MI · Certificate Level

Cost Accounting

Cost units and cost centres, materials costing (FIFO, LIFO, and weighted average methods for stores issues), labour costing (time-based pay, piecework, bonus schemes — Halsey and Rowan), overhead allocation and apportionment (direct allocation, step-down method, reciprocal method), overhead absorption rates (machine hour rate, labour hour rate, unit rate), and over- and under-absorption of overheads with journal entries and worked examples.

40 min read

Learning Objectives

•Define cost units and cost centres and explain their purpose in a costing system
•Calculate the cost of materials issued from stores using FIFO, LIFO, and weighted average methods
•Calculate labour costs under time-based, piecework, and bonus schemes (Halsey and Rowan)
•Distinguish between overhead allocation and overhead apportionment and apply appropriate bases
•Apportion service department overheads to production departments using the step-down and reciprocal methods
•Calculate overhead absorption rates using machine hours, labour hours, and unit bases
•Calculate and account for over- and under-absorption of overheads

Cost Units and Cost Centres

Cost unit: A unit of product or service to which costs can be related. It is the basic unit of output for which costs are accumulated. Examples: a car (vehicle manufacturer), a patient-day (hospital), a tonne of cement (construction), an audit engagement (accountancy firm), a room-night (hotel).

Cost centre: A location, function, department, or item of equipment for which costs are collected. Costs are first accumulated by cost centre, then allocated or apportioned to cost units.

Production cost centres: Departments directly involved in making the product — e.g., machining department, assembly department, finishing department
Service cost centres: Departments that support production but do not directly make the product — e.g., maintenance, canteen, stores, quality control, administration

The purpose is to trace costs to the products or services that cause them, enabling accurate product costing, cost control, and performance evaluation.

Materials Costing — Pricing Issues from Stores

When materials are purchased at different prices over time and then issued to production, we need a method to determine the cost of the materials issued and the value of remaining inventory. Three methods are commonly examined:

FIFO (First In, First Out)

Materials are assumed to be issued in the order they were received. The oldest stock is issued first. Closing inventory is valued at the most recent purchase prices.

Effect: In times of rising prices, FIFO gives a lower cost of issues (using older, cheaper prices) and a higher closing inventory value (recent, higher prices). This results in higher reported profit.

Advantage: Closing inventory is valued at close to current market prices (realistic SoFP value). Accepted under IAS 2.

Disadvantage: Issues to production may be at out-of-date prices, not reflecting current replacement costs.

LIFO (Last In, First Out)

Materials are assumed to be issued at the most recent purchase price first. The newest stock is issued first (on paper — the physical flow may be different).

Effect: In rising prices, LIFO gives a higher cost of issues (using recent, higher prices) and a lower closing inventory value (old, cheaper prices). This results in lower reported profit.

Advantage: Cost of issues reflects current prices — useful for decision-making and pricing.

Disadvantage: Closing inventory may be significantly understated (old prices). Not permitted under IAS 2 for external financial reporting — but may be used for management accounting purposes.

Weighted Average Cost (AVCO)

A new weighted average price is calculated each time a new delivery is received. All subsequent issues are made at this average price until the next delivery arrives.

New weighted average price = (Value of existing stock + Value of new delivery) ÷ (Quantity of existing stock + Quantity of new delivery)

Effect: Smooths out price fluctuations — issue prices and closing inventory values lie between FIFO and LIFO values.

Advantage: Simple to apply (one price for all issues), reduces the impact of price volatility. Accepted under IAS 2.

Disadvantage: The average price may not correspond to any actual purchase price.

Labour Costing

Labour costs are a significant element of production cost. The method of payment affects both the cost calculation and employee motivation.

Time-Based Pay

Workers are paid a fixed rate per hour (or per day/week/month) regardless of output. Pay = hours worked × hourly rate.

Overtime: Hours worked beyond the standard or contracted hours are paid at a premium (e.g., time and a half = 1.5 × basic rate; double time = 2 × basic rate).

