Discuss the possible conflicts between cost accounting for profit reporting and inventory valuation and the information for decision-making.
This is still part of "Pricing and Product Decision"!
1) Allocation and Apportionment
*Note: the first stage of analysis of Overheads is to determine the overhead cost for each cost centres.
Cost Allocation - this is possible only if we can identify a cost as specifically attributable to a particular cost centre (i.e., the salary of the manager of the packing department)
Cost Apportionment - is necessary when it is not possible to allocate a cost to a specific cost centre (i.e., the salary of the manager who is managing packing and operation department or the cost of rent and rates might be apportioned according to the floor space occupied by each cost centre).
2) Overhead Absorption
Overhead Absorption is the amount of indirect costs assigned to cost objects. Indirect costs are costs that are not directly traceable to an activity or product. Cost objects are items for which costs are compiled, such as products, product lines, customers, retail stores, and distribution channels.
Selecting the most appropriate absorption rate
It is generally accepted that a time-based method should be used wherever possible, i.e. the machine hour rate or the labour hour rate. This is because many overhead costs increase with time, for example, indirect wages, rent and rates.
However, each absorption method has its own advantages and disadvantages:
(a) Rate per unit. This is the easiest method to apply but it is only suitable when all cost units produced in the period are identical. Since this does not often happen in practice this method is rarely used.
(b) Direct labour hour rate. This is a favoured method because it is time-based. It is most appropriate in labour-intensive cost centres, which are becoming rarer nowadays and so the method is less widely used than it has been in the past.
(c) Machine hour rate. This is also a favoured method because it is time-based. It is most appropriate in cost centres where machine activity predominates and is therefore more widely used than the direct labour hour rate. As well as absorbing the time-based overheads mentioned earlier, it is more appropriate for absorbing the overheads related to machine activity, such as power, maintenance, repairs and depreciation.
(d) Direct wages cost percentage. This method may be acceptable because it is to some extent time-based. A higher direct wages cost may indicate a longer time taken and therefore a greater incidence of overheads during this time. However, the method will not produce equitable overhead charges if different wage rates are paid to individual employees in the cost centre. If this is the case then there may not be a direct relationship between the wages paid and the time taken to complete a cost unit.
(e) Direct materials cost percentage. This is not a very logical method because there is no reason why a higher material cost should lead to a cost unit apparently incurring more production overhead cost. The method can be used if it would be too costly and inconvenient to use a more suitable method.
(f ) Prime cost percentage. This method is not recommended because it combines methods (d) and (e) and therefore suffers from the combined disadvantages of both.
Absorption Costing
- Something to do in establishing COST PER UNIT (i.e., how much does it cost to produce something)
- AIM: Establish the Full (Production) Cost/unit
- Reasons:
- Pricing (i.e., Cost Plus)
- Product Profitability
- Statutory Reporting (i.e., Inventory valuation)
- Budgeting/Control/Decision-making
- Helping out the financial accountant to value the finished-goods stock at full production cost
Overhead Absorption Rate (OAR) = Budgeted Overhead cost/Budgeted Level of Activity
Level of Activity:
- Time Basis (Hours) - (i.e., labour hours or machine hours)
- Units (Output)
- Measure of Cost (%) - Direct Materials/Direct Labour/Total Prime Cost
Reciprocal Servicing - the service cost center not only provides the service to the production cost centers but also provides the service to the OTHER SERVICE COST CENTER.
This is critical - as we apportion and reapportion the costs until all the monies are out of the service cost centers.
Pricing
Cost Plus - simplest form of pricing. If we know already the cost, we simply add a margin on the cost to reflect our price.
Note: Cost Plus pricing doesn't consider volume. It doesn't take into account the market price.
Cost Base:
- Full Production Cost
- Full Cost (includes expenses) --> absorb the expenses to the product
- Marginal Cost
Understanding the difference between cost and price:
3) Predetermined overhead absorption rate
Predetermined overhead rates mean that the rates are calculated in advance of the period over which they will be used.
MAIN REASON: Overhead costs are not incurred evenly throughout the period - as it fluctuates every month.
Under-or -over absorption of overheads
Under- or Over- absorption of overhead exists when the actual spending is less or more as compared to predetermined overhead.
The reasons for under- or over- absorption of overheads
4) Activity based costing
Activity based costing - because production became more mechanised, thus the traditional absorption costing will not give an accurate rate as this is more applicable to labour-intensive production.
ABC is a refined absorption costing methodology, which uses cost pool and cost driver as compared to cost center and overhead absorption rate.
Two categories of cost driver:
Resource cost driver - measure of the quantity of resources consumed by an activity. This is used to assign the cost of a resource to an activity or cost pool.
Activity cost driver - measure of the frequency and intensity of demand placed on activities by cost objects. This is used to assign activity costs to cost objects.
The different stages in ABC calculation:
- Identify the different activities within the organisation. Compared to a traditional overhead system, ABC has more number of activities, which depends on how the management subdivides the organisation's activities
- Relate the overheads to the activities. This is the creation of 'cost pools.'
- Support activities are then spread across the primary activities. The base is the cost driver that is the measure of how the support activities are used.
- Determine the activity cost drivers. This is based on the factor that drives the consumption of the activity. The question is - what causes the activity to incur cost?
- Calculate activity cost driver rates = Total cost of activity/Activity driver
4 Categories of Activities
- Unit level activities - costs that are related to the number of units produced (i.e., indirect materials or consumables)
- Batch level activities - costs that are related to the number of batches produced (i.e., material ordering, where an order is placed for every batch production)
- Product level activities - costs that are driven by the creation of a new product line and its maintenance (i.e., designing the product)
- Facility level activities - costs that are related to maintaining the buildings and facilities (i.e., maintenance of buildings, plan security)
- In ABC, all costs are variable
- Environment - where ABC can apply:
- Production - repetitive nature
- Complex - multi-product or many processes
- High Overhead costs
- Problems of ABC
- Cost/Benefit
- Implementation risk
- Focus on Cost Allocation (Internal)
Marginal Costing
- The focus is on cost behaviour and the changes in the level of activity.
- Used for specific application like making decisions. The changes in the level of activity are vitally important
- Not used in statutory reporting purposes
Variable Cost
- Varies proportionately with the activity
- Variable Cost per unit is constant
- Product Cost
- Treatment: Charged to the cost unit and to the income statement as part of the cost of sales
Fixed Cost
- One that remains constant
- Fixed Cost in total is constant
- Period Cost
- Treatment: Charged to the Income Statement in the period in which they are incurred
Uses of Marginal Costing:
- Decision Making
- Budgeting (both marginal and absorption costing can be used in budgeting)
Terminologies:
- Marginal Cost = sum of variable costs (Variable cost and marginal cost are used interchangeably)
- Contribution = Sales - Variable Cost (Fixed cost + Profit)
Profit - is calculated for a period of time, thus marginal cost and absorption cost will differ because of the fixed cost. The change in stock will dictate the differences.
Overall the profit will be the same over time but in individual accounting periods, profits may differ.
Reconciling Item = Fixed Cost/unit X Change in Stock
Impact on Profit
Stock is constant - Marginal Costing profit (MCP) = Absorption Costing Profit (ACP)
Increase in Stock - Marginal Costing profit (MCP) < Absorption Costing Profit (ACP)
Decrease in Stock - Marginal Costing profit (MCP) > Absorption Costing Profit (ACP)
