DBS Management Accounting

Topic 2 Introduction to costing

Ycp30/7/2018/ 6/2/2017, 15/3/12
What is Cost Accounting or Costing?
 Cost accounting is concerned with finding out how much an item or service
costs. Cost accountants are also concerned with the management of costs and
inventory.

Cost classification & terminology

1. Costs object; is anything that management would like to know the costs of. A
costs object could be an inventory item, a service performed, a certain
department etc.

2. Direct cost; are costs that can be conveniently & easily “traced” to a
particular cost object.

3. Direct materials; are raw materials that are easily traceable to the product.

4. Direct labour is labour costs easily traceable to the product. Often referred as
touch labour.

5. Indirect costs / Manufacturing overhead; are costs that are impractical or

impossible to trace to a cost object. I.e. try tracing the factory manager’s salary,
electricity, depreciation of machinery, indirect materials like cost of solder, gum
used in a multi-product factory. Indirect costs are thus “allocated” to a cost object
using a cost driver.

6. Cost pool: a cost pool is an account where we dump all the costs. This will be
the overhead control account.
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7. Indirect labour: supporting and supervisory staff. Located on the production

floor and raw materials store. I.e. staff salaries like supervisors, forklift driver,
janitor, store clerk, production scheduling, maintenance.

8. Indirect materials; Cost of materials that are insignificant in costs I.e. screws,
plastic bags, label, solder, glue.

9. Cost driver: Any factor that causes cost to be incurred. I.e. direct labour hours,
machine hours, direct material used, number of deliveries, number of products
made etc. To be an accurate mechanism to allocate overheads, a cost
driver must have a close link to the accumulation of costs. Costs drivers are also
called costs allocation base.

10. Inventoriable or product cost; are cost of a product. I.e. Direct cost and
factory overhead. Factory O/H is part of the cost of inventory as it has future
benefits. Inventoriable costs are assets until sold.

11. Period costs; are expensed out in the period incurred. I.e. operating expenses
like selling and admin expenses

Costing
Suppose you work for management of a small factory making biscuits. Your boss
has asked you to produce the costing for the jam tarts the factory is now
producing for Chinese New Year. The boss would like to use your costing to set
selling price as costs plus 25% mark-up.

You meet up with the production people and after discussing with them,
produced the following numbers;
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Cost of Jam Tart Total costs Cost per unit

Raw materials RM5,600 0.14
Direct labour 150 hours x RM16.00 2,400 0.06

RM8,000 RM0.20

The above numbers are to make 40,000 pieces of jam tarts.

How much does each jam tart costs?

Is there something wrong with your costing?

 You should realise that the above costing is incomplete and too low as factory
overheads are left out. You also note that direct costs like direct materials and
direct labour costs are easily discovered / costed. The real costing problem is
costing overhead costs to products.

The Predetermined Overhead Rate (POR)

 Overhead is applied/absorbed to inventory using;

 POR X actual cost driver incurred for that period (month)

 POR = Budgeted Overheads

Budgeted costs driver

 The POR is also called the Overhead Absorption Rate (OAR) in some
textbooks.
 Let’s suppose the aforementioned jam tart factory has budgeted factory
overheads of RM768,000 for the whole year. The factory also has 20
workers and they work 8 hours a day for 240 days a year. The factory therefore
has a budgeted direct labour hour of 38,400 dlh

 The jam tart factory POR will be RM768,000 = RM20.00

38,400

The costing will then be

Cost of Jam Tart Total costs Cost per unit

Raw materials RM5,600 0.140
Direct labour 150 dlh x RM16.00 2,400 0.060
Overhead allocated 150 dlh X RM20 3,000 0.075
RM8,000 RM0.275
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Budgeted numbers?
 The POR makes use of budgeted numbers which means “predicted
numbers”. Businesses would normally prepare budgets at the end of the current
financial year for the next year.
 Budgeted overheads means forecasted / predicted factory overheads /
indirect costs for the whole of next year.
 Budgeted costs driver means forecasted / predicted number of direct
labour hours or machine hours to use for the whole of next year.

Why use budgeted and not actual numbers for overheads?

 Timely costing. We use budgeted numbers instead of actual numbers to
allow timely costing.
 Control function. For us to be able to measure efficiency or control costs,
we first need to know how much the cost should be.
 To eliminate seasonal effects. Usage of actual overheads would result
in higher costs during months with many holidays like February. Conversely,
lower costs will be experienced in months of higher productivity.

 Actual overheads
Actual dlh

What would happen if we use actual overheads and actual costs drivers
1st Q 2nd Q 3rd Q 4th Q Total
Actual Fixed overheads 4,000 4,000 4,000 4,000 16,000
Actual Variable overheads 9,000 5,250 9,000 12,000 35,250
Factory Overheads 13,000 9,250 13,000 16,000 51,250
Direct labour hours 6,000 3,500 6,000 8,000 23,500
Actual Mft OH per dlh 2.17 2.64 2.17 2.00 2.18
 Using a standard POR like RM2.18 for the entire year will result in the
same overhead costs per dlh for the whole year.

Normal costing
 Hence normal costing is

Actual direct material costs + actual direct labour costs + actual costs driver
consumed x POR

Which POR to use? 3 approaches

 A plant wide overhead rate – 1 cost pool & 1 POR
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 Departmental overhead rate – 2 or more cost pools and PORs

 Activity based costing (ABC) – many cost pools and PORs

 Both departmental and ABC overhead rates will NOT be examinable

here.

