Welcome to Lesson 1: Cost classification and behaviour

Unit 1: Cost units

In cost accounting, a cost unit is a unit of a product or service to which costs can be related.

Different organisations use different cost units.

For example, a cost unit for a train company might be a mile travelled, for a university, it might be a full-
time student and for a restaurant, it might be a meal served.

A cost unit is not always a single item. It might also be calculated in batches. For example, for an
organisation that manufactures bricks, a single cost unit might be a batch of 1,000 bricks.
A cost unit is linked to the product or service delivered to the customer.
There is a link between how a unit of production is costed and how it is eventually priced.
The same organisation may also have different cost units. For example, a baker might treat a batch of
30 loaves of bread as one cost unit, and an order for a wedding cake as another cost unit.
The following activity presents examples of different businesses and different cost units. For each cost
unit select the corresponding business by clicking on the appropriate example and dragging it onto the
scale.
Composite cost units
In some situations (particularly for organisations that provide a service) it may be more useful to use a
composite cost unit or a cost unit comprised of two parts.
For example, the composite cost unit for a bus company might be a passenger-kilometre (to determine
the cost of carrying one passenger for one kilometre) and
at a hotel it might be a room-night (to determine the cost of providing one room for one night).
Including two parts in the cost unit can help organisations to monitor costs more appropriately, with the
aim of improving cost control.
For instance, in the example of the bus company, the cost per passenger is not particularly useful for
decision-making because it will vary depending on the length of the passenger's journey. However, the
cost of carrying one passenger for one kilometre is not affected by the length of journey and is therefore
more useful for the monitoring and control of costs.

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Discussion
Can you think of another example of a service industry where a composite cost unit is more useful for
cost control than a non-composite cost unit? Why not post an example to the discussion board at the
end of this section and compare with other learners.

In the following activity, reflect on the questions then make a note of your thoughts in the spaces
provided, then click to view some feedback.
Suggest two useful cost units for products manufactured by a company that manufactures cell phone handsets.

1. A single handset
2. A 'batch' or production run of handsets, for example 300 'model Z' handsets.
There is no correct or incorrect answer here. However, your suggestions should enable costs to be
collected and considered logically.
Now consider a small cell phone repair company. Suggest two useful cost units for this business.

1. A customer appointment (to diagnose and repair a handset)

2. An employee hour (a composite cost unit).

Cost unit information

In order to make well-informed decisions, managers need to know the cost and resources required for
the production of cost units. This information can be used in a number of different ways.

In the following activity, click on each tab to learn more about the ways that cost-unit information is used.

To determine a selling price

Managers need to know the cost of a cost unit produced in order to determine the selling price required to earn a profit.

To decide what to produce

Managers need to know how much profit each cost unit is expected to make in order to decide what to produce.

To help with cost control

Over time, an organisation will know what the costs and production times should be for each cost unit. If they vary from
expectations (for instance, if they are significantly higher) then this will trigger an investigation and action may be taken to
bring things back on track.

To plan and budget

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Managers need information to help calculate a realistic budget. They need to know how much the planned output of cost
units will cost, what resources they will need and whether the organisation can afford it.

Budget: A budget is a plan expressed in monetary or quantity terms. There are many different types of budget, for example
the sales budget, the production budget, the expenditure budget and others.

Unit 2: Cost classification

Cost classification is the process of categorising costs on the basis of shared or common characteristics. There are five ways
of classifying costs.

In the following activity, click on each card to reveal examples of the different ways costs are classified.

Function - Costs can be classified according to their related business function. For example, production costs, sales and
marketing costs, or finance costs.

Responsibility - Costs can be classified according to the person responsible for their control. For example, a manager might
be responsible for the costs incurred at their branch.

Behaviour - Costs can be classified by their behaviour. For example, whether they increase if activity increases (variable
costs) or stay the same regardless of the level of activity (fixed costs).

Type - Costs can be classified by the item or activity they relate to. For example, the costs may relate to the work performed
(labour) or to the cost of items used in production (materials).

Traceability - Costs can be classified by how closely they can be traced to a specific cost unit. For example, whether it is
easily traceable (direct cost) or not easily traceable (indirect cost).

It is important to note that costs can be categorised in a number of different ways using more than one classification. This is
because different cost classifications look at the same cost from different perspectives. For example, fuel for a delivery van
might be classified by function (as a distribution cost), by behaviour (as a variable cost) or by traceability (as an indirect
cost).

Fuel for a delivery van may be an indirect cost because it cannot be directly traced to any specific cost unit (the
cost needs to be shared out among several cost units).
However, fuel for a specific delivery for a single customer might be classified as a direct cost of that delivery
because the cost is directly traceable to the cost unit (the delivery).

Different organisations will use different cost classifications depending on how they operate. This is a
prime example of the flexibility involved in cost and management accounting compared with financial
accounting.

Can you think of an example of a cost that might be categorised using more than one classification?

Scenario: Ravi's Quality Bakery

Let's take a moment to revisit Ravi's Quality Bakery (RQB).
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In the following activity, answer each question by selecting 'True' or 'False', and then click the 'Check
answer' button to see if you are correct.

Ravi classifies the cost of delivering products to local cafes as distribution costs. This is an example of classifying
costs by business function.
A: True
B: False

A - Ravi is grouping distribution costs together in a single classification. Distribution is an example of an

organisational function.

Ravi analyses RQB's main production costs between the ingredients used and the wages of employees working in
the bakery. This is an example of classifying costs by responsibility.
A: True
B: False
B - Ravi is classifying costs by the type of item they relate to (materials and labour).

Ravi has authorised the office manager to purchase office supplies and other products and services required to
run the office. Ravi reviews office and administration costs each month, asking the office manager to justify
expenditure. In this situation, Ravi is using both function and responsibility to classify costs.
A - Ravi has grouped administration costs together (classification by function) and has identified these as costs
that are controllable by the office manager (classification by responsibility).

Unit 3: Direct and indirect costs

In cost accounting, costs can be classified into direct and indirect costs depending on whether they
can be easily traced in full to a specific cost unit – for example, to the production of a specific unit of a
product or service.

Direct costs
A direct cost is a cost that can be traced in full to a cost unit, for example a kilogram of flour can be
traced to a batch of bread.

In the following activity, click on each segment to find out more about direct costs.

Direct materials
Direct materials are the materials which form part of the end product. For example, the cost of flour used
in the production of bread in Ravi's Quality Bakery (RQB).

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Direct labour
Direct labour is the labour involved in the production of the end product. For example, the cost of the
baker's wages in RQB.

Direct expenses
Direct expenses are the expenses incurred in the production of a specific cost unit. For example, if a
specialist machine had to be hired to decorate a speciality cake for a customer, the hire cost would be a
direct expense of the speciality cake. It can be traced in full to that specific cost unit.

