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AAF_C08.qxd 3/30/06 4:04 PM Page 249 Chapter 8 Full costing Introduction In this chapter we continue our consideration of management accounting by looking at an approach to deducing the cost of a unit of output that takes account of all of the costs. This contrasts with the approach that we looked at in Chapter 7, where we concentrated just on the variable costs. This full-costing approach, as it is called, is very widely used in practice. Many businesses base their selling prices on the full cost. Also, in deriving a business’s profit for a period, we need (as we saw in Chapter 3) to know the cost of the goods or service sold. We shall look at the traditional approach to full costing and at activity-based costing which represents an alternative approach. Finally, having considered how full costing is achieved, we shall consider its usefulness for management purposes. Learning outcomes When you have completed this chapter, you should be able to: n deduce the full cost of a unit of output in a single-product environment; n distinguish between direct and indirect costs and use this distinction to deduce the full cost of a job in a multi-product environment; n discuss the problem of charging overheads to jobs in a multi-product environment; n explain the role and nature of activity-based costing. 249 AAF_C08.qxd 3/30/06 4:04 PM Page 250 Chapter 8 Full costing The nature of full costing ‘ ‘ With full costing we are concerned with all costs involved with achieving some objective, such as providing a particular service. The logic of full costing is that all of the costs of running a particular facility, say an office, are part of the cost of the output of that office. For example, the rent may be a cost that will not alter merely because we provide one more unit of the service, but if the office were not rented there would be nowhere for providing the service to take place, so rent is an important element of the cost of each unit of output. Full cost is the total amount of resources, usually measured in monetary terms, sacrificed to achieve a particular objective. It takes account of all resources sacrificed to achieve the objective. Thus, if the objective were to supply a customer with a product or service, all costs relating to the production of the product or provision of the service would be included as part of the full cost. To derive the full cost figure, we must accumulate the costs incurred and then assign them to the particular product or service. In the sections that follow we shall first see how this is done for a single-product operation and then see how it is done for a multi-product operation. Deriving full costs in a single-product operation The simplest case for which to deduce the full cost per unit is where the business has only one product line, that is, each unit of its product is identical. Here it is simply a question of adding up all the costs of production incurred in the period (materials, labour, rent, fuel, power and so on) and dividing this total by the total number of units of output for the period. Activity 8.1 Fruitjuice Ltd has just one product, a sparkling orange drink that is marketed as ‘Orange Fizz’. During last month the business produced 7,300 litres of the drink. The costs incurred were as follows: Ingredients (oranges and so on) Fuel Rent of premises Depreciation of equipment Labour £ 390 85 350 75 880 What is the full cost per litre of producing ‘Orange Fizz’? This figure is found by simply adding together all of the costs incurred and then dividing by the number of litres produced: £(390 + 85 + 350 + 75 + 880)/7,300 = £0.24 per litre 250 AAF_C08.qxd 3/30/06 4:04 PM Page 251 Deriving full costs in multi-product operations ‘ There can be problems in deciding exactly how much cost was incurred. In the case of Fruitjuice Ltd, for example, how is the cost of depreciation deduced? It is certainly an estimate, and so its reliability is open to question. The cost of raw materials may also be a problem. Should we use the ‘relevant’ cost of the raw materials (almost certainly the replacement cost), or the actual price (historic cost) paid for the inventories used? If it is worth calculating the cost per litre, it must be because this information will be used for some decision-making purpose, so the replacement cost is probably more logical. In practice, however, it seems that historic costs are more often used to deduce full costs. There can also be problems in deciding precisely how many units of output there were. If making Orange Fizz is not a very fast process, some of the drink will be in the process of being made at any given moment. This, in turn, means that some of the costs incurred last month were for some Orange Fizz that was work in progress at the end of the month, so is not included in last month’s output quantity of 7,300 litres. Similarly, part of the 7,300 litres was started and incurred costs in the previous month, yet all of those litres were included in the 7,300 litres that we used in our calculation of the cost per litre. Work in progress is not a serious problem, but some adjustment for opening and closing work in progress for a period needs to be made if reliable full cost information is to be obtained. This approach to full costing, which can be taken with identical, or near identical units of output, is often referred to as process costing. Deriving full costs in multi-product operations Most businesses produce more than one type of product or service. In this situation, the units of output of the product, or service, will not be identical and so the approach that we used with litres of ‘Orange Fizz’ in Activity 8.1 cannot be used. Though it is reasonable to assign