NEW HORIZON COLLEGE MARATHALLI, BANGALORE. VI SEM BCOM Study Material COST MANAGEMENT. Prepared by Ms. HARSHA NAMBIAR

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1 NEW HORIZON COLLEGE MARATHALLI, BANGALORE VI SEM BCOM Study Material COST MANAGEMENT Prepared by Ms. HARSHA NAMBIAR

2 CHAPTER 1:COST REDUCTION AND COST CONTROL COST CONTROL CIMA, London has defined cost control as the regulation by executive action of the cost of operating an undertaking particularly where action is guided by cost accounting Cost Control is a process which focuses on controlling the total cost through competitive analysis. It is a practice which works to maintain the actual cost in accordance with the established norms. It ensures that the cost incurred on an operation should not go beyond the pre-determined cost. Cost Control involves a chain of functions, which starts from preparation of the budget in relation to the operation, thereafter evaluating the actual performance, next is to compute the variances between the actual cost & the budgeted cost and further, to find out the reasons for the same, finally to implement the necessary actions for correcting discrepancies. Steps in Cost control Establishing norms: The first step in cost control is to set norms or standards which may serve as yardsticks for measuring performance. these standards are set on the basis of past performance adjusted for changes in future and on the basis of studies conducted. Comparison with actual: The actual cost incurred are compared with established standard costs to know the level of achievement. The variations are analysed so as toy arrive at the causes which are controllable. Corrective Action: Remedial measures are taken to avoid the recurrence of variation in future and for revision of standards wherever necessary COST REDUCTION Cost Reduction is a process, aims at lowering the unit cost of a product manufactured or service rendered without affecting its quality by using new and improved methods and techniques. It ascertains substitute ways to reduce the cost of a unit. It ensures savings in per unit cost and maximisation of profits of the organisation. Cost Reduction aims at cutting off the unnecessary expenses which occur during the production, storing, selling and distribution of the product. To identify cost reduction, the following are the major elements: Savings in per unit cost.

3 No compromise with the quality of the product. Savings are non-volatile in nature. DIFFERENCE BETWEEN COST REDUCTION AND COST CONTROL Cost Controlis the activity of maintaining cost as per the established norms. Cost Reduction is the activity of decreasing per unit cost by applying new methods of production in such a way that it does not affect the quality of the product. Cost Control focuses on decreasing the total cost Cost Reduction focuses on decreasing per unit cost of a product. Cost Control is temporary in nature. Cost Reduction which is permanent. Cost Control does not guarantee quality maintenance Cost reduction100% quality maintenance is assured. Cost Control is a preventive function as it ascertains the cost before its occurrence. Cost Reduction is a corrective action. Cost control is the achievement of pre- determined targets of costs. Cost reduction is the achievement of the real and permanent reduction in costs. Cost control tends to assume a static state of affairs and that standard once set are not challenged. Cost reduction assumes the existence of concealed potential saving in the standards or pre- determined costs set for cost control and that these standards are always subject to challenge. Cost control is concerned with predetermining costs, comparing it with actual costs, analysing the variances and taking corrective measures. Cost reduction is not concerned with maintenance of performance according to predetermined targets. it is rather concerned with finding out new product design, methods,etc Cost control is a part of cost accounting function Cost reduction may be achieved even when no cost accounting system is in operation Cost control lacks dynamic approach to cost improvement Cost reduction is more dynamic approach to cost improvement