Prime cost
The prime cost is the total sum of the direct costs. This is sometimes referred to as simply the total direct
cost.

Indirect costs
An indirect cost is a cost that cannot be easily traced directly to a specific cost unit.

In the following activity, click on each segment to find out more about indirect costs.

Indirect materials
Indirect materials are the materials which do not form part of the end product. For example, the cost of
the cooking spray (grease) on each baking tray at RQB. Measuring the quantity of spray on each tray is
not worthwhile because the cost is not significant and so the cost is not traced directly to each unit of the
end product.

Indirect labour
Indirect labour is the cost of labour that is required for production, but which is not easily traced to a
specific cost unit. For example, the cost of wages for regularly cleaning RQB's factory floor.

Indirect expenses
Indirect expenses are the expenses incurred as part of production, but which are not traced to a specific
cost unit. For example, the electricity required to light the bakery and power the ovens.

The three indirect production costs (materials, labour and expenses) are sometimes grouped together
as production overheads.

Non-production overhead
Non-production overheads are the indirect expenses that are not incurred in the production process.
For example, the office manager's wages at RQB and the cost of advertising. In order to determine the
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full cost of producing and selling a cost unit, it will be necessary to include these costs in the
calculations.

In the following activity, select the correct cost classification for each of the costs described by clicking on the
radio buttons, then click 'View feedback' to see our thoughts and reveal the correct answers.

Indirect
Non-
Direct Direct Indirect Indirect expenses
production  
Direct materials labour expenses materials labour (production
overhead
overhead)

Small amounts of
View
icing sugar sprinkled
feedback
on some of the cakes

Wages of the factory View

supervisor feedback

Vehicle rental cost of View

a delivery van feedback

View
Eggs
feedback

Wages of the person

who packs the bread View
at the end of the feedback
production line

Office manager's View

wages feedback

Business rates (a local

View
government tax) bill
feedback
for the bakery
The cost of a one-off
machine set up for a
specific customer's
order

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 Unit 4: Cost behaviour: Variable costs and fixed costs
In the previous unit we looked at how costs can be classified in terms of direct and indirect costs. Costs
can also be classified by their behaviour.

Cost behaviour is the way that costs react as a result of changes in the level of activity – for example,
the number of units produced. Costs that change in response to changes in the level of activity are
known as variable costs. The costs which are unaffected by changes in the level of activity are fixed
costs. In the long term all costs are variable because costs (such as rent for the office) inevitably
change over time.

Some students fall into the bad habit of assuming that all direct costs are variable. This is because most direct
costs are variable. For example, if Ravi’s Quality Bakery increases production of bread, the bakery will use more
materials and more labour. However, if Ravi decided to produce a special batch of gluten-free bread (bread
without any standard wheat or barley), he may need to hire separate equipment to avoid cross-contamination.
This is a direct cost because it is easily traceable to the product – the gluten-free bread. However, if the rental
charge for the oven was a fixed monthly payment, this would be a direct fixed cost.

Variable costs
To see how variable costs work in practice, think again about Ravi's Quality Bakery:

 The cost of flour to produce 100 loaves of bread is $10

 If RQB produce 200 loaves then the cost of flour is $20.

Variable cost: Total cost

This graph shows that the total cost of flour increases as activity increases.

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 Note that the cost of flour per loaf does not change. What changes is the total cost of flour used in
production
 For example, the cost of flour per loaf to produce 100 loaves is $0.10 (calculated as $10 / 100 loaves)
 When activity increases to 200 loaves, the cost of flour per loaf remains at $0.10 (calculated as $20 / 200
loaves).

Variable cost: Cost per unit

This graph shows that the cost of flour per loaf of bread (per unit) remains the same.

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 
Exam Fixed costs
To see how fixed costs work in practice, consider the following example:

 Ravi rents the RQB premises for $1,000 per month

 The cost of rent is not affected by how much RQB produces (the activity level)

 Rent is a fixed cost.

In the following activity, click 'Next' to move through the screens and see how this fixed cost is shown in
a graph.

Fixed cost: Total cost

This graph shows that the total cost of rent does not change as activity increases.

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advice
Fixed cost: Cost per unit
This graph shows the cost per unit of this fixed cost.

Because the fixed cost of rent remains the same, the fixed cost per unit (loaf of bread) will decrease as
more loaves are produced. This is because the fixed cost of the rent is spread over more loaves of bread.
 The $1,000 rent per month shared out over 1,000 loaves of bread is a fixed cost of $1 per unit at this
activity level ($1,000 / 1000).
 If RQB produce 2,000 loaves in a month, then the total fixed cost of rent remains at $1,000 but the fixed
cost per loaf of bread is now only $0.50 ($1,000 / 2,000)

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 RQB now has lower unit costs and higher profit per loaf of bread by producing more loaves while
keeping the rent cost fixed.

Exam advice
You may be asked to identify different cost behaviours by identifying behaviour patterns presented in
graphs.

In the following activity, select the 'tick' or the 'cross' according to whether you think each statement is
true or false, then read the feedback text to check whether you are correct. Use the 'Next' button to
move on to the next statement.

The salary of an office manager is a fixed cost. (T)

In most organisations, the office manager is paid the same amount regardless of the activity level.
The cost of wages of a delivery driver paid an hourly rate is always a variable cost. (T)
This will not always be a variable cost. It depends on the employment arrangement. In most cases the driver's
hourly rate is a variable cost depending on the number of hours worked. However, in some cases the driver may
be paid an hourly rate for a fixed number of hours (for example, 40 hours per week), even if fewer hours are
worked. This would be a fixed cost.
The cost of ingredients for a restaurant is usually a variable cost.
Typically, the cost of ingredients varies depending on the number of meals served in the restaurant – the total
cost of ingredients increases as the level of activity increases.

Unit 5: Cost behaviour: Mixed costs and stepped-fixed costs

In the real world, not all costs are either wholly fixed or wholly variable.

Mixed costs

Some costs include a fixed element and a variable element. These are called mixed costs. This means
that only part of the cost is affected by changes in activity levels.

Mixed costs are sometimes referred to as semi-variable costs or as semi-fixed costs.

In the following activity, click on each card for an example of a mixed cost.

Utility bills
Services like electricity and cell phone services often include a fixed connection fee for the period and a variable
charge based on usage – for example, text messages and minutes.
 
Some wage schemes

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An employee's wages may include a fixed base salary for the period and an additional variable element linked to
the output achieved.
 
Machine or vehicle rental
Machine or vehicle rental may include a fixed rental charge for the period and a variable charge – for example, for
each hour the machinery is in use or for each kilometre the vehicle is driven.

Mixed cost examples generally use a 'rental + usage' format. Whenever you see this, check whether there is a

fixed element (rental) and a variable element (charges linked to use).Exam advice

In the following activity, click 'Next' to move through the screens and see how mixed costs are shown in a graph.

