Pages From BPP CIMA C1 COURSE NOTE 2012 New Syllabus

7/27/2019 Pages From BPP CIMA C1 COURSE NOTE 2012 New Syllabus

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Fundamentals of

Management Accounting

Certificate in Business Accounting

Paper C1

Course Notes

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Blank

Improving study material and removing errors

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C1 Fundamentals of ManagementAccounting

Study Programme PageIntroduction to the paper and the course.................... ................................. .................................. .......................... 4

1 Introduction to management accounting ................................... ................................... ............................. ... 112 Introduction to costing and performance measurement ................................. ..................................... ......... 193 Cost behaviour .............................. .................................... ................................... ........................... ............. 274 Overhead costs absorption costing .............................. ................................... ............................ .............. 35

Checkpoint 1 (including Course Test 1) Additional Study Guidance 53

5 Marginal costing and pricing decisions....... ................................... ................................... ............................ 576 Breakeven and limiting factor analysis ................................. ..................................... .......................... ......... 657 Standard costing ................................ ................................... ................................... ............................ ........ 778 Variance analysis ............................... ................................. .................................. ............................... ........ 83Checkpoint 2 (including Course Test 2) Additional Study Guidance 93

9 Budget preparation .............................. ................................. .................................. .............................. ........ 9710 Flexible budgeting ................................... ................................... ................................... ............................ . 11111 Cost bookkeeping .............................. ................................... ................................... ............................ ...... 11712a Process costing basic............... ................................... ................................... ............................. ............ 133


12b Process costing Work-in-progress (WIP) and joint and by-products .................................. ..................... 14513 Job and batch costing ............................... ................................... ................................... .......................... . 155

14 Service costing .............................. ................................... ................................... ........................... ............ 16115 Decision making and investment appraisal ................................... ..................................... ........................ 167


16 Answers to lecture examples......................... ................................... ................................... ....................... 18517 Appendix A : Maths tables.......... ................................... ................................... .............................. ............ 21

Prepare for and book your CBA!

You should plan to sit your CBA within the next couple of weeks while the knowledge from this course is still fresh in your

mind. In preparation use the Learning Media P&R Kit and i-Pass to test yourself on as many questions as you can,

revising from the Course Notes and Passcards any areas of the syllabus that cause you problems.

Contact your local BPP centre as early as you can to book your CBA and good luck!

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INTRODUCTION

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Introduction to Paper C1 Fundamentals of Management

Accounting

Overall aims of the syllabus

The aims of the paper, as stated in the CIMA syllabus, are to test the student's ability to:

Explain the purpose of management accounting.

Explain the role of the management accountant and CIMA as a professional body for

management accountants.

Apply methods for identifying cost.

Demonstrate cost behaviour.

Prepare budgetary control statements and statements of variance analysis.

Prepare integrated accounts in a costing environment and financial statements for managers.

Demonstrate the use of break-even analysis in making short-term decisions.

Apply basic approaches for use in decision making.

Demonstrate the use of investment appraisal techniques in making long-term decisions.

The syllabus

The broad syllabus headings and their relative weightings are:

Topic Study weightingA The context of management accounting 10%

B Cost identification and behaviour 25%

C Planning within organisations 30%

D Accounting control systems 20%

E Decision making 15%

Links with other papers

The areas covered in C1 will be covered further and developed in Paper P1 Performance Operations and Paper

P2 Performance Managementin the CIMA professional qualification.


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Assessment methods and format of the paper

The paper is tested by computer-based assessment. It is a two-hour assessment comprising 50 compulsory

questions each with one or more parts.

The pass mark is 50%.

Objective test questions are used. There are a variety of objective test question types that can be used. These

include multiple choice, true/false and numeric entry.


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Learning Phase Aims

Achieving CIMA's Learning Outcomes

A The context of management accounting (10%)

1a Define management accounting. Chapter 1

1b Explain the importance of cost control and planning within organisations. Chapter 2

1c Describe how information can be used to identify performance within an organisation. Chapter 1 & 2

1d Explain the differences between financial information requirements for companies,

public bodies and society.

Chapter 1 & 2

2a Explain the role of the management accountant and activities undertaken. Chapter 1

2b Explain the relationship between the management accountant and the managers being

served.

Chapter 1

2c Explain the difference between placing management accounting within the finance

function and a business partnering role within an organisation.

