CHAPTER 1 THE SCOPE OF COST ACCOUNTING

Introduction Welcome to Paper T2 of the ZICA Accountancy Programmed syllabus. This and the following two chapters will give an introduction to cost accounting. This chapter provides definitions and the lin between cost accounting! management accounting and financial accounting. The chapter will go further to e"plain various terminologies! which form the basis for the cost accounting framewor that will be used throughout the course. Contents #. The need for Cost Accounting systems. 2. $efinition of Cost Accounting. %. $efinition of &anagement Accounting. '. $efinition of (inancial Accounting. Learning outcomes After studying this chapter you should be able to) $efine Cost Accounting. *nderstand the range of information provided by the cost accounting system. Compare and contrast financial and cost and management accounting. +"plain the nature of responsibility accounting and use of cost centres! profit centres and investment centres.

1.0

COST AND MANAGEMENT ACCOUNTING

&anagers need detailed information about the wor ing of the business to enable them plan! control and ma e decisions. The cost and management accounting system provide financial information regarding the financial aspects of business performance needed by management. #.# Management accounting

&anagement accounting is the application of the principles of accounting and financial management to create! protect! preserve and increase value so as to deliver that value to the sta eholders of profit and not for profit enterprises both public and private. #.2 Cost accounting

Cost accounting is the establishment of budgets! standard costs and actual costs of operations! processes! activities or products and the analysis of variances profitability or social use of funds. #.2# #.22 Cost accounting and management accounting are terms which are used interchangeably. ,owever! this is not entirely right. Cost accounting is part of management accounting. Cost accounting provides a ban of data for the management accountant to use. Cost accounting aims to establish the following) a- the cost of goods produced or services provided. b- the cost of a department or wor section. c- what revenues have been. d- the profitability of a product! service or department or the organi/ation in total. e- selling prices. f- the value of stoc s of goods. g- future costs of goods and services. and h- comparison of actual and budgeted costs

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COST ACCOUNTING SYSTEM

A cost accounting system is a system used by an organi/ation to gather! store and analyse data about costs. The purpose of a cost accounting system is to provide management information about costs and profits. A cost accounting system is often the basis for a management accounting system. The term cost accounting and management accounting are often used to mean the same thing! although strictly there are differences. %.0 %.# INANCIAL ACCOUNTING AND COST AND MANAGEMENT ACCOUNTING (inancial accounting is the classification and recording of the monetary transaction of an entity in accordance with established concepts! principles! accounting standards and legal re1uirements and their presentation by means of profit and loss accounts! balance sheet and cash flow statements! during and at the end of an accounting period. &any businesses have a financial accounting system with a nominal ledger! sales ledger and purchases ledger and boo s of prime entry for recording transaction that have occurred during a given period. Com!arison o" "inancia# accounting and management accounting inancia# accounts 2imited companies are re1uired by law to prepare financial accounts. The law and financial reporting standards prescribe formats of published financial statements. &ost financial accounting information is of a monetary nature. (inancial accounts present an essentially historic picture of past operations. $.0 INTE%NAL %E&O%TING ST%UCTU%ES Management accounts There is no legal re1uirement to prepare management accounts. &anagement accounting formats are entirely at the discretion of management. &anagement accounts incorporate both monetary and non3monetary measures. &anagement accounts are both historical record and future planning tool.

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When costs are recorded! analysed and reported! it is important they are reported to the managers or departments responsible for the spending. In other words! the reporting of cost information should ideally be based on a system of responsibility accounting and responsibility centres. $.1 %es!onsi'i#it( accounting

A system of providing financial information to management where the structure of the reporting system is based on identifying individual parts of a business which are a responsibility of a single manager. $.) %es!onsi'i#it( centres

A responsibility centre is an individual part of a business whose manager has personal responsibility for its performance. &any businesses are structured into a hierarchy of responsibility centres. These might be cost centres! revenue centres! profit centres and investment centres. At the lowest level of the hierarchy is the cost centre and at the highest is the investment centre. $.* Cost centre

A cost centre can be defined as production or service location! function! activity or item of e1uipment whose costs may be accumulated and attributed to cost units. $.$ %e+enue centre

A revenue centre is part of the organi/ation that earns sales revenue. its manager is responsible for the revenue earned but not for the cost of the operation. $., &ro"it centre

A profit centre is a part of the business for which both the costs and revenues earned are identified. The manager is responsible for both costs and revenues.

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In+estment centre

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An investment centre is a profit centre with additional responsibilities for capital employed and possibly investment decisions. &anagers of investment centres are responsible not 4ust for decisions affecting costs and revenues but also investment decisions. ,.0 ALLOCATION O COSTS

Costs are incurred in business on the following) $irect materials. $irect labour. $irect e"penses. Production overheads. Administrative overheads. 5eneral overheads.

When costs are incurred! they are generally allocated to costs centres. Cost centres are simply collection points for costs for further analysis. ,.1 Cost units

6nce costs have been traced to cost centres! they can further be analysed in order to establish cost per unit. A cost unit is a unit of production or unity of activity in relation to which cost is measured. The cost unit is a basic control unit for costing purposes. 7.2 Cost units are measured for several reasons) To establish how much it has cost to produce an item or perform an activity. To measure profit or loss on an item. To value closing stoc s. To compare costs with budgeted costs. E.am!#es o" cost units 8tudent in a college 9arrel in the brewing industry :oom in a hotel

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Cost o'/ect

A cost ob4ect is any activity for which a separate measurement of costs is desired. If the users of management accounting want to now the cost of something this something is nown as cost ob4ect. +"amples of cost ob4ect include) The cost of a product The cost of a service The cost of operating a department

;.0 SOU%CES O DATA O% A COST AND MANAGEMENT ACCOUNTING SYSTEM ;.# T0E %OLE O ACCOUNTING TEC0NICIAN

As part of the cost accounting team! the accounting technician is li ely to be included in gathering and processing data to measure the costs of an organi/ation<s activities! products and services. ;.2 (or e"ample! in a manufacturing business! the accounting technician could be involved in measuring and analy/ing) ;.% The cost of raw materials used in manufacturing The value of stoc s of unused raw materials The cost of labour used in production The costs of other e"penses incurred in production 6verhead costs for each product Total cost for each product made by the business The profitability of each product.

&easuring costs and revenues is an important step in providing management with information to assist them with planning! control and decision ma ing.

C0A&TE% SUMMA%Y Cost centers are collection pools for costs before they are further analy/ed into cost unit. A cost unit is a unit of product or service to which costs can be related. A cost ob4ect is any activity for which a separate measure of cost is desired. A responsibility centre is a department or organi/ational function whose performance is the direct responsibility of a specific manager. Profit centers are responsibility centers that are responsible for both costs and revenues. :evenue centers are responsibility centers responsible for only revenue generation. An investment centre is profit centre that is also responsible for capital investment and possibly financing.

SEL %E1IE2 3UESTIONS SEL TEST 3UESTIONS #. $efine management accounting >#.#2. $efine cost accounting >#.2%. ,ighlight ey differences between management accounting and financial accounting >%.''. $efine responsibility accounting >'.#E4AMINATION TY&E 3UESTIONS 1. 25ic5 o" t5e "o##o6ing descri'es a cost unit7 A. Cost per unit of output 9. $irect cost C. *nit of product $. Production department ). A !ro"it center is8 A. The profit attributed to a business unit 9. A business unit whose manager is responsible for operating costs and revenues from the activities of the unit C. A unit of product or service for which costs and revenues are measured $. A business unit whose manager is responsible for investment decisions within the unit. Check for answers at the end of the text

CHAPTER 2 COST CLASSIFICATION

Introduction This chapter e"plains that costs can be classified in different ways according to the purpose for which the cost information is re1uired. @arious methods of classifying costs will now be described. Contents #. 2. %. '. 7. ;. Total productAservice costs. $irect cots and indirect costs. (unctional costs. (i"ed costs and variable costs. Product costs and period costs. 6ther cost classifications. Learning o'/ecti+es

After studying this chapter you should be able to) 6utline reasons for cost classification. $escribe different methods of classifying costs.

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CLASSI ICATION O COSTS

Cost classification is the analysis of costs into logical groups so that they may be summarised into meaningful information for management. &anagement in organi/ations re1uires information concerning a variety of issues which re1uire different types of cost summaries. Costs are thus classified in different ways according to the purpose for which they are to be used. The main classifications include) ).0 Cost by element $irect and indirect costs (unctional costs (i"ed and variable costs 6ther categories CLASSI ICATION 9Y ELEMENT

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The initial cost classification basis is according to the elements on which e"penditure is incurred) 2.# &aterials 2abour +"penses

Within costs elements! costs can be further classified according to the nature of e"penditure. (or e"ample material costs may be further classified according to whether they are raw materials! components! cleaning materials! maintenance materials etc. ).)0 DI%ECT AND INDI%ECT COSTS +ach cost element namely materials! labour and e"penses can be classified as either a direct cost or indirect cost. A direct cost is a cost that can be traced in full to the product! service or department that is being costed. An indirect cost or overhead is a cost that is incurred in the course of ma ing a product! providing a service or running a department! but which cannot be traced directly and in full to the product or service or department.

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Total e"penditure may therefore be analysed as follows)

Materials + Labour + Expenses Total cost = = = = Direct Materials + Direct Labour + Direct Expenses Direct cost + + + + Indirect Materials + Indirect Labour + Indirect Expenses Indirect Costs

).)) Direct materia# $irect material is all material that becomes part of the product >unless used in negligible amounts andAor having negligible costs+"amples of direct materials are) :aw materials used in a product e.g. flour used in ba ing a loaf of bread. 9ought in parts and assemblies e.g tyres in car manufacturing. Primary pac ing materials e.g a coo ing oil container.

).)* Direct 6ages $irect wages are all wages paid for labour >either as basic hours or overtimee"pended on wor on the product itself e.g salary paid to an audit cler in a firm of accountants. ).)$ Direct e.!enses $irect e"penses are e"penses which are incurred on a specific product other than direct material costs and direct wages. +"amples would include royalties paid per unit for a copyright design! plant or tool hire charges for a particular 4ob or batch. ).), Indirect costs

All material! labour and e"pense costs which cannot be identified as direct costs are termed indirect costs. The three elements of indirect costs. indirect materials! indirect labour and indirect e"penses are collectively nown as overheads. ).*0 UNCTIONAL ANALYSIS O COSTS

In financial accounting! costs or e"penses are commonly classified as cost of sales! administrative e"penses or sales and distribution costs. This is a method of

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analysing costs by function or according to the type of activity for which the costs were incurred. In cost accounting costs are often analy/ed by function and categories of functional analysis commonly used are) ).$ Production costs. Administration costs. 8elling costs. $istribution costs. :esearch and development costs. (inancing costs. I4ED AND 1A%IA9LE COSTS

A different way of analysing and classifying costs is into fi"ed and variable costs. A fi"ed cost is a cost which is incurred for a particular period of time and which within a certain activity levels is unaffected by changes in the levels of activity e.g rent paid by a business. A variable cost is a cost which tends to vary with the level of activity. +g materials used in manufacturing. )., &%ODUCT COST AND &E%IOD COSTS

Product costs are costs identified with a finished product. 8uch costs are initially identified as part of the value of stoc . They become e"penses only when the stoc is sold. Period costs are costs that are deducted as e"penses during the current period without ever being included in the value of stoc held. ).OT0E% COST CLASSI ICATIONS

A+oida'#e costs Avoidable costs are specific costs of an activity or business which would be avoided if the activity or business did not e"ist. Una+oida'#e costs *navoidable costs are costs which would be incurred whether or not an activity or sector e"isted.

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Contro##a'#e cost A controllable costs is a cost which can be influenced by management decisions and actions An uncontro##a'#e costs An uncontrollable costs is any cost which cannot be affected by management within given time span Discretionar( costs $iscretionary costs are costs incurred at the discretion of a manager and e"amples of discretionary costs include advertising! research and development and training. C0A&TE% SUMMA%Y Cost classification is the analysis of costs into logical groups so that they may be summarised into meaningful information for management. The main classifications include) o o o o o Cost by element $irect and indirect costs (unctional costs (i"ed and variable costs 6ther categories 8uch as . controllableAuncontrollable and avoidableAunavoidable

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SEL %E1IE2 3UESTIONS SEL TEST 3UESTIONS #. 2. %. '. What is cost classification >#.#&ention various cost classification categories >#.%$efine direct cost >2.2$istinguish fi"ed cost from variable cost >2.'-

E4AMINATION TY&E 3UESTIONS 1. DI%ECT O% INDI%ECT COST Classify the following e"penses as direct or indirect abcdef(actory rental. Insurance of machinery used for one product only. Warehouse rental. Insurance of office buildings. Costs of canteen for employees. Petrol for delivery vehicles.

). COST CLASSI ICATION $istinguish between and provide information to illustrate) a- Avoidable and unavoidable costs b- Cost centres and cost units Check for answers at the end of the text

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CHAPTER 3 COST BEHAVIOUR

Introduction In the last chapter! we loo ed at various ways of classifying costs. In particular! we covered the classification of costs into those that vary directly with changes in activity levels >variable costs- and those that do not change >fi"ed costs-. This chapter e"amines further this two way split of cost behaviour and e"plains methods of splitting semi3 variable costs into fi"ed and variable components. This information is important for management! who will use it in setting budgets! carrying out variance analysis and decision ma ing. Contents #. Introduction to cost behaviour. 2. Cost behavior pattern. %. $etermining the fi"ed and variable elements of semi3variable costs. Learning o'/ecti+es After studying this chapter you should be able to) +"plain the importance of cost behavior in relation to decision3ma ing. +"plain the nature of fi"ed! variable and semi variable costs $escribe other cost behavior patterns for individual items of cost. Identify! describe and illustrate graphically different types of cost behavior Provide e"amples of semi variable costs Analy/e semi3variable costs into their fi"ed and variable cost elements using the high3low method.

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1.0 DE INITION AND A&&LICATION O CONCE&T

COST 9E0A1IOU%

Cost behaviour is the way in which costs are affected by the changes in the volume of output. &anagement decisions are often based on how costs and revenues vary at different activity levels. 1.1 Cost 'e5a+iour and #e+e#s o" acti+it(

Although there are many factors which may influence costs! the ma4or influence is the volume of output or the level of activity. The term level of activity may refer to one of the following) 1.) Cumber of units produced. @alue of items sold. Cumber of items sold. Cumber of invoices issued. Cumber of units of electricity consumed. A!!#ication o" cost 'e5a+ior in"ormation

&anagement may use nowledge of cost behaviour pattern in the following management tas s) 1.* Controlling costs. Preparing budgets or forecasts. $eciding on output levels. Ad4usting selling prices. $eciding whether to accept or re4ect a contract. &a ing decision to 8ubcontract. Cost 'e5a+ior !rinci!#es

The basic principle of cost behaviour is that as the level of activity rises! costs will usually rise. It will cost more to produce 2000 units of output than it will cost to produce #000 units. ,owever not all items of cost will incur higher costs as the output level rises. This creates a problem for the management accountants who have to ascertain how each item of cost varies with increases or indeed decrease in activity levels.

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COST 9E0A1IOU% &ATTE%NS Cost behaviour analysis is concerned with how costs change with level of activity and by how much. Individual items of cost can be classified according to their cost behaviour. There are many cost behavior patterns but many costs can be classified according to behaviour as) (i"ed costs. @ariable costs. 8emi3variable costs. 8tep costs.

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I4ED COSTS A fi"ed cost is a cost which tends to be unaffected in total by increases or decreases in the volume of output. An e"ample of fi"ed cost is the rent of a factory which is a constant amount each period regardless of how much or how little is manufactured inside it. The factory rent will be #0 million whether you produce 2 units or #00 units of a product. In reality there must be a level of activity at which more than one factory would be re1uired for production. At that point rent is no longer a fi"ed cost. Therefore! fi"ed costs are constant within a reasonable range of activity. A s etch of a fi"ed cost would loo li e this) Gra!5 o" i.ed cost Cost : ;

i.ed cost

1o#ume o" out!ut <#e+e# o" acti+it(=

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+"amples of fi"ed costs would be) ).) The salary of a managing director per year. The rent of a single factory building per year or month. 8traight3line depreciation of a single machine. STE& COSTS A step cost is a cost that is fi"ed in nature but only within certain levels of activity. Consider the rent of a building whose ma"imum capacity is #000 units. 8uch a cost would be fi"ed if production remains below #000 units per month. If production e"ceeds #000 units a second factory would be re1uired and the rental costs would go up. Gra!5 o" ste! cost Cost ;

1o#ume o" out!ut ).* 1A%IA9LE COSTS A variable cost is a cost which tends to vary directly with the volume of output. The variable cost per unit is the same amount for each unit produced. A constant variable cost per unit implies that the price per unit of say! material purchased is constant and that the rate of material usage is also constant. ).*1 E4AM&LES O 1A%IA9LE COSTS Cost of raw materials. $irect labour costs. 8ales commission. 9onus payment.

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Cost Tota# 1aria'#e cost Gra!5 ;

1o#ume o" out!ut ).$ NON:LINEA% O% CU%1ILINEA% COSTS If the relationship between total variable costs and volume of output can be shown as a curved line on a graph! the relationship is said to be curvilinear. Two typical relationships are as follows)

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SEMI:1A%IA9LE COSTS A semi3variable cost is cost which contains both fi"ed and variable components and so is partly affected by changes in the level of activity.

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+"amples of semi3variable costs include) ).+lectricity bills 8alesman<s salary Costs of running a car

Ot5er cost 'e5a+iour !atterns

This graph illustrates an item of cost which is variable with output up to a certain level and then becomes constant thereafter.

This graph illustrates an item of cost which is variable with output subject to a minimum.

Fixed cost per unit decrease with the increase in activity

Variable cost per unit remains constant at all levels of activity

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DETE%MINING T0E 1A%IA9LE COSTS.

I4ED AND 1A%IA9LE ELEMENTS O

SEMI:

It is generally assumed that costs are one of the following) @ariable (i"ed 8emi3variable

8emi3variable costs are often separated into fi"ed and variable components. 6ne of the methods used to split the cost is the high3low method which wor s as follows) Ste! 1. :eview records the costs in the past periods Ste! ). 8elect the period with the highest activity level 8elect the period with the lowest activity level

$etermine the following Total cost at high level of activity Total cost at low level of activity Total units at high level of activity Total units at low level of activity

Ste! *.

Calculate the variable cost per unit by dividing the difference between the total cost at the lowest activity and total cost at high activity by the difference between the highest and lowest activity. Calculate the fi"ed cost by subtracting variable costs from the total cost at either the lowest or highest activity

Ste! $. E.am!#e

$olfin 2td has recorded the following total costs during the last five years Dear 2000 200# 2002 200% 200' 6utput >000;7!000 ?0!000 B0!000 ;0!000 =7!000 Total cost >E<000#'7!000 #;2!000 #=0!000 #'0!000 #;0!000

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%e>uired Calculate the total costs that should be e"pected in 2007 if output is B7!000 units.
SOLUTION Step 1 Period with highest activity Period with lowest activity !! !!"

Step 2 Total cost at high activity Total cost at low activity Total units at high activity Total units at low activity

#$!%!!! #&!%!!! '!%!!! (!%!!!

Step 3 )ariable cost per unit Total cost at high activity * total cost at low activity Total units at high activity * total units at low activity +#$!%!!! * +#&!%!!! '!%!!! * (!%!!! +"!%!!! "!%!!!units

Step 4 ,ixed cost = Total cost - high activity * total units - high activity x variable cost per unit +#$!%!!! * +.'!%!!! x #/ = K 80,000

Therefore total cost at 95,000 units are as follows + )ariable cost = '0%!!! x # '0%!!! ,ixed costs 1!%!!! Total costs #$0%!!!