Plant (factory) wide overhead rate

 This is the simplest method. Only one POR is calculated for the entire factory is
used to charge/absorb/apply overhead for its products.
 Plantwide POR is simplest to do; however, it may not be accurate if products
make “use of different amounts of overheads”.
 Using a single POR for the entire factory is viable if;
1) Overhead is not a large portion of costs
2) Products use similar resources
3) Costing is not used for pricing purposes

Example
Clayton Overhaul Business (COB) repairs and overhauls motor vehicles.

COB’s workshop (WIP) is organised into 5 departments.

 Motor Vehicle (MV) crash repair department

 Engine repair & maintenance department
 Maintenance Department
 Store

COB’s budgeted indirect expenses are as follows;

Depreciation for machinery – RM 20,000

Lighting – 24,000
Rental – 120,000
Insurance for building – 12,000
indirect salaries 88,000

RM 264,000

COB has invested a lot in machinery and equipment and the overhead costs above is
mainly machine related. Because of this management has decided on machine hours
as its costs driver. COB estimated 22,000 machine hours for the coming year.

Required

i. Calculate (using machine hours) the predetermined plant wide overhead

absorption rate for the entire factory
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POR = RM264,000 = RM12.00 per MH

22,000 mh
ii. Do the costing and pricing (assuming 50% mark-up) using the plantwide
overhead rate for a job that required;

 Materials RM4,000
 Direct labour is paid RM12 an hour
 Direct labour - MV Intensive care 20 direct labour hours
- Engine repair 50
 Machine hrs - MV Intensive care 120 machine hours
- Engine repair 10

RM
Direct materials 4,000
Direct labour RM12 x 70dlh 840
Overheads absorbed RM12.00 x 130 mh 1,560
Total costs 6,400
50% mark up 3,200
Invoice value 9,600

iii. What would be the costing and pricing (50% mark-up) for a maintenance job
that used up only the following costs.

 Materials RM150
 Direct labour is paid RM12 an hour
 Direct labour - MV Intensive care 0 direct labour hours
Engine repair 3
 Machine hrs - MV Intensive care 0 machine hours
Engine repair 1

RM
Direct materials 150
Direct labour RM12 x 3 dlh 36
Overheads absorbed RM12.00 x 1mh 12
Total costs 198
50% mark up 99
Invoice value 297
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Tutorial Questions
1. Define the term “cost”.

2. State the type of costs (direct, indirect, variable, operating expenses, fixed, semi-
variable, discretionary) the following items are;

a. Direct labour : Direct costs, variable costs

b. Indirect labour
c. Rental for factory
d. Seminars
e. Depreciation for machinery
f. Supplies
g. Raw materials
h. Gardeners salary
i. Electricity for factory
j. Maintenance of machinery
k. Charity
l. Salary of supervisors
m. Idle time – direct labour
n. Overtime premium– direct labour

3. Why must we charge manufacturing overhead into the cost object?

4. Why do we leave out operating expenses when we calculate the cost of an item?

5. Do we always leave out operating expenses in costing?

6. Explain by using 3 reasons why we use a predetermined overhead rate instead

of an actual overhead rate.

7. Define normal costing.

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8. Pan International Electronics (PIE) accountant is planning next year’s

predetermined overhead rate

PIE’s work in process (WIP) is organised into 5 departments.

 Wafer fabrication department

 Soldering department
 Maintenance Department
 Production planning
 Store

PIE’s budgeted indirect expenses are as follows;

Rental – RM 500,000
Indirect materials - 30,000
Depreciation for machinery – 240,000
Lighting – 60,000
Insurance for building – 80,000
Supplies - 8,000
Indirect salaries 270,000
RM1,188,000

PIE’s factory is labour intensive. The management is of the opinion that the
usage of direct labour hours will allow correct matching of overheads to its
products. PIE’s accountant is of the opinion that the company will consume
99,000 dlh next year.

Required

i. Calculate (using direct labour hours) the predetermined plant wide overhead
absorption rate for the entire factory

ii. Do the costing using the plantwide rate for 50,000 units of Goliath PCBs.

 Materials RM56,000
 Direct labour is paid RM8 an hour
 Direct labour - Wafer 60,000 direct labour hrs
Solder 15,000

 Machine hrs - Wafer 20,000 machine hours

Solder 30,000
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 PIE will mark up Goliath 25% to obtain its selling price.

9 Uchitech Industries are specialist printers. The following is the annual budget
for Uchitech

Budgeted machine hours 20,000

Budgeted direct labour hours 10,000
Budgeted direct labour costs RM300,000
Budgeted manufacturing overheads RM960,000

Uchitech had worked on 3 projects during the month of May.

Business Wedding Promotion

Cards invitations flyers
Actual machine 760 640 420
hours
Estimated budgeted 800 600 400
machine hours

Actual manufacturing overhead costs for May were RM88,579 and the actual
direct labour rate was RM20 hour.

Assume that the business uses machine hours as the costs allocation base.

Required

a. Calculate the predetermined plant wide overhead rate

b. Calculate the overhead costs of each of the 3 products

c. State the amount of overhead over/under absorbed for the month of May.

d. Discuss the accounting treatment for immaterial over absorbed and under
absorbed overheads.