Chapter 1

3a Explain the background to the formation of CIMA. Chapter 1

3b Explain the role of CIMA in developing the practice of management accounting. Chapter 1

B Cost identification and behaviour (25%)

1a Explain the concept of a direct cost and an indirect cost. Chapter 2

1b Explain why the concept of cost needs to be defined, in order to be meaningful. Chapter 2

1c Distinguish between the historical cost of an asset and the economic value of an asset

to an organisation.

Chapter 2

1d Prepare cost statements for allocation and apportionment of overheads, including

reciprocal service departments.

Chapter 4

1e Calculate direct, variable and full costs of products, services and activities using

overhead absorption rates to trace indirect costs to cost units.

Chapter 4 & 5

1f Apply cost information in pricing decisions. Chapter 5

2a Explain how costs behave as product, service or activity levels increase or decrease. Chapter 3

2b Distinguish between fixed, variable and semi-variable costs. Chapter 32c Explain step costs and the importance of timescales in their treatment as either variable

or fixed.

Chapter 3

2d Calculate the fixed and variable elements of a semi-variable cost. Chapter 3


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C Planning within organisations (30%)

1a Explain why organisations set out financial plans in the form of budgets, typically for a

financial year.

Chapter 9

1b Prepare functional budgets and budgets for capital expenditure and depreciation. Chapter 9

1c Prepare a master budget based on functional budgets. Chapter 9

1d Explain budget statements. Chapter 10

1e Identify the impact of budgeted cash surpluses and shortfalls on business operations. Chapter 9

1f Prepare a flexible budget. Chapter 10

1g Calculate budget variances. Chapter 10

1h Distinguish between fixed and flexible budgets. Chapter 10

1i Prepare a statement that reconciles budgeted contribution with actual contribution. Chapter 10

2a Explain the difference between ascertaining costs after the event and establishingstandard costs in advance.

Chapter 7

2b Explain why planned standard costs, prices and volumes are useful in setting a

benchmark.

Chapter 7

2c Calculate standard costs for the material, labour and variable overhead elements of the

cost of a product or service.

Chapter 7

2d Calculate variances for materials, labour, variable overhead, sales prices and sales

volumes.

Chapter 8

2e Prepare a statement that reconciles budgeted contribution with actual contribution. Chapter 8

2f Prepare variance statements. Chapter 8

D Accounting control systems (20%)

1a Explain the principles of manufacturing accounts and the integration of the cost

accounts with the financial accounting system.

Chapter 11

1b Prepare a set of integrated accounts, showing standard cost variances. Chapter 11

1c Explain job, batch, and process costing. Chapter 12 & 13

1d Prepare ledger accounts for job, batch and process costing systems. Chapter 12 & 13

2a Prepare financial statements that inform management. Chapter 4 & 5

2b Distinguish between managerial reports in a range of organisations, including

commercial enterprises, charities and public sector undertakings.

Chapter 14


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E Decision making (15%)

1a Explain the contribution concept and its use in cost-volume-profit (CVP) analysis. Chapter 6

1b Calculate the break-even point, profit target, margin of safety and profit/volume ratio fora single product or service.

Chapter 6

1c Prepare break-even charts and profit/volume graphs for a single product or service. Chapter 6

2a Explain relevant costs and cash flows. Chapter 15

2b Explain make or buy decisions. Chapter 15

2c Calculate the profit maximising product sales mix using limiting factor analysis. Chapter 6

3a Explain the process of valuing long-term investments. Chapter 15

3b Calculate the net present value, internal rate of return and payback for an investment. Chapter 15


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Certificate in Business Accounting

On successful completion of all five of the Certificate level computer-based assessments (or those for which you

have not been granted exemptions) you will be awarded the CIMA Certificate in Business Accounting.

The Certificate is considered by CIMA to be a qualification in its own right for those who do not wish to qualify

fully as a management accountant but who require a broad grounding in basic management accounting and

financial accounting issues. However, it is also the principal entry requirement for students aiming to attain the

Chartered Management Accountant qualification.

The knowledge content of the Certificate ensures that you understand:

the fundamental underlying concepts of management accounting (FMA);

the regulatory framework for financial accounting and reporting (FFA);

quantitative statistical methods used in management accounting (FBM);

the economic environment in which organisations operate (FBE); and

how formal business relationships between organisations are established (FBLW).The Certificate in Business Accounting clearly demonstrates to an employer that you have a thorough knowledge

of the basics of business accounting, and is a milestone in your career development!


