Lecture 4 & 5- Full Costing

Full Costing I
What is one the most crucial decisions that you need to decide on?
How to set prices for our products?
What is among the most important principles in setting prices?
We need to make a profit so ideally the prices for our coffee would be higher than the cost of
“selling coffee”

What do you need to sell coffee?

-space (rent)
-people (barista)
-pay for media (electricity, water, gas, etc)
-espresso machine
-tables, cups, etc
-coffee, milk, water, etc
-… =Cost of selling coffee

Cost of 1 cup=(Raw materials + other relevant costs)/cup Full cost of selling a cup of coffee

What is FULL COSTING?

Full cost is the total amount of resources, sacrificed in order to achieve an objective
Q: What is the cost of a university degree?
Fees + books/other materials + commute + …
In contrast to marginal analysis, which usually takes into account only the variable costs
Is it important to know the full cost? For what decisions can you use this information?

Uses of FULL COSTING by managers

FULL Costing applied to Single-Product Businesses (Process Costing)
Example 1 – Single Product Businesses Rustic Breweries has just one product (all units
produced are identical), a unique brand of beer that is marketed as ‘Old Rustic’.
During last month, the business produced 7,300 pints of the beer.
The costs incurred were as follows:
Ingredients £390
Labour £880
Fuel £85
Rental of brewery premises £350
Depreciation of brewery equipment £75

What is the full cost per pint of producing Old Rustic?

£(390 + 880 + 85 + 350 + 75) /7,300 pints = £0.24 per pint

Is this number the true cost?

Questions to think about:
How is depreciation calculated? It is an estimate
Cost of stock: Should we use the replacement cost or the historic cost?
Number of units produced.
 What about work in progress (equivalent units produced, e.g. if 10 units 80% finished,
then that give 8 full units)?
Notice! We can use the approach shown in Example 1, for businesses: - producing a single
product AND - where the units produced are identical / nearly identical
This full costing approach is often called PROCESS Costing.
Can you think of at least 2 industries where process costing may apply?

How to apply full costing to businesses producing non-identical products or services?

E.g. Repairs carried out by car repair shops
We can’t assign the same cost to each car repair!

FULL Costing applied to Multi-Product Businesses (Job Costing)

When units of output are NOT identical, we use a full costing approach called JOB
COSTING APPROACH
1. We separate costs into Direct and Indirect
2. Full Cost of a Job = Direct Costs + A fair share of the Indirect Costs
DIRECT costs-Costs that can be identified with specific cost units – the effect of the cost
can be measured in respect of each particular unit of output
INDIRECT costs or OVERHEADS-These are all other costs: That is, those that cannot be
directly measured in respect of each particular unit of output
Example 1 -Our coffee shop
Indirect costs: rent, insurance, equipment depreciation
Direct costs: Salary (if can be recorded) Coffee Milk, water, etc
Example 2

EMPIRICAL EVIDENCE: Direct and indirect costs in practice

The relationship between direct costs and indirect costs

The relationship between direct, indirect, variable and fixed costs of a particular job
COST BEHAVIOUR: How do costs behave as the volume of activity changes?
COST IDENTIFIABILITY: Can costs be directly identifiable (traceable) to a particular
unit of production or job?

MAIN PROBLEM with calculating the Full Cost for a Job (Job Costing)
How should we apportion the indirect costs to individual units/products? How is the fair
share of indirect costs or overheads to be decided?
Coffee Indirect costs: rent, insurance, equipment depreciation
Fair Share of Indirect Costs
Common ways of calculating a fair share include:
Direct labour hours: the more hours a job takes, the higher the share of indirect costs
Machine hours: the longer a product takes on a machine, the higher the share of indirect
costs
Labour hours is most often used

Technique: How to calculate the Full Cost for Job Costing

1.Identify Direct costs
2. Calculate Overhead absorption rate (OAR): [total indirect costs (Overheads)]/ [total labour
hours/ Machine hours] to work out the cost per hour
3. Use the OAR to compute the fair share of indirect costs for the job
4. Combine direct costs and fair share of indirect costs to calculate total cost
Example – Job Costing
Johnson Ltd, a business that provides a television repair service to its customers, has
overheads of £10,000 each month. Each month; 2,500 direct labour hours are worked and
charged to units of output (repairs carried out by the business). A particular repair job
undertaken by the business used direct materials costing £15. Direct labour worked on the job
was 15 hours and the wage rate is £5 an hour. Overheads are charged to jobs on a direct
labour hours basis.
Calculate the Full Cost of a Job.
Solution
Overhead absorption (recovery) rate: £10,000 / 2,500 = £4 per direct labour hour
Direct materials £15
Direct labour (15 * £5) £75
Total Direct Costs £90
Overheads (15 * £4) £60
Full cost of job £150
Think: why is this information useful?
• Calculating a price for the job
• Working out whether a profit or loss has been made S

