DEBRE MARKOS UNIVERSITY

INSTITUTE OF TECHNOLOGY
Manufacturing Engineering

PROCESS PLANNING AND PRODUCT

COSTING
Chapter Five – Principles of cost accounting & Break
Even Analysis

By: Mulatu M.(Asst.Prof)

March, 2024
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 PRINCIPLES OF COST ACCOUNTING

Cost accounting (costing) is the process of determining the actual cost of the
product after the manufacturing.
Cost accounting's goal is to provide timely and relevant information to managers.

 Management uses this information to decide

how to allocate resources to the most efficient
and profitable areas of the business.

 Generally, cost accounting is the process of;

 Identifying,
 Analyzing,
 Summarizing ,
 Recording and
 Reporting costs associated with business
operations.

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 Cost Accounting Systems Cont…

There are many different cost accounting systems,

but most of the important features of these
systems can be described in terms of two general
types.
 This are;

1.Traditional product cost accounting/absorption

costing system
2.Activity based product cost accounting
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 Traditional product cost accounting/absorption
costing system
• It is a costing approach in which all manufacturing costs are
charged to the product.
• The allocation of overhead costs under the system is based
on a rate determined by either a percentage of direct labor or
number of labour hours worked or another.

• Therefore, the reported allocation of overheads for a given

product may be incorrect. It is the main defect of absorption
costing.
• Traditional cost systems usually rely on volume measures such as
direct labor hours and/or machine hours to allocate all
overhead costs to products.
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 Cont…
 The allocation of overhead assumes that;
 Allocates overhead using a single predetermined rate.
o Direct labor cost is assumed to be the relevant activity
base. (Assumption was satisfactory when direct labor
was a major portion of total manufacturing costs).

o Machine hours is assumed to be the relevant activity

base. (Assumption was satisfactory when machine hours
was a major portion of total manufacturing costs).

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 Cont…
 Three methods of doing traditional costing:

1. Amount per Unit

2. Amount per direct Labour hour

3. Rate per direct Machine hour

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 Example 1: Costing Under Traditional Costing Cont…
DM Furniture company estimates its fixed production overhead costs
next year will be 18,000 birr and that it will produce 3,000 tables
incurring 4,000 Direct Labour/hours and 800 Machine/hours.

(a) Per Unit: Total Overheads = 18,000 = 6birr per Unit

No of Units 3,000

(b) Per Direct Labour/hr = 18,000 = 4.50birr per Labour/hr

4,000

(c) Per Machine/hr = 18,000 = 22.50birr per Machine/hr

800

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 Example 2: Costing Under Traditional Costing Cont…
The ABC Company has the following budgeted data for year 2014:
Estimated total overhead =800,000 Birr
Estimated direct labor hours = 10,000 hr

a) Calculate the overhead cost applied per direct labor hour.

b)Calculate the overhead applied if 9,500 actual direct labor hours are used
during 2016.
9,500 x 80 = 760,000 Birr

Over applied = applied overhead – actual overhead = 760,000 – 752,000

=8,000 Birr.
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 Example 3: Costing Under Traditional Costing
XYZ company produces two automotive antitheft devices:

• The Boot: A high volume item with sales totaling 25,000 per year.

• The club: A low volume item with sales totaling 5,000 per year.

• Total annual direct labor hours (DLH) 30,000 (25,0000 + 5,000).

• Each product requires 1 hour of direct labor.

• Direct labor cost is 12 Birr per unit for each product.

• Expected annual manufacturing overhead costs 900,000 Birr.

• Direct materials cost: The Boot = 40 Birr per unit and

The club = 30 Birr per unit.

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 Solution; Products
Manufacturing Costs The Boot The Club
Direct Materials 40Birr 30 Birr
Direct Labor 12 12
Overhead 30 30*
Total unit cost 82 Birr 72 Birr

* Predetermined overhead rate: 900,000 ÷ 30,000 DLH = 30 per DLH

Overhead = predetermined overhead rate x direct labor hours

= 30Birr × 1 hr
= 30 Birr

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Advantages of absorption costing system

 Provides a more complete picture of the total cost of a product by

including both direct and indirect costs.
 Helps in determining the total actual cost of goods sold and the
cost of inventory on the balance sheet.
 Allows a company to understand the full cost of each product or
service it provides.
Disadvantages of absorption costing system

 May not accurately reflect the incremental costs associated with

producing an additional unit of a product, as it includes fixed
overhead costs that do not vary with production volume.
 Can lead to distorted cost data if there are significant changes
in production volume.
 May not provide as much information for management decision-
making as variable costing.
 Activity based product cost
accounting

• Activity-based costing is an overhead cost control method used

primarily in the manufacturing sector, although it has applications in
other industries.

