Chapter 2 - Accounting for materials,

labour, and overheads

Learning Objectives

1 Identify, explain and calculate the costs of inventory.

2 Identify, explain and calculate the costs of labour.

3 Allocate production overheads.

4 Differentiate absorption costing and marginal costing.

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 Accounting for materials

Section 1

Inventory

Types of inventory:
• Raw Materials
• Work in progress
• Spare parts / consumables
• Finished goods

2
 Inventory control system

Ordering Purchase Receipt Storage Issue

Reasons for inventory control

Holding costs
Shortage consequences
Wastage costs
Quality control

3
 Inventory costs consist of:

•Lost sales •Storage

•Goodwill •Interest
•Production •Insurance
stoppages •Obsolescence and
•Labour frustration deterioration
•Cost of urgent
orders Cost of
Holdong
running
costs
out

Purchase Ordering
costs costs
• Admin
• Transport
• Production costs

Inventory control is to minimise holding, ordering, and stockout costs

Aspects of Inventory Control

Storage of raw materials– objectives:

 Speedy issue and receipt
 Easy identification
 Correct location
 Protection from damage
 Security
 Efficient use of space
 Maintenance of levels
 Up to date recordkeeping

4
 Aspects of Inventory Control

Bin cards
 Level of stock on location
• Receipts, Date, Quatity
• Issues, Date, Quantity
• Balance
Stocktake
 Periodic
 Continuous
 Advantages of continuous stocktaking

Inventory documents

STOCK IN

STORE DEPARTMENT PURCHASE DEPARTMENT

Purchase requisition Purchase order

SUPPLIER
Goods received note
Delivery note

ACCOUNNTING DEPARTMENT
Bin card
Store ledger account

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5
 Inventory documents

STOCK OUT

COST DEPARTMENT STORE DEPARTMENT

Materials/store Materials transfer note
requisition

ACCOUNTING DEPARTMENT

Store ledger account

Bin card

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Quick check 01

The following relate to procedures for materials:

1. Check the goods received note
2. Raise a stores requisition note
3. Update the stores ledger account for the purchase
4. Raise a purchase order
What would be the correct order of the above when in the
process of purchasing and using materials?
A 4,2,1,3
B 2,1,3,4
C 4,1,3,2
D 1,4,3,2

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6
 Quick check 02

Which department would normally be responsible

for completing a standard purchase requisition
for goods in a service organization?
A The buying (purchasing) department
B The department that requires the goods
C The goods inwards department
D The accounting department staff

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The materials inventory account

Materials Inventory Account

(a) Materials purchased x (b) Materials issued production x

C/f closing inventory x
x
x
B/f opening inventory x

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7
 Inventory control levels
Reorder Reorder __ Min. usage x
+
level Quantify Min. lead time

Maximum level
Number of units

Max. x Max. lead

usage time

Reorder point
usage
during Reorder __ Avg. usage x Avg.
order
lead level lead time
arrives
time

Minimum level

Working days

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Inventory control levels

Reorder level
» Order to be placed at this level
• Reorder level = maximum usage x maximum lead time
Minimum level
» Approaching stock-out levels
• = Reorder level – (average usage x average lead time)
Maximum level
» Approaching wasteful level
• Maximum level= reorder level + reorder quantity-
(minimum usage x minimum lead time)
Average inventory
• Average inventory = safety inventory + ½ reorder quantity

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8
 Quick check 03

A large retailer maintains a central warehouse. The following

information is available for item SF525:
Average usage 350/day
Minimum usage 180/day
Maximum usage 420/day
Lead time for replenishment 11 - 15 days
Reorder quantity 6,500 units
Calculate Reorder level? buffer stock? Maximum level?

reorder lv=420x15=6300

buffer stock=6300-350x13=1750

max lv=6300+6500-(180x11)=10820

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Inventory control levels

Max.
10,820 level
Number of units

6,300 Reorder
usage point
during order
lead arrives
time
1,750 Min.
level

Working days

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9
 Economic Order Quantity
Annual costs
($)

Total costs
EOQ is the
order quantity Holding costs
which
minimises
inventory costs

Ordering costs

Order quantity (units)

EOQ

CH = Cost of holding one unit of stock for one

time period
EOQ = 2COD
CO = Cost of ordering a consignment from a
CH
supplier
D = Demand during the time period

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Relevant Costs

Relevant Costs in EOQ considerations are:

