Cost

A cost is the value of money that has been used up to produce

something or deliver a service.
Example : Material,Labour,Advertisement expense
Classified into
By Nature or Element
By variability or Behaviour
By Functions

Marginal Costing and Absorption Costing

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The effect of absorption and marginal costing on inventory valuation
and profit

1. Marginal costing
Values inventory at the total variable production cost of a product.
e.g ; direct labor, direct material, direct expenses, and variable
production overheads

• Is appropriate for short-term pricing decisions.

• when used for pricing decisions includes the 'marginal (variable)
cost' of the product.

No FIXED overheads!

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 Absorption costing

Values inventory at the full production cost (including fixed

production overheads) of a product.
 Inventory values using absorption costing are therefore greater
than those calculated using marginal costing.
 Is appropriate for long-term pricing decisions.
 when used for pricing decisions includes the 'total cost' of the
product.
 Since inventory values are different, profits reported in the
Income statement (I/S) will also be different

The aim of traditional absorption costing is to determine the full

production cost per [Link] is a method of calculating the cost of a
product or enterprise by taking into account indirect expenses
(overheads) as well as direct costs.
Full Cost per unit = Variable cost per unit + Fixed Cost per unit

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 Overheads are absorbed into products using an appropriate absorption
rate based on budgeted costs and budgeted cost and budgeted activity
levels.

Overhead absorption rate = Budgeted Fixed Production Overhead

Budgeted Level Of Activity
Budgeted Level of activity
 Machine Hours
 Labour Hours
 No of units Produced

Example 1
The cost of Product A:
Direct materials $10
Direct labor $5 Direct expenses $2
Variable production overhead $6
Fixed production overhead $8
What will the inventory valuations be according to marginal and
absorption costing?

Example 2
Details of a product are as follows:
Direct material cost per unit $6
Direct labour cost per unit $4
Total production overhead $2,000 ; Total units 1,000 units
Required: Calculate full production cost per unit
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Example 3
Details of a product are as follows:
Material usage per unit 5 Kg
Material price per kg $10 per Kg
Labour hours per unit 3 Hours
Labour cost per hour $2 per hour
Estimated overheads $6,000
Estimated total labour hours 1,000 hours ; Calculate full production
cost per unit.
Example 4
Following is the cost information of Honda private limited CO.
Items Amount

Variable cost per unit $ 10

Fixed production overhead $ 10000

Fixed non-production overhead $ 20000

Labour hours 5000

Company apportions overheads based on labor hours. Each unit

requires 2 labor hours to be produced.
Calculate production cost per unit

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Example 5
Following is the cost information of Yamaha private limited CO.
Items Amount

Variable cost per unit $5

Fixed production overhead $ 15000

Fixed non-production overhead $ 20000

Machine hours 3000

Company apportions overheads based on machine hours. Each unit

requires 1 machine hour to be produced
Calculate production cost to be produced
Example 6
A company makes two products, the A and B
Labour hours per unit 2 5
Total production units 10000 6000
Total overhead $ 100,000
Total direct labour hours 50,000
What is the overhead cost per unit for A and B respectively if
overheads are absorbed on the basis of labour hours?

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Manufacturing businesses with high overhead costs use activity-
based costing to get a clearer picture of where money is going.
Because ABC gives specific production cost breakdowns, you can see
which products are actually profitable.
By using activity-based costing, you can:
 Take into consideration both the direct and overhead costs of
creating each product
 Recognize that different products require different indirect
expenses
 More accurately set prices
 See which overhead costs you might be able to cut back on

Illustration 1
Products A B
Production Units 1000 Units 2000 Units
Total Ordering cost $9000
Number of orders 700 200
Required
Calculate the total cost of both products using absorption costing
and Activity based costing

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Activity-based costing calculation
(Overhead for Cost Pool / Cost Drivers) X Amount of Activity Cost
Driver