Treatment of overtime premium:

If overtime is worked at the specific request of a customer (to meet their order deadline): the overtime premium is a direct cost charged to that specific job/order
If overtime is worked for general production reasons (high workload, covering absence): the overtime premium is an indirect cost (overhead) — spread across all production, not charged to a specific job
The basic rate portion of overtime hours is always a direct cost (assuming the worker is a direct worker)

Idle time: Time when workers are being paid but not producing (e.g., machine breakdowns, waiting for materials, power failures). Idle time is normally treated as an indirect cost (overhead) — it is an unproductive cost that should not be charged directly to products.

Piecework

Workers are paid a fixed amount per unit produced (piece rate). Pay = units produced × rate per unit.

Differential piecework: The rate per unit increases as output exceeds defined levels — e.g., first 100 units at £2 each, next 50 units at £2.50 each, units above 150 at £3 each. This incentivises higher productivity.

Guaranteed minimum: Workers on piecework may have a guaranteed minimum wage — if their piece-rate earnings fall below this, they receive the minimum instead.

Advantages: Direct link between pay and output, incentivises productivity, variable cost behaviour (cost per unit is fixed).

Disadvantages: May encourage quantity at the expense of quality, workers may resist changes to methods or rates, does not compensate for factors outside the worker's control (machine breakdowns).

Bonus Schemes — Halsey and Rowan

Bonus schemes reward workers who complete a job in less than the allowed (standard) time. The worker receives their basic time-based pay PLUS a bonus based on the time saved.

Halsey scheme:

Bonus = 50% × Time saved × Hourly rate

The worker receives 50% of the value of the time saved; the employer retains the other 50% (saving on labour cost).

Rowan scheme:

Bonus = (Time saved ÷ Time allowed) × Time taken × Hourly rate

The bonus is a proportion of the time-based pay for the actual time worked. The proportion is the ratio of time saved to time allowed.

Key difference: Under Halsey, the bonus increases linearly with time saved. Under Rowan, the bonus increases at a decreasing rate — it can never exceed the basic pay (the bonus fraction can never exceed 1). Rowan is designed to prevent excessive speed that might compromise quality.

Example: Standard time = 10 hours. Actual time = 7 hours. Rate = £12/hour.

Time saved = 10 − 7 = 3 hours
Halsey bonus = 50% × 3 × £12 = £18. Total pay = (7 × £12) + £18 = £84 + £18 = £102
Rowan bonus = (3/10) × 7 × £12 = 0.3 × £84 = £25.20. Total pay = £84 + £25.20 = £109.20

In this case Rowan gives a higher bonus because the time saved (3 hours) is moderate. If the time saved were much larger, Halsey would give the higher bonus (because Rowan's bonus growth slows as time saved approaches time allowed).

Overhead Allocation and Apportionment

Production overheads must be assigned to cost centres (and ultimately to cost units) using a systematic process:

Step 1 — Allocation: Where an overhead can be directly identified with a specific cost centre, it is allocated in full to that centre. Example: the salary of the machining department supervisor is allocated entirely to the machining department.

Step 2 — Apportionment: Where an overhead is shared between several cost centres (it cannot be directly identified with one), it is apportioned on a fair basis that reflects usage or benefit.

Common apportionment bases:

Overhead	Apportionment basis
Rent, rates, heating, lighting, insurance of building	Floor area occupied by each department
Depreciation of machinery, machine insurance	Value of machinery (or net book value) in each department
Canteen costs	Number of employees in each department
Supervisory salaries (shared)	Number of employees or time spent supervising each department
Power/electricity (for machines)	Machine hours or kilowatt-hour consumption
Material handling	Number of material requisitions or weight/volume of materials

Step 3 — Reapportionment of service department costs: Service departments (maintenance, canteen, stores, quality control) do not produce the final product, so their costs must be reapportioned to production departments. Two methods:

Step-Down (Specified Order) Method

Service departments are closed in a specified order — once a service department's costs have been reapportioned, it is "closed" and receives no further costs from other service departments. The order is typically from the service department that provides the most service to other departments, to the one that provides the least.

Advantage: Simpler than the reciprocal method.

Disadvantage: Does not fully account for reciprocal services — if the maintenance department uses the canteen and the canteen uses maintenance, one direction is ignored.