4 AREAS COVERED BY COST CONTROL AND COST REDUCTION 1. PRODUCT DESIGN Product design is the efficient and effective generation and development of ideas through a process that leads to new products. It covers : a. Ensuring correct production designs so that faulty design may be discontinued. b. Making research a regular feature to modify the existing minimum cost and optimum quality. 2. TARGET COSTING Target costing can be defined as a structured approach for determining the cost at which a proposed product with specified functionality and quality must be produced to generate a desired level of profitability at its anticipated selling price. A critical aspect of this definition is that it lays emphasis on the fact that target costing is much more than a management accounting technique. Target costing is a management technique aimed at reducing a product s life-cycle costs. A general concept of target costing is discussed here. Target Costing is a disciplined process for determining and realizing a total cost at which a proposed product with specified functionality must be produced to generate the desired profitability at its anticipated selling price in the future. CIMA defines target cost as a product cost estimate derived from a competitive market price Target costing is a formal process that attempts to match a proposed product s features (benefits) with a viable market price that achieves the company s profitability goals by: (a) Determining a price point (or range of prices) for an approximate combination of features and benefits. (b) Subtracting a desired profit from the market price to determine the maximum bearable level of costs. (c) Iterating the product design eliminating or reducing unnecessary attributes with costs that can t be recovered in higher prices until the cost target is met. (d) Revising the market price for the redesigned product in view of changed market conditions. Steps in Target Costing: Following are the main steps (or stages) involved in target costing: (i) To conduct market research in order to see what products are in the market place, what new products the competitors are trying to bring in the market, to ascertain customers requirement and the price they can afford for the product. (ii) Determining the price, margin and cost feasibility. Target price is determined on the basis of market survey, at which the product can be sold. On the selling price a standard

5 margin is determined to finally come to the cost figure (Target Price Target Profit = Target Cost). (iii) To meet margin target by design improvement. If the product designed cannot be produced in the cost range decided, value engineering is used to drive down the product cost to a level, at which target price and margin can be attained. (iv) To implement continuous improvement. This is needed to ensure that targeted cost levels are maintained subsequent to design phase. Value engineering technique is applied for reduction of waste, misuse, etc. and for elimination of non-value added costs and processes, etc. Objectives of Target Costing: Broadly speaking, a target costing system has three objectives: a. To lower the costs of new products so that the required profit level can be ensured. b. The new products meet the levels of quality, delivery timing and price required by the market. c. To motivate all company employees to achieve the target profit during new product development by making target costing a companywide profit management activity. For any system to be effective in supporting decision making in an organization, the staff from the relevant departments must come together in order to tap their creativity so as to achieve goals. In other words, the company requires a non-conflicting and rational system for consensus building and decision-making. Target Costing Process: Just as there is no single definition of target costing, there is no single target costing process. Nevertheless, all companies share a series of general steps: a. Establishing the target price in the context of market needs and competition; b. Establishing the target profit margin; c. Determining the allowable cost that must be achieved; this cost should motivate all personnel to achieve; d. Calculating the probable cost of current products and processes; and finally, e. Establishing the target amount by which current costs must be reduced. 3. VALUE ANALYSIS Value analysis is an approach to cost saving that deals with product design. Here, before buying any equipment or materials, a study is made as to what purpose these things serve? Would other lower- cost design work as well? Is there a cheap material which can serve the same purpose? So value analysis is a procedure which specifies the function of

6 products or components, establishes appropriate costs, determines the alternatives and evaluates them. Thus the objective of value analysis is the identification of such costs in a product that do not in any manner contribute to its specification or functional value. Thus, it is the process of reducing the cost without sacrificing the predetermined standards of performance. It is a supplementary device in addition to the conventional cost reduction methods. Value analysis is closely related to Value Engineering. It is very helpful in industries where production is done on a large scale and in such cases even a fraction of savings in cost would help the firm significantly 4. VALUE ENGINEERING Value engineering is a systematic and organized approach to provide the necessary functions in a project at the lowest cost. Value engineering promotes the substitution of materials and methods with less expensive alternatives, without sacrificing functionality. It is focused solely on the functions of various components and materials, rather than their physical attributes. Also called value analysis. The reasoning behind value engineering is as follows: if marketers expect a product to become practically or stylistically obsolete within a specific length of time, they can design it to only last for that specific lifetime. The products could be built with highergrade components, but with value engineering they are not because this would impose an unnecessary cost on the manufacturer, and to a limited extent also an increased cost on the purchaser. Value engineering will reduce these costs. A company will typically use the least expensive components that satisfy the product's lifetime projections. 5. BUSINESS PROCESS RE-ENGINEERING (BPR) Michael Hammer and Champy, 1993 (in O Neill, 1999) described the Business process reengineering as the fundamental rethinking and radical design of the process to achieve dramatic improvement in critical, contemporary measures of performance, such as cost, quality, service and speed. BPR advocates that enterprises go back to the basics and reexamine their very roots. It doesn t believe in small improvements. Rather it aims at total reinvention. BPR focuses on processes and not on tasks, jobs or people. What to reengineer? : A business process is a series of steps designed to produce a product or a service. It includes all the activities that deliver particular results for a given Customer(external or internal). Talking about the importance of processes just as companies have organization charts, they should also have what are called process maps to give a picture of how work flows through the company. The 3 C s Of BPR Customers More discriminating than ever before means more demanding and creating greater pressure for value, service and quality. Competition Deregulation and technological change have intensified rivalry new entrants can now challenge dominant players barriers to entry are falling and margins are declining

