Traditional costing methods

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Cambridge International AS & A Level Accounting 9706

Traditional Costing Methods

The big idea: Absorption costing loads a share of every production overhead onto each unit so that the full cost can be priced and inventory valued. Marginal costing separates variable from fixed costs and judges each product by its contribution, which is the right tool for short-term decisions such as break-even, special orders, make-or-buy and scarce resources.

Summary — What This Chapter Covers

Job, batch and unit costing build up the cost of a job, a batch or a single unit, in manufacturing or service businesses.
Overheads are allocated to the cost centre that caused them, apportioned on a fair basis when shared, and reapportioned from service to production departments.
An overhead absorption rate (OAR) = budgeted overheads / budgeted activity, on a basis that fits the department (machine hours or direct labour hours).
Actual overheads above the amount absorbed = under-absorption (reduces profit); below = over-absorption (adds to profit).
Contribution = selling price − variable cost. Break-even = fixed costs / contribution per unit. C/S ratio = contribution / sales.
Marginal and absorption profits differ by the change in inventory × fixed overhead absorbed per unit.
For decisions, compare the relevant (future, changing) costs and revenues, and weigh non-financial factors.

1. Job, Batch and Unit Costing

Syllabus 2.2.1 · AS Level · Papers 1 & 2

Building up the cost of what is sold

Job costing is used when each order is different and made to a customer’s specification (a kitchen fitted, a machine repaired, a print order). Each job collects its own direct materials, direct labour and direct expenses, and absorbs overheads using the departments’ OARs. Batch costing treats a group of identical items as one job, then divides the batch cost by the number of units. Unit costing is used for continuous output of identical units: total cost / units produced. Service businesses use the same idea with a composite cost unit, such as a room-night, a patient-day or a tonne-kilometre.

Worked example: job costing

Job 88 uses direct materials of $1,240. It takes 30 direct labour hours in Machining at $16.00 and 12 in Assembly at $14.00. Machining absorbs overheads at $10.00 per machine hour (Job 88 uses 18 machine hours) and Assembly at $5.00 per direct labour hour. Administration overheads are 10% of production cost and the price gives a mark-up of 25% on total cost. Prepare the job cost card.

Job cost card: Job 88
	$	$
Direct materials		1,240
Direct labour: Machining 30 hours × $16.00	480
Assembly 12 hours × $14.00	168	648
Prime cost		1,888
Production overheads: Machining 18 machine hours × $10.00	180
Assembly 12 direct labour hours × $5.00	60	240
Production cost		2,128
Administration overheads (10% of production cost)		212.80
Total cost		2,340.80
Profit (mark-up 25% of total cost)		585.20
Selling price		2,926

The mark-up of 25% on cost equals a margin of 20% on the selling price (585.20 / 2,926.00).

Worked example: batch costing

A batch of 500 brackets uses direct materials $3,600, 80 direct labour hours at $15.00, a machine set-up costing $450 and 40 machine hours in Machining at $10.00. Calculate the cost per bracket.

Batch cost statement: batch of 500 brackets
	$
Direct materials	3,600
Direct labour: 80 hours × $15.00	1,200
Machine set-up for the batch	450
5,650
11.30

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Also in the full note

Getting overheads into the production departments
From department totals to a rate per hour
Full cost for pricing and inventory
How many units must be sold to cover fixed costs?
Why the two profits differ, and how to reconcile them
Make or buy, special orders, closure, limiting factors
Testing “what if” before deciding

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Traditional costing methods