Reciprocal Method

Accounts for the mutual services between service departments — e.g., maintenance serves the canteen, and the canteen serves maintenance. Uses simultaneous equations or repeated distribution to resolve the circularity.

Simultaneous equations example:

Let M = total maintenance cost (including share from canteen), C = total canteen cost (including share from maintenance).

If maintenance's own costs are £50,000 and it receives 10% of canteen's costs, and canteen's own costs are £30,000 and it receives 20% of maintenance's costs:

M = £50,000 + 0.10C
C = £30,000 + 0.20M

Solving: substitute M into C: C = £30,000 + 0.20(£50,000 + 0.10C) = £30,000 + £10,000 + 0.02C → 0.98C = £40,000 → C = £40,816.

Then M = £50,000 + 0.10 × £40,816 = £54,082.

These total service department costs are then apportioned to production departments based on usage.

Advantage: More accurate — fully accounts for reciprocal services.

Disadvantage: More complex to calculate.

Overhead Absorption Rates (OAR)

After all overheads have been collected in production cost centres, they must be absorbed into (charged to) individual cost units using a predetermined overhead absorption rate.

OAR = Budgeted overhead for the department ÷ Budgeted activity level

Common absorption bases:

Basis	Formula	When most appropriate
Machine hour rate	Budgeted OH ÷ Budgeted machine hours	Machine-intensive departments where overheads are driven by machine usage (e.g., automated manufacturing)
Direct labour hour rate	Budgeted OH ÷ Budgeted direct labour hours	Labour-intensive departments where overheads correlate with labour time (e.g., assembly, hand-finishing)
Unit rate	Budgeted OH ÷ Budgeted units of output	Only appropriate where all units are identical — rare in practice. Simple but often inaccurate.
Percentage of direct materials cost	Budgeted OH ÷ Budgeted direct materials cost × 100	Where overheads are driven by materials usage (e.g., material handling, purchasing). Less common.
Percentage of direct labour cost	Budgeted OH ÷ Budgeted direct labour cost × 100	Where overheads are driven by labour cost (similar to labour hours but accounts for different wage rates). Less common.

The choice of basis should reflect the factor that most closely drives the overhead costs. Using an inappropriate basis leads to inaccurate product costs.

Over- and Under-Absorption of Overheads

Because the OAR is based on budgeted figures (estimated before the period), the amount of overhead absorbed into products will rarely equal the actual overhead incurred.

Overhead absorbed = OAR × Actual activity level

Situation	Calculation	Treatment
Over-absorption	Overhead absorbed > Actual overhead	Too much overhead has been charged to products. The excess is credited to the profit or loss account (reducing cost of sales / increasing profit).
Under-absorption	Overhead absorbed < Actual overhead	Not enough overhead has been charged to products. The shortfall is debited to the profit or loss account (increasing cost of sales / reducing profit).

Causes of over/under-absorption:

Actual overhead differs from budgeted overhead: e.g., actual rent increased, actual utilities cost was higher/lower than expected (expenditure variance)
Actual activity level differs from budgeted activity: e.g., actual production was higher or lower than planned (volume variance)
In practice, both factors often occur simultaneously

Journal entries:

Over-absorption (too much absorbed):
Dr Production overhead control account (reduce the overhead balance)
Cr Income statement / cost of sales (credit = reduces cost = increases profit)

Under-absorption (not enough absorbed):
Dr Income statement / cost of sales (debit = increases cost = reduces profit)
Cr Production overhead control account (reduce the overhead balance)

Examiner Focus

Materials costing (FIFO, LIFO, AVCO) is tested frequently with inventory cards showing receipts and issues. You MUST be able to calculate the cost of each issue and the closing inventory under all three methods. Remember: in rising prices, FIFO gives the lowest cost of issues (highest profit) and LIFO gives the highest (lowest profit). AVCO is in between.

Common Pitfall

Students often forget to recalculate the weighted average price ONLY when a new delivery arrives, not when an issue is made. After an issue, the average price stays the same — only the quantity and total value change.

Study Tip

For bonus schemes: Halsey = 50% × time saved × rate (simple). Rowan = (time saved/time allowed) × time taken × rate (proportional). At low time savings, Rowan gives a higher bonus. At very high time savings, Halsey gives a higher bonus. The crossover point is when time saved = 50% of time allowed.