7 Change Product and service lifecycles have been radically reduced, and product opportunities open and close extremely rapidly Some of the BPR Objectives Improve Efficiency e.g reduce time to market, provide quicker response to customers Increase Effectiveness e.g deliver higher quality Achieve Cost Saving in the longer run Provide more Meaningful work for employees Increase Flexibility and Adaptability to change Enable new business Growth COMMON PROBLEMS WITH BPR 1. Process under review too big or too small 2. Reliance on existing process too strong 3. The Costs of the Change Seem Too Large 4. Isolated Activity not Aligned to the Business Objectives 5. Allocation of Resources 6. Poor Timing and Planning 7. the Team and Organization on Target

8 CHAPTER 2 MARGINAL COSTING Definition of marginal cost The amount of any given volume of output by which aggregate costs are changed if the volume of output is increased by one unit. Definition of marginal costing The Institute of Cost and Management Accountants, London, has defined Marginal Costing as the ascertainment of marginal costs and of the effect on profit of changes in volume or type of output by differentiating between fixed costs and variable costs. The main characteristics of marginal costing are as follows 1. It is a technique of analysis and presentation of costs which help management in taking many managerial decisions and is not an independent system of costing such as process costing or job costing. 2. All elements of cost production, administration and selling and distribution are classified into variable and fixed components. Even semi-variable costs are analyzed into fixed and variable. 3. The variable costs (marginal costs) are regarded as the costs of the products. 4. Fixed costs are treated as period costs and are charged to profit and loss account for the period for which they are incurred. 5. The stocks of finished goods and work-in-process are valued at marginal costs only. Prices are determined on the basis of marginal cost by adding contribution which is the excess of sales or selling price over marginal cost of sales. Marginal costing vs. absorption costing or full costing The basic differences between Absorption costing and Marginal Costing are as follows: 1. Absorption costing is the total cost technique. Absorption costing is the practice of charging all costs, both variable and fixed, to operations, processes, or products. In marginal Costing technique only variable costs are treated as product costs, fixed cost is treated as period cost and is charged to profit and loss account for that period. 2. In absorption costing, the stock of finished goods and work-in-process is valued at total cost which includes both variable and fixed cost. In marginal costing, such stocks are valued at marginal cost, i.e., variable cost only.

9 3. In absorption costing arbitrary apportionment of fixed costs, over the products, results in under or over-absorption of such costs. While marginal costing excludes fixed costs, the question of under or over absorption of fixed costs does not arise. In absorption costing, managerial decision-making is based upon profit which is the excess of sales value over total cost. While in marginal costing, the managerial dec1sjon are guided by contribution which is the excess of sales value over variable cost. Breakeven analysis The study of cost-volume profit analysis is often referred to as break-even analysis. In its broad sense, break-even analysis refers to the study of relationship between costs, volume and profit at different levels of sales or production. In its narrow sense, it refers to a technique of determining that level of operations where total revenues equal total expenses, i.e., the point of no profit, no loss. The break-even analysis is based upon the following assumptions: 1. All elements of cost, i.e., production, administration and selling and distribution can be segregated into fixed and variable components. 2. Variable cost remains constant per unit of output irrespective of the level of output and thus fluctuates directly in proportion to changes in the volume of output. 3. Fixed cost remains constant at all volumes of output. 4. Selling price per unit remains unchanged or constant at all levels of output. 5. Volume of production is the only factor that influences cost. 6. There will be no change in the general price-level. 7. There is only one product or in case of multi-products, the sales mix remains unchanged. 8. There is synchronization between production and sales. Illustration 1 From the following data, you are required to calculate: a) P/V ratio b) Break-even sales with the help of P/V ratio. c) Sales required to earn a profit of Rs. 4,50,000 Fixed Expenses = Rs Variable Cost per unit Direct Material = Rs.5 Direct Labor = Rs.2 Direct Overheads = 100% of Direct Labor Selling Price per unit = Rs. 12

