Chapter 3

Calculating unit cost

Part 2

Phuong Thao NGUYEN

NEU - SAA
Chapter 3

01 Absorption costing

02 Activity – based costing

03 Costing method

04 Other approaches to cost management

1. Absorption costing
 Overhead expenses
1. Allocate
2. Apportion

Direct production Indirect Non-production

costs production costs overheads
1. Allocate
2. Apportion

Production Service
Allocated cost centre cost centre
directly Re apportion

3. Absorption of overhead

Full Production cost per cost unit

1.1. Calculating the absorption cost of a cost unit
Direct material

Direct labour Prime cost

Direct expenses

Share of Indirect Costs Overhead

3 stages to Absorption cost

determine (full cost)
 1.1. Calculating the absorption cost of a cost unit

Stage 1
Overhead allocation

Stage 2
Overhead apportionment

Stage 3
Overhead absorption
 1.2. Overhead allocation
Charged directly
A production department

A production service
department
Cost
Overhead An administrative
centres department
A selling/ distribution
department
Collecting place
An overhead cost centre
 1.2. Overhead allocation
Wages of the supervisor of
department A - £200
101 Department A

Wages of the supervisor of

department B - £150
102 Department B
Indirect materials consumed
in department A - £50
201 Rent
Rent of the premises shared
by departments A & B Record day to day
 1.3. Overhead apportionment
Step 1 Step 2
1. Apportion production department 1
general overheads
to cost centres
production department 2

Overhead Service cost

Re apportion

centres
That allocated to
general overhead Administration, selling
cost centres 2. Re-apportion the cost of
and distribution service centres to production
department departments
 1.3. Overhead apportionment – step 1
Apportionment bases
Basis Overhead
Floor area Rent, rates
(m2) heating & lighting
repairs and depreciation of buildings
Cost/ book value of Depreciation
equipment Insurance
No. employee Personnel office, canteen,
Labour hour welfare, wages and costs offices, first aid
Volume of space Heating
(m3) Lighting
 1.3. Overhead apportionment – step 1
Apportionment bases
Example Basis
Rent A. Volume of cost centre
Heating costs
B. Value of machinery in cost
Insurance of machinery centre
C. Number of employees in cost
Cleaning costs centre

Canteen costs D. Floor area of cost centre

 1.3. Overhead apportionment – step 2
Re-apportionment bases

Service cost centre Example of possible bases of apportionment

Stores Number of material requisitions
Maintenance Hours of maintenance work done for each cost
centre
Production planning Direct labour hours worked in each production cost
centre
 1.3. Overhead apportionment – step 2
NOTES
1. First apportionment: the service cost centre has the largest
costs
2. Cost of the second service centre: include some costs of
the first centre cost
3. Bases of apportionment: what largely/primarily related – fair
basis
4. Service centre costs must ultimately be apportioned to the
production cost centre
 1.4. Overhead absorption (overhead recovery)

Production Production Non-production

overheads overheads overheads (A-S/O)
Allocated Absorpted

Full production
cost per unit cost

Inventories Total cost of sales

 1.4. Overhead absorption (overhead recovery)

1. Predetermined absorption rates:

• set annually in advance:

- Many actual overheads are not known until the end of the year

- Actual overhead could fluctuate => inconsistent overhead charged to

production

- Production output might vary

 1.4. Overhead absorption (overhead recovery)
1. Predetermined absorption rates:
• Calculating
𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑
𝑇ℎ𝑒 𝑎𝑏𝑠𝑜𝑟𝑝𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 =
𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑙𝑒𝑣𝑒𝑙 𝑜𝑓 𝑎𝑐𝑡𝑖𝑣𝑖𝑡𝑦

Usually labour hour or machine hour

 1.4. Overhead absorption (overhead recovery)
1. Predetermined absorption rates:
• Bases of absorption – related intensive environment

• Labour hour: a labour – intensive environment

• Machine hour: production controlled by machines

• Rate per unit: all units are identical

NOTE for exam:
• Predetermined absorption rates: lead to over/ under absorption => adjustment

• In certain situation in the scenario-based question: may see actual absorption

rates to avoid this adjustment
 1.4. Overhead absorption (overhead recovery)
2. Types of absorption rates

Blanket absorption rate

04 03 02 01
(single factory overhead absorption rate)
RATES

Departmental absorption rates

 1.4. Overhead absorption (overhead recovery)
3. Over absorption of overheads
Budgeted Actual Absorpted
Overheads Actual overheads Overheads charge to the cost
2 2
3 3
Activity Actual activity
2 3 Over absorption 3 2
Absorption Actual overheads Overheads charge to the cost
rates
2 2
Actual activity

2 Over absorption 2
 1.4. Overhead absorption (overhead recovery)
3. Under absorption of overheads
Budgeted Actual Absorpted
Overheads Actual overheads Overheads charge to the cost
2 2
Activity Actual activity
2 Under absorption 2
Absorption Actual overheads Overheads charge to the cost
rates
3 2 2
Actual activity

2 Under absorption 2 3
 1.4. Overhead absorption (overhead recovery)
NOTE

Budgeted overhead Actual overhead

Budgeted activity Rate = Actual activity

budgeted overhead
Absorbed overhead Over/under absorption:
Budgeted activity
= rate x actual activity = actual overhead –
absorbed overhead

