Chapter 7 Understand the alternatives in conventional costing systems

Not one costing system, but many! §Major sources of variation in conventional costing systems stem from l the way costs are measured l the focus of the costing system l the method used to allocate manufacturing overhead to products l the costs included in product (or service) costs

Measuring costs §Actual costing l actual costs are assigned to products §Normal costing l actual direct material and labour, and predetermined overhead rate §Standard costing l budgeted cost of direct material and direct labour, and predetermined overhead rate

The focus of the costing system §Job costing l costs are assigned to individual jobs §Process costing l cost are traced to processes/departments and averaged across units produced §Hybrid costing l combinations of two or more costing systems

Allocating manufacturing overhead to products §The number of overhead rates l plantwide manufacturing overhead rate l departmental overhead rates §The measure of cost driver volume l budget volume l normal volume l theoretical capacity l practical capacity

Selecting which costs to include §External reporting purposes l product costs must include a share of fixed manufacturing overhead costs, and no non- manufacturing costs §Management decision-making purposes l product costs may exclude fixed manufacturing overhead (variable costing), and/or l include non-manufacturing costs

The framework for responsibility accounting §Most costing systems help managers control costs by tracking costs to responsibility centres or departments, as well as products §This can encourage departmental managers to control costs

Costing systems in service versus manufacturing organisations §Job costing is more common in service firms because of the heterogeneous nature of services §Process costing can be used in service organisations where services are repetitive §Primary use of costing in a service firm is to cost responsibility centres, not services

Variable costing and absorption costing §Absorption costing - all manufacturing costs are assigned to products l direct materials, direct labour, variable and fixed manufacturing overhead §Variable costing - only variable manufacturing costs assigned to products l direct materials, direct labour and variable manufacturing overhead

Calculating profit under variable costing §Contribution (or contribution margin) statement - highlights the variable and fixed costs of the business §Total contribution margin - total sales revenue less total variable cost §Variable cost of goods sold - total of direct materials, direct labour and variable overhead assigned to units sold

Calculating profit under absorption costing §Profit statement separates manufacturing from non-manufacturing costs §Use of gross margin §Consistent with external reporting requirements

Reconciling profit under variable and absorption costing §When inventory increases or decreases during the period l difference in fixed overhead expensed under absorption and variable costing, equals the change in inventory multiplied by predetermined overhead rate per unit l Over the long term, differences in profits between the two methods will diminish

Variable or absorption costing? §Valuing inventory l only absorption costing is allowed for external reporting purposes §Providing relevant cost information l variable costing - useful for short-term decisions l absorption costing - for longer term decisions Cont.

Variable or absorption costing? §Profit information from variable costing l classification of fixed and variable costs simplifies prediction of the effects of changes in sales on profit l link between sales performance and profit performance is easily understandable l highlights the impact of fixed costs on profits by isolating them Cont.

Variable or absorption costing? §Profit information from absorption costing l no direct relationship between sales and profit so l provides a poor basis for planning and control may encourage managers to increase inventories to drive profits up l meets the requirements for external reporting

Problems with conventional product costing systems §General features l direct material and direct labour costs are traced to products l manufacturing overhead costs are allocated to products using a predetermined overhead rate l the manufacturing overhead rate is calculated using some measure of production volume l non-manufacturing costs are not assigned to products Cont.

Problems with conventional product costing systems §Failure to adapt to the changing business environment l increasing levels of non-volume-driven manufacturing overhead costs l substantial non-manufacturing costs l changing cost structures l changing product structures

Indicators of problems with conventional product costing §Direct labour costs decrease §Manufacturing overhead costs increase §The amount of manufacturing overhead costs, not related directly to production volume, increases §Non-manufacturing costs which are product- related become substantial; and product diversity increases

Problems with costing in service businesses §Service firms tend to use firm-wide volume- based overhead rates l overhead costs are increasing in importance and are increasingly non-volume driven §Customers are demanding more diverse and higher quality services l increases in product diversity and in overhead costs

Exhibit 7.1

Exhibit 7.2

Exhibit 7.3

Exhibit 7.5