evaluating how product and process designs affect activities and costs. Companies can then work with their customers to evaluate the costs and prices of alternative design choices. For example, creative design decisions that decrease the complexity of the products or services. Planning and managing activities Most companies implementing ABC systems for the first time analyse actual costs to identify activity-cost pools and activity-cost rates. Many companies then use ABC systems for planning and managing activities. They specify budgeted costs for activities and use budgeted cost rates to cost products using normal costing. At year-end, budgeted and actual costs are compared in order to provide feedback on how well activities were managed. Adjustments are also made for under- or overallocated indirect costs for each activity area. ABC systems are integrated with other operational and strategic performance systems as well as financial reporting systems. Costing 67

68 Exercise Crowchester NHS Trust Crowchester NHS Trust has a compound manufacturing unit that forms part of its central pharmaceutical services. The unit operates as an independent profit centre within the trust. One part of the processing unit, called the Non Sterile Compounding Unit (NSCU), processes drug compounds from raw materials and dispenses them to the rest of the trust and to other trusts in the area. The NSCU is further divided into three departments, Processing and Compounding, Quality Control, and Packaging and Sales. As part of its annual costing exercise, the NSCU is currently reviewing the cost of four of its products, compounds A, B, C and D, with a view to adjusting prices charged for the coming year. In order to carry out this exercise the following information has been provided. Direct staffing costs: Cost Processing and Quality control Packaging compounding and sales Pharmacy technicians 81,000 28,500 - Technical assistants 35,600 17,250 6,500 Administrative assistants 7,200 7,200 22,400 Laboratory technicians 13,100 26,720 - Operative assistants 2,000-27,000 Indirect staffing costs: The manager of the NSCU costs 32,000 per annum. His time is split as follows: Processing and compounding 35% Quality control 35% Packaging and sales 30% Overheads The NSCU has general trust overheads of 120,000 per annum, and other overheads of 175,000 per annum, that are allocated as follows: General trust overheads Other overheads Processing and compounding 35% 40% Quality control 35% 40% Packaging and sales 30% 20% The four products have direct materials costs per batch as follows: Compound A 240 Compound B 720 Compound C 810 Compound D 620 Costing 68

69 Some investigations have been done into the principal activities that drive the cost of each of the three departments. These are as follows: Processing and compounding Quality control Packaging and sales Processing time Number of tests carried out Number of orders Each year the relevant departments of the NSCU carry out 10,000 tests, expect to receive around 7,000 orders and use 6,000 hours of processing time. Each batch of the compounds requires the following: Processing & compounding Quality control Packaging and sales Compound A 20 hours 20 tests 15 orders Compound B 15 hours 25 tests 12 orders Compound C 4 hours 12 tests 30 orders Compound D 8 hours 36 tests 17 orders (a) (b) Requirement: Using Activity Based Costing techniques, determine the full cost of each of compounds A, B, C and D. (12 marks) With reference to part (a) explain the following terms: (i) Cost pool. (ii) Cost driver. (4 marks ) (c) Briefly explain why an organisation may choose to use Activity Based Costing as opposed to using traditional costing methods. (4 marks) Total 20 marks Costing 69

70 Summary In this session we have learnt that traditional absorption costing methodology has received considerable criticism over recent years. ABC has attempted to respond to some of these criticisms by focusing on overheads as they relate to activities as well as highlighting the importance of cost drivers. Our discussion of the two broad approaches (absorption costing and ABC) suggests that each has its strengths and weaknesses this is not to say, however, that they are mutually exclusive. It is possible to incorporate the best elements of each within a single system: for example, trying to use cost drivers to define apportionment bases; using multiple absorption rates rather than plantwide or simple departmental ones; and avoiding nebulous definitions of activities and cost drivers. In addition, several features of absorption costing are common to both approaches. For example, the need for care in selection of an activity measure is every bit as important in ABC as it was for a volume measure in the traditional method; and predetermined absorption rates are often a practical necessity, whether these are based on simple measures such as machine hours or on the relevant cost driver. You should now be able to: Calculate product & service costs using ABC Explain the limitations of traditional absorption costing systems Calculate product & service costs using ABC Discuss the differences between ABC and traditional absorption costing systems Describe the factors to be considered when designing an ABC system Costing 70

71 Additional exercises Exercise Dodo Plc (Exam standard) Dodo Plc. manufactures three products, A, B and C. Data for the period just ended is as follows: A B C Output (units) 20,000 25,000 2,000 Unit Price Direct Unit Cost Materials Labour For this period, production overheads totalled 190,000. Currently, these are absorbed on the basis of direct labour hours. The following additional data about the breakdown of these production overheads is available: Production Overhead Activities 000 Machining 55 Production Planning 40 Quality Control 25 Set-up 25 Receiving 30 Packing The following information is also available about last period s production: Other data A B C Labour Hours/per unit Machine Hours/per unit Total No. of production runs Total No. of component receipts Total No. of customer orders Requirement: a) Using (i) Absorption Costing (ii) Activity Based Costing (ABC) show the total cost and profit per unit for each product during the period. State your assumptions where necessary. (13 marks) b) Discuss what implications there would be for the management of Dodo Plc if it implemented an ABC system based on your method at a) (ii) and what factors would be relevant to the company deciding whether or not to implement ABC. (7 marks) Total 20 marks Costing 71