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Syllabus Guide Learning Outcomes

Having studied this chapter you will be able to:

define management accounting.

describe how information can be used to identify performance within an organisation.

explain the differences between financial information requirements for companies, public bodies and society.

explain the role of the management accountant and activities undertaken.

explain the relationship between the management accountant and the managers being served.

explain the difference between placing management accounting within the finance function and a business

partnering role within an organisation.

explain the background to the formation of CIMA. explain the role of CIMA in developing the practice of management accounting.

Chapter Context

This chapter introduces the paper by looking at what management accounting is and the role of both management

accountants within organisations and CIMA itself. There are a couple of relatively lengthy definitions in the middle of the

chapter but the key thing at this stage is to be comfortable with the main areas of management accountancy in section 1.

Introduction to

management accounting


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1: INTRODUCTION TO MANAGEMENT ACCOUNTING

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Overview


Costing Planning Performance evaluation

Decision-making Control

Main areas

The role of CIMAPosition in Organisation Definitions


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1 Management accounting

It is useful to start by looking at a definition:

1.1 CIMAs definition of management accounting

CIMA define management accounting as the application of the principles of accounting andfinancial management to create, protect, preserve and increase value for the

stakeholders of for-profit and not-for-profit enterprises in the public and private sectors.

Management accounting is an integral part of management. It requires the identification,

generation, presentation, interpretation and use of relevant information...

1.2 The main areas of management accountancy

Following on from the above definition we could break down management accounting into

five main areas:

(a) COSTING

What is the cost of goods or services?

We need to know this for the income statement, to help set prices and to value

inventory in the balance sheet.

(b) DECISION-MAKING

There are many decisions managers may have to make such as:

What should we produce?

How should we finance the business?

Is a project worthwhile?

(c) PLANNING

Planning involves defining objectives and assessing future costs and revenues to set

up a budget.

Planning is essential to help assess purchasing/production requirements of the

business.

(d) CONTROL

Once plans have been made, the company must ensure they are being followed and

assess any inefficiencies in the business.

(e) PERFORMANCE EVALUATION

Employees and divisions can be assessed by comparing their performance against

targets or budgets.

2 The role of the management accountant

2.1 The management accountant assists in the management of an organisation by providing

relevant information to help it achieve its objectives, and also by improving the systems that

produce that information.

Although it is important to appreciate that businesses will have many objectives in order to

satisfy various different groups (e.g. employees, customers, suppliers, the government) the


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assumption that will usually be made in your studies is that companies wish to maximise the

wealth of their shareholders. Usually this will be achieved by maximising profit.

It should however be noted that the role of the management accountant isnt solely

restricted to producing information in monetary terms.

For a more detailed description of the role of a management accountant it is worthwhile torefer to some definitions:

2.2 CIMAs definition

Chartered Management Accountants help organisations establish viable strategies and

convert them into profit (in a commercial context) or into value for money (in a not-for-

profit context). To achieve this they work as an integral part of multi-skilled management

teams in carrying out the:

Formulation of policy andsetting of corporate objectives;

Formulation ofstrategic plans derived from corporate objectives;

Formulation of shorter-termoperational plans; Acquisition and use offinance;

Design of systems, recording of events and transactions and management of

information systems;

Generation, communication and interpretation of financial and operating

information for management and other stakeholders;

Provision of specific information and analysis on which decisions are based;

Monitoring of outcomes against plans and benchmarks, financial and non-

financial, quantitative and qualitative, for monitoring and control; and

Improvement of business systems and processes through risk management and

internal audit review.

Through these forward-looking roles and by application of their expert skills management

accountants help organisations improve their performance, security, growth and

competitiveness in an ever more demanding environment.

2.3 IFAC definition of the role and domain of the Professional Accountant in Business

IFAC (The International Federation of Accountants) recognise that the roles of professional

accountants who work in business are extraordinarily varied in terms of work, experience

and responsibilities. IFAC have defined the domain of the Professional Accountant in

Business as: The generation or creation of value through the effective use of resources (financial

and otherwise) through the understanding of the drivers of stakeholder value (which

may include shareholders, customers, employees, suppliers, communities, and

government) and organisational innovation

The provision, analysis and interpretation of information to management for

formulation of strategy, planning, decision making and control

Performance measurementand communication to stakeholders, including the

financial recording of transactions and subsequent reporting to stakeholders typically

under national or international Generally Accepted Accounting Principles (GAAP)


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Cost determinationand financial control, through the use of cost accounting

techniques, budgeting and forecasting

The reduction of waste in resources used in business processes through the use of

process analysis and cost management

Risk management and business assurance

3 The management accountants position

3.1 Given that traditionally management accountants focussed on producing cost information

they could use the same basic data as financial accountants and it therefore made sense for

them to be based in the finance function.