Mixed cost: Total cost

The following graph shows the behaviour of the total cost of a mixed cost (i.e. the variable portion of the
total cost and the fixed portion of the total cost).

As you can see, the total cost increases as the level of activity increases. For example, the total cost of
renting a vehicle increases as the kilometres driven increases. Note that even if the rented vehicle is not
driven at all, there is still a cost – the fixed rental cost!

Mixed cost: Total cost

The following graph shows the behaviour of the cost per unit of a mixed cost.

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Because the total fixed cost remains the same for all levels of activity, the cost per unit decreases as the
level of activity increases. For example, in a hired vehicle, the total cost per kilometre decreases when the
number of kilometres driven increases (assuming that the rental agreement is the same price regardless
of the number of kilometres driven).

Stepped-fixed costs
The final type of cost behaviour is stepped-fixed costs. Stepped-fixed costs remain fixed over a certain
range of activity, but once the level of activity increases past a certain point, the cost takes a significant
'step up'. For example, a jeans manufacturer might have the machinery, employees and workspace to
produce a maximum of 50 pairs of jeans per week. If the weekly production requirement rises to 200
pairs, then the organisation may need to invest in new machinery, hire more employees and rent more
work space to meet this production load. This cost behaviour, stepping up in stages, is called a step
cost.

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 Stepped-fixed costs can be demonstrated on a graph as follows:

Stepped-fixed cost: Total cost

Note that once the upper limit of an activity level is reached then a new higher level of fixed cost
becomes relevant.

Summary
By now, you should have a good understanding of the four different cost behaviours. Can you think of an
example of each type? This will reinforce your understanding and help you to identify the behaviour in
similar products or services.

It is important for the exam that you can recognise different cost behaviour patterns, both from graphs
and sets of figures. When looking at graphs, train yourself to always check the labels on the axis –
particularly whether the graph represents total cost or unit cost (you will not be asked to identify the unit
cost for stepped-fixed graphs). Then, identify the pattern of cost behaviour from the explanations we
provided in this unit.

Summary
In this lesson we have learned about cost classification and behaviour. In particular, we looked at how costs can
be classified based on whether they are direct or indirect, variable, fixed, mixed or stepped-fixed costs. You
should now be able to do the following:
 Explain the concept of cost units, and why managers need to know the cost of the production of cost units
 Identify and describe the five ways of classifying costs
 Explain the difference between direct and indirect costs
 Outline the four different cost behaviours and recognise how these behaviours are depicted on a graph.

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Cost units
What is a prime cost?
A: The sum (total) of all variable costs
B: Direct material costs plus direct labour costs
C: Direct material costs plus direct expenses
D: The sum (total) of all direct costs

Cost behaviour
A company sells products on its website and delivers them to customers using a number of different courier
companies. A $5 payment is made to the couriers for each delivery made. What type of cost behaviour do delivery
costs display?
A: Fixed
B: Variable
C: Mixed
D: Stepped-fixed
The delivery costs display a variable cost behaviour. This is because the total cost increases with the
level of activity: as the number of sales transactions increase, the number of deliveries and the total
amount paid also increases.
As the cost is variable, without any fixed component, the other options are all incorrect.

Cost behaviour
An organisation rents a factory that has the workspace to produce a maximum of 5,000 units per month.

The organisation has received an order for 14,000 units to be produced within two months. How would you
classify the cost behaviour of the rent cost?
A: Mixed
B: Variable
C: Stepped-fixed
D: Fixed
In this situation, rent is a stepped-fixed cost. If production rises above 5,000 units per month the
organisation will need to rent an additional factory, which would result in a significant step up in the rent
cost.
It is not a mixed cost because, in this scenario, the costs do not increase evenly with activity but 'jump'
when a certain level of activity (5,000 units per month) is reached.
It is not a variable cost because the cost is fixed over a large area of activity.
It is not a fixed cost because it increases after a certain level of activity.
See Lesson 1, Unit 5 if you want to revise this topic.

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MA1 Section 2 optional exam questions
Multiple Choice
1/1 point (ungraded)
A direct cost can be defined as which of the following?
A cost that can be directly traced back to a specific cost unit
A production cost
A cost paid for directly at the time of purchase, rather than on credit
A cost that relates directly to the main business of the organisation
correct
Submit
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Show Answer
Correct (1/1 point)
Review

Multiple Choice
1/1 point (ungraded)
A company that manufactures bicycles will treat which of the following as an indirect cost?
Rubber for the tyres
Metal for the frame
Wages for the production line workers
Oil for the machinery used
correct
Submit
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Show Answer
Correct (1/1 point)
Review

Multiple Choice
1/1 point (ungraded)
The diagram below is most likely to represent which of the following costs?

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 Direct labour costs
The salary of the managing director
Cost of materials
Power for the factory
correct
Submit
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Show Answer
Correct (1/1 point)
Review

Multiple Choice
1/1 point (ungraded)
What is meant by cost classification?
Allocating costs to the appropriate cost centres
Assigning cost codes for management accounting purposes
Ranking costs according to authorisation limits
Grouping costs based on their common attributes
correct
Submit
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Show Answer
Correct (1/1 point)
Review

Multiple Choice
1/1 point (ungraded)

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The full production cost of a manufactured product consists of which of the following?
Direct labour and direct materials
Direct labour, direct materials and direct expenses
Prime cost and production overhead
Prime cost, production overhead and selling and administration overheads
correct
Submit
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Show Answer
Correct (1/1 point)
Review

Multiple Choice
0/1 point (ungraded)
An organisation produces soap. Which of the following cost units would be the most useful?
A single bar of soap
A batch of 20 soaps correct
A kilogram of soap
A production run
incorrect
Explanation
A batch of 20 soaps would be the most useful cost unit.
A single bar of soap is likely to be too small a unit. A kilogram of soap may or may not relate to the
actual number of bars of soap that would be produced. A production run is also unlikely to be the best
choice of cost unit as the output produced may not all be identical. For example, batches of different
sizes and fragrances may be produced.
Submit
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ResetReset Your Answer Show Answer
Answers are displayed within the problem
Review

Multiple Choice
1 point possible (ungraded)
Which of the following statements about marginal and absorption costing is/are true?

I. Under marginal costing the cost per unit calculation will not include fixed production costs

II. Absorption costing treats fixed production costs as a period cost

III. Marginal costing treats fixed production costs as a product cost

I only
I and II only
All these statements are true
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 None of these statements are true
unanswered
Submit
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ResetReset Your Answer

Multiple Choice
1/1 point (ungraded)
The manager of a profit centre has responsibility for which of the following?

