Management Accounting – Full Costing
February 23, 2010 2 Comments
In our list of ways to define cost, we’re onto number 3:
- Differential future cash flows (DFC)
- Cost behaviour in relation to output
- Assignment to cost object
- Financial statement perspective
- Business function
Assignment to Cost Object, which considers Direct and Indirect costs.
So let’s quickly define what the difference between Direct and Indirect costs are.
Direct costs – Costs that we can identify in specific cost units.
Indirect costs – Costs that we can’t!
So here’s a quick example. A loaf of bread for £1.00 is a direct cost, as we can measure it in a real cost unit (pounds). The cost of a business losing an employee with lots of contacts is indirect, as you can’t put a monetary value on the contacts he or she knows.
Another quick point: Cost object is anything that we might want to get a measurement of cost for.
The full cost
So, this is what we call the total amount of resources that are sacrificed to achieve an objective. It includes everything related to producing the product or providing the service.
Managers use full costs for four things:
- Decision making
- Measuring income
- Budget planning
We’re going to work out the full cost per unit of a product. In one month a company produces 1,000 DVD players.
They incur these costs:
- £400 in materials
- £900 in labour
- £50 electricity
- £400 rent
- £100 depreciation
So what is the full cost per DVD player? Try and work it out for yourself then press Ctrl+A for the answer.
Ok, this is actually really easy to work out.
First we add up all the costs that were incurred, so: 400 + 900 + 50 + 400 + 100 = £1850.
Now we divide it by how many units were produced, so: £1850 / 1000 = £1.85
Making the full cost per DVD player £1.85
This is how a business identifies the full cost of a unit of output when they make multiple products. So, let’s say a business makes both peanuts and nut allergy medicine. The factory where they are made costs £500/month in rent. How much of this rent do we allocate to each product? One way of doing this is by looking at the absorption rate.
2 things we often also look at the see what the proportion of costs should be are the direct labour hours and the machine hours. In both cases, the longer something takes, the higher share of indirect costs it is allocated. Labour hours are more commonly used.
Calculating full cost
There are a few easy steps we can follow.
- Work out what the direct costs are
- Work out the absorption rate, which is: (total indirect costs / total labour OR machine hours)
- Then combine the direct costs and indirect costs to get total cost
We’ll do an example now to demonstrate it because it can look a bit confusing.
A business that repairs fridges has £10,000/month overheads. Every month 2,500 direct labour hours are worked and charged to units of output. In this case, a unit of output is repairing a fridge. A particular repair job used direct materials costing £15. The direct labour worked on the job was 15 hours paid at £5/hour. The overheads are charged to jobs on a direct labour hours basis. Calculate the full cost of the job.
Instead of blanking out the answer, I’ll work through it and explain each step.
So first of all we need the overhead absorption rate. The overheads are £10,000/month, and there are 2,500 direct labour hours, so that gives an absorption rate of (10000/2500) = £4 per direct labour hour.
Now we need to work out the other costs and add them up.
- £15 direct materials
- £5 × 15 hours direct labour = £75
- Overheads: £4 per direct labour hour × 15 hours = £60
So the total is: £15 + £75 + £60 = £150 is the full cost of the job.
How about another example?
A company makes gazebos amongst other things. In the next month they expect to incur these costs:
- £9000 – indirect labour
- 6000 hours – direct labour time
- £3000 – Machinery depreciation
- £5000 – Rent
- £30,000 – Direct labour costs
- £2000 – Electricity bills
- 2000 hours machine time
- £500 – indirect materials
- £200 – other misc indirect costs
- £3000 – direct materials cost
The company has received an enquiry about a gazebo that is estimated to take 12 direct labour hours to make, and will need 20 square metres of cloth (cost: £2/sq m)
They use a direct labour hour basis to charge overheads for individual jobs.
What is the full cost of making the gazebo?
Again, we’ll go through it step by step.
