COURSE MANUAL

C9: Accounting and Finance Course

Module 1

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Copyright
© Commonwealth of Learning 2012

All rights reserved. No part of this course may be reproduced in any form by any means without prior
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Acknowledgements
The Commonwealth of Learning (COL) wishes to thank those below for their contribution to the
development of this course:
Course author William (Bill) Ross
Ross Management Ltd.
Company Director & Business Consultant
Auckland, New Zealand

Course content specialist Ingrid McLeod-Dick, CA

Schulich School of Business
York University, Canada

Subject matter experts Gabreil Ahinful

Kwame Nkrumah University of Science & Technology, Ghana

L. P. S. Gamini, PhD
Open University of Sri Lanka, Sri Lanka

Nazim Hussain
Allama Iqbal Open University, Pakistan

Ibrahim Idrisu, PhD

National Open University of Nigeria, Nigeria

Aubrey Pereira
University College of the Caribbean, Jamaica

Ai Ping Teoh, DBA

Wawasan Open University, Malaysia

Educational designers Symbiont Ltd.

Otaki, New Zealand

Course editor Symbiont Ltd.

Otaki, New Zealand

COL would also like to thank the many other people who have contributed to the writing of this
course.
 C9: Accounting and Finance Course

Contents
About this course manual 1
How this course manual is structured ................................................................................ 1

Course overview 3
Welcome to C9: Accounting and Finance Course ............................................................ 3
C9: Accounting and Finance Course — is this course for you?........................................ 4
Course outcomes ............................................................................................................... 4
Timeframe ......................................................................................................................... 5
Study skills ........................................................................................................................ 6
Need help? ......................................................................................................................... 7
Assignments ...................................................................................................................... 7
Assessments ....................................................................................................................... 8
Activities ........................................................................................................................... 8

Getting around this course manual 9

Margin icons ...................................................................................................................... 9

Module 1 10
Welcome to Module 1 ..................................................................................................... 10

Unit 1 11
Managing the organisation .............................................................................................. 11
Introduction ............................................................................................................ 11
Terminology .................................................................................................................... 11
Purpose and definition of management accounting ............................................... 12
Management functions ........................................................................................... 13
Corporate governance and responsibility ............................................................... 20
Business ethics ....................................................................................................... 22
Activity 1.1 ...................................................................................................................... 24
Unit summary .................................................................................................................. 25

Unit 2 26
Costing systems ............................................................................................................... 26
Introduction ............................................................................................................ 26
Terminology .................................................................................................................... 26
Costing concepts and terminology ......................................................................... 27
Absorption costing ................................................................................................. 33
Variable costing ..................................................................................................... 34
Comparison between absorption and variable costing ........................................... 35
ii

Activity 1.2 ...................................................................................................................... 41

Unit summary .................................................................................................................. 43

Unit 3 44
Activity-based costing ..................................................................................................... 44
Introduction ............................................................................................................ 44
Terminology .................................................................................................................... 44
Conceptual overview of activity-based costing ..................................................... 45
The ABC terminology ............................................................................................ 45
Identifying activities .............................................................................................. 46
Identifying cost drivers .......................................................................................... 47
Advantages and disadvantages of activity-based costing ...................................... 48
ABC example ......................................................................................................... 49
Activity 1.3 ...................................................................................................................... 53
Unit summary .................................................................................................................. 55

Activity feedback 56
Activity 1.1 ...................................................................................................................... 56
Activity 1.2 ...................................................................................................................... 56
Activity 1.3 ...................................................................................................................... 58
 C9: Accounting and Finance Course

About this course manual

How this course manual is

structured
The course overview
The course overview gives you a general introduction to the course.
Information contained in the course overview will help you determine:
 If the course is suitable for you
 What you will already need to know
 What you can expect from the course
 How much time you will need to invest to complete the course.

The overview also provides guidance on:

 Study skills
 Where to get help
 Course assignments and assessments
 Activity icons
 Units.

We strongly recommend that you read the overview carefully before

starting your study.

The course content

The course consists of eight modules. Each module is broken down into
units. Each unit comprises:
 An introduction to the unit content
 Unit outcomes
 New terminology
 Core content of the unit with a variety of learning activities
 A unit summary
 Assignments, as applicable.

1
About this course manual

Your comments
After completing the C9: Accounting and Finance Course, we would
appreciate it if you would take a few moments to give us your feedback
on any aspect. Your feedback might include comments on:
 Course content and structure
 Course reading materials and resources
 Course assignments
 Course assessments
 Course duration
 Course support (assigned tutors, technical help, and so on)

Your constructive feedback will help us to improve and enhance this

course.

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 C9: Accounting and Finance Course

Course overview

Welcome to C9: Accounting and

Finance Course
This course is designed for a management-oriented student, rather than a
specialist in accounting. Although financial accounting, management
accounting and finance can be seen as disciplines in their own right, it is
difficult to undertake one without a rounded understanding of the other
two. Therefore, a governing assumption is that the student will have
undertaken the Financial Accounting pre-requisite course or otherwise
have acquired grounding in financial accounting. This course will
concentrate on management accounting and financial management.

The financial crisis of 2008 has raised a strong debate around the
adequacy of corporate governance and ethical business practice.
Although the student will be exposed to established techniques and tools
for decision-making, there is a need to encourage an ethical approach to
determining the strategic thrust of organisations. Hand-in-hand with this
is the need to identify the determinants of an organisation’s value and the
associated risks such that the interests of all its stakeholders are
recognised.

The management accounting will be addressed in the first half of the

course and will teach understanding and skills in using data to produce
decision-useful information for determining the likely profitability of a
business undertaking or aspects thereof. The purpose is to prepare the
student to conduct and take responsibility for strategic decisions. The
second half of the course will focus on financial management and teach
understanding and skills essential for the formation and monitoring of
policy and practice that optimises the financial governance of an
organisation. Throughout the course the student will be given
opportunities to reflect on real-life situations and critique the subject
matter.

It is intended that this course will provide students in the CEMBA/MPA

with a solid understanding of management accounting and financial
management. However, it is assumed that students seeking a detailed
study of corporate finance will advance to the module E10 Corporate
Finance.

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Course overview

C9: Accounting and Finance

Course — is this course for you?
This course is intended for people who have sufficient knowledge in
financial accounting with a pre-requisite or supplementary course before
attempting to study the CEMBA/MPA course C9: Accounting and
Finance Course.

Students should therefore be familiar with financial accounting theory

and terminology and be able to interpret and analyse financial reports.

Course outcomes
Upon completion of C9: Accounting and Finance Course, you will be
able to:

 Demonstrate knowledge and understanding of the role and

applications of management accounting and their contribution to
good governance.
 Demonstrate knowledge and understanding of the planning and
Outcomes control processes in management accounting and their
contribution to strategic decision-making.
 Demonstrate knowledge and understanding of the management
of resources with specific regard to budgeting and capital
investment for planning and production decisions.
 Demonstrate knowledge and application of performance
measurement with particular reference to setting strategic targets
in a multinational corporate setting.
 Demonstrate knowledge and understanding of the need for
financial management and its impact on the corporation, together
with the ability to perform common financial and investment
calculations.
 Demonstrate knowledge and application of securities for the
strategic funding of corporate activities and the valuation thereof.
 Demonstrate knowledge and application of alternatives and
techniques for the management of capital, and awareness of
foreign exchange implications in a multinational setting.

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 C9: Accounting and Finance Course

Timeframe
This course will take you approximately 120 hours of study time.

[How much formal study time is required?]

[How much self-study time is expected/recommended?]

How long?

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Course overview

Study skills
As an adult learner your approach to learning will be different from that
of your school days: you will choose what you want to study, you will
have professional and/or personal motivation for doing so and you will
most likely be fitting your study activities around other professional or
domestic responsibilities.
Study skills
Essentially, you will be taking control of your learning environment. As a
consequence, you will need to consider performance issues related to
time management, goal setting, stress management, and so on. Perhaps
you will also need to reacquaint yourself with areas such as essay
planning, coping with exams and using the Web as a learning resource.

Your most significant considerations will be time and space — that is, the
time you dedicate to your learning and the environment in which you
engage in that learning.

We recommend that you take time now – before starting your self-study –
to familiarise yourself with these issues. There are a number of excellent
resources on the Web. A few suggested websites are:
 http://www.how-to-study.com/

The “How to study” web site is dedicated to study skills resources. You
will find links to study preparation (a list of nine essentials for a good
study place), taking notes, strategies for reading text books, using
reference sources, test anxiety.
 http://www.ucc.vt.edu/stdyhlp.html

This is the web site of the Virginia Tech, Division of Student Affairs.
Under “Cook Counselling Center” you will find links to time scheduling
(including a “where does time go?” link), a study skill checklist, basic
concentration techniques, control of the study environment, note taking,
how to read essays for analysis, memory skills (“remembering”).
 http://www.howtostudy.org/resources.php

Another “How to study” web site with useful links to time management,
efficient reading, questioning/listening/observing skills, getting the most
out of doing (“hands-on” learning), memory building, tips for staying
motivated, developing a learning plan.

The above links are our suggestions to start you on your way. At the time
of writing, these Web links were active. If you want to look for more, go
to www.google.com and type “self-study basics”, “self-study tips”, “self-
study skills” or similar.

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 C9: Accounting and Finance Course

Need help?
Is there a course web site address?

What is the course instructor's name? Where can s/he be located (office
location and hours, telephone/fax number, e-mail address)?
Help
Is there a teaching assistant for routine enquiries? Where can s/he be
located (office location and hours, telephone/fax number, e-mail
address)?

Is there a librarian/research assistant available? Where can s/he be located

(office location and hours, telephone/fax number, e-mail address)?

Is there a learners' resource centre? Where is it located? What are the

opening hours, telephone number, who is the resource centre manager,
what is the manager's e-mail address)?

Who do learners contact for technical issues (computer problems, website

access, etc.)

Assignments
There are two assignments that you must complete for this course.

Assignment 1
Due date: XX/XX/XXXX
Assignments
Value: 25%

Format: Eight assignment questions

Modules covered: Modules 1–4

Assignment 2
Due date: XX/XX/XXXX

Value: 25%

Format: Essay (3000-3500 words)

Modules covered: Modules 5–7

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Course overview

Assessments
Date: XX/XX/XXXX

Value: 50%
Assessments
Format: 3 hours, closed book

Blocks covered: All

Activities
There are many activities that can help you review and apply what you
learn. The answers to the activities are at the end of each module.