I. Costs

II. Revenues

III. Investments
I only
II only
I and II
I, II and III
correct
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Show Answer
Correct (1/1 point)
Review

Multiple Choice
1/1 point (ungraded)
Which of the following is the most accurate definition of the standard hour?
The work carried out in an average hour
The amount of work achievable, at the expected level of efficiency, in an hour.
The proportion of an hour for which the organisation expects the employees to be productive
The unit upon which employee remuneration is based
correct
Submit
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Show Answer
Correct (1/1 point)
Review

Multiple Choice
1/1 point (ungraded)
ROCE would be an appropriate performance measure for which type of business unit?
Profit centre
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 Investment centre
Cost centre
Production centre
correct
Submit
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Show Answer
Correct (1/1 point

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Lesson 2: Calculating and reporting the profit of a product or service
There are many different factors to consider when calculating the cost of a single product.
Think about the production costs involved in producing one loaf of bread at Ravi's Quality Bakery.
How much are the ingredients?
How much are the wages for the bakery staff?
How much does it cost to run the ovens?
Is there any specialist machinery that needs to be hired?
In this lesson we will learn how to calculate and record the costs involved in the production and sale of a
single unit of a product.
We will then look at two different methods of accounting for the costs of production overheads and how
each method results in different inventory values and hence also different profit figures.
Finally, we will look at the advantages and disadvantages of each costing method and why some
organisations might favour one approach over another.

Unit 1: Calculating the cost of a product or service

To calculate the total cost of a product, an organisation must first identify every part of its cost. One way
of doing this is by using cost cards.
A cost card records the costs involved in the production and sale of a single unit.

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These days, a cost card is rarely a physical card containing handwritten information. Instead, cost cards
are usually held in a computer file, either as part of a computerised accounting software package or as a
spreadsheet file.

Scenario: Ravi's Quality Bakery

Return now to Ravi's Quality Bakery (RQB):

 RQB's biggest selling product is the standard loaf

 RQB produces 10,000 loaves per year

 Ingredients for the standard loaf (including flour, yeast, salt and water) have a combined cost
of $0.50

 Each loaf requires 2 minutes of labour, at $10 per hour

 Fixed production overheads incurred in producing the standard loaf are $1,000 per year

 The cost of selling, administration and distribution is $0.05 per loaf sold.

Given this information, how might you go about completing the RQB cost card?

In this example a single loaf is being used as the cost unit. Typically, a batch is used as a cost unit for lower
value items of production. This is because the numbers are more manageable. This is especially true where
products are sold in batches to customers.

Direct materials

Direct labour

Total direct (Prime cost)

Production overheads

Total production cost

Non-production overheads

Total cost

Cost card: RQB loaf

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Calculating the cost of providing a service
Cost cards may also be used to establish the cost of providing a single unit of a service.

For example, a barber may use a cost card to establish the cost of providing a single haircut.

The key difference when considering the costs of services (compared to products) is that the direct
labour costs (the barber's wages) are likely to be the most substantial.

The cost of materials used (for example, haircare products) are likely to be relatively insignificant
compared to the labour cost, and are also likely to be classified as production overheads and not
traced to individual cost units.

If a specific product is purchased for a particular job (for example, if a customer requires a specialist
shampoo that is not used on other customers), this would be classified as a direct expense.

Unit 2: Absorption costing and marginal costing

Absorption costing and marginal costing are two different methods of dealing with production
overheads. Each method results in different profit figures for an accounting period.

Under absorption costing, fixed production overheads are included in the cost per unit calculation. The
unit cost of a product includes all production costs, including fixed production overhead costs.
Absorption costing provides the full cost of producing an item. This means that the sales price will
generate enough revenue to cover the production overheads as well as the prime cost. In other words,
the production costs are absorbed by production and the subsequent sale of goods.

Under marginal costing (sometimes called variable costing), fixed production overheads

are excluded from the production cost per unit calculation. Fixed production costs are treated as a cost
of the period (a period cost), rather than as part of the product cost. Marginal costing therefore
establishes the total cost of making each additional unit of output.

Under absorption costing, the cost of a unit of output includes the following costs:

Under marginal costing, the cost of a unit of output includes

the following costs:

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The cost of each unit of production will be higher under absorption costing than under marginal costing. The
two methods result in different inventory values and different profit figures.

The job of the cost accountant is to calculate cost per unit for management, for example, to help them
build budgets. One step along the way will be for them to produce a cost card.
That cost card can be put together under one of two assumptions, but in either case, it's there to show a
breakdown of cost per unit produced.

Under marginal costing, the costs are broken down into direct costs and variable overheads.
So direct labour, direct materials, direct expenses and those variable overheads.

If we add just one more line to that, which is an element of fixed production overheads, this turns this
cost card into an absorption cost card, or full production cost card.

Relating an element of fixed production overheads may be important for certain purposes such as
pricing products, for although those fixed production overheads, such as factory rent, don't vary with
output, it's essential that they are considered when you're setting prices.
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Fundamentally, the only difference between absorption costing and marginal costing is the way in which
we treat those fixed production overheads, but that difference does give us two different looking income
statements when they are used internally.

A marginal costing income statement starts off with sales, we deduct from those sales all the variable
production costs coming down to a number called contribution, and this is the contribution that our sales
make towards our fixed costs and our profits.

We then deduct fixed costs below that to come to our net profit figure.
Fixed costs are kept very separate from production costs, in other words.

With absorption costing, we start off with sales, and we take off all our production costs from there,
whether they are variable or fixed, so that element of fixed production costs comes off before we get to
what's known as gross profit, and then any non-production costs, whether they're variable
or fixed doesn't matter, are taken off below gross profit to get to net profit.

Fundamentally, with absorption costing, we are relating, as you can see in the income statement, those
fixed production costs to items being produced.
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Although these income statements look very different, in fact, they both contain all the fixed and all the
variable costs within them.

There's only one reason why the net profit figure reported will differ between the marginal costing
statement and the absorption costing statement, and that's the way in which we value inventory.

Under absorption costing, we will include an element of those fixed production overheads, so any
item of inventory will appear to be more valuable under absorption costing than under marginal costing.

As a result of this, if in any one period we're building up inventories, so our closing inventory is higher
than our opening inventory, the net result of that is that we're carrying fixed costs forward into the
following period under absorption costing, which means the reported profit there will be higher when
compared to marginal costing.

However, if inventories are reducing over that period, the opposite would be the case, we'll be net
bringing fixed costs into this period under absorption costing, meaning that absorption costing profits will
appear to be lower this period compared to marginal costing profits.

The only time they'll be completely the same is if we're neither building stocks nor eating into stocks, so
stock levels remain constant.

Profit statements
Information gathered using marginal costing and absorption costing can be presented in a profit
statement. A profit statement presents the revenue and costs of a particular job or activity for a specific
period of time, and calculates the profit or loss. Profit statements are important as they enable a
business to calculate and consider the profitability of different activities.

