1. 1FE105 M ANAGEMENT A CCOUNTING P RODUCT AND SERVICE COSTING Elin K. Funck

2. T ODAYS AGENDA What is Cost Accounting? How can Cost Accounting be used? Direct and indirect costs Traditional costing method (full costing/product costing) How to calculate material and labour Overhead and overhead absorption rate

3. W HAT IS C OST A CCOUNTING ? “Cost Accounting is a method to calculate positive and negative consequences of a decision.” It’s a model, a simplified picture of the reality. Reality Our model

4. H OW CAN COST ACCOUNTING BE USED ? Costing involves the gathering of cost information and its attachment to cost objects in a certain situation. Cost objects:Situations: Product Component Order Project Department Customer Market Pricing Profitability calculations Cost control Product choice (what, how, how much) Produce ourselves/ outsource

5. P RODUCT COSTING In a manufacturing environment there are three basic components of cost: Material costs Labour costs Production overheads These are often classified as: Direct costs Indirect costs Direct expenses

6. E XAMPLE : D IRECT AND INDIRECT COSTS A bus company arrange bus tours for older people. Which costs are direct and indirect for a specific tour which include entrance, coffee and food? a.) Salary to the bus driver and the guide b.) Costs for administration c.) Reparation of heater in the office d.) Fuel e.) Entrance to a guided tour f.) Advertising Direct Indirect Direct Indirect

7. F ULL COSTING MODEL /P RODUCT COSTING Type of cost -material -labour costs -heating -advertising Cost object -Product -Order -Batch Cost centres -departments -functions Direct costs Indirect costs (overheads) Apportioned costs Why do we call it full costing? Because all costs taken together add up to the total cost of running the business.

8. P RODUCT COSTING ( THE BASIC MODEL ) Direct material : material costs that directly can be assigned to the product. Direct labour : labour that directly an be assigned to the product. Direct expenses : other expenses that directly can be assigned to the product. Production overheads : all those costs of running the production facility which cannot be directly identified with units of production. Other overheads : indirect costs not incurred in the production facility.

9. P RODUCT COSTING + Direct material + Direct labour + Direct expenses = PRIME COST + Production overheads = PRODUCTION COST + Other overheads = TOTAL COST Direct costs Indirect costs

10. E XAMPLE : P RODUCT COSTING A company produces jeans and has the following total costs per month: jeans fabric1000 SEK salary to dressmakers3000 SEK tread, buttons etc 200 SEK heating in production 200 SEK electricity in production 100 SEK administration2000 SEK 1. What is the prime cost, the production cost and the total cost for the company? Prime cost = 4 200 SEK, Production cost = 4 500 SEK, Total cost = 6 500 SEK

11. E XAMPLE : T YPE OF COST What type of cost is the following costs normally? a) Joint advertising for all our products b) Royalty to the inventor of one of our products c) Invoice on reparation of a truck used in the production d) Salary to Smith at material handling e) Rent for a copying machine at the administration f) Sales commission for product Zig g) Salary to purchaser Johnson h) Heating in production i) New forms to personnel j) Participation in an exhibition where the company's entire range of products is demonstrated a)Other overheads b)Direct expense c)Production overhead d)Production overhead e)Other overheads f)Direct cost g)Production overhead h)Production overhead i)Other overheads j)Other overheads

12. O THER IMPORTANT COST CONCEPTS Period cost : costs which are incurred in a specific period of account. Example. We want to know the costs of each quarter of a year. Smiths yearly salary = 400 000 SEK jan-marapril-junejuly-sepoct-dec 100 000 SEK100 000 SEK100 000 SEK100 000 SEK Absorption costing : the same as full-costing. A costing system that allocates all manufacturing costs, including fixed manufacturing costs, to products.

13. O THER IMPORTANT COST CONCEPTS Product costing : the accumulation of costs related to the production of a large number of identical units. - Dependent of the time aspect. (year, month, quarter) - Common when we have a single product/service or products that are similar. - Common in mass production. Ex. Textile, food industry

14. O THER IMPORTANT COST CONCEPTS Job costing : the accumulation of costs related to one identifiable job or task. - Independent of the time aspect. - Common when the cost object differs in resource consumption (other material, work methods, distribution etc.) - Common in insurance companies, building companies, banking industry

15. O THER IMPORTANT COST CONCEPTS When it is not possible to classify accumulation systems to product or job costing. The goods have some common and some individual characteristics. A combination to use is then... Batch costing : accumulation of costs related to a batch of identical products. Example. Footwear or furniture. A batch is a variation of a single design.

