Prof. Cristiano Busco - Dott. Fabrizio Granà

Responsibility CostingCost Allocation

Direct vs. Indirect Costs

Planning & Control

Responsibility Based Cost Measurement Systems

Importance of costing (full costing)

Costing terminology

Categories of costs

•Direct and indirect (focus on)

Allocation of costs

2

Why do managers want to know the full cost?

Pricing decisions

Outsourcing (make or buy decision)

Planning/Budgeting for the future

Control and benchmarking

Performance evaluation

Responsibility Based Cost Measurement Systems

Costs(resource

consumption)

Responsibility Centers Products

Responsibility Based Cost Measurement Systems

Records, tracks and reports information on resources consumed by cost objects in the organization.

Allows organizations to test the success of initiatives (including products and services) in achieving goals.

Helps managers make informed decisions about products, processes, units, employees.

Why do companies need a cost measurement system?

Responsibility cost measurement systems use

responsibility centers as the focal point of cost

collection.

A responsibility center is any subunit in the

organization that has a manager who is

responsible for performance and has a

budget.

Overview of Responsibility Cost Measurement Systems

Record costs as incurred into normal descriptive

categories (direct materials, supplies, direct labor,

indirect labor, rent, utilities, etc.)

Assign those costs to responsibility centers

When responsibility center works on cost object,

attach the costs in the responsibility center to the cost

object as it passes through.

Responsibility Cost Measurement Systems

•Materials

•Wages and

salaries

•Utility costs

•Sales

commissions

•Equipment

purchase

•Advertising

•Supplies

Functional

Costs

•General &

Administrative

•Sales/marketing

•Financing

Responsibility

Centers

•Stamping

•Assembly

•Testing

Inventory

Cost

Cost of

Goods

Sold

Products

•HK 195

•HK 290

•Others

Cost

Elements

Period

Expenses

Production

manufacturing

Non -

manufacturing

Responsibility Cost Measurement Systems

Definition of cost

Cost – the monetary value of the resources sacrificed to

achieve a specific objective (FULL COST)

Cost Object – anything for which a separate

measurement of costs is desired (e.g., product, service,

project, activity, department, etc).

Cost center – an organizational unit (responsibility

center) in which a manager is accountable only for costs

Product – a bicycle

Service – an airline flight from Manchester to Rome

Project – an airplane assembled by Airbus for BA

Activity – a test to determine the quality of a car

Department – the resources consumed by the marketing dpt.

Different Costs Classification for different purposes

Cost behavior in relation to Output

*Fixed and *Variable Costs

Assignment to Cost Object

*Direct and *Indirect Costs

Financial statement perspective

*Product (capitalized) and *Period Costs

Business Function

*Manufacturing (raw material, labor, other manufacturing costs)

*Non-Manufacturing: (marketing, distribution, customer service, legal)

(COSTING SYSTEMS – 1ST PART

JOB COSTING AND PROCESS COSTING

(COSTING SYSTEMS – 2ND PART

ACTIVITY-BASED COSTING

Direct and indirect costs

Direct Cost of a Cost Object

Cost that is related to the particular

cost object and that can be traced to

it in an economically feasible way.

Indirect Cost (Overhead) of a Cost Object

Cost that cannot be traced to the cost

object in an economically feasible way

and need to be allocated to it.

1. Direct (raw) materials - cost of materials that can be

economically traced to a unit of output

2. Direct labor - labor cost that can be economically

traced to the creation of particular unit of output

• Other direct costs - cost that can be economically traced

to the creation of particular unit of output

3. Manufacturing overhead - all other manufacturing

costs except direct material and direct labor

1

2

Cost Classifications

Indirect or

Manufacturing Overhead Costs

Overhead costs include all costs incurred to manufacture a

product/service that cannot be uniquely or economically

traced to that product/service.

Components of Overhead Costs:

Indirect materials (packing supplies, forms, cleaning

products, lubricants . . .)