A profit statement produced using the absorption costing approach is presented slightly differently from a
marginal costing statement.

In the following activity, click on each text label to find out more about the basic composition of a profit
statement under absorption costing and marginal costing.

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Opening Inventory - This is the inventory held at the start of the accounting period.

Total production cost - Under absorption costing, production costs include direct costs plus production
overheads. Non-production overheads are also included in the cost of sales, but on this statement they
are identified on a separate line.

Cost of sales - This is the cost of producing and selling the units that were sold in the accounting
period.

Profit or Loss - This is the difference between the sales revenue and the cost of sales for the period. If
sales revenue exceeds the cost of sales, then a profit has been made. If the cost of sales exceeds the
sales revenue, then a loss has been made.

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 The variable production cost of sales includes direct materials, direct labour and variable production
overheads.
Variable non-production overheads include variable selling and distribution costs.
Under marginal costing, the cost of sales includes variable costs only, as all fixed costs are charged
to the period rather than to units of production.

Marginal costing allows management to calculate the contribution provided by each unit. The
contribution per unit is the selling price per unit less all variable costs per unit. Total contribution is
revenue less all variable costs. This represents the amount available to cover fixed costs and profit
(contribution is also known as 'contribution towards fixed overhead and profit').

Fixed cost - This is all of the fixed overhead incurred, including the fixed production overhead, the fixed
administration and selling overhead and so on.

Profit or loss - This is all of the fixed overhead incurred, including the fixed production overhead, the
fixed administration and selling overhead and so on.

In this unit, we have learned about absorption costing and marginal costing and the different profit
statements produced under each method. In the next unit you will have an opportunity to apply what you
have learned.

Unit 3: Absorption costing and marginal costing compared

In the previous unit, we looked at the key differences between an absorption costing profit statement and
a marginal costing profit statement. We learned that a profit statement produced using the absorption
costing approach will often result in a different profit figure from a statement produced using the marginal
costing approach. The statements are also presented slightly differently, with contribution emphasised
in the marginal costing statement.

Scenario: The Blue Jeans Company

To see how absorption and marginal costing profit statements compare in practice, think again
about The Blue Jeans Company (BJC) discussed in Section 1, Lesson 1:

 BJC produces 1,000 units of blue jeans per month

 On February 1, there are 80 units in the opening inventory

 Each pair of jeans requires 2 hours of labour. Labour costs are $10 per hour

 Each pair of jeans requires 2 square metres of material. Material costs $5 per square metre

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 Fixed production overheads are $2,000 per month

 Each pair of jeans sells for $50

 February sales were 1,000 units. In March, sales were 900 units.

How would you present this information in a profit statement using absorption costing? How would you
present the same information in a profit statement using marginal costing?

In the following activity, complete the absorption and marginal costing profit statements for BJC by
entering the missing values, then click 'Check answers' to see if you are correct. Use 'Next' to move
through to the next question. Once you have completed the activity, click 'Feedback' to see our thoughts.

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 In February, the absorption costing profit and the marginal costing profit were both $18,000. This is
because the quantity sold in February matched the quantity produced and so the opening and closing
inventories were the same. Both the absorption and marginal costing methods would have resulted in $2,000
of fixed production overheads being charged against profit.
 In March, 1000 units were produced, but only 900 units were sold. The closing inventory (180 units) was
therefore higher than the opening inventory (80 units) by 100 units.
 Under marginal costing, this difference between the opening and closing inventory makes no difference
to the fixed overheads charged against profit: $2,000 of fixed production overheads are charged against the
period.
 Under absorption costing, each of the 100 unsold units held in inventory included $2 absorbed fixed
overheads: 100 units × $2 = $200. This is carried forward as part of the value of the closing inventory and
charged against profit in a future period (when the units are sold).
 The $200 of fixed overheads absorbed and held in closing inventory explains the $200 higher profit
under absorption costing ($16,200) compared with the profit under marginal costing ($16,000). This is
because the cost of sales deducts the value of closing inventory. The fact that absorption costing values
inventory higher than marginal costing means that if inventory levels are rising in the period, the closing
inventory is valued higher than the opening inventory. This reduces cost of sales and so values profit higher.

Advantages and disadvantages of absorption and marginal costing

Both the absorption costing and marginal costing methods have advantages and disadvantages, and the
method used will depend on the particular circumstances and the organisation. The following tables
outline the advantages and disadvantages of absorption costing and marginal costing:

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 Advantages of absorption costing Advantages of marginal costing

 The inventory value obtained under absorption costing  Highlights contribution, which helps
complies with the relevant accounting standards so is management to focus on the short-term financial
appropriate for external financial reporting. impact of a decision.

 Considers all costs, so provides a better understanding  Focuses on the immediate and direct
of the whole picture. impact of an action or decision.

 May be more appropriate when considering long-term 
decisions, because it considers long-term fixed costs. For
example, if a factory is not profitable over a long term because
of high fixed costs such as rent, the company may need to
move offices.
More appropriate for short-term decision
making because it focuses on the costs that are
likely to change in the short term as a result of
the decision.

Disadvantages of absorption costing Disadvantages of marginal costing

 Overemphasises the importance of costs that
do not change regardless of the course of action and it
may lead to inappropriate decisions, especially in the
short term.
 The inventory value produced is unsuitable for
financial accounting (as it does not comply with the
relevant accounting standards).
 By ignoring fixed costs, the long-term impact
and wider implications of decisions are not taken into
account.

In the following video, a tutor shares their thoughts on when marginal costing is more suitable than
absorption costing for decision making. Click 'Play' to watch the video.

When we compare marginal costing to absorption costing, they're just different. One isn't necessarily
better than the other, it just depends on the circumstances in which you are using the numbers.

For example, absorption costing is probably more useful for pricing, so that if you set prices based on
absorption costing plus a little bit, you're at least then aiming to cover all your costs, whether they are
variable or fixed.

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However, for a one-off decision, let's say we have some spare capacity in our factory and we want to
fulfil an order for a special new customer, and all we want to do is not lose money on that order, then we
might look at the marginal costs of producing that item.
If we sell that item for its marginal cost, we'll neither be increasing nor decreasing profits.

Cost cards
Cost cards often identify prime cost. Which of the following costs would not be included in the prime cost of
producing an unusual, one-off, wooden table?
A: The wood used
B: Direct labour
C: Factory rent
D: The cost of hiring specialised machinery

Correct
Prime cost is the sum of direct costs. Factory rent is an indirect production cost.
The cost of wood (direct materials), direct labour and the cost of hiring specialised machinery (a direct expense)
are all part of the prime cost.

