09-10-2021

Costing Systems and Method

Absorption Costing

Case: Classic Pen Company

Dr. Keyur Thaker

Professor - Finance and Accounting Area
Indian Institute of Management Indore

Absorption Costing - Overview

1. Overview of Absorption costing and Variable Costing
2. Review how costs for Manufacturing are transferred to the product
3. Job Order Vs. Process Costing
4. Overhead Application
- Under applied Overhead
- Over applied overhead
5. Problems with Absorption Costing
6. Concluding Comments

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Absorption Costing
How to allocate manufacturing costs to the product ?
- Direct Materials
- Direct Labour
- Overhead
Absorption Costing is a process of tracing the variable costs of production
and the fixed costs of production to the product.

Variable Costing traces only the variable costs of production to the product
and the fixed costs of production are treated as period expenses.

Absorption Costing
There are three different types of Absorption Costing Systems:
- Job Order Costing
- Process Costing
- ABC Costing
In Job Order Costing costs are assigned to the product in Batches or lots.
- Printing
- Furniture manufacturing
- Bicycle Manufacturing
In Process Costing, costs are systematically assigned to the product,
since there are no discreet batches to assign costs.
- Oil Distilling
- Soda Manufacturing
ABC Costing assigns cost from cost centers to the product
- Best in a multi product firm, where there are different volumes.

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Job Costing & Process Costing System

 Job Costing System: In this system cost object

is a job. It may be unit or multiple units of distinct
product or service.
 E.g. Construction project, Missile, Repair job, adv campaign

 Process Costing System: Cost object is

masses of identical or similar units of product or
service
 E.g.Bank offering same service to all customer, Intel offering same
chip to multiple pc’s, Frozen orange juice by Priya,refining

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Two systems as opposite ends of Continuum

Process
Job Costing
Costing
System
System

Masses of
Distinct units Identical or
of a product Similar units
or service of Product or
Service

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General Approach to Job Costing

1. Identify the job that is the chosen cost
object
2. Identify the direct costs of the job
3. Select the cost allocation basis for
allocating Indirect cost to the Job
4. Identify indirect cost allocated with each
cost allocation bases

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General Approach to Job Costing

5. Compute the rate per unit of each cost
allocation base used to allocate indirect
costs to the job
6. Compute the indirect costs allocated to the
job
7. Compute the total cost of the job by
adding all direct and indirect cost assigned
to the job.

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J
INDIRECT
All Mfg O/H Cost O
COST POOL B

INDIRECT COST
C
ALLOCATION BASE Direct Mfg O
Labor Hrs S
T
I
Per unit Direct N
mfg labor hrs G

COST OBJECT:
Mfg o/h cost O
SPLZ MACHINE V
Direct Cost E
R
V
I
DIRECT COST Direct Direct E
W
Material Mfg Labor
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Need for Refining Costing System

 Increase in Product Diversity
 Increase in Indirect cost
 Advances of Information technology
 Competition in Product Markets
 Cost Cutting

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Guidelines for Refining

Costing System
 Direct Cost Tracing: Classify as many of the total
costs as direct cost s of cost object as economically
feasible
 Indirect Cost Pools: Expand number of indirect cost
pools until each of these pools is more homogeneous. I.e..
Same cause-effect relationship.
 Cost allocation Basis: Use cause effect criteria when
possible to identify the cost allocation base (the cause) for
each indirect cost pool (effect).

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Activity Based Costing

 One of the best tool for refining costing

system
 ABC refines a costing system by
identifying the individual activities as the
fundamental cost objects.

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Assignment to
other cost objects

Fundamental Cost Objects

Cost of
Cost of •Products
Activities
Activities •Services
•Customers

Activity Based Costing

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Cost Hierarchies
Categorizes indirect costs into different cost
pools on the basis of the
a. different types of cost drivers or cost
allocation bases or
b. different degrees of difficulty in
determining cause and effect relationship

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Steps in Implementing ABC

1. Identify the products that are the chosen
cost objects
2. Identify the direct costs of the products
3. Select the cost allocation bases to use for
allocating indirect cost to products
4. Identify the indirect cost associated with
each cost allocation base

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Implementing ABC
5. Compute the rate per unit of each cost
allocation base used to allocate indirect
cost to the products
6. Compute the Indirect Cost allocated to the
products
7. Compute the total cost of products by
adding all direct and indirect cost assigned
to the products

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INDIRECT COST POOL Molding

Distr-
Activity Design Setup m/c Shipping
ibution
Admn
operation
Cubic Ft
INDIRECT COST Parts Setup M/c kms Dir- Mfg
ALLOCATION BASE Shipments
Sq Ft Hrs hrs Delivered Labor hrs

A
Per Per Per Per Per Per
B

COST OBJECT:
C
Indirect Cost
SPLZ MACHINE
Direct Cost

Mould
DIRECT COST Direct Direct
Clng
Material Mfg Labor
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ABC v/s Traditional System

 Fundamental focus on Activities

 ABC traces more costs as direct costs
 ABC create homogeneous cost pools linked to
different activities (No. of Cost pool may
increase)
 For each activity pool ABC seeks a cost
allocation basis (More cost drivers) that has a
cause and effect relationship with costs in cost
pool.
 More information and sophistication required
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Improving Cost Mgmt and

Profitability with ABC

 Pricing and Product Mix Decisions

 Cost Reduction and Process Improvement
Decision
 Design Decisions
 Planning and Managing Activities

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When do we need ABC?

Provide Most Benefits.
 Significant amount of indirect costs are allocated
using only one or two cost pools
 All or most indirect costs are identified as output
unit level costs (Few indirect costs are described
as batch level cost, product sustaining cost or
facility sustaining cost)

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When do we need ABC?

Provide Most Benefits cont..
 Products Make diverse demands on resource
because of difference in volume process steps,
batch size or complexity
 Products that a company is well suited to make
and sell show small profits and vice versa
 Operations staff have significant disagreements
with the account staff about the cost of mfg and
marketing products and services.

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