10 Solution Selling price per unit 12 Less: variable cost per unit Direct material 5 Direct labor 2 Direct overheads 2 9 Contribution per unit 3 a) P/V ratio = contribution/ sales * 100 = 3/12 * 100 = 25% b) Breakeven sales = fixed expense /P/V ratio = 90,000 / 25% = 90,000 * 100/25 = 3,60,000 c) Sales to earn a profit of 4,60,000 = (fixed expense + profit) / P/V ratio = (90, ,50,000) / 25% = 5,40,000/25% = 5,40,000 * 100/25 = 21,60,000 Illustration 2 Calculate a) Amount of fixed expenses. b) The number of units to break-even. c) The number of units to earn a profit of Rs. 40,000. The selling price per unit can be assumed at Rs The company sold in two successive periods 7,000 units and 9,000 units and has incurred a loss of Rs. 10,000 and earned Rs. 10,000 as profit respectively Solution Period 1 Period 2 Sales 7,00,000 9,00,000 Profit -10,000 10,000 P/V ratio = Change in profit / change in sales * 100 = 20,000 / 2,00,000 * 100 = 10%

11 Contribution of period 1 = 7,00,000 * 10% = 70,000 Loss of period 1 (given) = -10,000 i. Fixed cost = contribution profit = 70,000 - (-10,000) = 70, ,000 = 80,000 ii. Breakeven point = fixed cost / P/V ratio = 80,000 / 10% = 80,000 * 100/10 = 8,00,000 Number of units to breakeven = breakeven sales / S.P. per unit = 8,00,000 / 100 iii. Number of units to earn a profit of 40,000 = 8000 units = (fixed cost + profit) / P/V ratio = (80, ,000) /10% = 1,20,000 / 10% = 1,20,000 * 100/10 = 12,00,000 Advantages of marginal costing 1. Simple to operate and easy to understand 2. Removes complexities of under-absorption of overheads 3. Helps management in production planning. 4. No possibility of fictitious profits by over-valuing stocks 5. Facilitates calculation of important factors like B.E.P. 6. Valuable aid to management for decision-making 7. Facilitates study of relative profitability 8. Complimentary to standard costing and budgetary control 9. Helps in cost control. 10. Profit planning 11. Management reporting

12 Limitations of marginal costing 1. The technique of marginal costing is based upon a number of assumptions which may not hold good under all circumstances 2. All costs are not divisible into fixed and variable. There are certain costs which are semi-variable in nature. It is very difficult to classify these costs into fixed and variable elements. 3. Variable costs do not always remain constant and do not always vary in direct proportion to volume of output because of the laws of diminishing and increasing returns. 4. Selling prices do not remain constant for all levels of output due to competition, discounts for bulk orders, changes in the general price level, etc. 5. Fixed costs do not remain constant after a certain level of activity. 6. Stocks valued on marginal costing are undervalued and the profit and loss account cannot reveal true profits. 7. Although the technique of marginal costing overcomes the problem of under or overabsorption of fixed overheads, the problem still exists in regard to under or overabsorption of variable overheads. 8. Marginal costing completely ignores the time factor. 9. Cost control can be better be achieved with the help of other techniques, viz., standard costing and budgetary control than by marginal costing technique. 10. Fixation of selling prices in the long run cannot be done without considering fixed costs. Thus, pricing decisions cannot be based on marginal cost alone Illustration 3 Company A and Company B both under the same management makes and sells the same type of product. Their budgeted profit and loss accounts for the year ending 1996 are as follows: Company A Company B Rs Rs Rs Rs Sales 3,00,000 3,00,000 Less variable 2,40,000 2,00,000 costs Fixed costs 30,000 2,70,000 70,000 2,70,000 Profit 30,000 30,000

