ACCOUNTING FOR

DECISIOM MAKING

Week 4 Lecture

(Seminar 5 – Calculating the

unit cost and pricing the
product or service )

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 Blanket Overhead Rate

Blanket Overhead Rate

A single overhead rate used throughout

an entire factory. A simple method,
but one that can distort unit product costs.

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 Blanket Overhead Rate

Production Overhead
Absorption Base
Direct Labor-Hours

Labor Intensive Jobs Capital Intensive Jobs

Job A Job B
Job 1 Job 2

The above procedure results in high overhead costs for labor

intensive jobs with high direct labor-hour content and low
overhead costs for capital intensive jobs with low direct labor-
hour content.
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 Blanket Overhead Rate

Production Overhead
Absorption Base
Machine-Hours

Labor Intensive Jobs Capital Intensive Jobs

Job 1 Job 2
Job A Job B

The above procedure results in high overhead costs for

capital intensive jobs which require heavy machine
processing and low overhead costs for labor intensive jobs
which require low machine processing.
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 Blanket Overhead Rate
• Direct labor or machine-hours has often used as the
absorption base for calculating the blanket
predetermined overhead rate.
• Such absorption bases used are based on time spent in
production cost centres (the higher the output, the
higher the labor-hours/machine-hours, the higher the
overhead applied).
• They fail to reflect many overhead cost items are not
driven by the time spent in production cost centres
( i.e. product design, product planning, processing
production orders, supervisor’s salary).

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Activity-Based Costing (“ABC”)

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 Activity-Based Costing (“ABC”)

Activity-based costing is an attempt to more

accurately assign manufacturing overhead costs
to products based on the activities required to
products and the resources consumed by those
activities.

ABC is based on the principle that:

Products cause Activities; Activities cause Costs

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 Activity-Based Costing (“ABC”)
1) Identify activities involved in the manufacture of the
product

Machine Machine Product General

Cost Pools Processing Setup Design Factory
Admin.

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 Activity-Based Costing (“ABC”)
2) Calculate the total cost of each activity (the ‘cost pool’)

Activity 1 Activity 1 Activity 1 Activity 1

Activity 2 Activity 2 Activity 2 Activity 2

Machine Machine Product General

Processing Setup Design Factory
Cost Pools Admin.

$10,000 $2,000 $6,000 $16,000

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 Activity-Based Costing (“ABC”)
3) Determine what causes each activity (the ‘cost driver’)

Machine Machine Product General

Cost Pools Processing Setup Design Factory
$10,000 $2,000 $6,000 Admin.
(Cost $16,000
Driver) (machine (setups) (Hours of (Labor
hours) Design) Hours)

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 Activity-Based Costing (“ABC”)
4. Calculate Cost Driver Rate (“Predetermined Overhead
Rates ”).

Machine Machine Product General

Cost Pools Processing Setup Design Factory
(Cost $10,000 $2,000 $6,000 Admin.
Driver) (1,000 (10 (200 $16,000
machine setups) design (400 labor
hours) hours) hours)

Cost Driver
Rate $10/ $200/ $30 / $40
machine setup Design / labor
hour hour hour

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 Activity-Based Costing (“ABC”)
5) Assign costs to products on the use made of the activity
(applying the ‘cost driver rate’).

Cost Driver
$10/ $200/ $30 / $40
Rate machine setup design / labor
hour hour hour

Job 101 Job 102 Job 103

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 Activity-Based Costing (“ABC”)
In practical terms, an ABC costing system consists of
five steps:

1) Identify activities involved in the manufacture of the

product
2) Calculate the total cost of each activity (the ‘cost pool’)
3) Determine what causes each activity (the ‘cost driver’)
4) Calculate the average cost per driver (the ‘cost driver
rate’)
5) Assign costs to products on the use made of the
activity (applying the ‘cost driver rate’).

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Seminar Question 1
Two products, X and Y, are made using similar equipment and methods. The
data for an accounting period is as follows:
X Y
Units produced 6,000 8,000
Machine hours per unit 4 2
Production set-ups 15 45
Orders handled 12 60

The production overheads for the period can be analysed as follows:

Production set-ups 179,000

Order handling 30,000

Machine running costs 55,000

264,000
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Seminar Question 1

1) Calculate the overheads to be absorbed by each product using a

traditional machine hour rate:

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Seminar Question 1

2) Calculate the overheads to be allocated to each product using the ABC

method:

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 Absorption Costing vs. Marginal Costing
Manufacturing Costs

Total Absorption Costing

Direct
Materials (or Absorption Costing)
+ is referring a costing
Direct
Labor
Cost Tracing
Cost
method in which all
Object manufacturing costs are
+
(Job) absorbed or included
into a finished unit of
Production
Overheads Cost absorption /
product.
application