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C0A&TE% SUMMA%Y Eey points covered include the following) Costs which are not affected by the level of activity are fi"ed costs or period costs 8tep fi"ed costs are fi"ed with a certain range of activity @ariable costs increase or decrease with the level of activity and they are assumed to be constant per unit 8emi3variable costs are costs that are part fi"ed and part variable. The fi"ed and variable elements of semi3variable costs can be determined by the high3low method

STUDENT:SEL TESTING SEL %E1IE2 3UESTIONS #. What does the term cost behaviour refer toF >#.02. ,ow is the nowledge of cost behaviour used in cost and management accountingF >#.2%. 6utline some e"pected cost behavioural patterns >2.0'. outline steps involved in using the high3low method >%.0-

E4AMINATION TY&E 3UESTIONS

;a!iri G#ass Ltd Eapiri 5lass 2td recorded the following costs for the past si" months &onth # 2 % ' 7 ; %e>uired +stimate the fi"ed cost per month <$ mar?s= +stimate the total costs for the following activity levels in a month iii=7 units B0 units <- mar?s= Check for answers at the end of the text Activity level *nits >000'0 %0 %; %? '2 %% Total cost E<000 ;!7?; 7!?2; ;!2?2 ;!%B; ;!=00 ;!072

CHAPTER 4 COSTING OF MATERIALS

Introduction This is the first of several chapters that deals with the accounting and costing of the elements of costs namely materials! labour and e"penses. These could either be direct or indirect costs. CONTENTS #. $irect and indirect materials 2. Procedures and documentation of materials %. Purchasing of materials '. Pricing of issues 7. Accounting for material costs Learning outcomes After studying this chapter you should be able to) +"plain the distinction between direct and indirect material costs. $escribe the documentation used for recording of materials. Calculate the costs of materials used in production and the values of closing stoc s using the (I(6! 2I(6 and weighted average cost methods of stoc valuation. Account for material costs in the ledger accounts.

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DI%ECT AND INDI%ECT MATE%IALS

In cost and management accounting! materials are commonly classified as either direct or indirect. $irect materials are the materials that can be directly attributed to a unit of production! or specific 4ob or service provided directly to a customer. In a manufacturing business direct materials include) :aw materials Components

Indirect materials are other materials that cannot be directly attributed to a unit of production. An e"ample of indirect materials might be the oil used for the lubrication of production machinery or other consumable such as cleaning materials. ).0 STOC; CONT%OL

As the cost of purchasing stoc is usually one of the largest costs faced by a business it is important that an effective stoc control system is established within an organi/ation. 8toc control for a business should cover the following functions) *.0 *.1 The ordering of stoc . The purchase of stoc . The receipt of the ordered items. 8torage of stoc items. The issue of stoc items. The maintenance of sufficient stoc s. &%OCEDU%E AND DOCUMENTATION O% MATE%IALS &urc5ase !rocedure

As bought in materials and services normally represent a large proportion of a firm<s cost! it is essential that the materials purchased are most suitable from the utility and cost basis. *.) &urc5ase re>uisition

Any re1uest for material purchase should be made on a purchase re1uisition. The purchasing manager will verify that re1uisitions are authorised in accordance with

established policy before placing orders. An e"ample of a purchase re1uisition is shown below) &U%C0ASE %E3UISITION %e>. No8 @@. $epartmentAGob no 8uggested supplier :e1uested by ) ) $ate re1uested )

2atest date re1uired ) Huantity Code number $escription +stimated costs *nit E

Authorised signature )

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Ordering

The purchase order is the basis for a legal contract between the firm and the supplier. The issue of a purchase order must be closely controlled and signing restricted to a few senior people. *pon receipt of a duly authori/ed purchase re1uisition! the purchasing department will place a purchase order with one of the selected suppliers. Copies of the order are sent to the accounts! goods reception and progress chasers.

&urc5ase orderA con"irmation Purchase order ref) To Address of supplier Please deliver to the above address Ordered by. Passed and chec ed by. Total order value !.

8ubtotal

@at I#=.7J

Total *.$ %ece!tion and ins!ection !rocedure

When materials are received from suppliers! they are normally delivered to the stores department. The stores personnel must chec that the goods delivered are the ones that have been ordered! in the correct 1uantity! of the correct 1uality and in good condition The stores department raises a 5oods :eceived Cote >5:C- from the delivery note details. The 5:C is used to update the stores record with the 1uantities of goods received. *., &urc5ase in+oices

A copy of the 5:C will be sent to the purchasing department attached to the copy purchase order. When the supplier<s invoice is received! the three documents will be passed to the appropriate individual to approve payment of the invoice.

$ate )

GOODS %ECEI1ED NOTE Time)

6ur order CoKKKKKKKK.. 8upplier and suppliers advice note CoKKKKKKKK. H*ACTITD CAT C6 $+8C:IPTI6C

%ECEI1ED IN GOOD CONDITION Name@@@@@@@@@@@@.. Signature@@@@@@@@@@@ *.Storage

In any stoc control system! there should be a continual record of the current 1uantities of each of the stoc item held in store. :eceipt into store and issues from store must be recorded! so that the current balance in stoc can be ept up3 to3date. 8tore eeping involves storing materials to achieve the following ob4ectives 8peedy issue and receipt of materials (ull identification of materials at all time Correct location of all materials at all times Protection of materials from damage and deterioration Provision of secure stores to avoid pilferage! theft and fire +fficient usage of storage space &aintenance of correct stoc levels Eeeping correct and up3to3date details of receipts! issues and stoc levels

When the stores control system is a paper3based system! there could be two separate stoc records 9in card system

8toc ledger system 9in card

Part code noKKKKKKKKKKKKK 9in CumberKKKKKKKKKKKKK $ate :eceipts Huantity 5:C $ate

2ocationKKKKKKKKKKKK.. stores 2edger noKKKKKKKKK. Issues Huantity :e1 Co 8toc balance

Stores Ledger Card &aterialsKKKKKKKKKKK. Code KKKKKKKKKKKKK $ate :eceipts

5:C Co Huantity *nit price Amount

&a"imum Huantity &inimum Huantity Issues

8tores :e1 Co Huantity *nit Price Amount

8toc
Huantity *nit price Amount

$.0 $.1

MATE%IAL ISSUES AND &%ICING Materia# issues

The issue of materials must be appropriately authori/ed and amount issued recorded so that the appropriate charge can be made to production or to the receiving cost center. The usual way this is done is by a material re1uisition. This document performs two functions3it authori/es the stoc eeper to release the goods and acts as a posting medium to the stores ledger and bin card.

Materia#s %e>uisition Note $ate re1uiredKKKKKKKKK. Huantity Item code Cost centre noA 4ob CoKKKKKKK $escription E

8ignature of re1uisitioning &anagerAforemanKKKKKKKKKKKKKKK. $.) &ricing issues

$ateKKKKKKKK..

When materials are purchased! they are valued based on the price charged by the supplier plus any carriage inward costs. The cost should be net of any trade discount given. When materials are issued from stores! a cost or price has to be attached to them. When a 1uantity of materials is purchased in its entirety for a specific 4ob! the purchase cost can be charged directly to the 4ob. '.% A business might use any of several valuation methods for pricing stores issued such as) $.$ (irst in (irst 6ut >(I(62ast In (irst 6ut >2I(6Weighted Average Cost >A@C6E.am!#e

The following data will be used to illustrate the three common methods of stoc valuation namely) #. (irst in (irst 6ut >(I(62. 2ast In (irst 6ut >2I(6%. Weighted Average Cost >A@C6Date Details #*4an '*4an #0*4an !*4an '*4an 5alance b67 Issue 8eceipt 8eceipt Issue 2nits #!! &! 0! 0! $! 2nit Price +3!!! 0! 00 (! )alues +3!!! 0%!!! %$0! "%!!!

$.$1

irst In irst Out < I O= *sing this method material issues are priced at the unit price of the oldest batch in stoc until all the units of the batch have been e"hausted after which the price of the ne"t oldest batch is used.
Stores Ledger Card 8eceipts Issues Price )alues units Price +3!!! +3!!! +3!!! &! 0! 0! 00 (! %$0! "%!!! 0!

Date

Details units

)alues +3!!! %!!!

units #!! (! (! 0! (! 0! 0! &! 0!

#*4an5alance 57 '*4anIssues #0*4an8eceipts !*4an 8eceipts

5alance Price )alues +3!!! +3!!! 0! 0%!!! 0! "%!!! 0! "%!!! 00 %$0! 0! "%!!! 00 %$0! (! "%!!! 00 (! % !! "%!!!

'*4an Issues Issues

(! #!

0! 00

"%!!! 00!

$.$)

Last In irst Out <LI O= *sing this method! issues are charged out at a price of the most recent batch received and continue to be charged thus until a new batch is received.

Date

Details 2nits

8eceipts Price )alues +3!!! +3!!!

2nits

Issues Price +3!!! 0!

)alues +3!!! %!!!

2nits #!! (! (! 0! (! 0! 0! "! (!

#*4an 5alance 57 '*4an Issues #0*4an 8eceipts !*4an 8eceipts

&! 0! 0! 00 (! %$0! "%!!!

5alance Price )alues +3!!! +3!!! 0! 0%!!! 0! "%!!! 0! "%!!! 00 %$0! 0! "%!!! 00 %$0! (! "%!!! 00 0! #%(0! "%!!!

'*4an Issues Issues

0! !

(! 00

"%!!! #%#!!

$.$*

2eig5ted A+erage Cost <A1CO=

With this method all 1uantities of stoc are valued at Weighted Average Cost. A new Weighted Average Cost is calculated each time there is a new delivery into stoc .
Date Details units #*4an5alance 57 '*4anIssues #0*4an8eceipts !*4an 8eceipts '*4an Stores Ledger Card 8eceipts Issues Price )alues units Price +3!!! +3!!! +3!!! &! 0! 0! 00 (! %$0! "%!!! $! 00 "%1 1 0! 5alance Price )alues +3!!! +3!!! #!! 0! 0%!!! (! 0! "%!!! ##! 0 0%$0! #(! 00 1%$0! '! 00 &%'

)alues +3!!! %!!!

units

$.,

COM&A%ISON O ISSUE MET0ODS

Provided that the system is used consistently and suits operating conditions of the firm! any of the system could be used. While (I(6 and Weighted Average Cost are acceptable for financial reporting purposes! 2I(6 is not. ,owever! in cost accounting! the rules of financial reporting do not apply! and businesses can use 2I(6 if they wish. $ifferences between valuation methods are only significant in the times of inflation. The relative advantages and disadvantages of (I(6! 2I(6 and A@C6 are! therefore discussed below in relation to inflationary situations. MET0ODS AD1ANTAGES I O Produces Current values for closing stoc . DISAD1ANTAGES Produces out3of3date production costs and therefore potentially overstates profit Complicates stoc records as stoc must be analysed by delivery Produces unrealistically low closing stoc values. Complicates stoc records as stoc must be analysed by delivery Produces both stoc values and production costs which are li ely to differ from current values

LI O

Produce realistic production costs and therefore more realisticAprudent profit figures

A1CO

8imple to operate3 calculations within stoc records are minimi/ed

,.0

ACCOUNTING O% MATE%IAL COSTS

In cost accounting we are concerned not only with the cost of individual items of stoc ! but with the total costs of all raw material stoc s used and the total costs of all finished goods sold during the year. These total costs! which are the sum of all the costs on individual stores ledger records! are recorded as follows) ,.1 In raw materials stores account for raw material stoc s. In wor in progress all materials under production. In finished good stoc s account for finished goods.

E.am!#e At # Ganuary 20L7! the total value of items held in stoc was E70 million. $uring the month the following transactions occurred. $etail &aterials purchase from suppliers on credit &aterials returned to suppliers &aterials purchased for cash $irect materials issued to production &aterials issued to the maintenance services department $irect materials returned to stores from production %e>uired +nter the above transaction in a stores ledger account! balancing off the account. E< &illion ;0 % ? 77 20 '

SOLUTION
Stores Account +3!!! 5alance b67 Creditors Cash 8eturns 7ro< 9IP 0!%!!! (!%!!! 1%!!! &%!!! 5alance c67 # 5alance b67 %!!! &&%!!! &&%!!! # %!!! 9or: In Progress Production ;verhead 8eturns to suppliers +3!!! 00%!!! !%!!! "%!!!

C5a!ter summar(

$irect materials are materials that can be directly attributed to a unit of production or a specific 4ob or service provided directly to a customer. Indirect material are materials that cannot be directly attributed to a unit of production (I(63 (irst in (irst out method of stoc pricing 2I(63 2ast in (irst out method of pricing A@C63Weighted average method of stoc pricing The total cost of all raw materials stoc s used during the accounting period is recorded in the raw materials stoc account. The total cost of stoc s manufactured in the production department is recorded in the wor in progress The total cost of finished goods sold in an accounting period are recorded in the finished goods account

SEL %E1IE2 3UESTIONS SEL TEST 3UESTIONS #. 2. %. '. 6utline the functions of stoc control >2.0&ention % commonly used methods for pricing material issues >%.06utline ey documents used in stoc handling >%.0 M %.=What are the advantages and disadvantages of the following methods for pricing issues >'.7 (I(6 2I(6 A@C6 7. What is the function of the purchase re1uisition note >%.2;. Who raises the 5oods :eceived Cote M 5:C >%.'=. What is the function of the materials :e1uisition note >'.#-

E4AMINATION TY&E 3UESTIONS T5e "o##o6ing in"ormation re#ates to >uestions 1B ) and *.

The stoc record for component 9LD for the month of Ganuary showed) $ate 6pening stoc 7 Ganuary #2 Ganuary #? Ganuary #B Ganuary 27 Ganuary %# Ganuary 1 :eceipts *nits 700 #!000 #!;00 #!200 #!700 @alue E N 000 #!270 2!=70 '!'?0 %!'?0 '!%70 #!?00 Issues *nits

2!#00

Using t5e I O met5od o" !ricing issuesB t5e cost o" issues <in ;C000= during t5e mont5 6as8 A. 9. C. $. E##!270 E#0!?00 E#0!?77 E##!%00

).

Using t5e LI O met5od o" !ricing issuesB t5e +a#ue o" stoc? at *1st Danuar( issues <in ;C000= is8 A. 9. C. $. E'!#00 E%!=20 E7!#20 E%!B70

*.

Using t5e A1CO met5od o" !ricing issuesB at 65at !rice 6ou#d t5e issues on *1st Danuar( 'e made <ca#cu#ate to t6o decima# !#aces= A. 9. C. $. E%.00 E2.B7 E2.B0 E2.?%

Check for answers at the end of the text

CHAPTER 5 MATERIALS STOCK CONTROL

The previous chapter loo ed at how transactions involving materials are recorded and valued. This chapter loo s at the monitoring of stoc levels as a means of controlling the stoc costs. Contents #. Costs of stoc holding and stoc 3outs 2. 8toc ta ing %. +conomic 6rder Huantity '. 8toc reorder level 7. 6ther stoc control systems Learning outcomes After studying this chapter you should be able to) $escribe the procedures re1uired to monitor stoc and minimise stoc discrepancies and losses. +"plain the costs of stoc holding and stoc 3outs. +"plain and illustrate minimum stoc levels! ma"imum stoc levels and stoc reorder levels. Calculate and interpret optimal order 1uantities.

1.1

25( stoc? contro#7

The costs of purchasing stoc are usually one of the largest costs faced by an organisation and once obtained! stoc has to be carefully controlled and chec ed. 1.) T5e 'ene"its o" stoc? 5o#ding

The main reasons for holding stoc can be summari/ed as follows) 1.* To ta e care of possible future shortages. To ensure sufficient goods are available to meet e"pected demand. To absorb seasonal fluctuation and any variations in usage and demand. To allow production processes to flow smoothly and efficiently. As a deliberate investment policy! especially in times of inflation. 0o#ding costs

Though beneficial! holding stoc s can be an e"pensive business. The ob4ective of a stoc policy should be to minimise the total annual costs associated with stoc holding. 8uch costs include) 1.$ 8torage costs Interest costs Insurance costs :is of obsolescence $eterioration Order costs

These are costs that are incurred every time stoc is purchased from a supplier and they are high when stoc s are ordered in smaller 1uantities but more fre1uently. 8uch costs include) 1., Clerical and administrative. Transport costs. Production runs costs. Stoc? out costs

An additional type of cost which may arise if stoc s are ept too low is the type associated with running out of stoc . These include) ).0 2ost contribution from lost sales 2oss of future sales due to disgruntled customers 2oss of customer goodwill Cost of production stoppages 2abour frustrations over stoppages +"tra costs of urgent orders MONITO%ING STOC;S AND STOC; LOSSES

8toc s can be monitored using stoc ta ing. 8toc ta ing involves counting the physical stoc on hand at a certain date and then chec ing this against the balance shown on the stoc records. There are two methods of carrying out this process. These are periodic stoc ta ing and continuous stoc ta ing.

).1

&eriodic stoc?ta?ing NA process whereby all stoc items are physically counted and valued at a set point in time! usually at the end of an accounting period.< "#$A Official Terminology

).)

Continuous stoc?ta?ing NThe process of counting and valuing selected items at different times on a rotating basis< "#$A Official Terminology This involves a specialist team counting and chec ing a number of stoc items each day so that each item is chec ed at least once a year. @aluable items or items with a high turnover could be chec ed more fre1uently.

2.%

The advantages of continuous stoc ta ing compared to periodic stoc ta ing are as follows) There will be occasions when stoc chec s disclose discrepancies between the physical amount of an item in stoc and the amount shown in the stoc records. When this occurs! the cause of the discrepancy should be investigated and appropriate action ta en. ).$ O'/ecti+e o" stoc? contro#

The overall ob4ective of stoc control is to ensure that the total of the following costs is minimised) *.0 ,olding costs. 6rdering costs. 8toc out costs. %e:order #e+e# s(stem

This is a more sophisticated version of the two bin system! which involves the setting of three control levels based on an analysis of past stoc usage and delivery times. These levels are) :e3order level &inimum stoc level &a"imum stoc

*.1

%e:order #e+e#

The reorder level is the level of stoc at which a replenishment order should be placed. :eorder 2evel O &a"imum *sage " &a"imum 2ead time *.) Minimum stoc? #e+e#

The minimum stoc level for an item of stoc is a warning level at which management should chec to ensure that a new delivery of the item will be received from the supplier before stoc out occurs. This may call for emergency action to replenish stoc s. Minimum stoc? #e+e# E %eorder #e+e# F <a+erage usage . a+erage #ead time= *.* Ma.imum stoc?

This is the ma"imum amount of stoc that should ever be held in stoc . This also acts as a warning level to signal management that stoc s are reaching a potentially wasteful level. Ma.imum stoc? E reorder #e+e# G reorder >uantit( F <minimum usage . minimum #ead time= *.$ A+erage stoc? #e+e#

Although average stoc is not a control level itself! you may need it to calculate estimated stoc holding costs. If we assume that a replenishment order arrives at the point at which stoc reaches the buffer or safety stoc level! and then thereafter stoc is used evenly until it reaches reorder level and an order is placed! the average stoc level can be calculated as A+erage stoc? E sa"et( stoc? G H reorder >uantit( If we assume that no safety stoc is held! so that a delivery is received 4ust as stoc falls to /ero! then the formula for calculating the average stoc is A+erage stoc? E H o" reorder >uantit(

*.,

E.am!#e Zam Tyre 2td deals in 5ood year tyre for which the following information is available) Average usage &inimum usage &a"imum usage 2ead time :eorder Huantity %e>uired %ased on this information calculate a. &eorder level b. $inimum stoc level c. $aximum stoc level #'0 tyres per day B0 tyres per day #=7 tyres per day #0 M #; days %000 tyres

*.-

So#ution :eorder level O &a"imum *sage " &a"imum 2ead Time 1I, . 1- E )BJ00 Minimum stoc? #e+e# E %eorder #e+e# F <a+erage usage . a+erage #ead time= )BJ00 F <1$0 . 1*= E KJ0 Ma.imum stoc? E reorder #e+e# G reorder >uantit( F <minimum usage . minimum #ead time= )BJ00 G *B000 F <K0 . 10= E $BK00 *.I ECONOMIC O%DE% 3UANTITY

6rdering in large 1uantities reduces the annual costs of ordering. 6n the other hand! large orders increase storage re1uirements which increases stoc holding costs. The economic order 1uantity minimises the combined costs of stoc ordering and stoc holding.

De"inition +conomic 6rder Huantity >+6H- is the order 1uantity for a stoc item that will minimise the combined costs of stoc ordering plus stoc holding over a given period! say a year. +6H is based on the following assumptions) There should be no stoc 3out of the item. There is no buffer stoc . A new delivery of the stoc item is received from the supplier at the e"act time that e"isting stoc s run out. The stoc item is used up at an even rate and predictable rate over time. The delivery lead3time from the supplier is predictable and reliable.

