Full (absorption) costing is a widely used approach that takes into consideration of all the costs of producing a particular product or service. We can use this approach to deduct costs of some activities, but it will depend on whether each product or service is identical or whether each job has its own individual characteristics. This costing can be very useful for management purposes.
Full costing is the total amount of resources, expressed in monetary terms to achieve business objective. If our objective is to supply customer with product or service, the goal is to determine full cost all the resources required to make the product.
A cost unit is a unit of whatever is having its cost determined. Usually, it is one unit of output of a particular product or service.
The full costs calculations can help with management decisions in various ways:
1. Pricing and output decisions. Having full costs will impact on the price charged to the customer for product or service or number of products to be produced.
2. Exercising control. We can exercise cost control, if the full cost is considered as too high, the individual elements of those costs can be examined to see whether there are any opportunities for savings. Also budgets are expressed in full cost terms.
3. Assessing relative efficiency. Full cost may help to determine the cost of carrying out an activity in a particular way.
4. Assessing performance. As we know profits are an important measures of performance. The profit and revenues should be compared with full costs in generating that revenue. This can help in assessing past decisions as well as guide future decisions.
Single product costing - Process costing
The simplest way of determining of the full costs is when business produces a single product. To identify the full cost per unit we should average the total manufacturing costs over the number of units produced. This would be, for example adding up the costs of materials, labour, rent, fuel, power and so on. Then dividing it by the total number of units. This is called process costing.
Process costing tends to be quite straightforward as it involves tracking of the production of items. But there may be some issues with determining certain costs, such as depreciation, the cost of raw materials because questions arise on whether we should include the "relevant" costs or "historical costs" of the materials. Even though "relevant" costs seem like more logical solution, often companies use "historical costs". Additionally, there also may be an issue on determining how much output is has been produced as some items may only be semi-finished at a particular time. "Work in progress" should also be taken in consideration when calculating the total output.
Where all the units of outputs are identical, the full costs can be calculated as follows:
Cost per unit = Total cost of output / Number of units produced
Job-costing
Sometimes companies provide multiple products, so the above calculations would be inappropriate. Where a business supply different products job-costing might be more suitable.
Job-costing involves accumulating for each individual unit of output in order to determine its full cost. We must, however, first understand the difference between direct and indirect costs.
Direct and indirect costs
When the cost units are not identical, the starting cost is to separate the costs into two categories:
Direct cost. This is a cost that can be identified with specific cost unit. For example materials and direct labour. Usually workers are asked to record how much time they spend on each job and pay rates are also available, and by multiplying it we have the labour costs.
Indirect costs (overheads). This comprises all other elements of total costs. For example rent.
Job costing
To calculate the full cost of a job, we normally identify the direct costs that are normally straightforward. But we have to then apply a relevant share of indirect costs. Therefore a full cost of a particular job is the are the direct costs and share of the cost of creating the environment in which production take place.
Total cost behaviour
The total cost of a job is the sum of the costs that remains the same (fixed costs) and that which varies depending on the level of activity (variable costs). Fixed costs and variable costs are defined in terms of cost behaviour in relation to the changes of the volume of activity. However, direct costs and indirect costs measure the extend to which they can be identify with and in respect to particular job. A fixed cost can often be an indirect cost and variable cost can be direct cost, we should not think these are the same.
Total cost is the sum of direct and indirect costs, but also the sum of fixed and variable costs.
Indirect costs
We must remember that the distinction between direct and indirect costs is only important for job-costing environment. Where outputs are not identical, we must achieve appropriate measure of full costs.
Overheads
Indirect costs (overheads) can be viewed as rendering a service to cost unit. Often the easiest way of calculating this is dividing the overhead cost between each product manufactured or service provided. But it is highly unlikely that the products or services are identical as they will differ both from size and complexity.
To determine how the job costing works we can use an example.
A computer servicing company has overheads costs of £10,000 per month and £1,000 of direct costs. A laptop repair takes direct materials of £15, plus time of 3 hours paid at £16 to employees. The company charges overheads at the direct labour hour basis.
First we must establish the overhead (absorption) recovery rate which is the rate at which individual repairs will be charged with overheads. That is £10,000 / £1,000 = £10.
Direct materials - £15
Direct labour (3 X £16) - £48
Overheads (3 X £10) - £30
Full cost of the job - £93
The number of labour hours (3 hours) appears twice in the deduction cost (with labour and overheads). These are two separate issues.
If all the jobs undertaken during the month are assigned overheads in similar manner, all £10,000 will be charged between various jobs. Jobs that require higher amount of labour will be assigned higher overheads.