• The method uses the relationships between costs, activities and

products to assign indirect costs to products with a higher degree of
precision.
• Complex manufacturing processes may require multiple allocation bases;
this approach is called Activity-Based Costing (ABC).
• ABC systems are more accurate than traditional costing systems. This is
because they provide a more precise breakdown of indirect costs.
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 Cont…
•The ABC system of cost accounting is based on activities, which refer to
any event, unit of work, or task with a specific goal, such as;
 Setting up machines for production,
 Designing products,
 Distributing finished goods, or operating machines.

•Instead of assigning an equal value to all

products, you can allocate the necessary
budget in each area when using activity-
based costing.

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 ABC Key terms Cont…
Activity: Any event, action, transaction, or work sequence that
causes a cost to be incurred in producing a product or providing a
service.

Activity Cost Pool: The overhead cost attributed to a distinct type

of activity.
Examples:
 Purchasing materials.
 Setting up machines.

Cost Drivers: Any factors or activities that have a direct cause-

effect relationship with the resources consumed.

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 OVERHEAD COSTS Cont…
Activity Cost Pools and cost drivers:

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 OVERHEAD COSTS Cont…
Activity Cost Pools and cost drivers:

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 OVERHEAD COSTS Cont…
Activity Cost Pools and cost drivers:

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OBJECTIVES OF ACTIVITY BASED COSTING
(ABC)

Some objectives of ABC are;

 To recognize several activities in the process of production,
including the activities that add value.
 To eliminate the non value-adding activities.
 To put emphasis on the high-cost activities
 To incorporate activities based on distribution overheads.
 To help in decision-making process in the identification of a
suitable price of product and services.
 To ensure accurate and precise cost determination of products
and services.
 To find options to improve the process and reduction of costs.
 Cont…

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 Four Steps of Activity-Based Costing

1. Identify and classify the major activities and allocate

manufacturing overhead costs to the appropriate cost pools.

2. Identify the cost driver that has a strong correlation

to the costs in the cost pool.

3. Compute the overhead rate for each pool.

4. Assign overhead costs for each cost pool to products

using the overhead rates.

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 Example 1: ABC Costing Cont…
DM software company interested in setting up new pieces of manufacturing equipment
throughout their facilities. They have 250 facilities total, and are considering a single piece
of new equipment per location. The equipment set-up activity is the only entity within the
current manufacturing cost pool. It has a budgeted cost of $250,000, and because of this
increase in cost and increase in the number of labor hours required, DM software company
decides to use the ABC system.
Calculate the activity-based costing for this manufacturing strategy;

Solution:
The cost driver for this activity is the number of machine set-ups

This means that the cost driver is 250, because that's the number of machines they require to
install one per facility.
When entering the variables into the ABC formula, they find;
Activity-based costing = 250,000 / 250
ABC = $1,000

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 Example 2: ABC Costing Cont…
The Mega Book manufacturer has the following budgeted data for

the year 2022:

Estimated Estimated Driver totals
Overhead in 2022

Set ups 300,000 Birr 150 set ups

Supervision 100,000 Birr 4,000 Direct labor hours

Shipping 140,000 Birr 3,500 Orders

a) Calculate the overhead cost applied each overhead category.

Setups: 300,000/150 = 2,000 Birr Per set Up

Supervision: 100,000/4,000 = 25 Birr Per Direct Labor Hour

Shipping: 140,000/3,500 = 40 Birr per Order

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 Cont…

b) Calculate the overhead applied for the following totals

for 2022:

Actual total setups: 145 x 2000 Birr = 290,000

Actual total Direct labor hour: 4,100 x 25 = 102,500

Actual total orders: 3,300 x 40: 132,000

Total Applied = 290,000 + 102,000 + 132,000 = 524,500 Birr

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Activity Based Costing Vs Traditional Costing
System

Traditional allocation method Activity based allocation method

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 BREAK-EVEN ANALYSIS
• Break Even Analysis is a tool that helps a company to decide at which
stage the products or services provided by the company will start making
profits.