(ormula 2CoD Ch $.0 $.1 Ot5er s(stems o" stoc? contro# T6o:'in s(stem

This is a system whereby each stores item is ept in two storage bins! say A and 9. When bin A is emptied! an order must be placed for re3supply. bin 9 will contain sufficient stoc s to last until the fresh delivery is received. $.) &eriodic re+ie6 s(stem

*nder this system the stoc levels are reviewed at fi"ed intervals e.g every four wee s. $.* A9C in+entor( ana#(sis

This is a selective approach to stoc control whereby materials are classified under A! 9 and C according to their e"pense group! A being the most e"pensive! group 9 the medium cost and group C the ine"pensive material. ,igh valued items are more carefully monitored compared to less valued ones. $.$ DIT s(stems

8ome manufacturing companies have sought to reduce their inventories of raw materials and components by using the Gust3In3Time philosophy. This is a system where raw materials are bought for production and not for stoc ing. Components are also made when there is readily available customer demand GIT philosophy is only possible when suppliers can be relied upon to deliver fresh supplies of an item at the re1uired time and to the re1uired 1uality standard. 8uch a system can be successfully adopted where the following features are present) 8table high volume of stoc consumption. Coordination of the daily production programmes of the suppliers and the consumer. Co3operation of suppliers. A convenient reliable transport system! or the supplier being in close pro"imity to the consumer.

The relative costs and benefits of GIT are as follows) Warehousing costs are almost eliminated. The 1uality control function has been made the responsibility of the supplier. Problems of obsolescence! deterioration! theft! cost tied up and all other costs associated with holding stoc have been avoided.

,owever! it should be noted that the GIT systems e"pose a business to huge costs such as unfulfilled customer orders when there is brea down in the supply chain networ . C5a!ter summar( Perpetual inventory refers to stoc recording system whereby the records >bin card and stores ledger card- are updated for each receipt and issue of stoc as it occurs. 8toc ta ing 3 counting and recording physical 1uantities of stoc 2ead time 3 the time between when an order is placed and the receipt of stoc 8toc control levels can be calculated in order to maintain stoc s at the optimum level. The three critical levels are reorder level! minimum level and ma"imum level 8toc costs include purchase costs! holding costs! ordering costs and stoc 3out costs. +conomic order 1uantity 3 the order 1uantity that minimi/es ordering and holding costs and can be computed using a table! a graph or formula.

SEL %E1IE2 3UESTIONS SEL TEST 3UESTIONS #. 2. %. '. 7. ;. =. ?. B. Why do organisations hold stoc >#.25ive e"amples of stoc holding costs >#.%5ive e"amples of stoc 3out costs >#.7What is stoc ta ing >2.08tate the formula for reorder level >%.#8tate the formula for minimum stoc level >%.28tate the formula for ma"imum stoc level >%.%8tate the +6H formula >%.=What are some of the benefits of operating a GIT system >'.'-

E4AMINATION TY&E 3UESTIONS A large retailer with multiple outlets maintains a central warehouse from which the outlets are supplied. The following information is available for part number Zed727. Average usage &inimum usage &a"imum usage 2ead time for replenishment :eorder 1uantity :eorder level #. %70 per day #?0 per day '20 per day ## M #7 days =000 units ;700 units

9ased on the data above what is the ma"imum level of stoc F A. 9. C. $. 7!270 ;!700 ##!%20 #2!?00

2.

What is the minimum stoc levelF A. 9. C. $. 200 #=70 2'70 '720

%.

&o/do uses the economic order 1uantity formula >+6H- to establish its optimal reorder 1uantity for its single raw material. The following data relates to the stoc costs Purchase price Carriage costs 6rdering costs 8torage costs Annual demand E#7!000 per unit E70!000 per order E7!000 per order #0 J of purchase price plus E200 per unit per annum '000 units

What is the +6H to the nearest whole unitF A. ';B0 units 9. #'#' units C. '2; units $. 70B units Check for answers at the end of the text

CHAPTER 6 LABOUR COSTING

Introduction In this chapter we loo at labour costs. We begin by loo ing at a number of remuneration methods and will consider the various types of incentive schemes that e"ist. We will also e"amine the procedures and documents re1uired for the accurate recording of labour. The procedure for accounting for labour costs will then be described and finally certain aspects of labour cost control will be e"plained such as monitoring labour turnover and productivity.

CONTENTS #. :emuneration methods 2. :ecording labour costs %. Classification of labour costs '. Accounting for labour 7. 2abour turnover ;. &easuring labour activity LEA%NING OUTCOMES After studying this chapter you should be able to) $escribe and illustrate different remuneration methods. +"plain how labour time might be recorded and traced to individual products! 4obs or activities. $istinguish between direct and indirect labour costs. +"plain the cause and costs of labour turnover and calculate turnover. $escribe and illustrate measures of labour efficiency and utilisation.

1.0

%EMUNE%ATION MET0ODS

There are three basic groups of remuneration method) 1.)0 Time related 6utput related 9onusAincentive schemes Time 'ased s(stems

9asic s(stem At the simplest level wor ers would be paid for the number of hours wor ed at a basic rate per hour up to say '0 hours per wee using the following formula. O%MULA Wages O ,ours wor ed " :ate of pay per hour 1.)1 E4AM&LE An employee is paid E7!700 per hour and is e"pected to wor at least a '? hour wee . What would he be paid for a standard '? hour wee F SOLUTION '? hours " E7!700 O E2;'!000 1.)) O1E%TIME &AY If an employee wor s more than the number of hours set by an organi/ation as daily or wee ly re1uirements! the additional hours wor ed are nown as overtime. In many organi/ations employees who wor overtime are paid an additional amount per hour for those e"tra hours that they wor . When the rate per hour for overtime is higher than the basic rate of pay in normal wor ing hours! the additional pay per hour is nown as overtime premium. (or e"ample if the day rate is E%0!000 and overtime is paid at time and half! eight hours of overtime would be paid E 9asic pay >? " E%0!0002'0!000 6vertime premium >? " E#7!000- #20!000 *-0B000

The over time premium is the e"tra rate per hour which is paid and not the whole of the payment for the overtime hours. 1.)* 0IG0 DAY %ATE SYSTEMS This is a time based system which is designed to provide a strong incentive by paying rates well above normal basic rates in e"change for above average output and performance. (or its successful application it is necessary to ensure that the output levels are the result of detailed wor studies and that there is agreement from labour force and the unions involved on the re1uired production level. ).0 &IECE2O%; Piece wor is also nown as payment by results or output related pay. It is an alternative to time related pay. Piece wor is where a fi"ed amount is paid per unit of output achieved irrespective of the time spent. ).1 E4AM&LE If an amount paid to an employee is E%!000 per unit produced and that an employee produces ?0 units in a wee ! how much should be paid in wagesF SOLUTION ?0 units " E%!000 O E2'0!000 2.2 ).1 1ariations o" !iece6or?

&iece rate 6it5 guaranteed minimum Piece rate with guaranteed minimum operates to give the employees some security where they may suffer loss of earnings when production is low through no fault of their own. The way the system wor s is that if an employee<s earnings for the amount of units produced in the period are lower than guaranteed amount! then the guaranteed amount is paid instead.

).)

E4AM&LE

Gonasi is paid E%!000 for every unit that he produces but he has a guaranteed minimum wage of E2?!000 per eight3hour day. In a particular wee he produces the following number of units) $ay *nits &onday #2 Tuesday #' Wednesday B Thursday #' (riday ? %e>uired Calculate Gonasi< wage for this wee . ).* SOLUTION $ay &onday >2 " E%000Tuesday >#' " E%000Wednesday >guaranteeThursday >#' " E%000(riday >guaranteeTota# ).$ A DI E%ENTIAL &IECE2O%; SYSTEM E<000 %; '2 2? '2 2? 1I-

6ne ob4ection to straight piece wor system is that because a flat rate per unit is paid! the incentive effect at higher production levels declines. $ifferential piece wor see s to overcome this by increasing the rate progressively at various production levels e.g )., E4AM&LE Payment by results rates for an organi/ation are as follows) 6utput per wee # M #00 #0#3 #2% Above #2% %e>uired :ate per unit E<000 #7 #= 20

If an employee produces #%7 units in a wee ! how much will he be paidF

).SOLUTION
2nits #!! " # 13 8ate +3!!! #0 #$ ! Total +3!!! #0!! "'# &! 2131

).I

9ONUS AND INCENTI1E SC0EMES 9onuses are payments to employees on top of their basic pay and any overtime payments. They may be paid to employees for a variety of reasons. An individual employee! a department! a division or indeed the entire organisation may have performed particularly well and it is felt by management that a bonus is due to some or all of the employees.

).J

The features of any bonus or incentive scheme are as follows) +mployees are paid more for their efficiency. Additional profits are shared between employer and employee. The e"tra pay motivates employees.

*.0

LA9OU% TU%NO1E%

2abour turnover is a measure of the number of employees leavingAbeing recruited in a period of time e"pressed as a percentage of the total labour force. LA9OU% TU%NO1E% ! A+erage num'er o" #ea+ers 65o are re!#aced A+erage num'er o" em!#o(ees 4 100

The reasons for labour turnover include) Illness or accidents. A family moves away from the locality! marriage! pregnancy or difficulties with child care provision.

*.1

:etirement or death. Paying a lower wage rate. *nsafe wor ing conditions. 2ac of opportunity for career development. E.am!#e At the beginning of the year! a company employed '!;00 individuals. $uring the year! #!?00 individuals were recruited and at the end of the year! the company employed a total of 7!700 individuals. %e>uired What was the labour turnover during the year! to the nearest #JF
Employees =o o7 e<ployees &%(!! #%1!! (%&!! >t end o7 year 0%0!! There7ore leavers during the year '!! >t start o7 year 8ecruited during the year >verage nu<ber o7 e<ployees = .&%(!! + 0%0!!/6 = 0!0! La"our turno#er ! $%00& 0 0' ( 100) ! 1*.8) or 18)

%.2

People leave 4obs for a variety of reasons! some of which are avoidable! and it is normal to analyse the reasons for leaving so as to ta e corrective action where possible. Typical reasons for labour turnover include) *.* :edundancy $issatisfaction over prospects! pay! hours and other conditions Personal advancement 2ac of career structure 2ac of training &arriage! pregnancy $ischarge &ove from locality Changes in domestic circumstances Costs o" #a'our turno+er

The costs of labour turnover can be large and management should attempt to eep labour turnover as low as possible so as to minimi/e these costs. The costs arise in the following areas)

 *.$

2eaving costs 3 interviews! preparation of documentation! disruption of output :eplacement costs 3 advertising! selection! personnel ,uman resource department procedure Training costs 3 costs of re1uired internal and e"ternal courses 2earning costs 3 slower initial production! high scrap rate! tool brea ages! increased accident rate! poor service.

T5e !re+ention o" 5ig5 #a'our turno+er (ollowing actions could reduce labour turnover) Paying satisfactory wages 6ffering satisfactory hours and conditions of service Creating good informal relationship between members of staff 6ffering good training schemes and a well understood career or promotional ladder Improving the content of the 4ob to create 4ob satisfaction Improving human resource planning to avoid redundancies

$.0

ACCOUNTING O% LA9OU% COSTS

Accounting for the labour costs involves identifying and dealing with the following) $irect labour costs Indirect labour costs Cet pay $eductions

$.1

Dourna# entries in+o#+ed in accounting "or #a'our costs

Accounting for direct labour cost $: WIP C: Wages Control account Accounting for indirect labour cost $: Production 6verhead C: Wages control Accounting for Cet Pay $: Wages control C: 9an account

Accounting for deductions $: Wages control C: $eduction control ,.0 DI%ECT AND INDI%ECT LA9OU% COSTS +mployees can be classified as either direct labour or indirect labour. $irect labour means employees who are directly involved in producing goods or services for customers. Indirect employees refer to employees who are not directly involved in this wor . +"amples of indirect employees in a manufacturing business are) 8taff wor ing in administration! selling or distribution +mployees in production support departments such as maintenance and planning The aim of cost accounting is to identify direct labour costs and indirect labour costs which is not the same thing as the cost of direct labour and indirect labour employees.

,.1

Identi"(ing direct and indirect #a'our costs

All costs of indirect labour employees are indirect labour costs. Cot all the costs of direct labour employees are treated as direct. Costs of direct labour employees that are usually treated as indirect costs are) 3 The cost of idle time 3 The cost of overtime premium 3 Costs of labour time not spent in production such as when one is on training! sic or holiday.

,.)

E4AM&LE8 DI%ECT AND INDI%ECT LA9OU% COST ANALYSIS AND ACCOUNTING ENT%IES O% LA9OU% The following details are e"tracted from a monthly payroll for 70 employees at a small3scale farm for the month of Gune.
Paid to direct Labour +3!!! ( %'(0 #"%(!! "%&!! Paid to Indirect Labour +3!!! '%$0! 1%$0! %#'! Total ' %$#0 %"0! 0%0'!

;rdinary ti<e ;verti<e 5asic Pay Pre<iu<

?hi7t >llowance ?ic: Pay Total Net +a,

(%$0! "%&0! '!%#(0 *8,3-0

"%&'0 (0! &&%1"0 32,..0

#!% &0 &%#!! #"0%!!! 111,000

%e>uired a- What is the direct wages for the monthF b- Prepare the wages account for the wee ,.* SOLUTION a- E;2!B;7 P #%!;00 O E=;!7;7 >E<000b/ages contro0 account +3!!! 5an:@ net wages paid ###%!!! 9or: In Progress Deduction control account &%!!! Production ;verhead Indirect Labour ;ver ti<e pre<iu< ?hi7t allowance ?ic: pay #"0%!!! +3!!! $(%0(0 "1%0!! 0%0'! #!% &0 &%#!! #"0%!!!

-.0 DOCUMENTATION O LA9OU% TIME The tas of separating the total labour cost into direct and indirect is complicated! because of idle time! overtime premium and other non productive time. In addition! in order to measure the costs of different products or 4obs it is necessary to establish how much time the employee has spent on each 4ob. To do this there has to be a system for recording direct labour times and allocating the time spent to individual products or 4obs. ;.# The most common methods of recording how much time has been spent on particular activities! products or 4obs are) Time sheets Gob sheets Cost cards

-.)

TIME S0EETS

> ti<e sheet is a record o7 how a personAs ti<e at wor: has been spentB
The total hours that an employee has wor ed in a day or wee are nown from the employee<s cloc card but a brea down of how those hours were spent will be shown on time sheet. The employee fills out his or her own time sheet daily! wee ly or monthly basis depending upon the policies of the organi/ation. The employee will enter his name! cloc number and department at the top of the time sheet together with details of the wor he has been engaged on in the period and the hours spent on that wor . -.* TIME S0EET
T12e sheet =a<e@ 5ernard Phiri Depart<ent@ Maintenance 9ee: co<<encing@ 1 March !C( Date 1*Mar '*Mar "!*Mar "#*Mar #*>pr 4ob Machine C Machine E ?ic: leave Machine L Doliday ?tart !' "! !1 "! !' "! !' "! !' "! ,inish #$ "! ## "! #$ "! #$ "! #$ "! Dours $ " $ $ $ ;verti<e C0oc3 Nu2"er4 82 *3-

"

Total Dours ,ore<an3s signature @

"#

-.$

DO9 S0EET Gob sheets ta e are important for employees who are paid on results basis or time basis. In these situations the sheet is a record of the products produced and it is also used to calculate the payment due to the employee.
5o" sheet =a<e@ ?heba Phiri Depart<ent@ ,actory 9ee: co<<encing@ 1 March !C( Product 2nits Code Price +3!!! Dresses " D8E "B Trousers #& T8; &B# ?hirts # ?DI B0 C0oc3 Nu2"er4 82 *3-

5onus +3!!! #! ! '

Total +3!!! $"B( 0$B& 0 B0

Fross 9ages ,ore<an3s signature@

#'

#1"B0

I.0

MEASU%ING LA9OU% ACTI1ITY

&easures of labour activity include) I.1 E +fficiency ratio Capacity ratio Production volume ratio ICIENCY %ATIO

This is a ratio that compares the standard hours of wor produced with actual hours wor ed I.) CA&ACITY %ATIO A capacity is used to measure the utilisation of labour. 2abour utilisation refers to how much labour time is used! compared to how much available time was e"pected. The capacity ratio is e"pressed as a percentage and compares the actual number of hours actively wor ed with the budgeted labour hours for the period. I.* &%ODUCTION 1OLUME %ATIO

The productionAvolume ratio assesses how the overall production level compares to planned levels and is the product of the efficiency ratio and the capacity ratio. I.$ E.am!#e The following information relates to a small production unit during a period 9udgeted hours Actual hours wor ed 8tandard hours of wor produced %e>uired Calculate the following ratios a- +fficiency ratio b- Capacity ratio c- @olume ratio B!700 B!200 B!%00

I.,

So#ution A
E77iciency ratio = ?tandard Dours >ctual Dours = '"!! ' !! #!#G

Capacity =

>ctual Dours 5udgeted Dours

' !! '0!!

'$G

)olu<e

?tandard Dours 5udgeted Dours

'"!! '0!!

'1G

C5a!ter summar(

There are three basic groups of remuneration methods time based! piece wor and bonusAincentive schemes. 2abour attendance time is recorded on for e"ample an attendance record or cloc card. Gob time may be recorded on time sheets or 4ob sheets 6vertime is time that is paid for usually at a premium! over and above the basic hours for the period 2abour turnover is the rate at which employees leave a company and this rate must be ept as low as possible. The cost of labour turnover can be divided into preventative and replacement costs $irect labour cost is the cost of labour that is directly attributable to a cost unit. It consist of the cost of direct labour spent actively wor ing on production! but usually e"cludes any over time premium payments Indirect labour cost or labour overheads consist of the labour cost of indirect wor ers plus indirect labour costs of direct wor ers The wages control account acts as a collecting place for wages before they are analysed to wor in progress and production overhead control account. +fficiency ratio compares the e"pected time for producing output compared with the actual time e"pressed as a percentage. Capacity ratio compares the actual time wor ed with budgeted time for the period e"pressed as a percentage.

STUDENT:SEL TESTING SEL %E1IE2 3UESTIONS #. 2. %. '. 7. ;. =. &ention % remuneration methods >#.0What is overtime premium >#.22What is the high day rate systems >#.2%What is differential piece wor system >2.'What is labour turnover >%.0&ention some costs of labour turnover >%.%&ention % ratios used to measure labour activity >=.0-

E4AMINATION TY&E 3UESTIONS 9oot Ltd 9oot 2imited a manufacturer of industrial safety shoes operates a labour bonus payment system in its factory with bonus being paid at =7J of the base for all standard hours saved. The following is a summary of the labour information for month ; for three employees) Chila =2 '0 B20 '7 7 Cheta #?? #7 B;0 '; Chulu '%2 = B'0 '' 2

Wor issued and completed >Pairs8tandard time allowed 3 minsA pair 9asic ,ourly rate >EwachaTotal hours wor ed ,ours wor ed on indirect wor

The basic wor ing wee is '0 hours. the first three hours overtime is paid at time plus one third and the remainder at time plus one half. %e>uired a- Compute the individual employee<s gross wages payable b- Compute the net wages payable for each of the three employees c- Prepare 4ournal entries for the above data ta ing into account the following additional factors)

Ta"ation is at the rate of %0J of gross pay +ach employee pays E%000 as CAP8A +ach employee is a member of &u uba Pension 8cheme to which they contribute E2!700 monthly

Check for answers at the end of the text

CHAPTER 7 OVERHEADS AND ABSORPTION COSTING INT%ODUCTION

In the previous two chapters we have demonstrated how to attribute material and labour costs to units of production or services provided by an organi/ation. This chapter proceeds to e"plain the process involved in attributing indirect costs to products and services using a system nown as absorption costing. CONTENTS #. 2. %. '. 7. ;. =. ?. Product costs and service costs. 6verheads 6verhead allocation 6verhead apportionment 6verhead absorption 6ver and under absorption of overheads Con3production overheads 2edger entries relating to overheads LEA%NING OUTCOMES After studying this chapter you should be able to) +"plain the reason for using absorption costing $escribe the process of allocation! apportionment! re3apportionment and absorption to establish product cost in absorption costing Calculate overhead absorption rates Calculate costs using the absorption costing method +"plain why predetermined overheads absorption rates are used Calculate the underAover absorption costs $escribe and apply methods of charging administration overheads and sales and distribution overheads to cost unit

1.0 #.#

&%ODUCT COSTS AND SE%1ICE COSTS

Commercial organisations either sell products or provide services and they should now how much it costs them to provide these services and products in order to do the following) Carry out product profitability analysis. Price products and services. @alue stoc s.

