Content List

1.0 Introduction ……………………………………………………………………………….2

2.0 Marginal Costing ………………………………………………………………………….2

2.1 Purposes for marginal costing ………………………………………………………2-3

3.0 Absorption Costing …………………………………………………………………...…..3

3.1 Practical Reasons of Using the Absorption Costing

…………………...…………...3-4

4.0 Activity-Based Cost Systems …………………………………………………………...4-5

4.1 Benefits and Limitations of ABC

………………………………………………......5-7

5.0 Standard costing ……………………………………………………………………...…...7

5.1 Budgets Costs and Standard Costs ……………………………………………….…..8

5.2 Benefits and Limitation of Standard Costing

……………………………………….8-9

5.3 Purposed of Standard Costing ……………………………………………………...…9

5.4 Flexed Budget ………………………………………………...…………………...9-10

5.4.1 Materials Variances …………………………………………………………...…10

5.4.3 Labour Variances ………………………………………………………...……...10

5.4.3 Variable Overhead Variances ……………………………………...

………...10-11

5.4.4 Fixed Overhead Expenditure or Spending Variances

…………………………...11

6.0 Conclusion ……………………………………………………………………………….11

Reference List

Appendix A

Appendix B

Appendix C

Appendix D

1.0 Introduction

Cost management information is made up of financial

information about costs and revenues, and non-financial

information about productivity, quality and other main factors

that bring organization to success. Therefore, it provides

valuable information for planning and control, costing

products and services, and management decision making. The

information requirement for costing depends on the nature of

the object being cost and the managerial decisions.

Consequently, depending on required purposes, managers use

different costing systems, including marginal costing,

absorption costing or more complicated ABC systems. Thus,

managers should understand the use of these techniques to

provide valuable and accurate cost estimation for decision

making under different circumstances.

2.0 Marginal Costing

1

Marginal costing technique treats only variable costs and

variable production overheads as a product cost. While fixed

overhead is charged as period cost such as marketing and

administrative expenses, because it remains fixed over a short

period and therefore, not relevant for efficient planning

(Patel 2001). Marginal costing is often referred as direct

costing or variable costing.

In marginal costing, finished goods and work-in-progress are

also valued as variable production cost. Afterwards, variable

cost of sales is deducted form sales value to calculate the

profit, namely Contribution (Lucey 2003).

2.1 Purposes for marginal costing

Providing the basic information to managers for crucial

planning and decision making. It is particularly useful

for short-term decision with changes in volume or

activity and the subsequent change in cost.

It is appropriate in the routine cost accounting system

for determining the costs and the valuation of stocks

(Lucey 2003)

Marginal costing does not have difficulties with apportionment

and absorption of overheads, because fixed costs are

considered as expenses and deducted from contribution. That

also results with no problems in arbitrary apportionment of

fixed cost, that makes this technique very simple to

understand and easy to operate (Gupta et al. 2006). However,

stock valuation can be misleading in capital intensive

2

companies and the setting of prices for the long-term period

cannot be done without fixed overheads (Nigam and Jain 2001).

Inventory valuation using marginal cost approach allows the

firm showing higher profit in the case of decreasing stocks,

because it treats fixed cost differently comparing with

absorption costing. However, when the company has large stocks

of work-in-progress (W.I.P.), this technique cannot be

applied, because of very high relationship between value of

W.I.P. and turnover (Gupta et al. 2006).

As it has been mention above, marginal costing is very helpful

for managers in decision-making process. In the following

areas managers use marginal cost:

Setting product prices

Product mix decision under limiting factors

Decisions on replacement old equipment

Make or buy decisions

Discontinuation decisions

3.0 Absorption Costing

In absorption costing, also known as traditional or full

costing systems, both direct and indirect costs are traced to

the product. Indirect costs cannot be directly associated with

cost objects, because they often relates to several cost

centers. Therefore, assignment of indirect costs object is

determined using cost allocation, a process when a direct

measure of the amount of recourses used by a particular cost

object does not exist. Thus, all assigned costs will represent

3

the allocation of all costs to products to guarantee that all

costs are comprised of the cost base (Drury 2009).