Type of question:
• Determine one of the above missing information
2. Activity – based
costing (ABC)
 2. Activity based costing - ABC
Traditional costing Total overheads: Activity based costing
based on labour hour £2000
Production runs

1h 10 runs

1h 90 runs

Overheads cost per run: £20

Total overheads
Overheads per unit
£1 £1 Frozen Fresh
Total overheads
£1000 £1000 1000Sold 1000 £ 200 £ 1.800
 2. Activity based costing - ABC
• Problem with traditional absorption costing

Rely on subjective Low proportion of

Not a serious
basis of overhead in total
issue
apportionment cost

Problem:
- Large share to
High proportion of - Accurately identify
large volume
overhead in total unit costs
- Small share to
cost - Exert control over
small volume
these cost
2. Activity based costing - ABC
 2. Activity based costing - ABC
Category Driver

Cost driver Set up costs No. set ups

Something causing Materials handling costs Material movements

costs to change Production run
Inspection costs No. of inspection

Cost pool Category Cost pool

A grouping of costs relating Set up costs 50,000
to a particular activity in an
ABC system Materials handling costs 80,000
Inspection costs 100,000
 2. Activity based costing - ABC

Costs that vary with production levels in the

short term
Volume related cost drivers:
- Labour hours
- Machine hours

Costs that vary with some other activity (not

volume of production)
Transaction related cost drivers:
- No. of production runs
- Production scheduling activity
 2. Activity based costing – ABC
Calculating production costs using ABC

Step 1 Step 2 Step 3 Step 4

Identify Identify Collect Charge

major cost costs to cost to
activity drivers cost pool product

Exam: Not require to perform numerical calculation using ABC

3. Costing method
 3. Costing method
Continuous
operation costing
Process costing
Costing (output consist of a
methods continuous flow of
(depend on identical units)
nature of Job costing
operations)
Specific order
costing Batch costing
(each cost unit is
separately identifiable)
Contract costing
 3.1. Specific order costing
1. Job costing:
• Customer’s special requirements
• Each order: short duration

Total cost of the job

• Direct material issues (FIFO, LIFO…)
• Direct labour costs (time records)
• Production overhead costs
(absorbed from cost centre A, cost centre B…)
 3.1. Specific order costing
2. Contract costing
• Costs are attributed to contracts
• Each separately identifiable cost unit: long duration
• Often undertaken away from the organisation’s premises

Total cost of the contract

• Many direct material issues (FIFO,
LIFO…)
• Many direct employees
• Many overhead costs
(allocated directly or absorbed)
 3.1. Specific order costing
3. Batch costing
• A group (batch) of identical items is treated as a cost unit
𝑇𝑜𝑡𝑎𝑙 𝑏𝑎𝑡𝑐ℎ 𝑐𝑜𝑠𝑡
• Cost per item =
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑖𝑡𝑒𝑚𝑠 𝑖𝑛 𝑡ℎ𝑒 𝑏𝑎𝑡𝑐ℎ

Total cost of the batch

• The same as job costing
 3.2. Process (continuous operation) costing
Process costing: Applicable to continuous processes

• Output of one process => input of the subsequent

process

• Each process: cost centre => material, labour,

overhead costs are collected
• Cost per unit per process =
𝑇𝑜𝑡𝑎𝑙 𝑝𝑟𝑜𝑐𝑒𝑠𝑠 𝑐𝑜𝑠𝑡
𝑁𝑜.𝑜𝑓 𝑢𝑛𝑖𝑡𝑠 𝑝𝑟𝑜𝑑𝑢𝑐𝑒𝑑 𝑒𝑎𝑐ℎ 𝑝𝑒𝑟𝑖𝑜𝑑
Input cost of
subsequent
process
4. Other approaches to
cost management
 4. Other approaches to cost management
Life cycle costing
Tracks costs and revenues over entire life cycle

Other
Target costing
Approaches
Determines target cost by working backwards from selling
to cost
price
management

Just in time
Goods and services produced/ received only when needed
 4.1. Life cycle costing
Costs

• R&D costs • Retirement and

• Training costs disposal costs

• Production costs
• Distribution costs
• Marketing costs
Before During Production
production production ceased Time
Traditional systems Life cycle costing
assessed on a periodic basis Track and accumulate costs/revenues
over entire life cycle
 4.2. Target costing

Traditional systems Target costing

• Determine unit cost • Determine target cost

• Add desired profit margin • Deduct desired profit

• Determine selling price • Determine selling price

Importance: initial design of product

 4.3. Just in time (JIT)
Just-in-time: goods and services should be produced only when they are needed
• Just in time production
• Just in time purchasing

Push systems JIT - Pull system

 4.3. Just in time (JIT)

High quality Flexibility

Efficient Operation
Speed production requirement
planning for JIT

Reliability Reliable sales

forecasting
 4.3. Just in time (JIT)
An efficient JIT system enables
managers to control and reduce costs:

Warehousing Reduction in
costs waste

Improved Reduction in write-offs

capacity due to obsolescence
utilisation
PRACTICE