13 You are required to: 1. Calculate the break-even points for each company. 2. Calculate the sales volume at which each of the two companies will make a profit of Rs. 10, State which company is likely to earn greater profits in conditions of: i. Heavy demand for the product. ii. Low demand for the product. Solution Break even point = fixed costs / P.V. ratio P.V ratio = contribution / sales Contribution = Sales variable costs P.V. ratio, Company A = (3,00,000 2,40,000)/ 3,00,000 * 100 = 60,000/ 3,00,000 * 100 = 20% P.V. ratio, Company B = (3,00,000 2,00,000)/ 3,00,000 * 100 = 1,00,000/ 3,00,000 * 100 = 33.33% Breakeven point, Company A = 30,000/20% =1,50,000 Breakeven point, Company B = 70,000/33.3% = 2,10,000 Sales to earn a desired profit = (fixed cost + desired profit) / P.V. ratio Company A = (30, ,000) / 20% = 40,000 / 20% = 2,00,000 Company B = (70, ,000) / 33.33% = 80,000 / 33.33% = 2,40,000 i. In case of high demand, company B is better because it has a high P.V. ratio and it will earn large profit in conditions of heavy demand ii. In case of low demand, company A is better because breakeven point as well as fixed costs are low Break Even Chart [Graphic Method] It is the graphical presentation of breakeven point. It shows the relationship between sales volume, variable and fixed costs. It also shows the profit or loss at different levels of output or volume of sales. Construction of Break even Chart A Break even chart shows the total sales line, total cost line and the point of intersection

14 called the breakeven point. It is constructed using a database of variable costs, fixed costs, total costs and sales at different levels of output. The units of output or sales revenue are plotted along the X axis, using suitable scale of measurement. The costs and sales are plotted along the Y axis. The fixed costs line is plotted first. It forms a parallel line to the X axis indicating that the fixed cost remain constant at all levels of output. The variable cost line is plotted next, starting from zero it progresses continuously indicating that the variable cost increase with the volume fixed cost line of sales. The total cost line is plotted above the variable cost line. It starts from the fixed cost line on the Y axis and follows the same pattern of variable cost line. The sales line is plotted finally. It starts from the zero and progresses continuously, indicating that the sales increase with larger units of output. The point of intersection of sales line and total cost line indicates the Break even point. A vertical line drawn to the X axis from this point shows the volume of output required to Break even. Questions 2 marks:- 1. What is marginal costing? 2. What is marginal cost equation? 3. What is break even chart? 4. How do you calculate margin of safety? 5. How can P/V ratio be improved? 6. Write any two advantages of contribution? 7. What is absorption costing?

15 Meaning of Budget CHAPTER 3 BUDGETARY CONTROL A budget is the monetary or/and quantitative expression of business plans and policies to be pursued in the future period of time Objectives of budgetary control Budgetary control is essential for policy planning and control. It also acts as an instrument of coordination. The main objectives of budgetary control are as follows: To ensure planning for future by setting up various budgets. The requirements and expected performance of the enterprise are anticipated. To co-ordinate the activities of different departments. To operate various cost centers and departments with efficiency and economy. Elimination of wastes and increase in profitability. To anticipate capital expenditures for future. To centralize the control system. Correction of deviations from the established standards. Fixation of responsibility of various individuals in the organization. Advantages of budgetary control The budgetary control system helps in fixing the goals for the organization as a whole and concerted efforts are made for its achievements. It enables economies in the enterprise. Some of the advantages of budgetary control are: Maximization of Profit. The budgetary control aims at the maximization of profits of the enterprise. To achieve this aim, a proper planning and co-ordination of different functions is undertaken. Co-ordination. The working of different departments and sectors is properly coordinated. The budgets of different departments have a bearing on one another. The co-ordination of various executives and subordinates is necessary for achieving budgeted targets. Specific Aims. The plans, policies and goals are decided by the top management. All efforts are put together to reach the common goal of the organization. Every department is given a target to be achieved. Tool for Measuring Performance: By providing targets to various departments, budgetary control provides a tool for measuring managerial performance. The budgeted targets are compared to actual resultsand deviations are determined. Economy. The planning of expenditure will be systematic and there will be economy in spending. The finances will be put to optimum use.

