1
CHAPTER I
Managers working with any commercial, social or government entity have an important common objective. They must make good decisions to obtain and use the organization’s resources – including people, money, inventory, fixed assets, investments, technology and equipment in the most effective way so as to contribute in enhancement of wealth of the owners.
Management decisions concerning the acquisition provides answers to questions namely:
1. What products or services should be sold? 2. Where should they be sold?
3. What are the responsibilities of each management position? 4. Who should be hired to fill these positions?
5. How much does it cost to produce a product or offer a service? 6. What is the most profitable combination of products or service? 7. What will happen to profits if selling prices increased or decreased?
8. How much operating capacity I needed in the form of people, funds, inventory, and fixed assets?
9. How should the organization finance its various activities?
The general purpose financial statements are available to the managers of a business, but they have limited utility from the management angle. Managerial accounting is an important branch of accounting that provides the information needed by managers to determine how resources should be obtained, organized and controlled in any type of business, large or small.
Comparison of Financial Accounting with Managerial Accounting
Although the emphasis is different, both managerial and financial accounting involve three types of functions:
(1) Record keeping of financial transactions.
(2) Performance evaluation on the basis of reports that are compiled on classification and summarization of the financial results.
(3) Decision making that is performed by a wide variety of interested parties (both external and internal to the firm) who must choose between alternative courses of action regarding the business’s future.
Despite important similarities identified above, there are several important differences between the two types of accounting. These differences narrated below to learn the scope and utility of managerial accounting.
Financial Account Managerial Accounting
User Orientation Both external/internal users Exclusively for internal Users
Freedom of choice Mandatory to follow the Complete freedom of choice
Current IFAS
2 yearly, yearly etc. specific needs of the entity.
Accounting entity Mainly whole firm Mainly firm’s one or more
segments under investigation.
Reporting frequency Well defined schedule Whenever needed.
Degree of precision Objective principle More subjective
Other discipline used Little use Used often
Characteristics of Managerial Accounting.
The two important terms “data” and “information” are often used synonomously by accountants, a useful distinction can be drawn between them. Data are recorded facts; information is data that have been processed in some prescribed manner so they are more useful to a potential user. In order to make managerial accounting information to serve the desired utility to the managers, it should possess the following important characteristics:
1. Relevance 2. Accuracy 3. Timeliness 4. Understandability 5. Cost effectiveness
Role of the Controller
When a firm commits itself to managerial accounting, the position of controller usually is created and a person with an appropriate credentials and experience is assigned the responsibilities for the organization’s entire accounting function. The specific responsibilities of a controller vary significantly from firm to firm. Some of the important responsibilities that a controller normally undertake to discharge are:
1. Planning, evaluating, and controlling operations for all levels of management; 2. Safeguarding the organization’s assets and;
3. Communicating with interested parties outside the organizations such as shareholders, and regulatory bodies.
Code of conduct for Management Accountants
A management accountant is not obliged to observe the IASB, but he has ethical responsibilities which are grouped in four broad areas:
i) To maintain a high level of professional competence. How it can be achieved: a) By maintaining an appropriate level of professional expertise by continually
developing knowledge and skill.
b) Perform professional duties in accordance with relevant laws, regulations and technical standards.
3 d) Recognize and communicate professional limitations or other common
constraints.
ii) To treat sensitive matters with confidentiality:
a) Keep information confidential except when disclosure is authorized or legally required.
b) Inform all relevant parties regarding appropriate use of confidential informational. c) Refrain from using confidential information for unethical or illegal advantage.
iii) To maintain personal integrity.
a) Mitigate actual conflicts of interest. Advise all parties of any potential conflicts. b) Refrain from engaging in any conduct that would prejudice carrying out duties
ethically.
c) Abstain from engaging in or supporting any activity that might discredit the profession.
iv) To disclose information in credible fashion.
a) Communicate information fairly and objectively.
b) Disclose all relevant information that could reasonably be expected to influence an intended user’s understanding of the reports, analyses or recommendations. c) Disclose delays or deficiencies in information, timeliness, process or internal
controls in conformance with organization policy and/or applicable law.
Cost Classification by Business Functions
Costs are incurred in all types of organizations – service, merchandizing and manufacturing to secure revenues. The specific cost items incurred by a given organization and the way they are classified will depend on the business functions performed by the firm.
A manufacturing firm is generally has the most complex types of accounting data because it involves a manufacturing function, a selling function and an administrative function. The costs incurred by them can be classified on the basis of manufacturing, selling and administrative.
Manufacturing costs include all costs needed to acquire basic raw material from a supplier and converting them into finished products that are salable in different forms. Selling costs are all costs incurred to market and deliver the finished products including advertising, sales salaries, free samples, salesmen commission, transportation charges etc. Administrative costs are all costs needed for the general management of the organization and includes executive salaries, accounting services cost, office supplies etc.
4 Period Cost are all costs that are not product cost. It includes both selling and administrative costs of an entity of the given period. Period costs are not added to product cost or manufacturing cost of goods, instead period cost are assigned to the income statement in the period in which they are incurred on accrual basis of accounting.
Prime Cost & Conversion Cost
Manufacturing cost can further be classified into two distinct heads – prime cost and conversion cost. Prime cost is the sum of direct material and direct labour. Conversion cost which is involved to convert the direct material into the finished goods and hence comprises of direct labour cost and manufacturing overhead.
Prime Cost Conversion Cost
Direct Material + Direct Labour Direct Labour + Factory Overhead
Variable Cost : A variable cost is a cost that varies, in total, in direct proportion to changes in the level of activity. The level of activity can be expressed in many ways such as units produced, units sold, miles driven, beds occupied etc. The most common example of variable cost is raw material. The cost of direct material used during a period will vary in total, in direct proportion to the number of units that are produced. Other examples of variable costs include items such as shipping cost, sales commission and some elements of manufacturing overhead such as lubricants etc. The direct labour is also considered to be a variable cost but in many instances, it acts as a fixed cost.
Fixed Cost: A fixed cost is a cost that remains constant, in total, regardless changes in the level of activity. Unlike variable costs, fixed costs are not affected by changes in activity. Consequently, as the level of activity rises or falls, total fixed costs remains constant unless influenced by some outside forces such as price changes. Rent is a good example of fixed cost.
Very few costs are completely fixed. Most costs will change if the activity changes beyond a certain range. For example the capacity of an X ray machine at Services hospital is 100 X rays a day. If the number of patients are increasing and it would be necessary to rent an additional machine, there will be an increase in the fixed costs. When we say that the cost is fixed, we mean it is fixed within some specified range of activity.
Direct Cost : A direct cost is one that can easily and conveniently be traced to a specified cost object. The most frequent direct cost is direct material and direct labour, but there are other examples of direct cost like salary of sales manager etc.
