Correction for setup costs

If you apply actual costing, you must deal with the setup costs for a production order. In case of partial completion of the production order, the setup costs must be spread over all quantities that are completed. If you book all setup costs for the first completed quantity, this quantity will be more expensive than the following deliveries, and inventory valuation will not be correct.

To correct for the setup costs, a formula is used that assumes that setup hours are always posted at the start of an operation. So, the hours must be corrected in such a way that setup related costs are spread evenly over the end items.

The algorithm that is used as setup costs correction factor is based on the ratio of the following hours:

 A = Production hours * %complete * (1 + Average setup ratio).

 Average setup ratio = Planned setup time / Planned production hours 

In words: Hours that are required to report a production order as completed in case the setup time is spread over all time units.

B = (Production hours * %complete + Setup time).

In words: Hours that are expected to report a production order as completed if the setup time is consumed first.

Correction factor = A/B
= Production hours * %complete * (1 + Average setup ratio) /
(Production hours * %complete + Setup time)

1/20 = 0.05

20 * 0.25 * (1 + 0.05) / (20 * 0.25 + 1) = 5.25 / 6.00 = 0.875