Define Absorption costing
A way of finding an appropriate amount of overhead per cost unit so that the total cost of producing a product or job can be calculated
What are the steps to calculate the overhead cost per unit
- Allocation: total overheads charged to relevant cost centre
- Appourtionment: Overheads are shared across each cost centre using fair basis
- Reapportionment: all service cost centre overheads are shared out between production cost centres
- Absorption: Production cost centre overheads are absorbed into cost units
Equation for apportionment to cost centres
Value of apportionment base of cost centre/ total value x total overhead cost
What are the different bases chosen for absorption and when are they used
- Per labour hour: when production is labour intensive
- Per machine hour: when production is machine intensive
- Per unit: when one product is produced
What is OAR
Overhead Absorption rate
Rate at which overheads are charged to cost units calculated by dividing budgeted overheads by budgeted level of activity
What is the formula for amount absorbed
Actual production activity x OAR
What is the formula for over/under overhead expenditure
Amount of overhead absorbed - Actual overhead expenditure = Under/Over absorption
What is under and over absorption
Under : fewer overheads are absorbed than actually incurred - taken away from profits
Over: more overheads are absorbed that actually incurred - added back to profits
What are the reasons for under/over absorption
- Expenditure variance: actual overhead expenditure is different from budgeted
- Volume variance: actual production activity differed from expected activity levels
What are the advantages of absorption costing
- Inventory valuation using absorption costing complies with IAS 2
- Fixed costs will be considered (unlike marginal costing)
- Recognises that selling price must cover all costs
What are the disadvantages of absorption costing
- Unit cost includes cost which are not relevant for marginal decision making
- Nature of cost behaviour is obscured
- Method of absorption costin is arbitary to some extent
- Profits can be manipulated by changing production levels
What is ABC
Activity based costing - extension of absorption costing
- Alternative approach to absorption costing using cost drivers to assign activity costs to units
What are the conditions for ABC Analysis
- Production overheads are high in relation to direct costs
- Overhead resource consumtpion is not soley driven by production volume
- There is a wide variety of products
- Overhead resource input varies significantly across product range
What are the problems of absorption costing ABC attempts to overcome
- Tends to allocate too great a proportion of overheads to high volume products
- Tends to allocate too small a porportion of overheads to low volume products
What are the steps of using ABC in an organisation
- Identify an organisations major activity
- Identify the cost drivers which causes the costs of activities
- Collect costs associated with each activity into cost pools
- Charge the costs of activities to produce on the basis of their usage of activites using multiple OARs
What are potential cost pools
- Production set up costs = OAR = Number of production set ups
- Machine repairs = OAR = Machine hours
- Material Handling = OAR = Number of componenet reciepts
Define cost driver
Factor influencing level of cost
What are the types of cost drivers
- Volume related: costs that vary with production levels in short term
- Transaction drivers: costs that are driven by the number of times something is done
- Duration drivers: costs that vary with the length of time it takes for the activity
- Intensity drivers: determining what resources are used to make product or service
Which activities are ABC useful for in terms of the hierarchy of actiivites
Not useful
- Unit/Production level - volume of production dependent. costs
- Facility sustaining level - eg. rents
Useful
- Batch level eg. set up costs
- Product sustaining level
What are the benefits of ABC
- Cost control and reduction by efficient management of cost drivers
- Better costing informaiton used to assis pricing decisions
- A more realistic estimate
- Reanalysis of production and output/ product mix decisions
- Profitability analysis
What are criticisms of ABC
- More time consuming and expensive
- Limited benefit if overhead costs are primarly volume based
- Reduced benefit if company is only producing one product
- Complex situations might have multiple cost drivers
- Some arbitrary apportionment may still exist
true.falsoe
Short-term variable overhead costs should be traced to products using volume-related cost drivers, such as machine hours or direct labour hours. This is true because short-term variable overhead costs vary with the volume of activity, and should be allocated to products accordingly.
Long-term variable production overhead costs are driven partly by the complexity and diversity of production work, as well as by the volume of output. This statement is not completely true. Many overhead costs, traditionally regarded as fixed costs, vary in the long run with the volume of certain activities, although they do not vary immediately. The activities they vary with are principally related to the complexity and diversity of production, not to sheer volume of output. For example, set-up costs vary in the long run with the number of production runs scheduled, not the number of units produced.
Transactions undertaken by support department personnel are the appropriate cost drivers for long-term variable overhead costs. This is true: for example, the number of credit investigations undertaken within the credit review department of a bank would be the cost driver of the department’s costs.
Overheads should be charged to products on the basis of their usage of an activity. A product’s usage of an activity is measured by the number of the activity’s cost driver it generates. This is true: for example, a mortgage might require three credit investigations and hence the mortgage should bear a proportion of the departments’ costs to reflect the three credit investigations.
What are teh different activity levels
Unit level activities are those where the consumption of resources is very strongly correlated with the number of units (i.e. portions of food) produced such as fresh food purchases.
Batch level activities consume resources in proportion to the number of batches produced. For the catering firm this will reflect the number of buffets provided and will therefore include serving sets and delivery costs.
Product level activities relate to the existence of a product or product range – the hot food containers would be an example.
Facility level activities relate to the business as a whole – cleaning and kitchen unit rental would fall into this category.
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1. Costings28
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2. Full Cost techniques23
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3. Marginal Costing32
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4. Rationale for budgets30
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5. Budgeting Concepts29
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6. Short term decision making18
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7. Models for decision making14
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8. Limiting Factors16
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9. Risk and Uncertainty in decision making24
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10. Budgetary38
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11. Standard Costing and Variance analysis43
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12.Further variance analysis15