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 Absorption Costing vs. Marginal Costing
Manufacturing Costs Marginal Costing is
Direct
referring a costing
Materials method in which only
Cost
+
Direct Object variable costs are
Labor (Job)
included into a finished
Variable unit of product.
Variable Costs
+
Overheads
Under marginal costing,
Production
fixed production
Overheads
Fixed
Profit &
Loss
overheads are
Costs Account considered to be period
Fixed costs and treated as
Overheads expenses for the period.
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The characteristics of businesses using the three methods
are as follows:
Total absorption: Low production overheads compared
with direct costs; fairly limited product
range; used extensively in smaller
businesses where there is some variation
to the main product line e.g. printing
Marginal costing: Direct costs a high proportion of the
production cost; used by businesses
involved in fast moving consumer goods
(fmcg) where pricing decisions are
critical e.g. food industry
ABC: High production overheads; diverse
product range; products using very
different amounts of overheads e.g.
medical equipment manufacturers 19
 Costing System of a Manufacturer
BALANCE SHEET INCOME STATEMENT

Manufacturing Revenues
Costs when
sales
Direct Materials Work in Finished
occur Cost of
Direct Labor Process Goods Goods Sold
Production Inventory Inventory (an expense)
_
Overhead
Non-manufacturing Gross Profit
Costs Marketing, selling
Marketing, selling and administrative
and administrative expenses
expenses _ =
Net Profit
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Non-Manufacturing Overheads (Costs)

1. Research and development

2. Selling and distribution
3. Administration
4. Finance

Non-manufacturing overheads are usually

added to the manufacturing cost on a % basis.

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 Unit Cost
As output increase so the UNIT cost decreases

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 Process and Job-Order Costing

Job-Order Process
Costing Costing

• Many different products are produced each period.

• Products are manufactured to order.
• Cost are traced or allocated to jobs.
• Cost records must be maintained for each distinct
product or job.

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 Process and Job-Order Costing
Job-Order Costing
Direct
Materials
Job Finished Cost of
1 Goods Goods Sold
Direct
Labor
Job Finished Cost of
2 Goods Goods Sold
Manufacturing
Overhead

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Process and Job-Order Costing

Job-Order Process
Costing Costing

• Produces many units of a single product for long

periods.
• Products are homogeneous.
• Cost are accumulated in a process unit and then
evenly allocated to each product.
• Products flow through the production process on a
continuous basis.

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 Process and Job-Order Costing
Process Costing
Direct
Materials

Direct
Labor
Process Process Finished
1 2 Goods
Manufacturing
Overhead
Cost of
Goods Sold

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 Process and Job-Order Costing
Examples
Manufacturing Service Merchandising
Sector Sector Sector
Job- - Aircraft - Auditing - Special mail
Order assembly - Consulting order
Costing - House - Advertising Not Common
construction - Auto-repair
Process - Oil refining - Bank-check
Costing - Beverage clearing Not Common
production - Postal service
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 SALES MARGIN

&

MARK-UP COSTING

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 SALES MARGIN
The product is priced to achieve a standard
margin based on the SELLING PRICE

For example:
Cost £1.60
Sales margin required 20%
Selling price = £1.60 x 100 = £2.00
80
to get back to cost = £2.00 x 80% = £1.60

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 COST PLUS (MARK-UP)
Where the product is priced to achieve a
standard mark-up on COST

For example:
Cost £1.20
Mark-up required 25%
Selling price = £1.20 x 125 = £1.50
100
to get back to cost = £1.50 x 100/125 = £1.20

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 PREFERRED METHOD?
As a general rule:

Sales margin method is used by

manufacturers

Cost plus method is used by retailers

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What costs are covered?

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 SEMINAR QUESTION 2
The unit production cost of a Crusader Mountain Bike is £232 and the
company has budgeted £400,000 for selling, distribution and
administration costs, based on annual sales of 40,000 cycles per year .

(a) Calculate the total unit cost.

(b) Calculate the selling price to the cycle shop if the company wishes to
achieve a sales margin of 10%

(c) On the basis of the answer arrived at in (b), calculate the retail price
to the general public if the cycle shop’s policy is to mark-up
25% on cost to cover overheads and profit.

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 SEMINAR QUESTION 3
Try the following……….

If sales are £280 and the sales margin is 30%, calculate

the cost of sales:

If sales are £390 and the mark-up is 30%, calculate the

cost of sales:

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DEMAND BASED PRICING

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 DEMAND BASED PRICING
SEMINAR QUESTION 4

Demand for product A has been established as follows:

Demand (units) Selling price
20,000 £30
18,000 £35
15,000 £40
11,000 £45

If the variable cost per unit of product A is £20,

calculate the optimum selling price

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 Tutorial Exercise
Seminar 5: Questions 1 – 2

Students are required to hand in

handwritten solutions to the assigned
exercises at the beginning of the
tutorial sessions.

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 End of
Week 4
Lecture

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