 Total Ordering Costs

• Demand x ordering cost per order
EOQ

 Total Holding Costs

• EOQ x Holding Cost per unit per period
2

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10
 Quick check 04

The demand for a product is 12,500 units for a three month period. Each unit of
product has a purchase price of £15 and ordering costs are £20 per order placed.
The annual holding cost of one unit of product is 10% of its purchase price.
What is the Economic Order Quantity (to the nearest unit)?
A 1,577
B 1,816
C 1,866
EOQ=squr (2x20x12500x4)/(15x10%)=1155
D 1,155
total cost ord=20*12500*4/1155=866

total holding=eoq/2*Ch=1155/2*1.5=866

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Quick check 05

Data relating to a particular stores item are as follows:

Average daily usage 400 units
Maximum daily usage 520 units
Minimum daily usage 180 units
Lead time for replenishment of stock 10 to 15 days
Reorder quantity 8,000 units
What is the reorder level (in units) which avoids stock-outs?
A 5,000
B 6,000
C 7,800
D 8,000

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11
 Limiting Assumptions in EOQ Model

Demand for particular inventories can be

predicted with accuracy
Demand is constant over the period and does
not fluctuate e.g. Seasonally
There is no provision for buffer inventories
There are no discounts for bulk purchasing etc.
Despite the above, EOQ can be modified to
overcome above limitations and continues to be
useful for inventory control.

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EOQ and bulk discount

The total cost will be minimized at one of the following:

(1) At the pre-discount EOQ level, so that a discount is not
worthwhile
(2) At the minimum order size necessary to earn the discount

4 steps:
 Step 1: Calculate the EOQ ignoring discount.
 Step 2: Calculate total annual costs at that EOQ.
 Step 3: Calculate total annual costs with a discount.
 Step 4: Compare 2 results and make conclusion.

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12
 Quick check 06

The annual demand for an item of stock is 45 units. The item costs
$200 a unit to purchase, the holding cost for one unit for one year is
15% of the unit cost and ordering costs are $300 an order.
The supplier offer a 3% discount for order of 60 units or more.
Calculate the cost-minimizing order size.

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Economic Batch Quantity (EBQ)

Apply for production if finished products is produced in

batches.
Lead time = production time for the batch.

2COD
EBQ =
CH(1 –D/R)

R = production rate per time period

Co= set up cost per batch
D = usage per time period
CH = Cost of holding one unit of stock for one time period

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13
 Free stock level

Free stock level represents what is really available

for future use.
---> assists stock issuing, stock ordering and
controlling maximum and minimum stock levels.

Quantity in stock xxx

Quantity on order from supplier xxx
Quantity requisitioned/ not yet issued (xxx)
Free Stock Level xxx

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Quick check 07

There are 27,500 units of Part Number X35 on order with the
suppliers and 16,250 units outstanding on the existing
customers’ orders.
If the free stock is 13,000 units, what is the physical stock?
A 1,750
B 3,250
C 24,250
D 29,250

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14
 Quick check 08

Which of the following is correct with regard to stocks?

(i) Stock-outs arise when too little stock is held.
(ii) Safety stocks are the level of units maintained in case there is
unexpected demand.
(iii) A reorder level can be established by looking at the maximum usage and
the maximum lead-time.

A (i) and (ii) only

B (i) and (iii) only
C (ii) and (iii) only
D (i), (ii) and (iii)

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Quick check 09

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 Quick check 10

Point Ltd uses the economic order quantity (EOQ)

model to establish the reorder quantity for raw
material Y. The company holds no buffer stock.
Information relating to raw material Y is as follows:
Annual usage: 48,000 units
Purchase price: £80 per unit
Ordering costs: £120 per order
Annual holding costs:10% of the purchase price
a) Calculate:
-the EOQ for raw material Y, and
-the total annual cost of purchasing, ordering and
holding stocks of raw material Y.
b)The supplier has offered Point Ltd a discount of
1% on the purchase price if each order placed is
for 2,000 units. Calculate the total annual saving to
Point Ltd of accepting this offer.

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Inventory Valuation

Need Inventory Valuation for:

• Preparation of accounts
• Pricing of material issues to production
Financial Accounts Preparation
Inventories are valued at ‘lower of cost or net
realisable value’. This is undertaken at period end,
and inventory records are adjusted where necessary.

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16
 Charging inventory to production

Goods may move physically from stores by:

• Oldest goods first
• Latest goods first
• Random choice
• Easiest to reach etc.

However the valuation of these issues must be on a

consistent basis. This means goods may be issued
not necessarily at the price paid for them.