Costing methods
Which of the following would be excluded from the calculation of the cost per unit using marginal costing?
A: Direct material cost
B: Variable production overheads
C: Fixed production cost

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D: Direct labour cost

Correct
Using marginal costing, fixed production costs are excluded from the calculation of the cost per unit.

Costing methods
Which one of the following is an advantage of absorption costing?
A: An inventory valuation appropriate for financial accounting purposes
B: The information produced is suitable for short-term decision making
C: Focuses on the costs associated with producing an additional unit of output
D: Highlights the importance of contribution

Correct
It is an advantage of absorption costing that the inventory value obtained complies with the relevant accounting
standards so it is appropriate for financial accounting purposes.
Marginal costing is more suitable for short-term decision making, focuses on the costs associated with producing
an additional unit of output and highlights the importance of contribution.

Lesson 3: Cost centres, profit centres and investment centres

In order to effectively evaluate performance, organisations need to divide operations into sectors so that
managers are only held responsible for the costs, revenue and assets under their control. These sectors are
collectively known as the responsibility centres of an organisation and will be the focus of this lesson.

Unit 1: Cost centres: An introduction

This unit looks at the role of cost centres in an organisation.

A cost centre is an activity or area of responsibility in an organisation which generates costs, but is not
responsible for generating revenue or producing direct profit. In other words, it only adds costs. The
costs of a cost centre can be collected and analysed.

A cost centre may take many forms.

In the following activity, click on each item to learn more about the different forms or types of cost
centres in an organisation.

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Do you understand the difference between a cost centre and a cost unit? A cost centre is responsible for
accumulating costs, whereas a cost unit is an item of production that costs are calculated for. For
example, in a bicycle manufacturing company, the quality control activity might be a cost centre (a part
of the business for which costs can be accumulated) and a bicycle might be a cost unit. It's important
that you understand this distinction for the exam.

Scenario: Ravi's Quality Bakery

By now you should have a good understanding of the different types of cost centre within an
organisation. Now take a moment to think again about Ravi's Quality Bakery (RQB) and how RQB might
be divided into departments. Some of the departments within RQB will be cost centres, whereas others
will not.

In the following activity, select the 'tick' or the 'cross' according to whether you think each example is a
cost centre at RQB, then read the feedback text to check whether you are correct. Use the 'Next' button
to move on to the next example.

The baking department √

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Correct
The baking department is a cost centre at RQB. The baking department incurs costs but is not responsible for
revenue. Although the baking department produces the products which will be sold, the selling of RQB products
is not their responsibility.
The sales function including the RQB shop x
 
Correct
At RQB the sales function is responsible for maximising sales of RQB products and therefore has responsibility
for generating revenue. It is not a cost centre.
The delivery department √
 
Correct
If RQB provides its delivery service free of charge, then there is no revenue associated with the delivery
department and so it is a cost centre. However, if RQB charges a fee for delivery and revenue is earned in this
way, then RQB's delivery service is not a cost centre.
Finance and administration √
 
Correct
The finance and administration function is a cost centre. The finance and administration function incurs costs
but is not responsible for revenue.
The positive impact of cost centres
Cost centres accumulate costs but have no income or revenue attributed to them. This can result in cost
centres being:

 Perceived negatively and viewed as having a negative effect on profit while failing to contribute
to the value of an organisation

 Targeted for cutbacks and redundancies when an organisation is under pressure to reduce

costs.

Cost centre managers often find it difficult to justify expansion – for example, the need to invest in
additional employees, training or equipment. The emphasis on costs makes it difficult to demonstrate the
positive impact these investments may bring.

Despite these difficulties, cost centres can have a positive impact on an organisation. Although cost
centres do not earn income, they do help the organisation earn income. For example, without the
production function there would be no products to sell, and without the human resources function
employees would not be as well equipped to perform well.
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In the next unit we will look at an important role of cost centres and how managers collect cost centre
information.

https://www.accountingformanagement.org/vaac-mcqs/

Unit 2: Cost centres: Coding and responsibility accounting

Cost centres play an important role in an organisation by providing the basis to track expenditure. Each
cost centre will have a unique cost code (usually a combination of numbers and letters) so that costs
can be identified in the processing of transactions and allocated in the right way to the correct cost
centre. This allows an organisation to measure, budget and control costs for each cost centre in an
organisation.

Some transactions and expenditure are relatively easy to identify with a specific cost centre. For
example, salary payments for staff in the human resources team can easily be allocated to the human
resources department. However, some costs need to be shared out across more than one cost centre –
for example, the utilities bill for heating and lighting. Correct coding is therefore required to ensure that
the cost is spread correctly across the relevant cost centres. Cost codes are discussed in more detail in
Section 3, Lesson 1.

Scenario: Ravi's Quality Bakery

Think again about the baking department cost centre at Ravi's Quality Bakery (RQB). The baking
department is accountable for a number of different costs. Some of these costs are directly
attributable (related) to the cost centre; whereas others are costs that must be shared across a number
of different cost centres.

In the following activity, you will be presented with costs that have been incurred by the RQB baking
department. In each case, click the example at the top and then drag it to the appropriate column
according to whether it is directly attributable to the baking department or a cost that is shared with other
cost centres.

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The principle of responsibility accounting
By now you should understand that cost centres incur costs. However, when evaluating the performance
of a cost centre and of the person (or people) responsible for the cost centre performance (such as a
manager), a distinction should be made between controllable and uncontrollable costs. Cost centre
managers should only be judged or held accountable for costs they are able to influence or control. For
example, the electricity charges for the whole factory are shared across multiple cost centres and are
therefore outside a cost centre manager's control and would not be considered when judging the
manager's performance. This is the principle of responsibility accounting – managers should only be
judged or held accountable for costs they are able to influence or control.

Information provided to the cost centre manager, and to those judging the performance of the cost
centre, should therefore distinguish between controllable and uncontrollable costs.

Unit 3: Profit centres

This unit looks at the role of profit centres within an organisation. A profit centre is an activity or area of
responsibility in an organisation to which costs and revenue can be attributed. This is so that the
profitability of the centre can be measured – something that is not possible for a cost centre.

Examples of profit centres might include an individual health club in a chain of clubs owned by a
company, a salesperson, or the restaurant in a large hotel.

Like cost centre managers, profit centre managers are accountable for the costs under their control.
However, they are also responsible for the sales revenue earned by their centre and thus for the profits
of the areas they manage. The manager of the profit centre should have control (or at the very least,
influence) over both the revenue and costs of the centre.

In the following activity, click on each tab to learn more about profit centres.

Organisational hierarchy
In the hierarchy of an organisation, profit centres generally sit higher up than cost centres and there are often
several cost centres within a profit centre. This will not always be the case. Some profit centres also consist of
individual members of staff – for example, a sales representative whose generated income can be traced.

