MT 5043

COSTING AND MANAGEMENT ACCOUNTING

11. Terms in Costing

SAMUDITHA GANEPOLA
LECTURER (PROBATIONARY)
DEPARTMENT OF MARITIME TRANSPORTATION MANAGEMENT AND LOGISTICS
OCEAN UNIVERSITY
Learning Objectives
At the end of the session, students should be able to

● Explain the terms,

Joint Product Costing, By Product Costing, Marginal Costing, Absorption Costing, Service Costing and Activity
Based Costing

● Explain the difference between Marginal Costing and Absorption Costing

● Explain the concept, Activity Based Costing

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Session Outline
1. Joint Product Costing
2. By Product Costing
3. Service Costing
4. Marginal Costing vs. Absorption Costing
5. Activity Based Costing

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1. Joint Product Costing

▪ What is a Joint Product?

Two or more products that are produced from a common input
Eg: number of products are extracted from Crude oil including gasoline, lubricants,
chemicals

▪ The Split Off Point

▪ Joint Cost

Once the split off point is reached joint costs have already been incurred & can not be
avoided.

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1. Joint Product Costing

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1. Joint Product Costing

▪ Production cost

Up to Split off point : Joint costs - need to allocate to final product on a basis

After Split off point : Not Joint costs - can assign to a specific product

Allocating of Joint costs to products is done based on

✓ Sales Value
✓ Gross Margin

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 2. By Product Costing

What is a By Product?
………………………………………………………………………………………………………………………………………………

Eg: ………………………………………………………………………………………..

Methods of costing for By Products

1. Non cost / Sales value method
2. Cost methods

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 2. By Product Costing

1. Non cost / Sales value method

- Joint production cost is not allocated
3 methods to recognize sales value of By Product
Methods Debit Entry Credit Entry Inventory valuation

Recognize as Other Income Cash/ Bank/ Other Income Estimated value

Receivable
Add to the sales value from Cash/ Bank/ Sales Income At Nil
main product Receivable
Deduct from total cost Cash/ Bank/ Cost of Production At total production cost /
Receivable / Cost of Sales cost of sales

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 2. By Product Costing

2. Cost method

Methods used are

2.1. The Replacement Cost Method
2.2. Reversal Cost Method

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 2. By Product Costing

Cost method
2.1. The Replacement Cost Method
✓ This method is applied when By Products are used within the same production process as raw materials.
Then it avoids the need of purchasing material from outside.
Dr. The section / department which uses the By Product
Cr. Production cost of the main product (reduce the cost of production because of using By products as
raw materials)
✓ The cost assigned to the By Product is the purchase / replacement cost existing in the market.

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 2. By Product Costing

Cost method
2.2. Reversal Cost method
Cost of a By product is related to its sales value.
✓ Recognizes cost prior to its split off from the main product
✓ Manufacturing cost of main product is reduced by the estimated cost of By product.
Dr. By product A/C
Cr. Production cost of main product
✓ Additional cost charged on By product after the split off point are directly recorded in the By Product A/C
Dr. By Product A/C
Cr. Cash/ Bank/ Payable

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 2. By Product Costing

Cost method
2.2. Reversal Cost method contd…
Cost of a By product is related to its sales value.

✓ Sales value of By product is recorded in the By Product A/C

Dr. Cash / bank / Receivable
Cr. By Product A/C

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 3. Service Costing

➢ Service sector in the economy is becoming important and increasing.

➢ Characteristics of a service
• Intangibility
• Inseparability

• Heterogeneity

• Perishability

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 3. Service Costing

✓ Service Costing
• Determining costs incurred by the service organizations for creating and delivering services.
• This is a method of costing that collects , accumulates and ascertains costs for operating a service.

Features of Service Costing

• Focused on determining cost in creation of intangible output
• Cost unit is a composite unit
• Computation of cost is generally done period wise

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3. Service Costing

✓ Service Costing is identified as,

• Operating charges (variable costs)
• Standing charges (fixed costs)

❖ Services created by the organization are consumed by either internally or externally by customers.
Service Costing is applied when services are consumed by external customers.

❖ Forms of Service Costing

• Transport Costing
• Hotel Costing
• Canteen Costing
• Hospital Costing
• Power House Costing

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 4. Marginal Costing vs. Absorption Costing

Marginal Costing (Variable costing / Direct costing)

• Assigns only variable costs in determining product cost per units while fixed costs are written off as period
costs.

Variable Cost (Direct Material, Direct Labour, Variable portion of Manufacturing Overhead) : Product Cost

Fixed Cost (Fixed portion of manufacturing overhead and fixed non manufacturing overhead) : Period Cost

• Cost of a unit in inventory and in Cost of Goods Sold contains only variable cost

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 4. Marginal Costing vs. Absorption Costing

Absorption Costing (Full cost method since it includes all manufacturing costs)

• Assign direct costs and all or part of overhead to cost units using one or more overhead absorption rates.

• Treats all manufacturing costs as product costs, no matter they are variable or fixed.

Direct Material + Direct Labour + Variable Manufacturing Overhead + Fixed Manufacturing Overhead = Product Cost

❖ Portion of Fixed manufacturing Overhead is absorbed to each unit of product.