The reasons for that are:
* large jobs should attract large amounts of overheads because they are likely to have been rendered more "service". We can this way measure relative size through relative physical size.
* Most overheads are related to time, i.e lighting, energy, gas are all related to time thus making the calculation based on time seems logical.
But there is no "correct" way of assigning overheads to a job, but we must find a way of assigning a share of total overheads to a job. The direct labour hour method is mostly used.
The final choice of calculating the overhead costs is a matter of judgement.
The nature of the overheads should influence the basis for charging them to the job. In capital-intensive production environment the overheads are primary machine based (depreciation, maintenance, power and so on).
Let's look at another example. If a service company plans to incur overheads of £20,000 with 1,600 direct labour hours and machines operating 1,000 hours. Two large jobs will be performed:
Job 1 Job 2
Direct labour hours 8,000 8,000
Machine hours 700 300
If overheads are being charged on direct labour hours the overheads recovery rate would be £20,000/1,600 = £12.5 direct labour hour, so:
Job 1 = £12.5 X 800 = £10,000
Job 2 = £12.5 X 800 = £10,000
If overheads are being charged on the machine hour basis the overhead recovery rate would be £20,000/1,000 = £20.0 per machine hours
Job 1 = £20.0 X 700 = £14,000
Job 2 = £20.0 X 300 = £6,000
We can see that the share of total overheads for a month can vary significantly depending on the basis used.
Segmenting the overheads
Charging the same overheads to different jobs is not feasible. We can, however, charge one segment of total overheads on one basis and another segment on another.
If from the example above, we know that the total £20,000 overheads relates to £8,000 for machines (depreciation, maintenance, rented space) and £12,000 to more general overheads. We can then calculate the overheads for the jobs if the machine related overheads are to be charged on the machine hour basis and the remaining overheads on direct hours basis.
Direct labour hours overheads recovery rate = £12,000/1,600 = £7.50 per direct labour hour
Machine hours basis overheads recovery rate = £8,000/1,000 = £8,00 per machine hour
Overheads charged to jobs
Job 1 Job 2
Direct labour hours basis
£7.50 X 800 £6,000
£7.50 X 800 £6,000
Machine hours basis
£8,00 X 700 £5,600
£8,00 X 300 £2,400
Total £11,600 £8,400
Overheads on a cost centre basis
Small businesses are divided into departments who carry our separate tasks. They can charge overheads based on cost unit based on department-by-department basis. But it does not guarantee accuracy but it is not an expensive exercise. It works on the basis of passing of a job through departments, picking up costs as it goes. Each department is known as a "cost centre". The business keeps the record of the number of hours of direct labour worked on a particular job and grade of labour with different rates depending on different grades of pay, the costs of direct materials and any other direct cost elements, for example some subcontracted costs.
The total production overheads are then broken down at the cost centre basis. The sum of the overheads of each cost centre will equal the total overheads for the entire business.
Batch costing
Many goods or services are produced in batch of identical or nearly identical units. In these circumstances the cost is calculated using "batch costing" approach that involves:
* using a job costing approach (taking into account direct and indirect costs)
* dividing the cost by individual item. The cost of the batch is derived using job-costing basis and this is divided by the number on the batch to determine the cost of each cost unit.
A variation of job costing where each job consist of a number of identical units:
Cost per unit = Cost of the batch ( direct + indirect ) / Number of units in the batch
Forward looking nature of full costing
Deducting the full cost can be done after the work has been completed, but frequently it is predicted in advance as it is needed for setting the selling price. But predictions are generally far from accurate.
Activity based costing
As we have seen above the traditional job costing involves in identifying a part of cost measured for particular job/batch. Overheads are then charged to individual jobs respectively.
Costing and pricing - the old way
The traditional approach, still widely used to costing developed around the time of UK industrial revolution and displayed the following characteristics:
* In direct-labour-intensive and direct-labour-paced production the labour is at the heart of the production. Machinery supports the efforts of the direct labour and speed the production.
* In the low level of indirect costs relating to direct costs environments very little is spend on power, machinery and human resources.
* In relatively uncompetitive market a business can prosper without being too scientific in the approach of deriving full costs. They simply add margin or profit to arrive at the selling price. Customers would also generally accept the offer.
There was no much attention paid to calculating overhead costs as the benefits of controlling it were relatively small. Overheads for individual jobs were charged based on the direct labour hours basis as most of the overheads were supporting the direct labour ( place of work, heating, lightning, power, supervisors etc).
Costing and pricing - the new way
Since the UK Industrial Revolution the working environments have significantly changed. New ways are characterised by:
* In capital-intensive and machine-based production the machines are in the heart of production and most labour supports the efforts of the machines by maintaining them. Machines also dictate the peace of production.
