Chapter 3 : Calculating cost of a unit

Part 2

Chapter 9 : Standard Costing &

variance analysis
Calculating the full cost of a product:
Absorption Costing
Absorption costing is a method of inventory costing in which all variable
manufacturing costs and all fixed manufacturing costs are included as
inventoriable costs. That is, inventory “absorbs” all manufacturing costs.
Example:
A company has just completed its first year of trading. The budgeted production volume of 26,000 units was
achieved and the sales volume was 24,500 units at BDT 40 each.

The following actual cost information is available. (Nov-Dec ‘15)

Particulars BDT
Variable cost per unit:
Manufacturing 18.5
Selling and administration 9.2
Budgeted fixed cost:
Manufacturing 91,000
Selling and administration 49,000
Required:
Calculate the net profit using both absorption costing and marginal (variable) costing.
Calculating the full cost of a product:
Particulars Absorption Variable/
costing Particulars Marginal
Sales Revenue: costing
24,500 units @ BDT 40 each 980,000 Sales Revenue:
24,500 units @ BDT 40 each
Cost of goods sold: 980,000
Opening inventory -
Var. manuf. cost @ 18.50 per unit for Variable cost:
26,000 units 481,000
Fixed manuf. cost for budgeted 26,000
Manufacturing cost @ 18.50 per unit (453,250)
units 91,000
Manufacturing cost of 26,000 units 572,000 Selling and admin. cost @ 9.2 per unit (225,400) (678,650)
Less: Closing Inventory
(572,000/26000*1,500) (33,000) (539,000) Contribution margin 301,350
Gross profit 441,000
Selling and administration cost: Fixed cost:
Variable (BDT 9.2 per unit for 24,500 units) (225,400) Manufacturing (91,000)
Fixed (49,000) (274,400) Selling and admin (49,000) (140,000)
Net profit 166,600 Net profit 161,350

Absorption costing is also called full costing as it takes account of all manufacturing costs in calculating a
product cost.
• Why is absorption costing profit higher than variable costing profit?
• What is the value of closing inventory under absorption costing and variable
costing?
Closing inventory valuation Absorption vs Variable/marginal costing:
Absorption Marginal/
costing variable costing

}
Variable
manufacturing cost

Product cost as part of closing

Fixed inventory

}
manufacturing
cost Period
cost
expensed
Non-manufacturing in the
cost (variable and period
fixed)

• In absorption costing, fixed manuf. costs are part of the closing inventory, i.e. inventoriable cost.
• In variable/marginal costing, fixed manuf. cost are not inventoriable cost, rather period cost.
• All other variable and fixed non-manufacturing costs are period costs.
Absorption costing is also called full costing as it takes both direct and indirect cost of production.
 Determining the share of overhead:
Stage 1 : Overhead allocation

 Allocation is the process by which whole cost items are charged direct to a cost
center.
 A cost center acts as a collecting place for costs before they are analysed.

Stage 2 : Overhead apportionment

 Step1: Apportioning  Step 2: Service cost center

general overheads cost apportionment
Stage 3 : Overhead absorption

 Production overheads  Admin, selling and distribution

are added to get the overheads are included to get the
full cost of sales
full cost of production
Past question (May-June 2013):
A manufacturing company has three production departments and 2 service departments.
Departmental Expenses for the month of December 2016 are as follows:
Production BDT Service BDT
Department Department
X 24,000 A 7,020
Y 19,500 B 9,000
Z 21,000
Service department expenses are charged out on a percentage basis, viz.
Service Production Department Service Department
Department X Y Z A B
A 20 25 35 - 20
B 25 25 40 10 -