Indirect labor (salaries of plant managers, supervisors,

inspectors, engineers)

Other (plant utilities, training programs, equipment

depreciation, property taxes. .)

Some definitions

Prime cost is the cost of direct materials, direct

labour and other direct costs of production

Manufacturing (production) overhead is the total

of indirect materials, indirect labour and other indirect

costs of production

Total product cost (full cost) =

Prime cost plus production overhead cost

Conversion costs = direct labor + manufacturing

overhead used to "convert" materials into product

Statement of cost of a production item

£ £

Direct materials xxx

Direct labour xxx

Other direct costs xxx

Prime cost xxx

Indirect materials xxx

Indirect labour xxx

Other indirect costs xxx

Manufacturing (Production) Overhead xxx

Total product cost (full cost) xxx

Costing Terminology: from Financial Accounting(inventories)

Raw materials (inventory): materials purchased for

making products for re-sale (but not yet used).

Work in Progress (inventory) : goods that are

partially completed (but not yet finished)

Finished Goods: Products ready for sale (but not

yet sold)

16

Job — individual products or services for a particular

client (custom home, individual lawsuit, etc)

Batch (Operations) - A group of like products produced

according to specifications (Chubby Hubby Ben & Jerry’s

ice cream, 5000 pairs of Levi’s 505 jeans)

Continuous process — homogenous products

produced on a continuous basis (oil refineries, breweries)

Jobs, Batches, or Continuous Process

Define the cost object !

Trace direct costs to responsibility centers and

to cost objects

Allocate indirect costs (overhead) to

responsibility centers and to cost objects.

Steps in Determining Product or Service FULL Cost

A record is created to accumulate cost data for the job or batch.

As the job or batch is worked on in a responsibility center, costs of

direct materials and direct labor used is recorded directly on the job or

batch’s record.

The job or batch is charged a “fair” share of the responsibility center’s

overhead cost using an allocation method.

Job or Batch Costing

Overhead Allocation Systems

Two systems:

Traditional volume-based cost system

Uses allocation bases that are related to

number of units produced (direct labor

hours, dollars, machine hours, etc.)

Activity-based cost system (ABC) - Use

multiple allocation bases called drivers.

Both systems typically use Predetermined

Overhead Rates

Rate=

Estimated indirect/overhead costs

Estimated volume of allocation base

When a product passes through a responsibility center, it

can be charged with its (1) direct material and (2) direct

labor costs, and then using the predetermined rate, it

can also be charged for a fair share of (3) overhead.

• The three of these costs together constitute the manufacturing

cost of the product.

• Notice that this cost excludes the cost of marketing,

administration, and financing the company.

Predetermined Overhead Rates

Budgeted!

• Old Time Potter manufactures custom designed pottery products for gift shops. Its product line includes coffee mugs, beer steins, footpath stones, and pasta bowl sets. Gift shops specify custom design options and place orders for a minimum quantity of each item ordered. Since goods are custom designed, Old Time Potter defines the cost object as a batch of products produced for a customer’s job.

• Products go through three production responsibility centers: shaping, paint & glaze, and firing. George, the owner of Old Time Potter, after recording costs into descriptive categories such as rent, utilities, direct material, labor, supplies, etc., traces all direct manufacturing costs (direct materials, direct labor) to the production center that incurred the cost. For the month of June, the following costs were directly traceable to each production center:

Old Time Potter

Direct Materials $16,000

Direct Labor $13,000

Shaping Paint & Glaze Firing

Direct Materials $1,000

Direct Labor $5,000

Direct Material $5,800

Direct Labor $12,000

• In addition to the direct manufacturing costs, Old Time Potter incurs indirect production (manufacturing) costs (MOH) including rent, depreciation on equipment, insurance, supplies, and repairs & maintenance. George develops a predetermined overhead rate at the beginning of each year using (1) budgeted overhead cost for the year divided by (2) budgeted direct labor dollars (the allocation base), Old Time’s measure of volume in its different products. For this year, Old Time uses an overhead rate of approx 20% of its direct labor cost to assign overhead to responsibility centers and to products.