However, over time their role has widened to encompass the production of both financial

and non-financial information. This, coupled with the fact that much of the basic information

production can now be automated, has led to the argument that the managementaccountant should be based outside the finance function acting as a business advisor and

working in cross-functional teams.

3.2 It is important that management accountants recognise that the information needs of

managers will vary depending on their level within the organisation. Decision-making

operates at three levels:

Level Nature of tasks Nature of information

Strategic Developing long term

organisational goals and

objectives

Unstructured, forward looking

and externally focussed,

qualitative and quantitativeManagement Implementing the strategy set

efficiently and effectively

Routine reports for example

showing budget v actual

Operational Ensuring that specific tasks are

being carried out in an efficient

and effective way

Detailed, structured, numerical

and internally focussed

4 CIMA and its role in management accounting

CIMA is global accounting body based in the UK. It is the worlds largest professional body

of management accountants. It has over 183,000 members and students in 168 countries.

4.1 The history of CIMA

CIMA was founded in 1919 as The Institute of Cost and Works Accountants (ICWA).

It specialised in the development of accounting techniques for use in the internal

control of manufacturing, service and public sector operations.

It changed its name from ICWA to the Institute of Cost and Management Accountants

(ICMA) in 1972

It changed its name again in 1986 to the Chartered Institute of Management

Accountants (CIMA) after the granting of a Royal Charter in 1975.


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4.2 CIMA and the profession of management accounting

CIMA are committed to upholding the ethical and professional standards and to

maintain public confidence in management accounting.

CIMA regulates the activities of its members by a code of practice, a discipline

committee and a continuing education scheme.

It is the responsibility of each student and member to ensure they comply with both

CIMA's regulations and any specific regulations and legislation as required by their

country of residence.

Members and students must uphold the Code of Ethics and refrain from any conduct

which might discredit the profession.


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Overview


Costing Planning Performance evaluation

Decision-making Control

Main areas

The role of CIMAPosition in Organisation Definitions


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END OF CHAPTER


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explain the importance of cost control and planning within organisations.

describe how information can be used to identify performance within an organisation.

explain the differences between financial information requirements for companies, public bodies and society.

explain the concept of a direct cost and an indirect cost.

explain why the concept of cost needs to be defined, in order to be meaningful.

distinguish between the historical cost of an asset and the economic value of an asset to an organisation.

Chapter Context

This chapter introduces some important concepts and terms that are fundamental for this paper including the benefit ofsplitting total costs into different categories to help us run the organisation effectively. It also looks at how we mightassess the financial performance of a company and the performance of a not-for-profit organisation.

Introduction to costing

and performance

measurement


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Overview

Costing and Performance

Performance

Financial measures Value for money

Production v non-production

Direct v indirect Environmental

Costing

Definitions Classifications


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1 Costing definitions

1.1 Costobject

A cost object anythingfor which cost data is desired. e.g. products, product lines, jobs,

customers or departments and divisions of a company1.2 Costunit

A cost unit is a unit of product or service in relation to which costs may be ascertained.

The cost unit should be appropriate to the type of business. For example:

Business Appropriate cost unit

Car manufacturer

Ball bearing manufacturer

Builder

Management consultant

1.3 Costcentre

A cost centre is a function or location for which costs are ascertained (and related to costsunits for control purposes).

Production Servicecost centre cost centre

(E.g. Assembly, (Eg Canteen,processing, finishing) maintenance, stores)

2 Introduction to cost classification

Cost classification is the arrangement of cost items into logical groups. For example:

classification bynature (e.g. materials, wages etc.) classification by function (e.g. administration, production)

One of the eventual aims is to determine the cost of making a product or providing a service.

2.1 Classification by function

$DirectProd'n cost

Production costs XIndirectProd'n cost

Non-production costsAdministration costs X

Selling and distribution costs XTOTAL COST X


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The management accounting techniques in this paper are mostly concerned withproduction costs.

2.2 Direct production costs

Direct costs are those costs which can be specifically identified with and allocated to aparticular cost object. Usually the cost object will be a cost unit and therefore direct costscan be attributed in full to a particular unit of production.

Examples of direct production costs:

TOTAL DIRECT COSTS = PRIME COST

2.3 Indirect production costs (production overheads)

Indirect production costs are those costs which are incurred in the course of making aproduct/service but which cannot be identified with a particular cost object (which is usuallya cost unit)

Examples of indirect production costs:

TOTAL PRODUCTION COST = PRIME COST + PRODUCTION OVERHEADS

2.4 Non-production costs

All other costs required to run the business are non-production costs.