5 words a common cost is a cost that is incurred to support a number of cost objectives but cannot be traced to them individually. Indirect cost are peculiar examples of common cost.
Differential Cost and Revenue : The element of differential cost or revenue is involved when choosing between available alternatives. In business decisions each alternative will have cost and benefit that must be compared to the cost of benefit of the other available alternatives.
A differential cost is also known as an incremental cost, although technically an incremental cost should refer only to an increase in cost from one alternative to another, a decrease in cost can be referred as decremental costs. Differential cost is broader term, encompassing both cost increases and cost decreases between alternatives.
Relevant costs are future expected costs that will differ in a decision depending on the alternative selected. For example, if two new sewing machines are being evaluated and the cost of thread for each machine is significantly different, than the cost of thread is relevant.
Irrelevant costs are those costs that remain unaffected regardless of the alternative chosen in a given decision. If the two new sewing machines use the same thread in production of a pair of jeans, the cost of thread will be irrelevant.
Opportunity cost : Opportunity cost is the potential benefit that is given up when one alternative is selected over another. Opportunity cost are not usually found in the accounting record of an organization, but they are costs that must be explicitly considered in every decision made by managers.
Sunk cost: A sunk cost is a cost that has already been incurred and that cannot be changed by any decision made now or in the future. Because sunk costs cannot be changed by any decision, they are not differential costs. And because only differential costs are relevant in a decision, sunk cost can and should be ignored.
Controllable costs : It is a cost that can be regulated or influenced by a given level of management decision during a specified time frame. The manager of Sewing Department would be responsible for the direct materials and direct labour used in her department because both items are controllable.
Uncontrollable costs : It is a cost that cannot be regulated or influenced at a given level of management decision during a specific time period. The depreciation on a particular sewing machine is uncontrollable by the Sewing Department manger once the machine has been purchased.
6 Multiple Choice Questions
1. A cost which is incurred for a period and which, within certain output and turnover limits, tends to be unaffected by fluctuation in the levels of activity (output/turnover) is termed as:
a) Historical costs b) Conversion cot c) Fixed cost d) Prime cost
The answer is (c) because fixed cost remains fixed within certain output and turnover limits.
2. The term “discretionary cost” refers to those:
a) Costs which management decides to incur in the current period to enable the company to achieve objectives other than filling of customer’s orders.
b) Costs which are likely to respond to the amount of attention devoted to them by a specified manager.
c) Costs which are governed by past decisions that established the present levels of operating and organizational capacity and which only change slowly in response to small changes in capacity.
d) Costs which can be unaffected by current managerial decisions.
The answer is (a). A discretionary cost refers to such types of costs which can be changed with the management’s decision during the current period, but it does not relate with the cost of the product. For example entertainment expenses. The management may decide to reduce or fixed entertainment expenses at a certain level.
3. The term “cost” refers to:
a) An asset that has given benefit and is now expired. b) The price of products sold or services rendered.
c) The value of the sacrifice made to acquire goods or services. d) An asset that has not given benefit and is now expired. e) The present value of future benefits.
The answer is (c). Here sacrifices mean the price made or cost incurred to acquired an asset.
4. A cost that may carry components of both variable and fixed cost is termed as:
a) Variable cost c) Fixed cost
b) Prime Cost d) Conversion cost
e) Mixed Cost
7 5. The term “sunk costs” refers to :
a) Past costs that are now irrevocable.
b) Costs that are directly influenced by unit managers.
c) Costs that should be incurred in a particular production process.
d) Costs that many be eliminated if some economic activity is changed or deleted.
The answer is (a). A sunk cost is one which has already been incurred on the basis of past decisions and cannot be eliminated or avoided by current decisions.
6. The management of X’s budgeted production of 800,000 units at a cost of Rs.1,600,000. If actual production was 800,000 units at a cost of Rs.2,000,000, then Xs production performance shall be regarded as :
a) Effective c) Efficient
b) Both effective and efficient d) Neither effective nor efficient
The answer is (a). We cannot regard it as efficient because they have incurred extra cost than what was budgeted.
7. Which of the following is “cost appropriate to a specific management decision”?
a) Production cost c) Joint cost
b) Product cost d) Relevant cost
The answer is (d). In decision making the cost which must have important bearing is termed as relevant cost.
8. Which of the following is the difference in total cost between alternatives calculated to assist decision making.
a) Indirect cost c) Product cost
b) Conversion cost d) Differential cost
The answer is (d). In case of choice between two cost alternatives, it is the differential cost which is significant and important.
9. Which of the following is the cost of one unit of product or service which would be avoided if that unit were not produced or provided?
a) Marginal cost c) Prime cost
b) Estimated cost d) Conversion cost
The answer is (a). The marginal cost is the cost of producing an additional product which can be avoided if that unit were produced or provided.
10.Which of the following is the value of benefit sacrificed in favour of alternative course of action?
a) Opportunity cost c) Indirect cost
8 The answer is (a). In case of alternative course of action, it is the opportunity cost that has to sacrificed while selecting a certain course of action.
Exercise 1
The following cost and inventory data are taken from the accounting records of Mason Company for the year just completed:
Cost Incurred
Direct labour cost $ 70,000
Purchase of raw materials 118,000
Indirect labour 30,000
Maintenance, factory equipment 6,000
Advertising expense 90,000
Insurance factory equipment 800
Sales salaries 50,000
Rent, factory facilities 20,000
Supplies 4,200
Depreciation, office equipment 3,000
Depreciation, factory equipment 19,000
Beginning of End of
The year year
Inventories
Raw materials $ 7,000 $15,000
Work in Process 10,000 5,000
Finished goods 20,000 35,000
Required :
1. Prepare a schedule of cost of goods manufactured in good form
2. Prepare the cost of goods sold section of Mason Co.’s income statement for the year.
Answer 1
Schedule of Cost of Goods Manufactured Direct material
Raw material inventory (opening) $ 7,000
Purchases 118,000
Raw material available for use 125,000
Less material inventory (closing) 15,000
Raw material consumed 110,000
Direct labour 70,000
Manufacturing overhead
Indirect labour 30,000
Maintenance, factory equipment 6,000
Insurance, factory equipment 800
9 Depreciation – factory equipment 19,000 75,800
Total Manufacturing cost 255,800
Add Work in Process Inventory (beginning) 10,000
265,800
Less Work in Process Inventory (closing) 5,000
Cost of goods manufactured 260,800
Schedule of Cost of Goods Sold
Finished goods Inventory (Beginning) 20,000
Add Cost of goods manufactured 260,800
Cost of goods available for sale 280,800
Less Cost of goods Inventory (Closing) 35,000
Cost of goods sold 245,800
Exercise 2
Income Statement for Broad Corporation for four years are presented below:
Income Statement
Sales ? ? 240,000 225,000 Finished goods, beginning inventory 32,500 ? ? ? Work in Process, beginning inventory 10,000 ? ? 7,500
Raw material used 44,500 47,500 30,000 42,500
Direct labour cost ? 52,500 50,000 27,500
Manufacturing overhead 50,500 ? 37,500 30,000
Work in Process, ending inventory 15.000 ? ? ? Cost of goods manufactured ? ? 112,500 95,000 Finished goods, ending inventory 42,500 ? ? 11,500 Cost of goods sold 145,500 144,500 121,000 ? Gross Profit 137,500 ? ? 105,000 Operating Expenses 42,500 37,500 ? 35,000
Net Income ? 90,000 60,000 ?