* In environments with high level of indirect costs relating to direct costs businesses have a very high depreciation costs and power costs as well as high costs of human resources and staff welfare. At the same time, there are very low direct labour costs. This makes the indirect costs (overheads costs) more dominant.
* In highly competitive markets markets are tend to be highly price competitive and customers demand custom-products made to their own requirements. Businesses need to know their product costs to a greater degree of accuracy.
The changes in the competitive environment lead to much closer attention to issue of overheads.
Activity based costing and traditional approach
The Activity-based-costing views overheads as being caused by activities such as operating a storage area. The more costs the activities produce, the more overheads they incur. The overheads are analysed into "cost pools" ( as opposed to "cost centres" in the traditional approach). There is one "cost pool" with each activity. The overheads are then charged to the units of outputs through activity cost driver rates. The rates represent the extend to which the cost unit cause the overheads.
"Cost pools" are much the same as "cost centres", except that each "cost pool" is linked to a particular activity rather then more general cost centre. It potentially provides more realistic use of overheads for a particular product or service. For a manufacturing company these can include materials ordering, materials handling, storage, inspections etc. The cost of various support activities makes the total of the overheads.
Managers must carefully examine business operations:
* each of the various support activities involved in the process of making a product or service,
* costs to be attributed to each supportive activity,
* the factors that cause a change to the costs of each activity (cost drivers).
Identifying the cost drivers is the vital element of the Activity-based costing. They have a cause-and-effect relationship,
Attributing overheads
Once we have identified the various activities, their costs and factors that drive them, the approach requires:
The overhead "cost pool" to be attached to each activity,
The total cost associated with each activity to be allocated to the relevant "cost pool",
The total cost of each pool is then charged to output using the relevant "cost driver". This is done dividing the total amount of each cost by the total estimated usage of each driver. We then derive the cost per unit of the cost driver.)We multiply the figure by the number of units of the cost driver that has been used by a particular product or service. It will be the total overheads costs assigned to a product or service.
For example, for a company that runs a storage area for a product with estimated cost of £90,000 next year. This will be the cost allocated to finished goods store cost pool. If Product A will spend on average a week in stores before being sold and Product B four weeks then the "product weeks" is the cost driver. If, for example 50,000 pf Product A and 25,000 of product B will go through stores next year, the "product weeks" cost driver will be calculated as below:
Product A = 50,000 X 1 week = 50,000
Product B = 25.000 X 4 weeks = 100,000
Total = 150,000
The cost per unit of cost driver will be the total number of cost divided by the product weeks = £90,000/150,000 = £0.60
The figure £0.60 should then e multiplied by the product weeks. Each unit of Product A will be charged at £0.60 per week ( £0.60 X 1), and Product B - £2.40 ( £0.60 X 4 weeks).
The difference between the traditional approach and the ABC (Activity-based-costing) is presented in the figure below.
Source: Atrill P. ( et al.), 2018, "Accounting and Finance for non-specialists", Pearson Education
With the traditional approach overheads are first assigned to product cost centres and then absorbed by cost unit based on the overhead recovery rate for each cost centre. With ABC overheads are assigned to cost pools and then cost units are charged to the extend that the drive the cost in various pools.
the ABC approach aims to establish more accurate costs for each unit of product or service that help managers to determine the product profitability. It also helps to establish pricing. By analysing different activities and defining what causes them to change managers can get a better understanding of the business to improve efficacy. It also helps in forward planning or access effect of new products and processes on activities and costs.
ABC and service industries
Early uses of ABC were manufacturing businesses, but we might say, that ABC is even more relevant to service industry because in service the total cost is largely affected by the overheads costs. Studies suggest that in the service industry the overheads costs represent around over 51% of total costs for services and, for manufacturing industry approx. 25%.
Criticism of ABC
Critics of ABC argue that calculating costs using this approach is time consuming and costly itself. There are costs of setting up the ABC system as well as the costs of running it and maintenance. These costs can be very high if a company operates in a complex activities environment. Generally large, sophisticated, operating in a competitive service industry companies would use ABC.
Using full cost information
Both the traditional and the ABC methods are criticised for using historical cost as the past costs are irrelevant. However, they can provide useful information to guide the long-run average cost.
The IAS 2 accounting standard, requires that all inventories including work in progress are to be valued at full cost and included in the financial statements. Business apply full costing to work in progress and final product inventories.
Bibliography
Atrill P. ( et al.), 2018, "Accounting and Finance for non-specialists", Pearson Education, Chapter 7 and 8
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