Part 2 Selecting a basis for charging overheads

Selecting a basis for charging overheads

In the TV repair exercise we used direct labour hours, as a basis for apportioning overheads
to different TV repairs (jobs).
This is not the only way to allocate overheads!

The basis chosen is a matter of judgement

Factors taken into account when making the decision should include:
 the nature of the overheads and
 the nature of the business (labour intensive or capital intensive)

WORKED EXAMPLE 1 – A company making sails for sailing boats

Part a ABC Ltd. undertakes a range of work including making sails for sailing boats. ABC
Ltd. expects to incur the following costs in the next month:

The business has received an enquiry

about a sail and it is estimated that the sail will take 12 direct labour hours to make and will
require 20 square metres of sail cloth (which costs £2 per square metre).
The business normally uses a direct labour hour basis of charging overheads to individual
jobs. Q: What is the full cost of making the sail?

TECHNIQUE - Full Costing for Businesses Producing multiple products (non-identical units)

How to calculate the FULL COST OF ONE JOB?

1. Identify and Compute all Direct Costs
2. Choose a basis for apportioning Indirect Costs (i.e. overheads), if not specified
3. Calculate the Overhead Absorption Rate: Total Overheads / Basis (e.g. direct labour hours)
4. Fair share of Overheads: Overhead Absorption Rate x Number of direct labour hours (i.e.
the basis) used for this job
5. FULL COST = Direct Costs + Fair Share of Overheads

Solution – Worked Example 1 (part a)

Direct costs:

Total Indirect Costs:

The company uses direct labour hours to allocate overheads to a job so the overhead recovery
rate is: £19,700 / 6,000 = £3.28 per direct labour hour
Full cost of the sail would be:

Graphical Demonstration: Applying overheads and direct costs to the sail

example
WORKED EXAMPLE 1 – part b
Suppose that Marine Suppliers allocate their overheads based on machine hours, rather than
labour hours.
What is the full cost of making the sail assuming it takes 5 machine hours (and everything
else remains the same)?
Solution – Worked Example 1 (part b)
Direct costs:

Total Indirect costs:

The company uses direct machine hours to

allocate overheads to a job so the overhead recovery rate is: £19,700 / 2,000 = £9.85 per
machine hour
Full cost of the sail would be:
Which is the correct full cost?

Which is the correct full cost?

◼ Matter of judgement
◼ Whichever is most appropriate to the nature of the overheads
◼ Need to allocate fairly
◼ Think of a big chocolate cake…

Test your knowledge:

Q1 A business provides only one standard service.
What is the value to this business of distinguishing between direct and indirect costs?
Q2 ‘Direct costs are always variable relative to the level of output, indirect costs are always
fixed.’
Is this statement true?

Full Costing II
The relationship between direct costs and indirect costs
Price of 1 cupcake = ?
Price of 1 cupcake = Purchase costs + fair share of overheads (rent,
electricity, wages, depreciation…)

PART 1 Dealing with overheads on a departmental basis

A departmental structure

Most businesses are divided into departments.

Each departments usually records its own costs. Why do you think this happens?
In the above diagram, where is the product being produced?
Departments as Cost Centres
When costs are allocated on a departmental basis, each department is called a cost centre.
Two types of cost centres:
 A product cost centre (attracts direct costs)
 A service cost centre (doesn’t attract any direct costs)
TASK: Figure out the type of cost centre
1. Assembly Dept Product Cost Centre
2. Accounting Dept Service Cost Centre
3. Maintenance Dept Service Cost Centre
4. Finishing Dept Product Cost Centre
5. Human Resources Dept Service Cost Centre
6. Catering Dept (i.e. the employee canteen) Service Cost Centre
Analysis of the number of cost centres within a business

A departmental structure

KEY CHALLENGE: How to figure out the FULL Cost of a product, since it only passes
from the Operations Department (i.e. only from the Product cost centre)?