Required : Fill in the missing information (Hint 1990 data provide information required to find 1989 unknown).
Answer 2
Income Statement
1987 1988 1989 1990
Raw material used 44,500 47,500 30,000 42,500
10
Manufactured overhead 50,500 44,500 37,500 30,000
Total Manufacturing Cost 160,500 144,500 117,500 100,000
Add Work in Process
Beginning 10,000 15,000 12,500 7,500
170,500 159,500 130,000 107,500
Less Work in Process Closing 15,000 12,500 7,500 12,500
Cost of goods manfuactured 155,500 147,000 122,500 95,000
Add Finished goods
Beginning 32,500 42,500 45,000 36,500
Cost of goods available for
Sale 188,000 189,500 167,500 131,500
Less Finished Goods closing 42,500 45,000 36,500 11,500
Cost of Goods Sold 145,500 144,500 131,000 120,000
Sales 283,000 272,000 240,000 225,000
Cost of Goods Sold 145,500 144,500 131,000 120,000
Gross Margin 137,500 127,500 109,000 105,000
Operating Expenses 42,500 37,500 59,000 35,000
Net Income 95,000 90,000 50,000 70,000
1990
Net Income = 105,000 – 35,000 = 70,000 Cost of goods sold = Sales - Gross Profit
225,000 – 105,000 = 120,000 Cost of goods manufactured =
Total Mfg. Cost + WIP (Beg) - WIP (End)
95,000 = (42,500 + 27,500 + 30,000) + 7,500 - ? = 12,500 Finished goods beginning
Cost of goods sold = Cost of goods Mfg. + Finished goods (Beg.) - Finished goods (End) 120,000 = 95,000 + ? - 11,500 = 36,500
1989
Sales - Cost of goods sold = Gross Profit 240,000 - 121,000 = 119,000
Cost of goods Manufactured
Total Mfg. Cost + WIP (Beg) - WIP (End)
112,500 = 30,000 + 50,000 + 37,500 + ? - 7,500 = 2,500
Cost of goods sold = Beg. Finished goods Inventory + Cost of Goods Manufactured – Ending Finished Goods Inventory
11 Exercise 3
Visic Corporation, a manufacturing company, produces a single product. The following information has been taken from the company’s production, sales and cost records for just completed year.
Production in units 29,000
Sales in units ?
Ending finished goods inventory in units ?
Sales in dollars $1,300,000
Costs
Advertising $105,000
Entertainment and travel 40,000
Direct labour 90,000
Indirect labour 85,000
Raw materials purchased 480,000
Building rent (production uses 80% of the
space; adm. & sales uses the rest) 40,000
Utilities factory 108,000
Royalty paid for use of production
Patent, $1.50 per unit produced ?
Maintenance, factory 9,000
Rent for special production equipment,
$ 7,000 per year plus $ 0.30 per unit produced)
Selling and Adm. Salaries 210,000
Other selling and Adm. Expenses 17,000
Beginning End of
of the year year
Inventories
Raw materials $ 20,000 $ 30,000
Work in Process 50,000 40,000
Finished goods 0 ?
The finished goods inventory is being carried at the average unit product cost for the year. The selling price of the product is $ 50 per unit.
Required :
1. Prepare a schedule of cost of goods manufactured for the year. 2. Compute the following :
12 Answer 3
1.
Schedule of Goods Manufactured Direct Material
Raw Material opening 20,000
Raw material purchased 480,000
Raw material available for use 500,000
Less Raw material closing 30,000
Raw Material used 470,000
Direct labour 90,000
Manufacturing overhead
Indirect labour 85,000
Building rent 32,000
Utilities – factory 108,000
Rent for patent on units produced 43,500
Maintenance factory 9,000
Rent for special product (7,000 + 8,700) 15,700
Other factory overhead 6,800 300,000
Total manufacturing cost 860,000
Add Work in Process (beginning) 50,000
910,000
Less Work in Process (ending) 40,000
Cost of goods manufactured 870,000
2(a) Units in Finished Goods Inventory
Total units produced 29,000
Less units sold
(Sales/unit price) 1,300,000/50 26,000
Units in finished goods inventory 3,000
2(b) Cost of Finished Goods Inventory
Cost of goods manufactured 870,000
Number of units produced 29,000
Cost per unit (870,000/29,000) 30 Cost of finished goods inventory (3,000 x 30) 90,000
c)
Income Statement
Sales (26,000 x 50) 1,300,000
Less Cost of goods sold (26,000 x 30) 780,000
13 Operating Expenses
Advertising 105,000
Entertainment 40,000
Building 8,000
Selling & Adm. Expenses 210,000
Total Operating Expenses 17,000 380,000
14
CHAPTER II
Predetermined Overhead Rate
As against direct material and direct labour, the overhead cost of a job is difficult to determine especially when that job is completed and needed to be invoiced. In order to manage this situation many organizations typically base their predetermined rates on the estimated, or budgeted amount of the allocation base for the upcoming period. An example will help to understand why it is used and helpful in practice. Suppose a company acquired a CD duplicating machine which is capable of producing a new CD every 10 seconds from a master CD. The lease cost is $180,000 per year, and this is the company’s only manufacturing overhead cost. With allowances for set ups and maintenance, the machine is theoretically capable of producing upto 900,000 CDs per year. However, due to weak retail sales of CDs, the company’s commercial customers are unlikely to order more than 600,000 CDs next year. The company uses machine as the allocation base to apply manufacturing overhead to CDs. These data are summarized below:
Total manufacturing overhead cost $ 180,000
Allocation base – machine time per CD 10 seconds per CD
Capacity 900,000 CDs per year
Budgeted output for next year 600,000 CDs
Here using the capacity of the machine for estimating manufacturing overhead rate will provide incorrect data. Instead the estimated budgeted output of the machine shall reflect a more accurate information to the management.
