Session 8

Accounting - 1

Accounting – Cost allocation and full cost calculation 1

Definitions
 Cost unit/object is a unit of product or service in relation to which costs
are ascertained. Stated simply: of what are you trying to find the cost?
 Composite cost unit is made up of two parts. (e.g. average cost per
patient per day)
 Direct cost can be directly related to a specific product or saleable
service.
 Indirect Cost/overhead cannot be economically identified or traced to a
specific product or service.
 Allocate means assign a whole item of cost to single cost unit.
 Apportion means spread costs over two or more cost units.

Concepts
Cost allocation and apportionment
 Explanation
Tracing Costs of products A, B ad C (How do we divide the production
overheads fair/equally?)

 Depending on the Cost item, we can apportion the cost depending on

the use of the item in a cost centre.
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Accounting - 2

Absorption costing
 Approach to glow of overhead costs (Traditional Approach)
o Identify overhead costs and identify cost centres that accumulate
costs.
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Accounting - 3

o Steps
 1. Allocate indirect costs to cost centres

 2. Apportion service cost centre to production cost centre

 3. Absorb overhead costs into product.

 Divide total cost of each department by the number
of direct labour hours
o Assembly: £29,569 / 55,000 hours = 53.76
pence per direct labour hour
o Finishing: £51,031 / 64,000 hours= 79.74 pence
per direct labour hour
 This job takes 2 hours assembly and 3 hours finishing
per unit).
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Accounting - 4

 Absorbing Cost into Product

o Can use any:
o Cost per direct labour hour, cost per machine hour, cost per £ of
labour cost, cost per unit, predetermined overhead rates
 The benefits of using the absorption costing method
o To ascertain the full cost
o To make decisions about the profitability
o To possibly make pricing decisions
o To value stock in manufacturing
 3. Step: Absorb costs using a predetermined overhead absorption or
o recovery rate =
Total expected overheads / Total expected volume measure.
 Estimated at the start of a reporting period and adjusted to actual at the
end of the period
o If actual overheads absorbed are greater than actual overheads
incurred this is over absorption. It will be subtracted from total
costs in the Income Statement / Profit and Loss account.
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Accounting - 5

o If actual overheads absorbed are less than actual overheads

incurred this is under absorption. It will be added to total costs in
the Income Statement / Profit and Loss account.
o Calculate the OAR (Overhead absorption rates), then, multiply the
units of absorption base used by the OAR. After, Find the
difference between this and the actual overheads.

Activity based costing (ABC)

 Cost structures become predominantely overhead cased  new
approaches need to be used to deal with allocation of overheads
 ABC says that not the products or services cause the costs but the
activities behind these products and services. (Focus on cost drivers)
 When to use it:
o We have a diverse range of products, customers and processes.
o Our overhead proportion is large and difficult to assign.
o When we increase our volume in production, overheads stay do
not vary.
 How to:
o 1. Identify the major activities
o 2. Determine the cost drivers
o 3. Create cost centres based on cost driver activity
o 4. Trace costs from the cost centres to the cost unit via the specific
cost driver rate.
Benefits Pitfalls
Improves management Selection of cost drivers can be
understanding of costs difficult
Process improvement culture Time and cost of implementation
Non-financial performance measures More complex and resource
demanding
Targets cost reduction Not suitable for companies with
stable products and markets.
Helps design of new products,
services.