Activities

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 C9: Accounting and Finance Course

Getting around this course manual

Margin icons
While working through this course manual you will notice the frequent
use of margin icons. These icons serve to “signpost” a particular piece of
text, a new task or change in activity; they have been included to help you
to find your way around this

A complete icon set is shown below. We suggest that you familiarise

yourself with the icons and their meaning before starting your study.

Activity Assessment Assignment Case study

Discussion Terminology Help Note it!

Outcomes Reading Reflection Study skills

Summary How long? Tip

9
Module 1

Module 1

Welcome to Module 1
This module introduces the purpose of management accounting, the goals
of the organisation and the role of management accounting in good
corporate governance. In addition the module identifies cost behaviour
and how this is applied to absorption and variable costing and finally
there is an introduction to the principles of activity-based costing (ABC).

Upon completion of this module you will be able to:

 Understand the role of management accounting and how this fits

with the goals of the organisation.
 Explain how management accounting can add to corporate
governance.
Outcomes
 Identify how costs behave.
 Explain the difference between absorption and variable costing.
 Discuss the principles of activity-based costing.
 Explain the difference between activity-based costing and
absorption and variable costing.

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 C9: Accounting and Finance Course

Unit 1

Managing the organisation

Introduction
This unit is intended to provide students with an introduction to the
nature and purpose of management accounting.

The unit comprises:

 An introduction to managing the organisation
 Management functions
 Corporate governance
 Business ethics

Upon completion of this unit you will be able to:

 Explain the difference between management accounting and

financial accounting.
 Describe the purpose of management accounting.
 Identify the different functions of management.
Outcomes
 Explain the role of corporate governance in managing an
organisation.
 Identify the different parties involved in the governance of an
organisation.
 Describe and explain corporate governance principles.
 Explain the role of ethics in business.

Terminology
Corporate The set of processes, customs, policies, laws, and
governance: institutions affecting the way an organisation is
directed, administered or controlled.

Cost accounting: The collection, assignment, and interpretation of

Terminology costs.

Financial accounting: The provision of financial information primarily

for external users of the organisation.

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Unit 1 Managing the organisation

Management The provision of financial information primarily

accounting: for internal users of the organisation.

Purpose and definition of management accounting

Comparison of financial and management accounting
There are two broad types of accounting information:
 Financial accounting. Geared toward external users of
accounting information it provides information to present and
potential shareholders and creditors such as banks or vendors,
financial analysts, economists and government agencies. Because
these users have different needs, the presentation of financial
accounts is very structured and subject to many more rules than
management accounting.
 Management accounting. Aimed more at internal users of
accounting information it is used to provide information to
employees, managers, owner-managers and auditors.
Management accounting is concerned primarily with providing a
basis for making management or operating decisions.

Although there is a difference in the type of information presented in

financial and management accounts, the underlying objective is the same
– to satisfy the information needs of the user.

The table below summarises the key differences between financial

accounts and management accounts.

Financial accounts Management accounts

Financial accounts describe the Management accounts are used to help

performance of a business over a specific management record, plan and control the
period and the state of affairs at the end of activities of a business and to assist in the
that period. The specific period is often decision-making process. They can be
referred to as the “Trading Period” and is prepared for any period (for example,
usually one year long. The period-end date many retailers prepare daily management
is the “Balance Sheet Date”. information on sales, margins and stock
levels).

Limited liability companies are required by There is no legal requirement to prepare

law to prepare and generally make management accounts, although few (if
available their financial accounts any) well-run businesses can survive
(sometimes in abbreviated form) to without them.
external users. The level of detail required
in these accounts reflects the size of the
business, with smaller companies
generally being required to prepare only
brief accounts.

The format of published financial accounts There is no pre-determined format for

is determined by several different management accounts. They can be as
detailed or as brief as management

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 C9: Accounting and Finance Course

Financial accounts Management accounts

regulatory elements: requires.
 Company law
 Accounting standards
 Stock exchange

Financial accounts concentrate on the Management accounts can focus on

business as a whole rather than analysing specific areas of a business’s activities. For
the component parts of the business. For example, they can provide insights into
example, sales are aggregated to provide performance of:
a figure for total sales rather than publish a
detailed analysis of sales by product,  Products
market and so on.  Separate business locations (such as
shops)
 Departments or divisions

Most financial accounting information is of Management accounts usually include a

a monetary nature. wide variety of non-financial information.
For example, management accounts often
include analysis of:
 Employees (such as number, costs
and productivity)
 Sales volumes (units sold)
 Customer transactions (for example,
number of calls received into a call
centre)

By definition, financial accounts present a Management accounts largely focus on

historic perspective on the financial analysing historical performance. However,
performance of the business. they also usually include some forward-
looking elements, such as a sales budget
or cash-flow forecast.

Figure 1 Differences between Financial and Management Accounts

Management functions
Managing requires numerous skill sets. Among those skills are vision,
leadership and the ability to procure and mobilise financial and human
resources. All of these tasks must be executed with an understanding of
how actions influence human behaviour within, and external to, the
organisation. Furthermore, good managers must have endurance to
tolerate challenges and setbacks while trying to forge ahead. To
successfully manage an operation also requires follow-through and
execution. However, each management action is predicated upon some
specific decision. Thus good decision-making is crucial to being a
successful manager.

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Unit 1 Managing the organisation

Decision-making
Consistently good decisions can only result from diligent accumulation
and evaluation of information. This is where managerial accounting
comes in – providing the information needed to assist the decision-
making process. Managerial decisions can be categorised according to
three interrelated business processes: planning, directing and controlling.
Correct execution of each of these activities culminates in the creation of
business value. Conversely, failure to plan, direct, or control could
potentially lead to business failure.

Key elements to be focused on are:

 business value results from good management decisions
 decisions must occur across a spectrum of activities (planning,
directing, and controlling)
 quality decision-making can only consistently occur by reliance
on information.

We will now take a closer look at the components of planning, directing

and controlling.

Planning
A business must plan for success. Planning is about thinking ahead – to
decide on a course of action to reach desired outcomes. Planning must
occur at all levels. Initially it occurs at the high level of setting strategy. It
then moves to a broad-based plan about how to establish an optimum
“position” to maximise the potential for the realisation of goals. Finally,
planning must be undertaken from the perspective of the consideration of
financial realities/constraints and anticipated monetary outcomes, in other
words, budgets.

Strategy
A business typically invests considerable time and money in developing
its strategy. Strategic planning ultimately defines the organisation.
Specific strategy-setting can take many forms, but generally includes
elements relating to the definition of core values, mission and objectives.
 Core values. An entity should clearly consider and define the
rules by which it will play. Core values can cover a broad
spectrum involving concepts of fair play, human dignity, ethics,
employment, promotion, compensation, quality, customer
service, environmental awareness and so on. If an organisation
does not require its members to understand and focus on these
important elements, it will soon find participants becoming solely
“profit-centric”. This behaviour inevitably leads to a short-term
focus and potentially illegal practices that provide the seeds of
self-destruction. Remember that managements build business
value by making the right decisions; and decisions about core
values are essential.

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 C9: Accounting and Finance Course

 Mission. Many companies attempt to prepare a concise statement

about their mission. For example:
At IBM, we strive to lead in the creation, development and
manufacture of the industry’s most advanced information
technologies, including computer systems, software, networking
systems, storage devices and microelectronics.
We translate these advanced technologies into value for our
customers through our professional solutions and services
businesses worldwide. (IBM Corporation 1994, 2011. Retrieved
from http://www.ibm.com/ibm/us/en/)
Such mission statements provide a snapshot of the organisation
and provide a focal point against which to match ideas and
actions. They provide an important planning element because
they define the organisation’s purpose and direction.
 Objectives. An organisation must also consider its specific
objectives.
The objectives of a business organisation must include delivery
of goods or services while providing a return (that is, driving
performance) for its investors. Without this objective, the
organisation serves no purpose and will cease to exist.
Positioning

An important part of the planning process is positioning the organisation

to achieve its goals. Positioning is a broad concept and depends on
gathering and evaluating accounting information.
Cost-volume-profit analysis and scalability

In a subsequent module, we will discuss cost-volume-profit (CVP)

analysis. It is imperative for managers to understand the nature of cost
behaviour and how changes in volume impact profitability. In doing this
we will calculate break-even points and how to achieve target income
levels. We will also discuss different business models and the ability, or
inability to bring them to profitability via increases in scale. Managers
call upon their internal accounting staff to pull together information and
make appropriate recommendations.
Global trade and transfer

The management accountant frequently performs significant and complex

analysis related to global business activities. This requires in-depth
research into laws about tariffs, taxes and shipping. In addition, global
enterprises may transfer inventory and services between affiliated units in
alternative countries. These transactions must be fairly and correctly
measured to establish reasonable transfer prices (or potentially run the
risk of contravening tax and other rules of the various countries
involved). Once again, the management accountant assists with this task.

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Unit 1 Managing the organisation

Branding, pricing, sensitivity, competition

In positioning a company’s products and services, considerable thought

must be given to branding and its impact on the business. To build a
brand requires considerable investment with an uncertain payback.
Frequently, the same product can be “positioned” as an elite brand via a
large investment in up-front advertising, or as a basic consumer product
that depends upon low price to drive sales. Information is needed to make
these decisions, and management will probably enlist the internal
accounting staff to prepare prospective information based upon
alternative scenarios. Likewise, product pricing decisions must be
balanced against costs and competitive market conditions, and sensitivity
analysis is needed to determine how sales and costs will respond to
changes in market conditions.

