 Dear students, in our last session we have discussed the steps of cost allocation. We will today do some practical problems, so that you can actually see how the steps are used. But I will just take a brief recap, see you have the total cost at one end and you ultimately want to calculate the cost of the product. Now this cannot be directly done, because in a particular company or in a particular production setup you may have 100 type of products. So it is impossible to link the total cost to the cost to the products and we also want detail analysis of the cost, cost center wise or department wise. So what is done is the total cost is first linked to cost centers and through cost centers it is charged to products. Now the question which may come is what is a cost center, which we have discussed last time, but I will just repeat it again that cost center could be a location or it could be an equipment or it could be a person or group or combination of this for which the cost is accumulated. So at one end you have the cost, you link them to cost centers and through cost centers you charge them to products. Now what is a product, product is any cost unit though I am using the term product it could also be a service, but what you are ultimately delivering to customer is a product in that sense I am using the term. So you want to essentially cost the particular product or a service. So the total cost first are linked to cost center. Now what are the steps for this linking? For this linking the first step is cost allocation. So what can be charged directly, it charge directly that is called allocation. So all exclusive costs are linked to cost centers, remaining costs or indirect costs are known as overheads and so the step number one is allocation. Step number two is apportionment. So the common pool of costs or the overheads are apportioned on some logical basis to cost centers that is called as apportionment. The third step is known as absorption. So now from cost they are allocated to cost centers, allocated or apportioned to cost centers. From cost centers you want to take them to product. Now how it is done? Let us say that in a particular cost center 10,000 identical units of x are made and the total cost of the cost center is 10 lakhs. How much will be the cost per product? 10 lakh is a cost of a cost center. Let us say C 1 cost center 1 and you are making 10,000 units of x. How much will be the product cost of x? Very simple because you can divide 10 lakhs by 10,000. This is nothing but absorption. I think now it will be clear to you. So your total cost you divide it by some base. The base in this case was number of unit. So you could get the cost per unit of product x. Now take another scenario the cost of cost center 2, C 2 is also 10 lakhs but it is not serving only one cost center, one product. It makes product x, y and z. Now what will you do? Now you cannot divide the total units of x plus y plus z because they are not identical. So you have to take some other base. Now what could be some other base? Number of units you cannot take now. So what could be the other base? The other base could be number of machine hours. So in cost center C 2, if 5000 hours of work is done, what will be the cost per machine hour? 10 lakh is the total cost, 5000 hours of work is done. What will be the cost per machine hour? You are going to divide 10 lakhs by 5000. So you know that cost per hour is 200. Now you will find out how much hours are consumed by x, y and z and accordingly charge the cost. Are you getting? What we are discussing now is known as absorption. So the base for absorption could be one number of units, second number of machine hours. Can you think of any other base? Sometimes neither units are known, neither it is very easy to know the number of machine hours. So the base could be percentage of direct cost. Say in a service industry like software, there is nothing like machining hours, there is nothing like units, they may use the development cost which is a direct cost and other cost may be charged as a percentage of development cost. So point is different bases are used. So at one side you have got the total accumulated at a cost center and then that is being charged to products using some logical basis. That step is known as absorption. Now let us look at some practical problem, so that whatever we are discussing could be more clear to you. Now let us look at this case number one. This is a very simple one, we are yet to actually go into next steps. The first step is to identify direct and indirect. What this step is known as? Can you name this step? This step is known as cost allocation. This is the first important step. Now material costs are 27000. So how what will be, will it be D or direct or indirect? Mostly direct, nothing more is given but usually all material costs are treated as direct costs. So let us put D here, factory rent, factory rent cannot be for one product, it is common in nature. So we will consider it as indirect wages. Again we do not know but generally wages are direct in nature, depreciation usually it is indirect because it is not for one product, it is for the facilities which are common in nature. So it is indirect, salaries generally indirect because they are for maintenance for supervising admin and so on, direct expenses as the name suggests it is direct, insurance usually indirect. So it is clear, this is step number one where costs are identified as direct or indirect. Now let us go to the second sum. Here some data is given about the machine. You know