3.1 Practical Reasons of Using the Absorption Costing

Absorption complies with the requirements of “IAS 2” and

“GAAP”, because fixed costs are unavoidable within the

production and should be included in inventory valuation

(ACCA 2010).

Full costing helps in pricing decisions, especially for

companies that involved in jobbing or contract work,

because in setting the selling price companies add mark

up to the full of production. If the absorbing costing

did not take into account, it would be resulted in loss

when the product is sold. Moreover, if the costing was

traced only to one department it could make the unit for

that department expensive (ACCA 2010).

It establishes profitability for the variety of products,

allocating overhead cost and charging to the cost of

sales of each product (ACCA 2010).

Absorption costing system is based on volume cost driver or

arbitrary allocation, such as direct labor hours and machine

hours for tracing all production overhead costs, that causes

the distortion in the cost of products. Because whenever

product is manufactured, it is assumed that costs is arisen.

However, this assumption cannot be applied for activities that

does not belong directly to the production. Thus, it provide

information on what is spent, but does not explain why it is

4

spent. Consequently, when firms try to reduce the total costs

by cutting the overheads, this results in quality loss rather

than in long term reduction of the cost. Allocations are

likely to lead in inaccurate allocations of indirect costs to

cost centers, that does not meet decision-making requirements

(Marx 2009).

Thus, absorption costing system is very simplistic to operate

in the term of inexpensiveness and easiness, and more relies

on arbitrary allocation of indirect costs, consequently

resulting in inaccuracy of cost assignment, high level of

errors and reporting misleading information (Drury 2009).

Absorption costing method is more appropriate for the

organization with the next characteristics:

few number of competitors

organizational resources fairly equally allocated to the

products mix range

non-volume-related indirect costs take a small part of

total indirect costs (Drury 2009)

4.0 Activity-Based Cost Systems

Traditional absorption costing systems calculate production

costs and stock valuations, ensuring that all production

overheads are absorbed into the total production cost (Proctor

2009). While ABC systems provide more accurate cost for each

product, assigning costs of main activities to the product

that causes those costs, based on the consumption of resources

5

used. Thus, ABC provides enough information to managers for

understanding which activities caused the utilization of

resources (Practor 2012).

ABC system uses a two-stage approach:

Identifying the main activities that cause overheads, and

after that, they are grouped into cost polls.

Assigning costs to products, using both volume and non-

volume cost drivers rather than only on volume-based

drivers in traditional costing systems (Drury 2009). If

the company has a large proportion of overheads relating

to non-volume overhead costs it results in more accurate

product costs. But it also creates some difficulties in

term of setting appropriate measure for linking

activities with cost objects.

Traditional and Activity-Based Cost Systems (Horngren et al.

2006)

6

According to Khan and Jain (2010) organization can choose from

three types of activity cost driver: Transaction, Duration and

Intensity.

4.1 Benefits and Limitations of ABC

The main benefit of ABC is more accurate production costing

due to the following reasons:

ABC uses numerous cost pools with more relevant cost

drivers to trace overhead costs that results in assigning

costs more directly.

Tracing overheads cost directly to activities helps to

identify some indirect cost as direct that allows manager

to have more control over these activities and their

costs.

ABC provides more accurate cost data that contributes to

setting selling prices to achieve desired profitability

levels, especially in a more competitive environment.

Using the multiple cost drivers allows recognizing

complexity of manufacturing, with wider product ranges,

shorter product life-cycles and more complex production

processes (Kimmel 2010).

ABC system provides better product cost, but it has some

limitations:

The increasing cost of determining numerous activities

and applying cost drivers to pools makes ABC expensive

and complicated to operate.

7

Despite of assigning overheads directly to products,

certain overheads costs are continued to be allocated

using arbitrary volume-based cost drivers such as labor

or machine hours (Kimmel 2010).

