ACCA F5

Kns Institute of Business

Costing a product
Businesses incur both direct and indirect (overheads) cost for producing a product. Direct costs are those which are specifically traced on a product. However, overheads like rent, depreciation, insurance and maintenance are incurred in general and need to be charged on units in some appropriate way. As the direct cost is specific to a unit, it is easy to calculate and less prone to error. However when distributing general cost on the products it is possible that we do it in an unfair way, leading to inappropriate cost per unit.

Why we need to cost per unit Inventory valuation To record cost in income statement To price products Decision making like product continuation and discontinuation decisions and make vs buy decisions.

Incorrect cost can lead to incorrect decision making in all above aspects.

Traditional approach for dealing with overheads: Traditionally to calculate overhead cost per unit, either total overheads were divided by total units produced (especially used where units were similar) or they were allocated on units using machine hrs or labor hrs. Problem with Absorption Costing: All the overheads are not varied by labor hrs or machine hrs or the volume produced and this may lead to inappropriate charging of overheads to units.

However, this approach was acceptable in past as Overheads used to be only small proportion of total cost. Products were simple with little changes in them. In past, most of the overheads used to be volume driven.

Faculty: Irfan Sharif

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ACCA F5

Kns Institute of Business

However, with increased automation overheads now constitute major proportion of total cost, and also companies now produce products which take extensively different level of efforts in production.

Activity Based Costing:

ABC is a system of allocation of overheads to products; it involves identification of the major cost incurring activities (called cost drivers) and charging the overheads based on these activities consumed by the product.

Here are some major cost incurring cost incurring activities and their drivers Raw material handling cost Machine setup cost Inspection cost Dispatching cost number of raw materials handled number of setups number of inspections required number of dispatches required

However basic infrastructure cost and some other cost for which drivers are difficult to identify is still charged on the basis of labor hrs or machine hrs.

Case 1: Malls ice cream company produces two flavors of ice cream vanilla and mango. In a particular month company produced 50 kgs of each flavor ice cream. Direct cost incurred on each kg of both flavors are given below Vanilla: Rs. 30 per kg Mango: Rs. 50 per kg Total overheads incurred are 5000 in the month, which are to be incurred using labor hrs as the basis. Vanilla flavor incurred 100 labor hrs in total and mango flavor incurred 150 labor hrs. Requirement: Calculate total cost per unit of both ice creams

Faculty: Irfan Sharif

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ACCA F5

Kns Institute of Business

Case 2-a Pigloo ice cream company produces two flavors of ice cream strawberry and cassata. Cassata ice cream is made up with seven different flavors, with each clearly and separately apparent on the ice cream. In the month company produced 100 kgs of both strawberry and cassata flavor. Direct cost incurred on each flavor is as below Strawberry flavor: Rs: 50 per kg Cassata flavor: Rs: 40 per kg Total overheads in the month were 10,200 and it is to be apportioned on machine hrs basis. Total machine hrs incurred on processing of strawberry 250 and and on processing of cassatta. 220 each.

Calculate: Cost per unit of each flavor, using machine hrs as a basis of absorption of overheads

Case 2-b: Breakdown of the total overheads (given in case 2 above) is given below. Each time a raw material is purchased, Rs 200 are incurred. Each time a setup is made Rs 300 are incurred Each time product is inspected Rs 400 are incurred General rent and machinery cost: 2600 Strawberry flavor requires one time purchasing, one machine setup and one time inspection. Whereas, cassata flavor requires 7 times purchases, 7 machine setups and 8 times inspections.

Calculate: Cost per unit of each flavor, identifying the activities which incur cost and charging the overheads on the basis of these activities.

Faculty: Irfan Sharif

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ACCA F5

Kns Institute of Business

Activity An event or task or work with specified purpose. Setting up machines Designing products Purchasing materials

Cost pool Collection of cost relating to the activity. Machine set up cost Product designing cost Materials purchasing cost

Cost driver The factor which causes the change in the cost of an activity.

Appling the ABC system: An step by step approach should be followed. Step 1: Identify the organizations major activities Step 2: Identify the cost associated with each activity and make the cost pools. (no more totality of overhead) Step 3: Identify the cost driver for each activity. Step 4: Divide the cost in each cost pool by the cost driver to calculate cost per driver for each activity. Step 5: Calculate the total cost for each product, according to the products usage of each activity.

Faculty: Irfan Sharif

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ACCA F5

Kns Institute of Business

How more appropriate cost per unit and better understanding of cost drivers can help business?
Businesses need to take important decisions about pricing, product promotion or discontinuation of product and redesigning products and developing new ways to do business. Pricing

Promoting or discontinuing products

Redesigning products and developing new products or new ways to do business

Advantages of ABC More accurate cost per unit Better understanding of what drives the cost Can be applied to all overheads, not just to production overheads Can be used easily both in service and product costing

Disadvantages of ABC Little or no benefit if overheads products have little or no difference, overheads are only in small proportion of total cost and activities consumed by products are in equal amount Impossible to relate all the overheads to specific activities. Not necessarily all the overheads within a pool are run by the driver we choose. Choice of activities, cost pools and cost drivers might be inappropriate. The benefits obtained from ABC might not justify its cost. ABC may be difficult to apply and explain to managers. More detailed cost and accounting records are needed to be maintained for ABC.

Faculty: Irfan Sharif

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