72 Exercise Abracadabra PLC (Exam standard) Abracadabra plc has produced the following information about the last accounting period: PRODUCT X PRODUCT Y PRODUCT Z TOTAL Product price Production (units) 30,000 20,000 8,000 58,000 Direct material cost per unit Direct labour hours per unit 1 1 /3 2 1 Machine hours per unit 1 1 /3 1 2 Direct labour cost per unit Total no. production runs Total no. customer deliveries Total no. component receipts Total no. production orders The company has recently redesigned its costing system by aiming to recover overheads using two different absorption bases: a materials handling overhead rate based on direct material cost for recovering the costs of receiving materials and a machine hour rate for all other overhead costs. It is recognised that this may not be sufficiently sophisticated. Prices are determined by adding a mark-up that varies between 20 and 25% across the three products. The overhead costs, by activity, for the last period were:- Set-up 30,000 Machining 760,000 Receiving 435,000 Packing 250,000 Engineering 1 373,000 1,848,000 Note 1: Engineering costs are considered fairly similar per production order. Requirement: As the company's management accountant: a) Compute the product unit costs using the current system for absorbing overheads (5 marks) b) Compute product unit costs using an activity based costing system, making clear the basis for your assumptions about appropriate cost drivers. (10 marks) c) Briefly explain the difference between the resulting costings in a) and b) using products X and Z as particular comparative examples, and the implications of the results calculated in b) above. (5 marks) Total 20 marks Costing 72

73 Exercise Devo PLC (Exam standard) Devo plc produces two products, A and B. Each product has two components specified as sequentially numbered parts; that is parts 1 and 2 for A, and parts 3 and 4 for B. Two production departments, machinery and fitting, are supported by five service activities, namely material procurement, material handling, maintenance, quality control and set up. Product A is a uniform product, manufactured in 12 monthly high volume production runs. Product B is made in low volume customised batches involving 25 separate production runs a month. The budget for the overheads is: Material handling Material procurement Set up Maintenance Quality control Machinery (power, depreciation, etc.) Fitting (power, depreciation, etc.) 000 1,500 2,000 1,500 2,500 3,000 2,500 2,000 15,000 Current Absorption Base Direct material cost Direct material cost Direct labour hours Machine value Direct labour hours Using the traditional apportionment methods outlined above, 9,000k is to be attributed to the machinery department, and 6,000k to the fitting department. It is anticipated that activity in the production departments will be: Product A Product B Annual volume 300,000 units 300,000 units Annual direct labour hours: Machinery department Fitting department 500, , , ,000 Traditional overhead absorption methods were used at the budgeting stage to derive product costs for pricing purposes. However, a combination of the Production Manager s unhappiness about the use of overhead absorption based on direct labour hours (DLH), and concern throughout the company to see more modern Activity Based Costing principles introduced, prompted a recent work study exercise. This identified cost drivers for the overhead cost items as shown below: Potential Cost Drivers: Material movements Number of orders Number of set ups Maintenance hours Number of inspections DLHs Machinery DLHs Fitting Predicted annual cost driver volume per component: Part 1 Part 2 Part 3 Part 4 Total ,000 1,200 2, ,000 4,000 6, ,000 5,000 10,000 8,000 30, ,400 1,000 4, , , , ,000 1,100,000 50, ,000 60, , ,000 Costing 73

74 The Management Accountant on the work study team has since departed, leaving you to finish the review. Requirement: A memorandum to the Production Manager in which you: (a) generate unit overhead costs for Products A and B using: (i) (ii) traditional Absorption Costing with direct labour hours as the absorption base an Activity Based Costing system. (13 marks) (b) briefly compare the results produced, clearly explaining the main reasons for any differences, and consider whether an Activity Based Costing system would be suitable for Devo, identifying briefly the practical requirements of such a system. (7 marks) Total 20 marks Costing 74

75 Exercise Quaffers PLC (Exam standard) Quaffers plc has three business divisions: a series of wine shops across the UK, a wine importing division and a division specialising in wine tasting courses. They wish to appraise the performance of each division, but first, the company wishes to improve its system for attributing Head Office costs to these divisions. Head Office costs relate to the following departments: Senior Management, Information Technology, Finance and Personnel. Recharges have been determined for all departments except Personnel. It is recognised, though, that these departments provide services to each other as well as to the three business divisions, but the firm have so far chosen to ignore such relationships and are attributing all Head Office costs directly to the three business divisions. For Personnel, there is a view that the range of activities suggests a need for a fairly sophisticated costing method, though the Director of Finance is keen that simpler alternatives are explored too. Work has been done to identify the activities of Personnel and the time spent by Personnel staff on each activity: Activity Proportion of staff productive time (%) Recruitment 25 Disciplinaries 12 Staff grievances 6 Processing staff leavers 5 Reviewing staff appraisals 5 Running internal training courses 17 Personnel administration (1) 20 Responding to ad hoc queries 10 Note (1) This includes a range of tasks including reviewing legislation, producing and monitoring statistics and staff development activities. The cost of this activity area should be charged on an appropriate basis to other Personnel activities. Total direct Personnel costs can also be broken down into the following cost items: Budgeted cost ( ) Staff 1,800,000 Recruitment advertisements 300,000 Office supplies 250,000 Internal training course materials 50,000 Legal advice (relating to disciplinaries) 50,000 External staff development courses for Personnel 50,000 staff 2,500,000 Costing 75