Decisions about positioning a company’s products and services are quite

complex. The prudent manager will need considerable data to make good
decisions. Management accountants will be directly involved in providing
such data. They will usually work side-by-side with management in
helping them correctly interpret and utilise the information.
Budgets

A necessary planning component is budgeting. Budgets outline the

financial plans for an organisation. There are various types of budgets,
including:
 Operating budgets. A plan must provide definition of the
anticipated revenues and expenses of an organisation. These
operating budgets can become fairly detailed, to the level of
mapping specific inventory purchases and staffing plans. Also,
budgets sometimes delineate allowable levels of expenditures for
various departments.
 Capital budgets. Operating budgets will also reveal the need for
capital expenditures relating to new facilities and equipment.
These longer-term expenditure decisions must be evaluated
logically to determine whether an investment can be justified and
what rate and duration of payback is likely to occur.
 Financial budgets. A company must assess financing needs,
including an evaluation of potential cash shortages. These tools
enable companies to meet with lenders and demonstrate why and
when additional support may be needed.

Directing
To realise a plan requires the initiation and direction of numerous actions.
Often, these actions must be well co-ordinated and timed. Resources must
be ready and authorisations in place to enable people to act according to
the plan. The managerial accountant has a major role in putting business
plans into action. Information systems must be developed to allow
management to understand the organisation. For example, management
must know that inventory is available when needed, that productive

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 C9: Accounting and Finance Course

resources (human and machine) are scheduled appropriately and that

transportation systems will be available to deliver output. In addition,
management must be ready to demonstrate compliance with contracts and
regulations. These are complex tasks. They cannot occur without strong
information resources. A major element of management accounting is to
develop information systems to support the ongoing direction of the
business effort.

Managerial accounting supports the “directing” function in many ways.

Areas of support include costing, production management and special
analysis.
Costing

An effective manager understands how costs are captured and assigned to

goods and services. Costing is such an extensive part of the management
accounting function that many people refer to management accountants
as cost accountants. But cost accounting is only a subset of managerial
accounting applications. With that in mind, let’s focus on cost
accounting.
 Cost accounting. This can be defined as the collection,
assignment and interpretation of cost. In following modules we
will discuss alternative costing methods. It is important to know
what products and services cost to produce. The ideal approach to
capturing costs is dependent on what is being produced.
 Costing methods. In some settings, costs may be captured by the
job costing method. For example, a home builder would probably
capture costs for each house constructed. The actual labour and
material that goes into each house would be tracked and assigned
to that specific home (along with some matching amount of
overhead), and the cost of each home can be expected to vary
considerably.
Some companies produce homogenous products in continuous
processes. For example, consider the costing issues faced by the
companies that produce the lumber, paint, bricks or other such
homogenous components used in building a home. These types
of items are produced in continuous processes where costs are
pooled during production and output is measured in aggregate
quantities. It is difficult to see specific costs attaching to each
unit. Yet, it is important to make a cost assignment. To deal with
these types of situations, accountants use process costing
methods.
Now, let’s consider the architectural firms that design homes.
Such organisations need to have a sense of their costs for the
purposes of billing clients, but the firm’s activities are very
complex. An architectural firm must engage in many activities
that drive costs but do not produce revenues. For example,
substantial effort is required to train staff, develop clients, bill
and collect, maintain the office, print plans, visit job sites, consult

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Unit 1 Managing the organisation

on problems identified during construction and so forth. The

individual architects are probably involved in multiple tasks and
projects throughout the day; therefore it becomes difficult to say
exactly how much it costs to develop a set of blueprints for a
specific client. The firm might consider tracing costs and
assigning them to activities (for example, training or client
development). Then an allocation model can be used to attribute
activities to jobs, enabling a reasonable cost assignment. Such
activity-based costing (ABC) systems can be used in many
settings, but are particularly well suited to situations where
overheads are high, and/or a variety of products and services are
produced.
 Costing concepts. In addition to using alternative methods of
costing, a good manager will understand different theories or
concepts about costing. In a general sense, the approaches can be
described as absorption costing and direct costing concepts.
In the absorption concept, a product or service is assigned its full
cost, including amounts that are not easily identified with a
particular item. Overhead items include facilities depreciation,
utilities, maintenance and many other similar shared costs. With
absorption costing, these overheads are schematically allocated
among all units of output. In other words, output absorbs the full
cost of the productive process. Absorption costing is required for
external reporting purposes under generally accepted accounting
principles (GAAP).
However, reliance on absorption costing numbers can sometimes
lead to bad decisions. As a result, internal cost accounting
processes in some organisations focus on a direct costing
approach. Using direct costing, a unit of output will be assigned
only its direct cost of production (for example, the direct
materials, labour and overheads that occur with each unit
produced). We will discuss the differences between absorption
and direct costing, and consider how they influence the
management decision process in a later module.

In summary, to properly direct an organisation requires a keen sense of

the cost of products and services. Costing can occur by various methods
and theories, and a manager must understand when and how these
methods are best utilised to facilitate the decisions that must be made.
Analysis

Certain business decisions have recurrent themes, for example whether to

outsource production and/or support functions, what level of production
and pricing to establish, whether to accept special orders with private
label branding or special pricing.

Managerial accounting provides models of calculations needed to support

these types of decisions. Subsequent modules will provide insight into the
logic and methods that are employed to manage these types of business
decisions.

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 C9: Accounting and Finance Course

Controlling
Things rarely go exactly as planned, and management must be able to
monitor and adjust for deviations. The managerial accountant is a major
facilitator of this control process, including exploration of alternative
corrective strategies to remedy unfavourable situations.
Monitor

Business managers must rely on systematic monitoring tools to maintain

awareness of where the business is headed. Managerial accounting
provides these monitoring tools, and establishes a logical basis for
making adjustments to business operations.
 Standard costs. To assist in monitoring productive efficiency
and cost control, managerial accountants may develop
“standards”. These standards represent benchmarks against which
actual productive activity is compared. Importantly, standards
can be developed for labour costs and efficiency, materials cost
and utilisation, and more general assessments of the overall
deployment of facilities and equipment (the overhead).
 Variances. Managers focus on standards, keeping a particularly
sharp eye out for significant deviations from expectations. These
deviations, or “variances”, may provide warning signs of
situations requiring corrective action by managers. Accountants
help managers focus on the exceptions by providing the results of
variance analysis. This process of focusing on variances is also
known as “management by exception”.
 Flexible tools. Great care must be taken in monitoring variances.
For example, a business may have a large increase in customer
demand. To meet demand, a manager may prudently authorise
significant overtime. This overtime may result in higher than
expected wage rates and hours. As a result, a variance analysis
could result in certain unfavourable variances. However, this
added cost was incurred because of higher customer demand and
was perhaps a good business decision. Therefore, it would be
unfortunate to interpret the variances negatively. To compensate
for this type of potential misinterpretation of data, management
accountants have developed various flexible budgeting and
analysis tools. These evaluative tools “flex” or compensate for
the operating environment in an attempt to sort out confusing
signals.
 Scorecard. The traditional approach to monitoring organisational
performance has focused on financial measures and outcomes.
Increasingly, companies are realising that such measures alone
are not sufficient. For example, such measures report on what has
occurred and may not provide timely data to respond
aggressively to changing conditions. As a result, many
companies have developed more involved scoring systems. These
scorecards are custom tailored to each position, and draw focus

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Unit 1 Managing the organisation

on evaluating elements that are important to the organisation and

under the control of an employee holding that position. For
example, a fast food restaurant would want to evaluate response
time, cleanliness, waste and similar elements for the front-line
employees. These are the elements for which the employee
would be responsible; presumably, success on these points
translates to eventual profitability.
 Balance. When controlling via a scorecard approach, the process
must be carefully balanced. The goal is to identify and focus on
components of performance that can be measured and improved.
In addition to financial outcomes, these components can be
categorised as relating to business processes, customer
development and organisational betterment. If these balanced
scorecards are carefully developed and implemented, they can be
useful in furthering the goals of an organisation. Conversely, if
the elements being evaluated do not lead to enhanced
performance, employees will spend time and energy pursuing
tasks that have no linkage to creating value for the business.

In conclusion, managerial accounting is surprisingly broad in its scope of

involvement. Before looking at these topics in more detail we will look at
the related topics of corporate governance and ethics.

Corporate governance and responsibility

Introduction
One of the significant influences on how a company is managed is the
system of corporate governance that is used.

Corporate governance is the set of processes, customs, policies, laws and

institutions affecting the way an organisation is directed, administered or
controlled. Corporate governance also includes the relationships among
the many stakeholders involved and the goals for which the organisation
is governed. The principal stakeholders are the shareholders, the board of
directors, employees, customers, creditors, suppliers and the community
at large.

Corporate governance is a complex subject. An important theme of

corporate governance is to ensure the accountability of certain individuals
in an organisation through mechanisms that try to reduce or eliminate the
principal-agent problem. The principal-agent problem treats the
difficulties that arise under conditions of incomplete and asymmetric
information when a principal hires an agent.

The principal-agent problem is found in most employer-employee

relationships, for example, when shareholders appoint the board of
directors who then hire the top executives.

There has been renewed interest in the corporate governance practices of

modern companies since 2001, particularly due to the high-profile
collapses of a number of large United States firms such as Enron

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Corporation and MCI Inc. (formerly WorldCom). In 2002, the United

States federal government passed the Sarbanes-Oxley Act, intending to
restore public confidence in corporate governance.

Parties involved in corporate governance

As stated above, the shareholder delegates decision rights to the manager
to act in the principal’s best interests. This separation of ownership from
control implies a loss of effective control by shareholders over
managerial decisions. Partly as a result of this separation between the two
parties, a system of corporate governance controls is implemented to
assist in aligning the incentives of managers with those of shareholders.
With the significant increase in equity holdings of investors, there has
been an opportunity for a reversal of the separation of ownership and
control problems because ownership is not so diffuse.

A board of directors often plays a key role in corporate governance. It is

the board’s responsibility to endorse the organisation’s strategy, develop
directional policy, appoint, supervise and remunerate senior executives
and ensure accountability of the organisation to its owners and
authorities.

All parties to corporate governance have an interest, whether direct or

indirect, in the effective performance of the organisation. Directors,
workers and management receive salaries, benefits and reputation, while
shareholders receive dividends and capital return. Customers receive
goods and services; suppliers receive compensation for their goods or
services. In return these individuals provide value in the form of natural,
human, social and other forms of capital.

A key factor in an individual’s decision to participate in an organisation,

for example through providing financial capital, is trust that they will
receive a fair share of the organisational returns. If some parties are
receiving more than their fair return then participants may choose to not
continue participating, leading to organisational collapse.