Examples of non-production costs:

TOTAL COSTS = PRODUCTION COSTS + NON-PRODUCTION COSTS

3 Historical cost v economic value of an asset

3.1 In practice most organisations record assets at historical cost.

3.2 Historical cost of an asset is the original cost to the organisation.

3.3 However, assets can also be measured at their economic value.

3.4 Economic value of an asset is the most someone is willing to give up in order to obtain theasset. How much a person is willing to pay for the asset tells us the economic value.


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4 Environmental costing

4.1 Increasingly, businesses need to be aware of the environmental costsassociated with business activities. In the past, environmental costs such as energy costswere treated as production overheads and effectively hidden from management scrutiny.

4.2 Classification of environmental costs.In order to manage environmental costs it can be useful to classify them into 4 categories

Environmental prevention costs costs incurred to prevent the production of wastethat could cause damage to the environment.

Environmental appraisal costs costs incurred to assess whether a firms activitiescomply with environmental laws and standards.

Environmental internal failure costs costs incurred after waste has been producedbut not discharged into the environment.

Environmental external failure costs costs incurred after waste has been producedand discharged into the environment. Some of these costs may be paid by society asa whole.

Lecture Example 1

MBash Ltd produces catalytic convertors that are purchased by a wide range of motormanufacturers.

Required

Identify possible environmental costs that MBash may incur in each of the four categories.

Solution

5 Performance measurement

One of the main roles of the management accountant is the evaluation of performance. Toassist in this a number of financial performance measures can be calculated.

5.1 Thegross profit margin is calculated as

(gross profit sales) 100%.


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5.2 Thenet profit margin is calculated as

(net profit sales) 100%.

5.3 Return on capital employed (ROCE) (also calledReturn on investment (ROI)) iscalculated as

(net profit/capital employed) 100%

5.4 Asset turnoveris calculated as

sales capital employed

5.5 Note that ROCE = net profit margin x Asset turnover

Lecture Example 2

MPRUV plcs summarised results for the last two years are shown below.

20X1 20X2$000 $000

Sales 40,000 50,000Gross profit 11,000 15,000Net profit 6,000 8,000Capital employed 30,000 40,000

Required

Calculate the ratios shown in section 5 for both 20X1 and 20X2

Solution


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6 Value for money

Many organisations are run on a notforprofit basis, in this case the performancemeasures in the previous section are less valid. It is more important to assess whether theorganisation is getting good value for money by measuring economy, efficiency, and

effectiveness.

(a) Economy purchase of inputs of appropriate quality at minimum cost

(b) Efficiency use of these inputs to maximise output

(c) Effectiveness use of these inputs to achieves it goals (quality, speed of response)

Lecture Example 3

Birmington University is a public sector higher education institution with 27,000 students, 500 staff

and an annual budget of $243m.Required

Identify possible performance measures for Birmington University that would give an indication ofits economy, efficiency and effectiveness.

Solution


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Overview

END OF CHAPTER

Costing

Definitions

Costing and Performance

Performance

Financial measures Value for money

Production v non-productionDirect v indirect Environmental

PreventionAppraisal Internal failure External failure

Economy Efficiency Effectiveness

Gross profit margin Net profit margin ROCEAsset turnover

Cost object Cost unit Cost centre

Classifications


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explain how costs behave as product, service or activity levels increase or decrease.

distinguish between fixed, variable and semi-variable costs.

explain step costs and the importance of timescales in their treatment as fixed or variable.

calculate the fixed and variable elements of a semi-variable cost.

Chapter Context

This chapter firstly covers an important way of classifying costs based on what happens when we increase or decreaseoutput. We can split them between those that stay the same (fixed costs) and those that change (variable costs). It then

moves on to look at how we can calculate the fixed and variable elements of an organisations total costs.

Cost behaviour


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Overview

Cost behaviour

Stepped

Fixed

Mixed

Variable

High-low

method

Line of best fit

method


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1 Cost behaviour and output

A business needs to know how costs behave with output so that predictions of costs can bemade.

It is expected that costs will increase as production increases (i.e. as output increases) but,the exact way costs behave with output may vary.