an identical cost to units of output that are identical, it is not reasonable to do this where the units of output are obviously different. It would not be reasonable, for example, to assign the same costs to each car repair carried out by a garage, irrespective of the complexity and size of the repair. Direct and indirect costs To provide full cost information, we need to have a systematic approach to accumulating costs and then assigning these costs to particular units of product or service on some reasonable basis. Where units of output are not identical, the starting point is to separate costs into two categories: direct costs and indirect costs. ‘ n Direct costs. These are costs that can be identified with specific cost units. That is to say, the effect of the cost can be measured in respect of each particular unit of output. The main examples of these are direct materials and direct labour. Thus, in costing a motor car repair by a garage, both the cost of spare parts used in the repair and the cost of the mechanic’s time would be direct costs. Collecting direct costs is 251 AAF_C08.qxd 3/30/06 4:04 PM Page 252 Chapter 8 Full costing ‘ ‘ n a simple matter of having a cost-recording system that is capable of capturing the cost of direct materials used on each job and the cost, based on the hours worked and the rate of pay, of direct workers. Indirect costs (or overheads). These are all other costs, that is, those that cannot be directly measured in respect of each particular unit of output. Thus the rent of the garage premises would be an indirect cost of a motor car repair. We shall use the terms ‘indirect costs’ and ‘overheads’ interchangeably for the remainder of this book. Overheads are also sometimes known as common costs because they are common to all outputs of the production unit (for example, factory or department) for the period. Real World 8.1 provides some insight to the direct/indirect cost balance in practice. Real World 8.1 Direct and indirect costs in practice A survey of 176 fairly large UK businesses, conducted during 1999, revealed that, on average, total costs of businesses are in the following proportions: Direct costs Indirect costs 70% 30% Perhaps surprisingly, these proportions did not vary greatly among manufacturers, retailers and service businesses. The only significant variation from the 70/30 proportions was with financial and commercial businesses, which had an average 52/48 split. Source: Based on information taken from Drury and Tayles (see References section at the end of the chapter) A more extensive (nearly 2,000 responses) and more recent (2003) survey of management accounting practice in the USA showed similar results. Like the 1999 UK survey, this tended to relate to larger businesses. About 40% were manufacturers and about 16% financial services; the remainder were from a range of other industries. This survey revealed that, of total costs, indirect costs accounted for between: 34% 42% for retailers (lowest) and for manufacturers (highest), with other industries’ proportion of indirect costs falling within the 34% to 42% range. Financial and commercial businesses showed an indirect cost percentage of 38%. Source: Ernst and Young (see References section at the end of the chapter) The differences between the UK and the USA could be accounted for by a higher level of capital intensity in US industry, which would tend to increase indirect costs relative to direct ones. The fact that the US survey is more recent may have some influence on the results. Job costing ‘ 252 The term job costing is used to describe the way in which we identify the full cost per unit of output (job) where the units of output differ. To cost (that is, deduce the full cost of) a particular unit of output (job), we first identify the direct costs of the job, AAF_C08.qxd 3/30/06 4:04 PM Page 253 Deriving full costs in multi-product operations Figure 8.1 The relationship between direct costs and indirect costs The full cost of any particular job is the sum of those costs that can be measured specifically in respect of the job (direct costs) and a share of those costs that create the environment in which production (of an object or service) can take place, but which do not relate specifically to any particular job (overheads). which, by the definition of direct costs, is fairly straightforward. We then seek to ‘charge’ each unit of output with a fair share of indirect costs. This is shown graphically in Figure 8.1. Activity 8.2 Sparky Ltd is a business that employs a number of electricians. The business undertakes a range of work for its customers, from replacing fuses to installing complete wiring systems in new houses. In respect of a particular job done by Sparky Ltd, into which category (direct or indirect) would each of the following costs fall? The wages of the electrician who did the job. Depreciation of the tools used by the electrician. n The salary of Sparky Ltd’s accountant. n The cost of cable and other materials used on the job. n Rent of the premises where Sparky Ltd stores its inventories of cable and other materials. n n Only the electrician’s wages earned while working on the particular job and the cost of the materials used on the job are direct costs. This is because it is possible to measure how much time (and therefore the labour cost) was spent on the particular job and the amount of materials used in the job. All of the other costs are general costs of running the business and, as such, must form part of the full cost of doing the job, but they cannot be directly measured in respect of the particular job. It is important to note that whether a cost is direct or indirect depends on the item being costed – the cost objective. People tend to refer to overheads without stating what the cost objective is; this is incorrect. 