Corporate governance principles

Key elements of good corporate governance principles include honesty,
trust and integrity, openness, performance orientation, responsibility and
accountability, mutual respect and commitment to the organisation.

Of importance is how directors and management develop a model of

governance that aligns the values of the corporate participants and then
how they evaluate this model periodically for its effectiveness. In
particular, senior executives should conduct themselves honestly and
ethically, especially concerning actual or apparent conflicts of interest
and disclosure in financial reports.

Commonly accepted principles of corporate governance include:

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Unit 1 Managing the organisation

 Rights and equitable treatment of shareholders. Organisations

should respect the rights of shareholders and help shareholders to
exercise those rights. They can help shareholders exercise their
rights by effectively communicating information that is
understandable and accessible and encouraging shareholders to
participate in general meetings.
 Interests of other stakeholders. Organisations should recognise
that they have legal and other obligations to all legitimate
stakeholders.
 Role and responsibilities of the board. The board needs a range
of skills and understanding to be able to deal with various
business issues and have the ability to review and challenge
management performance. It needs to be of sufficient size and
have an appropriate level of commitment to fulfil its
responsibilities and duties.
 Integrity and ethical behaviour. Ethical and responsible
decision-making is not only important for public relations, but it
is also a necessary element in risk management and avoiding
lawsuits. Organisations should develop a code of conduct for
their directors and executives that promotes ethical and
responsible decision-making. It is important to understand,
though, that reliance by a company on the integrity and ethics of
individuals is sometimes bound to failure. This happens for a
number of reasons including individual morals and ethics being
different from corporate morals and ethics; and individual
motivation, including greed, which works to the detriment of the
organisation.
Because of this, many organisations establish compliance and
ethics programmes to minimise the risk of the firm stepping
outside of ethical and legal boundaries.
 Disclosure and transparency. Organisations should clarify and
make publicly known the roles and responsibilities of the board
and management to provide shareholders with a level of
accountability. They should also implement procedures to
independently verify and safeguard the integrity of the
company’s financial reporting. Disclosure of material matters
concerning the organisation should be timely and balanced to
ensure that all investors have access to clear, factual information.

Business ethics
As mentioned in the section above, one of the key corporate governance
principles is integrity and ethical behaviour.

Business ethics (also known as corporate ethics) examines ethical

principles and moral or ethical problems that arise in a business
environment. It applies to all aspects of business conduct and is relevant
to the conduct of individuals and business organisations as a whole.

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The range and quantity of business ethical issues reflects the degree to
which business is perceived to be at odds with social values. Historically,
interest in business ethics accelerated dramatically during the 1980s and
1990s, both within major companies and within academia. For example,
today most major corporate websites lay emphasis on commitment to
promoting non-economic social values under a variety of headings (for
example, ethics codes, or social responsibility charters.). In some cases,
companies have redefined their core values in the light of business ethical
considerations (for example, BP’s “beyond petroleum” environmental
tag-line).

The globalisation of business has highlighted the issue of adhering to

acceptable business practices in different parts of the world. Such issues
include:
 the search for universal values as a basis for international
commercial behaviour
 comparison of business ethical traditions in different countries
 comparison of business ethical traditions from various religious
perspectives
 ethical issues arising out of international business transactions,
for example, the fair trade movement and transfer pricing
 globalisation and cultural imperialism
 varying global standards, for example, the use of child labour
 the way in which multinationals take advantage of international
differences, such as outsourcing production (for example,
clothes) and services (for example, call centres) to low-wage
countries
 the permissibility of international commerce with pariah states.

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Unit 1 Managing the organisation

Activity 1.1
For the organisation that you are currently involved with:
1. List all of the areas where accounting information is used to help
with decision-making.
2. Describe how the organisation is governed.
Activity
3. Does your organisation have a code of ethics? If so, how does the
organisation ensure compliance with the code?
4. Are there any operational areas that may lead to an ethical
dilemma? If so, how does the organisation deal with this type of
situation?

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Unit summary
In this unit you learned:
 the key differences between management accounting and financial
accounting;
Summary  the three critical roles of management are planning, directing and
controlling;
 the importance of corporate governance; and
 the important role of business ethics.

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Unit 2 Costing systems

Unit 2

Costing systems
Introduction
The objective of this unit is to discuss the various ways costs can be
classified and then to look at two different methods of applying costs to
products or services. Classification of the costs assists managers in the
decision-making process, hence it is important to understand the
classification of costs and the terms used to define costs.

The unit comprises three main sections:

1. Costing concepts and terminology
2. Absorption costing
3. Variable costing

Upon completion of this unit you will be able to:

 Explain different classifications of cost.

 Describe how costs behave.
 Explain the principles of absorption costing.
Outcomes  Explain the principles of variable costing.
 Identify the differences between absorption and variable costing.

Terminology
Differential cost: A cost that differs between alternatives.

Direct labour: A portion of labour cost that can be easily traced to

a product.
Terminology Direct materials: Raw material inputs that become an integral part
of a finished product and can be easily traced to it.

Fixed costs: Costs that remain constant in total for changes in

activity within the relevant range.

Manufacturing All manufacturing costs other than direct materials

overhead: and direct labour.

Opportunity cost: The potential benefit that is given up by selecting

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one alternative over another.

Period cost: Costs that are expensed in the time period in which
they are incurred.

Product cost: Costs that are added to units of product

(“inventoried”) as they are incurred and are not
treated as expenses until the units are sold.

Relevant range: The range of activity within which the

assumptions about variable and fixed costs are
valid.

Sunk costs: A cost that has already been incurred and that
cannot be changed by any decision made now or in
the future.

Variable cost: A cost that is constant per unit of activity but

changes in total as the activity level rises and falls.

Costing concepts and terminology

Introduction
In this section we will introduce some common costing concepts and
terminology. As a manager you should become familiar with these
concepts and an understanding of the common terminology that is applied
in costing.

Cost classifications for preparing external financial

statements
In this section we will deal with the problem of valuing inventories and
determining cost of goods sold for external financial reporting purposes
(for the income statement and balance sheet). To understand the nature of
cost of goods sold we must be able to explain the difference between a
manufacturing and a merchandising firm.
 Manufacturing companies convert raw materials into a product.
The company then sells that product either to other companies or,
less commonly, directly to individuals. Manufacturing includes
the business of restaurants, movie studios, and other types of
service companies as well as the more obvious examples of
manufacturing such as automobile (cars) and clothing production.
 Merchandising companies, by contrast, buy finished products
and resell the products to customers such as supermarkets.

To assist in understanding the valuation of inventories and determining

cost of goods sold we first need to understand what categories of costs are
parts of the value of inventories or cost of goods sold.

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Unit 2 Costing systems

Manufacturing costs

These costs are incurred to make a product. Manufacturing costs are

usually grouped into three main categories: direct materials, direct labour,
and manufacturing overhead.
 Direct materials consist of those raw material inputs that
become an integral part of a finished product and can be easily
traced to it. Examples include the aircraft engines on a Boeing
777 aeroplane and the Intel processing chip in a personal
computer.
 Direct labour consists of that portion of labour cost that can be
easily traced to a product. Direct labour is sometimes referred to
as “touch labour” since it consists of the costs of workers who
“touch” the product as it is being made.
 Manufacturing overhead consists of all manufacturing costs
other than direct materials and direct labour. These costs cannot
be easily and conveniently traced to products. Examples include
miscellaneous supplies such as rivets on a Boeing 777 aeroplane,
supervisors, janitors and factory facility charges.
 Prime versus conversion costs. Prime cost consists of direct
materials plus direct labour. Conversion cost consists of direct
labour plus manufacturing overhead.
Non-manufacturing costs

In addition to manufacturing costs, many other costs are incurred by an

organisation. Typically, for financial reporting purposes most of these
other costs are classified as selling (marketing) costs and administrative
costs. Selling and marketing and administrative costs are incurred in both
manufacturing and merchandising firms.
 Selling and marketing costs include the costs of making sales,
taking customer orders and delivering the product to customers.
These costs are also referred to as order-getting and order-filling
costs.
 Administrative costs include all executive, organisational and
clerical costs that are not classified as production or marketing
costs.
Period versus product costs

Costs can also be classified as period or product costs.

 Period costs are expensed in the time period in which they are
incurred. All selling and administrative costs are typically
considered to be period costs. In determining these costs the
usual rules of accrual accounting apply. For example,
administrative salary costs are “incurred” when they are earned
and not necessarily when they are paid to employees.
 Product costs are added to units of product (“inventoried”) as
they are incurred and are not treated as expenses until the units

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are sold. This can result in a delay of one or more periods

between the time in which the cost is incurred and when it
appears as an expense on the income statement. Product costs are
also known as inventorial costs. Generally, all manufacturing
costs are treated as product costs.
Inventory valuation and cost of goods sold

In a manufacturing firm, raw material purchases are recorded in a raw

materials inventory account. These costs are transferred to a work in
process inventory account when the materials are released to the
production departments. Other manufacturing costs – direct labour and
manufacturing overhead – are charged to the work-in-process inventory
account as incurred. As work in process is completed, its costs are
transferred to the finished goods inventory account. These costs become
expenses only when the finished goods are sold.
Schedule of cost of goods manufactured

Because of inventories still on hand at the end of the period, the cost of
goods sold for a period is not simply the manufacturing costs incurred
during the period. Some of the cost of goods sold may be for units
completed in a previous period. And some of the units completed in the
current period may not have been sold and will still be on the balance
sheet as assets. The cost of goods sold is computed with the aid of a
schedule of costs of goods manufactured, which takes into account
changes in inventories. The schedule of cost of goods manufactured is not
ordinarily included in external financial reports, but must be compiled by
accountants within the company in order to arrive at the cost of goods
sold.

The following example demonstrates the link between the cost of goods
manufactured and the cost of goods sold and the resulting income
statement.

Case study/Example The cost of goods manufactured schedule is used to calculate the cost of
producing products for a period of time. The cost of goods manufactured
amount is transferred to the finished goods inventory account during the
period and is used in calculating cost of goods sold on the income
statement. The cost of goods manufactured schedule reports the total
manufacturing costs for the period that were added to work-in-process,
and adjusts these costs for the change in the work-in-process inventory
account to calculate the cost of goods manufactured.