Predetermined = Estimated total manufacturing overhead cost overhead rate Estimated total amount of the allocation base
$ 180,000
600,000 x 10 seconds per CD 0.03 per second
Since each CD requires 10 seconds of machine time, each CD will be charged for $0.30 of overhead cost.
In general the actual factory overhead may not agree with applied factory overhead. When the applied factory overhead turns out to be more than the actual factory overhead for the respective period, the excess amount is called over applied factory overhead. Similarly the factory overhead charged during the period may be less than the actual amount of overhead, the situation will then be termed as under applied factory head.
Exercise 4
15 painting department is based on direct labour cost. At the beginning of the year, the company’s management made the following estimates:
Department
Molding Painting
Direct labour hours 12,000 60,000
Machine hours 70,000 8,000
Direct material cost $510,000 $650,000 Direct labour cost $130,000 $420,000 Manufacturing overhead cost $602,000 $735,000
Job 120 was started on June 1 and completed on June 10. The company’s cost records show the following information concerning the job.
Department
Molding Painting
Direct labour hours 30 85
Machine hours 110 20
Materials placed into production $470 $332
Direct labour cost $290 $680
Required :
1. Compute the predetermined overhead rate used during the year in the Molding Department. Compute the rate used in Painting Department.
2. Compute the total overhead cost applied to Job 120.
3. What would be the total cost recorded for Job120? If the job contained 50 units, what would be the unit product cost?
4. At the end of the year, the records of Fancy Pottery works revealed the following actual costs and operating data for all jobs worked on during the year.
Department
Molding Painting
Direct labour hours 10,000 62,000
Machine hours 65,000 9,000
Materials placed into production $430,000 $680,000
Manufacturing overhead $570,000 $750,000
What was the amount of under or overapplied overhead in each department at the end of the year.
Answer 4
i) Predetermined overhead rate
16 ii) Applied overhead
Molding = 110 x $ 8.60 = $ 946
Painting = $680 x 1.75 = $ 1,190
Total applied overhead cost $ 946 + 1,190 = $ 2,136
iii)
Department
Molding Painting
Direct material cost 470 332
Direct labour cost 290 680
Manufacturing overhead cost 946 1,190
Total Cost 1,706 2,202
Total product cost 50 units 1,706 + 2,202 = ,3,908
Cost per unit 3,908/50 = $78.16
iv) Applied overhead for the year
Molding Actual $ 570,000
Applied 559,000 (65,000 x 8.60)
Underapplied 11,000
Painting Actual $ 750,000
Applied 763,000 (436,000 x 1.75)
Overapplied 13,000
Exercise 5
M/s ‘B’ makes furniture using the latest automated technology. The company uses a job order costing system and applies manufacturing overhead cost to products on the basis of machine hours. The following estimates were used in preparing the predetermined overhead rate at the beginning of the year.
Machine hours 75,000
Manufacturing overhead cost $900,000
During the year due to excessive imports from China, the sale was badly affected resulting in cutting back product and build up of furniture in the company’s warehouse. The company’s cost records revealed the following actual cost and operating data for the year:
Machine hours 60,000
Manufacturing overhead cost $ 850,000
Inventories at year end:
Raw materials $30,000
Work in Process (includes overhead $100,000 Applied $36,000)
17 Cost of goods sold (includes overhead $1,400,000
Applied 504,000)
Required :
1. Compute the company’s predetermined overhead rate. 2. Compute the under or overapplied overhead.
3. Assume that the company closes any under or overapplied directly to Cost of Goods Sold. Compute the revised cost of goods sold.
4. Assume that the company allocates any under or overapplied overhead to Work in Process, Finished goods, and Cost of Goods Sold on the basis of the amount of ovherhead applied that remains in each account at the end of the year. Compute the amount to be adjusted to all the three inventories.
5. How much higher or lower will net operating income be if the under or overapplied overhead is allocated rather than closed to Cost of Goods Sold?
Answer 5
i) Predetermined overhead rate : $900,000/75,000 = $ 12 per machine hr. ii) Applied overhead
Machine hours : 60,000
Rate $ 12 per machine hr.
Overhead applied 60,000 x $12 = $720,000
Actual Overhead cost $ 850,0000
Overhead under applied $ 850,000 – 720,000 = $ 130,000
iii) Cost of goods Sold $1,400,000
Add overhead under applied $130,000
Revised cost of goods sold $1,530,000
iv) Overhead cost allocated to all inventories including cost of goods sold
Work in Process 36/720 x 130,000 $ 6,500
Finished Goods 180/720 x 130,000 32,500
Cost of goods sold 504/720 x 130,000 91,000
Total 130,000
WIP Overhead 36,000 36/720
Finished Goods overhead 180,000 180/720 Cost of goods sold overhead 504,000 504/720
Total 720,000
v) Overhead underapplied transferred to
Cost of goods sold under part (iii) $ 130,000 Overhead underapplied transferred to
Cost of goods sold under part (iv) 91,000
18 The net operating income will be higher by $ 39,000 by using the method (iv).
Service Department Allocations
Most of the organizations have both operating department and service departments. The main function like manufacturing is carried out by the operating department. Whereas service departments do not directly engage in operating activities, instead, provide services or assistance to the operating departments to accomplish their tasks.
The overhead costs of operating departments commonly include allocations of costs from the service departments. To the extent that service department costs are classified as production costs, they should be included in unit production costs and thus must be allocated to operating departments in process costing systems.
Three approaches are used to allocate the costs of service departments to other departments: the direct method, the step down method and reciprocal method.
Direct Method: It is the simplest of the three allocation methods. It ignores the services provided by a service department to other service department and allocates all service department costs directly to operating departments. Even if a service department (such as personnel) provides a large amount of service to another service department (such as the cafeteria), no allocations are made between the two departments. Rather all costs are allocated directly to the operating departments, by passing the other service departments.
Step Down Method: Unlike the direct method, the step down method allocates service department’s costs to other service departments, as well as to operating departments. The step down method is sequential. The sequence typically begins with the department that provides the greatest amount of service to other service departments. After its costs have been allocated the process continues, step by step, ending with the department that provides the least amount of services to other service departments. This method of allocating cost is termed as step down method.
19 Exercise 6
Karachi University has provided the following data to be used in its service department cost allocation.
Service Departments Operating Departments Facility Undergraduate Graduate Administration Service Programme Programme Departmental cost
Before allocations $2,400,000 $1,600,000 $26,800,000 $5,700,000
Student credit hours 20,000 5,000
Space occupied – 25,000 10,000 70,000 30,000 Square feet
Required :
Using the direct method, allocates the cost of the service departments to the two operating departments. Allocate administrative costs on the basis of student credit hours and facility services costs on the basis of space occupied.
