Uniit 1.

2: Costing Systems

Lesson 1: Introduction to costing systems

What is a costing system?

A costing system is essentially a system that collects and reports financial

information to management to assist them in their role. It is probably one
of the most important systems in a company because it often forms the
backbone of the information that managers use to make decisions
regarding the making and selling of their products and services.

Rule of thumb

As a general principle you would require more accurate (and expensive)

system when:

- There are many different products or customised products, where

accurate allocations between products is important
- There are a high proportion of indirect costs vs direct costs and you
have more of a need to understand indirect costs more accurately
- The cost of an inaccurate system is high, for example, you operate
in a highly competitive environment

You would require less accurate (and cheaper) system when:

- There are few production (or a single product) that are relatively
standardised and so accurate costing wont differ much to a less
accurate systems that makes more assumptions
- There are a low proportion of indirect costs vs direct costs and so
you have less of a need to understand your indirect costs more
accurately, as they are not a large part of your overall costs
- The cost of an inaccurate system is low, for example, you operate in
an uncompetitive environment, or you are the only person making
and selling the products

Process and Job Costing

There are tow main costing systems that are widely used.

Process costing is a costing system that accumulates or collects costs

separately for each process rather than worrying about the cost for each
object itself. We then determine an average object cost by looking at how
many objects were manufacturers by that process. It is more appropriate
to use this system when the objects themselves are all identical.

Job costing is a costing system that accumulates or collects costs

separately for each ‘job’. At a high level what this means is that we want
to be able to track cost information to a particular object that is being
manufactured for the job. This is important when each object might be
different, and an average cost is not appropriate.

Direct and Indirect costs

Use ACTUAL
Direct costs costs

Traditional
costing
systems
Cost Object
Cost allocation Use (product)

Indirect costs BUDGET costs

ABC systems

Direct costs are traceable to the object, so they are simpler to identify and
accurately include in the cost of the product. Indirect costs are not
traceable to the object, and as a result the primary challenge with any
costing system it how to include the indirect costs in the cost of the
product as there is no direct link between the cost and the product.

Lesson 2: Variable Costing

Variable costing system

Variable (marginal or direct) system

- Only direct labour costs are allocated to inventory

o Direct labour
o Direct material
o Direct manufacturing overhead
- Indirect manufacturing (production) costs expensed as a period cost
- Direct and indirect non-manufacturing costs (i.e. all)
o Are expensed as period costs even if variable
o Selling, general and admin costs

Illustrative example 1
Solution

Step 1 – determine unit schedule

Step 2 – determine variable costs and allocated fixed costs for inventory/
COS

- No allocated fixed costs as Variable costing

- No opening balance calculation as inventory opening balance is
given
- Production costs and closing balance are calculated in solution
below

Step 3 – prepare income statement

A key point that you need to take away from this lesson is that there is a
difference between a variable costing system and the information needed
for a CVP analysis.

- With a variable costing system, the focus is on inventory and

therefore the gross profit is based only on revenue, less variable
manufacturing costs
- With CVP analysis the focus is on decision making and therefore the
contribution margin is based on revenue, less all variable costs.
Lesson 3: Absorption Costing

IFRS – IAS 2

- Costs to include
- Costs of conversion
o Including systematic allocation of production overheads
- Other costs bringing into present location and condition
- Costs to exclude
o Abnormal waste

Absorption

- All production costs allocated to inventory

o Direct labour
o Direct material
o Direct manufacturing overheads
o Indirect manufacturing overhead (absorbed)
 Machinery depreciation, factory rent
 Support costs – IT department supporting production
machinery
o Direct and indirect non-manufacturing costs
 Expensed as period costs
 Selling, general and admin costs
o Allows for matching of product expenses with product income
 Through expenses remaining in inventory
o Logic – all production costs even if hard to allocate are still
part of the cost of the cost of the product.