Cost Pool Possible Cost Driver

Ordering Cost Number of orders
Materials handling costs Number of production runs
Machine set-up costs Number of machine set-ups
Machine operating costs Number of machine hours
Production scheduling costs Number of production runs
Despatching costs Number of orders despatched
*Number of Machine runs and Number of Production runs are same
Benefits of activity-based costing
ABC costing can help with:
 Budgeting
 Overhead decisions
 Product pricing
Drawbacks of an ABC system
Before implementing this type of costing method, consider the cons:
 Complex
 Not 100% accurate

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Illustration 2
Product Total Material Labour Labour Production
Units cost per hours cost per runs in the
unit per unit unit period
W 10 20 1 5 2
X 10 80 3 15 2
Y 100 20 1 5 5
Z 100 80 3 15 5

Overhead costs $
Set up costs 10920
Material handing cost 7700
Prepare unit cost of each product using
a) Absorption costing (overheads are absorbed using direct abour
hours )
b) Activity based costing

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 Sample Questions
[Link] TWO of the following statements about activity based costing
(ABC) are true?
 ABC recognises the complexity of modern manufacturing by the
use of multiple cost drivers.
 ABC establishes separate cost pools for support activities.
 ABC reapportions support activity costs.
 ABC is an appropriate costing system when overheads vary with
time spent on production
2. List of steps Correct order
Calculate the overhead cost per unit of
Step 1 - Calculate the absorption rate for each 'cost driver'.
Step 2 - Determine what causes the cost of each activity – the 'cost
driver'.
Step 3 - Identify major activities within each department which
creates cost.
Step 4 - Create a cost centre/cost pool for each activity – 'the activity
cost pool'.
3. A company which makes two products, Alpha and Zeta, uses
activity-based costing to absorb its overheads. It has recently
identified a new overhead cost pool for inspection costs and has
decided that the cost driver is the number of inspections.
The following information has been provided:
Total inspection costs $250,000
Alpha Zeta
Production volume (units) 2,500 8,000
Machine hours per unit 1 1.5

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 Units per batch 500 1,000
Inspections per batch 4 1
What is the inspection cost per unit of product Alpha? Select from
the list below.
List options are as follows:
• $23.81
• $17.24
• $71.43
• $80.00

Supply Chain Management

In commerce, supply chain management deals with a system of procurement,
operations management, logistics and marketing channels, through which raw
materials can be developed into finished products and delivered to their end
customers

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 JUST IN TIME (JIT)

→ Pull System.
" System whose objective is to produce products or components as they
are required by a customer or for use,rather than for [Link] in time
system pull system, which responds to demand, in Contrast to a push
System, in which Stock act as a buters between the different elements
of the System Such as purchasing , Production & sales,when needed.
Benefit ;

Disadvantages;

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Key characteristics for successful in JIT operation:
 High quality
 Speed
 Reliability
 Flexibility
 Low costs

Total quality management (TQM)

A core definition of total quality management (TQM) describes a
management approach to long-term success through customer
satisfaction. In a TOM effort, all members of an organization
participate in improving processes, products, services, and the culture
in which they work

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 Throughput accounting
Throughput accounting is a management account technique used to
maximize return in bottleneck scenarios.
Bottleneck resource or Binding Constraint
Bottleneck resource (or binding constraint) is a process that has a
lower capacity than preeceding or subsequent activities,thereby
limiting throughput.

In Throughput accounting only direct material cost is considered as a

variable cost,labour cost and overheads are period costs or fixed
costs .

Throughput Contribution = Selling price – Direct Material Cost

Test Your Understanding 1

Product Lays
Selling Price $15 Per unit
Direct Material cost $5.5 Per unit
Direct Labour $2 Per unit
Variable Overhead $1 Per unit
Fixed Overhead $1.3 Per unit
Calculate Throughput Contribution Per unit.
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 Test Your Understanding 2
Process A B C D E
Time per 5 6 10 12 10
Units (Min)
Time 100 60 110 144 120
Available(Min)
Output
Capacity
Required ; Identify the Bottleneck Process

Bottleneck process is the process with least output capacity

Test Your Understanding 3

Process Peeling Mixing Filing Packing
Time per Units 3 Min 2 Min 3.5 Min 4 Min
(Min)
Time 30 Min 16 Min 35 Min 48 Min
Available(Min)
Output Capacity