253 AAF_C08.qxd 3/30/06 4:04 PM Page 254 Chapter 8 Full costing Activity 8.3 Into which category, direct or indirect, would each of the costs listed in Activity 8.2 fall if we were seeking to find the cost of operating the entire business of Sparky Ltd for a month? The answer is that all of them will be direct costs, since they can all be related to, and measured in respect of, running the business for a month. Naturally, broader-reaching cost units, such as operating Sparky Ltd for a month, tend to include a higher proportion of direct costs than do more limited ones, such as a particular job done by Sparky Ltd. As we shall see shortly, this makes costing broader cost units rather more straightforward than costing narrower ones, since direct costs are easier to deal with than indirect ones. Full costing and the behaviour of costs ‘ We saw in Chapter 7 that the full cost of doing something (or total cost, as it is usually known in the context of marginal analysis) can be analysed between the fixed and the variable elements. This is illustrated in Figure 8.2. The similarity of what is shown in Figure 8.2 to that depicted in Figure 8.1 seems to lead some people to believe, mistakenly, that variable costs and direct costs are the same and that fixed costs and overheads are the same. This is incorrect. The notions of fixed and variable are concerned entirely with cost behaviour in the face of changes to the volume of activity. Directness of costs, on the other hand, is entirely concerned with collecting together the elements that make up full cost, that is, with the extent to which costs can be measured directly in respect of particular units of output or jobs. These are two entirely different concepts. Though it may be true that there is a tendency for fixed costs to be indirect costs (overheads) and for Figure 8.2 The relationship between fixed costs, variable costs and total costs The total cost of a job is the sum of those costs that remain the same irrespective of the level of activity (fixed costs) and those that vary according to the level of activity (variable costs). 254 AAF_C08.qxd 3/30/06 4:04 PM Page 255 Deriving full costs in multi-product operations Figure 8.3 The relationship between direct, indirect, variable and fixed costs of a particular job A particular job’s full (or total) cost will be made up of some variable and some fixed cost elements. It will also be made up of some direct and some indirect (overhead) elements. ‘ variable costs to be direct costs, there is no link, and there are many exceptions to this tendency. For example, most activities have variable overheads. Labour is a major element of direct cost in most types of business activity but is usually a fixed cost, at least over the short term. The relationship between the reaction of costs to volume changes (cost behaviour), on the one hand, and how costs need to be gathered to deduce the full cost (cost collection), on the other, in respect of a particular job is shown in Figure 8.3. Total cost is the sum of direct and indirect costs. It is also the sum of fixed and variable costs. These two facts are independent of one another. Thus a particular cost may, for example, be fixed relative to the level of output on the one hand, and be either direct or indirect on the other. The problem of indirect costs ‘ Distinguishing between direct and indirect costs is related only to deducing full cost in a job-costing environment, that is, where units of output differ. When we were considering costing a litre of ‘Orange Fizz’ drink in Activity 8.1, whether particular elements of cost were direct or indirect was of absolutely no consequence, because all costs were shared equally between the litres of ‘Orange Fizz’. However, where we have units of output that are not identical, we have to look more closely at the make-up of the costs to achieve a fair measure of the full cost of a particular job. Indirect costs of any activity must form part of the cost of each unit of output. By definition, however, they cannot be directly related to individual cost units. This raises a major practical issue: how are indirect costs to be apportioned to individual cost units? 255 AAF_C08.qxd 3/30/06 4:04 PM Page 256 Chapter 8 Full costing Overheads as service renderers It is reasonable to view the overheads as rendering a service to the cost units. A legal case undertaken by a firm of solicitors can be seen as being rendered a service by the office in which the work is done. In this sense, it is reasonable to charge each case (cost unit) with a share of the costs of running the office (rent, lighting, heating, cleaning, building maintenance and so on). It also seems reasonable to relate the charge for the ‘use’ of the office to the level of service that the particular case has received from the office. The next step is the difficult one. How might the cost of running the office, which is a cost of all work done by the firm, be divided between individual cases that are not similar in size and complexity? One possibility is sharing this overhead cost equally between each case handled by the firm within the period. Most of us would not propose this method unless the cases were close to being identical in terms of the extent to which they had ‘benefited’ from the overheads. If we are not to propose equal shares, we must identify something observable and measurable about the cases that we feel provides a reasonable basis for distinguishing between one case and the next in this context. In practice, time spent working on the cost unit by direct labour is the basis that is most popular. It must be stressed that this is not the ‘correct’ way, and it