According to recent survey commissioned by ACCA (2010),

ABC is adopted only by 20 percent of all organizations,

that proves that it is relatively new technique and many

companies is reluctant to introduce it due to

management’s lack of knowledge of its principles and

methods (ACCA 2010).

As it has been mention in ACCA (2010, 28) that recent

journal researches have found that switching to ABC is

problematic, because it often does not solve all problems

and difficultness in identifying relevant cost drivers.

Although ABC is considered useful, it is not compliant with

generally accepted accounting principles. Assignment of all

manufacturing costs to products is one of the reason why ABC

is not complaint with GAAP. Because some expenses is not

related to production such as factory security or heating, and

therefore these costs are not relevant to decision-making, but

for GAAP they are important.

ABC system is more appropriate for the organization with the

flowing characteristics:

High level of competition;

Non-volume-related overheads are in a high proportion of

total indirect costs;

8

Wide range of products, all used organizational resources

in significant difference in proportions (Drury 2009)

ABC systems are ideal for using in service companies, where

most of the costs are treated as fixed and indirect (Kaplan

and Cooker 1998). For example, banks can calculate the costs

of various activities, such as opening and closing

accountings, Visa and ATM transaction, and administration

mortgages (Drury 2009).

Thus, ABC systems provide valuable information for mangers to

identify profitable mixes, improve efficiency and satisfy

customers. However, it is not useful for pricing decisions,

especially in cases where these systems are applied to a

public service based on. ABC helps to understand, manage and

reduce cost for activities that were charged lower than the

actual costs because of fairness and community-building

reasons (Hongren et al. 1999). As a result, ABC systems trace

indirect costs to cost objects by identifying activities and

cost drivers, giving greater insight than traditional systems

into managing of these indirect costs.

5.0 Standard Costing

Standard costing provides predetermined estimates of the costs

per product or service that should take place under efficient

operating conditions (Drury 2009).

Standard costing systems are used in cost centers where “the

output can be measured and the input required to produce each

9

unit of output can be specified” (Drury 2009,277). Thus, this

system is most suitable for organizations that have the degree

of repetition in the production process so that average or

expected utilization of resources can be found. Therefore, it

can be more beneficial to apply in mass production and

repetitive nature work. However, service companies such as

banking sector also can use it, measuring the output in the

term of amount of issued cheques or loads applied (Drury

2009). Standard costing system is less suited for companies

whose operations are not based on repetitive nature, and that

produce to customer demand and requirements (ACCA).

There are two methods of setting standard cost. The first

method is based on analyzing the historical data, taking into

account expected changes in efficiency and external economic

factors. The second method is engineering study, which uses

the assessment of each work specification of product and to

cost it accordingly (Emmanuel et al. 1990).

According to KMPG (2010) many companies prefer to use

historical approach, that provide accurate measurement, but in

the volatile time it has been resulted in significant

variances due to non-controllable macro-economic factors.

5.1 Budgets Costs and Standard Costs

Budgets costs and standard costs are valuable techniques in

controlling costs for managers as they involved in estimating

cost for a future period. However, there is essential

difference between them to the extent that budget costs

10

relates to entire activity or operation, while standard

costing involves information per unit basis (Drury 2009).

Both methods are better in combination with the other. When

standard costs has been estimated, it is relatively easy to

calculate budgets for production costs and sales. Furthermore,

in determining standard costs, in is required to define the

level of production for the period and this is much easier

when budgeted level has been established. It is solidified

with the evidence that in UK and US most of the companies use

both the system for managerial planning (Vijayakumar 2010).

5.2 Benefits and Limitation of Standard Costing

Standard costs system allows company gaining many benefits

from adapting it:

Carefully estimated standards result in more accurate

budgeting.

Standard costs provide the measure against which actual

costs can be compared.

The establishment of standards involves identifying the

best materials and methods, which help in economies.

It provides a way of motivation to managers to achieve

better productivity, and to employers to reach a target

of efficiency and cost-consciousness (ACCA 2010).

