Part 4 Costs and decisions (1) PDF

1 Part 4: Full (or absorption) costing methods ▪ 4.1 Principles of full costing methods ▪ 4.2 Uses of full costing methods ▪ 4.3 Overhead allocation rate method (single and multiple) 4H1CD – 2024-2025  2 Reminder: Direct cos...

1 Part 4: Full (or absorption) costing methods ▪ 4.1 Principles of full costing methods ▪ 4.2 Uses of full costing methods ▪ 4.3 Overhead allocation rate method (single and multiple) 4H1CD – 2024-2025  2 Reminder: Direct costing – contribution margin Direct, Indirect,  The profit equation: variable variable Profit= CMu * Q – FC costs costs Q= (Profit + FC)/ CMu Cost  Breakeven point object Q= FC / CMu  Indifference threshold Direct, Indirect, fixed costs fixed costs Q= ∆FC / ∆CMu  Short-term pricing CMu > 0 4H1CD – 2024-2025  3 Reminder: Advanced contribution margin method Direct, Indirect, variable variable  ACM= CMu * Q – DFC costs costs  Discontinuation Cost decisions object ACM < 0  Specific indifference Direct, Indirect, fixed costs fixed costs threshold Q = ∆DFC / ∆CMu 4H1CD – 2024-2025  4 From specific to full costs Cost Direct, Indirect, object variable costs variable costs A Cost object Indirect Cost costs Cost object object Direct, Indirect, C B fixed costs fixed costs How should indirect costs be shared among the cost objects? Cause-and-effect or arbitrary allocation 4H1CD – 2024-2025  5 Full (or absorption) costing methods: general principles  Full (or absorption) cost of a cost object = the total resources consumed by that cost object  General principle of full costing methods: as many costs as possible should be attributed to those objects for which we aim to calculate the cost 4H1CD – 2024-2025  6 Full (or absorption) costing methods (1) Direct costs Cost tracing Full cost Costs of cost Overhead allocation rate method objects Indirect Traditional two-stage costs allocation method Activity-based costing (ABC) 4H1CD – 2024-2025  7 Cost allocation – key notions ▪ Tracing: Repartition of costs through a direct relationship ▪ Allocation: Repartition of indirect costs between cost objects ▪ Allocation base: Quantitative base used to allocate indirect costs ▪ Allocation rate: Value of indirect costs per unit of allocation base ▪ Cost center / Cost pool: Location to which costs are assigned ▪ Indirect costs / Allocation base = Allocation rate 4H1CD – 2024-2025  8 Part 4: Full (or absorption) costing methods ▪ 4.3 Overhead allocation rate method (single and multiple) 4H1CD – 2024-2025  9 Uses of overhead allocation rate method ▪ Small-to-medium size companies and/or not highly diversified (narrow product portfolio): ▪ small proportion of indirect costs ▪ no requirement to invest in a sophisticated cost accounting system ▪ Companies operating on demand (working to customer orders): required to produce rapid cost estimates/quotations 4H1CD – 2024-2025  10 Single-rate allocation method Cost object Indirect Allocation base 1 costs 30 Cost A Cost object 100 20 2 Cost B 50 Cost C Cost object 3 4H1CD – 2024-2025  11 Allocation method Indirect 150 000 Cost Nb of Allocation costs object units base / Allocation A 100 400 3 000 base B 200 1 600 = Allocation 50 C 400 1 000 rate * Allocation = Indirect * Allocation = Indirect base / unit cost / unit base cost A 400 / 100 50*4=200 400 20 000 B 1 600 / 200 50*8=400 1 600 80 000 C 1 000 / 400 50*2.5=125 1 000 50 000 4H1CD – 2024-2025  12 Allocation bases and repartition of indirect costs Cost Volume Direct Machine Direct … object labor /u hours /u costs /u A 100 2 1 20 B 200 1 2 15 C 400 1.5 0.5 25 Direct labor % Machine H % Direct costs % 100*2= 200 20 100*1= 100 20 100*20= 2000 13 200*1= 200 20 200*2= 200 40 200*15= 3000 20 400*1.5= 600 60 400*0.5= 200 40 400*25= 10000 67 850 500 15 000 4H1CD – 2024-2025  13 Exercise Cosmetic 4H1CD – 2024-2025  14 Overhead allocation rate method Single-rate overhead Multiple-rate overhead allocation method allocation method Pool all indirect costs Pool indirect costs (overheads) into one cost (overheads) into different cost centre centers (subpools) Choose a single allocation Choose an allocation base base and calculate a “blanket and calculate an overhead overhead rate” or “plant-wide (allocation) rate for each cost (overhead) rate” or “unique center absorption rate” Allocate the indirect costs of Allocate indirect costs to cost each cost center to the cost objects based on this single objects based on these overhead rate different rates 4H1CD – 2024-2025  15 Multiple-rate allocation method Allocation bases Cost object Indirect 1 costs 30 100 20 Cost A 50 Cost object 10 2 Cost B 100 10 80 Cost C 25 Cost object 3 100 50 25 4H1CD – 2024-2025  16 Exercise Fun Silver 4H1CD – 2024-2025  17 Full (or absorption) cost calculation ▪ Classify costs as direct or indirect costs in relation to the object for which we want to calculate the cost ▪ Trace direct costs to particular cost objects ▪ Allocate indirect costs (or overheads) to the different cost objects that consume them ▪ Full cost of a cost object = direct cost + share of indirect costs allocated to that cost object ▪ Analytical income of the cost object = sales of the cost object - full cost of the cost object 4H1CD – 2024-2025  18 Example (1) ▪ A company manufactures two products L & M ▪ Indirect costs are allocated via a single allocation base: total direct costs ▪ For year N, indirect costs are equal to €30,400 and direct costs €76,000 of which €40,000 are for product L  Compute the full cost of products L and M 4H1CD – 2024-2025  19 Example (2) Blanket overhead rate = total amount of indirect costs / total amount of direct costs ▪ Blanket overhead rate = 30,400 / 76,000 = 0.40 ▪ Indirect costs to be allocated to each type of products = amount of direct costs consumed by this product x blanket overhead rate 4H1CD – 2024-2025  20 Example (3) In € Product L Product M Total Direct costs 40,000 36,000 76,000 Indirect costs 40,000 x 0.40 36,000 x 0.40 30,400 = 16,000 = 14,400 Full cost 56,000 50,400 106,400 4H1CD – 2024-2025  21 Relevant uses of full costing methods ▪ Value stocks (or inventories) ▪ Set long-term prices (policy for fixing selling price) ▪ Analyse profitability: breaking down overall income by product, geographic area, market segment, business unit, etc. ▪ Measure performance ▪ Control/manage costs ▪ Support strategic decision making (forward-looking approach) 4H1CD – 2024-2025 4H1CD – 2024-2025