(allocation, apportionment and absorption)

❖ Cost of a unit in inventory and Cost of Goods Sold contains full production cost (variable & fixed costs)

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 4. Marginal Costing vs. Absorption Costing
Difference between Marginal Costing and Absorption Costing

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Difference between Marginal Costing and Absorption Costing

Exercise 1.
Following cost items are extracted from HiTech (Pvt) Ltd, a company produces a high tech manufacturing
equipment for apparel industry. (cost items are in Rs. value)
Per equipment Per month
Selling price 100,000 Calculate
i. Unit production cost
Direct Material 19,000
ii. net operating income for the
Direct Labour 5,000 period under Marginal Costing
method and Absorption
Variable Manufacturing Overhead 1,000
Costing method
Fixed Manufacturing Overhead 60,000
Variable Selling & Admin. expenses 10,000
Fixed Selling & Admin. expenses 20,000

❖ No. of equipment produced and sold during the month: 05.

❖ No. of machine hours per equipment: 15 hours (take machine hours as the absorption basis)

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 4. Marginal Costing vs. Absorption Costing

Difference between Marginal Costing and Absorption Costing

❑ In Marginal costing, closing stock is valued at where as in Absorption costing,

closing stock is valued at
❑ Both Marginal costing and Absorption costing are in complete agreement of as
period costs. The disagreement exists whether should be regarded as
or

❑ When opening and closing stock levels are similar profit reported under Marginal Costing and Absorption
costing are similar. When opening and closing stocks levels are differ, profit reported are also differ under
two methods.

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 4. Marginal Costing vs. Absorption Costing

Difference between Marginal Costing and Absorption Costing

Effects of Opening stock and Closing stock

Effects can be explained in three situations

Situation 1 Situation 2 Situation 3

Production = Sales Production > Sales Production < Sales
No stock difference Closing Stock > Opening Closing Stock < Opening
Stock Stock
The profits are same for both Profits are higher in Profits are higher in Marginal
methods Absorption costing Costing System

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 4. Marginal Costing vs. Absorption Costing

Difference between Marginal Costing and Absorption Costing

Arguments against Marginal Costing

• Not proper to disregard fixed cost for product cost determination and inventory valuation
• Use of variable cost for long term decision making is not ideal
• Not good for long run continuity of the business because it disregards recovering fixed cost through
product pricing
• Exclusion of fixed cost from inventory valuation does not conform to accepted accounting standard and
practice

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 4. Marginal Costing vs. Absorption Costing

Difference between Marginal Costing and Absorption Costing

Arguments against Absorption Costing

• Reduced practical utility of cost data for control purposes since this method uses arbitrary method of
apportionment of overhead
• All fixed cost are not charged against the revenue of the year in which they are incurred because fixed
cost related to closing stock is carried forwarded to the next year and fixed cost related to opening stock
is charged to the current year instead of previous year.

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 4. Activity Based Costing (ABC)

❖ An approach to the costing and monitoring activities, which involves tracing resource consumption and
costing final outputs.

Principles behind ABC

• Activities cause costs. (Activities include ordering, material handling, machining, assembly, scheduling and
dispatching)
• Producing products creates demand for activities
• Costs are assigned to a product on the basis of the product’s consumption of the activities.

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 4. Activity Based Costing (ABC)

❖ The reason for the development of ABC

• Traditional costing systems assume that all products consume all resources in proportion to their
production volumes.
• Therefore, they tend to allocate
too great proportion of overheads to high volume products (high volume products have little diversity and
hence consume less support services)
and
too small proportion of overheads to low volume products (low volume products have greater diversity and
hence use more support services)

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 4. Activity Based Costing (ABC)

Outline of an ABC system

1. Identify organization's major activities

1. Identify Cost drivers

Cost drivers = factors which determine the size of the costs of an activity / cause the cost of an activity

3. Collect the costs associated with each cost driver into cost pools

4. Charge the cost of each cost pool to products on the basis of their usage of activity using a cost driver

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Practice Qs.

XYZ (Pvt) Ltd manufactures 04 products using same plant and processes. Following information are for one
month.
Product Volume Material cost Direct labour Machine time Labour cost
per unit (Rs.) per unit per unit per unit (Rs.)
A 500 1250 ½ hours ¼ hours 1000

B 5000 1250 ½ hours ¼ hours 1000

C 600 850 2 hours 1 hour 775

D 7000 950 1 ½ hours 1 ½ hours 750

Total production overhead Overhead item Amount (Rs.)

Machine related cost 37,425

Set Up cost 4,355

Cost of ordering material 1,920

Handling materials 7,580

Administration for spare parts 8,600

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Practice Qs. Contd…

Product No. of set ups No. of materials No. of times No. of spare
ordered material handled parts
A 1 1 2 2

B 6 4 10 5

C 2 1 3 1

D 8 4 12 4

Calculate the cost per unit using ABC.

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 4. Activity Based Costing (ABC)
Difference between ABC and Traditional costing
✓ The way in which overheads are absorbed into products.
ABC : uses many cost drivers as absorption basis
Traditional costing : commonly uses two absorption bases (machine hours & labour hours)
✓ The flow of absorption process
ABC : overheads are first related to activities / cost pools and then related to cost objects
Traditional costing : overheads are first related to cost centers and then related to cost objects

Merits of ABC
➢ Multiple cost drivers - recognizes complexity in business environment
➢ Accurate product pricing – good understanding on what drives costs. So can assess product profitability
realistically

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4. Activity Based Costing (ABC)

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