Prepare a statement showing apportionment of expenses of the two service departments to the
production department.
Solution to Past question (May-June 2013):
Production Department Service Department
Particulars Ratio
X Y Z A B
Departmental cost 24,000 19,500 21,000 7,020 9,000
Apportionment 1:
Service Department A expenses (20:25:35:20) 1,404 1,755 2,457 (7,020) 1,404
Total 25,404 21,255 23,457 - 10,404
Service Department B expenses (25:25:40:10) 2,601 2,601 4,162 1,040 (10,404)
Total 28,005 23,856 27,619 1,040 -
Apportionment 2:
Service Department A expenses (20:25:35:20) 208 260 364 (1,040) 208
Total 28,213 24,116 27,983 - 208
Service Department B expenses (25:25:40:10) 52 52 83 21 (208)
Total 28,265 24,168 28,066 21 -
Apportionment 2:
Service Department A expenses (20:25:35:20) 4 5 8 (21) 4
Total 28,269 24,173 28,074 - 4
Service Department B expenses (25:25:40:10) 1 1 2 - (4)
Total 28,270 24,174 28,076 - -

We will do the apportionment until the service department costs are zero. We will consider decimal places
as negligible.

You may add it or not add it. Decision is yours.

Solution to Past question (May-June 2013):
Production Department Service Department
Particulars Ratio
X Y Z A B
Departmental cost 24,000 19,500 21,000 7,020 9,000
Apportionment 1:
Service Department A expenses (20:25:35:20) 1,404 1,755 2,457 -7,020 1,404
Service Department B expenses (25:25:40:10) 2,601 2,601 4,162 1,040 -10,404
Apportionment 2:
Service Department A expenses (20:25:35:20) 208 260 364 -1,040 208
Service Department B expenses (25:25:40:10) 52 52 83 21 -208
Apportionment 3:
Service Department A expenses (20:25:35:20) 4 5 8 -21 4
Service Department B expenses (25:25:40:10) 1 1 2 - -4
Total 28,270 24,174 28,076 - -

Please solve:
Nov- December 2014 (Question no 1 (b) too.
Overhead absorption rate:
Predetermined absorption rate:

• In absorption costing, it is usual to add overheads into product costs by applying a pre-determined
overhead absorption rate.

• The pre-determined rate is usually set annually in advance, as part of the budgetary planning
process.

• Overheads are not absorbed on the basis of the actual overheads incurred but on the basis of
estimated or budgeted figures (calculated prior to the beginning of the period).

Formula:

𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑
Pre-determined absorpotion rate=
𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝐿𝑒𝑣𝑒𝑙 𝑜𝑓 𝑎𝑐𝑡𝑖𝑣𝑖𝑡𝑦

Budgeted level of activity may be budgeted direct labour hours or budgeted machine hours.
Overhead absorption rate:
Blanket absorption rate:
• A blanket or single absorption factory overhead absorption rate is an absorption rate used
throughout a factory

 For all jobs

 Units of output .

• No consideration is made in which department or departments they were produced.

Using a blanket absorption rate might sometimes lead to inaccurate product costing. (page 59-60 MI book)

Actual overhead cost may vary from the budgeted overhead cost. This leads to variance. Variances may be
of the following types:
Favourable
unfavourable

Both favourable and unfavourable variances may need to careful attention.

Past question November December 2015 & May June 2012:

Solution:
Per unit Hours required Cost
Cost
Finishing
Machini Productio Machinin Finishin Finishing Total per
cost Machining
ng cost n (Units) g cost g cost cost center cost Unit
center cost center
center center center
Production Overheads 38,000 10,350 48,350
Machine hours:
Product Bubble (800 units*6; 800 units*2) 6 2 800 4,800 1,600 24,000 7,200 31,200 39.00
Product Squeak (700 units*4; 700 units*1) 4 1 700 2,800 700 14,000 3,150 17,150 24.50
Some examples:
Some examples:

Solution:
Past question Nov - Dec 2014 & Nov-Dec 2011:

Solution:
Particulars BDT Cost under-absorbed= actual
Actual overheads 694,075 cost higher than budgeted cost
Less: under-absorption of overheads (35,000)
Budgeted overheads 659,075
Cost over-absorbed= actual cost
Actual hours 32,150 lower than budgeted cost
Budgeted overhead rate per hour 20.50
Past question May –June 2014 & May – June 2010:

Solution:
Particulars Formula BDT
This is adverse/
Overhead absorbed (Tk 4.50 *44,000) Budgeted rate * actual hours 198,000 unfavourable
Actual overhead Actual rate* actual hours 215,000 variance of BDT
Overhead under-absorbed (17,000) 17,000
 Example

Solution:
𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑
1. Pre- determined overhead rate=
𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝐿𝑒𝑣𝑒𝑙 𝑜𝑓 𝑎𝑐𝑡𝑖𝑣𝑖𝑡𝑦
$250,000
= + $ 2 𝑝𝑒𝑟 𝑑𝑖𝑟𝑒𝑐𝑡 𝑙𝑎𝑏𝑜𝑢𝑟 ℎ𝑜𝑢𝑟
40,000
= $ 8.25 per direct labour hour

2. Applied overhead = $ 8.25 * standard hours allowed i,e, 38,000 hours

= 313,500
Variance Analysis – A snapshot (Details in Chapter 9):
Material Variances

Material total
variance = Standard Material cost – Actual material cost

Material price
variance = (SR – AR) * AQ

Material usage
variance = (SQ– AQ) * SR

In summary, if you add material price variance and material usage variance, then you
will get the total material variance
Variance Analysis – A snapshot (Details in Chapter 9):
Labour Variances

Total labour
variance = Standard Labour cost – Actual Labour cost

Labour rate
variance = (SR – AR) * AH

Labour efficiency
variance = (SH– AH) * SR

In summary, if you add Labour rate variance and Labour efficiency variance, then you
will get the total labour variance.
Past question (Nov-Dec 2014):
S Limited has extracted the following details from the standard cost card of one of its products.

Labour standard 4.5 hours @ Tk.6.40 per hour

During March, S Limited produced 2,300 units of the product and incurred wages costs of Tk.
64,150. The actual hours worked were 11,700.

Calculate labour rate and efficiency variance.

Past question (May-June 2014):
Past question (May-June 2016):

Answer (a):
• Interdependencies among the variances could arise for the spending and efficiency variances.
• For example, if the chosen allocation base for the variable overhead efficiency variance is only
one of several cost drivers, the variable overhead spending variance will include the effect of
the other cost drivers.
• As a second example, interdependencies can be induced when there are misclassifications of
costs as fixed when they are variable and vice versa
Variance Analysis – A snapshot (Details in Chapter 9):
Variable overhead Variances
Total variable overhead Standard variable overhead cost – Actual variable
variance = overhead cost

Variable overhead
expenditure variance = (SR – AR) * AH

Variable overhead efficiency

variance = (SH– AH) * SR

In summary, if you add Labour rate variance and Labour efficiency variance, then you will get the total
labour variance.

Fixed overhead Variances

Fixed overhead expenditure variance = SFOH- AFOH
Past question (May-June 2012):
Variance Analysis – A snapshot (Details in Chapter 9):
Sales Variances

Total sales
variance = Actual sales – Budgeted sales

Sales price
variance = (AP – SP) * AQ

Sales volume
variance = (AQ– BQ) * SC

***SC= Standard contribution per unit

In summary, if you add sales price variance and sales volume variance, then you will
get the total sales variance.
Past question (Nov-Dec 2016):

(b) Standard contribution = Standard Selling price per unit - VC per unit
= Tk. (84 - 70)
= Tk. 14

Budgeted sales in units = (210,000 /84) = 2,500 units

Sales Volume variance = (AQ - BQ) * Standard Contribution

= (2,650 - 2,500) * Tk. 14
= 2,100 Favaourable
Activity based costing (ABC):
In modern Production environment
• High level of overhead cost in relation to total cost.
• Arbitrary allocation of overheads under traditional costing can lead to wrong unit cost calculation.
• Cost control may be inaccurate