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Unit 2 Costing systems

Bluewater Manufacturing Limited

Cost of goods manufactured schedule
For the year ended December 31, 20X0

Direct materials used

Beginning raw materials inventory $6,200

Add: cost of raw materials purchased $49,400

Total raw materials available $55,600

Less: ending raw materials inventory ($5,800)

Total raw materials used $49,800

Direct labour $125,600

Manufacturing overhead

Indirect materials $4,100

Indirect labour $43,700

Depreciation – factory building $9,500

Depreciation – factory equipment $5,400

Insurance – factory $12,000

Property taxes – factory $4,500

Total manufacturing overhead $79,200

Total manufacturing costs $254,600

Add: beginning work-in-process inventory $10,200

$264,800

Less: ending work-in-process inventory ($9,800)

Cost of goods manufactured $255,000

The cost of goods manufactured for the period is added to the finished
goods inventory. To calculate the cost of goods sold, the change in
finished goods inventory is added to or subtracted from the cost of goods
manufactured.

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Bluewater Manufacturing Limited

Income statement
For the year ended December 31, 20X0

Sales $427,000

Cost of goods sold

Beginning finished goods inventory $14,500

Cost of goods manufactured $255,000

Total goods available for sale $269,500

Ending finished goods inventory ($12,600)

Cost of goods sold $256,900

Gross profit $170,100

Operating expenses

Selling expenses

Sales salaries

Depreciation – sales equipment

Total selling expenses $86,300

Administrative expenses

Office salaries

Depreciation – office equipment

Insurance expense

Office supplies expense

Total administrative expenses $58,400

Total operating expenses $144,700

Income from operations $25,400

Interest revenue $5,100

Income before taxes $30,500

Income taxes $10,675

Net income $19,825

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Unit 2 Costing systems

Cost classifications to describe cost behaviour

Managers often need to be able to predict how costs will change in
response to changes in activity. The activity might be the output of goods
or services or it might be some measure of activity internal to the firm,
such as the number of purchase orders processed during a period.

While there are other ways to classify costs according to how they react
to changes in activity, for the purposes of this section we will use the
simple variable and fixed classifications.
 A variable cost is constant per unit of activity but changes in total
as the activity level rises and falls.
 A fixed cost is constant in total for changes in activity within the
relevant range. Note: just about any cost will change if there is a
big enough change in activity. Fixed costs do not change for
changes in activity that fall within the “relevant range”. When
expressed on a per unit basis, a fixed cost is inversely related to
the level of activity – the per unit cost decreases when activity
rises and increases when the activity level falls.
 Relevant range is the range of activity within which the
assumptions about variable and fixed costs are valid. In other
words the relevant range is the anticipated activity level at which
the organisation will perform. The relevant range is also applied
when considering fixed costs. Many fixed costs are only fixed for
a certain level of production. For example, a machine or
manufacturing plant can reach capacity. To increase production
beyond a certain level, additional machinery (or a new plant, or
additional supervisors) must be deployed. This will cause a major
step upward in the fixed cost. Fixed costs that behave in this
fashion are also called step costs. The key point is to note that
fixed costs are only fixed over some particular range of activity,
and moving outside that range can significantly alter the cost
structure.

Cost classifications for assigning costs

Managers often want costs to be assigned to cost objects, such as
products, customers, or departments, for pricing or other purposes.
 A direct cost is a cost that can be conveniently and easily traced
to a particular cost object, for example the materials and labour
needed to produce a product.
 Indirect costs are everything else. There are two reasons why a
cost would be considered indirect: either it is impractical or it is
impossible to trace the cost to the cost object. Examples of
indirect costs include rent, administrative expenses and utilities.

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Cost classifications for decision-making

Every decision involves choosing from among at least two alternatives.
Only those costs and benefits that differ between alternatives are relevant
in making the selection.
 Differential costs. A differential cost is one that differs between
two alternatives. The cost may exist in only one of the
alternatives or the total amount of the cost may differ between the
alternatives. In the latter case, the differential cost would be the
difference between the cost under one alternative and the cost
under the other alternative. Differential costs are also called
incremental costs. Differential costs and opportunity costs (see
below) should be the focus of decision-making. They are the only
relevant costs and all others should be ignored. An example of
differential costs would arise where a retailer is considering
distributing its products via a third party rather than distributing
the products themselves. In this situation the retailer would
consider additional revenues and costs in the proposed
arrangement compared with their current arrangement.
 Opportunity costs. An opportunity cost is the potential benefit
that is given up by selecting one alternative over another. As the
opportunity cost is the benefit foregone by choosing an
alternative it is not an actual expenditure and it is rarely (if ever)
shown on the accounting books of an organisation. It is, however,
a cost that must be considered in decisions. For example, you are
employed in a company that pays you $30,000 per year. You are
thinking about leaving the company and returning to school.
Since returning to school would require that you give up $30,000
salary. The foregone salary would be an opportunity cost of
seeking further education.
 Sunk cost. A sunk cost is a cost that has already been incurred
and that cannot be changed by any decision made now or in the
future. Since sunk costs cannot be changed and therefore cannot
be differential costs, they should be ignored in decision-making.
For example, assume that a company paid $50,000 several years
ago for a special purpose machine. The machine was used to
make a product that is now obsolete and is no longer being sold.
Even though in hindsight the purchase of the machine may have
been unwise, no amount of regret can undo that decision, plus it
would not make sense to continue making the obsolete product to
recover the original cost of the machine. In short, the $50,000
originally paid for the machine has already been incurred and
cannot be a differential cost in any future decision. For this
reason, such costs are said to be sunk costs and should be ignored
in decision-making.

Absorption costing
The practice of charging all costs both variable and fixed to operations,
products or processes is termed as absorption costing.

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Unit 2 Costing systems

Absorption costing is a costing system which treats all costs of

production as product costs, regardless of whether they are variable or
fixed. The cost of a unit of product under the absorption costing method
consists of:
 direct materials, plus
 direct labour, plus
 variable overhead, plus
 a proportion of fixed overhead.

Absorption costing allocates a portion of fixed manufacturing overhead

cost to each unit of product, along with the variable manufacturing cost.
Because absorption costing includes all costs of production as product
costs, it is frequently referred to as the full costing method.

A company has a job that is produced in a single cost centre (for example,
a factory). A job has the following information:
 The direct material cost for the job was $10,000.
Case study/example  The direct labour cost for the job was $10,000.
 Direct labour hours for the job were $1,000.

Therefore the direct costs for this job were $20,000. However, in order to
determine how much this job should be sold for, the overhead cost also
needs to be covered.

The company has a total factory overhead of $50,000 and the factory
could generate a total of 15,000 labour hours.

Therefore, to allocate a portion of the total overhead to this job we would

divide the overhead ($50,000) by the labour hours (15,000) and multiply
by the number of hours spent on the job (1,000) giving an overhead cost
of $3,333. This then gets added to the prime cost (direct cost) for a total
production cost of $23,333.

Variable costing
Variable costing is a costing system under which those costs of
production that vary with output are treated as product costs. This would
usually include:
 direct materials, plus
 direct labour, plus
 variable portion of overhead.

Fixed manufacturing cost is not treated as a product cost under variable

costing. Rather, fixed manufacturing cost, like selling and administrative
expenses, is charged off in its entirety against revenue each period. In
other words, it is treated as a period cost. Consequently the cost of a unit

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of product in inventory or cost of goods sold under this method does not
contain any fixed overhead cost.

Using the same information as the absorption costing example above,

only the direct material of $10,000 and the direct labour of $10,000
would be included for a total production cost of $20,000 (compared with
$23,333 under absorption costing).

Variable costing is sometimes referred to as direct costing or marginal

costing.

To complete this summarised comparison of absorption and variable

costing, we need to consider briefly the handling of selling and
administrative expenses. These expenses are never treated as product
costs, regardless of the costing method in use. Thus under either
absorption or variable costing, both variable and fixed selling and
administrative expenses are always treated as period costs and deducted
from revenues as incurred.

Comparison between absorption and variable costing

Treatment of costs
A summary of the treatment of the various costs comparing absorption
and variable costing is shown in Figure 2 below.

Cost classifications – absorption versus variable costing

Absorption Variable
Type of cost
costing costing

Direct materials
Direct labour Product
Product Variable manufacturing overhead cost
cost
Fixed manufacturing overhead

Variable selling and administrative expenses Period cost

Period
cost Fixed selling and administrative expenses

Figure 2 Cost classifications summary

Format of income statements

The formats for profit reporting are different for variable costing and
absorption costing.

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Unit 2 Costing systems

Absorption costing Variable costing

Revenues Revenues
minus minus
Cost of goods sold Variable manufacturing
equals minus
Gross margin Variable sell & admin
minus equals
Variable sell & admin Contribution margin
minus minus
Fixed sell & admin Fixed manufacturing
equals minus
Profit Fixed sell & admin
equals
Profit

Figure 3 Differences between Absorption costing and variable costing

reports

The profit figures under the two approaches will not always be the same.

The difference between the two income-measurement approaches is

essentially the difference in the timing of the charge to expense for fixed
factory overhead cost.

In the absorption costing method, fixed factory overhead is first charged

to inventory; thus it is not charged to expense until the period in which
the inventory is sold and included in cost of goods sold (as an expense).

In contrast, in the variable costing method, fixed factory overhead is

charged to expense immediately, and only variable manufacturing costs
are included in product inventories.

Therefore, if inventories increase during a period (that is, production

exceeds sales), the variable costing method will generally report less
operating income than will the absorption costing method; when
inventories decrease, the opposite effect will take place.

We will demonstrate this with some examples at the end of this section.

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To illustrate the computation/calculation of unit product costs under both

absorption and variable costing, consider the following example.

A small company that produces a single product has the following cost
Case Study/Example structure.