#.2

Costs incurred in business can be recorded as) ).0 $irect materials $irect labour $irect e"penses 6verheads O1E%0EADS

An overhead is the cost incurred in the ma ing of a product! providing a service or running a department! but which cannot be traced directly and in full to the product! service or department. An overhead is actually the total of the following) Indirect material Indirect labour Indirect e"penses

Indirect costs are usually classified by function as shown below) ).1 Production overhead Administration overheads 8elling and distribution overheads &%ODUCTION O1E%0EADS

Production overheads represent indirect materials! indirect wages and indirect e"penses attributable to production and also the service activities associated with production.

2.2

Indirect production costs are incurred in three main ways) Acti+it( Production 8ervice +stablishment O+er5eads e.g (uel! protective clothing depreciation super vision The costs of operating non production departments within the factory such as materials handling! production control and canteen 5eneral overheads such as factory rentArates! heating and lighting and production management salaries.

*.0

O1E%0EAD COSTING &%OCEDU%ES To attribute production overheads to cost units! a se1uence of procedures is under ta en) i+stablishing cost centers iiCollecting overheads by item iiiAllocation of overheads ivApportionment of overheads v:eapportionment of service center costs viComputation of overhead absorption rates viiAbsorbing of production overheads into cost units viii- Computation of overAunder absorption *.1 O1E%0EAD ALLOCATION

Allocation is the process by which whole cost items are charged direct to a cost unit or cost center. *.) O1E%0EAD A&&O%TIONMENT

This is a stage which follows overhead allocation. It is a process of sharing out general overhead costs to beneficiary cost centres on fair basis such as these shown below) E.am!#e o" o+er5ead 9asis o" a!!ortionment :ent! rates! heating and lighting and (loor area occupied by each cost depreciation of buildings centre $epreciation! insurance of Cost or boo value of e1uipment e1uipment Personnel office! canteen! welfare! Cumber of employees! or labour wages and cost offices! first aid hours wor ed in each cost centre

 *.*

,eating! lighting

@olume of space occupied by each cost centre

E4AM&LE8 O1E%0EAD A&&O%TIONMENT 9utton 2td has the following budget for overhead costs@
+3!!! #%!!! (!! #%0!! 1!! !! "'! #!! '!! 0%&'!

Depreciation o7 7actory ,actory repairs and <aintenance ,actory o77ice costs Depreciation o7 eHuip<ent Insurance o7 eHuip<ent Deating Lighting Canteen

Information relating to the production and service centers in the factory is as follows)
Production centers Dept > Dept 5 ,loor space .sHuare <eters/ )olu<e .cubic <eters/ =u<ber o7 e<ployees .head count/ 5oo: value o7 eHuip<ent .+3!!!/ #% !! "%!!! "! "! #%(!! (%!!! "! ! ?ervice centers Dept C Dept E 1!! %&!! #0 #! &!! #%(!! #0 !

&e'uired $etermine how the overhead costs should be apportioned between the four departments *.$ SOLUTION
5asis o7 apportion<ent Total cost Production centers Production centers +3!!! Dept > Dept 5 Dept C Dept E #%!!! (!! #%0!! 1!! !! "'! #!! '!! "!! #1! 0!! "!! $0 '! "! "!! &!! &! 0!! !! 0! #1! &! "!! !! # ! 0! #!! 0 $ ! #0! #!! (! 0! !! 0! &1 #! #0!

Ite< o7 Cost

Depreciation o7 7actory ,loor area ,actory repairs and <aintenance ,loor area ,actory o77ice costs =u<ber o7 e<ployees Depreciation o7 eHuip<ent 5oo: value Insurance o7 pay<ent 5oo: value Deating )olu<e Lighting ,loor area Canteen =u<ber o7 e<ployees

,-%0

1,**

1,%10

%3*

8.8

*.,

%E:A&&O%TIONMENT O SE%1ICE CENT%E COSTS

A factory is divided into several production cost centers and also many service cost centers such as stores maintenance and canteen. The third stage in overhead costing concerns the treatment of overheads in service centers. 9ecause no production cost units pass through the service cost centers! it is necessary to apportion the service department costs to the production cost centers so that all production costs >including those of the service departments- are accounted for. Typical bases for re3apportionments are shown below. Ser+ice De!artment 8tores &aintenance Personnel office Production planning 9asis o" a!!ortionment Cumber of re1uisitions @alue of materials issued &aintenance ,ours Cumber of employees $irect labour hours per each department

%.;

There are three ways of re3apportionment of service centre costs) Continuous allotment $irect method +limination method

+ach of these methods will be demonstrated using the information given below for an organi/ation with two production centers and two service centers)
Production centers Dept > Dept 5 +3!!! +3!!! #!%!"! 1%'$! ?ervice centers Dept C Dept E +3!!! +3!!! #!%!!! 1%!!!

;verhead costs

Total +3!!! "$%!!!

The service depart<ents are expected to spend their ti<e as 7ollows@ Dept > "!G 1!G Dept 5 0!G #!G Dept C * #!G Dept E !G *

Depart<ent C Depart<ent E

a= IGNO%ING %ECI&%OCAL SE%1ICES

Production centres Dept > Dept 5 +3!!! +3!!! #!%!"! 1%'$! "%$0! $%### 20,8%1 (% 0! 11' 1.,10% ?ervice centres Dept C Dept E +3!!! +3!!! #!%!!! 1%!!! .#!%!!!/ .1%!!!/ 6 6

5asis ;verhead costs Dept C Dept E Tota0 "!@ 0! 1!@ #!

Total "$%!!! * * 3*,000

'=

ELIMINATION MET0OD

The methods wor s by first apportioning one of the service cost centres to all other centres which ma e use of its services. When the remaining service center costs is reapportioned! the wor done for other service cost centres is ignored.
5asis Production centres Dept > Dept 5 +3!!! +3!!! #!%!"! 1%'$! "%!!! 1%11' 21,%1% 0%!!! #%### 1 ,081 6 6 ?ervice centres Dept C Dept E +3!!! +3!!! #!%!!! 1%!!! $10,000' %!!! $10,000' 3*,000

;verhead costs Dept C Dept E Tota0 " @ 0@ 1@ #

Total +3!!! "$%!!!

c=

%ECI&%OCAL <%E&EATED DIST%I9UTION= MET0OD O A&&O%TIONMENT

5asis Production centres Dept > Dept 5 +3!!! +3!!! #!%!"! 1%'$! "%!!! 1%!!! "!! #(! ( & 21, 00 0%!!! #%!!! 0!! ! #! ?ervice centres Dept C Dept E +3!!! +3!!! #!%!!! 1%!!! $10,000' #%!!! $1,000' ! $ 20' %!!! $10,000' !! $ 200' & $ -' 0 3*,000 Total +A!!! "$%!!!

;verhead costs Dept C Dept E Dept C Dept E Dept C Dept E Tota0 "@0@ 1 @ # @# "@0@ 1 @ # @# "@0@

1 , 00

$.0

O1E%0EAD A9SO%&TION

The final stage in the process is overhead is to reflect the cost of overheads in individual cost units. This is nown as overhead absorption. To determine the overhead to be absorbed by a cost unit! it is necessary to establish an overhead absorption rate which is calculated as
;verhead >bsorption 8ate = Total 5udgeted ;verhead Total 5udgeted Level o7 >ctivity

$.1

A9SO%&TION 9ASES

6verheads can be absorbed into cost units by means of) $.) *nits produced Total prime cost Total &aterial cost Total direct wages $irect labour hours &achine hours

E4AM&LE The budgeted production overhead and other budget data for Eampsi/e 2td are as follows)
5udget Cost ;verhead cost .+3!!!/ $ %!!! Direct Materials .+3!!!/ (&%!!! Direct Labour Cost +3!!!/ 1!%!!! Machine Dours #!%!!! Direct Labour hours #1%!!! 2nits o7 production # %!!!

%e>uired Calculate the absorption rates using various bases. $.* So#ution
Percentage o7 direct <aterial cost $ %!!!%!!! (&%!!!%!!! $ %!!!%!!! 1!%!!!%!!! C #!! = ## B0G

Percentage o7 direct labour cost

C #!! = '!G

Percentage o7 pri<e cost

$ %!!!%!!! C #!! = 0!G #&&%!!!%!!! $ %!!!%!!! #!%!!! $ %!!!%!!! #1%!!! $ %!!!%!!! # !! = +$% !! per hour

8ate per <achine hour

8ate per Labour hour

= + &%!!! per hour

8ate per unit

= +(!%!!! per hour

$.$

I##ustration8 a'sor!tion *sing each of the overhead absorption rates calculated above! estimate production overheads that would be absorbed in Product LDZ which has the following details)
Direct Material cost Direct Labour cost Pri<e cost Machine Dours Labour Dours +1!%!!! +10%!!! +#(0%!!! #0 0

$.,

SOLUTION
>bsorption base Percentage o7 direct <aterial cost Percentage o7 direct labour cost Percentage o7 pri<e cost 8ate per <achine hour 8ate per Labour hour 8ate per unit ;verhead >bsorption rate ## B0G '!G 0!G $% !! &%!!! (!%!!! >ctual activity +1!%!!! +10%!!! +#(0!%!! #0 0 # >bsorbed +'!%!!! +$(%0!! +1 %0!! +#!1%!!! +#!!%!!! +(!%!!!

Though in theory any basis of absorption can be used! a company should choose a basis for its costs which seems to be fairest. ,.0 &%E:DETE%MINED A9SO%&TION %ATE

The overhead absorption rates used for absorption are calculated prior to the accounting period using budgeted overheads and budgeted activity. The main reason for this is that the actual overhead and actual activity is not nown until the end of the period and the actual overhead absorption rate would not be calculated until then. This would mean that product cost can not be calculated until the end of the period and this would create unacceptable delays for such activities as invoicing and cost estimation. The only solution is to use predetermined rates. ,.1 UNDE% O% O1E% A9SO%&TION

6verhead absorption rates are based on budgeted overhead costs and the budgeted volume or activity. In practice we should e"pect that)

Actual overhead e"penditure will differ from budgeted overhead e"penditure. and The actual volume activity will differ from the budgeted volume of activity

As a conse1uence the amount of overheads charged to product costs will differ from the actual overhead e"penditure. We might charge more overhead costs to production than the amount of overheads e"penditure actually incurred. If so there is o+er a'sor!tion or o+er reco+er( of overheads. Alternatively! we might charge less overhead costs to production than the amount of overheads e"penditure actually incurred. If so there is under a'sor!tion or under reco+er( of overheads. ,.) E4AM&LE Pemba 2td has budgeted production overheads of E70 million and a budgeted activity of #0!000 machine hours. The overhead absorption rate is thus E7!000 per hour. ,.* %e>uired

Calculate the underAover absorbed overhead under each of the following circumstances)
6utcome abcActual 6verhead Cost E<000 '=!000 70!000 '=!000 Actual &achine ,ours #0!000 ?!700 ?!700

,.$

SOLUTION
aActual 6verheads Absorbed 6verheads O+er a'sor!tion bActual 6verheads Absorbed 6verheads Under a'sor!tion EQ000 '=!000 70!000 *B000

>#0!000 L E7-

>?!700 L E7-

70!000 '2!700 <IB,00=

cActual 6verheads Absorbed 6verheads Under a'sor!tion

>?!700 L E7-

'=!000 '2!700 <$B,00=

-.0

T%EATMENT O NON:MANU ACTU%ING O1E%0EADS (or financial reporting purposes! it is not necessary to allocate non3manufacturing overheads to products. This is because many of the overheads are non3 manufacturing and are regarded as period costs and are written off as a charge to the profit and loss account. (or internal reporting purpose and for a number of industries which base the selling price on their product on estimate of total cost or even actual cost! a total cost per unit output may be re1uire. (or product pricing purposes and for internal management reports it may therefore be appropriate to allocate non3manufacturing overheads to units of output.

-.1

9ASES O% A9SO%9ING NON MANU ACTU%ING COSTS Administration overheads might be absorbed into unit costs as a percentage of full product cost. 8ales and distribution overheads might be absorbed into unit costs as percentage of full production cost. -.) E4AM&LE

9ic son 2imited has budgeted the following sales and costs for ne"t year
,ull Production Costs >d<inistration overheads ?ales and distribution overheads ?ales revenue + &!%!!! (!%!!! 1!%!!! &0!%!!!

Production overheads will be absorbed at a rate of E'00 per direct labour hour. Administration overheads will be absorbed as a percentage of full production cost. 8ales and distribution overheads will be absorbed as a percentage of full production cost. Required Calculate the fully absorbed cost of sales for a product that has a direct material cost of E2'!000 and a direct labour cost of E#;!000 with labour paid at E?00 per hour.

-.*

So#ution
Administration overhead absorption rate O Administration overhead (ull production overhead ;0!000 2'0!000 8ales and distribution overheads absorption rate L #00

#00 O

27J

8ales R $ist overheads (ull production overhead ?0!000 2'0!000

#00

#00 O

%%.%%J

$irect &aterials $irect 2abour Production overheads >20SS hours L E'00(ull production cost Administration overheads >27J L E'?8ales and distribution overheads >%%.%%J L E'?u## cost o" sa#e

EQ000 2' #; ? '? #2 #; I-

** hours per unit = labour cost per unit/ labour rate per hour.

C5a!ter summar( 6verhead is the cost incurred in the course of ma ing a product! providing a service or running a department! which cannot be traced directly and in full to the product! service or department. The main reasons for absorbing overheads into products are for stoc valuations! pricing decisions and product profitability analysis. The three main stages in absorption costing are) o Allocation o Apportionment o :e3apportionment o Absorption Apportionment is the process by which whole cost items are charged directly to a cost unit or cost centre. Apportionment is a procedure whereby indirect costs are spread fairly between costs centres. :e3apportionment is a procedure where service center costs are spread fairly to production centres using one of the following methods) o $irect method o :eciprocal method o 8tep method 6verhead absorption is the process whereby costs of production cost centres are added to a unit! 4ob or batch costs. 6verhead absorption is called overhead recovery. *nder absorption occurs when the overheads absorbed into the product is less than overheads incurred. It is charged as an e"pense in the profit and loss account. 6verhead absorption occurs when the overheads absorbed in the product is greater than overheads incurred. This amount is credited to the profit and loss account.

STUDENT:SEL TESTING SEL %E1IE2 3UESTIONS #. 2. %. '. 7. ;. =. ?. What are overheadsF >2.02ist steps involved in overhead costing >%.0&ention some bases for overhead apportionment >%.2&ention three methods for re3apportionment of service center costs >%.;6n what bases can overheads be absorbed into products or services >'.#Why is a predetermined overhead absorption rate usedF >7.0What causes under or over absorption of overheads >7.#,ow are non3 manufacturing overheads absorbed into products or services >;.#-

E4AMINATION TY&E 3UESTIONS 3UESTION ONE #.# The process of cost apportionment is carried out so that) A. 9. C. $. #.2 Cost may be controlled Cost units gather overheads as they pass through cost centres Whole cost items of cost can be charged to cost centres Common costs are shared among costs centres

An overhead absorption rate is used to A. 9. C. $. 8hare out common costs over benefiting cost centres (ind the total overheads for a cost centre Charge overheads to products Control overheads

#.%

A company absorbs overheads on machine hours which were budgeted at ##!270 with overheads of E27?!=70!000. Actual results were #0!B?0 hours with overheads of E27'!;B2!000. 6verheads were) A. 9. C. $. *nder absorbed by E2!#72!000. 6ver3absorbed by E'!07?!000. *nder absorbed by E'!07?!000. 6ver3absorbed by E2!#72!000.

#.'

A firm absorbs overheads on labour hours. In one period ##!700 hours were wor ed! actual overheads were E#%? million and there were E 2% million over absorption. The overhead absorption rate per hour was)

A. 9. C. $.

E#0!000 E#'!000 E#2!700 E#=!000

3UESTION T2O &oombo 2imited is a manufacturing company and has the following budgeted overhead costs for two production departments >&achining and Assembly departments- and two service departments >8tores and &aintenance- for the ne"t financial year.
Indirect &aterials &achinery department Assembly department 8tores department &aintenance department Indirect wages &achinery department Assembly department 8tores department &aintenance department #00!000 ?0!000 70!000 #7!000 )$,B000 B0!000 ;0!000 =0!000 77!000 )I,B000 &anagers 8alaries $epreciation of machinery ,eating and 2ighting 9uilding insurance Insurance of &achinery :ent and rates Total =0!000 #70!000 70!000 27!000 #00!000 =7!000 KK0B000

The following additional information is provided)

Details >rea occupied .M / Production depart<ents ?ervice depart<ents Machining >sse<bly ?tores Maintenance 0!! $%0!! $%!!! 0%!!!

=u<ber o7 e<ployees )alue o7 <achines .+wacha/ Materials issued 7ro< stores .+wacha/ Machine hours Direct labour hours Maintenance hours

#0 %!!!%!!! 0!%!!! &0%!!! #!!%!!! &%0!!

! 0!!%!!! !%!!! "!%!!! 1!%!!! &%"!!

#% !!

:e1uired a- Prepare an overhead analysis sheet showing clearly the basis of apportionment used for each item of e"pense. b- Calculate appropriate overhead absorption rates for the two production departments to two decimal places. c- Gob L passes through two production departments and uses the following hours)

Machining >sse<bly Labour hours Machine hours #!!! &!! 1!! 0!!

Direct <aterial cost + !!%!!! Labour rate per hour +0%!!!

Calculate the total cost for 4ob L.

CHAPTER 8 ABSORPTION AND MARGINAL COSTING

Introduction This chapter defines marginal costing and absorption costing system. As you will learn! absorption costing recogni/es fi"ed costs as part of a product cost! whereas in marginal costing fi"ed costs are treated as period cost. We shall be loo ing at the arguments in favour of and against each method. As each method produces a different profit figure! we shall demonstrate how to reconcile the profit figures. CONTENTS #. 2. %. '. 7. (ull cost and marginal costing. Contribution concept. Profit statements under absorption and marginal costing. Advantages and disadvantages of marginal costing. Advantages and disadvantages of absorption costing.

LEA%NING OUTCOMES After studying this chapter you should be able to) $efine marginal costing. +"plain the concept of contribution. Prepare profit statements using absorption and marginal costing principles. :econcile the profits reported by absorption and marginal costing. $iscuss advantages and disadvantages of absorption and marginal costing systems.

1.0

MA%GINAL COST AND MA%GINAL COSTING &arginal cost is the part of the cost of one unit of product or service which would be avoided if the units were not produced! or which would increase if one e"tra unit were produced.

#.#

The marginal production cost per unit of an item usually consists of the following) $irect materials. $irect labour. @ariable production overheads. 1.) Margina# costing

&arginal costing is the accounting system in which variable costs are charged to cost units and fi"ed costs of the period is written off in full against the total contribution. 1.* Margina# cost o" sa#es

&arginal cost of sales usually include marginal cost of production ad4usted for stoc movement plus variable selling costs! which would include items such as sales commission and possibly some variable distribution costs. ).0 &rinci!#es o" margina# costing The principles of marginal costing are that) 2.# (i"ed costs are the same for any volume of activity. 9y producing and selling an e"tra unit or service only the variable cost increases. 9y producing and selling the additional unit! the total profit increase by the amount of contribution from that unit.

