Chapter 1 Costing

1. Objectives

1.1 Explain the general concepts of costs.

1.2 Explain the computation of overhead allocation and apportionment.
1.3 Explain the concept of over and under absorption of overheads.
1.4 Explain and compare the difference between absorption costing and marginal costing.

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2. Introduction

2.1 Costing is the process of determining the costs of products, services or activities.
2.2 Cost accounting is used to determine the cost of products, jobs or services. Such costs
have to be built up using a process known as cost accumulation.

3. Overheads

3.1 If a company manufactures a product, the cost of the product will include the cost of
the raw materials and components used in it and cost of the labour effort required to
make it. These are direct costs of the product. The company would, however, incur
many other costs in making the product, which are not directly attributable to a single
product, but which are incurred generally in the process of manufacturing a large
number of product units. These are indirect costs or overheads. Such costs include the
following, for example:
(a) Factory rent and rates;
(b) Supervision costs;
(c) Machine depreciation;
(d) Heating and lighting, etc.

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3.2 Key Terms

(a) A direct cost is a cost that can be traced in full to the product, service or
department that is being costed.
(b) An indirect cost or overhead is a cost that is incurred in the course of
making a product, providing a service or running a department, but which
cannot be traced directly and in full to the product, service or department.
(c) Cost allocation (成本分配) is the process of allocating the whole overhead to a
cost centre where this cost can be identified with a particular cost centre.
(d) Cost apportionment (成本分攤) – When an overhead is common to more than
one cost centre, it must be shared out or split on an equitable basis.

3.3 Overhead cost allocation and apportionment

3.3.1 This section we focus in more detail on the two-stage overhead process of assigning
overhead to products. The procedure is as follows:
(a) Assign all factory overheads to production and service cost centres.
(b) Reallocate service centre costs to production cost centres.
(c) Calculate separate overhead rates for each cost centre.
(d) Assign cost centre overhead to products.
Items (a) and (b) comprise stage one while (c) and (d) relate to stage two of the
overhead assignment procedure.

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3.3.2 Also, the item (a) is called the primary apportionment which is the distribution of
overheads basing on the data from source documents, such as utilities bills, to
respective cost centers. The item (b) is called the secondary apportionment which is
the further re-distribution of overhead costs from service cost centres to the production
costs centres. Costs of goods manufactured can then be calculated basing on the
overhead costs per unit after secondary apportionment.

3.3.3 Example 1
A company is preparing its production overhead budgets and determining the
apportionment of those overheads to products. Cost centre expenses and related
information have been budgeted as follows.

Total Machine Machine Assembly Canteen Maint.

Dept A Dept B
$ $ $ $ $ $
Indirect wages 78,560 8,586 9,190 15,674 29,650 15,460
Consumable materials 16,900 6,400 8,700 1,200 600 -
Rent & rates 16,700
Buildings insurance 2,400

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 Power 8,600
Heat and light 3,400
Depn. (machinery) 40,200
Value of machinery 402,000 201,000 179,000 22,000

Power usage (%) 100 55 40 3 2

Direct labour (hours) 35,000 8,000 6,200 20,800 - -
Machine usage (hours) 25,200 7,200 18,000 - - -
Area (sq. ft.) 45,000 10,000 12,000 15,000 6,000 2,000

Required:

Using the direct apportionment to production department method and bases of

apportionment which you consider most appropriate from the information provided,
calculate overhead totals for the three production departments.

Solution:

Total Machine Machine Assembly Canteen Maint. Basis of

Dept A Dept B apportion.
$ $ $ $ $ $
Indirect 78,560 8,586 9,190 15,674 29,650 15,460 Actual
wages
Consumable 16,900 6,400 8,700 1,200 600 - Actual
materials
Rent & 16,700 3,711 4,453 5,567 2,227 745 Area
rates
Buildings 2,400 533 640 800 320 107 Area
insurance
Power 8,600 4,730 3,440 258 - 172 Usage
Heat and 3,400 756 907 1,133 453 151 Area
light
Depn. 40,200 20,100 17,900 2,200 - - Value of
(machinery) machine
166,760 44,816 45,230 26,832 33,250 16,632
Reallocate - 7,600 5,890 19,760 (33,250) - Direct
labour

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 Reallocate - 4,752 11,880 - - (16,632) Machine
usage
Total 166,760 57,168 63,000 46,592 - -

OH absorb. Machine Machine Labour

basis hour hour hour
OAR 57,168 63,000 46,592
7,200 18,000 20,800
= $7.94 $3.50 $2.24

3.3.4 The choice of an absorption basis is a matter of judgement and common sense.
There are no strict rules or formulae involved. But the basis should realistically
reflect the characteristics of a given cost centre, avoid undue anomalies and be
fair.

3.4 Over and under absorption of overheads

3.4.1 Over- or Under-absorbed Overhead

(a) Over-/under-absorbed overhead occurs when overheads incurred do not

equal overheads absorbed.
(b) Over absorption means that the overheads charged to the cost of sales are
greater than the overheads actually incurred.
(c) Under absorption means that insufficient overheads have been included in
the cost of sales.