76 The following information is available about the three business divisions: Wine Wine Courses Shops Importing Direct cost ( ) 10m 3m 2m Staff numbers Staff training days New recruits Staff leavers Queries: relative time spent 70% 20% 10% Requirement: (a) Determine full cost-based recharges of Personnel s direct costs to the three business divisions using: (i) (ii) staff numbers as the recharge basis for all Personnel costs, and an activity-based approach, clearly showing your methodology and assumptions. (15 marks) (b) Discuss briefly some ways in which the firm s costing methodology may be further developed. (5 marks) Total 20 marks Costing 76

77 Exercise Public sector discursive (Exam standard) Public sector organisations have traditionally been noted for their lack of sophisticated costing systems and their use of relatively unsophisticated budgeting and control systems, compared with large manufacturing organisations. This is now changing with many public sector organisations such as NHS Trusts and local authorities now introducing Activity-Based Costing. As a recently qualified accountant in your organisation you have been asked to give a talk to the trainee accountants on Activity-Based Costing. You have been asked to cover certain areas on Activity-Based Costing in your talk. Requirement: Prepare the notes for your talk covering the following areas: (a) (b) (c) The main stages to be considered in the design of an Activity-Based Costing system. (11 marks) The three major categories activities can be classified into, together with a brief explanation of each. (3 marks) The advantages and disadvantages of an Activity-Based Costing system. (6 marks) Total 20 marks Costing 77

78 Costing 4.4 Marginal costing and absorption costing Learning objectives Recognise the different rationales for marginal costing and absorption costing Calculate and compare profit statements using marginal costing and absorption costing Explain when marginal costing or absorption costing is appropriate Costing 78

79 4.4.1 Marginal costing introduction So far, under absorption costing, costs have been classified so as to enable the full costs of jobs, processes etc. to be established. However, there will be circumstances within organisations when marginal costing is also relevant. Marginal costing is a principle whereby only marginal costs of cost units are ascertained the fixed costs will be known but usually only as a total amount. Only variable costs are charged to cost units, while fixed costs are treated as period costs, i.e. costs assumed to remain constant during a given period. Thus the 2 key definitions are: Fixed costs A cost which accrues in relation to the passage of time and which, within certain output limits, tends to be unaffected by changes in output e.g. rent, rates, insurance and executive salaries are usually fixed costs for a certain period. Variable costs A cost which tends to vary directly in proportion to changes in the level of output. We usually assume for simplicity that variable costs are linear with regard to output i.e. if output rose by 10% a variable cost item would increase by 10% too. Usually, though not always, direct costs (refer back to absorption costing) are considered to be variable (e.g. materials and production workers). But also there will often be some variable production overhead (e.g. power). Contribution A key term in marginal costing is the CONTRIBUTION. This is the difference between the sale price and variable cost. Thus, this difference is the contribution made to fixed costs and profit. In marginal costing decisions, management will look for a product to make a positive contribution (i.e. to cover its variable cost) towards fixed costs and once the fixed costs are covered, to profit. Remember the formula S - VC = Contribution Contribution = FC + Profit Costing 79

80 Breakeven analysis The Breakeven Point (BEP) is the level of sales volume at which neither a profit nor a loss is made. The total sales value (total income) is equal to total costs (total expenditure). There is no profit or loss. A third way to say breakeven is that at the BEP, total fixed costs equal the total contribution. At outputs above the BEP, all extra contribution will result in profit as fixed costs have already been covered. The relevant formula is as follows: BEP (units) = Total fixed costs Contribution per unit [where contribution per unit = sale price - unit variable cost] Another useful formula within Breakeven Analysis is as follows: Level of sales needed for target profit = Fixed costs + Target profit Contribution per unit Marginal costing and decision making When management is confronted by a choice between a number of alternative courses of action, it is important to understand how costs behave under each option. There are therefore a number of potential situations where marginal costing principles can be used. For example: a) Breakeven point and profit assessment: number of sales needed to breakeven number of sales needed to make a certain level of profit evaluation of marketing options (effect on profit and breakeven point) evaluation of investment in more efficient plant and machinery b) Deleting a segment: Should a department continue producing a product when it is reporting a loss under an absorption costing system? c) Special price: reducing sale price in order to increase sales volume selling below usual sale price (e.g. special discount) d) Make or buy decisions: Should we buy in a component or manufacture it in house? (including opportunity cost) Costing 80

81 In each of these possible situations, we are concerned with making the best use of existing facilities. In the short run, organisations generally face fixed capacity therefore fixed costs will remain unchanged so that the marginal cost will be the relevant cost of an option or for a decision to be made. In these cases, the key decision rule is does the option make a contribution? And if competing options are available (i.e. those using the same resources), the decision rule is which achieves the highest contribution? Conclusion From this introduction to the principles of marginal costing, it is crucial to realise that marginal costing and absorption costing are not alternatives to each other in the sense that we have to choose one or the other approach. In the long run, all costs have to be recovered by profit-seeking organisations; hence the full absorption cost is a key calculation, perhaps underpinning a sales price. However, in certain short-term situations, usually associated with some spare capacity, the costs of which are largely fixed (and hence, wont change in a short period) rational managers should identify the marginal cost of using such spare capacity, and ensure that any option generates income above this identified marginal cost (i.e. contribution). Hence, absorption and marginal costing can be viewed as complementary costing approaches within organisations. We will investigate the use of marginal costing for decision making in workbook 5, for now we are going to investigate the differences between absorption and marginal costing. Costing 81