Absorption costing system

Costs to include

- Budgeted indirect production costs

- Not actual production costs
- Variance at the end will adjust to actual

Allocation base

- Budgeted or normal capacity

- Not actual production
- Not practical capacity
- Not maximum capacity
Process

- System is set up at beginning of period

- System absorbs based on actual items produced
- Comparison at end of period between actual cost and what system
absorbed – variance

Allocation base

Budgeted capacity (management accounting)

- Expected production over the next period

- Include planned maintenance
- Usually units, can be labour/machine hours etc

Normal capacity (IFRS requires)

- Average expected production over a number of periods

- Includes planned maintenance
- Not technically budgeted capacity

Maximum capacity

- The most you could possibly product

Practical capacity

- The most you could reasonably expect to produce

Variances

- System allocates as you produce but

o Never product exactly at normal/budgeted capacity – volume
 o Never exactly meet your budgets – expenditure
- Under absorbed (unfavourable)
- Need to produce more of an expense
o System recorded too little
o Actual costs were more than budgeted
o Production was less than normal/budgeted capacity
- Over absorbed (favourable)
- Need to process less of an expense
o System recorded too much
o Actual costs were less than budgeted or
o Production was more than normal/budgeted capacity
- Expense variance/difference as a period cost

Illustrative example 2
Solution

Step 1 – Determine unit schedule

Step 2- Determine fixed overhead absorption rate

Step 3 – Determine variable costs and allocated fixed costs for

inventory/COS

- No opening balance cal necessary as inventory opening balance is

given
- Variable production costs and closing balance costs are calculated in
situation below
- Fixed costs allocated to inventory in situation below

Step 4 – Prepare income statement

Practical Advice
- Use the COS calculation as part of your layout
o O/B + Production – C/B = COS
o Then all you need to do is value the opening and closing
balance
- Opening inventory
o Based on PRIOR YEAR information
 PY actual variable costs
 PY budgeted overhead costs
 PY normal capacity
 Any variance was expensed/adjusted for last year
 Fixed costs in closing balance based on absorption
rate
- Closing inventory and production costs
o Use the same information other than the number of units
 FIFA- assumes all opening inventory would have been
sold first
 Closing inventory must generally be based on CY
production
Example 5 – Absorption costing – Labour Hours
Reconciling absorption and variable costing

Reconciling profit

- Only difference is the inventory effect (NB)

Comparing the impact on profit

- If production equals sales

o Inventories do not change
o Nothing additional is absorbed/kept in inventory
 VC profit will equal ABS profit
- If production is greater than sales
o Inventories will increase
o More costs are stored in inventory under ABS
 VC profit will be less than ABS profit
- If production is less than sales
o Inventories will decrease
 o Less costs are stored in inventory under ABS

Effect on fixed overheads in inventory

- Opening inventory effect

o Decreases absorption profit relative to variable profit
- Closing inventory effect
o Increases absorption profit relative to variable profit
- Rand amount of different
o Opening balance difference = PY absorption rate x units
o Closing balance difference = CY absorption rate x units
o OR compare balances to get differences
 ABS o/b – VC o/b
 ABS c/b – VC c/b

An important recap on the reconciliation between absorption and variable

costing profit figures covered in the video on the previous page, lets
reflect on the following:

- As these systems are inventory valuation systems, the impact on

profit is seen through the measurement of inventory and the
recording of the associated cost of sales

VC (E1) to ABS (E2)

Variable vs absorption costing

Advantages of variable costing

- Short term decision making and control

o Focus on costs that change in the short term and are therefore
controllable
o Clearly shows how profits will change with volume
 CVP
o Profits are not influenced by inventory levels
 Especially if reporting monthly
o Less manipulation – use for managerial performance
 Avoids costs being capitalised into unsaleable stock
o In the long run business must cover fixed costs
 But decisions are often made case by case
 E.g., airline seats, stadium seats, any unutilised capacity