Calculating the Full Cost in Businesses organised on a departmental basis

◼ To identify the full cost of a product, overheads from service cost centres need to be
allocated to product cost centres
◼ All overheads must eventually find their way into the cost of particular jobs / products.
Steps in calculating the FULL Cost of a Product/Service for businesses organised on a
departmental basis
Graphical Representation of Steps
STEP 1: Allocate Specific departmental Overheads to the relevant department

Examples:
- Salaries of HR Dept’s staff are allocated to the HR Dept
- Rent of Maintenance Dept, if located in a separate building, can be directly allocated to the
Maintenance Dept
STEP 2: APPORTION general overheads between departments

Examples:
- If all Depts are located in the same rented premises, APPORTION a proportion of rent to
each dept based on a logical basis
- The same applies for any overhead that is not specific to a particular dept
Examples of bases for apportioning general overheads to cost centres

STEP 3: SUM UP allocated and apportioned overheads (OHs) for each dept
STEP 4: APPORTION service department costs to product cost centres

Examples of bases for apportioning service cost centre overheads to product cost centres

Important Note regarding Step 4 For the purposes of this course:

We assume that services cost centres ONLY render a service to the product cost centres. -
In practice, the HR Dept may also render a service to the maintenance Dept. For the purposes
of this course, though, we ignore any service rendered between service cost centres.
Note that textbook exercises 4.5 and 4.6 are solved assuming that a service is rendered
between service cost centres. You can ignore this.
STEP 5: Sum up PRODUCT cost centre Overheads

STEP 6: Calculate a departmental overhead absorption rate for each product cost centre
STEP 7: Cost units absorb overheads as they pass through product cost centres

Dealing with overheads on a departmental basis:A Worked Example

EXAMPLE of full costing, when overheads are charged on a departmental basis
Some general overheads are provided below:

Info about the departments

 We have three departments in the business.
 Which departments are product cost centres and which are service cost centres?

Some additional info about each department is given below.

Apportion general overheads across departments (STEP 2)

BASES used to apportion costs to Departments

Info about the departments

Working notes
Note 1 – Rent = The basis is floor area; for assembly multiply total by 3/12, for finishing by
6/12, for maintenance by 3/12
Note 2 – Depreciation & Note 3 – Insurance = The basis is machinery value; for assembly
multiply total by 3/10, for finishing by 5/10, for maintenance by 2/10.
Note 4 – Indirect materials = The basis is direct materials; for assembly multiply total by
400/900, for finishing multiply by 500/900
Note 5 – Indirect labour = The basis is employees; for assembly multiply total by 10/40, for
finishing by 25/40, for maintenance by 5/40
Apportion general overheads across departments (STEP 2)
Apportion service cost centre overheads to product cost centres (Step 4)

Step 4: Working notes

Basis for apportioning maintenance dept overheads to
product cost centres : Value of machinery Proportions
30,000 : 50,000

Calculate a departmental overhead absorption rate for each department (Step 6 )

Cost units absorb overheads as they pass through product cost centres (Step 7)
Assume a job that takes 2 hours to assemble plus 3 hours to cut.
What are the overhead costs that this job will absorb?

Part 2 Combining Full Costing and Relevant Costing A worked example

WORKED EXAMPLE – part a
A company has been invited to tender for a contract to produce 1000 widgets. The company
estimates that it will require 1 month to complete the order. For the production of each widget
the company will require the following materials: 2 metres of material X (purchase cost (pc):
£3, replacement cost (rc): £4, scrap value (sv): £1) and 1 metre of material Y (pc: £5, rc: £6.5,
sv: £3).
Material X is in continuous use by the business, whereas Y is not used anymore and would be
scrapped otherwise.
i) What are the direct material costs for the production of the 1000 widgets?
ii) What are the relevant material costs for the production of the 1000 widgets?
Solution – part a
WORKED EXAMPLE – part b
For the production of widgets the company will require skilled labour. Skilled labourers exist
in the business and are currently paid £6 per hour. The business has been facing a downturn
lately and excess capacity of skilled labour exists within the business to complete the widget
contract. Each widget will require 10 minutes of skilled labour.
Overheads are charged to jobs on a direct labour hour basis. The business estimates that its
overall overheads for the one month period will be £40,000. The direct labour hours for the
same period are estimated as 10,000 hours.* The total overhead cost is not expected to
increase as a result of undertaking the widget contract.
Required:
i) Calculate the direct labour costs and indirect costs relating to the widget contract.
ii) Calculate the relevant labour costs and relevant overhead costs relating to the
widget contract.
iii) Finally, combine parts a & b of the question to estimate the full cost of producing
the 1000 widgets, as well as the relevant cost of producing them.