1.1 Types of cost behaviour

(a) Fixed cost

Total cost $

Output (units)

(b) Stepped cost

Total cost $

Output (units)(c) Variable cost

Total cost $

Output (units)

(d) Mixed cost (semi-variable)Total cost $

Output (units)


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2 Behaviour of manufacturing costs

With the linear assumption all costs can be categorised as either fixed or variable. This fitstogether with previous definitions:

2.1 Direct costsBy their nature direct costs will be variable costs.

2.2 Indirect costs/overheads

Overheads can be fixed (e.g. rent) or variable (e.g. tool hire)Fixed Variable

Direct costs X 9Production overheads 9 9Non-manufacturing costs 9 9

2.3 The importance of timescale

Whether a cost is classified as fixed or variable will depend on the timescale beingconsidered. The longer the timescale the greater the proportion of costs that can beconsidered as variable. For example rent is fixed in the short run, but can be considered astepped cost in the medium term, and even a variable cost in the long run.

3 Determining the fixed and variable elements of semi-

variable costs

TotalCost ($)

Variable cost (VC)

Fixed cost (FC)

Output

3.1 Total cost = Fixed cost + (VC/unit x Output)

3.2 How can we estimate fixed and variable costs if we only know total cost?

High-low method

Line of best fit method.


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4 High-low method

This is a four-step method.

Lecture Example 1The total costs of a business for differing levels of output are as follows.

Month Output Total Costs(units) ($000)

January 500 70February 200 30

March 800 90April 1,000 110

Required

(a) What is the fixed and variable elements of the total cost using the High-Low method?A Y = $30,000 + $100x B Y = $10,000 + $110xC Y = $30,000 + $110x D Y = $10,000 + $100x

(b) What is the total cost if output is 400 units?

Solution


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5 Line of best fit method

A scattergraph with total cost on the vertical axis and output on the horizontal axis isprepared.

A line of best fit, which is a line ofjudgementis drawn to pass through the middle of thepoints.

A scattergraph of the cost and output in Lecture Example 1 is shown below.

Total costs($'000) 100

80

60

40

20Output (units)

200 400 600 800 1,000 1,200

The point where the line cuts the vertical axis (approximately $10,000) is the fixed cost.

If we take the value of one of the plotted points which lies close to the line and deduct thefixed cost from the total cost, we can calculate variable cost per unit.

Example: Total cost for 1,000 unit = $110,000

Variable cost for 1,000 units = $110,000 $10,000 = $100,000Variable cost per unit = $100,000/1,000 = $100 per unit

Note: As C1 is examined by CBA you will not be required to draw a scattergraph; howeveryou could be required to answer objective test questions about how the techniqueworks.

x

x

x

x


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Overview

Cost behaviour

Stepped

Fixed

Mixed

Variable

High-lowmethod

Line of best fitmethod

Used to split fixed and variable elements Find highest and lowest activity levels Subtract Low from High Use remainder to calculate VC Substitute VC back into High or Low total

cost formula to calculate FC

Provides more accurate costestimation than High-low method


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END OF CHAPTER


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prepare cost statements for allocation and apportionment of overheads, including reciprocal service departments.

calculate direct, variable and full costs of products, services and activities using overhead absorption rates totrace indirect costs to cost units.

prepare financial statements that inform management.

Chapter Context

In this chapter we start to look at one of the key questions that management accountants have to answer: How muchdoes it cost to produce each item of our product? Absorption costing is one method used to answer this question, andwe will look at another approach in the following chapter. Absorption costing takes all of the production costs (both fixedand variable) and attributes them to individual units of production. By definition overheads are going to be the mostdifficult costs to deal with because they cant objectively be traced to an individual cost unit.

Overhead costs

absorption costing


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Overview

Absorption costing Proforma incomestatement

AC Cost cardPrime costProductionoverhead

Steps

(2) Allocate and apportionoverheads to cost centres

(1) Allocate direct coststo units

(4) Absorb overheadsinto cost units

(3) Reapportion service costcentre overheads

Service costcentres

Productioncost centres

Direct method Reciprocalmethod

Step method

Overheadabsorption rates


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1 Overview

1.1 Businesses need to put a cost on goods/services they produce (i.e. cost units) for manyreasons.

AIM To find the cost of making one unit

PricingWHY? Inventory valuation

Profitability analysis

Absorption costing (this chapter)HOW? OR

Marginal costing (Chapter 5)

1.2 Absorption costing

Absorption costing is a product costing/inventory valuation method which includes allproduction costs in the valuation and is required by IAS 2 for external reporting purposes.