9ased on the above points marginal costing argues that) *.0 The valuation of stoc should be at variable production costs >direct materials! direct labour and direct e"penses-. Profit measurement should be based on contribution analysis A'sor!tion costing

*nder absorption costing both variable and fi"ed costs are absorbed into cost units. The fundamental difference between marginal and absorption costing is one of timing. In marginal costing fi"ed costs are written off in the period incurred. In

absorption costing fi"ed production costs are absorbed into units and written off in the period in which they are sold. Margina# costing Closing stoc s are valued at marginal production cost (i"ed costs are treated as period costs are written off in full to the profit and loss account Cost of sales does not include a share of fi"ed overheads A'sor!tion costing Closing stoc s are valued at full production cost (i"ed costs are treated as part of product costs Cost of sales does not include a share of fi"ed overheads

*.1

&roduct cost under margina# and a'sor!tion costing

E.am!#e) A company produces a single product and has the following budget 8elling $irect materials $irect wages @ariable overheads E #0!000 %!000 2!000 #!000

(i"ed production overhead is E#0 million per month. production volume is 7!000 units per month. %e>uired Calculate the cost per unit to be used for stoc valuation under) a- Absorption costing b- &arginal costing *.) SOLUTION u## a'sor!tion cost !er unit $irect materials $irect wages @ariable overheads Absorbed fi"ed overhead E#0&A7000 u## cost E %!000 2!000 #!000 2!000 JB000

Margina# cost !er unit $irect materials $irect wages @ariable overheads Margina# cost !er unit *.* Contri'ution Conce!t E %!000 2!000 #!000 -B000

Contribution is the difference between sales value and the marginal cost of sales. The term contribution is really short for contribution towards covering fi"ed overheads and ma ing a profit. *.$ 20Y IS CONT%I9UTION SIGNI ICANT Contribution is an important concept in marginal costing. Changes in the volume of sales! or in sales price! or in variable costs will all affect profit by altering the total contribution. &arginal costing techni1ues can be used to help management to assess the li ely effect on profits of higher or lower sales volume! or the li ely conse1uences of reducing the sales price of a product in order to increase demand and so on. The approach to any such analysis should be to calculate the effect on total contribution.
7or2at 8or 9arg1na0 cost state2ent > ?ales ;pening ?toc: - variable cost )ariable production cost Closing stoc:- variable costs )ariable production cost o7 sales )ariable selling expenses Total variable costs + CCC CC CC CC CC CC CC :: C C C ::

> * 5 Contribution ,ixed costs Production ?elling and ad<inistration ;ro81t & $Loss'

7or2at 8or A"sor+t1on cost state2ent +

>

?ales ;pening ?toc:- 7ull cost Production cost Closing stoc: -7ull cost Cost o7 ?ales

CCC CC CC .CC/ CC CC .C/ .C/ .C/ ::

> * 5 Fross Pro7it 2nder6 .over/ absorption )ariable selling expenses ,ixed selling and >d<in costs ;ro81t & $Loss'

*.,

E4&LANATION O T0E DI

E%ENCE IN &%O IT

The difference in profits reported under the two costing systems is due to the different stoc valuation methods used. If stoc levels increase between the beginning and end of a period! absorption costing will report the higher profit. This is because some of the fi"ed production overhead incurred during the period will be carried forward in closing stoc >which reduces cost of sales- to be set against sales revenue in the following period instead of being written off in full against profit in the period concerned. 6n the hand marginal costing will report a lower profit if the stoc increase. If stoc levels decrease! absorption costing will report the lower profit because as well as the fi"ed overhead incurred! fi"ed production overhead which had been carried forward in opening stoc is released and is also included in cost of sales. In this case! marginal costing will report higher profit. *.E4AM&LE8 COM&%E0ENSI1E ILLUST%ATI1E MA%GINAL AND A9SO%&TION COSTING 3UESTION ON

L 2imited commenced business on #st Ganuary ma ing one product only! with the following costs)
Direct Labour Direct Material )ariable production overhead ,ixed production overhead Tota0 cost +3!!! 0 1 0 20

The fi"ed production overheads figure has been calculated on the basis of a budgeted normal output of %;!000 units per annum.

Dou are to assume that there is no e"penditure or efficiency variance and that all budgeted e"penditure is incurred evenly over the year. 8elling! distribution and administration e"penses are) ,ixed +# ! <illion )ariable #0G o7 the sales value The selling price per unit is E%7!000 and the number of units produced and sold were) March 2nits Production %!!! ?ales #%0!! %e>uired Prepare profit statement for each of the months of &arch and April using) a- &arginal costing. and b- Absorption costing principles >pril 2nits "% !! "%!!!

*.I
21

SOLUTION
&roduction O+er5ead %;!000 L 7 O Per year #?0!000 Per month #7!000

2)

Se##ing and admin o+er5ead <;C000= Per year #20!000

Per month #0!000 &arch EQ000 72!700 April EQ000 #07!000

Margina# cost statement 8ales 2or?ings E%7 L #!700

2or?ings E%7 L %!000

6pening 8toc @ariable production cost Closing stoc @ariable production cost of sales @ariable selling e"penses Total variable costs Contribution (i"ed costs Production >W#8elling and admin >W2Profit A >2oss-

E#7 L 2!000 E#7 L 700 #7J L 72!700

3 %0!000 >=!70022!700 =!?=7 %0!%=7 22!#27

E#7 L %!200 E#7 L =00 #7J L #07!000

=!700 '?!000 >#0!700'7!000 #7!=70 ;0!=70 ''!270

>#7!000>#0!000>2!?=7-

>#7!000>#0!000#B!270

A'sor!tion cost statement 8ales 6pening 8toc Production cost Closing stoc Cost of 8ales 5ross Profit *nderA >over- absorption @ariable selling e"penses (i"ed selling and Admin costs &ro"it A <Loss= 2or?ings E%7 L #!700

&arch EQ000 72!700 3 '0!000 >#0!000%0!000 22!700 >7!000>=!?=7>#0!000<*I,=

2or?ings E%7 L %!000

April EQ000 #07!000 #0!000 ;'!000 >#'!000;0!000 '7!000 #!000 >#7!=70>#0!000)0B),0

E20 L 2!000 E20 L 700

E20 L %!200 E20 L =00

2*

UnderA o+er a'sor!tion Actual Absorbed <Under=AO+er

&arch E#?0!000A#2 2000 L 7 #7!000 #0!000 <,B000=

April E#?0!000A#2 %200 L 7 #7!000 #;!000 1B000

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%ECONCILITION O T0E DI E%ENCE 9ET2EEN MA%GINAL AND A9SO%&TION COST &%O ITS.
Profit as per Absorption costing Profit 2ess) (i"ed costs in the closing stoc s Add) (i"ed costs in the opening stoc 700 L 7 &arch >%=7>2!7003 =00 L 7 700 L 7 April 20!270 >%!7002!700

Profit as per &arginal costing Profit

>2!?=7-

#B!270

A%GUMENTS IN A1OU% O MA%GINAL COSTING AND A9SO%&TION COSTING A9SO%&TION It is fair to share fi"ed production costs to units of production as such costs are incurred in production Closing stoc s are valued accordance with 88AP B in MA%GINAL COSTING Absorption costing encourages management to produce goods in order to absorb allocated overheads instead of meeting mar et demands

It is easier to determine product profitability where a company produces more than one product Where stoc building is necessary ! fi"ed costs should be included as product costs to avoid fluctuation in reported results

Co apportionment of fi"ed assets

(i"ed costs are period costs that do not change with output.

&arginal costing is useful in decision ma ing *nderAover absorption of overheads is avoided. 8imple to operate.

C5a!ter summar( &arginal cost is the variable cost of one unit of product or service. Contribution is an important measure in marginal costing! and it is calculated as the difference between sales value and marginal or variable costs.

In marginal costing! fi"ed production costs are treated as period costs and are written off as they are incurred. In absorption costing! fi"ed production costs are absorbed into cost units and are carried forward in stoc to be charged against sales for the ne"t period. 8toc values using absorption costing are therefore greater than those calculated using marginal costing. 88AP B recommends the use of absorption costing for the valuation of stoc s in financial accounts

STUDENT:SEL TESTING SEL %E1IE2 3UESTIONS #. 2. %. '. 7. $efine marginal costing. >#.08tate principles of marginal costing >2.0What are the differences between marginal and absorption costingF >%.0What is contributionF >%.%8tate the arguments in favour of marginal and absorption costing >'.0-

E4AMINATION TY&E 3UESTIONS In"ormation re#ates "or t5e >uestion t5at "o##o6s 'e#o68 &unyaule develops musical C$s for which the budgeted profit per unit is as follows) E 2!000

&aterials

2abour @ariable Production overhead (i"ed Production overhead @ariable selling cost (i"ed 8elling e"penses Profit Sa#es &rice

%!000 %!000 '!000 #!000 2!000 7!000 )0B000

9oth types of fi"ed overheads were based on a budget of #0!000 C$s a year. In the first year of production! the only difference from the budget was that &unyaule produced ##!000 musical C$s and sold B!000. %e>uired Prepare) a- Profit statement made under absorption costingF b- Profit statement made under &arginal costingF c- A statement reconciling the profit figures in >a- and >b-

CHAPTER 9 ACTIVITY BASED COSTING

Introduction We have so far seen how to incorporate indirect costs into cost ob4ects using the traditional approach referred to as absorption costing. This chapter will introduce you to an alternative approach to dealing with overheads nown as Activity 9ased Costing

>A9C-. A9C was developed in the #B=0s and #B?0s as alternative to absorption costing. Absorption costing was found to be limited in the modern manufacturing environment where indirect costs were becoming a significant proportion of the product cost. This chapter will give a full bac ground to the development of A9C and will demonstrate the application of the concept. Contents #. 9ac ground to A9C. 2. Identification of activities. %. Identification of cost drivers. '. Accounting for overheads using A9C. 7. Contrasting A9C and the traditional approach. ;. 6ther uses of A9C. Learning outcomes After studying this chapter you should be able to) +"plain the limitation of the traditional approach to costing. *nderstand the concept of activities and cost drivers. Contrast the A9C approach and the traditional approach. +"plain other uses of A9C.

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9AC;G%OUND TO A9C

A9C was developed in the #B=0s and #B?0s as an alternative to absorption costing. 8ince the time when absorption costing was initially developed >at the time of the Industrial :evolution-! many aspects of manufacturing have changed and it was felt that absorption cost was not providing information of sufficient 1uality and accuracy. 8ome of these changes observed by the advocates of A9C are) 1.1 &roduct range

The traditional cost accumulation systems of absorption costing were developed at a time when most organisations produced only a narrow range of products! so that products under went similar operations and consumed similar proportions of overheads. 1.) Le+e# o" indirect costs

The traditional cost accumulation systems of absorption costing was developed at a time when overheads were only a very small fraction of total costs! direct labour and direct material costs accounted for the largest proportion of the cost. As such the benefit of more accurate systems of overhead allocation would probably have been relatively small. 1.* In"ormation !rocessing costs

The traditional costing systems were developed at a time when information processing costs were so high that on a cost benefit analysis basis! the introduction of A9C would not be approved in most organisations. 1.$ La'our costs. Traditional costing mainly allocated costs on the basis of labour component in a cost ob4ect. With the advent of Advanced &anufacturing Technology! labour has drastically declined >to as low as 7J of a product cost in some cases- and cannot be 4ustified as a correct absorption base. ).0 DE INITION O A9C

Activity 9ased Costing is an approach to costing and monitoring of activities which involves tracing resource consumption and costing final output. :esources are assigned to activities and activities to cost ob4ects based on consumption estimates. The later utili/es cost drivers to attach activity costs to outputs (C !" #fficial $erminolo%&'

The ma4or ideas behind A9C are as follows) 2.# Activities cause costs Producing products creates demand for the activities Costs are assigned to a product on the basis of the products consumption of the activities

Designing an A9C s(stem (our steps involved in the design of A9C are to) ).) Identify ma4or activities that ta e place within an organisation. Assign costs to cost poolsAcost centres for each activity. $etermine the cost driver for each ma4or activity. Assign costs to products according to products demand for activities. IDENTI ICATION O MADO% ACTI1ITIES

Activities are composed of the aggregation of units of wor or tas s and are described by verbs associated with tas s. (or e"ample activities in a stores department include such tas s as) :eceiving a purchase re1uest. Identifying suppliers. Preparing purchase orders. &ailing purchase orders. Performing follow3ups.

The number of activities to include in the system is a matter of 4udgment by management. ).* ASSIGNING COSTS TO EAC0 ACTI1ITY

After the activities have been identified the cost of resources consumed over a specified period must be assigned to each activity. The aim is to determine how much the organisation is spending on each of its activities. Costs shared by several activities have to be apportioned on some fair bases. ).$ IDENTI ICATION O COST D%I1E%S

In order to assign costs attached to each activity to products! a cost driver must be selected for each activity.

(efinition of cost driver A cost driver is any factor that causes a change in the cost of an activity. (C !" #fficial $erminolo%&' )., E4AM&LES O COST D%I1E%S Costs 6rdering costs &aterials handling Production scheduling costs $espatching costs ).&ossi'#e cost dri+ers Cumber of orders Cumber of production runs Cumber of production runs Cumber of dispatches

ASSIGNING COSTS TO &%ODUCTS

Costs are charged to products on the basis of their usage of the activity. A product<s usage of an activity is measured by the number of the activity<s cost driver it generates. ).I 3UESTION8 A9SO%&TION COSTING 1E%SUS A9C

,aving attended a ZICA conference on activity 9ased Costing you decide to e"periment by applying the principles of A9C to the four products currently made and sold by your company. $etails of the four products and relevant information are given below for one period) Product 6utput in units Costs per unit) $irect materials $irect 2abour &achine hours per unit A #20 ?!000 7!;00 2 9 #00 #0!000 '!200 #.7 C ?0 ;!000 2!?00 # $ #20 #2!000 '!200 #.7

The four products are similar and are usually produced in production runs of 20 units and sold in batches of #0 units. The production overhead is currently absorbed by using a labour hour rate and the total of the production overhead for the period has been analysed as follows)

Product ;C000 Assembly department cost >rent! rates ? '%0 depreciation and supervision8et up costs 7 270 8tores receiving % ;00 InspectionAHuality control 2 #00 &aterial handling and despatch ' ;20 Total 2' 000 Dou have ascertained that the cost drivers to be used are as listed below for the overhead costs shown) Cost 8et up costs 8tores receiving InspectionAHuality control &aterial handling and despatch Cost $river Cumber of production runs :e1uisition raised Cumber of production runs 6rders e"ecuted

The number of re1uisitions raised on the stores was 20 for each product and the number of orders e"ecuted was '2! each order being for a batch of #0 of a product. %e>uired Calculate the total costs for each product if overheads using) a- Traditional costing b- A9C system. SOLUTION Traditiona# Costing Products $irect &aterial $irect 2abour Prime Cost 6verheads Total cost *nits Cost per unit ?!000 7!;00 #%!;00 B!000 22!;00 #20 1JJ.** A #0!000 '!200 #'!200 7!270 #B!'70 #00 1K$.,0 9 ;!000 2!?00 ?!?00 %!000 ##!?00 ?0 1$I.,0 C #2!000 '!200 #;!200 ;!=70 22!B70 #20 1K1.), $ Total %;!000 #;!?00 72!?00 2'!000 =;!?00

2O%;INGS O% T%ADITIONAL COSTING W#

6verhead Absorption :ate O 9udgeted 6verhead 9udgeted Activity O 2'!000!000 O %!=70 ;!'00

W2
9udgeted ,ours A 9 C $ Tota# *nits #20 #00 ?0 #20 ,ours per unit 20 #' #0 #7 Total ,ours 2!'00 #!'00 ?00 #!?00 -B$00

W%
Products A 9 C $ Tota# *nits #20 #00 ?0 #20 ,ours 20 #' #0 #7 6,A: %!=70 %!=70 %!=70 %!=70 Absorbed 6, B!000!000 7!270!000 %!000!000 ;!=70!000 )$B000B000

A9C SOLUTION A9C statement Products Assembly 8et up 8tores Inspection &aterials ,andling Total Prime Cost Total Cost *nits Cost per unit 2O%;INGS A %!#20 #!700 B00 ;00 #!%20 IB$$0 #%!;00 )1B0$0 #20 1I,.** 9 #!?20 #!270 B00 700 #!#00 ,B,I0 #'!200 1KBII0 #00 1KI.I0 C #!0'0 #!000 B00 '00 ??0 $B))0 ?!?00 1*B0)0 ?0 1-).I, $ 2!%'0 #!700 B00 ;00 #!%20 -B--0 #;!200 ))BJ-0 #20 1K0.,0

W# ACTI@ITD 6verhead cost $rivers Cost Per $river Assembly ?!'%0 ;!700 #.%0 8et up 7!270 2# 270 8tores %!;00 ?0 '7 Inspection 2!#00 2# #00 &aterials ,andling '!;20 '2 ##0

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AD1ANTAGES O A9C A9C facilitates a good understanding of what drives overheads and assists companies to remain cost competitive and also help in the accurate assessment of product profitability. A9C recogni/es the comple"ity of the modern manufacturing environment by using multiple cost drivers. *nli e absorption costing which concentrates on factory overheads! A9C does account for non factory overheads and this ta es management accounting beyond its traditional factory floor boundaries. C%ITICISMS O A9C Cot all arbitrary cost apportionment is eliminated! some of it still remains e.g rent may still have to be apportioned to various activities. It is still doubtful whether a single cost driver can e"plain the cost behaviour of all items within a cost pool. A9C is sometimes introduced because it is fashionable! not because it will be used to provide meaningful product costs or e"tra information. The cost of implementing and maintaining an A9C system can e"ceed the benefits of improved accuracy.

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%.2

Implementation of A9C can be problematic due to such factors as) The incorrect belief that A9C can solve all organisations problems. 2ac of correct type of data. $ifficulty in determining appropriate cost drivers. *.*0 OT0E% USES O A9C Information which is gathered in the process of designing and implementing A9C can be used in the management functions of planning! control and decision ma ing. *.*1 &#anning

6ne of the critical steps in the design of an A9C system is the analysis of the organisation<s activities! cost drivers and the relation ship between the activities! productsAservices and their costs. This type of information would be very relevant for the budgeting e"ercise. *.*) Contro#

A9C clearly identifies what causes costs for an organisation in the service and support departments. This ma es it possible to control costs by managing the activities which underlie the support departments. *.** Decision ma?ing

9y providing accurate and reliable cost information A9C information can be used to ma e the following decisions) Pricing Promotion or discontinuing products or parts of the business :edesigning products and developing new products or new ways to do business.

C5a!ter summar( Activity 9ased Costing is an alternative costing method to absorption costing. A9C was developed to remedy wea nesses inherent in the absorption costing approach such as the reliance on labour for cost allocation and absorption when labour is a declining as a proportion of product cost. A9C involves the identification of the factors which cause costs >cost driversof an organisation<s ma4or activities and charging support overheads to products on the basis of usage of an activity. 8teps involved in A9C are) o o o o Identification of ma4or activities within an organisation. Assigning overheads to the activities. Identifying cost drivers for each cost pool. (inding cost per driver and assigning the cost to cost ob4ects.

6ne of the ey advantages of A9C is that it recogni/es the comple"ity of the modern manufacturing environment by using multiple cost drivers Information from A9C can be used by management for planning! control and decision3ma ing.

STUDENT:SEL TESTING

SEL %E1IE2 3UESTIONS #. 2. %. '. 7. ;. What developments have led to the introduction of A9CF >#.#3#.'$efine A9C >2.0&ention four steps involved in the development of A9CF 2.# What is a cost driver >2.'What are the advantages of A9CF %.0 &ention the ma4or criticisms of A9C >%.#-

E4AMINATION TY&E 3UESTIONS (alcon limited uses a single plant and production process to manufacture its candle and matches for its mainly rural mar et. An e"tract of production data for these products for the period ending %#st &arch 20L7 has been given as follows)
Huantities produced >*nits$irect 2abour hours per unit &achine hours per unit 8et3ups in the period 6rders handled in the period 6verhead costs :elating to &achine activity :elating to production run set ups :elating to handling of orders &atches 7000 # % #0 #7 Candles =000 2 # '0 ;0 ;L000 220!000 20!000 '7!000 2?7!000

%e>uired Calculate the production overheads to be absorbed by one unit of each of the products using) i- Traditional costing ii- Activity 9ased Costing approach

CHAPTER 1 5O< AND <ATC= COSTIN>

INT%ODUCTION In this chapter! we loo at the first costing method! nown as 4ob costing. We will see circumstances in which 4ob costing should be used and how the costs of 4obs are calculated. We shall proceed to consider batch costing. These costing systems are usually associated with absorption costing methodology and the costs calculated for each batch or each 4ob produced are normally a fully absorbed costs. CONTENTS #. Costing methods. 2. Gob costing. %. 9atch costing. LEA%NING OUTCOMES After studying this chapter you should be able to) $escribe the characteristics of 4ob costing and batch costing. Identify situations where the application of 4ob costing or batch costing is appropriate. $iscuss and illustrate the treatment of direct! indirect and abnormal costs. Complete cost records and accounts in 4ob and batch costing situation. +stimate 4ob costs from given information. Apply cost3plus pricing in 4ob costing.