Examiner Focus

Overhead absorption: always use BUDGETED figures to calculate the OAR, then apply the OAR to ACTUAL activity. The difference between absorbed and actual is over/under-absorption. Over = credit to P&L (reduces cost). Under = debit to P&L (increases cost).

Watch Out

LIFO is NOT permitted under IAS 2 for external financial reporting. It can be used for management accounting purposes. If a question asks about financial statements, use FIFO or AVCO only. If it asks about management costing, all three may be relevant.

Common Pitfall

Overtime premium: the BASIC rate portion of overtime is always a direct cost (for direct workers). Only the PREMIUM (the extra above basic rate) may be treated as indirect. If a worker's basic rate is £10/hr and overtime is time-and-a-half (£15/hr), the direct cost is £10 and the indirect overhead portion is £5.

Key Definitions

Cost unit

A unit of product or service to which costs can be related — the basic unit of output for costing purposes. Examples: a car, a patient-day, a tonne of output.

Cost centre

A location, function, department, or item of equipment for which costs are collected. May be a production cost centre or a service cost centre.

FIFO (First In, First Out)

Materials issued at the price of the oldest stock first. Closing inventory is at the most recent prices. Accepted under IAS 2.

LIFO (Last In, First Out)

Materials issued at the price of the most recent stock first. Closing inventory is at the oldest prices. NOT permitted under IAS 2 for external reporting.

Weighted average cost (AVCO)

A new weighted average price is recalculated each time a delivery is received. All issues are made at this average until the next delivery. Accepted under IAS 2.

Idle time

Time when workers are paid but not productive (machine breakdowns, waiting for materials). Treated as an indirect cost (overhead), not charged directly to products.

Halsey bonus scheme

A bonus scheme where the worker receives 50% of the value of time saved (time allowed − time taken) multiplied by the hourly rate. Bonus = 50% × Time saved × Rate.

Rowan bonus scheme

A bonus scheme where the bonus = (Time saved ÷ Time allowed) × Time taken × Rate. The bonus proportion increases at a decreasing rate, preventing excessive speed.

Overhead allocation

Assigning an overhead directly to a cost centre when the overhead can be specifically identified with that centre (e.g., departmental supervisor's salary).

Overhead apportionment

Sharing an overhead between several cost centres using a fair basis (e.g., floor area for rent, number of employees for canteen costs) when the overhead benefits multiple centres.

Reciprocal method

A method of reapportioning service department costs that accounts for mutual services between service departments, using simultaneous equations or repeated distribution.

Overhead absorption rate (OAR)

The predetermined rate used to charge overheads to cost units. OAR = Budgeted overhead ÷ Budgeted activity. Common bases: machine hours, labour hours, units.

Over-absorption

Overhead absorbed (OAR × actual activity) exceeds actual overhead incurred. The excess is credited to the P&L (increases profit).

Under-absorption

Overhead absorbed is less than actual overhead incurred. The shortfall is debited to the P&L (reduces profit).

Key Formulas

Worked Examples

Practice Questions

Question 1 of 8

Under FIFO, in a period of rising prices, the cost of materials issued to production will be:

Question 2 of 8

Standard time for a job is 8 hours. Actual time taken is 6 hours. Rate is £10/hour. The Halsey bonus is:

Question 3 of 8

Using the same data as Q2, the Rowan bonus is:

Question 4 of 8

Budgeted overheads are £200,000 and budgeted machine hours are 40,000. The machine hour OAR is:

Question 5 of 8

Using the OAR from Q4, actual machine hours are 42,000 and actual overheads are £208,000. The overhead is:

Question 6 of 8

Rent costs should be apportioned to departments on the basis of:

Question 7 of 8

Which of the following stores pricing methods is NOT permitted under IAS 2?

Question 8 of 8

Under-absorption of overheads results in:

Source and Version

Syllabus: ICAEW ACA Certificate Level 2026 · Reviewed: 2026-05-04

ICAEW ACA syllabusLocal syllabus coverage review

Absorption and Marginal Costing