16. C ALCULATION OF M ATERIAL COSTS A company buys 5000 units of material for 1 SEK each. What’s the total cost of material transferred into production? A company buys 5000 units of material for 1 SEK each. A further 5000 units are purchased 20 days later at 1,50 SEK each. At the end of the month 6000 units were issued to job Z. What’s the total cost of material transferred into production? How do we make sure the right pricing is used? 5000 x 1 SEK = 5000 total cost

17. C ALCULATION OF M ATERIAL COSTS Two alternatives: 1. First in, First out (FIFO) 2. Weighted Average cost (AVCO) Back to our example: 6000 items were issued to job Z. 5000 bought for 1 SEK and another 5000 for 1,50 SEK. Alternativ 1: 5000 items x 1 SEK + 1000 items x 1,50 SEK = 6 500 SEK. Alternativ 2: (5000 items x 1 SEK + 5000 items x 1,50 SEK) = 12 500 SEK 12 500 SEK / 10 000 units = 1,25 SEK 1,25 SEK x 6 000 units= 7 500 SEK.

18. C ALCULATION OF L ABOUR COSTS As long as a worker is involved in just one production we have no problem. BUT what if they work on a range of different cost units. How do we make sure the right cost is booked on each cost object?

19. C ALCULATION OF L ABOUR COSTS 1. Employees performs a combination of direct and indirect labour tasks. Example. Work in the production but also perform more general tasks like cleaning the machine, sweeping up, etc. Allocate time between direct and indirect 2. Variation in methods of payment. Example. Basic salary but also special payment for working overtime or unsocial hours, or fixed amount and bonus. Grade direct labour

20. C ALCULATION OF L ABOUR COSTS 3. Idle or non-productive time. Example. If a machine brakes down or the time we spend on breaks, lunches or talking to colleges. Is usually accounted for. Instead we use an hourly rate for each grade of labour.

21. E XAMPLE : C ALCULATION OF L ABOUR COSTS An employee in the production with an average salary of 50 SEK/hour has reported his monthly work hours: at assembly line product A100 hours administration 30 hours quality control product A 10 hours breaks and lunches 20 hours How much of his time is direct labour cost? Direct labour 110 hours

22. O VERHEADS Type of cost -material -labour costs -heating -advertising Cost object -Product -Order -Batch Cost centres -departments -functions Direct costs Indirect costs (overheads) Apportioned costs

23. O VERHEADS Detailed steps in allocating costs to cost objects: 1. Decide upon direct costs 2. Allocate indirect costs to cost centres 3. Decide how indirect costs should be apportioned

24. H OW TO CALCULATE OVERHEAD ABSORPTION RATE Four possible approaches: 1. Rate per machine hour 2. Rate per labour hour 3. Rate per unit of production 4. Percentage of direct labour 5. Percentage of direct material The most important thing to remember is that overheads absorption should be based on what drives the costs.

25. H OW TO CALCULATE OVERHEAD ABSORPTION RATE 1. Rate per machine hour : If manufacturing is machine intensive this approach is usually most appropriate. Example. Car industry. Example. Overhead cost is 56 000 SEK and machine hour per year is 16 000 hours overhead absorption rate = 56 000 / 16 000 = 3,50 SEK per machine hour

26. H OW TO CALCULATE OVERHEAD ABSORPTION RATE 2. Rate per labour hour: If manufacturing is labour intensive this approach is usually most appropriate. Example. Textile industry Example. Overhead cost is 48 000 SEK and direct labour hour is 24 000 hours overhead absorption rate = 48 000 / 24 000 = 2 SEK per labour hour

27. H OW TO CALCULATE OVERHEAD ABSORPTION RATE 3. Rate per unit of production: Sometimes a good approach is to calculate per unit. Example. Quality control activity Example. Overhead cost is 32 000 SEK and estimated units of production is 16 000 units overhead absorption rate = 32 000 / 16 000 = 2 SEK per unit

28. H OW TO CALCULATE OVERHEAD ABSORPTION RATE 4. Percentage of direct labour: When we may assume that direct labour drives the cost. Example. Personnel activities Example. Overhead cost is 30 000 SEK and direct labour cost is 120 000 SEK overhead absorption rate = 30 000 / 120 000 = 0,25 or 25% 5. Percentage of direct material: When we assume that direct material drives the cost. Example. Material handling

29. O VERHEADS Detailed steps in allocating costs to cost objects: 1. Decide upon direct costs 2. Allocate indirect costs to cost centres 3. Decide how indirect costs should be apportioned 4. Calculate overhead absorption rate 5. Apportion overhead costs to cost object 6. Calculate total cost

30. E XAMPLE P RODUCT COSTING A company produces two products X and Y. They have the following direct costs: XY Direct material SEK/unit128 Direct labour SEK/unit2228 Summary3436 The company produces 10 000 X and 12 000 Y per year. Indirect costs per year is: Production overheads216 200 SEK(overhead rate 26 %) Other overheads118 584 SEK(overhead rate 12 %) a) Calculate the total cost per unit for X and Y. b) What will the total cost for the company be if X is reduced to 8 000 units/year and Y is increased to 14 000 units/years?