16 Determining Weaknesses. The deviations in budgeted and actual performance will enable thedetermination of weak spots. Efforts are concentrated on those aspects where performance is less than stipulated. Corrective Action. The management will be able to take corrective measures whenever there is a discrepancy in performance. The deviations will be regularly reported so that necessary action is taken as soon as possible. Consciousness. It creates budget consciousness among the employees. By fixing targets for the employees, they are made conscious of their responsibility. Everybody knows what he is expected to do. Reduces Costs. In the present day competitive world budgetary control has a significant role to play. It helps in reducing costs. Introduction of Incentive Schemes. Budgetary control system also enables the introduction of incentive schemes of remuneration. The comparison of budgeted and actual performance will enable the use of such schemes. Limitations of budgetary control Uncertain Future. The budgets are prepared for the future period. Despite best estimates made for the future, predictions may not always come true. Budgetary Revisions Required. Budgets are prepared on the assumptions that certain conditions will prevail. Because of future uncertainties, assumed conditions may not prevail necessitating the revision of budgetary targets. Discourages efficient persons. Under budgetary control system the targets are given to every person in the organization. The common tendency of people is to achieve the targets only and nothing more. Problem of Co-ordination. The success of budgetary control depends upon the co-ordination among different departments. The lack of co-ordination among different departments results in poor performance. Conflict among different departments. Budgetary control may lead to conflicts among functionaldepartments. Every departmental head worries for his department goals without thinking of business goal. Depends upon Support of Management. Budgetary control system depends upon the supportof top management. If at any point of time there is a lack ofsupport from top management then this system will collapse.

17 Difference between flexible and fixed budget Basis Fixed budget Flexible budget Rigidity A fixed budget remains the same irrespective of changed situations. It remains inflexible even if volume of business is changed. Conditions Cost Classification Changes in Volume Forecasting Cost Ascertainment A fixed budget assumes that conditions will remain constant. In fixed budgets costs are not classified according to their nature. If the level of activity changes then budgeted and actual results cannot be compared because of change in basis. Forecasting of accurate results is difficult. Under changes circumstances costs cannot be ascertained A flexible budget is recast to suit the changed circumstances. Suitable adjustments are made if the situation so demands. This budget is changed if level of activity varies. The costs are studied as per their nature, i.e., fixed variable, semi-variable. The budgets are redrafted as per the changed volume and a comparison between budgeted and actual figures will be possible. Flexible budgets clearly show the impact of expenses on operations and it helps in making accurate forecasts. The costs can be easily ascertained under different levels of activity. This helps in fixing prices. Illustration 1 From the following data for 60% activity, prepare a flexible budget for 80% and 100% capacity. Production (60% capacity) 600 units Materials 100 per unit Labor 40 per unit D. Expenses 10 per unit Factory O/H 40,000 (40% fixed) Administration expenses 30,000 (60% fixed)

18 Solution Flexible production budget 60% capacity (600 units) 80% capacity (800 units) 100% capacity (1000 units) Unit cost Total cost Unit cost Total cost Unit cost Total cost Materials , , ,00,000 Labor 40 24, , ,000 D. Expenses ,000 Prime cost , ,20, ,50,000 Factory O/H Fixed(40% * , , ,000 40,000) Variable 40 24, , ,000 Works cost ,30, ,68, ,06,000 Administrative expenses Fixed(60% * 30 18, , ,000 30,000) Variable 20 12, , ,000 Total cost ,60, ,02, ,44,000