82 4.4.2 Differences between absorption and marginal costing Absorption costing: Costs are charged to cost units (including fixed production costs) via - Allocation - Apportionment - Absorption (Overhead absorption rates) Stocks/inventory (or work in progress) carried forward between costing periods are valued with fixed elements included. Marginal costing: Only variable costs are charged to cost units. Fixed costs are written off or charged in full against contribution. i.e. fixed costs are charged to the time period in which they are incurred (period/time related costs) Stocks/inventory (or work in progress) carried forward between costing periods are valued excluding any fixed costs i.e. valued at variable cost only. Absorption and marginal costing 1. Absorption costing (also known as full costing) traces all manufacturing costs to products and treats non-manufacturing overheads as a period cost. 2. Marginal costing (also known as direct or variable costing) traces all variable costs to products and treats fixed manufacturing overheads and non-manufacturing overheads as a period cost. 3. Therefore variable and absorption costing differ in the treatment of fixed manufacturing costs. Costing 82

83 Absorption costing Variable production costs Fixed production costs Variable nonproduction costs Fixed nonproduction costs Products Stocks P & L a/c Marginal costing Variable production costs Variable nonproduction costs All fixed costs Products Stocks Contribution P & L a/c As we saw in absorption costing earlier, in practice an absorption costing system would set up a predetermined overhead absorption rate based on budgeted figures for overhead costs and output and that rate would then be used to charge/absorb an amount for fixed (production) overheads to each unit of production This almost invariably results in over/under absorption Exercise Requirement (a) Define under/over absorption. (b) State the circumstances in which under and over absorption will occur. Costing 83

84 4.4.3 Introduction to costing statements The following operating statement has been produced by AN Ltd: Absorption costing statement Product A Product B Product C Sales 20,000 30,000 40,000 Cost of sales 15,000 35,000 20,000 Profit 5,000 (5,000) Loss 20,000 Total Profit 20,000 Question: What would be the impact on profit if AN Ltd stops production of product B? Answer: Given the data available we would assume that profits would increase by 5,000. Sales would reduce 30,000 to 60,000 but costs would also reduce, by 35,000, to 35,000 giving revised profits of 25,000. A manager asked to improve company performance would therefore cease production of product B. Question: Given the following information about cost behaviour: Product A Product B Product C Variable costs 5,000 25,000 10,000 Fixed costs 1 10,000 10,000 10,000 ( 1 The fixed costs relate to head office and are apportioned and absorbed by the 3 products equally.) What would be the impact on profit if production of B ceased? Costing 84

85 Marginal costing statement Given that the fixed costs are related to head office the cost will not change simply because fewer units/products are made in total therefore we need to use marginal costing to assess this: Answer: Sales 20,000 30,000 40,000 less variable costs 5,000 25,000 10,000 Contribution 15,000 5,000 30,000 TOTAL CONTRIBUTION 50,000 Less fixed costs 30,000 PROFIT 20,000 If product B were no longer produced, contribution would reduce by 5,000. This would have an equal impact on profit, it would also reduce by 5,000. Sales would reduce by 30,000 but only 25,000 costs would be saved. The organisation would be worse off. It is important to be aware of cost behaviours in decision making. Again, we will return to this in workbook 4. This session tests that you are able to produce operating statements for each method of costing, marginal and absorption costing. It is important that you learn how to lay out these statements. Costing 85

86 Marginal costing profit statement Sales less COS opening stock (Production VCs only) production less closing stock less other non-production variable costs Period1 Period2 Period3 Contribution less production FCs less non-production FCs Profit Absorption costing profit statement Sales less COS opening stock (all production costs) production less closing stock Period1 Period2 Period3 (under)/over absorption Gross profit Less non-production fixed costs Less non-production variable costs Net profit Key differences: In the top half of the marginal costing statement should sit all variable costs whether they relate to production or not. In the top half of the absorption costing statement all production related costs are included both variable and fixed. In the bottom half of the marginal costing statement all fixed costs are shown whether production or non-production related costs. In the bottom half of the absorption costing statement all non-production related costs are shown, fixed and variable. Costing 86

87 Worked example The following information is available for periods 1-6 for a company that produces a single product: Unit selling price 10 Unit variable cost 6 Fixed costs for each period 300 Normal activity is expected to be 150 units per period (thus 300/150 units gives a predetermined absorption rate of 2 per unit) and production/sales for each period are as follows: Period 1 Period 2 Period 3 Period 4 Period 5 Period 6 Units sold Units produced There were no opening stocks at the start of period 1, and the actual manufacturing fixed overhead incurred turned out to be 300 per period as expected. Assume that non-manufacturing overheads are 100 per period. Costing 87