generally machine is treated as a cost center in production type of setups. So machine is treated as a cost center. You have been asked to calculate machine hour rate which is absorption rate for charging the machining cost to the products. So different data is given about the machine. You can have a look cost of the machine, expected life, scrap value, repair cost, lighting cost everything is given about the machine. And it is also given that the machine occupies one fourth of the area of the factory and it has two light points of the total 10 points. And Foreman typically devotes one sixth of his time for the machine. Now we have been asked to calculate machine hour rate that is a cost per hour of machine consumption. Now how to calculate from where will you start? First we will have to accumulate the total cost of the machine for a particular period. Let us say one year and we will divide by number of machine hours to get the machine hour rate. So we will try to calculate the cost of machine operation. Will you include the cost of the machine in that? No, because it is a long term cost expected life of the machine is 10 years. So I will ignore that. Scrap value is also one time information but using these three data that is the cost of the machine, expected life and scrap value I can calculate depreciation of the machine per year that will be considered as a machining cost. How much will be the depreciation? Can you calculate orally 2 lakh is the cost of the machine, life is 10 years, scrap value is 10000. So 2 lakh minus 10000, 1 lakh 90000 divided by 10. So 190 is the total cost for 10 years, we divide by 10 so each year it is 19000. Next is repairs throughout the life, can you consider it? I cannot consider the whole amount but I can divide it by 10. So repairs throughout the life are estimated to be 30000 divided by 10. So again you get 3000 per year. Can you tell me instead of giving repairs for the year, why throughout the life repairs are estimated? Because many times what happens is, repairs may not be much repairs in the beginning but you will require lot of repairs towards the end that is towards 7th, 8th, 9th year or 10th year of the machine. Now it is illogical to charge the repairs only at that time. It is more appropriate if we estimate the total repairs and charge them throughout the life of the year because we want to get a better estimate for the whole life not just for that particular year. That is why the total repairs are given and a proportionate amount will be charged. Next is total usage in hours which is 950. So how much will be for particular year 950 upon 10, so 95 hours that will be our base we will see it later. Next is electricity consumption, units per hour are given. So again we will have to calculate it to know the cost per year. Let us look at the solution because I think we have discussed too many things. So if we try to solve it, you can see how depreciation can be calculated. The cost of the machine minus scrap value upon life I think we have already done it it is 19,000. So cost of the machine is depreciation I mean machine cost per annum depreciation. So depreciation per year is 19,000. Next which we just discuss is repairs which is the total repairs upon life which comes to 30,000. Now how will you calculate electricity? Electricity charge per unit is given, total units per hour is also given multiplied by total hours. So you can see here electricity consumption is 15, rate is 0.5 and we know that about 95 hours of consumption takes use takes place per year. So you have 95 into 15 plus into 0.5 right 95 into 15 into 0.5. So you have got 7125. Next monthly rent of the department is 5000. How much will be charged to the machine? In the footnote you can see that machine occupies one fourth of the area of the department. So what will be the charge for the machine of the rent? Total rent per month is 5000 first multiplied by 12. So 60000 becomes rent for the whole year and again it is divided by 4 because one fourth area is used by this machine. So let us look at rent calculation. So rent into 12 into percentage area occupied I think there is some problem I will try to recalculate. So you know 5000 into 12 upon 4. So 15000 is a cost of the rent. Lighting charges are given to be 8000 and it has two light points out of total of 10 light points. So how much is a cost for the machine? So you can see it is light charges into light points for the machine upon total light points that is 2 by 10. So it is 1600. Next is monthly salary of the foreman which is 10000. How much will be charge over for the machine? It is given that the foreman devotes about one sixth of his time. So foreman salary into 12 upon one sixth. So you get 20000. Anything else? Expenses per month is given to be 500. So miscellaneous expenses 500 into 12 so you get 6000. Last item insurance premium is 1 percent. So how much premium will be charged? So it is 1 percent generally of the cost of the machine. You know the cost of machine is 2 lakhs. So 1 percent of 2 lakhs means 2000. Is it right? So I think we will recheck the calculation of electricity charges. Electricity charges are how much? Consumption is 15 and rate is 0.5 per unit. So 15 into 0.5 into the number of hours per annum which should be 95. So you can go back and check. It is given that the total usage in hours in the whole of the lifetime is 950. So per year it is 95. So you get 712.5. So the operating cost of the machine comes to 67312 divided by it is not 950. We will take it 95 because you are doing the yearly calculation. The machine