Answer 6
Service Departments Operating Departments Facility Undergraduate Graduate
Administration Service Programme Programme
Departmental cost
Before allocations $2,400,000 $1,600,000 $26,800,000 $5,700,000
Administration cost -2,400,000 $ 1,920,000 $ 480,000
Facility Service -1,600,000 $ 1,120,000 $ 480,000
Total Cost Allocation 0 0 $28,112,000 $6,660,000
Cost allocation Administration : 20,000/25,000 x 2,400,000, 5,000/25,000 x 2,400,000 Cost allocation Facility Serv. : 70,000/100,000 x 1,600,000, 30,000/100,000 x 1,600,000
Exercise 7
The Oxford Publishing House has three service departments and two operating departments. Selected data from a recent period on the five department follow:
Service Departments Operating Departments Administrat. Janitorial Maintenance Binding Printing Total
Overhead costs $140,000 $105,000 $ 48,000 $275,000 $430,000 $998,000 No. Employees 60 35 140 315 210 760 Square feet of space 15,000 10,000 20,000 40,000 100,000 185,000 occupied
20 The company allocates service department costs by direct method in the following order:
Administration (number of employees), Janitorial (space occupied) and maintenance (hours of press time).
Repeat the same using the step down method, allocates the service department cost on the same line mentioned above.
Answer 7
Direct Method
Service Departments Operating Departments Administrat. Janitorial Maintenance Binding Printing Total Overhead costs $140,000 $105,000 $ 48,000 $275,000 $430,000 $998,000
Administration -140,000 84,000 56,000 140,000
Janitorial -105,000 30,000 75,000 105,000
Maintenance -48,000 16,000 32,000 48,000 Total cost after
Allocation -0- -0- -0- 405,000 593,000 998,000
Administration : Binding 315/525x140,000 Printing 210/525x140,000
Janitorial : Binding 40,000/140,000x105,000 Printing 100,000/140,000x105,000 Maintenance : Binding 30,000/90,000x48,000 Printing 60,000/90,000x48,000
Step Down Method
Service Departments Operating Departments Administrat. Janitorial Maintenance Binding Printing Total
Overhead costs $140,000 $105,000 $ 48,000 $275,000 $430,000 $998,000 Administration -140,000 7,000 28,000 63,000 42,000 140,000 Janitorial -112,000 14,000 28,000 70,000 112,000 Maintenance -90,000 30,000 60,000 90,000 Total cost after
Allocation -0- -0- -0- 396,000 602,000 998,000
Administration : 35/700x140,000, 140/700x140,000, 315/700x140,000, 210/700x140,000
21
CHAPTER III
COST BEHAVIOUR ANALYSIS AND USE
We have so far discussed the various types of costs. Under cost behavior analysis we shall study how a cost would change as the level of activity changes. The understanding of this behavior is relevant because it provides an insight to the managers that an increase or decrease in production not necessary results in increasing cost or decreasing income. Let us first recapitulate the three cost elements which are involved in production process.
Variable Cost : A variable cost is a cost whose total dollar amount varies in direct proportion to changes in the activity level. If the activity level doubles, the total variable cost also doubles. If the activity decreases to one half, the variable cost will also decrease by 50%.
A cost to be variable, it must be variable with respect to something. That “something” is its activity base. An activity base is a measure of whatever causes the changes in variable cost. An activity base is some time called the cost driver. Some of the most activity base are direct labour hours, machine hours, unit produce and unit sold. Other examples of activity bases include the number of miles driven by salespersons, the number of pounds of laundry cleaned by a hotel number of calls handled by technical support staff at a software company, and the number of beds occupied in a hospital. The undernoted chart shall help to understand the variable cost drivers in different types of organizations.
Types of Organization Costs that are normally variable
with respect to output - Drivers
1. Merchandizing company Cost of goods (merchandise) 2. Manufacturing company Direct material
Direct labour
Variable elements of manufacturing overhead Indirect materials
Lubricants Supplies Power
3. Both merchandizing & Variable elements of selling and
Manufacturing administrative costs like commission, shipping Sales in Dollars
No. of units sold
4. Service Organization Variable elements of variable cost e.g. Banks No. of accounts
22 True Variable versus Step Variable Costs
Not all variable costs have exactly the same behavior pattern. Some variable costs behave in a true variable or proportionately variable pattern. Other variable costs behave in a step variable patterns.
True Variable Costs : Direct materials is a true or proportionately variable cost because the amount used during a period will vary in direct proportion to the level of production activity.
Step Variable Costs : The cost of a resource that is obtainable only in large chunks and that increases or decreases only in response to fairly wide change in activity is known as a step-variable cost. For example, the wages of skilled repair technicians are often considered to be a step variable.
Fixed Costs : A fixed costs is one that remains constant within a relevant range of activity. Since fixed costs remain constant in total, the average fixed cost per unit decreases with the level of activity. For example a group of 20 student have occupied a room in a hotel at a monthly rent of Rs.5,000. The average rent per student would be Rs.250 per month. If the number of students were increased to 50, the average rent per student would drop to Rs.100.
Types of Fixed Cost : Fixed costs are sometimes referred to as a capacity costs, since they results from outlays made for buildings, equipment, skilled professional employees, and other items needed to provide the basic capacity for operations. For planning purposes, fixed costs can be viewed to either committed or discretionary.
Committed Fixed Costs : Investment in facilities, equipments and the basic organization that cannot be significantly reduced even for short periods of time without making fundamental changes are referred to as committed fixed costs.
Discretionary Fixed Costs : Discretionary fixed costs (often referred to as managed fixed costs) usually arise from annual decisions by management to spend on certain fixed cost items. Examples of discretionary fixed costs include advertising, research public relations, operating system, special software etc.
To make the fixed cost more identifiable, a discretionary fixed cost is short term in nature, usually a single year. By contrast committed fixed costs have planning horizon that is spread over several years. Secondly, discretionary fixed costs can be cut for short periods of time with minimal damage to the long run goals of organization, but committed fixed costs cannot be altered without making major changes in the organization set up and operation.
Mixed Costs
23 account. Since mixed cost has a relationship with the level of activity, it can be expressed with the undernoted equation:
Y = a + bX
In this equation,
Y = The total mixed cost
a = The total fixed cost (the vertical intercept of the line) b = The variable cost per unit of activity (the slope of the line) X = The level of activity.
Since the variable cost per unit equals the slope of the straight line, the steeper the slope, the higher the variable cost per unit.
