Chapter 7

Understand the alternatives in conventional costing systems

Not one costing system, but many!

Major sources of variation in conventional costing systems stem from the way costs are measured the focus of the costing system the method used to allocate manufacturing

overhead to products the costs included in product (or service) costs

Measuring costs

Actual costing actual costs are assigned to products

Normal costing actual direct material and labour, and

predetermined overhead rate

Standard costing budgeted cost of direct material and direct

labour, and predetermined overhead rate

The focus of the costing system

Job costing costs are assigned to individual jobs

Process costing cost are traced to processes/departments and

averaged across units produced

Hybrid costing combinations of two or more costing systems

Allocating manufacturing overhead to products

The number of overhead rates plantwide manufacturing overhead rate departmental overhead rates

The measure of cost driver volume budget volume normal volume theoretical capacity practical capacity

Selecting which costs to include

External reporting purposes product costs must include a share of fixed

manufacturing overhead costs, and no non-manufacturing costs

Management decision-making purposes product costs may exclude fixed manufacturing

overhead (variable costing), and/or include non-manufacturing costs

The framework for responsibility accounting

Most costing systems help managers control costs by tracking costs to responsibility centres or departments, as well as products

This can encourage departmental managers to control costs

Costing systems in service versus manufacturing organisations

Job costing is more common in service firms because of the heterogeneous nature of services

Process costing can be used in service organisations where services are repetitive

Primary use of costing in a service firm is to cost responsibility centres, not services

Variable costing and absorption costingAbsorption costing - all manufacturing costs are

assigned to products direct materials, direct labour, variable and fixed

manufacturing overhead

Variable costing - only variable manufacturing costs assigned to products direct materials, direct labour and variable

manufacturing overhead

Calculating profit under variable costing

Contribution (or contribution margin) statement - highlights the variable and fixed costs of the business

Total contribution margin - total sales revenue less total variable cost

Variable cost of goods sold - total of direct materials, direct labour and variable overhead assigned to units sold

Calculating profit under absorption costing

Profit statement separates manufacturing from non-manufacturing costs

Use of gross margin Consistent with external reporting

requirements

Reconciling profit under variable and absorption costing

When inventory increases or decreases during the period difference in fixed overhead expensed under

absorption and variable costing, equals the change in inventory multiplied by predetermined overhead rate per unit

Over the long term, differences in profits between the two methods will diminish

Variable or absorption costing?

Valuing inventory only absorption costing is allowed for external

reporting purposes

Providing relevant cost information variable costing - useful for short-term

decisions absorption costing - for longer term decisions

Cont.

Variable or absorption costing?

Profit information from variable costing classification of fixed and variable costs

simplifies prediction of the effects of changes in sales on profit

link between sales performance and profit performance is easily understandable

highlights the impact of fixed costs on profits by isolating them

Cont.

Variable or absorption costing?

Profit information from absorption costing no direct relationship between sales and profit

so provides a poor basis for planning and control

• may encourage managers to increase inventories to drive profits up

meets the requirements for external reporting

Problems with conventional product costing systems

General features direct material and direct labour costs are traced

to products manufacturing overhead costs are allocated to

products using a predetermined overhead rate the manufacturing overhead rate is calculated

using some measure of production volume non-manufacturing costs are not assigned to

products

Cont.

Problems with conventional product costing systems

Failure to adapt to the changing business environment increasing levels of non-volume-driven

manufacturing overhead costs substantial non-manufacturing costs changing cost structures changing product structures

Indicators of problems with conventional product costingDirect labour costs decreaseManufacturing overhead costs increaseThe amount of manufacturing overhead costs,

not related directly to production volume, increases

Non-manufacturing costs which are product-related become substantial; and product diversity increases

Problems with costing in service businesses

Service firms tend to use firm-wide volume-based overhead rates overhead costs are increasing in importance and

are increasingly non-volume driven

Customers are demanding more diverse and higher quality services increases in product diversity and in overhead

costs

Exhibit 7.1

Exhibit 7.2

Exhibit 7.3

Exhibit 7.5