hour rate that is total cost of the machine operation upon the machine hours comes to 708.55. Is it clear to you how it is calculated? Now where you can use it? What is the use of this calculation of the machine hour? Now you may be processing a number of products using this machine. Suppose product A is processed for 3 hours. Then we can charge 3 into 708 or suppose customer as for a quotation and the work of the customer requires 2 hours of time on this machine. We can immediately add 708 into 2 as the cost of usage of this machine. I am not saying the total job of the customer but for this machine cost it is 2. So like that on any product or any service we will add the cost of the required machining and that will become the total production cost. Are you getting? So this is how machine hour calculation helps us to calculate the cost of any product or any service. Now let us look at slightly more complicated problem. So here we will try to look at all the steps which we have discussed so far. So here company has 3 departments you can see it as department A, B, C and there is also one service department. Certain costs are given which are common in nature or overhead costs and certain information about various factors are also is also available. And technical assessment says that service department essentially devotes this much of benefit for other departments which is 30, 25 and 45. Using all these data we are required to calculate the per hour cost for these departments. By cost only indirect cost because we are not considering material and labor now we are focusing on overhead costs which are listed here. Now how to go about can you think of? So here you have got time keeping and accounts cost how to link it perhaps difficult. Let us take the next power how to link it look at the data below and try to link the factor to the cost is it possible to link. There is a information given about horse power of the machine so that is a good proxy to charge the power cost assuming that the consumption is more or less similar. So you have got that information about horse power capacity of the departments that will be used as a base for charging power cost. What about canteen? Generally the canteen cost will be based on the number of workers. So number of workers could be a base for canteen cost stores below you can see it clearly says the value of store requisitions. So that is a cost driver. That can be used for store cost depreciation capital cost in lax is given. So that could be used as a proxy for depreciation rent floor space is given indirect wages very difficult to link because they are indirect in nature but the best way is direct wages. So I think now it is clear to you a cost and the cost related factor or a cost driver. Now let us see how the calculation can be done. So this is how it is done. So timekeeping and accounting cost again generally will depend on number of workers. So you know the number of workers in each and you can find out the total which is 40 just add the total column for more clarity. So total hours are 40 and total timekeeping cost you know is 30,000. So based on the number of hours the allocation has been done like this. I think it is clear to you power as we have just now discussed depending on the horse power of the machine. The total horse power of the machines comes to 15,000 and the total cost is 80,000. So in the ratio of horse powers it has been divided then canteen on the number of hours stores on the value of store requisitions depreciation on the capital cost rent is on the floor space indirect wages as a proportion of direct wages. So here all the calculations have been done. Now at this stage one problem may come is we want to also charge the store cost to the production cost. Because in the first level all cost got charged to ABC plus service department but service department itself is not producing anything it is just providing service to ABC. That is why this is the second stage or you can say sub stage of apportionment which is known as reapportionment. So in reapportionment each of the cost of service department are charged to ABC. So the technical estimation was given to us that approximately it is 30 percent 25 percent and 45 percent of the benefit from service department to these three departments. So same ratios are used for charging the service department cost which are common in nature to production department cost which is ABC. So here the costs are charged. Now we get the total cost for A which includes its apportion cost 7,500 plus that part of service cost which is charged which is 1125. So you get 8625 it is clear same way you can see power. So the power cost for A was 29,867 to this it is also burdened with 1600 from service department. So 29,867 plus 1600 so the total cost is 31,461 and so on. So like this the cost of each of the individual costs are charged to ABC and at this stage if we take a sum we will get the total cost which is charged to AB and C is it clear? So which steps we have done now up till this level we have done apportionment which was done in the first table. Then we have done reapportionment of service department to ABC and now we have taken total. So what is the next step now? Next step is absorption because now the costs are collected at ABC but we want to charge them to the products. Now for absorption again we have to see what is the base. So you can see some information is available about number of workers and so on. So what could be the base for absorption of cost to the products? Can you think of what will be the