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33 UNIT 5 : ACTIVITY BASED COSTING Activity-Based Costing Activity-based costing is a method of assigning indirect costs to products and services which involves finding cost of each activity involved in the production process and assigning costs to each product based on its consumption of each activity. Activity-based costing is more refined approach to costing products and services than the traditional costing method. It involves the following steps: Identification of activities involved in the production process; Classification of each activity according to the cost hierarchy (i.e. into unit-level, batch-level, product level and facility level); Identification and accumulation of total costs of each activity; Identification of the most appropriate cost driver for each activity; Calculation of total units of the cost driver relevant to each activity; Calculation of the activity rate i.e. the cost of each activity per unit of its relevant cost driver; Application of the cost of each activity to products based on its activity usage by the product. Cost Hierarchy The first step in activity-based costing involves identifying activities and classifying them according to the cost hierarchy. Cost hierarchy is a framework that classifies activities based the ease at which they are traceable to a product. The levels are (a) unit level, (b) batch level, (c) product level, and (d) facility level. Unit level activities are activities that are performed on each unit of product. Batch level activities are activities that are performed whenever a batch of the product is produced. Product level activities are activities that are carried out separately for each product. Facility level activities are activities that are carried out at the plant level. The unit-level activities are most easily traceable to products while facility-level activities are least traceable. Example Alex Erwin started Interwood, a niche furniture brand, 10 years ago. He ran the business as a sole proprietorship. While he has 50 skilled carpenters and 5 salesmen on his payroll, he has been taking care of the accounting by himself. Now, he intends to offer 40% of the ownership to public in next couple years, and is willing to make changes and has hired you as the management accountant to organize and improve the accounting systems. Interwood's total budgeted manufacturing overheads cost for the current year is $5,404,639 and budgeted total labor hours are 20,000. Alex applied traditional costing method during all of the 10 years period, and based the pre-determined overhead rate on total labor hours. Interwood's sofa range includes the 2-set, 3-set and 6-set options. Platinum Interiors recently placed an order for 150 units of the 6-set type. The order is expected to be delivered in 1 month time. Since it is a customized order, Platinum will be billed at cost plus 25%. You are not a fan of traditional product costing system. You believe that the benefits of activitybased costing system exceeds its costs, so you sat down with Aaron Mason, the chief engineer, to identify the activities which the firm undertakes in its sofa division. Next, you calculated the total cost that goes into each activity, identified the cost driver that is most relevant to each activity and calculated the activity rate. The results are summarized below: Activity A (in $) Relevant Cost Driver B C=A/B (in $) Production of 2,313,132 Machine hours 25, components Assembly of 1,231,312 Number of labor 20,000 62

34 components hours Packaging 213,123 Units 5, Shipping 231,230 Units 5, Setup costs 34,243 Number of setups Designing 123,132 Designer hours 1, Product testing 24,234 Testing hours Rent 1,234,233 Labor cost $1,645,644 75% Once the order was ready for packaging, Aaron gave you a summary of total cost incurred and a statement of activities performed (also called the bill of activities) as shown below: Order No: 15X2013 Customer: Platinum Interiors Units: 150 Type: 6 unit Amounts in $ Cost of direct materials 25,000 Cost of purchased components 35,000 Labor cost 15,600 Activity Relevant Cost Driver Activity Usage Production of components Machine hours 320 Assembly of components Number of labor hours 250 Packaging Units 150 Shipping Units 150 Setup costs Number of setups 15 Designing Designer hours 70 Testing Testing hours 22 Rent Labor cost 4500 Part A Calculate the total cost of the order and the invoice value of the order based on traditional costing system. Solution In the traditional costing system, cost equals materials cost plus labor cost plus manufacturing overheads charged at the pre-determined overhead rate. The pre-determined overhead rate based on direct labor hours = $5,404,639/20,000 = $270 per labor hour The actual number of labor hours spent on the order is 250. Once we have this data, we can estimate the manufacturing overheads and the total cost as follows: Direct materials 25,000 Purchased components 35,000 Labor cost 15,600 Manufacturing overheads ($ ) 67,500 Total cost under traditional product costing system 143,100 Platinum is billed at cost plus 25%, so the amount of sales to be booked would amount to $178,875 (= $143, ).

35 Part B You know activity-based costing is a more refined approach. Now, since you have all the data needed, calculate the order cost using activity based costing. Solution In activity-based costing, direct materials cost, cost of purchased components and labor cost remains the same as in traditional product costing. However, the value of manufacturing overheads assigned is more accurately estimated. The following worksheet estimates the manufacturing overheads that should be assigned to the order of Platinum Interiors: (A) (B) (A B) Activity Activity Rate Activity Usage Activity Cost Assigned Production of components ,760 Assembly of components ,500 Packaging ,450 Shipping ,900 Setup costs ,145 Designing ,610 Product testing ,056 Rent 75% 15,600 11,700 82,121 Total cost of the order is hence: US$ Direct materials 25,000 Purchased components 35,000 Labor cost 15,600 Manufacturing overheads 82,121 Total cost under activity-based costing 157,721 Based on the more accurate estimation of the order cost, the invoice should be raised at $197,150 (=$157, ) instead of $178,875 calculated under traditional product costing system. The example highlights the importance of correct estimation of the product cost and the usefulness of activity-based costing in achieving that goal.