CHAPTER 5 METHODS OF COSTING

5.1. Job costing 5.2. Process costing 5.3. Activity based costing (ABC) 5.1. Job costing
General approach to job costing Job costing is a form of specific order costing: the attribution of costs to jobs. The main purposes of job costing are to establish the profit or loss on each job and to provide a valuation of W-I-P. The main objective is to charge all costs incurred to the particular job. In Job costing system, costs are assigned to a distinct unit, batch or a lot of a product or service. A job is a task for which resources are expended in bringing a distinct product or service to market. A batch is a form of costing which applies where a quantity of identical articles are manufactured as a batch. Job costing six steps: Step 1: identify the job that is the chosen cost object. Step 2: identify the direct costs for the job. Step 3: identify the indirect cost pools associated with the job (cost pool/a grouping of individual cost items). Step 4: select the cost-allocation base to use in absorpting each indirect-cost pool to the job. Step 5: OAR calculation to allocate indirect costs to job. Step 6: assign the costs to the cost object by adding all direct costs and all indirect costs.

Source documents: Job cost record (job cost sheet)- the key source document Materials requisition record Labour time record Computer records Example 1 A company produces small articles to order and the following data is available: Department D1 D2 D3 D4 Budgeted overheads mu 360,000 860,000 400,000 300,000 Overhead absorption base 1,500LH 2,500MH 1,800LH 1,000LH

A batch nr.25 composed by 100 articles, incurred the following costs: Materials Labour mu. 62,140 128H-D1 at 105mu/H 452H-D2 at 110mu/H 90H-D3 at 105mu/H 175H-D4 at 96mu/H Rent for a special equipment in D3 mu.10,500 The time booking in the D2 was 643MH. Required Calculate the total cost of the batch, the unit cost and the profit per article if OAR are for Selling deparment 10% and Administrative department 20% of production cost, and the selling price was mu.6,500 per article. Solution example 1

5.2. Process costing Definition Process costing (PC) applies when standardised goods are produced from a series of intrconnected operations e.g.: oil refining, food processing, paint and varnish manufacture. The common features in most PC systems are: a) Cleary defined PC centres and accumulation of all costs by the cost centre; b) The maintenance of accurate records of units produced and the cost incurred by each process; c) The averaging of the total costs of each process including partly completed units; d) The charging of the cost of the output of one process as the raw materials input cost of the following process; e) Cleary defined procedures for separating costs where the process produces two or more products or where by-products arise during production. The costs relating to a process for a period are collected and divided by the number of units produced during the period (average cost per unit). This can be done in four steps: Step 1: open a separate account for each process; Step 2: debit the process account with the direct costs incurred; Step 3: if absorption costing is being used, debit the process account with absorbed overheads; Step 4: divide total costs by the number of units produced to calculate the cost per unit, to value the output of the process which is credited to the process account. Example 2 BLL Chemicals makes many products including paint stripper. For january, the following information is available: Materials used: A B C 600kg at mu1/kg 500kg at mu2/kg 300kg at mu3/kg

Two workers operate the mixing machine and their wages are mu160 per week and they work 40 hours a week each.

Output:2,000 lts. Required Calculate the cost per liter using as absorption rate mu2 per labour hour. Solution example 2 Potential problems in PC are: I) II) III) i) Losses Work in progress (WIP) Joint products and by-products. Losses: normal and abnormal.

Normal losses (NL) are inherent in the production process; are expected from the operation of a process; cannot be eliminated; are uncontrollable and unavoidable; their costs are absorbed into completed production; are usually expressed as a percentage of the input volume (evaporation, material wastage). Abnormal losses (AL) are not expected to occur; are not included in process cost but reported separately; are controllable and avoidable (inferior material, unexpected pilferage, incorrect cutting of cloth, improper mixing of ingredients). Calculation AL = Actual loss Normal loss NL = Input *%NL Expected good output (EGO) = Input NL Cost per unit = Total production cost incurred/Expected good output If the normally lost units have a scrap value, this is used to reduce the costs of the process spread over the EGO; in this case cost per unit will be calculated: Cost per unit = (total cost expected scrap value)/EGO Example 3 Input materials 1,000kg costing mu45,000; labour cost mu90,000; overhead cost mu67,500. A normal loss equal to 10% of input was expected. Actual output 900kg.

Required Calculate the cost per kilogram of product.

Solution example 3

Example 4 Additional information for example 2: actual production 850kg, scrap value mu45/kg. Required Calculate the cost per kg of output.