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 Seniority of profit centre managers
Profit centres tend to cover a significant area of operations. For example, a profit centre might cover an entire
division of an organisation. Profit centre managers are expected to generate income as well as control or minimise
the costs incurred. The role is wide and demanding and therefore attracts a high level of seniority.

External and internal revenue

Profit centres can generate revenue externally or internally (by making sales to other parts of the organisation). It
is not important where the source of revenue originates as long as it is recorded and the profit is measurable and
controllable.

From cost centre to profit centre

It is possible for a cost centre to become a profit centre – for example, if a delivery driver becomes a general
courier service used by other organisations, or if an internal service function starts charging for the services it
provides. For instance, if the information technology function generates an internal revenue by charging other
functions for the work carried out it would become a profit centre.

Profit centres and cost centres compared

In assessing whether an activity or area of responsibility of an organisation is a profit centre or a cost
centre, there are three relevant questions:

 Does it incur costs?

 Does it generate revenue?
 Can the profit be measured?
If the answer to all three questions is 'yes', then it is a profit centre.

In the following activity, you will be presented with examples of profit centres and cost centres. In each
case, click the example at the top and then drag it to the appropriate column depending on whether it is
a profit centre or a cost centre.

Unit 4: Investment centres

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Like profit centres, investment centres incur costs and generate revenue. The distinguishing feature of
an investment centre is that the investment centre manager is also responsible for making investment
decisions regarding the assets available for use (capital investment), such as the purchase and sale
of non-current (long-term) assets. An investment centre is therefore a business unit that has control over
costs, revenue and capital investment. Examples of investment centres include the PlayStation division
of Sony and the Cadillac division of General Motors.

Cost centre Profit centre Investment centre

Generates costs ☑ ☑ ☑

Generates revenue ☑ ☑

Non-current asset procurement ☑

In the following example, click 'Next' to learn more about the features of an investment centre.

A common example of an investment centre is a subsidiary company – for instance, an international subsidiary
of a global organisation.
If a global organisation has subsidiary companies in other countries and each country's operations are treated as
separate business units with responsibility for capital investment, then each business unit is an investment
centre.
An investment centre may be created and managed on the basis of a particular product (or brand). For example,
Coca-Cola may have different investment centres for Sprite, Fanta and Dr Pepper drinks.
To be classified as an investment centre, the costs, revenue and capital expenditure must be separately
identifiable and controllable by the manager of the investment centre.
Separately identifiable accounting information is used as an investment centre performance measure.
Subsidiary company: A company that is owned or partly owned by another company that holds a controlling
interest.

Responsibility centres
Together, cost centres, profit centres and investment centres are referred to as the responsibility
centres of an organisation.

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The following activity represents the hierarchical structure. Note that investment centres sit at a higher
level in the organisation's hierarchy than profit centres.

In the following activity, click on each part of the pyramid to view the three different types of
responsibility centre.

Investment centre
Requires information relating to costs, revenue, profits and capital investment

Profit centre
Requires information relating to costs, revenues and profits

Cost centre
Requires information relating to costs

Now take a moment to test your understanding of the difference between the three responsibility
centres.

In the following activity, you will be shown a series of statements relating to cost centres, profit centres
and investment centres. In each case drag and drop the appropriate centre into the blank space
provided, then click the 'Check answer' button to see if you are correct.

The manager of a  profit centre has responsibility for both costs and sales.

Managers of  investment centres have the authority to make capital expenditure decisions.

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A  cost centre manager is not responsible for revenue.

A  cost centre does not generate any revenue.

The basis for control at a very senior level is provided by  investment centres.

A  cost centre is generally the lowest within the organisational hierarchy.

By this stage you should have a good understanding of cost centres, profit centres and investment centres. If any
of your answers in the previous activity were incorrect, then look back over the units in this lesson and try again. It
is important that you are able to recognise these key differences for the exam.

Responsibility centres
Adam is a manager responsible for the costs incurred and revenue earned by his department. He is not responsible
for investment. Which type of responsibility centre is Adam's area of business?
A: An investment centre
B: A cost centre
C: A revenue centre
D: A profit centre

Correct
Profit centres are responsible for both costs and revenue.
A cost centre is not responsible for revenue.
A revenue centre is only responsible for revenue (this is not something you need to learn for the MA1 syllabus).
An investment centre is responsible for investment as well as revenue.

Responsibility centres
Which one of the following statements identifies the main difference between cost centres and profit centres?
A: Profit centres are larger than cost centres
B: The manager of a cost centre has some influence over both costs incurred and revenue earned
C: The manager of a profit centre has some influence over both revenues earned and costs incurred
D: Profit centres always generate profit

Correct
The manager of a profit centre has influence over costs and revenue.

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In a large organisation, a profit centre may be smaller than a cost centre.
The manager of a cost centre only has influence over costs.
Profit centres can make a loss – for example, if costs exceed revenue.

Lesson 4: Measuring performance

Measuring performance in a meaningful way requires a target or benchmark for comparison.

If an organisation's sales for the year are $1million, what does this tell us?

By itself, knowing that an organisation's sales for the year are $1million is not sufficient to gauge
performance. It needs a comparison. For example, if last year's sales were $10million, then this is a poor
result, but if last year's sales were $500,000, then this year's sales are excellent.

In this lesson, we will learn about how a business can effectively measure performance. To do this, we
will look at a number of different measures and comparisons that can be used to monitor the
performance of cost centres, profit centres and investment centres.

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 Unit 1: Performance measurement: An overview
Performance measurement and control is the process of gathering information about the tasks in an
organisation and comparing it to the pre-established expectations outlined in budgets, plans and targets.

By measuring performance, an organisation can ensure that its resources are being used effectively and
that goals are being met – for example, by providing an early warning if things are not proceeding to
plan.

Performance is measured at different levels across an organisation. For example, this could be at the
level of a function, an individual or the organisation as a whole. The factor being measured depends on
what is being assessed. For example, a salesperson may be evaluated on the value of sales achieved,
whereas for the organisation as a whole, profitability is more important.

The performance of a cost centre can be measured in terms of:

 Productivity
 Cost compared with budget
 Cost per unit
 Standard hours produced
 Ratios.

In this unit we will learn about the first three of these performance measures. Standard hours and ratios
are discussed in more detail in the following units.

Productivity
The productivity performance measure looks at how effectively a cost centre uses its resources. This is
established by comparing the inputs and outputs of the cost centre.

There are several ways in which an organisation's productivity levels can be measured.

In the following activity, drag the pointer or click on the tabs to consider the different ways in which an
organisation's productivity levels can be measured.

Units per hour

One way of measuring an organisation's productivity is by calculating the number of units produced per
hour. For example, in Ravi's Quality Bakery, this would be the number of loaves of bread baked in one
hour.
Units per employee
One way of measuring an organisation's productivity is by calculating the number of units produced per
employee. In RQB, this would be the number of loaves of bread baked by each employee.

