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Absorption Costing and Activity Based Costing

Week 7

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Methods of Costing The cost of a unit of production = variable

costs Direct Materials Direct Labour (Labour specifically related to the unit) Other Direct Costs Eg patents, royalties Fixed costs (overheads) are covered by

contribution to profit Thereafter each unit made and sold

contributes “pure” profit of Selling price – variable cost

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Full or Absorption costing Treats overheads as resources

consumed during manufacture Each unit consists of Direct resources consumed (direct

costs) Proportion of Overheads Distinction between Production related overheads Non-production related overheads

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Allocation of overhead costs

Two stage process Relate overheads to production

departments Allocation Directly ascribing a cost or class of

costs to a distinct department Eg Assembly department

supervisor’s salary Is Allocable overhead of Assembly

department

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Apportionment Where costs or class of costs cannot be

directly linked to distinct department Need to devise method of apportioning the

cost to all relevant departments Apportionment base must be Related to type of cost Equitable Eg costs of rent Apportionment base could be Floor area Therefore department with greatest use of

space is attributed with greatest proportion of rent costs

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Methodology Establish production and non-production

departments Allocate costs Establish apportionment bases for other

overheads Apportion costs Gives TOTAL overhead costs for each department ABSORB costs into units of production by

appropriate base Eg labour hours/machine hours Full product unit cost = Direct costs + Absorbed overhead cost

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Benefits

The benefits of full costing are that:

All the costs are included Duplication of costs can be

avoided Decisions are made with an

awareness of all costs

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Potential Disbenefits Absorption costing is often crude Particularly if the proportion of

indirect costs in the institution is high in relation to direct costs

The method is simple to administer and easy to understand

May be appropriate when direct costs are of most significance

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Worked Example

Marmoset Ltd 1. Allocate costs to departments 2. Apportion costs on appropriate

bases Rent – Floor Area Light & Heat – Power Usage Depreciation – Machine Value Insurance – Floor Area

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Worked Example

Apportionment of Rent Total Floor Area = 2,600 Floor Area of Machining = 1,000 Apportionment = 1,000 / 2,600 X Overhead

(600,000) = 230,769, etc….

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Worked ExamplePhase 2

Full costs of both Production and Non-Production service

departments Have been established Re-apportionment Service Costs to

Production Departments The FULL OVERHEAD COST of

production depts now known

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Worked ExamplePhase 2

There needs to be a link between the costs of the production depts and the product

Use Labour Hours (that’s all we’ve got) Calculate Labour Hours for each dept. Machining = 50,000 X 1 + 25,000 X 2 = 100,000 hours Assembly = 50,000 X 1.5 + 25,000 X 2 = 125,000 hours

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Worked ExamplePhase 2

Calculate OVERHEAD ABSORPTION rate

Machining = Total Overhead / Total labour hours = 967,714 / 100,000 = £9.68 per labour

hour Assembly = 722,286 / 125,000 = £5.78 per labour

hour

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Worked ExamplePhase 3

For each unit of Gibbon or Baboon made

Absorb proportion of overheads into it in proportion to the number of labour hours worked on it in each department

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Unit CostsCost Card

Gibbon Baboon

Raw materials

18.00 £15.00

Labour - M £5.80 £11.60

Labour - A £9.75 £13.00

Overhead M

£9.68 £19.36

Overhead A

£8.67 £11.56

Total £51.90 £70.52

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Activity Based Costing (ABC)

Cost objects consume activities Activities consume resources The consumption of resources

is what DRIVES costs If you can understand the

relationship you can control the costs

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The steps to ABC

Identify activities Determine costs for each

activity Determine cost drivers Collect activity data Calculate product cost

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Activity Based CostingWorked Example

Osprey Ltd

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Disadvantages of ABC

Needs a lot of work to establish “cost “drivers”

Expensive and time consuming What if cost drivers are wrong? How to deal with (say) Rent? What if product mix changes?