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Charging inventory to production

 Three popular methods of pricing inventories for issue to

production are based on the following assumptions:
 First in First Out (FIFO)
 Last in First Out (LIFO)
 Weighted Average Cost (AVCO)

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17
 Inventory valuation illustration
Calculate the cost of issues ad the closing inventory in the following transactions:
Purchases Price/Unit Value Issues
Units £ £ Units
15-Jan 400 3 1200
19-Jan 150 2 300
23-Jan 200
07-Feb 300 2.5 750
14-Feb 340

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Charging inventory to production

 FIFO (First in First Out):
 Assumes materials issued in order in which they were
delivered into inventory. Priced at cost of earliest
delivery remaining in stock.
Advantages Disadvantages

Logical, represents what is FIFO can be cumbersome to

physically happening operate

Easy to explain Managers can be confused

by constantly changing prices

Closing inventory valuation In period of inflation, issue

nearer to replacement cost prices are below market
value

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18
 Charging inventory to production

 LIFO (Last in First Out):

 Assumes materials issued in reverse order to delivery.
Most recent issued first
Advantages Disadvantages

Inventory issued at a price LIFO can be cumbersome to

close to market value operate. Tendency to jump
from batch to batch.
Managers made aware of LIFO usually opposite to what
recent costs for making is physically happening-
decisions confusing
Decision making affected by
constantly changing prices

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Charging inventory to production

 AVCO (Cumulative Weighted Average Cost):

 Calculates weighted average price for all units in
inventory. Issues are priced at this average cost (total
cost/total units)
Advantages Disadvantages

Price fluctuations are evened Issue price can bear no

out. Easier data for decision relation to an actual price
making paid.
Easier to administer than Prices tend to lag behind
FIFO and LIFO. No need to current market values in time
identify batches separately of inflation

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19
 Accounting for labour

Section 2

39

Remuneration Methods

Time work

Wages = Hours worked x rate of pay per hour

Piece work

Wages = Units produced x rate of pay per unit

Incentive/Bonus scheme

High day rate system

Individual bonus schemes
Group bonus schemes
Profit sharing schemes
Incentive schemes involving shares
Value added incentive schemes

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20
 Remuneration Methods

 Time work: Wages = Hours worked x hourly rate of pay

 May be subject to overtime premium (extra rate per hour above basic)
• Easy to understand
• Simple to negotiate or review
• Encourages quality against quantity
• No incentive to improve performance

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Remuneration Methods

 Piecework: Wages = units produced x rate per unit

 May be subject to guaranteed minimum wage to cover
low production periods
• If guarantee is set too high, discourages effort to exceed
minimum
• Mixed popularity
• May be seen to drive to work too hard. Counter-productive.

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21
 Remuneration Methods

Bonus/Incentive Schemes
 Aim to compensate time work for increased efficiency.
Encourages productivity
• More pay for efficiency
• Profits from improvement shared with employees
• Improves morale of employees

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Quick check 11

An organization operates a piecework system of remuneration, but also

guarantees its employees 80% of a time-based rate of pay which is
based on $20 per hour for an eight hour working day. Three minutes is
the standard time allowed per unit of output. Piecework is paid at the
rate of $18 per standard hour.
If an employee produces 200 units in eight hours on a particular
day, what is the employee’s gross pay for that day?
A $128
B $144
C $160
D $180

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22
 Quick check 12

A jobbing company operates a premium bonus scheme for its

employees of 75% of the time saved compared with the standard time
allowance for a job, at the normal hourly rate. The data relating to job
1206 completed by an employee is as follows:
Allowed time for job 1206 4 hours
Time taken to completed job 1206 3 hours
Normal hourly rate of pay £8
What is total pay of the employee for job 1206?

A £24
B £30
C £32
D £38

45

Measuring labour activity

Labour activity is usually measured by:

Production Productivity
 Quantity or volume  Efficiency with which
produced output has been produced
 Can be measured by
productivity ratio:

Standard hrs ÷ actual hrs x 100

Or
Standard Units ÷ actual units x 100

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23
 Controlling production and productivity

Production Productivity
 Production levels can be  Improvement in productivity –
controlled by: achieve targets in fewer hours
 Working overtime - lower cost.
 Hire extra staff  Productivity can be raised by:
 Subcontract  Better training for staff
 Better management  Increase in worker morale
 Increase in production will not  Increase in productivity
result in lower unit costs if reduces unit cost.
there is no improvement in
productivity.

