Accounting L6: Costing (Definition, Classification + Absorption Costing)

Concept of Cost

Definition: Cost is defined as a resource sacrificed or foregone to achieve a specific objective.

• Expression: Cost can also be seen as expenditure incurred.

• Variability: Different answers exist based on context:

  • Historical cost vs. replacement cost

  • Full cost vs. marginal cost

  • Actual costs vs. budgeted costs

• Consideration: The appropriate costing method depends on the decision being made.

Costing: Definition and Purposes

• CIMA 2005 Definition: Gathering cost information and attaching it to cost objects.

• Purpose:

  • Decision Making: Establish appropriate pricing for products or services.

  • Tendering: Accurate future cost estimates necessary for project bidding.

  • Short-Term Decisions: Considerations for accepting discounted orders while not at full capacity.

  • Financial Accounts: Essential for inventory valuation in annual reports.

Cost Classification

• By Function: Differentiating costs related to production, marketing, research, and administration.

• By Element: Classification with respect to material, labor, and overheads.

• By Nature: Categories based on specific characteristics of the costs.

• By Behavior: Classification into:

  • Direct Costs: Costs traceable to a specific cost object.

  • Indirect Costs: Costs associated with a cost object but non-traceable economically.

Direct and Indirect Costs

• Direct Costs: Related to a specific cost object (product or department) and traceable.

• Indirect Costs: Related but non-traceable in an economically feasible way.

Case Study: Limited Ltd

• Departments:

  • Production: Assembly and Finishing

  • Service: Maintenance and Personnel

• Direct Costs:

  • Assembly Department: €70,000

  • Finishing Department: €50,000

• Indirect Costs:

  • Maintenance Department: €40,000

  • Personnel Department: €24,600

• Cost Allocation: Maintenance costs allocated equally among production departments.

Breakdown of Costs by Type

• Direct Costs Examples:

  • Factory materials

  • Labor

  • Overhead

  • Cost Breakdown:

    • Prime Cost: All direct costs.

    • Conversion Cost: associated conversion of prime inputs into finished goods.

Absorption Costing

• Definition: Method to obtain the full cost of a product or service.

• Usage: Inventory valuation in financial reports; basis for determining product price.

Example: Sponge and Chocolate**

• Departments: 3 departments - 2 production (Sponge and Chocolate) and 1 service (Maintenance).

• Prime Costs:

  • Sponge Cakes: £35 for 10,000 produced.

  • Chocolate Cakes: £42 for 8,000 produced.

• Overheads:

  • Indirect ingredients: Distributed costs based on production volume.

  • Building costs: Allocated based on area.

Allocation of Building Costs

• ** Cost Apportionment Method**:

  • Indirect building costs based on department area.

  • Building costs: £30,000 allocated based on square meters occupied.

Final Cost Analysis

• Sponge Cakes Total Product Cost Calculation:

  • Total Overhead = Indirect ingredients + Building costs = £31,200

  • Cost per Sponge Cake = Total Overhead / Number Produced = £3.12

  • Total Product Cost = Prime Cost + Overhead = £38.12

• Chocolate Cakes Total Product Cost Calculation:

  • Building costs proportionate based on overheads and direct costs:

  • Total Product Cost = Prime Cost + Overhead = £45.35

Pricing Considerations

• Inventory valuations in annual reports for sponge (£38.12) and chocolate cakes (£45.35).

• Pricing strategy will involve adding a percentage for non-production costs and a profit margin.

Overhead Absorption for Multiple Production Centers

• Example of applying different methods for overhead absorption, including machine hours and labor hours.

• Tennis Racquets Example:

  • Production in departments for distinct processes;

  • Costs are distributed based on actual production requirements across departments.