CIMA (2008) highlights that standard costing system might lose

its effectiveness in current manufacturing environment.

Because JIT (Just in Time) organizations apply a climate of

11

continuous improvement, where they target on zero wastage and

increasing efficiency and the approach of normal wastage and

efficiency is not allowable under its principles.

Except this, according to CIMA (2008) standard costing has

some limitations:

It may be consuming and expensive to use, because in

today complex production it is required to produce a

broader analysis of variances.

The traditional standard costing was designed for

minimizing costs, but in today’s intensive competition,

the quality improvements and customer care must be aimed

for staying competitive.

Incorrect or outdated calculation of standard costing

will be reflected in misleading and incorrect variances.

With the rapid changing conditions in business

environment, the system will lose its attractiveness in

the term of its control and motivational effects.

Complicated variances, particularly in overheads, are

often ineffective because of difficultness in its

understanding by managers (CIMA 2008).

5.3 Purposed of Standard Costing

Standard costing systems are useful for decision making

and product costing. This is especially useful for

pricing decisions when firms are involved in extensive

bidding and which are paid on a cost-plus basis (Drury

2009).

12

Unit standards are an essential requirement for an

accurate budgeting system, which lead to better planning

and control system. Comparing actual and expected costs,

the overall variances can be found, that will provide

more information for manager. Consequently, it improves

productivity measurement and operational control (Drury

2009).

Standard costing help managers to manage cost by

introducing standards that reflects efficient operation

conditions. It also aims on understanding what is

necessary to improve, current and future performance

(Hansen and Mowen 2012).

Challenging targets of standards motivate the employees

to achieve high performance (Drury 2009), because they

know that performance below of standard targets should be

explained. Moreover, many reward systems for workers,

supervisors and managers are based on using standards.

Standards simplify the assignment of cost to products for

profit measurement and inventory valuation purposes

(Drury 2009).

5.4 Flexed Budget

Standards are used in revised flexed budget to compare

expected costs with actual levels of performance that allows

providing exception reporting of the analysis of variances

(Devies and Boczko 2005).

13

Meeting the established standards with actual performance is

very rare, and managers anticipate some random variations

within acceptable range of performance. However, when

variances are outside this range, the investigations should be

carried out for controllable cases or in the cases when

manager cannot control this factors he will need to revise the

standards. There are large number of different variances and

their causes.

5.4.1 Materials Variances

Usually direct material variances is determined by two

factors: the price of the materials and the quantity of

materials usage that helps to better understand real causes of

variances (Drury 2009). Adverse usage variances can be

attributed to different causes such as scrap, waste and

rework, and which is under production manager control, but

sometimes it is attributed to other factors that are outside

production process such as purchasing of lower-quality direct

materials. That could be the consequence of emphasizing too

much on meeting or beating the standards, when purchasing

department feels pressure to produce favorable material price

variances, buying cheaper direct material, not bothering about

its quality. Moreover, production manager can produce

favorable usage variances, allowing defective units to selling

that can help to avoid the problem of wasted materials. That

later will be contributed to dissatisfied customers (Hansen et

al. 2005).

14

5.4.2 Labour Variances

The variance in labour is usually determined by the price paid

for labour and the amount of labour used (Drury 2009).

Standard wage rate can be increased due to external factor

such as changing on the labour markets and union contract. The

variance can be the resulted from employing more skilled or

more highly paid worker. These will give rise in the price of

labour rate variances, but more skilled workers will increase

labour efficiency and decrease the rate of using direct

materials by minimizing waste and doing rework. Furthermore,

the causes of variances can be due to extra working hours used

to meeting the standards or possible rework of finished

products, because of frequent breakdowns of machinery and high

scrap of cheap materials (Hansen et al. 2005).

5.4.3 Variable Overhead Variances

Variable overhead include a large number of individual items,

such as indirect materials and labour, maintenance,

electricity and so on, therefore, the reasons of variances can

be broad and not very informative, but mainly variances are

due to changes in the price or inefficient usage of these

individual items (Drury 2009).