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Costing met5ods

A costing method is designed to suit the way goods are processed or manufactured or the way services are provided. +ach organisation<s costing method will therefore have uni1ue features but costing methods of firms in the same line of business will more than li ely have common aspects. #.# There are five costing methods to be considered in two categories) S!eci"ic order costing Gob costing. 9atch costing. Contract costing.

Continuous o!erationa# costing #.2 Process costing. 8ervice costing.

We will be considering two important costing methods in this chapter. ).0 Gob costing. 9atch costing. DO9 COSTING

Gob costing is a costing method applied where wor is underta en to customers< specific re1uirements and each order is of comparatively short duration. The wor relating to a 4ob moves through processes and operations as a continuously identifiable unit. Gob costing is most commonly applied within a factory or wor shop! but may also be applied to property repairs and internal capital e"penditure. *.0 &%OCEDU%ES O% T0E &E% O%MANCE O DO9S

The normal procedure in 4obbing concerns involves) The prospective customer approaches the supplier and indicates the re1uirements. A representative sees the prospective customer and agrees with him the precise details of the items to be supplied. The estimating department of the organi/ation then prepares an estimate for the 4ob. This will be based on the cost of materials to be used! the labour

 *.00 *.10

e"pense e"pected! the cost of overhead! the cost of any additional e1uipment needed specially for the 4ob and finally the supplier<s profit margin. If the estimate is accepted the 4ob can be scheduled. All the re1uired resources are arranged for the 4ob. DO9 COST IN O%MATION

Materia#s When material is re1uisitioned for a 4ob then the issue of materials will be recorded in the stoc ledger account. They will also be recorded at their issue price in the 4ob cost card as they are used as input into the particular 4ob. &aterials that have to be specially purchased for the 4ob in 1uestion will need to be priced by the purchasing department.

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Direct #a'our costs As the 4ob card travels with each 4ob! the hours wor ed by each grade of labour are logged onto the card. The relevant hourly labour rate is then applied to each grade of labour to give a cost for each grade and a total cost for the 4ob.

*.1)

Direct e.!enses $irect e"penses are any cost that can be directly attributed to that particular 4ob. The details of these costs are can be obtained from invoices and the cost accountant is responsible for recording these. *.1* &roduction o+er5eads

The estimated production overheads to be included in the 4ob cost will be calculated from predetermined overhead absorption rates and the actual hours wor ed. *.1$ Ot5er o+er5eads and /o' costs

In order to arrive at the total costs for a particular 4ob! any non3production overheads such as administration! selling and distribution should be included in the 4ob costs. A variety of methods such as percentage of full product costs etc could be used to estimate overheads to include in the 4ob. $.0 DO9 &%ICING The common method of fi"ing prices for 4obs is cost plus pricing where a re1uired profit mar 3up is added to the total cost in order to arrive at a selling price.

$.1

E.am!#e

A company has had two 4obs in the current month called 4ob L and 4ob D which were carried out in three production departments namely cutting! assembly and finishing. Production overheads rates based on labour hours for these departments are E#!2?;! E#!2'0 and E #!'0% respectively. Products L and D have the following estimated costs. Gob $irect &aterials $irect 2abour $epartment L D 2abour rates per ,our E#7'!000 E#0?!000 ,ours ,ours A 20 #; E%!?00 9 #2 #0 E%!700 C #0 #' E%!'00

%e>uired Assuming a profit mar 3up of 20J! calculate the price 1uoted for each 4ob. So#ution &aterials $irect 2abour $epartment A $epartment 9 $epartment C &rime Cost 6verheads $epartment A $epartment 9 $epartment C Tota# Cost Profit mar up 3uoted Se##ing &rice Do' 4 #7'!000 >20 " E%! ?00>#2 " E%! 700>#0 " E%! '00=;!000 >#; " %!?00'2!000 >#0 " %!700%'!000 >#' " %!'00*0-B000 27!=20 >#; " #2?;#'!??0 >#0 " #2'0#'!0%0 >#' " #'0%*-0B-*0 =2!#2; $*)BI,Do' Y #0?!000 ;0!?00 %7!000 '=!;00 ),1B$00 20!7=; #2!'00 #B!;'2 *0$B01J ;0!?0' *-$BJ))

>20 " #2?;>#2 " #2'0>#0 " #'0%-

The focal point of 4ob costing system is the cost sheet. +ach 4ob will be given a uni1ue 4ob number and a separate sheet will be opened for each 4ob! on which will be recorded) &aterials 2abour $irect e"penses 6verheads 9ATC0 COSTING

,.0

A batch is a group of identical but separately identifiable products that are made together. 9atch costing is a form of specific order costing in which costs are attributed to batches of products. +ach batch is very similar to a 4ob and in e"actly the same way as 4ob costing. The costs of that batch are gathered together on a batch cost card. These costs are materials! labour! e"penses and a batch<s share of overheads. ,.1 UNIT COST O A 9ATC0

As a batch is made up of a number identical products or cost units! the cost per unit computation differs from the 4ob. In order to find the cost of each product or cost unit the total cost of the 4ob is divided by the number of products in that batch. ,.) E.am!#e 9atch number L002 has the following inputs) 0# &ay #7 &ay &aterial L) %0 g I E#0!000 per g. '0 hours of grade II labour at E;!000 per hr. &aterial D) 20 g I E%0!000 per g. ;0 hours of grade III labour at E7000 per hr.

Production overheads are to be absorbed into the cost of each batch on the basis of labour hours at a rate of E700 per labour hour. :e1uired) Calculate the cost per unit in the batch.

So0ut1on +g "! ! Dours &! (! #!! Price #!%!!! "!%!!! 8ate (%!!! 0%!!! 0!! Total*+wacha "!!%!!! (!!%!!! &!%!!! "!!%!!! 0!%!!! 1,-%0,000

Material costs

C E Frade II Frade III

Labour

Production overheads Tota0

Cost per Product

#%&'!%!!! #!!

#&%'!!

C0A&TE% SUMMA%Y Gob costing is the costing method used where each unit is separately identifiable Costs of each 4ob are collected on a 4ob cost card &aterials for each 4ob are determined from the material re1uisition note 2abour times on each 4ob are recorded on a 4ob tic et! which is then costed and recorded on the 4ob cost sheet. 6verheads are absorbed into the into the cost of 4obs using predetermined overhead absorption rates. The common method of fi"ing prices within the 4obbing industry is cost plus pricing. 9atch costing is similar to 4ob costing in that each batch of similar articles is separately identifiable. The cost per unit manufactured in a batch is the total batch cost divided by the number of units in the batch.

STUDENT:SEL TESTING SEL %E1IE2 3UESTIONS #. 2. %. '. &ention five types of costing methods >#.#What is 4ob costingF >2.0,ow are 4obs priced >'.0What is batch costing >7.0-

E4AMINATION TY&E 3UESTIONS 3UESTION ONE A small management consultancy firm has prepared the following information) 6verhead absorption rate per consulting hour 8alary cost per consulting hour >senior8alary cost per consulting hour >GuniorE#!270 E2!000 E#!700

The firm adds '0J to total cost to arrive at selling price. Assignment number 27; too ?; hours of a senior consultants time and 220 hours of 4unior time What price should be charged for assignment number 27;F A. 9. C. $. E#!?%'!#00 E #=20!000 E#!B#0!000 E#!700!%00

3UESTION T2O A company manufactures carpets for the hotel industry. Co finished stoc s are carried as the company only manufactures specifically to customer order. At the end of

month ;! one incomplete 4ob >Gob "#2'- remained in progress. Production costs incurred on the 4ob to the end of month ; were as follows) $irect materials $irect 2abour Production overhead Total =22!000 ;0=!;00 #!0'#!;00 2!%=#!200

$uring month =! the company accepted two further 4obs >Gobs L#27 and Gob L#2;- and incurred prime costs as follows)

$irect &aterial issued from stores $irect returned to stores $irect &aterial transfers $irect 2abour hours

Gob L#2' Gob L#27 Gob L#27 ;B=!?00 #!?BB!'00 #!222!#00 >=00!000- 2#=!000 ?;!000 >?;!000=?0 2!%;' #!7#0

$irect labor is paid at a rate of E=00 per hour. Production overheads are absorbed at a rate of E#!200 per direct labour hour. $uring month = Gobs L#2' and L#27 were completed. 6n completion of a 4ob! 20J of the total production cost is added in order to recover distribution! selling and administration costs. The amounts invoiced to customers during month = for the completed 4obs were) Gob L#2' Gob L#27 %e>uired #. (or each of the 4obs calculate the following total costs a- $irect materials b- $irect labour c- Production overhead 2. Calculate the total costs and profitA >loss- of each 4ob L#2' and L#27 E;!000!000 E=!B00!000

CHAPTER 11

CONTRACT COSTING
Introduction We now turn attention to a third specific order costing method called contract costing. Contracts are basically large long term 4obs. &ost of the costing principles covered under 4ob costing are also applicable to contract costing. The main difference is the recognition of attributable profit part way through the contract. CONTENTS #. 2. %. '. 7. What is contract costingF (eatures of contracts. Contract account. Profit ta ing. Accounting entries. LEA%NING OUTCOMES After studying this chapter you should be able to) Enow the characteristics of contract costing. 9e able to prepare a contract account. Calculate profits on completed and incomplete contracts. Prepare balance sheets entries relating to long3term contracts. 9e able to summarise standard accounting re1uirements regarding profits! losses and contract balances.

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DE INITION Contract costing is a form of specific order costing in which costs are attributable to individual contracts.

#.#

Contract costing has many similarities to 4ob costing and is usually applied to wor which is) *nderta en to customer<s special re1uirements. :elatively long duration. 8ite based and sometimes overseas. (re1uently of a constructional nature.

The main difference between a 4ob and a contract is one of siMe and time s!an. Contract costing is used by firms! which underta e building or other constructional wor that ta es years or months to complete. 1.) C5aracteristics o" contract costing Although details vary! certain characteristics are common to most contracts costing systems) ).0 ,igher proportion of direct costs 2ow indirect costs $ifficulties of cost control 8urplus materials

T%EATMENT O COSTS +ach contract is a separately identifiable cost unit! against which cost are collected and later used in profit computations. The various elements of cost are dealt with as follows. ).1 Direct materia#s

&aterials charged to a contract include materials specifically purchased for the contract! materials transferred from other contracts and materials issued from the stores. At the end of an accounting period! the contract account should be credited with) *nused materials. &aterials transferred to other pro4ects. &aterials returned to stores.

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Direct 6ages

The direct wages include wor done by the design and drawing office! wor done on the site. All labour employed on the site of the contract is direct. Time sheets may be used to disclose time spent by wor ers at different sites. All such labour costs are debited to the contract account. ).* Direct e.!enses

$irect contract costs other than materials and labour are often very significant and the two ma4or items falling within this category are plant and subcontracted wor . Plant used on a contract could come from the following sources) Plant specifically purchased for the pro4ect. Plant transferred from other contracts. Plant hired from outside the company.

The contract account should be debited with the cost of using the plant and this is done as follows) (or plant hired! the hire charge is the cost of using the asset and is charged to the contract. (or the assets owned by the company! depreciation represents the cost of using the plant and is therefore charged to the contract. 8ubcontracted wor M it is common in contract operation to find that the main contractor hires subcontractors to underta e some of the activities on a contract. The cost of any subcontracted wor is a direct e"pense of a contract and is debited to the contract account.

*.0

TE%MINOLOGY %ELATING TO T0E O&E%ATION O A CONT%ACT. (or contracts a price is agreed between the company and customer. (or large companies where wor is spread over a number of months or years! the contractor will receive progress payments. 8uch interim payments are based on the wor done involving certain procedures) Arc5itects certi"icates3 the architect issues a certificate showing the value of the wor completed on the contract. 9ased on the certificates the contractor issues an invoice to the customer as a demand for progress payment. %etention monies: this refers to monies which a client withholds from the total invoice amounts as he ma es progress payments to the contractor. :etention monies act as motivation for possible future rectification wor by the contractor.

8uch retention monies are therefore paid upon the completion of the contract when any faulty wor has been done. $.0 TA;ING &%O ITS ON LONG TE%M CONT%ACTS Where a contract e"tends over a long period! IA8## allows the contractor to ta e credit for part of the attributable profit to the contract in each year<s contract. This provision avoids inconsistency of having a number of years with no profit from a particular contract and then suddenly ma ing a huge profit in the year when the contract is completed. In deciding to what e"tent profit can be ta en on uncompleted contract! the following matters should be considered) o The successful outcome of the contract should be certain before any interim profit is ta en. o Any profits should only be ta en in proportion to the wor completed to date on the contract. o Any anticipated overall loss on the contract should be provided for as soon as it is recogni/ed. $.1 Guide#ines on ca#cu#ating interim !ro"it @arious possibilities e"ist for estimating the profit on incomplete contracts and several options are shown here below. The overriding principle is that a prudent view must always be ta en and the profit ta en should reflect the degree of completion. If the contract is at an early stage >say less than %0J complete- no profit should be ta en. Interim profits however calculated! should only be ta en when the final contract outcome of the contract can be assessed with reasonable certainty. $.) O!tions "or estimating interim !ro"its )xam focus Cote that in the e"am the approach you should adopt in estimating profit should be based on the re1uirements of the 1uestion and the available information. O!tion 1 When substantial costs have been incurred >say %0J 3 ?0J complete- a formula which has been traditionally used in the construction industry is)

Pro7it ta:en = 6" or "6& o7 the notional pro7it C Cash received 7ro< progress pay<ents )alue o7 wor: certi7ied

(here notional profit "ertified O!tion )

) Value of (or "ertified * "ost of (or

This approach involves the following five steps) Ste! 1 $etermine the total sales value of the contract 3 for fi"ed price contracts. this is simply the agreed contract price. Call this >aSte! ) Compute the total e"pected costs to complete the contract which consists of two elements) The actual costs incurred to date on the contract! plus The estimated future costs necessary to complete the contracts

Call this >bSte! * The e"pected overall profit on the contract is given by >a- M >bSte! $ The attributable profit to date on the contract should reflect the amount of wor that has been completed so far. It can be calculated as follows)
@alue of wor certified to date Total contract price

+stimated overall profit L

It is important to reali/e that the attributable profit calculated in the above formula is the cumulative figure.

Ste! , The profit to be ta en this year is the cumulative attributable profit calculated at step ' less the profit on the contract recogni/ed in the previous year. $.* E4AM&LE8 TA;ING &%O ITS ON INCOM&LETE CONT%ACTS Contract 2#' commenced during 200' and has a fi"ed contract price of E200million. The cost incurred during the year 200' for materials! wages and subcontractors charges totaled EB0 million. Plant costing E20 million was purchased during 200' specifically for the contract. At the end of 200') The plant was valued at E#7 million *nused materials on the site were valued at E#B million @alue of architects< certificate issued were E#00 million It is estimated that further costs totaling E=' million would be incurred in order to complete the contract. The figure includes the appropriate cost of plant and subcontractors in the future. :etention monies representing 20J of the certified value of the wor completed has been held bac by the client. The balance of the money has been paid. The contractor credits the contract account with the full value of the architects< certificates as they are received. %e>uired Compute estimated profit for 200' $.$ SOLUTION
Actual cost to date &aterials! 2abour and sub contractors< costs 2ess ) &aterials on site at end of 200' Add ) Plant depreciation >20!000 3 7!000Contract cost to date ;L000 B0!000 >#B!000=#!000 7!000 I-B000

Pro4ect costs to completion Contract cost to end of 200' +stimated future costs Tota# estimated contract !rice

=;!000 ='000 1,0B000

+stimated total contract price

EQ000

Contract Price Contract Cost +stimated profit

200!000 >#70!000,0B000

@alue of wor certified to date Total contract price

+stimated overall profit L

Profit ta en in 200' O

#00!000 200!000

L E 70!000!000 O E27!000!000

As this contract commenced in 200' and! the whole cumulative profit computed is attributable to 200'. $., CONT%ACT COST ACCOUNTING ENT%IES

The additional re1uirement in the contract costing 1uestions is to account for the entries relating to the contracts in the profit and loss account and balance sheet. The following 1uestion will be used to show entries in the profit and loss account and the balance sheet. 3uestion At the end of the year! C,A construction has three contracts in progress and their details are as follows)
Contract Contract price Cost to date +stimated costs to completion @alue of wor certified Progress payments received Cost of wor certified C, #0 ;L000 #70!000 %7!000 ??!000 '0!000 %'!000 2?!000 C, ## ;L000 2=7!000 #''!000 B;!000 #;7!000 #'0!270 #%?!000 C, #2 ;L000 #?7!000 #7'!000 =!000 #=2!000 #';!200 #70!000

%e>uired a- 9y assessing the degree of completion! decide on which contracts profits should be ta en and by how much. b- 8how the profit and loss entries. c- 8how the balance sheet entries.

$.-

SOLUTION aPro4ects on which to ta e profit

A!!ro.imate degree o" com!#etion Cost to date Total costs &ercentage com!#etion C,#0 %7!000 #2%!000 )JN C,## #''!000 2'0!000 -0N C,#2 #7'!000 #;#!000 K-N

C,#0 3 As C, #0 is still in its very early stages! no profit will be ta en based on the prudence concept. C,##3 As contract C,## is 2A% complete profit will be ta en on this contract using the traditional notional profit formula. C,#23 As the contract is almost complete! profit will be ta en using the total profit approach. '= AMOUNT O &%O IT

CONT%ACT N011
Profit ta en O 2A% L Cotional profit L Cash received from progress payments @alue of wor certified

(here notional profit ) Value of (or "ertified * "ost of (or "ertified

Profit ta en O 2A% " >#;7!0003#%?!000- " #'0!270A#;7!000 1,B*00 <;C000=

CONT%ACT N01)
@alue of wor certified to date Total contract price

+stimated overall profit L

Profit ta en in 200' O

#=2!000 #?7!000

L 2'!000

E ))B*1$

c=

&%O IT AND LOSS ACCOUNTING ENT%IES The amount of turnover and cost of sales to be ta en to profit and loss account will be those that will produce the profits computed above.

Contract N010 Co entries will be made in the profit and loss account as no profit will be computed. Contract N011 +ntries made in the P R 2 for this contract should give a profit of E#7!%00 >000-as computed above. This is achieved as follows)
Turnover O 2A% L @alue of wor certified L Cash received from progress payments @alue of wor certified ;K*B,00

Turnover >E< 000- O

2A% " E#;7!000 " #'0!270A#;7!000 O

Cost of sales O 2A% L Cost of wor certified L

Cash received from progress payments @alue of wor certified

Cost of sales >E<000- O

2A% " #%?!000 " #'0!270A#;7!000 O

;IJB)00

Profit and loss extract

Profit and 2oss entries Turnover Cost of sales &ro"it EQ000 B%!700 =?!200 1,B*00

CONT%ACT N01)
@alue of wor certified to date Total contract price

Turnover O Contract price

Turnover >NE000- O

#=2!000 #?7!000

L #?7!000

O #=2!000

@alue of wor certified to date Total contract price

Cost of sales O Total cost

Cost o7 sales .I+!!!/ =

#$ %!!! #10%!!!

C #(#%!!!