Y
Maintenance Cost Variable Cost │
│ │ │ │
│_______________________________ Fixed Cost │
│ │ │
│______________________________ X No. of patients
Methods to Separate Mixed Cost into Fixed & Variable
Cost behavior with the help of Scattergraph Plotting
The first step in analyzing the cost and activity data is to plot the data on a scattergraph. This plot immediately reveals any non-linearities or other problems with the data. The scattergraph of maintenance costs versus patient day at Services Hospital is shown below:
Month Activity level Maintenance
Patient Type Cost incurred
January 5,600 $ 7,900
February 7,100 8,500
March 5,000 7,400
April 6,500 8,200
24
June 8,000 9,800
July 6,200 7,800
1. The total maintenance cost, Y, is plotted on the vertical axis. Cost is known as the dependable variable. Since the amount of cost incurred during a period depends on the level of activity for the period.
2. The activity, X (patient days in this case) is plotted on the horizontal axis. Activity is known as independent variable, since it causes variations in the cost.
Y
Maintenance Cost
16000 │
14000 │
12000 │
10000 │
8000 │
6000 │
4000 │
2000 │
│_____________________________ X 2000 4000 6000 8000 10000
No. of Patients
From the scattergraph, it is evident that maintenance costs do increase with number of patient days. In addition, the scattergraph reveals the relation between maintenance costs and patient days is approximately linear. In other words, the points lie more or less along a straight line. Such a straight line has been drawn using a ruler. Cost behavior is considered linear whenever a straight line is a reasonable approximation for the relation between cost and activity. Note that the data points do not fall exactly on the straight line. This will almost always happen in practice. The relation is seldom perfectly linear.
Note that the straight line has been drawn through the point representing 7,300 patient days and a total maintenance cost of $ 9,100. Drawing the straight line through one of the data points helps make a quick and dirty estimate of variable and fixed costs. The vertical intercept when the straight line crosses the Y axis in this case, about $ 3,300 – is the rough estimate of the fixed cost. The variable cost can be quickly estimate by subtracting the estimated fixed cost from the total cost at the point lying on the straight line.
Total maintenance cost for 7,300 patient days
(a point line on straight line) $ 9,100
Less estimated fixed cost (the vertical intercept 3,300 Estimated total variable cost for 7,300 patient days 5,800
The average variable cost per unit at 7,300 patient days is computed as follows:
25 High and Low Method
The other method which is more commonly used for estimating the fixed and variable cost is called the high and low method. Assuming that the scattergraph plot indicates a linear relationship between the cost and activity, a fixed and variable cost element of a mixed cost can be estimated using the high low method or the least square regression method. The high and low method is based on the rise over run formula for the slope of a straight line.
Variable cost = Slope of the line = Rise = Y2 - Y1 Run X2 - X1
To analyse mixed cost with the high-low method, begin by identifying the period with the lowest level of activity and the period with the highest level of activity. The period of lowest activity is selected as the first point in the above formula and the period with the highest activity is selected as the second point.
Variable cost = Cost at the high activity level - Cost at the low level of activity High activity level - Low level of activity
Variable cost = Changes in cost Changes in activity
9,800 - 7,400 = 2,400 = $ 0.80 per day 8,000 - 5,000 3,000
Fixed cost element = Total Cost – Variable cost element
$ 9,800 - $0.80 per patient x 8,000 patient days $ 3,400
Both the variable and fixed cost elements have been isolated. The cost of maintenance can be expressed as $ 3,400 per month plus 80 cents per patient a day or as:
Y = $3,400 + $0.80 X
Least Square Regression Method: It is a more accurate cost estimation technique because it mathematically determines the straight line (called the regression line) that minimizes the sum of the squared differences between that line and the various data point. When only two variables are considered (as is the case the number of patients and maintenance cost), the analysis is referred to as simple linear regression analysis. When more than two variables are considered, multiple linear regression analysis is needed.
The mathematics involved in linear regression analysis can be reduced to the solution of the following two equations that are derived from the basic equation for a straight line (y = a +bx).
26 Where b represents variable cost
X The level of activity
X mean Average level of activity
Y Total mixed cost
Y mean Average level of mixed cost
After determining the value the fixed cost can be computed with the help of original equation i.e. Y = a + b.
Note : For the purpose of calculating fixed cost the mean value of Y will be used in the equation and not actual value.
Multiple Choice Questions
1. Over applied factory overhead will always result when a predetermined factory overhead rate is employed and:
a. Production is greater than budgeted capacity. b. Actual overhead costs are more than expected. c. Defined capacity is less than normal capacity.
d. Actual overhead incurred is less than applied overhead.
2. If a predetermined factory over head rate not employed and the volume of production is reduced from the level planned, the cost per unit would be expected to:
a. Remain unchanged for fixed cost and increase for variable cost. b. Increase for fixed cost and remain unchanged for variable cost. c. Increase for fixed cost and decrease for variable cost.
d. Decrease for fixed cost and decrease for variable cost.
3. Factory overhead should be allocated on the basis of: a. An activity basis which relates to cost incurrence. b. Direct labour hours
c. Direct labour cost d. Machine hours.
4. When a manufacturing company has highly automated manufacturing plant producing many different products, the most appropriate basis for applying factory overhead to work in process is:
a. Direct labour hours b. Direct labour costs c. Machine hours d. Cost of material used
5. Which of the following should not be on a monthly cost control report of a department manager?
27 c. Depreciation on departmental equipment
d. Cost of materials used in the department
6. Periodic internal performance reports based upon a responsibility accounting system should not:
a. Distinguish between controllable and uncontrollable costs b. Be related to the organization chart
c. Include allocated fixed overhead in determining performance evaluation d. Include variances between actual and controllable costs
7. The concept of management by exception refers to management’s: a. Lack of a predetermine plan;
b. Consideration of only rare events;
c. Consideration of items selected at random;
d. Consideration of only those items which vary materially from plans.
Management by exception means when the costs incurred by on a specified head depart significantly from the standards fixed by the management, managers investigate the discrepancy to find the causes of problem and eliminate it. This process is called management by exception.
8. Of most relevance in deciding how much cost should be assigned to a responsibility centre is :
a. Avoidabiliy b. Causality c. Controllability d. Variability
9. An example of discretionary fixed costs would be: a. Executive salaries
b. Rent c. Insurance
d. None of the above
10.What effect does an increase in volume have on fixed cost: a. Unit fixed cost would increase
b. Total fixed cost would decrease c. Unit fixed cost would decrease d. Total fixed cost would increase
28 Exercise 8
Hot Coffee Points operates a number of coffee stands in busy suburban malls. The fixed weekly expenses of a coffee stand is $ 1,200 and the variable cost per cup of coffee served is $0.22.
Required: Fill in the following table with your estimates of total costs and cost per cup of coffee at the indicated levels of activity for a coffee stand. Round off the cost of a cup of coffee to the nearest tenth of a cent.