88 Solution Marginal costing statement Period 1 Period 2 Period 3 Period 4 Period 5 Period 6 Sales 1,500 1,200 1,800 1,500 1,400 1,600 Opening stock Production cost Closing stock - (900) - - (900) 180 (180) (900) - - (900) - - (1,020) 180 (180) (840) 60 Cost of sales (900) (720) (1,080) (900) (840) (960) Contribution Fixed costs (300) (300) (300) (300) (300) (300) Gross profit Less non-manufacturing fixed costs 300 (100) 180 (100) 420 (100) 300 (100) 260 (100) 340 (100) Net profit Absorption costing statement Period 1 Period 2 Period 3 Period 4 Period 5 Period 6 Sales 1,500 1,200 1,800 1,500 1,400 1,600 Opening stock Production cost Closing stock - (1,200) - - (1,200) 240 (240) (1,200) - - (1,200) - - (1,360) 240 (240) (1,120) 80 Cost of sales (1,200) (960) (1,440) (1,200) (1,120) (1,280) Adjustment for (under)/over recovery of (20) overhead Total costs (1,200) (960) (1,440) (1,200) (1,080) (1,300) Gross profit Less non-manufacturing costs 300 (100) 240 (100) 360 (100) 300 (100) 320 (100) 300 (100) Net profit Costing 88

89 Workings for under/over absorption of overhead To calculate under/over absorption, compare the amount of fixed overheads absorbed for each period to the actual cost incurred, using the following formula: FO absorbed - Actual FO Period 5: Absorbed (170 units x 2 per unit) = 340 Actual = 300 Over-absorbed = 40 Period 6: Absorbed (140 units x 2 per unit) = 280 Actual = 300 Under-absorbed = ( 20) (NB you must use PRODUCTION units not sales units.) Costing 89

90 4.4.4 Profit comparisons (Continuing from the example above) Profits are the same for both methods when production equals sales (no changes in stock levels) as in periods 1 and 4. Where production exceeds sales (increasing stock levels) the absorption costing system produces higher profits as in periods 2 and 5. This is because in absorption costing fixed costs are absorbed into the units produced and so if stock carries forward into the next period the fixed costs absorbed in that stock also carry forward to the next period. As marginal costing recognises all the fixed costs within the period marginal costing effectively shows higher costs than absorption costing and therefore lower profits. Where sales exceed production (declining stock levels) the marginal costing system produces higher profits as in periods 3 and 6. This is because if stocks are reducing then they are being sold and therefore the costs and incomes associated with that stock are being recognised, including fixed costs that were carried forward from previous periods absorbed in the stock. As a result more fixed costs are recognised under absorption costing than marginal costing where regardless of stock only the period fixed costs are recognised. That means in this instance absorption costing is showing higher costs and therefore lower profit. With an absorption costing system, profits can decline when sales volume increases and costs remain unchanged (e.g. period 6). Ultimately when all stocks are sold and all costs and incomes recognised, the balance of profits over the whole time period will be the same under both absorption and marginal costing. This can be seen by comparing the cumulative profits earned to the end of period 3. Reconciliation between marginal and absorption costing profits The difference between the levels of profit reported is due to movements in the stock held and the fact that stock values are different. There is a formula to represent this: Movement in stock x OAR = Difference in profits Costing 90

91 This will work for any time period: Period 3 Periods 1-6 Marginal Costing Profit ( ) 320 1,200 Opening Stock (units) 30 0 Closing Stock (units) 0 10 Movement x OAR ( ) (60) 20 Absorption Costing Profit ( ) 260 1,220 Arguments for marginal costing useful information for decision making removes the effect of stock changes from profit avoids fixed overheads being capitalised in unsaleable stock Arguments for absorption costing does not understate the importance of fixed costs avoids fictitious losses being reported (seasonal sales)* theoretically superior? (match sales and costs)* * Consider an event such as the Olympic games with a merchandise manufacturer who produces throughout the year but has sales in the few weeks leading up to and during the games. In the early months of the year there will be costs but no sales so stocks are being carried forward from month to month. With absorption costing the fixed costs incurred will get carried forward in the stock values but marginal costing charges fixed costs to the time period. So with no sales those early months will show as losses, until the time of the games when a huge profit is shown as all the sales income arrives. Thus absorption costing better matches sales and the costs of those sales Costing 91

92 4.4.5 When to use each method Absorption costing: the full production cost of product or job Marginal costing: the cost of one extra unit focus on contribution earned. choice depends on circumstances volatile sales and stock levels (and short term decisions) favour marginal costing seasonal sales with stock build up favours absorption costing Absorption costing must be used for external reporting purposes and IAS 2 requires that absorption costing is used for financial statements. For internal purposes, either method is allowable depending on the individual circumstance: Decision making Marginal costing distinguishes between variable and fixed costs. Any fixed costs will likely be unaffected by decisions in the short-term. If absorption costing is applied to financial analysis of a decision, there is a danger that incorrect decisions may result because: 1. the fixed overhead absorption rate treats fixed costs as if they were variable (the OAR being per unit or hour.) 2. some, or even all, of the underlying amount of the fixed costs being absorbed will be unaffected by a decision and is therefore irrelevant. Planning and control When budgets are being prepared, an appreciation of cost behaviour is necessary. If budgeted and actual volumes are different, which costs will react to this difference and which will not? Failure to allow for the impact of volume changes on budgeted and actual costs may undermine the value of a budget/actual comparison. If a budget based on one estimated volume is compared to actual results based on a different volume, then the differences between the two will result partly from the volume difference and partly from efficiency and price differences. Marginal costing should help clarify these issues by segregating fixed and variable costs. Absorption costing may make differentiation between volume, price and efficiency factors difficult because of the unitisation of fixed costs via the absorption rate. Costing 92