A cost card shows us the cost to make one unit

$/unitDirect materials XDirect labour XPrime cost XProduction overheads X

Product cost X

1.3 Prime cost (direct cost)

The direct costs of a cost unit are usually straightforward to ascertain since by definition theyare identified with a cost unit.

Direct materials: x kg of material at $y per kgDirect labour: a hrs of labour at $b per hour

This is step (1) in Method for absorption costing steps below.

1.4 Production overheadsSince these are not identified with specific cost units, some method must be used to chargea share of the total production overhead to each cost unit.

Steps (2) to (4) in the method below represent the traditional absorption costing method bywhich we achieve this.


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2 Absorption costing steps

2.1 Method

Total Production Costs

Direct Costs Indirect Costs(overheads) 2. Allocate &

ApportionCOST CENTRES

1. Allocate Production 1 Production 2 Service

Production 1 Production 2 3. Reapportion

4. AbsorbCOST UNITS

To get the full absorbed production cost there are four steps:

(1) Allocate direct costs to cost units(2) Allocate and apportion production overheads to cost centres(3) Reapportion overheads in service cost centres to production cost centres(4) Absorb overheads into cost units

3 Allocation and apportionment of production

overheads to cost centres

Step (2) of method

3.1 The first stage in valuing the overhead cost of a cost unit is to allocate and apportionoverheads between cost centres.

3.2 A cost centre is a location, function or item of equipment in respect of which costs may beascertained and related to cost units for control purposes.

Each cost centre acts as a 'collecting place' for certain costs before they are analysed

further.

Note:

(a) Cost centres may be set up in any way the business thinks appropriate.

(b) Usually, only manufacturing costs are considered and hence we will focus on factorycost centres.


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3.3 Service and production cost centres

(a) Production cost centres. Factory cost centres through which cost units actually flow;

(b) Service cost centres. Support/service the production cost centres.

Lecture Example 1

Split the following between two types of cost centres.

assembly, canteen, maintenance, packing, stores, finishing.

(a) Production cost centres

(b) Service cost centres

Solution

(a) Production cost centres (b) Service cost centres

3.4 Terminology

Allocation whole cost items are charged to a cost centre.

Apportionment cost items are divided between several cost centres.


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Lecture Example 2

Overhead allocation and apportionment (Step 2 of method)

Mars Ltd has the following overheads in the year ended 31 December 20X5:

Overhead: $Rent and rates 90,000Insurance of machinery and equipment 40,000Stores costs (wages and salaries) 75,000Heating costs 57,000

262,000

Required

Allocate and apportion overhead costs to mixing dept, stirring dept, stores and canteen using thefollowing information:

Mixing Stirring Stores Canteen TotalFloor space (square ft) 9,000 3,000 1,000 2,000 15,000NBV of machinery andequipment 2,000 1,000 600 400 4,000

Solution


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4 Reapportionment of service cost centre overheads

Step 3 of the method

4.1 All service cost centre overheads must be transferred to the production centres so that all

production overheads for the period are shared between the production cost centres alone as it is through these cost centres that cost units flow.

4.2 The reapportionment becomes a little more complicated where there is:

more than one service cost centre, and

the service centres do work for one another.

4.3 To reapportion service cost centre overheads to production cost centre there are threemethods.

Direct Step Reciprocal

method method method

Inter-service Some inter-service All inter-servicedepartment department work department work

work is ignored is recognised is recognised

Service centre Most widely used Therefore, the mostoverheads reapportioned service centre's accurate method

directly to production overheads arecost centres reapportioned toproduction and Two ways:

service cost centres. (i) Repeated distributionMainly used when only (Where not clear, methodhave one service centre reapportion the service (ii) Algebraic methodor service centres do centre with the (not examinable at

not work for each other largest overheads.) this stage.)

Used when morethan one servicecentre, but don'twork for each

other


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Lecture Example 3

Service Cost reapportionment

Production Depts. Service Centres

Mixing Stirring Stores Canteen$ $ $ $Allocated and apportioned

overheadsFrom Lecture example 2 108,200 39,400 90,800 23,600

Estimated work done by theservice centres for otherdepartments

Stores 50% 30% - 20%Canteen 45% 40% 15% -

Required

(a) After the apportionment of the service departments to the production department, what willthe total overhead costs for the production departments be?

Mixing Stirring

Direct $ $

Step $ $

Reciprocal $ $

(b) The most appropriate method to use would be the method.