Solution example 4

ii)

WIP

At the end of a period there may be some units which have been started but have not been completed, this are closing work in process units. To be able to spread costs equitable over part finished and fully complete unit, the concept of equivalent units is required. The number of equivalent units (EU) is the number of equivalent fully complete units which the partly complete units represent. For example: if the production was 3,000 complete units and 800 partly complete, and the partly complete units were deemed to be 60% complete, the total number of equivalent units will be: Total equivalent production = Completed units + Equivalent units in WIP = 3,000+ 800*60%=3,480 Cost/EU=Total cost/total EU To calculate the cost for finished products and for WIP a weighted average method is used. In this method opening WIP are added to current costs to provide an overall average cost per EU. Steps are the following:

Step 1

Establish the physical flow of total units: Op WIP+ units received=units completed+ Closing WIP

Step 2
Step 3

Calculate EU of work done for each type of input

Calculate costs to be accounted for

Step 4 Step 5 Example 5

Calculate CPEU for the period for each input cost to be apportioned Determine costs for finished units and for WIP

Process information for month ended December 31: op WIP 15,000u two-fifth complete, mu10,250 value (materials mu9,000; conversion cost mu1,250); units started during December 30,000; units completed 40,000;closing WIP 5,000u half-completed for conversion cost; materials cost added in month mu24,750; conversion cost added in month mu20,000 Required Calculate the value of finished production and closing WIP. Solution example 5

iii)

Joint products and by-products

Joint products are products obtained simultaneously in the course of processing and have significant relative sales value. A by-product is produced in conjunction with one or more main products but has a small relative sales value. Joint and by-products may be separately identified at split-off point. Costs incurred before this point are joint or pre-separation costs and must be shared between the products produced on a number of basis: Physical quantity of output Market value at split-off point Net realisable value at SOP (final sales value less any post-separation cost). Physical quantity of output

Steps:

1. Calculation of joint cost per unit of output = Joint cost/Total weight of output 2. Joint cost per product = Joint cost per unit*weight of each product.

Example 6 For a chemical company the following information is available for the month of January: joint product costs for the month mu19,000; product data is as follows: Products Sales price per kg Sales value at SOP Output in kgs Further separation cost Required Prepare a statement showing the estimated profit or loss for each product and in total, using the following methods of allocating joint costs i) ii) iii) Weight of output Sales value at SOP Net realisable value P1 mu2.50 0.50 5,000 mu10,000 P2 mu5.00 2.75 2,000 mu5,000 P3 mu10.00 4.00 3,000 mu15,000

Solution example 6

Methods to be used for by-products may be the following: a) By-product net realizable value eliminated the total cost of production; b) Total costs are deducted from total sales value of main and by-products; c) By-products treated as joint products. Example 7 During a period were produced 1,200 units of product P and 30 kgs of by-product B. Sales prices are: P: mu10/u; B: mu8/kg. Total production cost mu8,500. Distribution cost for B mu2.20/kg. What were the net production costs and the gross profit for the year? Solution example 7

5.3. Activity based costing-(:ABC) The basic premises of ABC: activities consume resources and products consume activities; activities cause costs, not products. Organization is divided in small activities used to determine overheads. An activity is an event, task, or unit of work with a specified purpose, such as: designing products, setting up machines, operating machines etc. ABC systems calculate the costs of individual activities and assign costs to cost objects by using cost drivers. Examples of cost drivers: number of purchase orders number of production set-ups number of inspections number of dispatches

Cost calculation Product cost = Direct cost + A Share of overheads related to the number of Cost drivers units Overheads allocated to a product cost =Activity cost driver rates x Number of cost driver units Activity cost driver rate =Activity cost /total number of cost driver units The steps for developing an ABC system: Step 1: Group production overheads into activities, according to how they are driven. A cost pool is an activity which consumes resources and for which overhead costs are identified and allocated. For each cost pool, there should be a cost driver. The term activity, and cost pool are often used interchangeable. Step 2: Identify cost drivers for each activity, i.e. what causes these activity costs to be incurred.

Step 3: Determine the cost per unit of driver for each activity. The cost per unit of driver is calculated in the same way as the absorption OAR.

Step 4: Absorbed the activity costs into the product. Step 5: Calculate the full production cost and/or the profit or loss.

Advantages and disadvantages of ABC Advantages of ABC it provides a more accurate cost per unit. As a result, pricing, sales strategy, performance management and decision making should be improved. It provides much better insight into what drives overhead costs. ABC recognizes that overhead costs are not all related to production and sales volume. ABC can be applied to all overhead costs, not just production overheads. ABC can be used just as easily in service costing as in product costing. Disadvantages of ABC It is impossible to allocate all overhead costs to specific activities. The choice of both activities and cost drivers might be inappropriate. The benefit obtained from ABC might not justify the costs.

Example 8 A company manufactures two products Plus and Doubleplus. The direct costs of production are mu12/u for Plus (P) and mu24/u for Doubleplus (DP). Information relating to annual production and sales is as follows: P 24,000u 1.0 10 12 DP 24,000u 1.5 140 240

Annual production and sales Direct labour hours per unit Number of orders Number of batches

Number of setups per batch Special parts per unit

1 1

3 4

Information relating to production overhead costs is as follows: Cost driver Setup costs Number of setups Special parts handling Number of special parts Other materials handling Number of batches Order handling Number of orders Other overheads Annual cost mu73,200 60,000 63,000 19,800 216,000 432,000

Other overhead costs do not have an identifiable cost driver, and in an ABC system, these overheads would be recovered on a direct labour hours basis. Required (a) Calculate the production cost per unit of P and DP if the company uses traditional absorption costing and the overheads are recovered on a direct labour hours basis. (b) Calculate the production cost per unit of P and DP if the company uses ABC. (c) Calculate and comment the reasons for the differences in the production cost per unit between the two methods.

Solution example 8