Introductory

Management Accounting

Lecture 6 & 7

Full Cost

ChunLei Yang
 Lecture Plan

1. The concept of full cost and its usefulness for

management

2. Cost accounting systems

Job costing & process costing

3. Conventional Absorption costing vs. Activity-Based

Costing

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1. The concept of full cost

Different Costs Classification for different purposes

• Managerial decision making

Relevant costs and irrelevant costs
Sunk costs and opportunity costs
• Cost behavior in relation to Output
Fixed and Variable Costs
• Assignment to Cost Object
Direct and Indirect Costs
• Financial statement perspective
Product (capitalized) and Period Costs
• Business Function
Manufacturing (raw material, labor, other manufacturing costs)
Non-Manufacturing: (marketing, distribution, customer service, legal)
• Methods of cost accumulation
Job costing and process costing systems

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1. The concept of full cost

Definitions
1. Full cost:
The total (not just relevant) amount of resources, usually
measured in monetary terms, sacrificed to achieve a
particular objective.
2. Full costing:
A general approach for deducing the cost of a unit output,
which takes account of “all” of the costs.
3. Cost accounting systems:
Techniques, forms and accounting records used to provide
timely information about the cost of manufacturing specific
products (or providing specific services) and of performing
certain functions.
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1. The concept of full cost

The usefulness of full cost information

1. Full costing gives per unit cost of a product or
service, which is the basis for:
– Stock evaluation (B/S)
– Cost of sales (P/L account)
2. Unit cost information is influential in:
– Pricing and output decisions
3. Monitoring and improving performance:
– Enhancing control

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2. How full cost is achieved—cost accounting systems

Cost Accounting Systems

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2. How full cost is achieved—cost accounting systems

Cost Accounting Systems

Process costing systems Job costing systems
• Used where production involves • Used for one-off "products" (or
steady stream of similar products, batches)
passing through a number of
processes • Costs are accumulated separately
for each JOB
• Costs are accumulated within each egs: building contracts
process over a period of time and motion pictures
then allocated over the equivalent
full units of production (ie at the consultancy project
average cost of the process)

• Total of all processes = cost of • Allocation of overheads included

finished production
• Allows calculation of profit/ loss
• Provides stock valuation / cost of on any individual job
sales
eg: oil refineries
breweries
assembly lines 8
Question 1
In each of the following​situations, determine
whether job costing or process costing would be
more appropriate.

1. Bushmills Irish Whiskey

2. The refinery business of Shell
3. An accounting firm-PWC
4. A furniture factory
5. A leading advertising agency-McCANN

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3. Full product cost

Measuring full costs

Direct Cost Tracing
Costs
Cost
Objects

Indirect
Costs (OHs) Cost Allocation

What is in the product cost?

– Certain costs may be excluded, eg. managing directors costs; marketing costs. Why?
– Direct Cost: is related to the particular cost object and thus can be traced to it in an
economically feasible way. In single product situations, all costs can be linked to that product
– Indirect Cost of a Cost Object: shared, cannot be traced to the cost object in an economically
feasible way and need to be allocated to it—some basis of allocation must be used.
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Question 2

Consider the following two​businesses:

(1) a garage that specialises in repairing the body

work of motor cars.
(2) a manufacturer of a​single, identical product that is
used as a component for aircraft engines.
Which of the above businesses would normally find it useful to
distinguish between direct and indirect cost for the purposes of
determining the full cost of each unit of​output?

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Question 3
Classify the following labour costs of producing a
unit of​output into direct labour and indirect
labour cost.

1. A bonus paid to the warehouse manager

2. Costs of the accountants
3. The wages of an operation personnel paid on the basis of
output achieved
4. ​Factory supervisors' salaries

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Question 4
Match each of the following costs on the left with what you
think would be the most suitable allocation base (ie, cost
driver) on the right.
1. Rent A. Machine hours usage in each cost
centre.
2. Depreciation of computers B. Number of employees within each
cost centre.
3. Property insurance C. Floor area of each cost centre.

4. Personnel costs D. Volume (cubic metres) occupied by

each cost centre.

5. Power used by machinery E. Value of assets within each cost

centre.
6. Lighting and heating F. Value of computers within each cost
centre.

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 Allocating Overheads
• Key Issue:
What basis should be used in allocating overheads?
• Difficulty:
Identify a “reasonable” basis for allocating overhead (overhead
absorption rate)
• Significance:
Various approaches to overheads allocation will affect
reporting, pricing, and control.
• General idea:
Includes indirect and common costs in product costs by
spreading them over production
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3. Full product cost

The conventional approach—Absorption Costing

Direct Cost Tracing

Costs

Cost
Traditional Objects
Indirect Cost Allocation
Costs (OH)
ABC

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3. Full product cost

Functional View of Organisation

FUNCTIONS (structures)…. Purchasing Production Sales

“Who” is consuming resources?