Number of units produced 12,000

Variable costs per unit:
Direct materials $4
Direct labour $8
Variable manufacturing overhead $2
Variable selling and administrative expenses $6
Fixed costs per year:
Fixed manufacturing overhead $60,000
Fixed selling and administrative expenses $20,000

The unit product cost under the absorption costing method is calculated
as follows:

Unit product cost

absorption costing method
Direct materials $4
Direct labour $8
Variable manufacturing overhead $2
--------
Total variable production cost $14
Fixed manufacturing overhead ($60,000 / 12,000) $5
--------
Unit product cost $19
=====

The unit product cost under the variable costing method is calculated as
follows:

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Unit 2 Costing systems

Unit product cost

variable costing method
Direct materials $4
Direct labour $8
Variable manufacturing overhead $2
--------
Unit product cost $14
=====

Note: the $60,000 fixed manufacturing overhead will be charged off in

total against income as a period expense along with selling and
administrative expenses.

Under absorption costing, all production costs, variable and fixed, are
included when determining the unit product cost. Thus if the company
sells a unit of product and absorption costing is being used, then $19
(consisting of $14 variable cost and $5 fixed cost) will be deducted on the
income statement as cost of goods sold. Similarly, any unsold units will
be carried as inventory on the balance sheet at $19 each.
Under variable costing, all variable costs of production are included in
product costs. Thus if the company sells a unit of product, only $14 will
be deducted as cost of goods sold, and unsold units will be carried in the
balance sheet inventory account at only $14. In addition, total fixed costs
of $60,000 will be expensed in the period.

We now look at a more complex example that illustrates the effect on

overall profit when:
 sales = production,
Case study/example  sales are less than production, and
 sales are greater than production.

For the above three scenarios assume the following (per unit).
Direct materials 2.5 lbs @ $4.00 = $1.00
Direct labour 0.5hr @ $16.00 = $8.00
VOH 0.5 hr @ $4.00 = $2.00
FOH $40,000 total divided by 16,000 units) = $2.50
Actual output 16,000 units
Variable S&A $6.00 per unit
Fixed S&A $60,000
Selling price $40.00

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Scenario 1. The respective income statements if actual sales equal the actual
production of 16,000 units.

Absorption costing Variable costing

Revenue ($40)(16000) 640,000 Revenue ($40)(16000) 640,000
Cogs ($22.50)(16000)* 360,000 Vbl Mfg ($20)(16000) 320,000
GM ($17.50)(16000) 280,000 Vbl S+A ($6)(16000) 96,000
Vbl S+A ($6)(16000) 96,000 CM 224,000
Fx S+A 60,000 Fx Mfg 40,000
Profit $124,000 Fx S+A 60,000
Profit $124,000

Figure 3
Note: Each unit has a cost of $22.50 which is equal to: $10 + $8 + $2 +
$2.50.
Note: When sales equals production, profit under absorption
costing and direct costing are equal.
Scenario 2. The respective income statements if actual sales are 12,000 units
and the actual production is 16,000 units.

Absorption costing Variable costing

Revenue ($40)(12000) 480,000 Revenue ($40)(12000) 480,000
Cogs ($22.50)(12000) 270,000 Vbl Mfg ($20)(12000) 240,000
GM ($17.50)(12000) 210,000 Vbl S+A ($6)(12000) 72,000
Vbl S+A ($6)(12000) 72,000 CM ($14)(12000) 168,000
Fx S+A 60,000 Fx Mfg 40,000
Profit $78,000 Fx S+A 60,000
Profit $68,000

Figure 4
Note: When production exceeds sales, absorption profit exceeds variable
costing profit.
Scenario 3. The respective income statements if actual sales are 18,000 units
and the actual production is 16,000 units.

Absorption costing Variable costing

Revenue ($40)(18000) 720,000 Revenue ($40)(18000) 720,000
Cogs ($22.50)(18000) 405,000 Vbl Mfg ($20)(18000) 360,000
GM ($17.50)(18000) 315,000 Vbl S+A ($6)(18000) 108,000
Vbl S+A ($6)(18000) 108,000 CM ($14)(18000) 252,000
Fx S+A 60,000 Fx Mfg 40,000
Profit $147,000 Fx S+A 60,000
Profit $152,000

Figure 5

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Unit 2 Costing systems

Note: When sales exceed production, variable costing profit exceeds

absorption profit.
Analysis of the above scenarios:
 Absorption unit cost is higher than variable unit cost.
 Output-level (production-volume) variance exists only under
absorption costing.
 Absorption costing uses business functions to classify costs, for
example, manufacturing, marketing and administration.
 Variable costing uses cost behaviour to classify costs, e.g.
variable and fixed.
Reconciliation of the profit differences in Scenarios 2 and 3.

General formula:

Absorption Profit - Variable Profit = (fixed overhead per unit) * (units

produced - units sold)

or (fixed overhead per unit) * (change in inventories).

Scenario 2 78,000 - 68,000 = 2.50(16,000 - 12,000) = $10,000

Scenario 3 147,000 - 152,000 = 2.50(16,000 - 18,000) = -$5,000

Summary of costing comparison

Variable and absorption costing differ in only one respect: how to
account for fixed manufacturing costs. Under variable costing, fixed
manufacturing costs are excluded from inventorial costs and are a cost of
the period in which they are incurred. Under absorption costing, these
costs are inventorial and become a part of cost of goods sold in the period
when sales occur.

Under variable costing, reported operating income is driven by the unit

level of sales. Under absorption costing, reported operating income is
driven by the unit level of production as well as by the unit level of sales.

Although absorption costing is the required inventory method for external

reporting in most countries, many companies use marginal (variable)
costing for internal reporting.

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Activity 1.2
1. Hawkins Electronics Limited manufactures a portable radio designed
for mounting on the wall of the bathroom. The following list
represents some of the different types of costs incurred in the
manufacture of these radios.
Activity
Classify each of the items as product (inventoriable) cost or period
(non-inventoriable) costs for the purpose of preparing external
financial statements.
a. The plant manager’s salary.
b. The cost of heating the plant.
c. The cost of heating executive offices.
d. The cost of printed circuit boards used in the radios.
e. Salaries and commissions of company salespersons.
f. Depreciation on office equipment used in the executive
offices.
g. Depreciation on production equipment used in the plant.
h. Wages of janitorial personnel who clean the plant.
i. The cost of insurance on the plant building.
j. The cost of electricity to light the plant.
k. The cost of electricity to power plant equipment.
l. The cost of maintaining and repairing equipment in the plant.
m. The cost of printing promotional materials for trade shows.
n. The cost of solder used in assembling the radios.
o. The cost of telephone service for the executive offices.

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Unit 2 Costing systems

2. Lee Company, which has only one product, has provided the following data
concerning its most recent month of operations:
Selling price $95
Units in beginning inventory 100
Units produced 6,200
Units sold 5,900
Units in ending inventory 400

Variable costs per unit:

Direct materials $42
Direct labour $28
Variable manufacturing overhead $1
Variable selling and administrative $5

Fixed costs:
Fixed manufacturing overhead $62,000
Fixed selling and administrative $35,400

The company produces the same number of units every month, although the sales in
units vary from month to month. The company’s variable costs per unit and total fixed
costs have been constant from month to month.

Required:
a. What is the unit product cost for the month under variable costing?
b. What is the unit product cost for the month under absorption costing?
c. Prepare an income statement for the month using the contribution format and
the variable costing method.
d. Prepare an income statement for the month using the absorption costing
method.
e. Reconcile the variable costing and absorption costing net incomes for the
month.

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Unit summary
In this unit you learned:
 that costs can be classified in a number of different ways
 the difference between period and product costs
Summary
 the difference between fixed and variable costs
 the relevant costs for decision-making
 that absorption costing allocates a proportion of fixed overheads
to a product cost
 that variable costing does not allocate any fixed overheads to
product costs.

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Unit 3 Activity-based costing

Unit 3

Activity-based costing
Introduction
In the previous unit we described two different costing techniques –
absorption and variable costing. In this unit we will describe another
costing system called activity-based costing (ABC).

An ABC system involves identifying the activity that causes the

incurrence of a cost, so an ABC system provides managers with more
accurate information on which to base decisions.

Upon completion of this unit you will be able to:

 Describe a typical ABC system.

 Explain the components of an ABC system.
 Identify activities and cost drivers.

Outcomes  Explain the advantages and disadvantages of ABC.

 Explain the difference between traditional costing systems and
ABC.

Terminology
Activity: Major tasks performed in an organisation.

Cost driver: Has a direct and positive relationship with the cost
that is being attributed to the product or service.
Terminology Cost pool: Accumulations of expenditure under a category
which describes a particular activity.

Resource driver: Measures the amount of resources used by an

activity.

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Conceptual overview of activity-based costing

Activity-based costing (ABC) is a management accounting information
system that identifies the various activities performed in an organisation,
collects costs on the basis of the underlying nature and extent of those
activities, and assigns costs to products and services based on those
activities. ABC should improve the quality of management accounting
information in situations where conventional overhead allocation
methods may produce misleading results.

ABC focuses on activities as the fundamental cost objects. It uses the cost
of these activities as the basis for assigning costs to such other cost
objects as products, services or customers. The distinctive feature of ABC
is that it focuses on activities as the fundamental cost objects whereas
traditional costing (absorption and variable costing described in the
previous units) focuses on the product or service as the cost object.
Under traditional costing, the assumption is made that products/services
consume resources. Under ABC, products/services consume activities
and activities consume resources.

The ABC terminology

Some terminology was given in the Terminology section and in this
section we expand on those terms. ABC uses a number of unique terms,
the most common of which are:
 Activity. This is discussed in more depth in the next section;
however, activities are major tasks performed in an organisation,
for example, receiving goods, inspecting goods and storing
goods. In the first stage of an ABC system, the costs of the
activities are calculated then the costs of the activities are traced
to product or services using a relevant cost driver.
 Resources. All activities consume resources. Typical examples
of resources are labour, materials, rent, depreciation, power,
travel and entertainment, insurance, supplies, and repairs and
maintenance.
 Resource driver. A resource driver measures the amount of
resources used by an activity. Examples include the number of
cubic metres for space and number of employees for salaries and
wages.
 Cost driver. A cost driver has a direct and positive relationship
with the cost being attributed to the product or service. An
increase in volume of the cost driver increases the cost allocated
to the product or service. We need to determine cost drivers
because we need to accurately measure costs. An example of a
cost driver is labour hours. As labour hours increase, so do the
labour costs. If we have a product that uses labour, the number of
labour hours is the cost driver to allocate labour cost to the
product. It is easy to determine cost and cost drivers with labour
costs (and direct materials) because these costs are direct costs. It

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Unit 3 Activity-based costing

is more subjective to identify cost drivers that drive overhead

costs.
 Cost pool. Cost pools represent accumulations of expenditure
under a category which describes a particular activity. For
example, a cost pool titled “quality assurance” is managed by
personnel from operations, sales and administration. The cost of
all quality assurance activities are assigned to the cost pool,
regardless of the department in which the activities are carried
out.
 Cost object. Information about a cost object assists
management’s decision-making. Examples of cost drivers are
products, services, customers and divisions. For example, XPT
Ltd has three factories in different locations, each manufacturing
pencils. It has eight major customers who purchase about 90 per
cent of the total annual production. XPT buys the graphite from
one supplier and the balsa wood from three different suppliers,
depending upon such factors as price, deliverability and quality
of the wood.
To promote sales, XPT Ltd begins an extensive advertising
campaign in professional journals. How many cost objects can
you identify in this case? The following list is not exhaustive.