5.4.4 Fixed Overhead Expenditure or Spending Variances

15

Fixed overheads consist of many individual items of fixed

expenditure and difference between actual and planned

activities may be due to a variety of reasons, however they

are supposed to be the same during the short period of time

and likely can be changed due to changes in the level of

activities. But sometimes, they also can be changed in

response to other factors such as changing in the expenses on

fixed costs, for example, rent rate, or changes in salaries

paid to supervisors (Drury 009).

6.0 Conclusion

Costing systems must be applied in different ways and for

different purposed, depending on type of actions and

organizations it is required for. Thus, marginal costing

system is more appropriate for short-run profit contribution

aspect of immediate sales such as cost-volume analysis as it

does not charge fixed overheads to cost of production. While

absorption costing is more suitable for pricing at the long

run total cost recovery, but more often result in distorted

cost information. ABC gives more accurate information

comparing to absorption, but it makes it expensive, therefore,

it is more appropriate for service organization with

production overheads that are in high proportion to total

costs and where production process is complex. Finally,

standards costing systems are very useful for analysing budget

deviations in companies with repetitive operations.

16

Reference List

ACCA (2010) F5 Performance Management, UK: BPP Learning Media

Davies, T and Boczko, T (2005) Business Accounting and Finance, McGraw Hill Education

Drury, C (2009) Management Accounting for Business, 3 ed, UK: Cengage Learning

Emmanuel,C , Otley, D and Merchant K (1990) Managerial Accounting, 2 ed. London: Cengage Learning EMEA

Gupta, S, Sharma, A and Ahuja, S (2006), Cost Accounting, India: V.K. Enterprises

Hansen, D and Mowen, M (2012) Cornerstones of Cost Management. 2 ed,UK: Cengage Learning

Hansen, D, M. Mowen, M and Guan, L (2005) Cost Management: Accounting and Control: Accounting and Control, 5 ed, Stamford: CengageLearning

Horngren, C , Foster, G and Datar, S (1999) Cost Accounting: A Managerial Emphasis, 10ed. Prentice Hall

Horngren, C, Sundem, G, Stratton, W, Teall, H and Gekas, G (2006) Management Accounting, 5ed, Canada: Person Education

Khan, M & Jain, P Management Accounting. 5 ed. McGraw Hill Education

Kimmel,P, Weygandt,J and Kieso,D (2010) Financial Accounting: Tools for Business Decision Making, John Wiley & Sons

Kaplan, R and Cooper, R (1998) Cost and Effect: Using Integrated Systems to Drive Profitability and Performance, Harvard Business School Press

17

Lucey, T (2003) Management Accounting, 5 ed. London: Cengage Learning EMEA

Nigam, L and Jain, I (2001) Cost Accounting: An Introduction. PrenticeHall

Patel, B (2001) Cost Accounting for Management Decisions, New Deli: Allied Publishers Limited

Proctor, R (2009) Managerial Accounting Decision Making and Performance Management, Pearson Education

Vijayakumar, T (2010) Accounting For Management, McGraw Hill Education

CIMA (2010) Standard costing, (Online) Available at: http://www.cimaglobal.com/Documents/Thought_leadership_docs/StandardCosting2010Insightsfromcompanies.pdf (Accessed: 20 November 2013)

CIMA (2008) Standard costing, (Online) Available at: http://www.cimaglobal.com/Documents/ImportedDocuments/cid_tg_standard_costing_and_variance_analysis_mar08.pdf.pdf (Accessed:20 November 2013)

Marx, C (2009) Activity Based Costing (ABC) And Traditional Costing Systems (Online) Available at: http://financialsupport.weebly.com/activity-based-costing-abc-and-traditional-costing-systems.html (Accessed: 19 November 2013)

18

Appendix A – Marginal Costing

Choosing a good product mix regarding scarce resources

A company ABC is able to product four products and is planning

its production mix for the next period. Estimated cost, sales,

and production data are given below.