Budgeted Manufacturing Overhead $63,000

Budgeted Direct Labor $312,000

Predetermined Overhead Rate 20.19%

Manufacturing Overhead

Budget for 2007

Cost Item Amount

Rent $20,000

Depreciation 10,200

Insurance 1,800

Supplies 22,800

Utilities 3,600

R&M 4,600

$63,000

Direct Labor Budget, 2007

Shaping $130,000

Paint & Glaze 122000

Firing 60000

$312,000

Old Time Potter (Overhead allocation)

12

Amelia’s Specialty Gifts ordered 1000 custom beer steins from Old Time Potter to be delivered in June. These steins went through each of the three production centers. As the steins passed through the center, the direct materials and direct labor costs (PRIME COSTS) for the order were recorded on the job card by the employees (given!) – EASY TO TRACE!

Shaping

Direct Materials $ 920.

Direct Labor 1,400

Amelia’ Gifts

Job Order 101

Paint & Glaze

Direct Materials $ 875

Direct Labor 2,250

Firing

Direct Materials $ 250.

Direct Labor 550

Amelia’ Gifts

Job Order 101

Amelia’ Gifts

Job Order 101

Old Time Potter

When Amelia’s job was complete, George applied overhead to the job and determined the total (manufacturing) cost of the job and the cost per stein. Based on the data collected, the total job cost $7,093.08, or about $7.09 per stein. From this, George can calculate the profit and determine if the proper amounts of materials and labor were used by each responsibility center for this job. By totaling the costs traced to all jobs in the month of June and comparing those totals to the costs incurred in each responsibility center, George can also understand how those centers are controlling their costs.

Amelia's Gifts

Job Number 101

Description: 1000 Beer Steins

Direct Materials Direct Labor Overhead

Department Amount Amount Amount Total

Shaping 920.00 1,400.00 282.69 2,602.69

Paint & Glaze 875.00 2,250.00 454.33 3,579.33

Firing 250.00 550.00 111.06 911.06

Total 2,045.00 4,200.00 848.08 7,093.08$

Cost per Stein 2.05$ 4.20$ 0.85$ 7.0931$

MOH

are 20,19%

of DL

Old Time Potter

Predetermined Overhead Absorption Rate=

Estimated indirect/overhead costs

Estimated volume of allocation base

Predetermined Overhead Rates

Budgeted!

At the end of the accounting period if the actual O/Hs and the actual activity base are the same as what was estimated (budgeted) then all is ok (rarely happens!).

However there is likely to be a situation where actual figures not equal to the estimates used:

• The total O/Hs to be allocated (the numerator in the previous formula) is different to what was anticipated

• The allocation base volume (the denominator in the previous formula) e.g. labour hrs or machine hrs are different to what was anticipated

• Both the O/Hs and the allocation base are different to what was anticipated

These differences cause under or over absorption of O/Hs 27

Under/Over

Absorption of O/Hs

Meaning of Under-absorption of overheads

Under-absorption of overheads means that the amount

of overheads absorbed in the production is less than the

amount of actual overheads-incurred.

For example if the overheads absorbed on a

predetermined basis are $1,000 and the actual overheads

incurred are $1,200, there is

under-absorption of $200.

Under-absorption is also termed as 'under recovery'

Meaning of over-absorption of overheads

Over-absorption of overheads means the excess of

overheads absorbed (based on budgeted data) over the

actual amount of overheads incurred. In other words when

the amount absorbed is more than the expenditure

incurred due to expenses being less than the estimates it

would mean over-absorption of overheads.

Over-absorption is also formed as 'over recovery'.

For example if the “absorbed” overheads are $3,000 and

the actual overheads are $2,750 then there will be over-

absorption of $250.