Cost objects Decision-making/other uses

Pencils Pricing/external reporting (ER)

Graphite Stock costing/ER

Customers Contribution to profits/marketing strategies

Wood Stock costing/pricing/ER

Sales personnel Contribution to profits/bonus calculations/decision

analysis, for example, add or remove staff

Factories Performance measurement by factory

Identifying activities
ABC assumes that activities cause costs. It is helpful to think of activities
at different levels.
 Unit-level activities are those that have a one-to-one
correspondence with a unit of output. For example, a telescope
manufacturer may have to perform some final calibration to each
finished product (whether it is an entry-level scope or an
advanced device). Therefore, calibration may be seen as an
activity.
 Batch-level activities are those that must be performed, but can
relate to one or more units of output. In some cases, shipping can
be seen as an excellent example of a batch process. Assume that

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Books R US is an online bookstore. Some customers order only

one book while others may order a dozen books at a time. In each
case the customer’s books must be packaged and shipped.
Roughly the same activity is required independent of how many
books are put in a box.
 Product-level activities are carried out at the product level, no
matter the volume of production. Product design, marketing and
so forth are activities that have a one-to-one correspondence with
the number of end products.
 Customer-level activities can take many forms. These include
technical support help lines, catalogues and sales calls. You
would generally expect this category to grow as the customer
base expands.
 Other activity levels might also be appropriate. Some businesses
will identify market-level activities. For example, most global
companies contract with an independent customs broker within
each market served. Therefore the cost of customs brokerage
services can be seen as a function of markets served. There are
also entity-sustaining activities. A publicly listed company will
incur costs of producing and distributing their annual report to
shareholders and other interested parties. The associated costs of
this exercise could be classified as entity-sustaining.
The identification of activities is unique to each company. The
above “levels” provide a frame of reference that is helpful in
considering the important activities of an organisation.

Identifying cost drivers

A cost driver is the unit of an activity that causes the change of an activity
cost. A cost driver is any activity that causes a cost to be incurred.

In traditional costing, the cost driver to allocate indirect cost to cost

objects is volume of output. With the change in business structures,
technology and thereby cost structures it was found that the volume of
output was not the only cost driver. Some examples of indirect costs and
their drivers are:
 maintenance costs, which are indirect costs, with the possible
driver being the number of machine hours.
 handling raw-material costs, which are indirect costs, and may
be driven by the number of orders received.
 inspection costs that are driven by the number of inspections or
the hours of inspection or production runs.

Generally, the cost driver for short-term indirect variable costs may be
the volume of output/activity; but for long-term indirect variable costs,
the cost drivers will not be related to volume of output/activity.

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Unit 3 Activity-based costing

Advantages and disadvantages of activity-based costing

Advantages of ABC
Traditional costing methods divide costs into product costs and period
costs. The period costs include selling, general and administrative items
and are charged against income in the period incurred. Product costs
comprise direct materials, direct labour and factory overhead. These are
traced/allocated to production under both job and process costing
techniques.

However, some managers reject this methodology as conceptually

flawed. For example, it can be argued that the cost of a finished product
should include not only the cost of direct materials, but also a portion of
the administrative cost necessary to buy the raw materials (for example,
many companies have a separate administrative unit in charge of all
purchasing activity, such as writing specifications, obtaining bids and
issuing purchase orders). Conversely, the cost of a plant security guard is
part of factory overhead, but some managers fail to see a correlation
between that activity and a finished product; after all, the guard will be
needed no matter how many units are produced.

Activity-based costing attempts to overcome the perceived deficiencies in

traditional costing methods by more closely aligning activities with
products. This requires abandoning the traditional division between
product and period costs, instead seeking to find a more direct linkage
between activities, costs and products.

This means that products will be charged with the costs of manufacturing
and non-manufacturing activities. It also means that some manufacturing
costs will not be attached to products. This is quite a departure from
traditional thought.

Another benefit of ABC is that a product is only charged with the cost of
capacity used. Idle capacity is isolated and not charged to a product or
service. Under traditional approaches, some idle capacity may be
incorporated into the overhead allocation rates, thereby potentially
distorting the cost of specific output. This may limit the ability of
managers to truly understand and identify the best business decisions
about product pricing and targeted production levels.

Disadvantages of ABC
One limitation of ABC is that external reporting must be based on
traditional absorption costing methods. Absorption costing requires the
traditional division between product costs and period costs, with
inventory absorbing all manufacturing costs and none of the period costs.
As a result, ABC may produce results that differ from those required
under generally accepted accounting principles (GAAP). Therefore, ABC
is usually viewed as supplemental in nature. It is used for internal
management decision-making, but it may not be suitable for public
reporting.

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The fact that ABC is not GAAP usually means that a company that
wishes to benefit from ABC must develop two costing systems — one for
external reporting and one for internal management. Some companies
feel they have enough to do without working through two costing
methods.

Another disadvantage of ABC is that it is usually more complex than

other approaches. Rather than applying all factory overhead on some
simple basis, such as labour hours, it requires the development of
numerous cost pools that must be individually allocated. In other words,
ABC is a more intensive technique, and the costs to implement and then
maintain the system may not be worth the trouble.

ABC example
The following example will be used to demonstrate the principles of ABC
and then to highlight the different outcomes compared with the
absorption costing technique.

Case study/example Y Limited manufactures and sells a wide range of machine tools. The
company uses absorption costing for both external reporting as well as for
individual product information for decision-making. However, on the
advice of the company’s financial consultants, management decided to
trial a system of ABC, while still retaining the traditional costing system.

The following information has been obtained from the company’s

management accountant:
 Production overhead application rate per direct labour hour for
absorption costing used for all products manufactured is $20.00.
 Activity cost pools, cost drivers identified, costs and driver units
used for the ABC system:
o Production Expenses

Activity cost pools Cost driver identified Cost ($) Driver units
Purchasing No. purchase orders 1,200,000 3,000
Materials handling & storage No. of components used 1,000,000 5,000,000
Machine set-up No. of setups 1,350,000 9,000
Quality control No. of batches 800,000 3,200
Labour & other overhead No. machine hours 10,650,000 500,000
Packaging No. of units 2,500,000 625,000

o Marketing Expenses

Activity cost pools Cost driver identified Cost ($) Driver units
Delivery expenses No. of sales orders 400,000 4,000
Sales commissions Sales dollars 2,000,000 40,000,000
After sales service No. of service calls 500,000 10,000

 Data for two of the many products produced by the company is

provided below:

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Unit 3 Activity-based costing

o Per unit data

Products X Z
Price $80 $400
Direct materials costs $20 $120
Direct wages $15 $60
Labour hours 1 hour 4 hours

o Other data

Products X Z
No. purchase orders 200 200
No. of components used 450,000 100,000
No. of set-ups 50 1,000
No. of batches 50 200
Total machine hours 30,000 8,000
No. of units produced & sold 30,000 2,000
No. of sales orders 300 400
Sales dollars $2,400,000 $800,000
No. of service calls 50 500

We will now calculate the cost drivers per unit for each activity cost pool
identified, as follows:
Activity cost pool Cost driver Cost Driver Cost per
$ units driver unit
$
Purchasing No. of purchase orders 1,200,000 3,000 400.00
Material handling & No. of components 1,000,000 5,000,000 0.20
storage used
Machine set up No. of set ups 1,350,000 9,000 150.00
Quality control No. of batches 800,000 3,200 250.00
Labour & other overhead No. machine hours 10,650,000 500,000 21.30
Packaging No. of units 2,500,000 625,000 4.00
Delivery expenses No. of sales orders 400,000 4,000 100.00
Sales commissions Sales dollars 2,000,000 40,000,000 0.05
After sales service No. of service calls 500,000 10,000 50.00

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Now we can prepare income statements for products X and Z using ABC
(ignore costs not allocated to products) and calculate the gross margin
percentage for X and Z.
X Z
Units Price Value Units Price Value
$ $ $ $
Sales 30,000 80 2,400,000 2,000 400 800,000

Production costs
Direct materials 30,000 20 600,000 120 240,000
Cost per
Driver Unit Driver Cost Driver Cost
Overhead costs $ Units $ Units $
Purchasing 400.00 200 80,000 200 80,000

Materials handling 0.20 450,000 90,000 100,000 20,000

& storage
Machine set up 150.00 50 7,500 1,000 150,000
Quality control 250.00 50 12,500 200 50,000
Labour & other 21.30 30,000 639,000 8,000 170,400
overhead
Packaging 4.00 30,000 120,000 2,000 8,000
Total 1,549,000 718,400
Gross margin 851,000 81,600

Marketing costs
Delivery expenses 100.00 300 30,000 400 40,000
Sales commissions 0.05 2,400,000 120,000 800,000 40,000
After sales service 50.00 50 2,500 500 25,000
Total 152,500 105,000
Net profit 698,500 (23,400)
Gross margin 35.46% 10.20%
percent
Net margin percent 29.10% -2.93%

So from the above we can see the performance of both products are
significantly different. The gross margin for X is 35.46 per cent compared
to 10.2 per cent for Y while the net margins are 29.1 per cent and -2.93
per cent respectively.