= #&'%(1(

Profit and loss extract

Profit and 2oss entries Turnover Cost of sales &ro"it EQ000 #=2!000 #'B!;?; ))B*1$

Summar( o" & O L entries "or t5e * contracts

Contract Turnover Cost o7 sales ;ro81t =D#! +3!!! * * 6 =D## +3!!! '"%0!! .$1% !!/ 1 ,300 =D# +3!!! #$ %!!! .#&'%(1(/ 22,31Total +3!!! (0%0!! . $%11(/ 3*,.1-

$.I

9ALANCE S0EET ENT%IES

+ntries in the balance sheet relating to contracts are of two types) i- 8traightforward entries such as) *nused materials which is reported as stoc s Plant on site which is reported under (i"ed assets

ii- Complicated entries which are) 8toc s) 2ong term3contract balances

2ong3term contract balances refers to wor which is done but not yet allocated to the profit and loss account. iiiCet difference 2ong term contract balances Cost incurred to date 2ess costs allocated to cost of sales LL >LLLL

De'tors8 Amounts reco+era'#e on #ong:term contracts This constitutes amounts ta en as turnover in the profit and loss account less progress payments received. Amounts recoverable on long3term contracts iAmounts ta en as turnover iiProgress payments received SSCet difference LL LL LL

++ ,hould a negative balance arise it is set off against the long- term contract balances.

9ALANCE S0EET ENT%IES USING T0E DATA A9O1E

Contract Amounts ta en as turnover 2ess progress payments Cet difference Cost to date Costs allocated to cost of sales Costs not allocated to cost of sales C,#0 EQ000 3 %'!000 >%'!000%7!000 3 %7!000 C,## EQ000 B%!700 #'0!270 >';!=70#''!000 =?!200 ;7!?00 C,#2 EQ000 #=2!000 #';!200 27!?00 #7'!000 #'B!;?; '!%#' Total EQ000 2;7!700 %20!'70 3 >7'!B70%%%!000 22=!??; #07!##'

Any negative balances under # are recovered from 2 and as such there would be no debtors 9a#ance s5eet entries8 Cet of #R2 8toc s) 2ong3term contract balances #!000 #B!070 %0!##' 70!#;'

C5a!ter summar( Contract costing is similar to 4ob costing and is used on relatively large scale! long3term contracts which are fre1uently site based. 9ecause of the separate nature of most site wor ! more costs can be identified as direct! including many which are normally indirect. The cost for use of plant bought for a contract is charged as depreciation. (or hired plant the cost charged is the hire fee. The contractor is paid interim amounts nown as progress payments >less retention monies- based on the surveyors certificates. :etention monies represent amounts deducted by the customer and are paid after the contract has ended. Profit on incomplete contracts should be underta en using conservative estimates. If a loss is e"pected for the contract as a whole the whole loss is recogni/ed in full in the accounts. Accounting entries must be made in the P R 2 and balance relating to long term contracts.

STUDENT:SEL TESTING

SEL %E1IE2 3UESTIONS #. 2. %. '. 7. ;. $efine contract costing >#.08tate some characteristics of contract costing >#.2,ow is the cost of using assets charged to contracts >2.%What are retention monies in relation to contract costingF >%.08tate the overriding principles in the computation of profit on contractsF >'.08tate one recommended method for computing profit in contract costingF >'.2-

E4AMINATION TY&E 3UESTIONS CONT%ACT COSTING 3UESTION A business has a contract that is due to run from #st Ganuary 20L7 to %0 Gune 20L;. The information about the contract at %#st $ecember 20L7 is as follows) Contract Price Wor certified at %#st $ecember 20L7 Cost incurred to %#st $ecember 20L7 (urther costs e"pected until end of contract %E3UI%ED The attributable profit for the year ended %#st $ecember 20L7 based upon the proportion of cost incurred to date is EKKKKK.. The attributable profit for the year ended %#st $ecember 20L7 based upon the proportion of the contract price completed is EKKKKK.. E'70 million E%00 million E2B7 million E=0 million

C=A;T?@ 12 PROCESS COSTING

Introduction ,aving loo ed at 4ob costing and batch costing in the previous chapter! we shall proceed to consider a third costing method called process costing. This chapter starts by considering the basics of the topic which are preparation of basic process accounts and later moving on to accounting for process losses and finally the valuation of wor in progress. The ne"t chapter will deal with the accounting for by products and 4oint products. CONTENTS #. Process costing. 2. Process losses. %. 8crap value. '. Abnormal gain. 7. +1uivalent units. ;. Closing Wor in progress. =. 6pening Wor in progress. LEA%NING OUTCOMES After reading this chapter you should be able to) Enow the features of process costing and the situation where the use of process costing is appropriate. 2earn how to prepare a process account. Enow the treatment of normal losses. Enow the treatment of abnormal losses and abnormal gains. 2earn how to account for scrap value of losses. *nderstand the concept of e1uivalent units for the valuation of wor in progress.

1.0

INT%ODUCTION TO &%OCESS COSTING

Process costing is a costing method used where production follows a series of se1uential processes. It is used in a variety of industries including) 1.) 6il refining (ood processing Paper ma ing 9rewing Chemical and drug manufacture EATU%ES O &%OCESS COSTING

Process production has the following features which ma e it different from other types of manufacturing operations) Process operations are continuous i.e. they never stop! materials are continually being added to operations and output is continually being produced e.g brewing and paint ma ing. $ue to the continuous nature of operations! there is normally opening wor in progress at the beginning and closing wor in progress at the end of the accounting period. The output of one process becomes input to the ne"t until the finished product is made in the final process. There is often a loss in process due to spoilage! wastage evaporation and so on. There could be more than one product produced from a common input. (or e"ample oil refinery may produce petrol! diesel! tar! etc. These products may be 4oint products or by products.

#.%

The main problems in process costing are) Preparation of process account Treatment of losses @aluation of wor in progress Costing of 4oint and by products

).0

&%E&A%ATION O &%OCESS ACCOUNTS

The following e"ample will be used to illustrate the preparation of a basic process account for a company operating a single process operation. In"ormation "or t5e &rocess In put to a process is 2000 g of materials costing E2 million 2abour cost was E# million Production overheads are absorbed at =7J of labour cost The process out put of 2000 g was transferred to the warehouse for sale. %e>uired Prepare a process account using the above information. P:6C+88 # ACC6*CT E<000 2 000 6utput to process 2 # 000 =70 * I,0 Tota#s

$irect materials $irect 2abour Production overheads Tota#s ).0

*nits 2!000

*nits 2!000

E<000 % =70

)B000

)B000

* I,0

&%OCESS LOSSES

$uring a production process! a loss may occur due to wastage! spoilage! evaporation and so on. These losses are dealt with as follows) ).1 Norma# #oss

Cormal loss is the e"pected amount of loss in a process. It is the level of loss or waste that management would e"pect to occur under normal operating conditions. Cormal loss is not given a cost. The cost of producing these units is borne by the good units. ).) A'norma# #oss

Abnormal loss is the amount by which the actual loss e"ceeds the e"pected or normal loss in a process. It can also be defined as the amount by which actual production is less than normal production. Abnormal loss is given a cost li e good units.

).*

A'norma# Gain

Abnormal gain is the amount by which actual output from a process e"ceeds the e"pected output. It is the amount by which actual loss is lower than e"pected loss. Abnormal gain is given a value. The value of abnormal gain is calculated in the same way we calculate the cost per unit of abnormal loss. It is calculated as the cost of production divided by the e"pected units of output. ).$ ILLUST%ATION F NO%MAL LOSS

The following e"ample will be used to demonstrate the accounting for normal loss! abnormal loss and abnormal gain. In put to a process is 2!000 g of materials costing E2 million 2abour cost was E #million Production overheads are absorbed at =7J of labour cost The process out put of #!?00 g was transferred to process 2 Cormal loss is #0J of input %e>uired 8how the process account.

*nit cost computation O

Process cost +"pected out >ta ing into account normal loss-

P:6C+88 ACC6*CT
$irect materials $irect 2abour Production overheads Tota#s *nits 2!000 E<000 2 000 # 000 =70 * I,0 6utput to process 2 Cormal loss Tota#s *nits #!?00 200 )B000 E<000 % =70 0 * I,0

)B000

).,

ACCOUNTING O% SC%A& 2oss may have a scrap value. The following basic rules are applied in accounting for this value in the process accounts.

>a>b-

:evenue from scrap is treated! not as an addition to sales revenue! but as a reduction in process costs. The scrap value of normal loss is used to reduce the material costs of the process as follows $+9IT 8crap account C:+$IT Process account with the scrap value of the normal loss.

>c-

The scrap value of abnormal loss is used to reduce the cost of abnormal loss as follows $+9IT 8crap account C:+$IT Abnormal loss account with the scrap value of abnormal loss! which therefore reduces the write3off of cost to the profit and loss accountF

>d-

The scrap value of abnormal gain arises because the actual units sold as scrap will be less than the scrap value of normal loss. 9ecause there are fewer units of scrap than e"pected! there will be less revenue from scrap as a direct conse1uence of the abnormal gain. The abnormal gain account should therefore be debited with the scrap value. $+9IT Abnormal gain account C:+$IT 8crap account with the scrap value of abnormal gain.

>e-

The scrap account is completed by recording the actual cash received from the sale of scrap as follows $+9IT Cash received C:+$IT 8crap account with the cash received from the sale of the actual scrap.

).-

ILLUST%ATION F A9NO%MAL LOSS

Input to a process is 2!000 g of materials costing E2 million 2abour cost was E #million Production overheads are absorbed at =7J of materials cost The process output of #!=00 g was transferred to process 2 Cormal loss is #0J of input %e>uired 8how the process account.

*nit cost O

Process cost +"pected output

E'!700!000 #?00 units

O E 2!700 per unit

1a#uation statement

+lement of output (inished goods Abnormal loss Tota#

*nits #!=00 #00

*nit cost @alues E E 2!700 '!270!000 2!700 270!000 $B,00B000

P:6C+88 ACC6*CT
$irect materials $irect 2abour Production overheads Tota#s )B000 *nits 2!000 ;C000 2!000 #!000 #!700 $B,00 6utput to process 2 Cormal loss Abnormal loss Tota#s *nits #!=00 200 #00 )B000 ;C000 '!270 0 270 $B,00

).I

ILLUST%ATION F A9NO%MAL GAIN

Input to a process is 2!000 g of materials costing E2 million 2abour cost was E #million Production overheads are absorbed at =7J of materials cost The process output of #!B00 g was transferred to process 2 Cormal loss is #0J of input %e>uired 8how the process account. *nit cost O Process cost +"pected output O E'!700!000 #!?00 units O E2!700 per unit

1a#uation statement 8tatement of valuation +lement of output (inished goods Abnormal gain Total *nits #!B00 #00 *nit cost @alues 2!700 E'!=70!000 2!700 E270!000 E7!000!000

P:6C+88 ACC6*CT
$irect materials $irect 2abour Production overheads Abnormal gain Tota#s *nits 2!000 E<000 2!000 #!000 #!700 270 $BI,0 6utput to process 2 Cormal loss Tota#s *nits #!B00 200 )B100 E<000 '!=70 0 $BI,0

#00 )B100

).J

T%EATMENT O SC%A& 1ALUE In order to illustrate the treatment of scrap value in process costing! the information in the above two illustrations >see paragraphs 2.; and 2.=- will be used.

).J.1

SC%A& 1ALUE AND A9NO%MAL LOSS All information as in paragraph 2.; e"cept that the loss has scrap value of EB00 per unit. All the relevant accounts will appear as shown below. *nit cost O Process cost less scrap from normal loss +"pected output O E'!700!000 M E#?0!000 #?00 units O E 2!'00 per unit

+lement of output (inished goods Abnormal loss Tota#

*nits #!=00 #00

*nit cost @alues E 2!'00 E'!0?0!000 E 2!'00 E2'0!000 ;$B*)0B000

P:6C+88 ACC6*CT
$irect materials $irect 2abour Production overheads Tota#s )B000 *nits 2!000 ;C000 2!000 #!000 #!700 $B,00 6utput to process 2 Cormal loss Abnormal loss Tota#s *nits #!=00 200 #00 )B000 ;C000 '!0?0 #?0 2'0 $B,00

A9C6:&A2 2688 ACC6*CT

Process account Tota#s *nits #00 100 ;C000 2'0 )$0 CashA9an PR2 Tota#s *nits #00 100 ;C000 B0 #70 )$0

C6:&A2 2688 ACC6*CT

Process account Tota#s *nits 200 )00 ;C000 #?0 1J0 CashA9an Tota#s *nits 200 )00 ;C000 #?0 1J0

).J.)

SC%A& 1ALUE AND A9NO%MAL GAIN All information as in paragraph 2.= e"cept that the loss has scrap value of EB00 per unit. All the relevant accounts will appear as shown below. *nit cost O Process cost less scrap from normal loss +"pected output O E'!700!000 M E#?0!000 #?00 units E ; )B$00 !er unit

STATEMENT O 1ALUATION +lement of output (inished goods Abnormal gain Tota# *nits #!B00 #00 *nit cost @alues E E 2!'00 '!7;0!000 2!'00 2'0!000 $BJ00B000

P:6C+88 ACC6*CT
$irect materials $irect 2abour Production overheads Abnormal gain Tota#s *nits 2!000 ;C000 2!000 #!000 #!700 2'0 $BI$0 6utput to process 2 Cormal loss Tota#s *nits #!B00 200 )B100 ;C000 '!7;0 #?0 $BI$0

#00 )B100

A9C6:&A2 5AIC ACC6*CT

CA2oss PR2 Tota#s

*nits #00 100

;C000 B0 #70 )$0

Process account Tota#s

*nits #00 100

;C000 2'0 )$0

C6:&A2 2688 ACC6*CT

Process Tota#s *nits 200 )00 ;C000 #?0 1J0 CashA9an Again Tota#s *nits #00 #00 )00 ;C000 B0 B0 1J0

*.0

COSTING O 2O%; IN &%OG%ESS

At the end of a period there may be some units that have been started but have not been completed. These are called closing wor 3in3progress. The costing problem to be dealt with is how to attribute costs to such incomplete units. The process account below will help to highlight the problem. P:6C+88 ACC6*CT
$irect materials $irect 2abour Production overheads Tota#s *nits 2!000 E<000 2!000 #!000 #!700 $B,00 (inished goods Closing WIP Tota#s *nits #!700 700 )B000 E<000 F F $B,00

)B000

As shown above! we have to apportion costs between finished output and the closing wor in progress. Apportioning costs in proportion to the number of units of finished output and closing WIP would not be fair because the closing WIP units are still incomplete. *.1 E3UI1ALENT UNITS To apportion costs fairly! we ma e use of the concept of e1uivalent units of production. +1uivalent units are notional whole units which represent incomplete wor ! and which are used to apportion costs between WIP and complete output.

E.am!#e Assume that in a given period production was 2!000 complete units and ;00 partly complete. The partly complete units are deemed to be =7J complete. Total e1uivalent production O Completed units P +1uivalent units in W3I3P O 2000 P T " ;00 O 2!'70 E )B$,0 *.) E4AM&LE F CLOSING 2O%;:IN:&%OG%ESS In a given period production and cost data were as follows) $aterials ./011 units costing !21.0. million 3abour costing !4.516 million Overheads costing ! 7 million Production was 2!?00 fully complete units and '00 partly complete units. The degree of completion of the '00 units WIP was as follows) $aterials 3abour Overheads %e>uired Calculate the total e1uivalent production! cost per unit and the value of WIP and the finished output. Cost &er Unit ;C000
%.%0 2.;0 2.00 I.K0

489 complete 719 complete 819 complete

E>ui+a#ent Units
Cost E#ement &aterial 2abour 6verheads Tota# 1a#uation o" C#osing 2or?:In:&rogress Cost E#ement &aterial 2abour 6verheads E>ui+a#ent Units F 2I& %00 2'0 200 Cost !er unit ;C000 %.% 2.; 2.0 (inished 6utput 2!?00 2!?00 2!?00 Closing WIP %00 2'0 200 Total %!#00 %!0'0 %!000

Tota# Costs ;C000

#0!2%0 =!B0' ;!000

1a#ue ;C000 BB0 ;2' '00

Tota#

)B01$

1a#uation o" inis5ed Goods Cost E#ement &aterial 2abour 6verheads Tota# E>ui+a#ent Units F 2I& 2!?00 2!?00 2!?00 Cost !er unit ;C000 %.% 2.; 2.0 1a#ue ;C000 B!2'0 =!2?0 7!;00 ))B1)0

&%OCESS ACCOUNT
$irect materials $irect 2abour Production overheads Tota#s *nits %!200 E<000 #0!2%0 =!B0' ;!000 )$B1*$ (inished goods Closing WIP Tota#s *nits 2!?00 '00 *B)00 E<000 22!#20 2!0#' )$B1*$

*B)00

*.*

O&ENING 2O%;:IN:&%OG%ESS

,aving dealt with closing WIP! it follows that there will be opening wor ing in progress at the beginning of the subse1uent period. This opening WIP will be partially complete and have a value brought forward from the previous period sometimes bro en down into various cost elements namely materials! labour and overheads each having a given level of completion and value. There are basically two approaches for dealing with situations involving opening WIP which are) The weighted average cost method (I(6 method

*.$

I O MET0OD 1ALUATION

This method assumes that units are dealt with on a first3in3first out basis so that the first wor to be done in a period is the completion of the opening WIP. The effect of this is that the closing WIP is valued at current period costs and part of the previous period<s costs brought forward in the opening WIP is attached to the cost of completed units. *., T0E 2EIG0TED A1E%AGE MET0OD

*nder this method the opening WIP values are added to the current costs to provide an overall average cost per e1uivalent unit. The effect of this is that both closing WIP and completed units are valued using the same average cost. Ceither of the valuation methods can be said to be incorrect or correct! they are simply two different cost attribution methods used to value wor in progress and completed output. *.E4AM&LE The following information relates to process 2 of a three stage process for the month of $ecember 20L7. At the beginning of period 2 there was ?00 units partly completed which had the following values)
Cost +lement &aterial transfer from Process # Added &aterials 2abour Production 6verheads Tota# $egree of Completion #00J 77J ;0J '7J EQ000 2'!;00 #;!?00 B!;00 =!200 ,JB)00

$uring the period #2 ;00 units were transferred from process # at a value of E#%B.7 million. The costs for the resources used in the current period were as follows)
&aterial 2abour 6verheads Tota# =2!000 7?!700 7'!;00 1J,B100

At the end of the period! the closing WIP was #!?00 units which were at the following stages of completion)
Cost +lement &aterial transfer from Process # Added &aterials 2abour Production 6verheads $egree of Completion #00J 70J '7J '0J

The balance of #%!700 was transferred to finished goods. %e>uired Calculate the value of units transferred to finished goods and the value of closing WIP and prepare process account using) iiiAverage cost method The (I(6 method

A1E%AGE COST MET0OD &%OCESS ACCOUNT

6pening WIP Transfer from P# $irect materials $irect 2abour Production overheads Tota#s *nits 2!'00 #2!B00 ;C000 7?!200 #%B!700 =2!000 7?!700 7'!;00 *J)BJ00 (inished goods Closing WIP Tota#s *nits #%!700 #!?00 1,B*00 ;C000 %70!B;0 %#!?'0 *J)BJ00

1,B*00

E>ui+a#ent Units Cost E#ement Trans"er "rom &1 &aterial 2abour 6verheads Tota# (inished 6utput #%!700 #%!700 #%!700 #%!700 Closing WIP #!?00 B00 ?#0 =20

Tota# Costs

Tot a#
1,B*00 1$B$00 1$B*10 1$B))0

Current Period

6pening WIP 2'!;00 #;!?00 B!;00 =!200 ,JB)00

Tota# Costs 1-$B100 JJBJ00 -JB100 -1BJ00 *J)BJ00

Cost &er Unit #0.=% ;.#= '.=; '.%7 1,.)I

#%B!700 =2!000 7?!700 7'!;00

1a#uation o" C#osing 2or?:In:&rogress

Cost E#ement Transfer from P# &aterial 2abour 6verheads Tota# 1a#uation o" inis5ed Goods