3.4.2 The rate of overhead absorption is based on estimates (of both numerator and
denominator) and it is quite likely that either one or both of the estimates will not
agree with what actually occurs.

3.4.3 Example 2
Suppose that the budgeted overhead in a production department is $80,000 and
the budgeted activity is 40,000 direct labour hours, the overhead recovery rate
(using a direct labour hour basis) would be $2 per direct labour hour. Actual
overheads in the period are, say $84,000 and 45,000 direct labour hours are
worked.
$

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 Overhead incurred (actual) 84,000
Overhead absorbed (45,000 x $2) 90,000
Over-absorption of overhead 6,000

In this example, the cost of production has been charged with $6,000 more than was
actually spent and so the cost that is recorded will be too high. The over-absorbed
overhead will be an adjustment to the profit and loss account at the end of accounting
period to reconcile the overheads charged to the actual overhead.

3.4.4 Exercise 1
The total production overhead expenditure of the company in Example 1 was
$176,533 and its actual activity was as follows.

Machine shop A Machine shop B Assembly

Direct labour hours 8,200 6,500 21,900
Machine usage hours 7,300 18,700 -

Required:

Using the information above and the results of Example 1, calculate the under- or
over-absorption of overheads.

Solution:

3.4.5 The overhead absorption rate is predetermined from budget estimates of overhead
cost and activity level. Under or over recovery of overhead will occur in the following
circumstances.
(a) Actual overhead costs are different from budgeted overheads.

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 (b) The actual activity level is different from the budgeted activity level.
(c) Actual overhead costs and actual activity level differ from those budgeted.

4. Absorption Costing and Marginal Costing

4.1 Key Terms

(a) Absorption costing (full costing) is a form of costing in which the costs of
products are calculated by adding an amount for indirect costs (overheads)
to the direct costs of production.
(b) Marginal costing (variable costing) is an alternative to absorption costing.
Only variable costs (marginal costs) are charged as a cost of sales. Fixed
costs are treated as period costs and are charged in full against the profit
of the period in which they are incurred.

4.2 Example 3
A company makes and sells a single product. At the beginning of period 1, there are
no opening inventories of the product, for which the variable production cost is $4
and the sales price $6 per unit. Fixed costs are $2,000 per period, of which $1,500
are fixed production costs. Normal profit is 1,500 units per period. In period 1, sales
were 1,200 units, production was 1,500 units. In period 2, sales were 1,700 units,
production was 1,400 units.

Required:

(a) Prepare profit statements for each period and for the two periods in total using
both absorption costing and marginal costing.
(b) Reconcile the profits between absorption costing and marginal costing for
period 1.

Solution:
(a)
Absorption costing
The absorption rate for fixed production overhead is $1,500/1,500 units = $1 per
unit. The fully absorbed cost per unit = $(4 + 1) = $5.

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 Period 1 Period 2 Total
$ $ $ $ $ $
Sales 7,200 10,200 17,400
Production costs
Variable 6,000 5,600 11,600
Fixed 1,500 1,400 2,900
7,500 7,000 14,500
Add: opening inventory b/f - 1,500 1,500
7,500 8,500 16,000
Less: closing inventory c/f (1,500) - (1,500)
Production cost of sales 6,000 8,500 14,500
Under-absorbed OH - 100 100
Total costs 6,000 8,600 14,600
Gross profit 1,200 1,600 2,800
Other costs (500) (500) (1,000)
Net profit 700 1,100 1,800

Marginal costing
The marginal cost per unit = $4.
Period 1 Period 2 Total
$ $ $ $ $ $
Sales 7,200 10,200 17,400
Production costs
Variable 6,000 5,600 11,600
Add: opening inventory b/f - 1,200 1,200
6,000 6,800 12,800
Less: closing inventory c/f (1,200) - (1,200)
Variable prod. cost of sales 4,800 6,800 11,600
Contribution 2,400 3,400 5,800
Fixed costs (2,000) (2,000) (4,000)
Profit 400 1,400 1,800

(b)
The profits reported for period 1 would be reconciled as follows.
$
Marginal costing profit 400

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 Adjusted for fixed overhead in inventory (inventory increase of 300
units x $1 per unit) 300
Absorption costing profit 700

4.3 Reconciliation of Profits between Two Methods

(a) If opening inventory = closing inventory, MC profit = AC profit

(b) If opening inventory > closing inventory, MC profit > AC profit
(c) If opening inventory < closing inventory, MC profit < AC profit

4.4 Exercise 2 – Manipulating Profits

ABC Co budgeted to make and sell 10,000 units of its product in 2011. The selling
price is $10 per unit and the variable cost $4 per unit. Fixed production costs were
budgeted at $50,000 per year. The company uses absorption costing and budgeted an
absorption rate of $5 per unit. During 2011, it became apparent that sales demand
would only be 8,000 units. The management, concerned about the apparent effect of
the low volume of sales on profits, decided to increase production for the year to
15,000 units. Actual fixed costs were still expected to be $50,000 in spite of the
significant increase in production volume.

Required:

Calculate the profit at an actual sales volume of 8,000 units, using the following
methods.
(a) Absorption costing
(b) Marginal costing
Explain the difference in profits calculated.

Solution:

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