47

Production and productivity illustration

 Production of 1 worker per week: 42 hrs = 126 units

 Productivity measure the rate of the actual hours
taken to produce 126 units.
 If it take 40 hrs  42/40  Productivity = 105%
 Alternative way, in 40hrs, he should make 3x40=120
units.
 As making 126 units  126/120 = 105% productivity
Productivity increase  Cost per unit reduce.

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 Measuring labor efficiency

Efficiency ratio (or Capacity Activity (Production

x =
Productivity ratio) ratio volume) ratio

Expected hours to make Actual hours Output measured in

output worked expected or standard
---------------------------------- x ----------------------- = hours
--------------------------------
Actual hours taken Hours budgeted Hours budgeted

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Measuring labor efficiency

Measures the Measures the

Compare with
efficiency of utilization of
budget
the labor force available capacity

> 100% efficient >100%  worked > 100%  Produced

labor above capacity more than budgeted

< 100 %  inefficient <100%  worked < 100%  Produced

labor under capacity less than budgeted

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 Labour efficiency illustration

Budgeted output 500 units

Budgeted hours 50 hours
Actual output 600 units
Actual hours 40 hours
Calculate Efficiency ratio, Capacity ratio, Production volume ratio

51

Quick check 13
Budgeted and actual production data for the year that has just ended are as follows

Product Budgeted production Actual

production
Units Standard machine hours Units
W 15,000 3,000 12,000
X 20,000 8,000 25,000
Y 14,000 7,000 16,000
Z 6,000 9,000 5,000
Total machine hours worked in the period amounted to 29,000 hours.
What was the capacity ratio in the year?
A 93.1%
B 103.3%
C 105.5%
D 107.4%

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26
 Quick check 14
Budgeted and actual production data for the year that has just ended are as follows

Product Budgeted production Actual

production
Units Standard machine hours Units
W 15,000 3,000 12,000
X 20,000 8,000 25,000
Y 14,000 7,000 16,000
Z 6,000 9,000 5,000
Total machine hours worked in the period amounted to 29,000 hours.
What was the efficiency ratio?
A 96.2%
B 103.3%
C 103.9%
D 107.4%

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Labour Turnover

 Rate at which employees leave the company

Replacements
Labour Turnover rate = x 100%
Average number of employees

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27
 Quick check 15

Company AA had 30 direct production employees at the

beginning of the last year and 20 direct production
employees at the end of the year. During the year, a total of
15 direct production employees had left the company to work
for a local competitor. The labour turnover rate for last year
was:
A 16.7%
B 20.0%
C 25.0%
D 60.0%

55

Reasons for labour turnover

Unavoidable Avoidable
 Illness, accident  Lower wages
 Family move  Unsafe conditions
 Marriage etc  Antisocial hours
 Retirement  Poor management
 Lack of career development
opportunities

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 Cost of labour turnover

Replacement costs Preventive costs

 Advertising, recruitment  Personnel admin
 Training  Flexi – time
 Learning curve  Welfare services
productivity  Work from home
 Increased wastage etc.  Corporate incentives

57

Direct vs indirect labour costs

Direct Indirect
workers workers
Normal basic pay Direct cost Indirect cost
General production: Overtime —basic pay element Direct cost Indirect cost
General production: Overtime —O/T premium Indirect cost Indirect cost
General non-production: Overtime —basic pay element Indirect cost Indirect cost
General non-production: Overtime —O/T premium Indirect cost Indirect cost
Specific overtime —basic pay element Direct cost Direct cost
Specific overtime —O/T premium Direct cost Direct cost

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 Quick check 16

Employee A is a carpenter and normally works 36 hours per week. The

standard rate of pay is £3.60 per hour. A premium of 50% of the basic
hourly rate is paid for all overtime hours worked. During the last week of
October, Employee A worked for 42 hours. The overtime hours worked
were for the following reasons:
Machine breakdown: 4 hours
To complete a special job at the request of a customer: 2 hours
How much of Employee A’s earnings for the last week of October
would have been treated as direct wages?
A £162.00
B £129.60
C £140.40
D £151.20

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Quick check 17

A machinist earns $10 per hour. During a given week he works 40

hours, of which he is idle 5 hours. For the week:
A $400 cost should be charged to direct labor
B $50 cost should be charged to overtime premium
C $50 cost should be charged to overhead
D $425 cost should be charged to direct labour and $25 cost
should be charge to overhead

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 Wages control account

Wages Control Account

$ $
Bank etc (actual wages) x WIP (direct labour) x
Production overheads (indirect labour) x
Statememt of P/L (balancing figure) x

x x

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Wages control account illustration