Required ; Identify the Bottleneck Process

Dept A Dept B Dept C

Hrs Per Unit = 3Hrs Hrs Per Unit = 2 Hrs Hrs Per Unit = 4

Total Hours Per Day = Total Hours Per Day = Total Hours Per Day = Daily Demand = 10
15 Hours 14 Hours 12 Hours Units

Units Per Day = 5 Units Per Day = 7 Units Per Day = 3

Units Units Units

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 Theory Of Constraints

Step 1: Identify the Constraint

Step 2: Exploit the Constraint
Step 3: Subordinate all Non-Constraints
Step 4: Elevate Constraint Performance
Step 5: Repeat

Throughput Accounting Ratio (TPAR)

It is the ratio of the throughput per unit of bottleneck resource to
the factory cost per unit of bottleneck resource.
Throughput accounting ratio = 𝐑𝐞𝐭𝐮𝐫𝐧 𝐩𝐞𝐫 𝐟𝐚𝐜𝐭𝐨𝐫𝐲 𝐡𝐨𝐮𝐫
𝐂𝐨𝐬𝐭 𝐩𝐞𝐫 𝐟𝐚𝐜𝐭𝐨𝐫𝐲 𝐡𝐨𝐮𝐫
Return per factory hour = 𝐓𝐡𝐫𝐨𝐮𝐠𝐡𝐩𝐮𝐭 𝐩𝐞𝐫 𝐮𝐧𝐢𝐭 𝐏𝐫𝐨𝐝𝐮𝐜𝐭𝐢𝐨𝐧 𝐭𝐢𝐦𝐞
𝐨𝐧 𝐛𝐨𝐭𝐭𝐥𝐞𝐧𝐞𝐜𝐤 𝐫𝐞𝐬𝐨𝐮𝐫𝐜𝐞

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(Throughput generated from one unit of bottleneck resource.)
Cost per factory hour = 𝐓𝐨𝐭𝐚𝐥 𝐟𝐚𝐜𝐭𝐨𝐫𝐲 𝐜𝐨𝐬𝐭𝐬
𝐓𝐨𝐭𝐚𝐥 𝐭𝐢𝐦𝐞 𝐚𝐯𝐚𝐢𝐥𝐚𝐛𝐥𝐞 𝐨𝐧 𝐛𝐨𝐭𝐭𝐥𝐞𝐧𝐞𝐜𝐤 𝐫𝐞𝐬𝐨𝐮𝐫𝐜𝐞
(The total factory cost is the operational expense [labour plus
overhead] of the organisation.)
In any organisation, you would expect the throughput accounting
ratio to be greater than 1.
This means that the rate at which the organisation is generating cash
from sales of this product is greater than the rate at which it is
incurring costs.
Interpretation of TPAR
− TPAR > 1 – throughput exceeds operating costs so the product
should make a profit.
− TPAR < 1 – throughput is insufficient to cover operating costs,
resulting in a loss.

Test Your Understanding 4

One of the products manufactured by a company is product X, which
sells for $40 per unit and a material cost of $10 per unit and a direct
labour cost of $7 per unit. The total direct labour budget for the year
is 50,000 hours of labour time at a cost of $12 per hour. Factory
overheads are $2,920,000 per year.
The company is considering the introduction of a system of
throughput accounting. It has identified that machine time is the
bottleneck in production. Product X needs 0.01 hours of machine
time per unit produced. The maximum capacity for machine time is
4,000 hours per year. What is the throughput accounting ratio for
product X (to 2 decimal places)?

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Test Your Understanding 5
Product A Product B Product C
Sales Price 2.8 1.6 2.4
Material Cost 1.2 0.6 1.2
Machine hours 0.5 Hours 0.2 Hours 0.3 Hours
per unit
Weekly sales 4000 Units 4000 Units 5000 Hours
demand
Machine time is a bottleneck resource and maximum capacity is
4,000 machine hours per week. Operating costs including direct
labour costs are $10,880 per week.

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