Cups of Coffee Served in a Week
2,000 2,100 2,200
Fixed Cost ? ? ?
Variable cost ? ? ?
Total cost ? ? ?
Cost per cup of coffee served ? ? ?
Does the cost per cup of coffee served increased, decrease ore remain the same as the number of cups of coffee served in a week increase? Explain.
Answer 8
Cups of Coffee Served in a Week
2,000 2,100 2,200
Fixed Cost 1,200 1,200 1,200
Variable cost 440 462 484
Total cost 1,640 1,662 1,684
Cost per cup of coffee served 0.82 0.79 0.77
The cost per cup of coffee is decreasing because with the increase in coffee sales, the fixed cost per cup is declining. As regards variable cost that remains constant at all level of production and has no role in the price of the cup.
Exercise 9
The Seerna Hotel’s guest days of occupancy and custodial supplies expenses over the last seven months were:
Guest Days of Custodial Supplies Occupancy Expenses
March $4,000 7,500
April 6,500 8,250
May 8,000 10,500
June 10,500 12,000
July 12,000 13,500
August 9,000 10,750
29 Guest days is a measure of the overall activity at the hotel. For example, a guest who stays at a hotel for three days is counted as three guest days.
Required:
Using the high low method estimate a cost formula for custodial supplies expenses.
Using the cost formula you derived above what amount of custodial supplies expense would you expect to be incurred at an occupancy level of 11,000 guest days.
Answer 9
Mixed cost = Changes in cost y2 – y1
Changes in activity x2 – x1
13,500 - 7,500 = 6,000
12,000 – 4,000 8,000
0.75
Y = a + b(x)
13,500 a + 12,000(0.75)
a 13,500 – 9,000 = 4,500
Y = a + b(x)
7,500 a + 4,000(0.75)
a = 7,500 – 3,000 = 4,500
c) Y = a + b(x)
4,500 + 11,000 (0.75) 12,750
Exercise 10
A controller is interested in an anlaysis of the fixed and variable cost of electricity as related to direct labour hours. The following data has been accumulated.
Months Electricity Cost Direct labour hours
January Rs. 15,480 297
February 16,670 350
March 14,050 241
April 15,340 280
May 16,000 274
June 16,000 266
July 16,130 285
30 Required :
The amount of fixed overhead and the variable cost using: a) The high and low points method
b) The method of least square
Answer 10
a) High and Low Method
Changes in Cost = 16,670 - 14,050
Changes in activity 350 - 241
= 2,620 ÷ 109 = Rs.24.037 per labour hr.
Y = a + bX
16,670 = a + 350 (24.037)
16,670 = a + 8,413
a = 8,257
b) Method of least square method
Months Labour Electricity (x – x mean) (y – y mean) (x – x mean)2 (x-x mean) (y–y mean) ___________________________________________________________________________ January 297 15,480 10.25 -272.50 105.06 -2,793.13 February 350 16,670 63.25 917.50 4,000.56 58,031.88 March 241 14,050 -45.75 -1,702.50 2.093.06 77,889.38 April 280 15,340 - 6.75 -412.50 45.56 2,784.38 May 274 16,000 -12.75 247.50 162.56 -3,155.63 June 266 16,000 -20.75 247.50 430.56 -5,135.63 July 285 16,130 1.75 377.50 3.06 - 660.63 August 301 16,350 14.25 597.50 203.06 8,514.38 ∑ 2,294 126,020 0 0 7,043.48 135,475.00
X mean = 2,294 = 286.75 hours
8
Y mean = 126,020 = Rs.15,725.5
8
Variable cos per hour = b ∑(x-x mean) (y-y mean) ∑ (x-x mean)2
=
135,475/7,043.48 = Rs.19.23 per hour
Y = a + b(x)
a = 15,752.5 – (19.23 x 286.75)
= Rs. 10,238.5
31 Exercise 11
AAB Company is planning its capacity for the year 2004 at 90% of the rated capacity. For the purpose of estimating ‘other FOH expenses’ company uses 5 years history and ‘simple regression analysis’ method. Data in hand is as under:
Five years history of ‘other FOH expenses’ is as under:
Other FOH Direct labour
Year Expenses (Rs.) Hours
1999 90,775 23,750
2000 83,125 18,750
2001 84,800 20,000
2002 99,084 21,000
2003 84,860 19,750
In the year 2002 other FOH expenses include a penalty of Rs. 12,734 on non compliance of certain labour laws.
Required :
You are required to calculate fixed and variable portion of estimated other FOH expenses at planned capacity.
Answer 11
Labour Other FOH (x-x mean) (y-y mean) (x-x mean)2 (x-x mean)
Years hrs Rs. (y-y mean)
1999 23,750 90,775 3,100 4,793 9,610,000 14,858,300 2000 18,750 83,125 -1,980 -2,857 3,610,000 5,428,300 2001 20,000 84,800 - 650 - 1,182 422,500 768,300 2002 21,000 86,350 350 368 122,500 128,800 2003 19,750 84,860 - 900 -1,122 810,000 1,009,800 ∑ 103,250 429,910 0 0 14,575,000 22,193,500
X mean = 103,250 = 20,650 hours
5
Y mean = 429,910 = 85,892
5
Variable cost per hour = b ∑(x-x mean) (y-y mean) ∑ (x-x mean)2
32 14,575,000
Y = a + b(x)
85,892 = a + 1.5227 (23,750)
a = 85,892 – 36,164 = Rs.49,728
High & Low Method
Variable cost = Changes in cost Changes in activity
= 90,775 - 83,125 23,750 – 18,750
= 7,650 / 5,000 = Rs.1.53
Y = a + b(x)
90,775 = a + 23,750(1.53)
33
CHAPTER IV
MARGINAL AND ABSORPTION COSTING
The most commonly accepted theory of product costing holds that the cost of producing a product includes direct material, direct labour and allocated portion of factory overhead. This method of costing is termed as absorption costing. Since absorption costing includes all costs of production as product cost, it is also termed as full costing method or traditional costing method.
Marginal costing contrary to the approach stated above is a technique under which costs of production that vary with output are treated as product cost. This would usually include direct material, direct labour and variable portion of manufacturing overhead. Fixed manufacturing cost is not treated as product cost, rather it is treated as period cost and hence charged against sales revenue in the period in which the revenue is earned like selling and administrative expenses. Marginal costing is some time referred to as direct costing or variable costing as well.
Why marginal costing is more frequently used by management accountants? Because under this approach the operating results of an entity are compiled after recognizing variable cost and fixed cost separately. Since fixed cost is not controllable at many times, the evaluation of performance and fixing of responsibility for variances from approved budgets becomes more accurate and logical under marginal costing.
