PGBM01 Financial Management & Control Lecture 6 Full Costing

Francis Kuagbela Senior Lecturer of Accounting & Finance The university of Sunderland School of Business & Law

Learning Outcomes
Distinguish between direct costs and indirect costs Allocate indirect costs absorption (full) costing Explain absorption (full) costing overhead recovery rate Limitations of absorption costing

Manufacturing Costs
Direct Materials Direct Labour Manufacturing Overhead

The Product

Direct and Indirect costs

Direct costs those costs clearly attributable to the production of a particular item or service intervention. Indirect costs those costs that are not attributable to a particular product, instead they serve several products.

Direct Materials
Those materials that become an integral part of the product and that can be conveniently traced directly to it.

Example: A radio installed in a car

Direct Labour
Those labour costs that can be easily traced to individual units of product.

Example: Wages paid to car assembly workers

Manufacturing Overhead
Manufacturing costs that cannot be traced directly to specific units produced.
Examples: Indirect labor, indirect materials and other manufacturing expenses (light, heat insurance .)

Wages paid to employees who are not directly involved in production work.
Examples: maintenance workers, cleaners and security guards.

Materials used to support the production process.

Examples: lubricants and cleaning supplies used in the car assembly plant.

Classifications of Costs
Manufacturing costs are often combined as follows:
Direct Materials Direct Labour Manufacturing Overhead

Prime Cost

Conversion Cost

Nonmanufacturing Costs
Marketing and selling costs . . .
Costs necessary to get the order and deliver the product.

Administrative costs . . .
All executive, organizational and clerical costs.

All these costs are considered indirect

Profit & loss account

000 Sales (turnover) Cost of sales Gross profit XXX

Direct costs + some indirect costs Indirect costs

(XXX) XXX (XXX) (XXX) XXX XXX XXX (XXX) XXX (XXX) XXX

Distribution and selling costs Administrative expenses Operating profit

Net interest receivable and other income Profit from ordinary activities before taxation Taxation on profit of ordinary activities Profit after tax Dividends proposed Retained profit for the financial year

Classification of costs
Cost of sales include Direct materials (direct cost) Direct labour (direct cost) MFG overheads (indirect costs) Distribution and selling costs (all indirect) Administrative expenses (all indirect)

Dealing with indirect costs

The key question is: Whether or not indirect costs are to be considered as part of product costs There are two opinions: 1 They can be ignored marginal (variable) costing 2 They can be apportioned in some wayabsorption costing

Marginal (variable) Costing

In marginal costing overheads (indirect costs) are not included in the cost of goods produced Products make a contribution towards paying for the overheads and then making a profit Danger in not having enough contribution to cover the overheads Unable to measure each products profit

Cost profile
Product A B Combined

Units
Labour hours Machine Hours Labour cost per hour Material cost per unit

1500
2.5 0.5 5 6.5

1500
2 1.5 5 7.5

Selling price per unit Total labour hours Total machine hours
Total overhead

22 3750 750

22 3000 2250

6750 3000 10000

Product contribution statements

Marginal Costing Sales Direct labour Direct Material Contribution Overhead A ? ? ? ? B ? ? ? ? Combined ? ? ? ? 10000

Profit

Product contribution statements

Marginal Costing A Sales Direct labour Direct Material Contribution Overhead 33000 18750 9750 4500 B 33000 15000 11250 6750 Combined 66000 33750 21000 11250 10000

Profit

1250

Product contribution statements

Marginal Costing A Sales Direct labour Direct Material 33000 18750 9750 B 33000 15000 11250 Combined 66000 33750 21000

Contribution
Overhead

4500

6750

11250
10000

Does A or B make more profit?

Profit

1250

Absorption (Full) Costing

Seeks to allocate the overheads fairly between the different products Knowing what the full cost of producing a product can be very useful in setting the price It can also help us assess the profitability of different products

Overhead allocation
But the question is: How can we allocate the indirect costs between products in a suitable and fair manner?
There is no correct allocation method!