We can compare the above ABC product income statements with those
prepared under a traditional absorption costing methodology. The
following are the product income statements for X and Y to gross margin:

Income statements - absorption costing

X Z
$ $
Sales 2,400,000 800,000
Costs
Materials 600,000 240,000
Labour 450,000 120,000
Overheads 600,000 160,000
1,650,000 520,000
Gross margin 750,000 280,000
Gross margin percent 31.25% 35.00%

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Unit 3 Activity-based costing

Note: In the absorption costing income statement:

 Labour costs have been calculated as 30,000 units x 1 hour x $15
per hour, total $450,000 for X and 2,000 units x 4 hours x $15
per hour, total $120,000 for Z.
 Overheads are calculated using a pre-determined rate of $20 per
direct labour hour. So for X this equals 30,000 units x 1 hour x
$20 per hour, total $600,000 and for Z, 2,000 units x 4 hours x
$20 per hour, total $160,000.

The following table compares the results of the two costing methods.

Gross margin – method Product X Product Z

ABC 35.46% (2.93%)

Absorption costing 31.25% 35%

Figure 6

The following general comments can be made from the above example:
 The two products (out of several manufactured) shows that the
product costing system in this company suffers from the
problems associated with overhead allocation under traditional
costing. Management is receiving incorrect product cost and
margin information that does lead to incorrect pricing and
product portfolio management strategy decisions, which could
have adverse effects on the market share of the company.
 ABC, by tracing costs to products on the basis of activity cost
drivers, has provided far more accurate product cost and margin
information for better pricing and product portfolio management
decisions. It should enable the company to better manage its
production and marketing effort.

In addition, the process of setting up an ABC system directs

management’s attention towards value adding and non-value adding
activities, as well as cost drivers. This information should enable
improvements to production processes and cost control.

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Activity 1.3
1. Explain how ABC differs from traditional costing methods.

2. DEM manufactures and sells medical equipment. DEM uses an

activity-based costing system. Direct materials and direct labour costs
are accumulated separately along with information concerning four
Activity
manufacturing overhead cost drivers (activities). Assume that the
direct labour rate is $20 an hour and that there were no beginning
inventories. The following information was available for 2010, based
on an expected production level of 400,000 units for the year:
Activity (cost driver) Budgeted Cost for Cost driver used as Cost allocation rate
2010 allocation base
$ $
Materials handling 3,600,000 Number of parts used $1.50 per part
Milling and grinding 8,800,000 Number of machine $11.00 per machine
hours hour
Assembly and 6,000,000 Direct labour hours $5.00 per labour hour
inspection worked
Testing 1,200,000 Number of units $3.00 per unit
tested

The following production, costs and activities occurred during the

month of September:
Units Direct materials Number of Machine hours Direct labour
produced/tested costs parts used hours
50,000 $3,500,000 275,000 95,000 160,000

Required:
a. Calculate the total manufacturing costs and the cost per unit
produced and tested during September using the ABC approach.
b. Explain the advantages of the ABC approach relative to using a
single predetermined overhead application rate based on direct
labour hours.

3. Williams Industries manufactures and sells tables. The company uses

an activity-based costing system. Direct materials and direct labour
costs are accumulated separately along with information concerning
three manufacturing overhead cost drivers (activities). Assume that
the direct labour rate is $15 an hour and that there were no beginning
inventories. The following information was available for 2010, based
on an expected production level of 50,000 units for the year:
Activity (cost driver) Budgeted Cost for Cost driver used as Cost allocation rate
2010 allocation base
$ $
Materials handling 250,000 Number of parts used $0.20 per part
Cutting and lathe 1,750,000 Number of parts used $1.40 per part
work
Assembly and 4,000,000 Direct labour hours $20.00 per labour
inspection hour

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Unit 3 Activity-based costing

The following production, costs and activities occurred during the

month of July:

Units Direct materials Number of Direct labour

produced/tested costs parts used hours
3,200 $107,200 70,400 13,120

Required:
a. Calculate the total manufacturing costs and the cost per unit
produced and tested during July using the activity-based costing
approach.
b. Assume, instead, that Williams Industries applies manufacturing
overhead on a direct labour hours basis (rather than using the
activity-based costing system described above). Calculate the total
manufacturing cost and the cost per unit of the tables produced
during July (hint: you will need to calculate the predetermined
overhead application rate using the total budgeted overhead cost
for 2010).
c. Compare the per-unit cost figures calculated in (a) and (b).
Which approach do you think provides better information for
manufacturing managers? Explain your answer.

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Unit summary
In this unit you learned that:
 An ABC system attempts to assign costs to activities undertaken
within an organisation.
Summary  There are different levels of activity within every organisation.
 Compared to traditional costing systems, ABC is more complex,
however it does provide more accurate information to decision
makers.
 There are numerous advantages and disadvantages for ABC
compared with traditional costing systems.

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Activity feedback

Activity feedback

Activity 1.1
Your answers will depend on the organisation you choose.

Activity 1.2
1. Classify each item as product (inventorial) cost or period (non-
inventorial) costs for the purpose of preparing external financial
statements.
a. Product.
b. Product.
c. Period.
d. Product.
e. Period.
f. Period.
g. Product.
h. Product.
i. Product.
j. Product.
k. Product.
l. Product.
m. Period.
n. Product.
o. Period.

2. Lee Company

Answers for (a.) and (b.), unit product costs:

Variable costing:
Direct materials $42
Direct labour $28
Variable manufacturing overhead $1
Unit product cost $71

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Absorption costing:
Direct materials $42
Direct labour $28
Variable manufacturing overhead $1
Fixed manufacturing overhead $10
Unit product cost $81

Answers for (c.) and (d.), income statements:

Variable costing income statement
Sale $560,500
Less variable expenses:
Variable cost of goods sold:
Beginning inventory $7,100
Add variable manufacturing costs $440,200
Goods available for sale $447,300
Less ending inventory $28,400
Variable cost of goods sold $418,900
Variable selling and administrative $29,500
$448,400
Contribution margin $112,100
Less fixed expenses:
Fixed manufacturing overhead $62,000
Fixed selling and administrative $35,400
$97,400
Net income $14,700

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Activity feedback

Absorption costing income statement

Sales $560,500
Cost of goods sold:
Beginning inventory $8,100
Add cost of goods manufactured $502,200
Goods available for sale $510,300
Less ending inventory $32,400
$477,900
Gross margin $82,600
Less selling and administrative expenses:
Variable selling and administrative $29,500
Fixed selling and administrative $35,400
$64,900
Net income $17,700

Answer for (e.), reconciliation:

Variable costing net income $14,700
Add fixed manufacturing overhead costs
deferred in inventory under absorption costing $3,000
Deduct fixed manufacturing overhead costs
released from inventory under absorption costing $0
Absorption costing net income $17,700

Activity 1.3
1. Explain how ABC differs from traditional costing methods.
 Both ABC and traditional costing methods allocate overhead
to cost objects, but the methods of doing this differ.
 ABC allocates overhead to a cost object (product, service,
customer, department and so on) by tracing the cost-causing
activities of an organisation directly to a cost object. This
results in activities (and their associated costs) being
allocated into cost pools and then each cost pool is traced to a
cost object.
 Some complex ABC systems can have several hundred
activities and multiple cost pools. The result is a more
accurate reflection of the cost object’s consumption of cost-
causing activities.

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 Traditional overhead allocation models also trace overhead to

a cost object, however they typically use a single overhead
driver (such as direct labour hours, or machine hours). The
result is often a distorted amount of overhead applied to the
cost object. This can be a significant problem in firms where
competition is high and/or overhead is a significant
proportion of the total cost.
2. DEM
a. Calculate the total manufacturing costs and the cost per unit
produced and tested during September.

Activity Cost driver Cost Allocated cost

used as allocation
allocation rate
base
$
Materials handling Number of 1.50 per part 275 000 parts $412 500
parts used
Milling and grinding Number of 11.00 per hour 95 000 MH $1 045 000
machine hours
Assembly and Direct labour 5.00 per hour 160 000 DLH $800 000
inspection hours worked
Testing Number of 3.00 per unit 50 000 units $150 000
units tested
$2 407 500

Total cost:
Direct material $3,500,000
Direct labour
(160,000 x $20) 3,200,000
Manufacturing overhead 2,407,500
Total cost $9,107,500
Units produced 50,000
Cost per unit $182.15

b. Explain the advantages of the ABC approach relative to

using a single predetermined overhead application rate based
on direct labour hours.
Multiple allocation rates, as used in ABC costing, overcome
the problem of unitising fixed costs since in smaller cost
pools an appropriate variable activity can be found. The cost
allocations are closer to economic reality and so are more
accurate. This is likely to result in more competitive
behaviour and better decision-making.

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Activity feedback

3. Williams Industries
a. Calculate the total manufacturing costs and the cost per unit
produced and tested during July using the activity-based
costing approach.
Activity (cost Cost driver used as Overhead Cost Allocated
driver) allocation base allocation rate cost
$ $
Materials handling Number of parts 0.20 per part 70 400 parts 14 080
used
Cutting and lathe Number of parts 1.40 per part 70 400 parts 98 560
work used
Assembly and Direct labour hours 20.00 per hour 13 120 DLH 262 400
inspection
$375 040

Total cost:
Direct material $107,200
Direct labour (13,120 x $15) $196,800
Manufacturing overhead $375,040
Total cost of 50,000 tables $679,040
Cost per table $13.58

b. Assume instead that Williams Industries applies

manufacturing overhead on a direct labour hours basis (rather
than using the activity-based costing system described
above). Calculate the total manufacturing cost and the cost
per unit of the tables produced during July.

Predetermined overhead absorption rate:

Estimated overhead/DLH = $6,000,000/200,000 (hours

calculated from assembly and inspection allocation = $30 per
hour

Total cost:
Direct material $107,200
Direct labour (13,120 x $15) $196,800
Overhead (13,120 x $30) $393,600
Total cost of 50,000 tables $697,600
Cost per table $13.95

c. Compare the per-unit cost figures calculated in a) and b).

Which approach do you think provides better information for
manufacturing managers? Explain your answer.
In this situation, the result is not that significant (only 2.7 per
cent between the ABC cost per unit of $13.58 and the
absorption costing rate of $13.95) but in many other
instances, this is not the case. A cost benefit analysis is

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always conducted before installing a new system. One of the

risks to be assessed is the consequences of making the wrong
decision.

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