In Activity-based costing

Organisation’s major activities are

identified

Cost drivers are identified

Activity –wise cost is pooled

Cost is allocated to the products

based on the usages at activity level
Past question (Nov-Dec 16):
Solution:
Under traditional costing method:
Total Manufacturing
Charger unit
Particulars Per DLH Hours worked Manufacturing overhead per
produced
O/H charger unit
Overhead cost 400 10 4,000 500 8

Under Activity-based costing method:

Batch Manufacturing
Activities Cost drivers Rate requirement overhead
Material handling Number of parts TK. 4 per part 100 parts 400
Assembly Labour hours Tk. 40 per hour 6 hours 240
Inspection Minutes at inspection station Tk. 6 per minute 2.5 minutes 15
Total 655
Per unit 13.10
Costing methods and techniques:

Approaches to
Specific order Process costing cost
costing
management

Job Life-cycle
costing costing

Contract Target
costing costing

Batch Just-in-
costing time
Question:

Solution:
Past question (May - June 16):
1.
a) What is cost-plus pricing? Briefly describe the methods of determining sales prices under cost-
plus pricing? 4
b) Differentiate the mark-up and margin with an example. 2
May –June 2015

Solution: Particulars BDT

Variable Material cost 8.0
Variable labour cost (per hour Tk 14) 42.0
Variable production O/H (per hour Tk 4) 12.0
Fixed production O/H (60,000/25,000*3) 7.2
Total production cost 69.2
Overheads- other 3.5
Full cost 72.7
Selling price per unit 109.0
Past question (May - June 11):
What is mark‐up and margin? Calculate the following: 2+6

1. If the full cost is Tk. 14 per unit, calculate the price to achieve a margin of 20% of the
selling price
2. The selling price is Tk.27 per unit, determined on the basis of full cost‐plus, if the full cost
is Tk.18 per unit, calculate the mark‐up percentage.
3. A selling price of Tk. 165 per unit earns a mark‐up of 106.25% of the full cost. What is the
full cost per unit?
4. A product selling price is determined by adding 33.33% to its full cost. What percentage
margin on sales price does this represent?
May – June 2013
Nov – December 2012
November – Dec 2011
May – June 2011
November – December 2010
May – June 2010
Problem
Problem on ABC
on ABC:
Cabal makes and sells two products, Plus and Doubleplus. The direct costs of production
are $12 for one unit of Plus and $24 per unit of Doubleplus. Information relating to annual
production and sales is as follows:

Information relating to production overhead costs is as follows:

Problem on ABC (continued):
Other overhead costs do not have an identifiable cost driver, and in an ABC system, these
overheads would be recovered on a direct labour hours basis.

a) Calculate the production cost per unit of Plus and of Doubleplus if the company uses
traditional absorption costing and the overheads are recovered on a direct labour
hours basis.
b) Calculate the production cost per unit of Plus and of Doubleplus if the company uses
ABC.
c) Comment on the reasons for the differences in the production cost per unit between
the two methods.
d) What are the implications for management of using an ABC system instead of an
absorption costing system?
Problem on ABC (continued):
Problem on ABC (continued):
Problem on ABC (continued):
Problem on ABC (continued):
(c) The reasons for the difference in the production cost per unit between the two
methods
■ The allocation of overheads under absorption costing was unfair. This method
assumed that all of the overheads were driven by labour hours and, as a result, the
Double Plus received 1.5 times the production overhead of the Plus. – However, this
method of absorption is not appropriate. The overheads are in fact driven by a
number of different factors.
■ There are five activity costs, each one has its own cost driver. By taking this into
account we end up with a much more accurate production overhead cost per unit.
■ Using ABC, the cost per unit of a Double Plus is significantly higher. This is because
the Double Plus is a much more complex product than the Plus. For example, there
are 140 orders for the Double Plus but only 10 for the Plus and there are 4 special
parts for the Double Plus compared to only one for the Plus. As a result of this
complexity, the Double Plus has received more than three times the overhead of the
Plus.
■ This accurate allocation is important because the production overhead is a large
proportion of the overall cost.
Problem on ABC (continued):
(d) The implications of using ABC:
■ Pricing decisions will be improved because the price will be based on more accurate
cost data.
■ Decision making should also be improved. For example, research, production and sales
effort can be directed towards the most profitable products.
■ Performance management should be improved. ABC can be used as the basis of
budgeting and forward planning. The more realistic overhead should result in more
accurate budgets and should improve the process of performance management. In
addition, an improved understanding of what drives the overhead costs should result in
steps being taken to reduce the overhead costs and hence an improvement in
performance.
■ Sales strategy should be more soundly based. For example, target customers with
products that appeared unprofitable under absorption costing but are actually
profitable, and vice versa.
Advantages & disadvantages of ABC
ABC has a number of advantages:

• It provides a more accurate cost per unit. As a result, pricing, sales strategy,
performance management and decision making should be improved.

• It provides much better insight into what drives overhead costs.

• ABC recognises that overhead costs are not all related to production and sales
volume.

• In many businesses, overhead costs are a significant proportion of total costs,

and management needs to understand the drivers of overhead costs in order to
manage the business properly. Overhead costs can be controlled by managing
cost drivers.

• It can be applied to derive realistic costs in a complex business environment.

• ABC can be applied to all overhead costs, not just production overheads.

• ABC can be used just as easily in service costing as in product costing.

Advantages & disadvantages of ABC
ABC has a number of disadvantages:

• ABC will be of limited benefit if the overhead costs are primarily volume related or
if the overhead is a small proportion of the overall cost.

• It is impossible to allocate all overhead costs to specific activities.

• The choice of both activities and cost drivers might be inappropriate.

• ABC can be more complex to explain to the stakeholders of the costing exercise.

• The benefits obtained from ABC might not justify the costs.
Performance Measurement Using Variances
Managers often use variance analysis when evaluating the performance of their subordinates.
Two attributes of performance are commonly evaluated:

1. Effectiveness: the degree to which a predetermined objective or target is met—for example, sales,
market share and customer satisfaction ratings of Starbucks’ new VIAR Ready Brew line of instant
coffees.

2. Efficiency: the relative amount of inputs used to achieve a given output level—the smaller the
quantity of Arabica beans used to make a given number of VIA packets or the greater the number of
VIA packets made from a given quantity of beans, the greater the efficiency.

Managers must be sure they understand the causes of a variance before using it for performance
evaluation. Suppose a Webb purchasing manager has just negotiated a deal that results in a favorable
price variance for direct materials.

The deal could have achieved a favorable variance for any or all of the following reasons:
1. The purchasing manager bargained effectively with suppliers.
2. The purchasing manager secured a discount for buying in bulk with fewer purchase orders.
However, buying larger quantities than necessary for the short run resulted in excessive inventory.
3. The purchasing manager accepted a bid from the lowest-priced supplier after only minimal effort to
check quality amid concerns about the supplier’s materials.
Performance Measurement Using Variances (continued)
■ If the purchasing manager’s performance is evaluated solely on price variances, then the
evaluation will be positive. Reason 1 would support this favorable conclusion: The purchasing
manager bargained effectively. Reasons 2 and 3 have short-run gains, buying in bulk or making
only minimal effort to check the supplier’s quality-monitoring procedures.
■ However, these short-run gains could be offset by higher inventory storage costs or higher
inspection costs and defect rates on Webb’s production line, leading to unfavorable direct
manufacturing labor and direct materials efficiency variances.

Bottom line: Managers should not automatically interpret a favorable variance as “good news.”
Managers benefit from variance analysis because it highlights individual aspects of performance.

The goal of variance analysis is for managers to understand why variances arise, to learn, and to
improve future performance.
Thank you for your patience