CHAPTER FIVE : COST ACCUMULATION – ABSORPTION COSTING

CHAPTER FIVE : COST ACCUMULATION – ABSORPTION COSTING

Some Definitions:

Ø  A cost accumulation system accumulates cost by responsibility centers and allocate those costs to cost units pass through the responsibility centre.

Ø  Overhead cost is an expenditure on labour, materials or services which cannot be economically identified with a saleable cost unit.

Ø  Marginal costing is an accounting technique which differentiates between fixed and variable costs and ascertains their effects on profits of changes in volume or production.

Ø  Absorption (full) costing is a system in which all the fixed manufacturing overheads are allocated to products. Under absorption costing, variable as well as fixed production costs are charged to stocks.

Factors Influencing the choice of cost centers within a business

Ø  The extend to which costs can be separately identified to different areas of activity.

Ø  Responsibility of individuals for separate parts of an organization

Ø  The effect on the accuracy of the charging of cost to other cost centers or to units of output.

The Problems with Overheads

The problems with overheads are in three-folds:

a)    For cost and management accountants

1.    when producing budgets and standard cost cards

2.    when trying to establish how much an individual unit of output has actually cost.

b)    When budgeting

1.    determine just how overheads vary with level of activity (many are semi-variable in nature and there is constant debate over a suitable measure of activity level)

2.    deciding whether or not to include fixed overheads in the standard cost card (whether to use absorption costing and treat fixed overheads as a product cost or use marginal costing and treat them as period cost)

    

c)    When recording actual costs

1.    when recording direct materials costs a document system can be set up to  show how much materials have been drawn from stores and what that materials cost

2.    when recording how much time production staff spent making a particular unit ( or batch of units).

Cost Allotment

Cost allotment (apportionment) is that part of cost attribution which shares cost among two or more cost centers or cost units in proportion to the estimated benefit received, using a proxy. The basis upon which the allotment is made varies from cost to cost.

The following table gives some commonly used basis for cost apportionment:

Cost	Basis of Apportionment
Rent, rates, cleaning	Floor area / Space occupied
Light , heat	Floor area / Space occupied
Power	Kilowatt hours / Capacity of machinery / Horespower
Employee related costs	Number of employees / Wages cost
Depreciation  of plant and machinery	Value of machinery / Age of machinery
Insurance of plant  and machinery	Value of machinery
Canteen costs, welfare, general administration, industrial relations	Number of employees
Store-keeping	Stores requisitions
Material handling	Weight of materials

The cost allotment (apportionment) of indirect costs to cost units involves the following sequence of procedures:

Step 1 : Collecting  production overheads costs by nature of expenses.

Step 2 : Establishing cost centers.

Step 3 : Allocating and apportioning overhead costs to cost centers.

Step 4 : Apportioning service cost centre costs to production cost centers.

Step 5 : Absorbing production cost center costs into cost units.

Overhead Absorption

To determine the overhead to be absorbed by a cost unit it is important to establish an overhead absorption rate (OAR). This is calculated by using two factors, namely; the overheads attributable to a given cost centre and the number of units of the absorption base that is deemed most suitable; thus,

OAR for cost center = Total overheads of cost center ÷ Total number of units of absorption base applicable to cost center.

Overhead can be absorbed in cost units by means of :

Ø  rate per unit

Ø  % of prime cost

Ø  % of direct wages

Ø  direct labour hour rate

Ø  machine hour rate.

Direct labour is the easiest and most common.

Worked Examples

1. Factory UTG incurs the following overhead costs:

	D
Machining Dept	2,900
Finishing Dept	4,800
Power	4,000
Rent	8,000
Canteen	4,000

The following additional information are given:

Area occupied         Machining Dept  2,500 sq. m

                                  Finishing Dept    1,000 sq. m

                                  Canteen                500 sq. m

Horsepower of machinery   Machining Dept  3.000 kh

                                               Finishing Dept    1,000 kh

Number of employees        Machining Dept    50    

                                              Finishing Dept   150

Apportion costs to the Machining and Finishing departments.

Solution

Cost Apportionment

Direct	Basis	Power (D)	Rent (D)	Canteen (D)	Machining (D)	Finishing (D)
	-	4,000	8,000	4,000	2,900	4,800
Apportionment:                         Power              Rent                 Canteen	Horsepower	(4,000)	-	-	3,000	1,000
	Area occupied	-	(8,000)	1,000	5,000	2,000
	No. of employees	-	-	(5,000)	1,250	3,750
			-	-	12,150	11,550

2. The annual overhead costs for a factory with three production developments – two machine shops and one assembly shops and two services departments – stores and maintenance departments are as follows:

	D	D
Indirect wages and supervision :
Machine shop : X	100,000
Y	99,500
Assembly	92,500
Stores	10,000
Maintenance	60,000
		362,000
Indirect materials :
Machine shop  : X	100,000
Y	100,000
Assembly	40,000
Stores	4,000
Maintenance	9,000
		253,000
Lighting and heating	50,000
Rent	100,000
Insurance of machinery	15,000
Depreciation of machinery	150,000
Insurance of buildings	25,000
Salaries of works management	85,000
		420,000
		1,035,000