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Units per tonne of material
One way of measuring an organisation's productivity is by comparing the number of units produced per
tonne of raw material input. In RQB, this would be the number of loaves produced per tonne of flour
consumed.
Costs compared with budgets
Cost centres have a set budget to work within. A comparison of the actual costs incurred against the
costs budgeted provides a useful measure of performance.

In the following activity, click on each segment to find out more about the advantages and disadvantages
of using budgets as a performance measure.

Easy to understand
The main benefit of using budgets as a performance measure is that budgets are easy to understand.
They compare the actual costs with the predicted or budgeted costs to show the variance. The question
'are we over or under budget?' is a simple one to answer.

No explanation
A comparison of the actual and budgeted costs shows the extent of the variance, but it does not
explain why the variance has occurred. A further investigation of significant variances is required.

Small area

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Individual budget figures focus on small areas of performance, which can be misleading. For example, a
comparison may show that a cost centre has incurred 25% less costs than budgeted, which seems like a
good outcome. However, if only 45% of the expected output has been produced, then the cost centre
has performed less well than expected.

Cost per unit

The cost per unit can be calculated by dividing the total costs by the number of units produced:

Cost per unit= Total costs

Number of units produced
This measure is particularly useful for production cost centres, such as production locations.

In the following activity, you are provided with an example of the total production costs and units
produced in a production cost centre for the last three months. How much is the cost per unit? In each
case, select the correct value from the dropdown menu. Then select the 'Click answers' button to see if
you are correct.

You now know how to evaluate performance using productivity, costs compared with budgets and cost
per unit measures. In the next unit we will move on to learn about how to measure performance using
the standard hour.

Unit 2: The standard hour

A standard hour is the estimated quantity of work achievable at a standard level of quality, in an hour,
under normal conditions.

To understand how this works in practice, let's take a moment to see how this performance measure
might be used in the context of Ravi's Quality Bakery.

The standard hour in performance measurement

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 The standard hour is a useful concept in performance measurement and is relevant to items C2(e) and
(f) in the Study Guide for MA1.

Definition
A standard hour is the amount of work achievable, at the expected level of efficiency, in an hour.

Illustration
X Co manufactures three products (A, B and C) in one of its production cost centres. It is expected that
10 units of product A can be manufactured per direct labour hour, 25 units of product B and 20 units of
product C.
The standard hour for product A is, therefore, 10 units, product B is 25 units and product C is 20 units.

The standard hour is especially useful as a common measure for combining heterogeneous (dissimilar)
products so that manufacturing performance for a cost centre (or production unit) as a whole can be
assessed.

Example
Budgeted production of the three products (A, B and C) in period 1 is:
 Product A - 12,400 units
 Product B - 10,000 units
 Product C - 18,500 units

The total budgeted direct labour hours for period 1 in the cost centre, based on the standard hour data
above, is:
 Product A - 1,240 hours (12,400 units ÷ 10 units per hour)
 Product B - 400 hours (10,000 units ÷ 25 units per hour)
 Product C - 925 hours (18,500 units ÷ 20 units per hour)
Total hours: 2,565

It can be seen that the budgeted production of the three different products can be combined into an
overall labour activity measure and this also can be applied to the actual production volumes, using the
same data about the standard hour of each product. This enables the effect of changes in the production
mix to be measured.

Example
In period 1, the actual production output of the three products was:

 Product A - 13,300 units

 Product B - 9,600 units
 Product C - 18,000 units
A total of 2,430 direct labour hours were worked in period 1.

Taking these actual results into account and the data concerning the standard hour of each product, the
total expected direct labour hours for the actual production output in period 1 can be calculated as
follows:

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 Product A - 1,330 hours  (13,300 units ÷ 10 units per hour)
 Product B - 384 hours  (9,600 units ÷ 25 units per hour)
 Product C - 900 hours  (18,000 units ÷ 20 units per hour)

Total hours: 2,614

Using the above data about the budgeted direct labour hours, the actual direct labour hours and the
expected direct labour hours to manufacture the actual output, a series of ratios can be calculated to
measure the performance of the cost centre as a whole in period 1 and to understand the causes. The
ratios are:
 Production volume ratio
 Capacity utilisation ratio
 Efficiency ratio

Production volume ratio

The production volume ratio measures how the actual production output for a period, measured in direct
labour hours, compares with that budgeted for a production cost centre. It is calculated as:

(Expected direct labour hours of actual output ÷ budgeted direct labour hours) × 100%.

A ratio of > 100% will indicate above budget production volume and vice versa.

The production volume ratio can be further analysed by:

 The number of hours worked compared with budget (measured by the capacity utilisation ratio).
 The efficiency with which the output is produced (measured by the efficiency ratio).

Capacity utilisation ratio

The capacity utilisation ratio measures whether the total direct labour hours worked in a production cost
centre in a period was greater or less than what was budgeted. It is calculated as:

(Actual direct labour hours worked ÷ budgeted direct labour hours) × 100%.

A ratio of > 100% will indicate that more direct labour hours were worked than budget and vice versa.

Efficiency ratio

The efficiency ratio measures whether the production output for a period in a production cost centre took
more or less direct labour time than expected. It is calculated as:

(Expected direct labour hours of actual output ÷ actual direct labour hours worked) × 100%.

A ratio of > 100% will indicate greater labour efficiency than budgeted and vice versa.

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Example
Continuing to use the above data concerning the total budgeted, actual and expected direct labour hours
in period 1 for the production cost centre, the three ratios can be calculated as follows:

Production volume ratio:

2,614 expected direct labour hours of actual output
÷ 2,565 budgeted direct labour hours
× 100%
= 101.9%

Capacity utilisation ratio:

2,430 actual direct labour hours worked
÷ 2,565 budgeted direct labour hours
× 100%
= 94.7%

Efficiency ratio:
2,614 expected direct labour hours of actual output
÷ 2,430 actual direct labour hours worked
× 100%
= 107.6%

Analysis
It can be seen, from the above ratios, that the actual output in the production cost centre in the period,
measured in expected direct labour hours, was 1.9% higher than budget (it may be noted that the total
number of product units manufactured was the same as budget, but the units of one product are not
comparable, in terms of production effort, with another).

The over-budget production activity occurred despite the fact that utilisation of capacity was only 94.7%
of the budgeted utilisation. This was because direct labour efficiency was 7.6% better than expected – ie
fewer hours than expected were required to produce the actual output.

The relationship between the three ratios can be demonstrated as follows:

Production volume 101.9% = [(capacity utilisation 94.7 × efficiency 107.6) ÷ 100] or, alternatively,
[(capacity utilisation 0.947 x efficiency 1.076) x 100]
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