The following illustration helps to understand the costing technique under each head:
Example :
Data
Beginning Inventory 0 Variable cost (per unit)
Production (units) 10,000 Direct Material $ 2
Sales (units) 9,000 Direct Labour 1
Selling Price $ 8.00 Factory overhead 0.30 Selling Expenses 0.20 Fixed Cost
Factory overhead $ 6,000 Selling expenses 15,000 Administration Expenses 12,000 Solution
Product Unit Cost
Absorption Costing Marginal Costing
Direct Material $ 2.00 Direct Material $ 2.00
Direct Labour 1.00 Direct Labour 1.00 Factory overhead (variable) 0.30 Factory overhead 0.30 Factory overhead (fixed) 0.60 (variable)
($ 6,000/10,000) ____ ____
34 Income Statement (Absorption Costing)
Sales (9,000 x $8.00) $ 72,000
Cost of Goods Sold
Cost of goods Manufactured
(10,000 x $ 3.90) 39,000
Less ending inventory
(1,000 x $ 3.90) 3,900
Cost of goods sold 35,100
Gross Margin 36,900
Selling & Administrative Expenses
Selling (15,000 + 1,800) 16,800
Administrative 12,000 28,800
Net Income 8,100
Income Statement (Marginal Costing)
Sales (9,000 x $8.00) $ 72,000
Cost of Goods Sold
Cost of goods Manufactured
(10,000 x $ 3.30) 33,000
Less ending inventory
(1,000 x $ 3.30) 3,300
Cost of goods sold 29,700
Manufacturing Margin 42,300
Less Selling Expenses (Variable) 1,800
Contribution Margin 40,500
Less Fixed Cost
Factory overhead 6,000
Selling Expenses 15,000
Administrative Expenses 12,000 33,000
Net Income 7,500
Reconciliation
Difference of profit under two methods $ 8,100 – 7,500 = 600
Inventory 1,000 Units
Fixed Manufacturing overhead $ 0.60 per unit
35 Exercise 12
The selected data of M/s Kiran Company’s operation for the last year is as follows. All currency values are in thousand of rupees.
Units beginning inventory 0
Units produced 250
Units sold 225
Units in ending inventory 25
Variable costs per unit
Direct material Rs. 100
Direct labour 320
Variable manufacturing overhead 40 Variable selling and administrative 20 Fixed costs
Fixed manufacturing overhead Rs.60,000 Fixed selling and administrative 20,000 Required:
1. Assume that the company uses absorption costing. Compute the unit product cost per unit.
2. Assume that the company uses variable costing. Compute the unit product cost per unit.
Answer 12
Unit Product Cost Absorption Costing Direct Costing
Direct material Rs. 100 Rs.100
Direct labour 320 320 Variable Mfg. overhead 40 40 Fixed Mfg. overhead
Rs.60,000/250 240 ____
Unit Product cost 700 460
Exercise 13
The following data is collected from the books of Amir Corporation for the month of September:
No. of units sold 100 units
Selling price per unit $ 20
Variable manufacturing cost/unit $ 5
Fixed manufacturing costs $ 300
36 Required: Prepare an Income Statement for the month of September using Absorption Costing (traditional) and direct costing (contribution margin) format separately.
Answer 13
Direct Costing/Contribution Margin Costing
Sales (100 x $20) $ 2,000
Less Variable manufacturing cost (100 x $5) 500
Manufacturing margin 1,500
Less variable selling & Adm. Cost (100 x $4) 400
Contribution Margin 1,100
Less Fixed manufacturing cost 300
Selling & Adm. Cost 110 410
Net Income 690
Absorption Cost / Traditional Costing
Sales (100 x $20) $ 2,000
Less Variable manufacturing cost (100 x $5) 500
Fixed manufacturing cost 300 800
Gross Margin 1,200
Less Selling & Adm. Cost Variable (100 x $4) 400
Selling & Adm. Cost (fixed) 110 510
Net Income 690
Exercise 14
M/s Lyna Co. manufactures and sells a single product. The following costs were incurred during the company’s first year of operations:
Variable cost per unit: Manufacturing
Direct materials $ 6
Direct labour 9
Variable manufacturing overhead 3 Variable selling and administrative 4 Fixed costs per year
Fixed manufacturing overhead $300,000 Fixed selling and admin. Expenses 190,000
37 Required :
i) Assume that the company uses the absorption costing method: a) Compute the unit product cost.
b) Prepare an income statement for the year.
ii) Assume that the company uses the variable costing method: a) Compute the unit product cost.
b) Prepare an income statement for the year.
Answer 14
Absorption Costing Method
United Product Cost
Direct Material $ 6
Direct labour 9
Variable Mfg. overhead 3
Fixed Mfg. overhead
($300,000/25,000) 12
Total 30
Income Statement (Absorption Costing)
Sales (20,000 x $50) 1,000,000
Cost of goods Sold
Cost of goods manufactured
(25,000 x $30) 750,000
Less ending inventory
(5,000 x $30) 150,000 600,000
Gross Margin 400,000
Operating Expenses
Selling & Adm. Expenses (Variable)
(20,000 x $ 4) 80,000
Selling & Adm. Expenses (Fixed) 190,000 270,000
Net Income 130,000
Variable Costing/Direct Costing Method
United Product Cost
Direct Material $ 6
Direct labour 9
Variable Mfg. overhead 3
38 Income Statement (Variable Costing)
Sales (20,000 x $50) 1,000,000
Cost of goods Sold
Cost of goods manufactured
(20,000 x $18) 360,000
Manufacturing margin 640,000
Less variable selling & adm. Expenses
(20,000 x $ 4) 80,000
Contribution Margin 560,000
Operating Expenses
Fixed manufacturing overhead 300,000
Fixed selling and administrative expenses 190,000 490,000
Net Income 70,000
Reconciliation
Difference in net income ($130,000 - 70,000) $ 60,000
Inventory in units 5,000
Fixed Mfg. overhead per unit $ 12
Difference in net income (5,000 x $12) $ 60,000
Multiple Choice Questions
1. A system of costing which helps in tracing all manufacturing costs (direct and indirect, fixed and variable) which contribute to the production of the product and traced to output and inventories is:
a) Job order costing c) Process costing
b) Absorption costing d) direct costing
2. The term that is most relevant of the type of cost accounting often called direct costing is
a) Fixed costing c) Variable costing
b) Relevant costing d) Prime Costing
3. The basic premise on which direct costing is based with respect to fixed cost is that a fixed cost is:
a) A controllable cost c) A product cost
b) An irrelevant cost d) A period cost
4. Operating income computed using direct costing would generally exceed operating income using absorption costing if,