Product W X Y Z

19

£ £ £ £

32 38 68 56

Selling price £ £ £ £

Labour (@ £6/hr) 18 12 40 30

Materials (@ £1 kg) 6 24 18 30 10 52 12 42

Contribution 8 8 16 14

Resources/Unit

Labour (hours) 3 2 7 5

Materials (kg) 6 18 10 12

Maximum demand (Units) 500

0

500

0

500

0

500

0

The company has a limited labour hours what is 50,000 in a

period and it is necessary to determine the most appropriate

mix under his constrain.

The products must be ranked in order of contribution per unit

of the constraint and the most profitable product mix

established.

Accordingly, the contribution per unit of the inputs is

calculated.

Product W X Y Z

£ £ £ £

20

Contibution/unit 8.00 8.00 16.00 14.0

0

Contribution/Labour Hour 2.67 4.00 2.29 2.80

To make all the products up the demand limit would require:

(5000*3)+(5000*2)+(5000*7)+(5000*5) = 85000

Labour hours, but as there is a limit of 50,000 hrs. in a

period, the products should be manufactured in order to

attractiveness related to labour hours which is X, Y, W and

finally Y.

Product 5000 units X using 10000 labour hours

5000 units Z using 25000 labour hours

5000 units W using 15000 labour hours

and no units of Y which uses the total of 50000 hours

available.

The above process of maximising contribution per unit of the

limiting factor can only be used where there is a single

biding constraint

In the case of various constrains linear programming will

indicate the optimum solution.

In general where no constraint is identified, a reasonable

decision rule is to choose the alternative which maximises

contribution per £ of sales value.

21

Appendix B – Absorption Costing System

Brocken Limited produces three different vacuum cleaners. These are coded BR1, BR2 and BR3. The

following budget data has been obtained for the year ended 30 June

Budgeted production overheads for the year are:

BR1 BR2 BR3

Direct materials cost per unit

£25 £20 £18

Direct labour hours per unit

3 4 2

Direct wages per unit

£24.60 £32.80 £16.40

Machine hours per unit

2 4 3

Production quantity

40,000 25,000 10,000

Number of production batches

5 10 25

Number of 15 25 120

22

component orders

Number of salesorders

15 10 25

Budgeted production overheads for the year are:

Activity £

Inspection 170,000

Machining costs 930,000

Material handling 330,000

Packing 195,000

Set up costs 183,000

Total 1,808,000

The company absorbs production overhead costs to products by using arate per machine hour for

machine costs and a rate per direct labour hour for the remaining overheads.

W1. Calculation of overhead absorption rate per machine hour

Product Machine hours per unit

Production quantity

Machine hours required

BR1 2 40,000 80,000

BR2 3 25,000 100,000

BR3 4 10,000 30,000

Total n.a. n.a. 210,000

Machining costs = £930,000

absorption rate = £930,000 /210,000 machine hours = £4.429 permachine hour

W2. Calculation of overhead absorption rate per direct labour hour

Product Machine hours Production Machine hours

23

per unit quantity required

BR1 3 40,000 120,000

BR2 4 25,000 100,000

BR3 2 10,000 20,000

Total n.a. n.a. 240,000

Total overheads, excluding machining costs = £1,808,000 -£930,000 = £878,000

absorption rate = £878,000 /240,000 labour hours =£3.658 per labour hour

Unit costs (absorption cost basis): BR1 BR2 BR3

£ £ £

Direct materials (given) 25.00 20.00 18.00

Direct wages (given) 24.60 32.80 16.40

Machining costs (machine hours ×absorption rate)

8.89 17.72 13.29

Other overheads (direct labour hours×absorption rate)

10.97 14.63 7.32

Total 69.46 85.15 55.01

Appendix C - ABC Systems

AIRCO Ltd of Johannesburg and Cape Town, South Africa, is a

manufacturer of industrial air conditioning units. The units

range in size and power from 5 to 20 tons. Each unit has more

24

than 200 parts, including holding tanks, electronic

controllers, metal sheets, cooling coils, wires, and

insulation material. Almost 90 percent of manufacturing

workers are hourly workers, and the company operates two

shifts. The organization of the manufacturing process is

conventional, with separate departments for purchasing,

engineering, job scheduling, materials handling, shipping,

accounting, and human resources. AIRCO developed an ABC system

to assist in the analysis of product profitability. Its first

step was to identify the resource cost pools that make up

total overhead of $4,458,610 at the plant. The resource costs

are from the firm’s accounting system, which collects

resources costs in these 11 categories.