The following information is also available:

	Book value of machinery (D)	Area occupied (sq meters)	No. of employees	Direct labour hours	Machine hours
Machine shop : X            Y	800,000 500,000	10,000 5,000	30 20	200,000 150,000	100,000 50,000
Assembly	100,000	15,000	30	200,000
Stores	50,000	15,000	10
Maintenance	50,000	5,000	10
	1,500,000	50,000	100	550,000	150,000

Maintenance department records indicate that the amount of time spent on the maintenance work in order departments was as follows:

Machine shop X	12,000 hours
Machine shop Y	8,000 hours
Assembly	5,000 hours
	25,000 hours

 Details of total material issues (i.e. direct  and indirect materials) to the production departments are as follows:

	D
Machine shop X	400,000
Machine shop Y	300,000
Assembly	100,000
	800,000

As the management accountant  of Success Power Ltd, you are required to allocate the items listed above to the production and service departments.

Solution

Production Departments			Service Department
Item of Expenditure	Basis of apportionment	Total (D’000)	Machine Shop X (D’000)	Machine Shop Y (D’000)		Assembly (D’000)	Stores (D’000)	Maintenance (D’000)
Indirect wage & supervision	Actual	362	100	99.50		92.50	10	60
Indirect materials	Actual	253	100	100		40	4	9
Lighting & heating	Area	50	10	5		15	15	5
Rent	Area	100	20	10		30	30	10
Insurance of machinery	Book value of machinery	15	8	5		1	0.50	0.50
Depreciation of machinery	Book value of machinery	150	80	50		10	5	5
Insurance of buildings	Area	25	5	2.50		7.50	7.50	2.50
Salaries of works management	No. of employees	80	24	16		24	8	8
	(1)	1,035	347	288		220	80	100
Reapportionment of Service department costs:
Stores	Value of material issued	-	40	30		10	(80)	-
Maintenance	Technical estimate	-	48	32		20	-	(100)
	(2)	1,035	435	350		250	-	-
Machine hours & direct labour hour			100,000	50,000		200,000
Machine hour overhead rate			D4.35*	D7.00**
Direct labour hour overhead rate						D1.25***

Workings:

* Machine shop X = D435,000 ÷ 100,000 machine hours = D4.35 per machine hr

**Machine shop Y = D350,000 ÷ 50,000 machine hours = D7.00 per machine hr

*** Assembly Dept = D250,000 ÷ 200,000 Direct Labour hours = D1.25 per direct labour hr

Under and Over Absorption of Overheads

Under (over) absorption of overheads occurs when the overhead absorbed differs from the actual amount incurred. The balancing figure on the production overhead account is referred to as over or under absorption of overheads.

(a) When the amount of overhead absorbed is less than the actual amount incurred, we have an under-absorption. Consider the following cases:

	Case A  (D)	Case B (D)
Overhead absorbed	720	390
Overhead incurred	850	750
Under-absorbed overhead	130	360

(b) When the amount of overhead absorbed is greater than the actual amount incurred, we have an over-absorption. Examples:

	Case A  (D)	Case B (D)
Overhead absorbed	1,560	1,080
Overhead incurred	1,140	980
Under-absorbed overhead	420	100

Under and over absorption of overheads occur when:

(a) the amount of overhead expenditure incurred differs from the amount budgeted; and

(b) the actual production volume differs from the budgeted production.

Treatment of Under and Over Absorbed Overheads

The amount of under absorbed overheads should be added to total costs before the profit is calculated and conversely the amount of over absorbed overheads should be subtracted from total cost.

Worked Example Three

(a) Give three reasons why over or under absorption of overheads may arise.

(b) Calculate the amount of over / under absorption of overhead (if any) given:

Cost Centre 123 for Period XYZ
	Budgeted	Actual
Direct labour hours	5,600	5,925
Direct wages	D19,040	D20,450
Machine hours	3,300	3,418
Direct materials	D26,200	D28,213
Units produced	81,000	85,296
Overheads	D57,500	D61,257

It is considered that overhead absorption based on labour hours is the most appropriate basis for Cost Centre 123.

Solution

(a) - Overheads not as budgeted

     - Activity level not as budgeted

     - Changes in labour or machine efficiency.

(b) Based on labour hours

OAR = D57,500 ÷ 5,600 = D10.27 per labour hour

Therefore overheads absorbed by production = 5,925 x D10.27 = D60,850

Therefore under absorbed (recovery) = D61,257 – D60,850 = D407

PRACTCE QUESTIONS

1.         The following information relates to Stemar Ltd – a manufacturing company:

                                                                                             GMD000

            Business rates and building insurance                            2,800

            Repairs and maintenance of machines                              800

            Depreciation of machines                                                  800

            Power consumption                                                           500

            Heating and lighting                                                         300

            Production manager’s salary and expenses                       130

            Supervisors’ salaries          Department A                           80                                                                                         Department B   110

                                                      Department C                           90

            Other data/information is as follows:

            Value of machines (GMD000) – A = 1,000, B = 500 and C = 500

            Floor area (sq. m) – A = 14,000, B = 7,000 and C = 7,000                                                                        

            Direct hours to be worked – A = 115,000, B = 75,000 and C = 60,000                                                    

            Number of direct employees – A = 60, B = 40 and C = 30                                                                        

            The production manager’s costs are to be apportioned in proportion to the number of direct employees.