“Which” department?
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3. Full product cost

Absorption Costing—the process of overheads allocation

Common service Cost centres (normally Cost Objects

costs production (eg, Product lines)
departments)

Service usage Volume

The process of overheads allocation involves two steps:

– Service costs allocated to production departments using service usage and then to
– Products using a measure of volume (often labour based).
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I.M.A. LTD
Business information
• 630 employees worldwide
• Annual turnover £150k
• Headquartered in Manchester
• Specialise in office supplies
• (To simplify the illustration), currently
make-sell three types of desks:
– The ‘angular’
– The ‘curvy’
– The ‘quirky’
• 7 functional areas/departments

Q: establish full product costs of A, C& Q

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 I.M.A. LTD
• Strategic decision-
making
• Coordination • PMM
• Communication
• Handling orders
• Accountancy
• Recruitment, training
BOD

Preparing materials,
Producing desks

Admin

Maintenance Engineering Marketing/Sales Purchase Production

• Repair machines • Research & Design • Supply materials, etc.

• Set up machines • Quality control • Logistics
• Maintenance/service of • Health& Safety • Managing warehouse
machines • Marketing, advertising • Storage
• Fix break-downs • customer relationship 20
• Cleaning
I.M.A Ltd: Allocating OHs on a ‘departmental’ basis
BOD Sales

Mainte.

£20k

Eng.
Prod
£10k
£40k
Admin.
38+40=78k
£5k

Purchase

£3k
20+10+5+3=38k 2nd step allocation based on volume based
measures (e.g., labour hours)
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1st step allocation based on service usage
3. Full product cost

Question 5: Absorption costing

Jo. Ltd provides household service to its customers.
It has £10,000 overhead each month. Also in each
month, 2,500 hrs are worked. A particular repair
job that took place in the middle of the month used
direct material £15. Direct labour worked on the
job for 15 hours and the wage rate was £5 each.
OHs are charged to the job on a direct labour hour
basis.

Requirement:
Establish the full cost of the job.
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3. Full product cost

Absorption Costing: Solution

First, establish the OH absorption rate

(₤10,000/2,500)=₤4 per direct labour hour

Second, establish the full cost for the job:

₤
Direct materials 15
Direct labour(15×₤5) 75
Overheads(15 ×₤4) 60

Full cost 150

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3. Full product cost

Criticisms of the Absorption Costing

• Financial accounting rules too influential
• Allocations have been too simplistic/arbitrary
• Modern advanced technology/manufacturing
– Increasing complexity of production
– A greater proportion of costs are “fixed”
– Labour is less important and therefore less
suitable as a basis for allocation

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3. Full product cost

The ‘Sophisticated’ Approach—ABC

Direct Cost Tracing

Costs

Cost
Traditional Objects
Indirect Cost Allocation
Costs (OH)
ABC

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3. Full product cost

What is Activity-Based Costing?

• Activity Based Costing (ABC) is a systematic, cause &
effect method of assigning the cost of activities to products,
services, customers or any cost object.

• ABC is based on the principle that "products consume

activities” (…it relies on Activity Accounting) .

• ABC has a very different way of thinking about business…

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3. Full product cost

Process View (activity based)

Purchasing Production Sales

Process 1 Production

Process 2 PROCESSES (activities)….

Output
Input

Process 3

Process 4

“Which” processes are consuming resources?

“What” activities are performed?
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3. Full product cost

Traditional Costing vs. ABC

Traditional cost systems are the answer to the question:

“Who is consuming resources within the organization? Which department?

– reflects a functional/hierarchical view…”

ABC requires a new way of thinking !

What activities are being performed through the usage of organizational
resources?

How much does it cost to perform organizational activities and business

processes?

How much of each activity is required for the organization’s products,

services and customers?
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3. Full product cost

Costing using ABC: key steps

Step 1 - Define the activities (understand organizational processes!)

Step 2 - Cost the activities (from resources expenses… to activities

expenses – how much does it cost to perform an activity)

Step 3 - Determine ‘cost drivers’ - i.e. what causes the costs to be

incurred (i.e., invoice costs driven by number of invoices;
set-up costs driven by number of production runs; testing
costs driven by number of machine hours used)

Step 4 - Calculate the ‘cost driver rate’ (e.g. set-up costs at £158
per production run) – this gives you the cost of performing
a specific activity!