Advantages of absorption costing

- Long term decision making and control

o Does not understate the importance of fixed costs
o Fixed costs need to be considered in the long run
o Cant continually sell without absorbing fixed costs
- Ongoing cost decisions can lead to losses
o You never recover your overheads
o You never cut back on capacity (fixed costs)
- Currently times expenses
o Production expenses are deferred in inventory to match when
the goods are sold
- Consistent with IFRS
o Managers want to focus on external reporting
 Market evaluates this
 They are rewarded based on this
o Better to have internal the same as external
Lesson 5: Activity Based Costing

Activity based costing

- System of allocating indirect costs

o Manufacturing and non manufacturing
o To different objects (product, services, customers etc)
o Based on the activity that drives those costs
 And in a way that aims to enhance decision making
 Insight into indirect relevant costs
 Danger that only direct costs are considered relevant
- IFRS
o ABC not acceptable for IFRS
o Effect: Run dual systems

Activity based management

- Use of ABC information to assist

o Decision making
  Product mix and pricing decisions
 Profitability of product lines, service lines and customers
o Cost reduction and control
 Removing non value added activities
 Control activities which drive costs

ABC activities

What is an activity?

- An aggregation of tasks, events or units of work that cause the

consumption of resources
- i.e., a group of actions that cause costs to increase
o Scheduling production
o Set-up machines
o Move materials
o Inspect items

Absorption costing

- Costs are collected by department, and

- Absorbed into objects (products) using an absorption rate
- i.e., arbitrary allocation

Activity based costing

- Costs are collected by the activities that cause the costs, and
- Assigned to objects (products) based on how the object uses the
activity
- i.e., casual allocation

Cost driver

- A measure that exerts the largest influence on the cost of an activity

- i.e., which ‘causes’ activity costs to change
o Number of labour hours cause direct labour costs
o Number of batches cause batch setup costs

Absorption costing
 - One or two volume based allocation bases
o Labour hours/machine hours/units produced
o Some costs are not volume driven
 No cause and effect between cost and volume
 E.g., the setup cost for a production run
 After setup can produce 100 or 10 000 units – no
change in cost
 Increased likelihood of arbitrary allocation bases

Result

- Complex products with expensive activities are allocated less costs

than they should
- Simple products with cheap activities are allocated more costs than
they should

Activity based costing

- Many casual allocation bases (cost drivers)

o Setups, inspections, etc as well as labour hours/machine
hours/units produced
o Significantly less likelihood of arbitrary allocation bases

Result

- Products have an allocation of costs based on how each product

used the activity which causes those costs
- Better understanding for decision making
o You now know that avoiding the product will avoid the cost
and
o When making the product what costs will be incurred

Note: Needs to have casual relationship

- Facility sustaining costs

o Costs which cannot be linked to the product (object) through
an activity
o E.g., factory rent – not assigned under ABC as no cause effect
(arbitrary)
ABC Methodology

The next step is to understand how to design an activity-based costing

system in order to calculate accurate cost information. This can be done
by following a logical process, which have been broken down into five
steps:

1. Identify the business activities and cost drivers

2. Determine the total cost or estimated cost of each activity
3. Determine the total activity level that is associated with each
activity’s cost
4. Calculate an activity cost driver rate
5. Assign costs to objects

Step 1

Determine the activities and cost drivers

- Identify the business activities that are linked to the object

o Batches
o Machine setups
o Inspections
o Purchase orders
- Identify the cost drivers which cause the activity cost
o Number of batches
o Number of machine setups
o Number of inspections
o Number of purchase orders
- In reality this is difficult to determine
- In a question – usually the activity and cost driver is given

Step 2

Determine the total cost or estimated cost of each activity

- This is based on the analysis and linking done in step 1

- May require allocating various indirect or par thereof to the activity
- Do NOT try and look at it at the object level (yet)
- Excludes
 o Direct costs – these can be traced
o Non-relevant costs – cannot effect decision at hand
 Possibilities
 Facility sustaining costs (on some occasions –
consider ease of expansion/downsizing)
 Non-cash flow (e.g., depreciation)
 Non-recurring/once off
 Factors affecting whether a cost can be altered would
include
 Nature of decision (short term/long term,
operational/strategic)
 Divisibility of cost (step)