            Power consumption is to be apportioned 50% to A, 30% to B and 20% to C.

            The direct hourly wage rates per hour are:

                   A      GMD9.00

                   B       GMD10.00

                   C       GMD11.00

            REQUIRED

a) Prepare an overhead analysis sheet. [8]

b) Calculate the direct hourly overhead absorption rates for each of the three

departments/cost centres, rounding to 2 decimal places where relevant. [3]

c) Prepare a price quotation for a job which requires 5 hours in Department A, 7 hours in

B and 5 hours in C.                                                                                                                                                 

The direct material cost is estimated at GMD890, and 50% is to be added to the production costs to cover administration and selling overheads and profit. [4]

2. The following information relates to The Fabulous Gardens Ltd, a local visitor attraction. It has three cost centres (shop, café and garden):

                                                                                             GMD000

            Departmental wages                            shop                         10

                                                                          café                         25

                                                                     garden                       240

            Business rates                                                                       80

            Management salaries                                                          120

            Insurance costs                                                                     60

            Depreciation of equipment                                                180

            Marketing                                                                                                                                                 80

            Repairs and maintenance                                                   120

            The budgeted cost of sales for the shop amounts to           40

            The budgeted cost of sales for the café amounts to            50

            The budgeted sales for the shop amounts to                     110

            The budgeted sales for the café amounts to                      190

            Other data/information is as follows:

            Value of equipment (GMD000): shop = 5, café = 15 and garden = 80.

            Based on previous data and market research the total number of customers who will visit the garden next year will be 160,000, paying, on average, GMD8 each.

            Based on analytical studies, overheads (other than depreciation of equipment) are to be apportioned on the following basis:

            Business rates, management salaries and insurance costs – 5% shop, 15% café, 80% garden

            Marketing – 5% shop, 10% café, 85% garden

            Repairs and maintenance – 10% shop, 20% café, 70% garden

           

            REQUIRED

a) Prepare an analysed budgeted profit and loss statement. Ensure that your answer shows

the gross profit for both the shop and the café and the net profit of all three cost centres.

 Also ensure that you have a total column which shows the total budgeted net profit. [12]

b) Explain the importance of the overhead absorption process. [8]

3. Lagrad Ltd manufactures four types of camera which all use “yugaras”, a component

made only in one factory. Each “yugara” costs GMD50 to purchase. Due to a

prolonged strike of workers in the “yugara” factory, Lagrad Ltd will only be able to

purchase 20,000 this year.

The following information relates to each type of camera manufactured by Lagrad Ltd.

	Digital Cameras	Cine Cameras	Closed circuit television cameras	Medical Cameras
Maximum demand (units)	10,000	4,000	3,000	500
Costs per camera	GMD	GMD	GMD	GMD
Yugaras	50	100	200	350
Other direct materials	40	90	98	300
Direct labour	20	30	30	55
Fixed costs	60	80	40	70
Profit per camera	50	70	52	490
Selling price per camera	220	370	420	1,265

REQUIRED:

(a) Calculate the numbers of each type of camera to be produced and sold that would

maximise the profit of Lagrad Ltd.      (21)

                                                                                                                                                                                

(b) Prepare a marginal cost statement showing the profit for the year.  (9)                                                                          

(c) Calculate the total annual sales revenue required by Lagrad Ltd to break-even this

year.       (6)

(d)   Outline two disadvantages that might be encountered if the planned production

pattern was adopted.                  (4)

4. You are Cost Accountant for Jerico Ltd, which makes 3 cleaning products – Kitchen

cleaner, Floor cleaner and Bathroom Cleaner. These all use the same manufacturing

process but require different grades of raw material.

The following estimates are for the 6 months ended 30 November 2009:

	Kitchen	Floor	Bathroom
Sales (litres)	60,000	19,500	33,000
Cost per litre of Direct Materials	GMD1.35	GMD3.90	GMD1.50
Cost per litre of Variable Overhead	GMD0.90	GMD3.60	GMD0.50
Direct labour paid at GMD3.00 per labour
Production rate in litres per hour	4	2	3
Selling Price per litre	GMD4.00	GMD7.00	GMD5.00

Fixed costs of GMD53,000 are recovered at the rate of GMD1.50 per direct labour hour. All

production is sold during the month of production – i.e, there are no opening or closing

stocks.

(a) Calculate the number of Direct Labour Hours altogether it wll take to manufacture 6 months’ production of Floor cleaner. (2)                                                                                                                                                               

 (b) From the above figures, draw up an estimated Profit Statement for all the three products for the 6 month period ending 30 November 2009, absorbing the overheads.                                                                                            (18)

(c ) (i) Using Marginal Costing, calculate the total contribution for each product for 6 months’ production.             (6)

(ii) Calculate the contribution per direct labour hour for each product.        (3)