base? Maybe here you can see the data more clearly, are the number of machine hours given? No, many times when machine hours are given we can calculate machine hour rate as it was done in the last sum. So here can you think of any other logical base this department ABC may not be doing a particular machining. So it may be tough to calculate machine hour rate or getting the total machine hours. So amongst the given options what will be the most suitable for absorption? Just think over it is very logical by absorption what I mean is we are going to charge to the customers or to the products. So how will you charge? Can you use number of workers or floor space? No, because they are for internal consumption. So the total cost of the rent of the factory is getting charged to ABC using floor space. But that cannot be the base for charging the customer. For charging the customer either it could be number of units if units are homogeneous or it could be machine hours it could be what else it could be? You can see one of them you can identify or it could be direct wages. So based on direct wages you can charge the customer sometimes it could be sale value of the product. But right now amongst the available data we will try to pick up the direct wages. Now we will not worry about service department we are going to charge only to ABC. So direct wages if it is taken as a base what will be the cost per department? So here what we are trying to find is percentage of direct labor. This is the absorption rate we have calculated I hope it is clear to you. Now how will you use this rate in practical circumstances? So suppose customer makes a query and for that work we require 5 hours of work in department A how much will you charge the customer? So you will calculate the direct labor for that 5 hours plus you will charge the 86 0.86 of the cost of the direct labor as a overhead cost. Most of the service industries like in software or in consulting they fix up a proportion of charge of the direct labor. So hourly rate is first charged and then on that hourly rate something extra is charged to cover up the overhead cost. So that is the rate we have calculated. You can see the rate is much higher for department A it is 0.86, 0.37 in B and 0.48 in C it may vary depending on the nature of the cost consumed by each of the departments. Is it clear to you? So here we have tried to look at all the stages starting from apportionment, reapportionment and absorption. Now one more step is left that step is known as under or over absorption. Thank you. So we have been discussing about how overhead expenses are accounted for. Now we will look at the next step before that a brief recap of the earlier steps. So in the first level it is costs are allocated that is you segregate the costs into direct and indirect. Direct are charged directly indirect are charged to some cost center. Next level is apportionment. So indirect costs are essentially a common pool. So you are required to apportion it on some logical basis. The next one is reapportionment. So the cost which are charged to service cost centers are again allocated to production cost centers. Next one is absorption which is very important and the one which we are talking now the fifth step is based on this fourth step. So in the fourth step absorption what we have done is the cost which are accumulated at a cost center level are being charged to products or cost units as they are technically known as. For example if the cost of a cutting cost center is 1 lakh rupees and the working there on is 1000 hours then we can say that the cost is approximately 100 per hour. So any job which is done in the cutting unit for 1 hour will be charged for 100 rupees and so on. So the objective of absorption is the costs which are accumulated at a cost center level should get charged to the product or service which is being delivered to the customer. Now one thing we should remember is this 100 rupee calculation was itself based on approximation because it is done using a budgeted cost of 1 lakh and a budgeted activity of 1000. So both are estimated and 100 which is calculated is known as predetermined absorption rate. It is called predetermined because a priori we do not know what will be the actual cost but we cannot wait till the whole accounting is done and the correct figures come. That is why in advance a rate is calculated that is 100 rupees which is a predetermined rate and the products are charged at 100 rupees as and when they are produced. Naturally what happens is at the end of the period if the actuals do not match with the figures which are estimated there will be some difference. For example, we are charging 100 rupees per hour for assumption that there will be 1000 hours and the total cost is 1 lakh suppose the hours remain same that is 1000 but the actual cost becomes instead of 1 lakh 1 lakh 5000. Now what will happen at the rate of 100 rupees for 1000 hours we will charge 1 lakh but the cost is 1 lakh 5000. So there will be a difference of 5000 which will be called as under absorption. I hope you are getting me. So 1 lakh 5000 is a cost actual cost as we will call it but the absorbed overheads are 1 lakh. So there is a difference of 5000 in this case it is a under absorption because the actual cost is not fully absorbed. Sometimes other way round may happen that more cost gets absorbed actual cost is less it will be a situation of over absorption. So at the end of the period the fifth step will be to calculate the under and over absorption and to account for these