Step 3

Determine the total activity level which caused the total cost in
step 2

- Sometimes you have bought capacity which you may not have used
(fixed)
o i.e., bought a machine which can do 1000 baches (capacity)
and costs R100 000 per year
o I have used only 800 batches and the rest is idle
o The total cost is R100 000 as the cost is fixed
o The activity level relating to the R100 000 is 1000 batches not
800
- Sometimes the level of activity is determined the total cost
(variable)
o i.e., I have 100 setups during the year which resulted in R500
costs
o The activity level relating to the R500 is 1000 setups
o Variable indirect costs vs variable direct costs
- Practical capacity – not normal/budget capacity (if choice)
o Maximum less planned maintenance
o Highlights costs of non-utilised capacity

Step 4

Calculate a cost driver rate for the activity

 - Total activity cost (step 2)/practical capacity or total activity
occurrence (step 3)

Step 5

Assign costs to object (products)

- Use the rate per activity (step 4)

- Use the total frequency of activities used by a product for a given
level of production
o Not on a per unit level
o i.e., we will not have a per unit product cost
o we are allocating costs in total for the level of production
 Simply splitting between two (or more) product
categories

Example 9 – Activity Based Costing

Scenario

Highwater manufacturers and sells specialised water distributors for use in

garden irrigation systems. Currently the product range is made up of two
products, popups and emitters

During the year the following cost information was recorded:

Popups need to be inspected twice during the production process while
emitters only once.

Popups are much larger and are packed in individual boxed whilst 8
emitters are packed in a single box

The management account showed the following:

Labour was at practical capacity whilst machinery has a practical capacity

of 250 000 hours.

Determine absorption rate

Normal capacity 20 000

Budgeted production overheads, R (assume actual) 420 000

Absorption rate, Rands per unit 21

Popups Emitters

Variable cost 40 55
Absorption rate 21 21

Total cost 61 76

Step 1 – Determine costs to absorb and identify the cost drivers

Cost Driver/activity

Machine related costs Machine hours

Manual assembly costs Labour Hours

Packing costs Number of boxes

Quality control costs Number of inspections

Step 2, 3 and 4 – Determine total cost of each activity, total

related activity level and cost per activity

Activity Cost (R) Frequen R per

cy activity
Machine hours 150 000 250 000 0.6
Labour hours 180 000 180 000 1
Number of boxes 26 000 13 000 2
Number of inspections 64 000 32 000 2

The frequency related to the cost is practical capacity

(12 000/1) + (8000/8) = 13 000

(12 000 x 2) + (8000 x 1) = 32 000

Step 5 – assign costs to products at the total relevant production

level

Step 6 – determine per unit cost

Popups Emitters
Raw materials 120 000 240 000
Direct variable overheads 360 000 200 000
Machinery related costs (based on 86 400 38 400
machine hours)
Manual assembly costs (based on 120 000 60 000
labour hours)
Packaging costs (based on boxes) 24 000 2000
Quality control costs (based on 48 000 16 000
inspections)
Total allocated costs 758 400 556 400
Cost per unit 63.20 69.55

Unallocated costs

Machinery – allocated 124 800

Machinery – actual 150 000

Period expense – highlights unutilised capacity 25 200

A key point that you need to take away from this lesson on
activity based costing:

- ABC uses more drivers that are casually connected to the object,
whereas ABS uses fewer, volume based drivers
- The focus of ABC is on decision making and control, whereas ABS
has a focus on financial reporting
- ABC uses practical capacity, whereas ABS uses normal capacity
- ABC will not allocate costs that are facility sustaining costs, whereas
ABS allocates all costs that are considered manufacturing costs

Activity based costing is a system implemented by a company to

provide decision-useful information and aid in management and
control

1. We use practical capacity instead of normal capacity as the

allocation basis in order to highlight the long term economic cost of
activities as well as the cost of under utilised capacity
2. We don’t allocate all production costs if these costs are considered
facility sustaining i.e., they are not avoidable at the level the
decision is being made