Costing methods

In this text we will examine just three of the costing methods.

Absorption costing

Absorption costing absorbs the fixed costs and overheads into the production of a good. In a single product business, absorption costing would produce the same result as the total cost approach. In many businesses the same machine can be used for a number of jobs.

A tea packaging plant makes teabags and boxes them for a number of different

brands all produced by the same company. There is no difference in the size of the teabag or box used and the same machinery copes with all brands. The blends of tea used differ, the number of perforations in the teabag differ between blends and the design of the packaging is distinctive according to the market at which it is aimed. How should the costs of acquiring and running the machines be allocated to each brand?

The costs can be allocated according to the length of time the machinery is used for a particular tea. Thus if the total cost for the running of the machinery over a period of time is £20 000, Brand A might have used the machines for 40 per cent of the time and will be, allocated costs of £8000; Brand B is allocated £5000; and Brand C £7000.

Absorption costing is useful in giving a general cost of production, in the valuation of stocks of finished and semi - finished goods and in the allocation of fixed costs between goods when there are reliable production statistics for guidance. It is less useful in the allocation of overheads. When overheads involve services to a product they are difficult to cost subjectively and expensive to cost objectively.

Marginal costing

This method is useful if a business has to make decisions on whether or not to accept an order, or whether or not to continue in business. Marginal costing accepts that, in the short run, certain costs are fixed and must be paid by the business whether or not it continues in operation or is operating at full or less than full capacity.

In the definition of marginal cost a distinction was made between an economist's and an accountant's definition. We will use the accountant's definition in the discussion of marginal costing, i.e. direct costs of production subtracted from revenue. This ignores fixed costs. They have to be paid so any contribution towards them minimizes the losses of the business in the short run.

A loss-making shop has six months to run on its lease, the cost of which is £5000 per year. The owner of the shop regrets renewing the lease, business had already begun to decline at that point, and wishes to discontinue trading. The accountant is less positive, and suggests a closer look at the trading figures. The owner of the shop is legally liable for £2500. To continue trading would incur the cost of bought in stock, heating, lighting, staff and other expenses to a total of £31 000, but would also generate revenue of £33 000.

So the owner of the shop would be worse off by stopping trading than by continuing. Stopping trading with six months to run on the lease will produce a debt of £2500. Continuing trading would reduce that debt to £500 - assuming, of course, that living expenses have been taken into account!

Arkwrights mass produces pressed steel gates. The cost of a single gate to fit a three foot opening is £30, of which £10 can be classified as indirect cost. A leading mail order company approaches Arkwrights and asks them to supply 500 gates at £28 per gate. Arkwrights' first inclination is to refuse. They then look at the order more closely. Their busiest time is in the summer when they operate at 100 per cent capacity. This order is for the period September to December when they operate, on average, at 200 under capacity. The mail order company will be including the product in their spring/summer catalogue which is sent out to agents in February. Arkwrights do some rapid calculations.

• Indirect costs are £10 per gate.

• Direct costs are £20.

• It would receive £28 in revenue.

• £20 would cover the direct costs of production and it would have £8 to contribute to a lowering of their indirect costs.

Arkwrights accepted the order.

Standard costing

Standard costs are decided in advance of production. In this it is similar to budgeting but unlike budgeting, it is limited to the detailed costs of the production process and takes no account of the overall objectives of the business.

Records of historic costs are, of course, an important element in deciding standard costs. It is also possible to introduce a target into the system. If the targets set are realistic then they can act as motivators to better performance, as well as giving managers a clear indication of the inefficient areas of their operation. The following example will help clarify the method:

A department has been given a standard cost for labour of £3.00 per hour. At the end of the accounting period it is discovered that the actual cost of labour was £4.25, an increase of over 40 per cent. Part of this increase could be the result of a negotiated pay rise. On the other hand it could be the result of inefficiencies in other parts of the organization that resulted in an unacceptable level of overtime being worked.

The difference between the standard cost and the actual cost is known as the variance. The variance for labour, from the example given above, can be calculated as follows:

(standard quantity x actual cost) / (quantity x standard cost).

2. Comprehension check.

Read the text again more carefully. Choose the correct answer for each statement from a, b, c.

1. Absorption costing absorbs:

a) fixed and storage costs

b) fixed costs and variables

c) fixed costs and overheads

2. In a single product business absorption costing would provide the similar outcome as:

a) the standard cost approach

b) the total cost approach

c) the travel cost approach

3. How should the costs of acquiring and running the machines be allocated to each brand?

a) according to the length of time the machinery is used for a particular tea box

b) according to the cost of machinery for a particular tea

c) according to the length of time the machinery is used for a particular tea

4. Absorption costing is useful in:

a) the valuation of stocks of finished and semi – finished goods

b) the reduction of stocks and semi – finished goods

c) the giving a sale value of finished and semi – finished goods

5. Absorption costing is less useful in:

a) the allocation of direct costs

b) the allocation of overheads

c) the allocation of standard costs

6. Marginal costing is useful in making a decision on whether or not:

a) to valuate stocks of finished and semi – finished goods

b) to stop variation of stocks of finished goods

c) to continue in business and to accept an order

7. Marginal costing accepts that in the short run:

a) certain costs stay permanent and must be paid by the business

b) certain costs are to be declared and must be paid by the business

c) no costs are fixed and must be paid by the business

8. Marginal costing ignores:

a) indirect costs

b) semi – variable costs

c) fixed costs

9. The owner of the business would suffer greater losses:

a) by stopping trading

b) by continuing trading

c) by launching a new line in trading goods

10. Standard costs are calculated:

a) during product life cycle

b) in advance of production

c) on completion of production

11. The difference between the standard cost and the actual cost is known as:

a) the overstating of norms

b) the revision of norms

c) the variance

3. Write down the names of costing methods and give definitions of these methods without looking into the text.

Writing

State one advantage and one disadvantage of each of the costing methods described in the text. Give specific reasons to support your answer.

Unit 7

Finance