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 Quick check 18

X Co has recorded the following wages costs for direct production workers for November.
$
Basis pay 70,800
Overtime premium 2,000
Holiday pay 500
Gross wages incurred 73,300
The overtime was not worked for any specific job.
The accounting entries for these wages costs would be:

A Work in progress account 72800 C Wages control account 73300

Overhead control account 500 Work in progress account 70800
Wages control account 73300 Overhead control account 2500

B Work in progress account 70800 D Wages control account 73300

Overhead control account 2500 Work in progress account 72800
Wages control account 73300 Overhead control account 500

63

Accounting for overhead

Section 3

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 There are 2 main methods of dealing with Overheads
in Cost Accounting:
 Absorption Costing
And
 Marginal Costing

65

Absorption Costing

Method of sharing out overheads incurred

amongst units produced on a fair basis.

The objective is to include in the cost of a product,

an appropriate share of the total overheads of the
organisation.

Ultimately the total overheads are absorbed by the

total units produced.

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33
67

How to deal with OH?

Stage 1: Allocation &

apportionment

Stage 2: Reapportionment

Stage 3: Absorption

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 Overhead Allocation

Whole cost items are charged directly to a cost unit

Cost Items
 E.g.
 Wages of foreman in Dept. A
 Wages of foreman in Dept. B
 Indirect Materials consumed in Dept. A
 Departmental Expenses A, B,
These overheads which can be clearly identified
with specific departments are allocated to these
departments.

69

Overhead Apportionment

 Process by which Indirect Costs are shared fairly between

cost centres.
 Requires application of appropriate basis of apportionment to
ensure that the distribution between the cost centres is fair.
 Floor area
• E.g. Rent, Rates, Heating, Light, Repairs,
 Equipment cost
• E.g. Depreciation, Equipment Insurance
 Number of employees /Labour hours worked
• E.g. Dept. wages, Welfare

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 Stage 1: Allocation & Apportionment

 Allocation is the process by which whole cost items are

charged direct to a cost unit or a cost centre.
Indirect materials, Indirect labors, Security
guard, Depreciation, Rent, etc.

Canteen Maintenance Machining Assembly

71

Overhead allocation & apportionment illustration

Service dept. Operating dept. Total

Canteen Maintenance Machining Assembly
Floor area (m 2) 1.200 300 1.300 2.200 5.000
Cubic capacity (m3) 4.000 1.000 4.500 10.500 20.000

Overheads:
Supervisors $ 60.000 $ 15.000 $ 72.500 $ 102.500 $ 250.000
Rent 1.000.000
Heat and light 300.000
Total overheads $ 1.550.000

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 Service dept. Operating dept. Total
Canteen Maintenance Machining Assembly
Floor area (m 2) 1.200 300 1.300 2.200 5.000
Cubic capacity (m3) 4.000 1.000 4.500 10.500 20.000

Overheads:
Supervisors $ 60.000 $ 15.000 $ 72.500 $ 102.500 $ 250.000
Rent 1.000.000
Heat and light 300.000
Total overheads $ 1.550.000

73

Service dept. Operating dept. Total

Canteen Maintenance Machining Assembly
Floor area (m2 ) 1.200 300 1.300 2.200 5.000
Cubic capacity (m3) 4.000 1.000 4.500 10.500 20.000
Supervisors 60.000 15.000 72.500 102.500 250.000

Overheads:
Rent $ 240.000 $ 60.000 $ 260.000 $ 440.000 $ 1.000.000
Heat and light 60.000 15.000 67.500 157.500 300.000
Total 360.000 90.000 400.000 700.000 $ 1.550.000

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Stage 2: Service Department Cost Reapportionment

 Service cost centre costs may be reapportioned to production

cost centres by using one of the following methods:
• Direct method
• Reciprocal method
• Step down method Service Operating
Department Department
(Canteen) (Machining)

Service Operating
Department Department
(Maintenance) (Assembly)

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Stage 2: Service Department Cost Reapportionment

 Direct method
 Costs of each service costs centre are apportioned only
to production cost centres
 Step down method
 Service costs apportioned to only some (not all) of
other service centres
 Reciprocal method
 Service costs apportioned to both production and
other service centres
 The results of the reciprocal method may also be
obtained using algebra and simultaneous eqations.