93 Weakness in absorption costing In addition to making differentiation difficult, absorption costing may suffer from another weakness. There is an element of subjectivity in the choice of apportionment and reapportionment bases. To the extent that such apportionments and reapportionments exist, control may be hampered. Many organisations must use absorption costing for external purposes, even though marginal costing may be superior for internal purposes. It might be possible to use marginal costing for internal reporting and absorption costing for external reporting, either by running the two systems in parallel or by employing marginal costing and making yearend adjustments. If a cost centre s budgeted and actual costs contain significant apportionments/reapportionments, we can ask to what extent these are genuinely controllable by the cost centre concerned. The fact that there are apportionments/reapportionments may not be obvious from absorption costing profit or cost statements. Marginal costing, for example by using a contribution analysis format, may help to highlight those costs which are specific to a cost centre and apportionments of general costs. Variability of profit Under absorption costing, net profit varies with both sales and stock changes, whereas marginal costing net profit varies with sales volume only. This aspect of absorption costing may cause confusion. Marginal costing may also be problematic with respect to variability of profit. In highly seasonal businesses (e.g. Olympic mechandise as mentioned earlier), stocks may be deliberately built up during the offpeak season in order to cope with peak demand. In this sort of situation, marginal costing profit is likely to fluctuate widely. By reacting to stock changes as well as to sales, absorption costing profit will somewhat smooth these fluctuations giving, perhaps, a more balanced picture of the business over the entire period. Costing 93

94 Marginal costing and price-setting You have learned in previous sessions that inclusion of fixed overheads in unit costs could be seen as an attempt to approximate longer-term cost. It might be said that by using only variable costs, marginal costing takes a particularly short-term view of cost, and that this may cause problems where selling price is based to any extent on cost. To ensure long-term profitability, revenue must cover all costs, whether direct, indirect, fixed or variable. Marginal costing, by excluding fixed costs from the cost per unit, may run the risk of understating unit costs, with an associated risk of failure to set a price high enough to cover all costs. Marginal vs. variable cost The terms marginal and variable are generally used as synonyms, but this is not always true. A marginal cost is the additional cost incurred to provide one extra unit. Within the relevant range of output volumes and time horizon, this may be the same as a unit s variable cost, but outside the relevant range this correlation becomes suspect. Consider the impact of step costs. As output increases, a volume will eventually be reached where the true marginal cost of the next unit will consist of that unit s variable cost plus the amount of increase in step cost resulting. Marginal and variable cost are roughly equivalent. Marginal costing is dependent on our ability to separate costs into their fixed and variable elements with tolerable precision. Costing 94

95 Exercise S Ltd The budget of S Ltd provides for the manufacture and sale of 10,000 spodgets per month, the unit standard cost being 6, made up as follows: Direct materials Direct labour Fixed overhead The selling price of the spodget being 8.0 Production and sales quantities for Periods I and II were as follows: Production Sales Period I 10,000 8,000 Period II 10,000 12,000 You are required to: (a) prepare operating statements for each of the two periods: (i) (ii) assuming the company uses marginal costing assuming absorption costing is used, and (b) comment on the differences of the two systems as regards: (i) (ii) stock valuations period profit Costing 95

96 Exercise T Ltd Using the information given below, prepare profit statements for the months of March and April using: (a) (b) marginal costing; absorption costing. Per unit: Sales price Direct material cost Direct wages Variable production overhead Per month: Fixed production overhead Fixed selling expenses Fixed administration expenses 99,000 14,000 26,000 Variable selling expenses, 10% of sales value Normal capacity was 11,000 units per month. Sales Production March units 10,000 12,000 April units 12,000 10,000 Costing 96

97 Summary In this session we have established that in marginal costing the product cost includes variable costs only; fixed costs are written off in the period; and closing stock is valued at variable cost. In absorption costing fixed manufacturing costs are allocated to individual products and are included in the production cost; over- or under-recovery of fixed overheads is adjusted for in the profit statement; and closing stock includes absorbed fixed manufacturing costs. With a system of marginal costing, profit is a function of sales volume only. With absorption costing, profit is a function of both sales volume and production volume. The difference between the profits under absorption costing and marginal costing is reconciled by recognising the fixed overheads being carried forward in stock valuations. It should be noted that IAS 2 requires the use of absorption costing for external reporting purposes. You should now be able to: Recognise the different rationales for marginal costing and absorption costing Calculate and compare profit statements using marginal costing and absorption costing Explain when marginal costing or absorption costing is appropriate Costing 97

98 Additional exercises Exercise Alpha Ltd (Exam standard) Alpha Limited produces and sells one product. At 1 January there is opening stock of 2,000 units valued at 72 per unit (full cost) of which 12 per unit represents fixed costs. Sales Production Jan (units) 6,000 12,000 Feb (units) 9,000 3,000 Selling price per unit Variable production costs per unit Fixed production overhead incurred Predetermined overhead rate Selling, distribution and admin costs (fixed) , , , , You are required to: (a) Present a comparative profit statement for each month using: 1) absorption costing 2) marginal costing (12 marks) (b) Explain the reason for any difference in profit using the two costing methodologies in (a) (3 marks) (c) Outline briefly the arguments for: 1) absorption costing 2) marginal costing (5 marks) Total 20 marks Costing 98