differences. Now let us look at it exactly what is to be done. So here we have defined the over and under absorption. So through the use of predetermined overhead rates they are charge on actuals as I have explained you and the predetermined rate itself are expected or budgeted costs. So they cannot match with the actual leading to differences which are known as under and over absorption. Here is a definition. So if the overhead absorbed are higher than the actually incurred it will be called as over absorption and exactly opposite when the overhead absorbed are less than the actual it is called as under absorption. Let us also look at the example to make it more clear to you. So please have a look at this example 4. So as you can see here the budgeted overhead cost is 360,000. The overhead machine hour rate is 180,000 and budgeted direct labor cost is 396,000. It is given that the predetermined absorption rate is based on machine hour and then these are the figures for the whole year 2012 based on the annual budget. Below this the actual costs for 2 months April and May are given. So once the month over the accounting system will provide us the actual data which has come for 2 months which shows that the actual overhead cost in April is 23,000. Actual machine hours in that month is 15,000 and the actual labor cost is 28,000. And we have been asked to compute under and over absorption and also show the calculation if this under and over absorption is based on direct labor hour rate. Basically we to begin with we will start with machine hours. Now can you think of what will be the under and over absorption? How will you calculate? Just give a thought how it can be calculated. First of all before calculating under or over absorption you should calculate how much is absorbed because actuals are given for the month of April but how much is absorbed is not given. Now how will you calculate that how much is absorbed? Even before that we need to know the rate of absorption. It is given that predetermined rate is based on machine hours. So we have to calculate based on machine hours what will be the rate of absorption. So just think of what will be the rate? I think it is very simple you can even do it without using computer calculator and so on. Just by observing you can calculate how much will be the cost per machine hour which is the rate of absorption. So can you calculate how much will be the cost? If you look at the budget the budgeted over rates are 360 and budgeted machine hours are 180. So how much is a cost per machine hour? Let us look at the solution. I hope you have calculated it orally. So the step number one is calculation of machine hour rate as it is known as. So 360 upon 180 we get 2 rupees per machine hour. This 2 rupee means is known as predetermined overhead absorption rate. So it is based on budget. So we call it predetermined. We do not know what will happen in April, May, June etc. But we have calculated that the overhead cost is going to be about 2 rupees per hour. Now let us see what happened in the month of April. So in the month of April actual overhead cost is 23 actual machine hours as you can see are 15. So if you absorb at 2 rupees per machine hour you will absorb 30,000. Now 23 is actual 30 is absorbed. So it leads to over absorption to the tune of 7000. I hope it is very simple and very clear to you. Now check it for the month of May. In the month of May you will observe that the actual cost has shot up. It has become 41. Actual machine hours have also increased but they have become 20. So at 2 rupees rate the absorption becomes 40, 20 into 2 but the actual is 41. So there is a difference of 1000 which is known as under absorption. So you are not able to absorb the full 40, 41. You have absorbed 40 actually 41. So there is an under absorption to the tune of 1000. Is it clear both? Now let us do it the same thing but taking direct labor cost as the basis. So here we are back to the problem again. Now think of the calculation if direct labor cost is to be the basis. Now how will you calculate? There are 3 stages just tell me what will be the 3 stages. So stage number 1 is calculate the absorption rate based on the direct labor cost that is item number 1. Second one calculate the amount absorbed for the month of for a particular month that is months of April and May and then compare the actuals with the absorbed amount. So let us look at the calculations. So what is the rate? Budgeted cost is 360 and budgeted overhead cost is 360, budgeted labor cost is 396. So 360 upon 396 means 91 percent of direct labor cost is our predetermined overhead rate. Earlier we calculated 2 per machine hour. Here it is calculated as a percentage of direct labor cost. We have discussed in the last session that various basis can be used. So one of the popular basis is machine hour. The second one is one which we are using now that is as a percentage of labor cost. Sometimes it is based on direct labor hour in very few cases but it can be also based on a percentage of material cost and so on. So in this case it is 91 percent of direct labor cost. Now let us look at the actual for the month of April. So for the month of April the actual cost, the actual overhead cost is 23, actual labor cost is 28. So if we absorb on the basis of 28 at 91 percent, 25,480 is the absorbed overheads. So there is over absorption to the tune of 2480. If you look at the month of May the actual is 41, the actual labor cost is 35. So you are able to absorb only 31,850. So there is an under absorption to the tune of 91150. So is