QUESTION:
Using a business as a case study, explain how you can estimate the cost of a product, service or activity within that business using applicable examples. For the estimates presented you need to discuss any judgements made and /or any limitations faced with the methodology used. Finally, you should comment if you feel that your estimates can be used by management.

For the estimates presented you need to discuss any judgements made and /or any limitations faced with the methodology used.  Finally, you should comment if you feel that your estimates can be used by management.

Typical length:        Approx 1500 words

The assessment feedback sheet, indicating the relative weightings of the assessment criteria;

Costing Analysis Feedback

Assessment criteria, with weightings:

Discussion on usefulness for decision making (10%)

Explanation of the methods and their associated

calculations (40%)

Discussion of any limitations (30%)

Discussion of how ABC may impact the management’s

approach to cost control and how its relevance may be

affected by the increasing use of technology (10%)

Was this convincing and well structured? (10%)

Module Aims

MODULE Content

INTENDED Learning Outcomes:

ASSESSMENT METHODS:

Lectures:

Lecture 1: Introduction to accounting

Lecture 2: Costing for decision making

Lecture 3: Costing and pricing approaches

Lecture 4: Budgets and budgetary control

Lecture 5: Financial Statements

Lecture 6: Interpretation of cash flow statements

Lecture 7: Capital Investment appraisal

Lecture 8: Working Capital Management & cash flow statement

Additional notes: COGS, Absorption Costing, ABC and IAS:

The relationship between Cost of Goods Sold (COGS), Absorption Costing, ABC, IAS and

Services Firms

 International Accounting Standard (IAS) 2 says that all production costs, both direct and

indirect (aka overheads), should be included in the value of inventory (i.e. the unsold

stock in our warehouses).

 The International Accounting Standards also say that Administrative and

Distribution/Marketing Costs should not be included in the value of inventory.

 Absorption Costing allocates both direct and indirect production costs to our inventory

value and thus complies with the requirements of IAS 2.

 ABC allocates, like Absorption Costing, allocates both direct and indirect production

costs to inventory value. In addition, ABC will allocate to inventory any Administrative

and Distribution/Marketing Costs since they are activities and thus each of these costs

will be apportioned to at least one cost pool/activities which in turn will be allocated to

each product.

 Since Administrative and Distribution costs are not permitted by IAS 2 to be included in

Inventory value, ABC is not an acceptable costing method by the IAS.

 Cost of Goods Sold (COGS) is effectively the value of all inventory that we managed to

sell during the year.

 Therefore Absorption Costing is used by all firms that have inventory and production

overheads (i.e manufacturing firms) in order to comply with IAS.

 Services Firms, like banks, have no inventory and thus they are not obliged to use

Absorption costing for Financial Reporting purposes. Also the International Accounting Standards do not say that ABC should be used anywhere. Try to remember that IAS is only concerned with Financial Accounting while ABC is exclusively a Management Accounting tool and thus it is not relevant to IAS.

Additional Notes, The difference between Absorption Costing and ABC:

 ABC may allocate Administrative, Distribution costs and production overhead costs into the cost

of the activity and the product.

 Absorption costing will not allocate Administrative and Distribution Costs and will instead focus

only on production overhead.

 Absorption costing, as a first step, will initially allocate costs to Departments (also called cost centres).

 Then Absorption costing’s next step will be to allocate the Department costs to the products,

using a production related driver such as direct machine production hours or direct labor

production hours. Only one driver is used at this last stage.

 Activity based costing will initially allocate costs to Activities (also called cost pools). Although,

sometimes a department may reflect an activity and be treated as such, in most cases activities

can be seen as a detailed breakdown of the actions carried out by a department.

 Then ABC’s next step will be to allocate the Activity costs to the products. Note that unlike

absorption costing, which uses only one driver, ABC can use many different drivers at this last

stage.

 Think of Absorption costing as using “blind averaging” whenever we have no visible information,

at our disposal. By “blind averaging” we are effectively saying that absorption costing uses

averaging in order to determine drivers, but does not take any action to correct the

consequences/mistakes caused by that averaging.

 If you go to Week 2’s slide 33 (TABLE 13.2), where we implemented absorption costing, you will

notice that whenever we had directly visible and accountable information we used it (i.e. Area

occupied by each Department, Asset Values of each Department, number of employees and

production orders).

 In that same slide however, whenever we did not have directly visible information, we were

averaging costs using a production related driver (i.e. direct machine hours and/or direct labor

hours) as our denominator. The same approach was again utilized in the next step (TABLE 13.3)

where we are averaging each department’s costs, using a volume related driver (direct labor

hours in this case).

 Now, let us remember the blue/magenta ink pen machine set up costs example from class. Even

if we manage to correctly attribute any machine set up costs to each department , the fact that

in the next stage we are averaging each department’s costs, using a volume related driver (like

we do in TABLE 13.3 using the direct labor hours), means that in our last stage, where costs are

allocated to the product (like we do in TABLE 13.4), our set up costs will be allocated to each

product based on the direct labor hours spent by each department on each product and not on

the actual cost of the machine set ups for each product.

 Similarly, if you go to our optician’s shop example, in week 3’s notes, you will notice that when

we were using absorption costing, we effectively “blind averaged” each department’s costs,

with a volume related driver, in a similar fashion to what we did in Table 13.3 in week 2.

 As a side note, please take into account that in our optician’s shop absorption costing example,

we used as our driver the production volume itself because we implicitly assumed that the

direct labor time (i.e. the production effort required to produce each pair of glasses), is the same

for both product lines. Thus, the two products (old and young people glasses) are estimated to

be similar in terms of direct production effort. Consequently, in this case, it was not necessary to

undertake the final step (i.e. the estimation we do in Table 13.4).

 It should be obvious by now that Absorption Costing’s tendency to “Blind Average” may be time

effective but also error prone. In contrast, ABCs tendency to break down departments into

smaller activities, on a case by case basis, and also factor activities such as machine set ups,

client argumentativeness and client response rates on a per product basis, may be more time

consuming and expensive but less error prone.

Bibliography and Learning Support Material:

Bibliography:

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8. Business accounting and finance – Tony Davies, Ian Crawford 2011 (electronic resource)
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18. Business finance: theory and practice – J. McLaney 2009 (electronic resource)

Principles of accounting – James M. Reeve, Carl S. Warren, Jonathan E. Duchacc20120538478942,9780538478946