99 Exercise Adams Plc (Exam standard) Adams plc produces one product which has the following standard costs per unit associated with its production Direct Labour 7.00 Direct Materials 9.00 Production Overheads 8.00 Production cost per unit The production overheads figure was based on the assumed activity level of 200,000 units per annum (50,000 per quarter). 25% of the production overheads cost at this level of output is expected to vary with changes in output, with the balance being fixed. The company absorbs production overheads in accordance with IAS 2. In addition there are some fixed selling and administration overheads of 1.6m per annum. Selling price of the last year was budgeted at 35 per unit. Assume there were no variances other than sales and production levels. Last year the actual production and sales were: Quarter Production (units) 50,000 60,000 50,000 40,000 Sales (units) 40,000 45,000 50,000 65,000 There were no opening stocks at the start of the first quarter. Requirement: a) Produce in columnar form quarterly - Marginal; and - Absorption costing statements for the year (16 marks) b) Using the figures explain the reason for the differences in the profit statements for each of the four quarters. (4 marks) Total 20 marks Costing 99

100 Exercise XYZ (Exam Standard) XYZ Limited produces and sells a single product, the Ratchet. The standard costs of one Ratchet are as follows: Direct materials (4 kgs at 14 per kg) Direct labour (3 hours at per hr) Variable production overhead 6.00 Fixed production overhead Total standard production cost The normal output of the Ratchet is 32,000 units per annum, and this is the capacity upon which the fixed production overhead is absorbed. In addition to the production costs, the company also incurs other fixed costs related to selling, administration and distribution. These are split into fixed costs of 360,000 per annum and variable costs that amount to 15% of the sales revenue. After some regular analysis by the management accountant, it is discovered that the only variance is a fixed overhead volume variance. The expenditure on fixed overheads is evenly spread over the year. On 1 January 2004 there were no units of Ratchet in the finished goods store. The selling price per ratchet is 280. For the year 2004, the number of Ratchets produced and sold was as follows: Six months ending 30 Six months ending 31 June 2004 December 2004 Production 17,000 14,000 Sales 14,000 16,000 Requirement: (a) Prepare profit statements for each six month period using: (i) Absorption costing. (ii) Marginal costing. (11 marks) (b) Prepare a statement that reconciles, for each period, the profit using marginal costing to that using absorption costing. (3 marks) (c) By referring to their respective features, outline the key strengths and weaknesses of absorption & marginal costing. (6 marks) Total 20 marks Costing 100

101 Costing 4.5 Cost volume profit analysis (CVP) Learning objectives Calculate breakeven points and margins of safety mathematically Construct and interpret a breakeven chart Construct a profit volume chart Apply sensitivity analysis to assess the impact of changes to the cost volume profit relationships of an organisation Explain the assumptions, limitations and practical applications of cost volume profit analysis Explain the difference between the accountant s and economist s models of cost volume profit analysis Discuss the use of cost volume profit analysis in practical situations Costing 101

102 4.5.1 Introduction to cost volume profit analysis (CVP) It is important for management to understand how costs, revenues and profits change in relation to different sales volumes. Cost volume profit analysis (CVP) is a systematic method used to examine the relationship between these factors. Although CVP is based on a number of assumptions it is a powerful tool for management to aid their decisionmaking process. For example, it may be of great importance for management to be aware of the volume of sales which must be achieved in order to cover costs and therefore avoid losses or to assess the required sales volumes to achieve a desired level of profit. CVP analysis is of particular relevance in public services given the increased need to price services, maximise the use of the fixed cost related resources (which are a significant proportion of the total costs in the public sector) and to cope with uncertain and changeable volume levels. For example, in the health sector, hospitals needing to break even are increasingly facing uncertain volume levels and therefore this technique will help to inform management of the effects of this variable. Local authorities may use CVP analysis to assess the financial performance and to inform pricing decisions for areas such as leisure services. Importance of cost behaviour analysis Knowledge of cost behaviour is crucial for management in the following areas: Budgeting Production Planning Performance Evaluation Breakeven Analysis (We will cover this next.) Short Term Decision Making (We will cover this in workbook 5.) Costing 102

103 Exercise Requirements (a) State the four types of cost behaviour and show how they would be represented graphically Costing 103

104 3. 4. Costing 104

105 4.5.2 Cost behaviour assumptions CVP analysis focuses on the relationship between output, costs, revenues and hence profits CVP analysis aims to identify key output levels such as the: - Breakeven output level -> Margin of Safety - Profit maximisation output level Essentially CVP is a short run model in that it assumes: - fixed capacity - constant total fixed costs - constant unit variable costs - constant unit price But many of the above assumptions can be easily flexed and incorporated into the CVP model. Costing 105

106 4.5.3 CVP - mathematical model Profit = Total Revenue - Total Cost => px - (a + bx) where p = price, x = output, a = total periodic fixed cost, b = variable cost per unit Breakeven Point is where: px = a + bx or x = a p-b i.e. x = Total Periodic Fixed Costs Unit (Price-Variable Costs) = Total Period Fixed Costs Unit Contribution -> Margin of Safety: (expressed as a % of Sales level) Expected Sales - Breakeven Sales x 100 Expected Sales The % by which sales can fall before a loss is made. You must learn these two formulae as they are not given on the formula sheet provided in the exam: Break-even point: Total Period Fixed Costs Unit Contribution Margin of Safety: Expected Sales - Breakeven Sales x 100 Expected Sales Costing 106