Absorption Costing
Common allocation methods used in the past have included:
Direct labour hours spent making a product/delivering a service Machine hours the time spent using special machinery in making a product

Find a standard (expected) cost per labour or machine hour

Overhead recovery rates

Total overhead/total labour hours = Overhead recovery rate per labour hour OR Total overhead/total machine hours = Overhead recovery rate per machine hour

Cost profile
Product A B Combined

Units
Labour hours Machine Hours Labour cost per hour Material cost per unit

1500
2.5 0.5 5 6.5

1500
2 1.5 5 7.5

Selling price per unit Total labour hours Total machine hours
Total overhead

22 3750 750

22 3000 2250

6750 3000 10000

Overhead recovery rate per labour hour = ?

Cost profile
Product A B Combined

Units
Labour hours Machine Hours Labour cost per hour Material cost per unit

1500
2.5 0.5 5 6.5

1500
2 1.5 5 7.5

Selling price per unit Total labour hours Total machine hours

22 3750 750

22 3000 2250

6750 3000

Overhead recovery rate per labour hour 10000 = 10000/6750hrs = 1.48/hr

Full Cost Statements

Absorption Costing - labour hours A B Sales 33000 33000 Combined 66000

Direct labour Direct Material Contribution

Overhead

18750 9750 4500

?

15000 11250 6750

?

33750 21000 11250

10000

Profit

1250

Full Cost Statements

Absorption Costing - labour hours A B Combined Sales 33000 33000 66000

Direct labour Direct Material Contribution

Overhead

18750 9750 4500

5556

15000 11250 6750

4444

33750 21000 11250

10000

Profit

-1056

2306

1250

Full Cost Statements

Absorption Costing - machine hours A 33000 18750 9750 4500 B Combined 33000 66000 15000 33750 11250 21000 6750 11250

Sales Direct labour Direct Material Contribution

Overhead

10000

Profit

1250

Cost profile
Product A B Combined

Units
Labour hours Machine Hours Labour cost per hour Material cost per unit

1500
2.5 0.5 5 6.5

1500
2 1.5 5 7.5

Selling price per unit Total labour hours Total machine hours
Total overhead

22 3750 750

22 3000 2250

6750 3000 10000

Overhead recovery rate per machine hour = ?

Cost profile
Product A B Combined

Units
Labour hours Machine Hours Labour cost per hour Material cost per unit

1500
2.5 0.5 5 6.5

1500
2 1.5 5 7.5

Selling price per unit Total labour hours Total machine hours

22 3750 750

22 3000 2250

6750 3000

Overhead recovery rate per machine hour 10000 = 10000/3000hrs = 3.333/hr

Full Cost Statements

Absorption Costing - machine hours A 33000 18750 9750 4500 B Combined 33000 66000 15000 33750 11250 21000 6750 11250

Sales Direct labour Direct Material Contribution

Overhead

2500

7500

10000

Profit

2000

-750

1250

Absorption Costing Issues

Several cost allocation methods available - use can be arbitrary Different types of cost can be allocated using different methods No perfect method exists The overhead absorbed into cost is the budgeted overhead - not the actual overhead incurred Absorption costing can send out wrong signals with regard to product profitability

Full Cost Statements

Different allocation methods can give different results!
A Labour Hours Profit Machine Hours Profit -1056 2000 B 2306 -750 Combined 1250 1250

Cost profile
Product Units Labour hours Machine Hours Labour cost per hour Material cost per unit Selling price per unit Total labour hours Total machine hours Total overhead A 30000 0.25 0.25 12 3 7 7500 7500 B Combined 42000 0.6 0.1 12 4 12 25200 32700 4200 11700 28,000

Work out the full profit for A and B using both labour hour and machine hour recovery rates

Absorption costing
Overhead recovery rate (labour hours) = 28,000/32700 = 0.8563 Overhead recovery rate (machine hours) = 28,000/11,700 = 2.393

Labour Hour Absorption

Sales

Combined 714,000

Labour
Materials Contribution Overhead recovery (0.8563/LH) Full Profit

210,000 504,000 90,000 302,400 (30,000 x (42,000 x 0.6 0.25 x 12) x 12) 90,000 168,000 (30,000 x 3) (42,000 x 4) 30,000 33,600

392,400
258,000 63,600

6,422 23,578

21,578 12,022

28,000 35,600

Machine Hour Absorption Sales

Combined 714,000

210,000 504,000

Labour
Materials

90,000
90,000

302,400
168,000

392,400
258,000

Contribution Overhead recovery (2.393/MH)

Full Profit

30,000
17,949 12,051

33,600
10,051 23,549

63,600
28,000 35,600

End of session 6

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