1. Absorption Costing and Activity Based Costing
Week 7

2. Methods of Costing The cost of a unit of production = variable costs
Direct Materials
Direct Labour
(Labour specifically related to the unit)
Other Direct Costs
Eg patents, royalties
Fixed costs (overheads) are covered by contribution to profit
Thereafter each unit made and sold contributes “pure” profit of
Selling price – variable cost

3. Full or Absorption costing
Treats overheads as resources consumed during manufacture
Each unit consists of
Direct resources consumed (direct costs)
Proportion of Overheads
Distinction between
Production related overheads
Non-production related overheads

4. Allocation of overhead costs
Two stage process
Relate overheads to production departments
Allocation
Directly ascribing a cost or class of costs to a distinct department
Eg Assembly department supervisor’s salary
Is Allocable overhead of Assembly department

5. Apportionment
Where costs or class of costs cannot be directly linked to distinct department
Need to devise method of apportioning the cost to all relevant departments
Apportionment base must be
Related to type of cost
Equitable
Eg costs of rent
Apportionment base could be Floor area
Therefore department with greatest use of space is attributed with greatest proportion of rent costs

6. Methodology Establish production and non-production departments
Allocate costs
Establish apportionment bases for other overheads
Apportion costs
Gives TOTAL overhead costs for each department
ABSORB costs into units of production by appropriate base
Eg labour hours/machine hours
Full product unit cost =
Direct costs + Absorbed overhead cost

7. Benefits The benefits of full costing are that:
All the costs are included
Duplication of costs can be avoided
Decisions are made with an awareness of all costs

8. Potential Disbenefits
Absorption costing is often crude
Particularly if the proportion of indirect costs in the institution is high in relation to direct costs
The method is simple to administer and easy to understand
May be appropriate when direct costs are of most significance

9. Worked Example Marmoset Ltd 1. Allocate costs to departments
2. Apportion costs on appropriate bases
Rent – Floor Area
Light & Heat – Power Usage
Depreciation – Machine Value
Insurance – Floor Area

10. Worked Example Apportionment of Rent Total Floor Area = 2,600
Floor Area of Machining = 1,000
Apportionment =
1,000 / 2,600 X Overhead (600,000) =
230,769, etc….

11. Worked Example Phase 2 Full costs of both Production and
Non-Production service departments
Have been established
Re-apportionment Service Costs to Production Departments
The FULL OVERHEAD COST of production depts now known

12. Worked Example Phase 2
There needs to be a link between the costs of the production depts and the product
Use Labour Hours (that’s all we’ve got)
Calculate Labour Hours for each dept.
Machining =
50,000 X ,000 X 2 = 100,000 hours
Assembly =
50,000 X ,000 X 2 = 125,000 hours

13. Worked Example Phase 2 Calculate OVERHEAD ABSORPTION rate Machining =
Total Overhead / Total labour hours =
967,714 / 100,000 = £9.68 per labour hour
Assembly =
722,286 / 125,000 = £5.78 per labour hour

14. Worked Example Phase 3 For each unit of Gibbon or Baboon made
Absorb proportion of overheads into it in proportion to the number of labour hours worked on it in each department

15. Unit Costs Cost Card Gibbon Baboon Raw materials 18.00 £15.00
Labour - M
£5.80
£11.60
Labour - A
£9.75
£13.00
Overhead M
£9.68
£19.36
Overhead A
£8.67
£11.56
Total
£51.90
£70.52

16. Activity Based Costing (ABC)
Cost objects consume activities
Activities consume resources
The consumption of resources is what DRIVES costs
If you can understand the relationship you can control the costs

17. The steps to ABC Identify activities Determine costs for each activity
Determine cost drivers
Collect activity data
Calculate product cost

18. Activity Based Costing Worked Example
Osprey Ltd

19. Disadvantages of ABC Needs a lot of work to establish “cost “drivers”
Expensive and time consuming
What if cost drivers are wrong?
How to deal with (say) Rent?
What if product mix changes?