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 Direct Method

Service Operating
Interactions Department Department
between service (Canteen) (Machining)
departments are
ignored and all
costs are
reapportioned directly
to operating Service Operating
departments. Department Department
(Maintenance) (Assembly)

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Direct Method illustration

Service Department Reapportionment base

Canteen Number of employees
Maintenance Maintenance hours used

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39
 Direct Method illustration

79

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40
 Step down method

Service Operating
Department Department
Once a service (Canteen) (Machining)
department’s costs
are reapportioned,
other service
department costs
are not reapportioned
back to it. Service Operating
Department Department
(Maintenance) (Assembly)

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Step down method

Service Operating
Department Department
Maintenance will (Canteen) (Machining)
have a new
total to
reapportion
to operating
departments; its
own costs plus Service Operating
those costs Department Department
reapportioned (Maintenance) (Assembly)
from
the Canteen.

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41
 Step down method illustration

83

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42
 Reciprocal Method

Service Operating
Department Department
Interdepartmental (Canteen) (Machining)
services are given
full recognition
rather than partial
recognition as with
the step method. Service Operating
Department Department
(Maintenance) (Assembly)

85

Reciprocal method illustration

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87

Quick check 19
A factory consists of two production cost
centres (P and Q) and two service cost centres
(X and Y). The total allocated and apportioned
overhead for each is as follows:
P Q X Y
$95,000 $82,000 $46,000 $30,000
It has been estimated that each service cost
centre does work for other cost centres in the
following proportions:
P Q X Y
Percentage of service cost 50 50 - -
centre X to
Percentage of service cost 30 60 10 -
centre Y to
The reapportionment of service cost centre
costs has been carried out, what is total
overhead for production cost centre P?
A $124,500
B $126,100
C $127,000
D $128,500

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 Quick check 20
A business operates with two production centres and
three service centres. Costs have been allocated and
apportioned to these centres as follows:
Production centres Service centres
1 2 A B C
£2,000 £3,500 £300 £500 £700
Information regarding how the service centres work for
each other and for the production centres is given as:
Work done for:
Production centres Service centres
1 2 A B C
By A 45% 45% - 10% -
By B 50% 20% 20% - 10%
By C 60% 40% - - -
Information concerning production requirements in the
two production centres is as follows:
Centre 1 Centre 2
Unit produced 1,500 units 2,000 units
Machine hours 3,000 hours 4,500 hours
Labour hours 2,000 hours 6,000 hours
Required:
(a) Using the reciprocal method calculate the total
overheads in production centre 1 and 2 after
reappotionment of the service centre costs.
(b) Using the most appropriate basis establish the
overhead absorption rate for production centre 1.
Briefly explain the reason for your chosen
absorption basis.

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Stage 3: Absorption

 Process whereby overhead costs allocated and apportioned

to production cost centres are added to unit costs.

trace Direct materials

+ Direct labor
+ Absorbed overhead
Product cost

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 Overhead absorption rate

 OH are usually added to cost units using a predetermined

Overhead Absorption Rate.

Total budgeted overhead costs

OAR =
Total budgeted activity level

 Overhead absorbed per unit = OAR x activity level per unit

 Choice of rate should reflect the characteristics of the cost centre

% direct materials
% direct labour
Rate per labour hour
Rate per machine hour etc.

91

Overhead absorption rate illustration

 Company A estimates that the total OH during 20X8 will

be $50,000. The company also estimates that a total of
100,000 direct labor hours will be worked during 20X8.
 OAR= $50,000/100,000hrs= $0.50 per direct labor hour.
 If product G takes 3 labor hours each to make, the OH
cost per unit absorbed for G will be:
$0.50 x 3 = $1.50

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46
 Separate OAR illustration

The Old Grammar School has two production departments, for which the following budgeted
information is available.
Department A Department B Total
Budgeted overheads $360,000 $200,000 $560,000
Budgeted direct labour hours 200,000 hrs 40,000 hrs 240,000 hrs
Job X has a prime cost of $100, takes 30 hours in department B and does not involve any work in
department A.
Job Y has a prime cost of $100, takes 28 hours in department A and 2 hours in department B.
What would be the factory cost of each job?

93

The Old Grammar School has two production departments, for which the following budgeted
information is available.
Department A Department B Total
Budgeted overheads $360,000 $200,000 $560,000
Budgeted direct labour hours 200,000 hrs 40,000 hrs 240,000 hrs
Job X has a prime cost of $100, takes 30 hours in department B and does not involve any work in
department A.
Job Y has a prime cost of $100, takes 28 hours in department A and 2 hours in department B.
What would be the factory cost of each job?