Step 5 - Apply the cost driver rate to cost products or services

(according to the usage/consumption of the cost driver)
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3. Full product cost

ABC —the process of overheads allocation

Common service Cost centres Cost Objects

costs (normally activity- (eg, Product lines)
based cost pools

Assign costs to Allocation based

individual activities on cost drivers

Service costs allocated to “activity-based cost pools” and then allocated

to products on the basis of appropriate cost drivers
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 I.M.A Ltd.: Allocating OHs on an ‘activity’ basis

Setting up machines £?

Repairing works £?

Servicing machines £?

Quality inspection £?

Product design and factory design £?

Handling customer orders/enquiries £?

Health & Safety Inspections £?

Training £?

… £?

£? (cost of activities)=cost driver rate× # of activities performed on the product.

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3. Full product cost

Why Activity-based techniques?

Management practices and methods have changed over the last three
decades and will continue to change

BUT…
Why have organizations turned to activity-based techniques?

• Organizations are moving from managing vertically to managing

horizontally.

• It is a move from a function orientation to a process orientation.

• From the way we look at our company (i.e., organizational chart) to the
way the customer look at us.

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3. Full product cost

Full costing:
Costing approaches compared- Illustration 1
The conventional ABC

Products A B Overheads(Machine maintenance) £20000

which comprise:
Price/ unit 12 10
Direct cost/ unit 8 7 a. Machine set-up
3000
Production level b. General maintenance
Labour hours 8000 2000 10000
(absorption base) c. Breakdown repairs 7000

Overheads(Machine maintenance) £20000 Products A

B

Production hours 8000

2000
Batches 1
5
Breakdowns 8 20
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3. Full product cost

Full costing:
Costing approaches compared- Illustration 1
Conventional approach: ABC:

1) Full Cost =Direct Cost + 1) Identify cost drivers for common

Allocated Overheads:
overheads (20,000);
2) Absorb overheads by labour
hours: 2) Establish unit cost per cost driver
by dividing total cost of an activity
3) Establish Unit cost, unit profit by its cost driver;
and so on.
3) Establish overheads for each
product by multiplying the unit
cost per cost driver with No. of cost
drivers it consumed…as follows

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3. Full product cost

Full costing:
Costing approaches compared- Illustration 1

Product A
B

1) Absorption costing (20000/10000hours)=2/hr 16,000 4,000

(£2*8,000hrs and 2,000hrs)

2) ABC
*10000 maintenance - production hours ?
10000/ 10000 hours = 1/ prod.hour (*8000 & 2000) 8,000
2,000
*7000 breakdowns - number of b'downs
7000/ 28 = 250/ breakdown (* 8 and 20) 2,000
5,000
*3000 set-up - number of batches
3000/ 6 =500/ batch (*1 and 5) 500
2,500
10,500 35
9,500
 Absorption costing and ABC compared

Which one seems better? Why?

Just how different is ABC from Absorption

costing?

Shall we go for ABC?

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3. Full product cost

Main Features of ABC

1. Reflects the complexity of production
*cost drivers for each cost element
2. Avoids the averaging implicit in traditional full cost allocations
*so most suitable with increasing diversity etc.
3. Develops two stage allocation
*Conventional full costing: cost centres – whole departments
*ABC: cost pools – activities
4. Gives “better” product costs:
Traditional cost systems allocate costs based on direct labor, material cost,
revenue or other simplistic methods. As a result, traditional systems tend to over-
cost high volume products services and customers (often, less complex in terms of
production) and under-cost low volume.
5. Improved knowledge of cost incidence—should improve cost
control BUT… 39
3. Full product cost

Main Features of ABC

6. But, to implement ABC the management need to identify
appropriate activities/ drivers etc., which can be time
consuming, expensive, and potentially disruptive.

FUNCTIONAL VIEW OF
PROCESS VIEW OF THE THE ORGANISATION
ORGANISATION

Purchasing Production Sales

PurchasingProduction Sales
Process 1 Production
Output

Process 2
Input

Process 3

Process 4
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3. Full product cost

Real World Perspectives

Guess which costing approach is more widely

used in the UK and worldwide?

A. Traditional absorption costing

B. ABC

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Question 6
Evaluate the following statements:
A. A key difference between ABC and the traditional
approach is the way in which they allocate OHs.
B. Adopting ABC involves committing to a new way of
thinking about and organising the business.
C. Implementing ABC is likely to incur considerable
‘organisational cost’.
D. Companies are better off staying away from ABC!
E. ABC can potentially help companies gain competitive
advantage in a competitive environment.
F. ABC can produce precisely accurate full cost information.
 Study checklist
 Explain the purposes of gathering full cost information
 Calculate full costs for cost objects
 Compare and contrast ABC and traditional absorption
costing (Additional readings on BB pertaining to the full
costing method debates).
 Atrill and McLaney, Chapter 4 and Chapter 5
 Prepare for the next demonstration lecture

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