Overhead Resource CostIndirect labor $2,786,

900Computer and

software

$731,40

5Product

transportation

$319,80

0Energy $170,60

0Facility and

vehicle rent

$165,87

0Business and

training travel

$66,000

Miscellaneous $65,480Maintenance $60,000Depreciation $48,200Advertising $40,000

25

Office and

utilities

$4,355

$4,458,

610

The next step is to identify production activities and to use

resource consumption cost drivers to assign the resource costs

to the activity cost pools.

(1) (2) (3) (4) (5)

=(2)/(4)Activity Cost Pool

BudgetedActivity Cost

Activity Cost Driver

BudgetedActivity

Activity-BasedApplication Rate

Machines $ 435,425 Number of

machine-hours

73,872 $ 5.89 per

hourData record

maintenance

132,596 Number of

products lines

14 9,471 per

lineMaterials

handling

1,560,027 Number of

products

16.872 92.46 per

product

Production

changeover

(setup)

723,337 Setup time

(hours)

72 10,046 per

hour

Scheduling and

production

Preparation

24,876 Number of

production runs

2.788 8.92 per run

Materials

receiving and

Handling

877,106 Number of

receipts

2,859 307 per

receipt

Product shipment 561,013 Distance (miles) 13,784,01 .041 per mile

26

5

Customer service 144,230 Number of

customer contacts

2,533 56.94 per

contact

Total $4,458,61

0

Overhead Allocation and Product Profitability under ABC

Costing

5-ton 6-ton 7.5-

ton

10-ton 12.5-

ton

15-ton 20-ton

Direct labor $

342.20

$

342.20

$

342.20

$

410.64

$

410.64

$

410.64

$

410.64Direct

material

665.00 665.00 665.00 1,957.

00

1,957.0

0

2,510.

00

2,510.

00

Overhead

(ABC-based)

174.63 404.27 160.26 172.62 1,029.5

2

343.95 309.90

Total

manufacturing

Cost

$

1,181.8

3

$1,411.

47

$1,167

.46

$2,540

.26

$

3,397.1

6

$3,264

.59

$3,230

.54

Selling price 1,000.0

0

1,300.0

0

1,750.

00

2,560.

00

3,200.0

0

4,572.

00

5,450.

00

Product

margin

$

(181.83

)

$

(111.47

)

$

582.54

$

19.74

$

(197.16

)

$1,307

.41

$2,219

.46

27

Appendix D – Standard Costing

Schmidt ltd. Produces machines that uses two types of

materials, Aluminum and PVC, and require 5 grade of direct

labour. The company additionally incurs some variable and

fixed production overheads, which are absorbed into the unit

cost of the product. The standard cost for a machine (one

unit) of the product may be represented as follows, where

overheads have been absorbed on the basis of direct labour

hours.

Direct Material £

Aluminum 4 pounds at £25 100

PVC 1 pound at £40 40

Diract Labour

5 Hours at £40 200

Variable factory Overhead

5 Hours at £12 60

Fixed Production Overhead

5 hours at £24 per hour 120

Total production cost 520

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Schmidt ltd. planned to produce 1000 machines during October 2010. The Budget for September was prepared using the standards costs. Fixed overheads are budgeted 150,000 for October and are

Budget costs for October

1,000 units

Production

Direct Material £

Aluminum 4 pounds at £25 100,000

PVC 1 pound at £40 40,000

Diract Labour £5000 Hours at £40 200,000

Variable factory Overhead £

5000 Hours at £12 60,000

Fixed Production Overhead £

5000 hours at £24 per hour 120,000

Total production cost 520,000

1,000 machines were planned to produced in the month at a manufacturing costs of 520,000

