Week 3 - Full costing Flashcards
Full (absorption) costing + definition
My additional points
1. VC distinguishes between variable vs fixed costs
2. For VC, Variable mfg cost charged to income stt. as COGS & Fixed mfg cost as period cost (=all other costs not incl. in product cost)
3. For FC (absorption costing), both variable & fixed mfg costs are charged to income stt. as COGS
= The sum of all the costs related to a product (or service) until it is delivered
- Used to SET PRICES
- All costs (both DIRECT & INDIRECT; VARIABLE & FIXED) are allocated to our products so that we know what we need to charge our customer
- Limitation: Different allocation methods may mean that the full cost of the product CHANGES.
> 1 method may result in the full cost analysis showing a loss result of the product, yet it may still be profitable to make. - Used for LONG-TERM PROFITABILITY analysis
- Should never be used to decide production programs (e.g. product mix),
i.e. which products that should be produced & should be closed down
The problem with variable costing
(2 problems)
- In the SHORT TERM, only variable costs are treated as relevant
- However in the LONG TERM, fixed costs (especially fixed overheads) may grow precisely as a result of short term decisions which treat them as irrelevant
eg. from W2, expanding the product range by accepting repeat special orders
- If short term thinking becomes the rule, competitive choices will be made on the basis of short term information & can have (adverse) effects in the whole industry, eg. American companies in the paper industry in the 1960s-80s (vs full costing in European companies)
^VC might lead co.s to produce more of the less profitable products - Assume that costs “vary” mainly in relation to VOLUME (traditional cost allocation base for indirect costs)
- but there are many other COST DRIVERS
- measurable reasons why costs vary, eg. product complexity, product mix heterogeneity, technology etc.
> turn the “measurable reasons” into COST ALLOCATION BASES
Indirect cost
Cost object
Cannot be traced to cost objects in an economically feasible way
Anything for which a separate measurement of cost is desired
Stand-alone & common (separable & joint) costs
Mainly for full or ABC costing:
1. Direct/indirect
2. Stand-alone & common
Mainly for variable costing
1. Variable/fixed
2. Flexible/committed
What are fixed and variable costs depends upon the SETTING. What is the example?
Stand-alone costs
- non-shared costs between users related to a particular activity, cost object or decision
eg. can separate how much material used per product
Common costs
- shared costs between users related to…
Inglis University Library case
- Librarian’s salary: Fixed to the library as a whole*
- Graduate assistant: Fixed to the library as a whole*
However, if the salaries are allocated on a FLEXIBLE HOURLY basis {TIME}, those costs could also be considered to be VARIABLE
Variable costing (contribution margin analysis)
Differences with full costing (My additional points)
1. VC distinguishes between variable vs fixed costs
2. For VC, Variable mfg cost charged to income stt. as COGS & Fixed mfg cost as period cost (=all other costs not incl. in product cost)
3. For FC (absorption costing), both variable & fixed mfg costs are charged to income stt. as COGS
- Used to check the (short-term) PROFITABILITY of products
- If the contribution margin is positive we should produce more of the product; if it is negative we should stop producing the product altogether
- This applies under the ASSUMPTION that FIXED COSTS DO NOT CHANGE, which often is the case in the short-term within the current relevant range of production. - Used to compare the profitability
of DIFFERENT PRODUCTS, ie. if we have capacity constraints and need to make a PRODUCT MIX decision - Should never be used to set prices since only variable costs are included in the contribution margin and the price is taken as given in the analysis.
3 common types of indirect costs/allocation bases (AB)
Indirect costs are allocated in different ways to it
eg. Foxconn case, ICE Ltd case
- Manufacturing overhead costs (MOH)
- AB: direct labour costs traditionally; nowadays machine hours
eg. plant rent, power, indirect manufacturing labour, maintenance and depreciation costs of machines - Indirect material costs (IDM)
- AB: direct material costs
eg. tools, lubricating oil, transport, warehousing - Sales, general & administrative costs (SG&A)
- AB: total manufacturing costs
eg. marketing, HR, IT, executive salary
Format of full cost for a product company & service company
Product company:
Direct labour
+ mfg overhead
Direct material
+ indirect material
= SUM OF MFG COSTS
+ sales & administration allocation
= SUM FULL COST
Service company:
Direct labour
+ Special direct costs (equipment, fixtures, food)
= SERVICE COST
+ indirect costs (IT, office rent, back office staff, marketing)
= FULL COST
3 possible volumes to use for calculating full cost.
Important to be aware of what volume is used & how it affects the full cost calculations
- Budgeted volume
- commonly used in practice
- b/c used in planning; to encourage employees to behave better, encourage innovation, efficiency… - Normal volume (over a biz cycle)
- often the recommended option as considered the most stable
> minimises volatility, bias
But problematic to calculate an AVERAGE volume - how many years to take? What is considered normal? - Actual volume (post-result calculation)
6 advantages of full costing
- Historically (and still) the MOST COMMON COSTING METHOD in companies (particularly in Europe)
- SIMPLE to do
- Makes managers AWARE of the TOTAL COST, to compare with product price
and market prices - Work(ed) well when DIRECT LABOUR IS A LARGE PART of the total cost of production
- Allocation of indirect (overhead) costs MAKES PPL QUESTION THE SIZE OF COSTS IN OTHER UNITS, e.g. headquarter costs
- The basis of allocations can lead people to BETTER INVESTIGATE THE SOURCES OF COSTS
4 disadvantages of full cost
- Works less well with INCREASING AUTOMATION of production
- (causing DL to become a smaller part of the total cost of production)
- Not unusual that the MOH mark-up is hundreds or thousands of percent of DL -> trouble! Significant issue if millions of products. - Small MISTAKES in calculating the labour costs are MULTIPLIED through percentage mark-ups
- Products in manufacturing do not UTILISE the FIXED EQUIPMENT in the same manner as they utilise labour in their production
- High mark-ups can lead to FALSE SIGNALS in the management control of the business
(see slides for eg.)
What is the assumption that we make for Warehouse cost for its allocation base?
- If assume the warehouse is used to store RAW MATERIALS for production, allocation base = DIRECT MATERIAL (the assumption used in the slides)
- If assume it is used to store unfinished products still in mfg process, allocation base = direct labour
- If assume it is used to store finished goods ready for shipping, allocation base = total manufacturing cost