certainly is not the only way. Job costing: a worked example To see how job costing (as it is usually called) works, let us consider Example 8.1. Example 8.1 ‘ Johnson Ltd, a business that provides a television repair service to its customers, has overheads of £10,000 each month. Each month 1,000 direct labour hours are worked and charged to units of output (repairs carried out by the business). A particular repair undertaken by the business used direct materials costing £15. Direct labour worked on the repair was 3 hours and the wage rate is £8 an hour. Overheads are charged to jobs on a direct labour hour basis. What is the full cost of the repair? First, let us establish the overhead absorption (recovery) rate, that is, the rate at which individual repairs will be charged with overheads. This is £10 (that is, £10,000/1,000) per direct labour hour. Thus, the full cost of the repair is: Direct materials Direct labour (3 × £8) Overheads (3 × £10) Full cost of the job 256 £ 15 24 39 30 69 AAF_C08.qxd 3/30/06 4:04 PM Page 257 Deriving full costs in multi-product operations Note, in Example 8.1, that the number of labour hours (3 hours) appears twice in deducing the full cost: once to deduce the direct labour cost and a second time to deduce the overheads to be charged to the repair. These are really two separate issues, though they are both based on the same number of labour hours. Note also that if all of the repair jobs that are undertaken during the month are assigned overheads in a similar manner, all £10,000 of overheads will be charged to the jobs between them. Jobs that involve a lot of direct labour will be assigned a large share of overheads, and those that involve little direct labour will be assigned a small share of overheads. Activity 8.4 Can you think of reasons why direct labour hours is regarded as the most logical basis for sharing overheads between cost units? The reasons that occurred to us are as follows: Large jobs should logically attract large amounts of overheads because they are likely to have been rendered more ‘service’ by the overheads than small ones. The length of time that they are worked on by direct labour may be seen as a rough and ready way of measuring relative size, though other means of doing this may be found – for example, relative physical size, where the cost unit is a physical object, like a manufactured product. n Most overheads are related to time. Rent, heating, lighting, non-current (fixed) asset depreciation, supervisors’ and managers’ salaries and loan interest, which are all typical overheads, are all more or less time based. That is to say that the overhead cost for one week tends to be about half of that for a similar two-week period. Thus, a basis of assigning overheads to jobs that takes account of the length of time that the units of output benefited from the ‘service’ rendered by the overheads seems logical. n Direct labour hours are capable of being measured for each job. They will normally be measured to deduce the direct labour element of cost in any case. Thus, a direct labour hour basis of dealing with overheads is practical to apply in the real world. n It cannot be emphasised enough that there is no ‘correct’ way to assign overheads to jobs. Overheads (indirect costs), by definition, do not naturally relate to individual jobs. If, nevertheless, we wish to take account of the fact that overheads are part of the cost of all jobs, we must find some acceptable way of including a share of the total overheads in each job. If a particular means of doing this is accepted by those who use the full cost deduced, then the method is as good as any other method. Accounting is concerned only with providing useful information to decision makers. In practice, the method that seems to be regarded as being the most useful is the direct labour hour method. Real World 8.2, which we shall consider later in the chapter, provides some evidence of this. 257 AAF_C08.qxd 3/30/06 4:04 PM Page 258 Chapter 8 Full costing Activity 8.5 Marine Suppliers Ltd undertakes a range of work, including making sails for small sailing boats on a made-to-measure basis. The business expects to incur the following costs during the next month: Direct labour costs Direct labour time Indirect labour cost Depreciation of machinery Rent and rates Heating, lighting and power Machine time Indirect materials Other miscellaneous indirect costs Direct materials cost £60,000 6,000 hours £9,000 £3,000 £5,000 £2,000 2,000 hours £500 £200 £3,000 The business has received an enquiry about a sail, and it is estimated that the sail will take 12 direct labour hours to make and will require 20 square metres of sailcloth, which costs £2 per square metre. The business normally uses a direct labour hour basis of charging overheads to individual jobs. What is the full cost of making the sail? The direct costs of making the sail can be identified as follows: Direct materials (20 × £2) Direct labour (12 × (£60,000/6,000)) £ 40.00 120.00 160.00 To deduce the indirect cost element that must be added to derive the full cost of the sail, we first need to total these costs as follows: Indirect labour Depreciation Rent and rates Heating, lighting and power Indirect materials Other miscellaneous indirect costs Total indirect costs £ 9,000 3,000 5,000 2,000 500 200 19,700 Since the business uses a direct labour hour basis of charging overheads to jobs, we need to deduce the indirect cost (or overhead) recovery rate per direct labour hour. This is simply: £19,700/6,000 = £3.28 per direct labour hour Thus, the full cost of the sail would be expected to be: Direct materials (20 × £2) Direct labour (12 × (£60,000/6,000)) Indirect costs (12 × £3.28) Full cost 258 £ 40.00 120.00 39.36 199.36