• To put it in simple language it is a tool that will help a company decide

how many products or services they should sell to cover the costs.
• It determines what level of sales is required to cover the total cost of
business (Fixed as well as variable cost). OR

• A break-even analysis is a financial calculation used to determine a

company’s break-even point (BEP).
• It is an analysis to study the point where neither profit nor loss is
occurred. This point is known as Break Even Point.

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 Cont…

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 Cont…
• The red line represents the total fixed
costs of $100,000.
• The blue line represents revenue per
unit sold. For example, selling 10,000
units would generate 10,000 x $12 =

$120,000 in revenue.
• The break even point is at 10,000
units. At this point, revenue would be
10,000 x $12 = $120,000 and costs
would be 10,000 x 2 = $20,000 in
variable costs and $100,000 in fixed

Figure: Graphically Representing the Break Even costs.

Point

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 For example;
Cont…
• When the number of units
exceeds 10,000, the
company would be making
a profit on the units sold.

• Likewise, if the number of

units is below 10,000, the
company would be
incurring a loss.

• Break-even point (BEP) represents the production quantity for which the
total cost of producing the goods equals the total sales price.

• At break-even point there will be neither any profit nor any loss to the
manufacturer.
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 Cont…
• The profit can be computed as;

• At breakeven, there is no profit or loss,

hence,

Profit = R –TC = 0
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 Cont…
The Total cost (TC) can also calculated as;

TC = FC + VC
Where;
TC = Total cost, FC= Fixed cost and VC = Variable cost

• It can be seen that we have profit if the production level is above the breakeven
quantity and loss if it is below.
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 Cont…
Example 1: Mr. X is the managerial accountant in charge of Company A, which sells
water bottles. He previously determined that the fixed costs of Company A consist of
property taxes, a lease, and executive salaries, which add up to 100,000 Birr. The variable
cost associated with producing one water bottle is 2 Birr per unit. The water bottle is sold
at a premium price of 12 Birr.

Determine the break even point of Company A’s premium water bottle;

Solution;
Break Even Quantity = Fixed Costs / (Sales Price per Unit – Variable Cost Per
Unit)

Break Even Quantity = 100,000 / (12 – 2) = 10,000

Therefore, given the fixed costs, variable costs, and selling price of the water bottles,
Company A would need to sell 10,000 units of water bottles to break even.

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 Cont…
Example 2
Company X sells a pen. The company first determined the fixed costs, which include a
lease, property tax, and salaries. They sum up to 100,000 Birr. The variable cost linked
with manufacturing one pen is 2 Birr per unit. So, the pen is sold at a premium price of 12
Birr.

Therefore, to determine the break-even point of Company X, the premium pen will be:

Break-even point = Fixed cost/Price per cost – Variable cost

= 100,000/(12 – 2)
= 100,000/10
= 10,000 units

Therefore, given the variable costs, fixed costs, and selling price of the pen, company X
would need to sell 10,000 units of pens to break-even.

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 Class work
Company Z have the following costs;
• Fixed factory overheads cost (60,000 Birr)
• Fixed selling overheads cost (12,000 Birr)
• Variable manufacturing cost per unit (12Birr)
• Variable selling cost per unit (3Birr)
• Selling Price per unit (24 Birr)

Then Find;
i) Break-even point
ii) Number of units that must be sold to earn a profit of 90,000 Birr.
Solution

Break – even point (in sales values) = 8,000 x 24 = 192,000 Birr

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 Importance of Break Even Analysis

• The break-even analysis helps the company to decide the least

number of sales required to make profits.
• With the help of break-even analysis, the company or the owner
comes to know how many units need to be sold to cover the

cost.
• Since the company or the owner knows at which point a company
can break-even, it is easy for them to fix a goal and set a budget for
the firm accordingly.
• For a new business, a break-even analysis is essential. It guides the
management with pricing strategy and is practical about the cost.

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