Start with direct costs:
Materials: 20 × £2 = £40
Labour: (£30,000 direct labour costs ÷ 6,000 direct labour time) × 12 = £60
TOTAL DIRECT COSTS: £40 + £60 = £100
Now the indirect costs:
£9000 indirect labour, £3000 depreciation, £5000 rent, £2000 electricity, £500 indirect materials and £200 misc costs adds up to £19,700
As the company uses direct labour hours for allocating overheads, the overhead recovery rate is £19700 ÷ 6000 hours = £3.28 per direct labour hour. As it takes 12 labour hours to make the gazebo, the indirect costs come to (12 × £3.28) = £39.36. Then the full cost of making the gazebo is just the total direct costs + the total indirect costs which comes to £139.36.
So to reiterate, we found the answer to this question by:
- Working out the cost of direct labour for the job: (direct labour costs ÷ direct labour hours) × (number of hours the job needs)
- Adding on the cost of the cost of direct materials (20 metres at £2 per metre, given in the question)
- Working out the total overheads for the company, then using the number of direct labour hours to determine the absorption rate
- Applying that absorption rate to the numbers of hours the job needed to get the total indirect costs
- Adding the total direct and indirect costs together
Another example — part 2!
Let’s say that the company decides to start doing overheads based on machine hours, and it takes 5 hours to make the gazebo. What’s the full cost now? Press Ctrl+A once you’ve had a go
The direct costs stay the same as before: £100 in total.
Indirect costs: £19700 (same as before) ÷ 2000 machine hours = £9.85 per machine hour.
Total indirect costs: 5 hours × £9.85 = £49.25
Full cost: £149.25
That example has taught us that we get different answers when we use machine hours compared to labour hours. Which one we use in our calculations is our choice. The main thing to remember is that the total overheads are going to be the same no matter what method is chosen. Here’s yet another example to drum it in some more!
Imagine your company will have overheads of £15,000 next month. Your company is expected to have 1500 hours direct labour time and 1000 hours machine time next month too.
You get offered 2 jobs for next month.
- Job 1 requires 750 direct labour hours and 300 machine hours
- Job 2 requires 750 direct labour hours and 700 machine hours
Let’s work out the overhead costs for each job depending on if we choose labour hours or machine hours.
Direct labour hours
Overhead absorption rate: £15,000 ÷ 1,500 labour hours = £10 per hour
Job 1 will have overhead costs of £10 × 750 hours = £7,500
Job 2 will also have £7,500 overhead costs as it too requires 750 direct labour hours.
£7,500 + £7,500 = £15,000
Absorption rate = £15,000 ÷ 1,000 machine hours = £15 per hour
Job 1 costs: £15 × 300 = £4,500
Job 2 costs: £15 × 700 = £10,500
Therefore the total comes to £15,000 in both cases.
If we decided to charge Job 1 on direct labour hours and Job 2 on machine hours, the total would be £18,000 (or £12,000 if vice versa). This is therefore wrong as it will total more than £15,000.
Therefore we can’t charge 2 jobs on different types of hours. There is an alternative to this though: If overheads are segmented into sub groups then the most appropriate basis can be charged to jobs. Here’s ANOTHER example:
Example 3 – continued
Using the same example from above, of the £15,000 overheads, £7,000 relates to machine activity and the other £8,000 to general activities.
Let’s say that machine activity is charged by machine hours and the general activities are charged by labour hours. How would the costs be now?
So the first thing to do is work out the overhead absorption rates.
On a machine hour basis this is: £7,000 ÷ 1,000 machine hours = £7 per hour
On a direct labour hour bases: £8,000 ÷ 1,500 direct labour hours = £5.33 per hour
Now to look at the 2 jobs:
Job 1 costs: (£7 × 300 hours) + (£5.33 × 750 hours) = £6,098
Job 2 costs: (£7 × 700 hours) + (£5.33 × 750 hours) = £8,898
Total: £14,996 (round up to £15,000)
That’s all for now