* The business tends not to alter the overhead absorption rate to reflect increases/decreases to
estimated total hours arising from new contracts.
Solution – part b
Relevant Labour Costs: 0 (no relevant labour costs) – The skilled labourers will be paid
regardless of whether the widget project is undertaken or not
Relevant Overheads: 0 (no relevant overheads) - the total overhead cost is not expected to
increase as a result of undertaking the widget contract.
Relevant cost for 1000 widgets: £11,000 (relevant material costs) + £0 (relevant labour
hours) + £0 (relevant overheads) = £11,000 5
Summary of the Solution

Conclusion to Worked Example

The full costing approach costs the widget project at £12,667, whereas the relevant cost
approach costs the widget project at £11,000.
The differences arise because the relevant cost approach is primarily future-oriented and it
considers opportunity costs and ignores sunk costs.
They each provide a different perspective to costing and are both useful.

Part 3 Other methods of full costing Activity-based Costing (ABC)

Traditional Full Costing
The methods of sharing out overheads that we have looked at so far are known as ‘traditional
full costing’
It was developed historically with industrial production in mind
Characteristics of industrial production:
 Direct labour intensive and ‘direct labour-paced’ production
 Low level of overheads relative to direct costs
 (Relatively) uncompetitive market

Less importance for overheads given their relative insignificance in comparison to

direct costs
Current Business Environment
Characteristics:
Capital intensive and machine-paced production
High level of overheads relative to direct costs
Highly competitive international market
Service industry dominated
Overhead recovery rates are now far exceeding direct labour rate per hour
Impact of a small change in labour time is a large increase in share of overheads under
traditional costing method – may not reflect a fair share of overheads

Activity Based Costing

Activity based costing - trace overheads to individual products, services, and customers
based on cost drivers.
ABC system uses a simple stage approach similar to traditional cost systems.
Instead of using cost centres for accumulating costs, it uses activities.
Example 1: Traditional Full Costing vs. Activity-based Costing
A business produces Product A and Product B
Each product takes the same amount of labour hours to produce.
Product A → spends 4 weeks (on average) in storage area
Product B → spends 1 week (on average) in storage area
Storage Area Overheads: transferred to product cost centre and then apportioned to Product A
& B according to direct labour hours
Both products take up equal space in the storage area

SHOULD Product A and B absorb the same amount of overheads per unit produced?
Product A gets most of the benefit of the storage area because of the longer time spent
there and so should take a bigger share of the cost
This incorporates the idea that costs (overheads) are driven by certain factors
This idea is how activity-based costing (ABC) seeks to allocate overheads to products –
allocate costs based on what is driving the cost
ABC is therefore thought to lead to better decision making / better control of overheads
Example 1: How to compute the overheads per product unit using ABC
Costs of running the storage space for the next year is £90,000 – this will be the stores ‘cost
pool’
Product A: 4 weeks in storage; Product B; 1 week in storage
Next year 25,000 units of product A and 50,000 units of product B are expected to be
produced
How much in storage space overheads should 1 unit of Product A and 1 unit of product B
attract, using Activity-Based Costing?
Answer
Product A will take up the following storage time: 25,000 units * 4 weeks = 100,000 weeks
Product B will take up the following storage time: 50,000 units * 1 week = 50,000 weeks
Total 150,000 weeks
Storage space overheads per unit = £90,000 / 150,000 = £0.60 per week spent
B will attract £0.60 x 1 week = £0.60 per unit
A will attract £0.60 x 4 weeks = £2.40 per unit

Benefits of ABC
Provides more accurate cost for each unit of product or service
Provides managers with a better understanding of the business

Criticisms of ABC
Time-consuming, costly and complex.
Not all businesses are likely to benefit from ABC – cost/benefit analysis.
Measurements and tracing problems can arise with ABC which may undermine any potential
benefits.
ABC is also criticised for the same reason that full costing in general is criticised (remember
ABC is a type of full costing – an alternative to traditional full costing): it uses past costs that
aren’t relevant, restricts consideration of future costs to outlay costs and so it does not
provide relevant information for decision making.