107 Worked example CVP Sale Price 5 per unit Annual Fixed Costs 40,000 Variable Costs 3 per unit Consider these independent questions: - What is the breakeven output level? - At what output level will 5,000 profit be made? - If fixed costs are instead stepped such that below 18,750 units fixed costs drop to 37,000, what is the impact on the breakeven position? - If instead the price is still to be set, what price would be required to breakeven at 19,000 units of output? Costing 107

108 Solution Breakeven output level: 40,000 = 20,000 units 5-3 Output to make 5,000 profit: To not only breakeven but to also make some profit the breakeven formula is adjusted so that you have fixed costs + the required profit on the top of the fraction: 40, ,000 = 22,500 units 5-3 If fixed costs are stepped: If fixed costs are stepped then which level of fixed costs do you put in the top half of the formula? The answer is that you do not chose, you calculate the two levels of fixed costs because having a stepped cost can result in there being more than one breakeven point: 37,000 = 18,500 units 5-3 Both 18,500 units and 20,000 units are breakeven points in this instance. Below 18,500 units losses are made but above 18,500 units profits are made. That is until the step in the costs is reached. At 18,750 units losses are again made because the cost steps up by a larger amount than the increased contribution. Losses are made until the second breakeven point is reached. This has quite an implication for decision making. If an organisation is going to increase capacity which means an increase in a semi-fixed cost, they must ensure that they increase production far enough over the step in costs to make the change worthwhile. Costing 108

109 CVP to set the price: If instead the price remains to be set for a product to ensure a breakeven position with a given demand for a product you use the same formula but need to rearrange it to establish the selling price (SP): Total Fixed Costs = Breakeven Point Contribution per unit 40,000 = 19,000 40,000 = SP - 3 SP 3 19, = SP SP = 5.11 Costing 109

110 4.5.4 CVP - graphical analysis Breakeven chart Used to show profits and losses at different output levels by plotting the total cost (TC) and total revenue (TR) functions. It is conventional to show on a graph the revenue or income and costs on the vertical (Y axis) plotted against output in units on the horizontal (X axis) It is drawn specifically to show the breakeven point(s) and loss/profit making activity ranges To draw - work out the breakeven point(s) mathematically first, both in terms of output and costs/revenue in order to determine the appropriate scale for each axis (algebraic formula) - determine the intersects on the vertical axis for the cost lines (fixed + variable) - determine another point on each cost function and join points with a straight line - similarly determine two points on the TR function (including the origin) -> where the TR function crosses the TC function is (are) the breakeven point(s) Profit is determined from the vertical difference between the TR and TC lines at a particular output level [NB: Profit volume graphs are also examinable] Exam tip Whenever you draw a graph, make sure you maximise your marks by making sure you label all the lines, include a title for the chart and for the axes and use an appropriate scale. Costing 110

111 Breakeven chart (using earlier example) Breakeven point Total revenue 120,000 Total cost 112, ,500 5,000 profit 100,000 Variable costs 80,000 60,000 40,000 Fixed costs 20, ,000 10,000 15,000 20,000 25,000 Output 22,500 Costing 111

112 Profit volume graph Breakeven point 20k 5k 0 10k 20k 22.5k 30k Output 20k 40k A profit volume chart, as the name suggests, shows the relationship between profit and volume. The breakeven point is where neither a profit nor a loss is made. Costing 112

113 IF FIXED COSTS EQUAL 37,000 BELOW 18,750 UNITS, AND 40,000 ABOVE 18,750 UNITS Y 120,000 BREAK EVEN POINTS 110, ,000 TR TC 90,000 80,000 70,000 60,000 50,000 BREAK EVEN POINTS: 1) 37,000 = 18,500 UNITS 5-3 2) 40,000 = 20,000 UNITS ,000 17,000 18,000 19,000 20,000 21,000 X 18,500 18,750 Output Costing 113

114 4.5.5 CVP - assumptions and limitations A number of potentially very limiting assumptions underlie CVP analysis: Volume is the only factor that can cause changes in costs and revenue => therefore assumes constant production efficiency, sales mix, price levels, etc. -> what about effect on cost of changes in non-volume cost drivers (as per ABC) e.g. product range / complexity? Costs can be categorised accurately as fixed or variable -> in practice this is very difficult as cost behaviour is volatile and dependent on factors such as the nature of the contract an organisation has with its resource inputs (e.g. consider range of types of staffing contracts -> affects cost behaviour in practice). TC and TR are linear functions of output -> curvilinear relationships may prevail Analysis applies only to a relatively narrow relevant range of outputs in which the linearity assumptions may well hold reasonably true. Single product or constant sales mix -> The assumptions are restrictive, but CVP analysis is a generally useful guide to short term decision making, especially within the relevant range. Costing 114

115 4.5.6 Two CVP models The accountant s model Assumes a linear relationship between costs, revenue and activity o costs & revenues are linear and proportional to activity fixed costs are fixed but recognise changes as they occur (stepped cost) one breakeven point identified (unless capacity & fixed costs increase) The economist s model Costs & revenues are curvilinear o e.g. reduce price to sell more o unit production costs may fall as volume increases due to economies of scale fixed costs are fixed but takes an average fixed cost if changes occur several breakeven points may be identified to some extent a more realistic model Across the relevant range the accountant s and economist s models should match each other and identify the same breakeven point. As the relevant range is a small area of a large curve the lines within the relevant range are very close to being straight. Costing 115