This is because

Solution

Workings


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5 Absorption of overheads into production (cost units)

Step (4) of the method

5.1 Bases

All of the production overhead costs have now been apportioned to the production costcentres. We now need to charge these to the cost units passing through the production costcentres. This is termed absorption. We are going to absorb an element of total productionoverhead into each cost unit.

OAR (overhead absorption rate) =levelActivity

overheadProduction

5.2 Choosing bases

Ideally, the basis chosen should be the one which most accurately reflects the way in whichthe overheads are in fact being incurred.

For example:

Basis

(a) Per unit(b) Per labour hour(c) Per machine hour(d) % of direct labour cost(e) % of direct materials cost(f) % of prime cost

Lecture Example 4

Calculating absorption rates

Mars Ltd has decided to use the step method to re-apportion service centre costs to its twoproduction departments, mixing and stirring.

As calculated in Lecture Example 3, this resulted in allocated overheads of $175,708 and $86,292to the mixing and stirring departments respectively.

During the year the following data has been collected.

Mixing StirringDirect labour hours 20,000 5,000Direct machine hours 2,000 60,000Number of units 10,000 10,000

Required

(a) The overhead absorption rate for the mixing department was $ per

(b) The overhead absorption rate for the stirring department was $ per


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Solution

Workings

(a)

(b)

Cost units

(c) Mars Ltd has one particular product, the 'Venus', for which you obtain the followinginformation.

Direct materials per unit $15Direct labour hours

Mixing 2 hours Stirring 0.5 hours

Direct machine hours Mixing 0.2 hours

Stirring 6 hoursLabour is paid $10 per hour

Required

What is the total cost of this product?

A $40 B $58.30 C $66.22 D $77.33

Solution

Workings

(c)


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6 Pre-determined overhead absorption rates

Businesses need to cost their production throughout the year, not at the end of anaccounting period. Therefore, they predetermine or estimate their absorption rates for theyear.

Pre-determined OAR =levelactivityBudgeted

overheadBudgeted

Note: activity level refers to production activity not sales.

6.1 Budget (or normal) activity level

IAS 2 states that the activity level used for absorption of overheads should always be the

budgeted (normal) activity, i.e. the expected long-term average. This is to stop fluctuationsin OARs due to fluctuations in activity.

6.2 Absorption into production

Businesses will record overheads regularly during the year.

Overhead = Actual Activity PredeterminedAbsorbed OAR

At the end of the yearactual overheads will be known

Under/(over)-absorption = Actual Overhead less Overhead Absorbed

If overheads absorbed are less than actual overheads = under-absorption

If overheads absorbed are greater than actual overheads = over-absorption

Overheads absorbed may differ from actual overhead costs incurred for either or both of thefollowing two reasons:

(a) Actual expenditure was more or less than budget.(b) Actual units produced (ie. volume) were more or less than budget.


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Lecture Example 5

Pre-determined overhead absorption rates

Gurney Halleck Limited had the following budgeted and actual figures for units of production

and overheads.Budget Actual

Units of production 20,000 24,000Overheads $100,000 $117,000

Required

Complete the following calculations.

Pre-determined absorption rate=

Overhead absorbed for period =

Under-/over-absorption =


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7 Proforma absorption costing

7.1 INCOME STATEMENT$ $

Sales X

Less: Cost of salesOpening inventory (@ full cost) XProduction costs:Variable costs materials X

labour X variable overheads X

Fixed overhead absorbed XX

Less: Closing inventory (@ full cost) (X)Production cost of sales XAdjustment for over-/under-absorbed overhead X

Total cost of sales (X)GROSS PROFIT XLess: sales and distribution

costs (X)

NET PROFIT X

Notes:

(a) Inventory is valued at full production cost.

(b) The method of costing by which 'actual production costs' include a figure based on apredetermined estimate is called normal costing.

Lecture Example 6

Selling price $25.

Cost card per unit:$

Direct materials 7Direct wages 8Variable production overheads 5Fixed production overheads 0.90

20.90


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There is a variable selling cost/unit of $0.50.Year 1 Year 2units Units

Normal/Budgeted production 12,000 12,000Actual production 14,000 11,500

Actual sales 13,000 12,500Actual fixed production overheads $11,000 $11,000Actual fixed selling costs $5,000 $5,000

There is no opening inventory. All variable costs were as budgeted for the two years.

Required

(i) The total budgetedfixed production overhead was

(ii) The overheads absorbed in Year 1 were

(iii) The net profit in Year 1 was

(iv) The overheads in Year 2 were absorbed by

(v) The net profit in Year 2 was

Solution

Workings

(i)

(ii)

Documents

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