it clear to you now? Please also see the comparison of two methods. So both the methods I mean are alternatives this or that can be used. You can see how much big difference is there in the calculation. Are you getting? So here in the month of May the under absorption was only 1000. Now the under absorption is as high as 91150 and there was over absorption of 7 but here there is over absorption of 2480. So the base of absorption becomes very important and the cost accounting data can change completely by the base of absorption. That is why when you do the product costing, when you say that product X cost me say 5000, it is very important to know what methods or what assumptions have gone into calculating that 5000. Because if you have used labor hour rate instead of say machine hour, the cost can be different. There can be vast differences in the cost. As if there are more and more products and more complexity, the differences can even be higher. So management has to be very very particular in using an appropriate rate of absorption. Now what will happen if you do not use the suitable rate for absorption? Say machine hour is better but you use labor cost. What will happen? What happens is in case of multiple products, you may have product A, B, C, D, E, F. One product gets charged more, the other product gets charged less. So what will happen? Let us say product A is consistently being over burdened, it is being charged more. Then our product will lose its competitiveness in the market because product A is costed on higher side, competitors may supply it at a lower price. So we lose the advantage in the market whereas product B, we are charging less. Definitely it will be sold more but we are selling it at a loss which we do not know. We feel we are selling it covering the full cost but actually we are covering less than the appropriate cost. That is why management has to be careful in choosing the correct rate of absorption. Not only that, they should also keep a track on regular basis. So in this sum, you can see that the calculation was done for the whole year based on the annual budget and now we are calculating it month wise. So in the month of April, May, June, if you in first 2-3 months you find lot of variation, you can perhaps change the rate to ensure that the correct costs are getting absorbed. Is it clear? Let us look at one more case to make our point even more clear. Now here, we have been given data about 2 companies. Have a look at it. I would not tell you many things now. So here you have 2 companies D and B. D does it using direct labor cost, B does it using machine hours. The data is given for budgeted overhead as well as the appropriate basis and you have been asked to calculate the under or over absorption. So at the end of the whole year, now the data is available. So D you can see 3 lakh was the budgeted overhead cost whereas the actual overhead cost has become 4 lakhs. So how much will be under or over absorption, are you able to calculate? Can we say that there is under absorption of 1 lakh because actually 4 budget is 3. Does it mean there is a under absorption of 1 lakh? No, it is a wrong calculation because it is not, we have not yet calculated the amount which is absorbed. So using the budgeted figures, first of all calculate the absorption rate. Then using that absorption rate and the actual that is 5 lakhs, calculate the overhead absorb and then we will get under or over absorption. So think over now, try to calculate it yourself. I think this is also simple, you can do it orally. So how much will be the rate? So 3 lakh is a budgeted overhead, 4 lakh is a labor cost. So it comes to 0.75 or in other words we can say it is 75 percent of direct labor cost is a rate of absorption for company D. So how much will be now the amount absorbed? So you can see the actuals are 4 lakh, actual labor cost is 5 lakh. So 5 lakh into 75 percent that means 375 has been absorbed. But since the actual is 4, the under absorption is to the tune of 25,000, it is clear. Now do for the other company, company B. So for company B, how much is over or under absorption? Now look at the budgeted rate 5 lakh for machine hours 2 lakhs. So how much will be the absorption rate 5 lakh upon 2 lakhs means 2.5 is the rate predetermined overhead absorption rate as we call is 2 per machine hour. So how much amount will be absorbed in the concern here? It is 3 lakhs, so 3 into 2.5. Let us look at the solution. So 5 lakh upon 2 lakh as we were discussing 2.5 per hour is a rate. So now for 3 lakhs at 2.5, we are absorbing 7,50,000, 5 lakh is actual, 750 is absorbed. So there is over absorption to the tune of 2,50,000 getting. So I hope the concept of under and over absorption is clear to you now. Now what are the reasons? The reasons for over absorption could be the actual hours work can be more or less than estimate then the actual labor cost may be different. So either the numerator or denominator can be different. The application method may not be correct, extraordinary expenses or there could be seasonal variations. Sometimes some major changes have been made in the either plant layout or the machines, mechanization and so on which are not accounted in calculating the rates. So it is very important that over and under absorption is calculated regularly and it is also suitably adjusted. So I hope now all the 5 steps that is starting with allocation, apportionment, reapportionment, absorption and over and under absorption are fairly clear to you. Thank you so much. We will be continuing in the next session.