94

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 Quick check 21
A company manufactures two products, X and Y, in a factory divided into two production cost centres,
Primary and Finishing. The following budgeted data are available:
Cost centre Primary Finishing
Allocated and apportioned fixed OH costs £96,000 £82,500
Direct labour minutes per unit:
- product X 36 25
- product Y 48 35
Budgeted production is 6,000 units of product X and 7,500 units of product Y.
Fixed overhead costs are to be absorbed on a direct labour hour basis.
What is the budgeted fixed overhead cost per unit for product Y?
A £11
B £12
C £14
D £15

95

Over and Under absorption

 Because predetermined overhead absorption rates are

based on estimates, actual resultant rates usually differ
from the rates applied and charged to cost of sales.

Actual overheads incurred - Overheads absorbed

= over / under absorbed overheads

Negative = over ; Positive = under

96

48
 Over and Under absorption illustration

 Actual production overheads $100,000

 OAR $2 per DLH
 Actual DLHrs 47,500

 Overheads absorbed = 47,500*$2 = $95,000

 Under-absorbed overheads = $100,000 - $95,000 = $5,000

97

Quick check 22

A company uses an overhead absorption rate of £3.50 per machine hour, based on
32,000 budgeted machine hours for the period. During the same period the actual total
overhead expenditure amounted to £108,875 and 30,000 machine hours were recorded
on actual production.
By how much was the total overhead under or over absorbed for the period?
A Under absorbed by £3,875
B Under absorbed by £7,000
C Over absorbed by £3,875
D Over absorbed by £7,000

98

49
 Over and Under absorption

Reasons for Over/Under Absorption

 Actual overhead costs are different from budgeted
overheads
 Actual activity level is different from budgeted
 Actual overhead costs and actual activity level
differ from budgeted

99

Ledger entries for over/under-absorbed overhead

Version 1

Production overheads PL account

Cash 100.000 Absorbed into WIP 95.000

Under-absorbed OH 5.000 Production overhead 5.000

100.000 100.000

Version 2

Production overheads Under-/Over-absorbed Overheads PL account

Cash 100.000 Absorbed into WIP 95.000

Under-absorbed OH 5.000 Production overhead 5.000 To PL account 5.000 Under-absorbed OH 5.000

100.000 100.000

100

50
 Marginal costing

 Marginal Cost:
 The cost of producing one additional item.
 Marginal (Variable) production cost consists of:
• Direct Materials
• Direct Labour
• Variable production overheads
 Marginal Costing:
 an approach to costing that excludes fixed costs

101

Marginal Cost Statement

Sales xxxx
Less: Variable Cost (xxxx)
Contribution xxxx
Less: Fixed Cost (xxxx)
Profit

102

51
 Marginal costing illustration

Year 1 Year 2
Normal/budgeted production 12.000 12.000
Actual production 14.000 11.500
Actual sales 13.000 12.500
Budgeted fixed production overheads $ 10.800 $ 10.800
Actual fixed production overheads $ 11.000 $ 11.000
Actual fixed selling costs $ 5.000 $ 5.000
Per unit
Selling price $25
Direct materials 7
Direct wages 8
Variable production overheads 5
Fixed production overheads ($10,800/12,000 units) 0,9
Total production costs 20,9
Variable selling cost 0,5

103

Marginal costing illustration

Income Statement - Marginal costing

Year 1 Year 2
$ $ $ $
Sales
Less Variable Cost of Sales
Opening inventory
Add Variable production cost
Less Closing inventory

Less Variable S&A. exp.

Cotribution
Less Fixed costs
Fixed production OH
Fixed S&A exp.

Operating profit

104

52
 Year 1 Year 2
Normal/budgeted production 12.000 12.000
Actual production 14.000 11.500
Actual sales 13.000 12.500
Budgeted fixed production overheads $ 10.800 $ 10.800
Actual fixed production overheads $ 11.000 $ 11.000
Actual fixed selling costs $ 5.000 $ 5.000
Per unit
Selling price $25
Direct materials 7
Direct wages 8
Variable production overheads 5
Fixed production overheads ($10,800/12,000 units) 0,9
Total production costs 20,9
Variable selling cost 0,5

Income Statement - Marginal costing

Year 1 Year 2
$ $ $ $
Sales
Less Variable Cost of Sales
Opening inventory
Add Variable production cost
Less Closing inventory

Less Variable S&A. exp.

Cotribution
Less Fixed costs
Fixed production OH
Fixed S&A exp.