At the end of October the actual output turned out to be 780 machines as follows:

Direct materials

Aluminum 3630 pounds at £26 per pound 94,380

PVC 720 pounds at £41 per pound

29,520

Direct Labor 3510 hours at £42 per hour

147,420

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Variable factory overhead 3510 hours at £11,58 per

hour 40,630

Fixed production overheads 3510 hours at £28.5 per

hour 100,000

Total production cost 411,950

780 machines actually produced in the month at a manufacturing

cost of 411,950

Flexible Budget

Direct Materials

Aluminum 3,120 pounds at £25 per pound

78,000

PVC 780 pounds at £40 per pound

31,200

Direct Labour 3,900 hours at £40 per hour

156,000

Variable factory overhead 3,900 hours at £12 per hour

46,800

Fixed production overheads 3,900 hours at £24 per hour

93,600

Total production cost 420,300

If 780 machines had been planned to be produced in the month

the standard manufacturing costing would have been 420,300

To determine how good Schmidt ltd. Performance was for October

it is necessary to provide an analysis of variances to explain

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the adverse total cost variance of 8,350 against budget

(420,300-411,950)

Budget Flexed Actual Difference

Actual-Flexed

units 1,000 780 780

Direct Materials

Aluminum 25*4,000 100,000 25*3,120 78,000 26*3,630 94,380 16,380 A

PVC 40*1,000 40,000 40*7,80 31,200 41*720 29,520 1,680 F

140,000 109,200 123,900 14,700 A

Direct Labour

5,000*40 200,000 3,900*40 156,000 3,510*41 147,420 8,580 F

Variableproduction overhead

5,000*12 60,000 3,900*12 46,800 3,510*11,58

40,630 6,170 F

Fixed 5,000*24 120,000 3900*24 93,600 3,510*28,5

100,000 6,400 A

Total cost

520,000 405,600 411,950

Flexed budget has been prepared, which in effect gives a new

starting point against which to compare actual performance

more realistically. We have therefore already built in a

variance, arising out of the change in volume from 1000 to 780

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machines. At a unit cost 520 the total of this difference, or

variance, is and favorable volume of 114,400 (220*520) or

520,000-405,600.

Volume:Variance 1,000 machines less 780 at a total unit cost of 520 per

machine 114,400 F

We also need to consider the individual cost element variances,

between actual cost

411,950 and the flexed budget costs 405,600.

Materials:

Aluminum usage was 510 pounds more that it should have been at a

standard cost of

£25 per pound 13,700 A

The aluminum price was £1 more per kilo than standard for the 3630

pounds used 3,630 A

PVC usage was 60 pounds less than it should have been at a standard

cost of

£40 per kilo 2,400 F

The PVC price was £1 more per pound than standard for the 720 pounds

used 720 A

Total materials variance actual versus flexed budget

15,650 A

Direct Labor:

Hours worked were 390 hours less than they should have been at

a standard rate

of 40 per hour 14,600

F

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The labor rate was 1 more per our than standard for the 3510

hours worked 3,510 A

The direct labor variance actual versus flexed budget

11,090 F

Variable production overhead:

Hours worked were 390 hours less than they should have been

at a standard rate

of 12 per hour 4,680 F

The overhead rate was 42p less per hour than standard for the

3510 hours worked 1,465 F

Total variable production overhead variance actual versus flexed budget 6,145 F

Fixed production overhead:

Hours worked were 390 hours less than should have been at a standard

rate

of 24 per hour 8,360 F

The overhead rate was 4,5 more per hour than standard for the 3510

hours worked 16,295 A

Total fixed production overhead variance actual versus flexed budget

7,935 A

Total variances [114400F+15650A+11,090F+6,145F+7,935A]

108,050 F

Budget total costs 520,000

Actual total costs 411,950

Total variance (favorable) 108,050 F

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