Welcome to the World of Costing!
In this chapter, we are going to dive into how businesses figure out how much their products actually cost to make. It’s not just about the wood in a chair or the flour in a cake; it’s also about the rent for the factory, the electricity for the machines, and the salary of the supervisor. This is what we call Absorption Costing and its modern cousin, Activity Based Costing (ABC).
Don't worry if this seems a bit heavy at first! Think of it like splitting a pizza bill with friends. Some people ate more, some less, and some only had a drink. Costing is just the business way of making sure everyone (or every product) pays their fair share of the "bill."
Part 1: Absorption Costing
Absorption costing is a method where we "absorb" all the manufacturing costs—both direct and indirect—into the cost of a single unit of a product. Its main goal is to make sure fixed overheads (like rent) are included in the product's price and inventory value.
The Three Steps of Handling Overheads
To get those tricky overheads into the product cost, we follow a simple three-step process. Think of it as moving costs from a "big bucket" into "smaller buckets" and finally onto the "product."
1. Allocation: This is used when an expense belongs entirely to one department.
Example: If the canteen has its own electricity meter, that bill is allocated directly to the canteen.
2. Apportionment: This is used when a cost is shared between several departments. We use a fair "basis" to split it.
Example: Rent is usually split based on floor area (square meters). The bigger the department, the more rent it "pays."
3. Absorption: This is the final step where the costs in the production departments are charged to the individual products using an Overhead Absorption Rate (OAR).
Calculating the Overhead Absorption Rate (OAR)
To find out how much overhead to add to each product, we use this formula:
\( \text{OAR} = \frac{\text{Budgeted Overheads}}{\text{Budgeted Activity Level (e.g., Labour Hours or Machine Hours)}} \)
Which activity level should I use?
- If the work is done mostly by hand, use Direct Labour Hours.
- If the work is done mostly by machines, use Machine Hours.
Under and Over Absorption
Because OARs are usually calculated at the start of the year based on estimates (budgets), reality often turns out differently!
- Under-absorption: You spent more on overheads than you expected, or you worked fewer hours. You haven't charged enough to your products!
- Over-absorption: You spent less or worked more hours than planned. You’ve charged too much!
Quick Review Box:
- Allocation: Direct to one department.
- Apportionment: Shared using a fair ratio (like floor space).
- Absorption: Charging it to the product using the OAR formula.
Part 2: Activity Based Costing (ABC)
As businesses became more complex, Absorption Costing started to feel a bit too "simple." For example, if a factory makes a standard blue pen and a high-tech gold pen, the gold pen might require way more quality checks and special setups, even if it takes the same amount of machine time. Activity Based Costing (ABC) was created to solve this.
Key Terms in ABC
Cost Pool: This is just a fancy name for the total cost of a specific activity.
Example: The total cost of "Setting up Machines."
Cost Driver: This is the factor that causes the cost to change.
Example: The number of times you have to "set up" a machine drives the setup cost.
How to do ABC (Step-by-Step)
1. Identify the main activities in the factory (e.g., ordering materials, inspecting quality).
2. Group the costs of these activities into Cost Pools.
3. Identify the Cost Driver for each activity.
4. Calculate a Cost Driver Rate:
\( \text{Cost Driver Rate} = \frac{\text{Total Cost in Pool}}{\text{Total Number of Driver Occurrences}} \)
5. Assign the costs to products based on how much of that "activity" the product used.
Why use ABC? (The Real-World Connection)
Imagine a restaurant. Absorption Costing is like splitting the bill equally among 10 friends. ABC is like everyone paying for exactly what they ordered. It is much more accurate, especially when a business makes many different types of products.
Did you know?
Modern companies like Amazon or Apple use versions of ABC because their logistics and shipping costs are driven by the number of orders, not just the "hours" it takes to pack a box!
Part 3: Comparing the Two Methods
Advantages of Absorption Costing:
- It is simple and cheap to operate.
- It follows Accounting Standards (IAS 2) for valuing inventory in financial statements.
- It ensures all fixed costs are covered in the long-run pricing.
Advantages of Activity Based Costing (ABC):
- It provides a much more accurate cost per unit.
- It helps managers understand what is driving costs, which helps them cut waste.
- It is better for pricing complex products.
Common Mistakes to Avoid:
1. Picking the wrong base: Don't use floor area to split the electricity for machines! Use something logical, like Kilowatt-hours or machine hours.
2. Mixing up OAR and Cost Driver Rate: Remember, OAR is usually for the whole department (Absorption), while Cost Driver Rate is for one specific activity (ABC).
3. Forgetting Fixed Costs: Remember that Absorption Costing must include fixed production overheads.
Key Takeaways for your Exam
- Absorption Costing uses a single rate (like labour hours) for a whole department. It's simple but can be inaccurate.
- ABC looks at the specific activities that cause costs. it's complex but very accurate.
- Under/Over absorption happens because we use budgeted figures instead of actual figures to calculate the OAR.
Top Tip: If an exam question asks you to "Evaluate" which method is better, always mention that while ABC is more accurate, it is much more expensive and time-consuming to set up!