Operating profit

105

Marginal costing illustration

Income Statement - Absorption costing

Year 1 Year 2
$ $ $ $
Sales
Less Cost of Sales
Opening inventory
Add Production cost
Less Closing inventory
Adj. for (Over-)/Under-
absorbed OH

Gross Profit
Less Selling & Admin. expenses
Operating profit

106

53
 Year 1 Year 2
Normal/budgeted production 12.000 12.000
Actual production 14.000 11.500
Actual sales 13.000 12.500
Budgeted fixed production overheads $ 10.800 $ 10.800
Actual fixed production overheads $ 11.000 $ 11.000
Actual fixed selling costs $ 5.000 $ 5.000
Per unit
Selling price $25
Direct materials 7
Direct wages 8
Variable production overheads 5
Fixed production overheads ($10,800/12,000 units) 0,9
Total production costs 20,9
Variable selling cost 0,5

Income Statement - Absorption costing

Year 1 Year 2
$ $ $ $
Sales
Less Cost of Sales
Opening inventory
Add Production cost
Less Closing inventory
Adj. for (Over-)/Under-
absorbed OH

Gross Profit
Less Selling & Admin. expenses
Operating profit

107

Profit Reconciliation

Year 1 Year 2 Total

Profit under absorption costing $ 43.400 $ 39.350 $ 82.750
Profit under marginal costing $ 42.500 $ 40.250 $ 82.750
Difference $ 900 $ (900) $ -

Year 1 Year 2
Normal/budgeted production 12.000 12.000
Actual production 14.000 11.500
Actual sales 13.000 12.500
Budgeted fixed production overheads $ 10.800 $ 10.800
Actual fixed production overheads $ 11.000 $ 11.000
Actual fixed selling costs $ 5.000 $ 5.000
Per unit
Selling price $25
Direct materials 7
Direct wages 8
Variable production overheads 5
Fixed production overheads ($10,800/12,000 units) 0,9
Total production costs 20,9
Variable selling cost 0,5

108

54
 Profit Reconciliation

 Difference in profits between the two systems is due to inventory

valuation methods
 If there is no change in inventory, there is no difference in profits
 If inventory levels increase, absorption costing will report higher
profit, and vice versa.

Difference in = Change in x Overhead

profit inventory level absorption rate

109

Quick check 23

Haywards Limited reported an annual profit of £47,500 for the year ended 31 March 2025. The company uses
absorption costing. One product is manufactured, the Heath, which has the following standard cost per unit:
£
Direct material (2kg at £5.0/kg) 10
Direct labour (4 hours at £6.50/hour) 26
Variable overheads (4hours at £1/hour) 4
Fixed overheads (4hours at £3/hour) 12
52
The normal level of activity is 10,000 units although actual production was 11,500 units. Fixed costs were as
budgeted. Stock level at 1 April 2024 were 400 units and at the end of the year were 600 units.
What would be the profit under marginal costing?
A $44,300
B $45,100
C $49,900
D $50,700

110

55
 Quick check 24

Haywards Limited reported an annual profit of £47,500 for the year ended 31 March 2025. The company uses
absorption costing. One product is manufactured, the Heath, which has the following standard cost per unit:
£
Direct material (2kg at £5.0/kg) 10
Direct labour (4 hours at £6.50/hour) 26
Variable overheads (4hours at £1/hour) 4
Fixed overheads (4hours at £3/hour) 12
52
The normal level of activity is 10,000 units although actual production was 11,500 units. Fixed costs were as
budgeted. Stock level at 1 April 2024 were 400 units and at the end of the year were 600 units.
What were the budgeted fixed overheads for the year ended 31 March 2000 and the actual under or
over absorption?
Budgeted overheads Under/Over absorbed
A £120,000 £18,000 over absorbed
B £120,000 £18,000 under absorbed
C £138,000 £18,000 over absorbed
D £138,000 £18,000 under absorbed

111

Quick check 25

Last month a manufacturing company’s profit was $2,000, calculated using absorption costing
principles. If marginal costing principles had been used, a loss of $3,000 would have occurred.
The company’s fixed production cost is $2 per unit. Sales last month were 10,000 units.
What was last month’s production (in units)?
A 7,500
B 9,500
C 10,500
D 12,500

112

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 Quick check 26

The following budgeted information related to a manufacturing company for the next period:
Units $
Production 14,000 Fixed production costs 63,000
Sales 12,000 Fixed selling costs 12,000
The normal level of activity is 14,000 units per period.
Using absorption costing the profit for the next period has been calculated as $36,000.
What would the profit for the next period be using marginal costing?
A $25,000
B $27,000
C $45,000
D $47,000

113

End of chapter 2

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