E>ui+a#ent Units : 2I& 1BJ00 K00 J10 I)0

Cost !er unit 10.I* -.1I $.I$.*,

1a#ue #B!%0; 7!770 %!?77 %!#2B *1BJ$0

Cost E#ement Transfer from P# &aterial 2abour 6verheads Tota#

E>ui+a#ent Units : 2I& 1*B,00 1*B,00 1*B,00 1*B,00

Cost !er unit 10.I* -.1I $.I$.*,

1a#ue #''!=B' ?%!270 ;'!2'7 7?!;=# *,0BK-0

I O MET0OD &%OCESS ACCOUNT

6pening WIP Transfer from P# $irect materials $irect 2abour Production overheads Tota#s *nits 2!'00 #2!B00 ;C000 7?!200 #%B!700 =2!000 7?!700 7'!;00 *J)BJ00 (inished goods Closing WIP Tota#s *nits #%!700 #!?00 1,B*00 ;C000 %7#.=0= %#!0B% *J)BJ00

1,B*00

Cost E#e men t (inished 6utput

Trans"er "rom &1 &aterial 2abour 6verheads Tota# 1a#uation o" C#osing 2or?:In:&rogress #%!700 #%!700 #%!700 #%!700

E>ui+a#ent Units Tota# Units 1)BK00 1*B0J0 1)BJI0 1*B1$0 Tota# costs ;C000 1*KB,00 I)B000 ,JB,00 ,$B-00 *)$B-00 Cost &er Unit ;C000 #0.?# 7.70 '.77 '.#; 1$.)1

Closing WIP #!?00 B00 ?#0 =20

6pening WIP >2!'00>#!%20>#!''0>#!0?0-

Cost E#ement Transfer from P# &aterial 2abour 6verheads Tota# 1a#uation o" inis5ed Goods

E>ui+a#ent Units : 2I& 1BJ00 K00 J10 I)0

Cost !er unit ;C000 10.J1 ,.,0 $.,, $.1-

1a#ue ;C000 #B!';7 '!B7' %!;?2 2!BB2 *1B0K*

Cost E#ement
Transfer from P# &aterial 2abour 6verheads

E>ui+a#ent Units : "inis5ed goods 11B100 1)B1J0 1)B0-0 1)B$)0

Cost !er unit ;C000 10.J1 ,.,0 $.,, $.1-

1a#ue ;C000 #20!0%7 ;=!0'; 7'!?#? 7#!;0? )K*B,0I

Tota#

STUDENT:SEL TESTING SEL %E1IE2 3UESTIONS #. 2. %. '. 7. ;. =. ?. 5ive e"amples of industries which use process costing >#.0 What are the ey features of process operations >#.2 What is normal loss >2.# What is abnormal loss >2.2 What is abnormal gain > 2.%,ow is scrap value treated in process costing >2.?# $efine e1uivalent units >%.# &ention two approaches for dealing with opening WIP >%.% -

E4AMINATION TY&E 3UESTIONS $ude Eings 2imited produces a detergent paste by putting it through a single process. Dou are given the following details for period 2) Input costs were 70!000 ilos at E'B; per ilo 2abour costs for #;!000 hours at E#!#00 per hour 6ver heads costs were E#2!;00!000 Dou are also informed that) iiiiiiivvCormal loss is 'J 8crap value of normal loss is E'00 per ilo (inished output amounted to %0!000 units Closing WIP amounted to #2!000 units and was fully complete for materials! U complete for labour and V complete for overheads. There was no opening WIP

%E3UI%ED a= Prepare the process account for period 2 detailing the value of the finished units and the wor 3in3progress. <10 mar?s= b- Prepare an abnormal loss account. <) mar?s=

CHAPTER 13 PROCESS COSTING ! BY PRODUCTS AND "OINT PRODUCTS

INT%ODUCTION The previous chapter introduced the process costing method including the treatment for losses and wor in progress. This chapter will deal with further complications in process costing where two or more products are output from the same process. When this happens the output items are called 4oint products or by products. In this chapter! attention will be focused on how to apportion the common process costs between 4oint products and by3products. CONTENTS #. The nature of 4oint products and by3products. 2. Goint costs. %. Costing 4oint products. '. Costing by products. 7. (urther processing decisions. LEA%NING OUTCOMES After studying this chapter you should be able to) $istinguish between 4oint products and by3products. +"plain the treatment of 4oint products and by3products at the point of separation. @alue by3products and 4oint products at the point of separation. $iscuss the usefulness of the cost and profit data for 4oint products. $ecide whether to further process products or not.

1.0

CONT%ASTING DOINT &%ODUCTS AND 9Y:&%ODUCTS

A single process might produce a number of different products. (or e"ample a chemical process such as oil refining might produce several products such as diesel! petrol! paraffin and lubricants from a single process. 8ome of these products could be classified as 4oint products while others would be by3products. #.# 9efore going further! the following ey terms would be defined) 1.) Goint products. 9y3products. Goint costs. 8plit3off point.

Doint !roducts Goint products are two or more products which are output from the same processing operation! but which are indistinguishable from each other up to their point of separation. They have significant or material sales value in relation to by3 products.

1.*

9(:!roducts A by3product is a supplementary or secondary product whose value is small relative to that of the principal product. 1.$ S!#it:o"" !oint

8plit3off point in a manufacturing operation is the point during manufacture where two or more products are produced from a common process. Items produced at the split3off point are either sold in their current form or put through further processing before sale. 1., Doint costs Goint costs or pre3separation costs are the costs incurred in a process up to the split3off point and must be apportioned amongst the products produced by the process. 1.20AT E4ACTLY SE&A%ATES A DOINT &%ODUCT 9Y: &%ODUCT7 %OM A

Doint !roducts have substantial sales value. They are regarded as important saleable items which should be costed separately and whose profitability should be analysed in the cost accounts.

The distinguishing feature of a '(:!roduct is its relatively low sales value in comparison to the main product. 9y3products are not an important saleable item and whatever revenue it earns is a bonus for the organi/ation. 9ecause of their relative insignificance! by products are not separately costed. ).0 &%O9LEMS IN ACCOUNTING O% DOINT COSTS

The problems in accounting for 4oint products relate to two main issues! namely) ).1 ,ow common costs should be apportioned between products in order to put value on closing stoc s and the cost of sales for each product. Whether it is more profitable to sell a 4oint product at one stage of processing or to process the product further and sell it at a later stage DEALING 2IT0 COMMON COST

The problem of costing 4oint products concerns common costs! i.e. those processing costs shared between the units of eventual output up to their split3off3 point. 8ome method needs to be devised for sharing the common costs between the individual 4oint products for the following reasons) 2.2 To put a value to closing stoc s of each 4oint product. To record the costs and therefore the profit from each 4oint product To assist in pricing

@arious methods might be used to establish the basis for apportioning or allocating common costs to each product including) Physical measurement 8ales value at split3off3point Cet reali/able value

).*

E.am!#e A process produces three 4oint products with the following volume and sales values at the split3off point)
Product L D Z Huantities in Eg #00!000 20!000 ?0!000 8elling price per Eg >Ewacha7!000 #0!000 '!700

The cost incurred in the process prior to the separation point of these three products were E2'0 million. %e>uired 8how how the 4oint costs would be apportioned to each product on the basis of) a- Physical 1uantities. b- :elative sales value at the point of separation. So#ution8 !5(sica# measures
aProduct L Proportions #00!000 200!000 20000 200!000 ?0!000 200000 L E2'0 million O EQ000 #20!000

L E2'0 million O

2'!000

L E2'0 million O

B;!000

Tota#

)$0B000

The sales values based on which the common cost is shared is determined as follows)
2or?ings "or sa#es +a#ues at t5e s!#it:o"":!oint 8elling price per Eg Product Huantities in Eg Ewacha #00!000 7!000 C 20!000 #0!000 E ?0!000 '!700 J Tota# sa#es +a#ue at s!#it:o"":!oint EQ000 700!000 200!000 %;0!000 #!0;0!000

b-

Product

Proportions

EQ000

700 #!0;0 200 #!0;0 %;0 #0;0

L E2'0 million O

##%!20?

L E2'0 million O

'7!2?%

L E2'0 million O

?#!70B

Total

2'0!000

).$ T0E NET ALLOCATION

%EALIPA9LE

1ALUE

MET0OD

COST

The net reali/able value of a 4oint product is its sales value minus its further processing costs after the point of separation. This is really a sales based method of apportionment which is used in situations where products are not sold at split3off3point but they are further processed. )., E4AM&LE Three 4oint products are produced from a common process)
Product L D Z Huantities 20!000 Eilos 7!000 2itres #0!000 2itres

The 4oint costs of processing up to the point of separation are E#;; million. Product Z can be sold immediately after separation for E#7!000 per litre. Product L needs further processing at a cost of E?!000 per ilo! before it is sold for E20!000 per ilo. Product D also needs further processing at a cost of E2!000 per ilo! before it is sold for E=!000 per ilo. %e>uired a- *sing the net reali/able value method apportion the 4oint process cost to the three products. b- Calculate the profit or loss per unit for each 4oint product. ).a=
Ste! 18 Determination o" net rea#isa'#e +a#ues Product

SOLUTION

>

*nits (inal selling Price (inal sales revenue >EQ000*nits (urther process cost per unit Total (urther process costs >EQ000Net rea#isa'#e +a#ue <?C000=

L 20!000 20!000 '00!000 20!000 ?!000 #;0!000 )$0B000

D 7!000 =!000 %7!000 7!000 2!000 #0!000 ),B000

Z #0!000 #7!000 #70!000 #0!000 3 3 1,0B000

Total

5 A6<

$1,B000

Ste! )8 A!!ortionment o" /oint costs using net rea#isa'#e +a#ue

L 2'0 '#7 27 '#7 #70 '#7 L E#;0 000 O ;L000 B2!7%0

L E#;0 000 O

B!;%B

L E#;0 000 O

7=!?%#

Total costs apportioned

E#;0!000

b&ro"it Statement Product (inal sales revenue Pre3separation costs (urther processing costs &ro"it *nits &ro"it !er unit <;C000= L EQ000 '00!000 >B2!7%0>#;0!0001$IB$I0 20!000 ;I.*I D EQ000 %7!000 >B!;%B>#0!0001,B*-1 7!000 ;*.0I Z EQ000 #70!000 >7=!?%#K)B1-K #0!000 ;K.))

*.0

ACCOUNTING O% 9Y:&%ODUCTS

8ince by products have very little sales value! it is pointless to try wor ing out a cost and a profit for units of by products. 9y3products are incidental output! not main products. %.# Accounting treatment of revenue from by3products)

Met5od 1 Income from the sale of by3product may be added to the sales of the main product! there by increasing sales turnover for the period. Met5od ) Instead of adding the income from by3product sales to total sales income in the profit and loss account! deduct the sales value of the by3product from the common processing costs. The pre separation costs for apportioning between 4oint products is therefore the actual pre3separation costs minus sales value of the by3products. $.0 E1ALUATING T0E 9ENE IT O U%T0E% &%OCESSING

A completely different costing problem arises when management decides what to do with 4oint products after the point of separation. A 4oint product might be in a condition to sell at the point of separation! but can also be processed further to sell at a higher selling price. In such cases management have to decide whether to sell the product immediately after the point of separation or whether to sell the product further before selling it. $.1 A!!roac5 to t5e !ro'#em is as "o##o6s8 The pre3separation costs of the common processing of the 4oint products are irrelevant to the further processing decision. The 4oint costs are not affected by whether individual products are further processed! and are therefore not relevant to the decision under consideration. In deciding whether to further process the individual product! incremental costs and revenues should be evaluated. Products whose additional revenue e"ceeds additional costs are the ones that should be further processed on financial grounds.

$.)

E4AM&LE

The following data relates to product L and D produced from a 4oint process)
Product Huantity Produced Eg #00 200 8ales at split3off3 point 27!000 #0!000 (urther processing Costs E#!'00!000 plus E#0!000 per g E?00!000 plus E=!000 per g 8ales price after further processing E'2!000 E22!700

A 9

Common costs prior to split3off point are E%.=7 million. %e>uired 8hould each product be sold at the split3off point or processed further before saleF $.* So#ution
L '2!000 27!000 #=!000 #00 #!=00!000 D 22!700 #0!000 #2!700 200 2!700!000

Products 8ales price after further processing 8ales at split3off3 point Incremental revenue per unit Cumber of units Total incremental revenue

Incremental costs) Cumber of units >Egs@ariable cost per unit >EwachaTotal variable costs >Ewacha(i"ed >EwachaTotal incremental costs >Ewacha-

#00 #0!000 #!000!000 #!'00!000 2!'00!000

200 =!000 #!'00!000 ?00!000 2!200!000

Net re+enue <cost= >Ewacha-

<I00B000=

*00B000

6n the basis of this computation it recommended that Product L is sold at split3off and product D is further processed.

C5a!ter summar( Goint products are two or more products separated in a process! each of which has a significant sales value compared to the other. A by3product is an incidental product from a process which has insignificant sales value compared to the main product The split3off3point or separation point is the point at which 4oint and by3products become separately identifiable. Goint costs are pre3separation costs incurred up to the separation point The main methods of apportioning 4oint costs! each of which can produce significantly different results. o Physical measures o 8ales value at split off3point o Cet realisable method 9y3products are not costed! but revenue which they generate can be directly added to sales or be deducted from the process costs. Where there is a possibility to further process 4oint products! the decision must be made by comparing incremental costs and revenue.

STUDENT:SEL TESTING SEL %E1IE2 3UESTIONS #. 2. %. '. 7. ;. =. What are 4oint costs >#.2What are 9y products >#.%What is the split3off point >#.'What are 4oint costs >#.7&ention the methods used apportion common costs >2.2,ow is by3product accounted forF >%.#What is the decision rule for ma ing further processing >'.#-

E4AMINATION TY&E 3UESTIONS Citrogen Chemicals 2td manufactures % chemicals! L D and Z from a single 4oint process. The information below relates to the month of 6ctober 20L7) Input into process $irect materials '0000 ilos I E;.' &illion $irect 2abour I E7.2 million (actory overheads I #70J of prime cost input

6utputs from processChemical L 3 2!700Eilos Chemical D 3 '00Eilos Chemical Z 3 700Eilos 9y3product normally account for #7J of input. $uring the month of 6ctober! by3products were actually #7J of input. This was sold for E#!700 per ilo and the proceeds from the sale were credited to the process account. 8elling Prices Chemical L 3 E#0!#;0 Chemical D 3 E#2!;'7 Chemical Z 3 E;!='0

%e>uired8 Calculate the total cost of each chemical L! D and Z using the following methods for splitting 4oint costs) a- @olume b- :elative sales value.

CHAPTER 14 SERVICE COSTING

Introduction In the previous chapters we have considered costing methods which are relevant to manufacturing operations. In this chapter we turn our attention to service costing! i.e. costing methods which are relevant to service organi/ations such as hospitals and education establishments. This costing method can also be used to cost output of service departments within an organisation. 8ervice costing is widely used today because more and more entities are operating in the service industry rather than manufacturing. CONTENTS #. 2. %. '. What is service costingF 8ervice costs and cost units. 8ervice costs analysis in service industry. 8ervice costing for internal services.

LEA%NING OUTCOMES After studying this chapter you should be able to) $escribe the circumstances in which service costing should be used. +"plain the practical problems that can arise with the costing of services. Illustrate suitable cost units that can be used in a variety of different service operations. Carry out service cost analysis in service industry situations. Carry out service cost analysis in internal service situations.

1.0

25at is ser+ice costing7 8ervice costing is a costing method concerned with establishing the costs! not of products but of services rendered.

1.1

25en to use ser+ice costing 8ervice costing is used in the following circumstances) A company operating in the service industry will use service costing to cost its output to customers. +"amples of service companies are telephone companies! power companies! auditing and management consulting firms. A service department such as IT department or repairs and maintenance within an organisation can use service costing methodology to cost the wor done for various internal departments.

#.2

8ervice costing compared with product costing The cost of direct materials will be relatively small compared with the costs of direct labour! direct e"penses and overheads Indirect costs will generally represent a higher proportion of total costs. 1.* Com!arison o" a !roduct and ser+ice

8pecific characteristics of services that distinguish them from products are intangibility! simultaneity! perishability and heterogeneity. 1.$ Intangibility M a service such as a hair cut is intangible. 8imultaneity M the production and consumption of a service ta e place at the same time. Perishability M a service cannot be stored for future consumption. ,eterogeneity M service provided cannot be e"actly the same every time.

Ser+ice costs and cost units A ma4or problem in service industries is the selection of a suitable unit for measuring the service. It is not easy to decide what service is actually being provided and what measures of performance are most appropriate to the control of costs. (re1uently a composite unit may be deemed more appropriate.

8ome of the cost units used in different activities are given below) Ser+ice ,otels +ducation ,ospitals Passenger transport Accountancy Cost unit 6ccupied bed3night (ull time student Patient days Passenger miles &an hour

A service business may use several different units to measure the various inds of service provided. (or e"ample a hotel with a restaurant and function rooms might use a different cost unit for each different service as shown below) SE%1ICE :estaurant ,otel service (unction facilities COST UNIT &eals served 5uest days ,ours rented

).0 COLLECTIONB CLASSI ICATION AND ASCE%TAINMENT O COSTS 2.# 6nce the appropriate cost unit has been identified! the ne"t critical step is to design an information system to collect appropriate statistical data. It is the responsibility of the cost accountant to design and manage the system for recording and analy/ing these costs. In a transport company! this may involve recording ilometers day by day for each vehicle in the fleet. A log sheet is normally used to capture this information. 6ther relevant information could include fuel usage per vehicle and loads or weight transported. (or each service! broad cost categories should be designed for the purpose of cost analysis. 8uitable cost codes would be re1uired to identify the categories. E.am!#e The costs of a transport underta ing can be classified under the following broad headings) 6perating and running costs :epairs and maintenance Annual direct e"penses Administration

2.2

2.% ).$

2.7

(or better cost analysis! there would be a need to have sub3classification of costs. (or e"ample the annual fi"ed costs could be bro en down as follows) ).:oad licence &otor vehicle insurance $epreciation @ehicle testing COST S0EETS

A cost sheet is a record of costs for each service provided. A typical cost sheet for a service would incorporate the following for the current details) Cost information under the appropriate headings Cost unit statistics Cost per unit Analyses based on the actual cost units

E4AM&LE F A COST S0EET O% A %ESTAU%ANT Cost Sheet Category (ood and $rin 2abour ,eating and 2ighting Consumables $epreciation Apportioned costs Cleaners Tota# Cumber of meals served Cost +er 2ea0 Cost 3 E #!#27!000 #!#27!000 #?=!700 ##2!700 #00!000 =70!000 ?=!700 3,-8*, 00 "$0 %,300

*.0

SE%1ICE COST ANALYSIS IN SE%1ICE INDUST%IES

3UESTION $ar (arms 2td operates a fleet of truc s whose standard costs have been established as follows) ;6ac 5a #0!000 #;0!000 #;0!000 700!000 700 270 #;0!000 ;00!000 #!000!000 #

Item o" e.!enditure 2oading cost ) 2abour >casual per hour+1uipment depreciation3 per wee 8upervision 3 per wee $rivers< wages Petrol per Eilometer :epairs per Eilometer $epreciation per wee per vehicle 8upervision 3 per wee 6ther general e"penses 2oading time per tonne 3 hours

There are ten drivers and ten truc s in the fleet. $uring a slac wee only si" 4ourneys were made and the details are as shown below) Gourney # 2 % ' 7 ; %e>uired Calculate the e"pected average full cost per tonneA ilometer for the wee . Tonnes carried 6ne way 7 ? 2 ' ; 7 $istance E& 6ne way #00 20 ;0 70 200 %00

*.1

So#ution Gourneys Total ; costs EQ000 EQ000 270 #!700 #!700 %!;70 =70 #!?27 2!700 ;!B=7

1aria'#e costs 2oading 2abour Petrol >both ways:epairs > both waysTota# +aria'#e costs i.ed costs +1uipment depreciation3 per wee 8upervision 3 per wee $rivers< wages $epreciation per wee per vehicle 8upervision 3 per wee 6ther general e"penses Tota# costs Gourney # 2 % ' 7 ; Tota# Tonnes carried 6ne way 27 '0 #0 20 %0 27

# 2 % ' 7 EQ000 EQ000 EQ000 EQ000 EQ000 270 '00 #00 200 %00 700 #00 %00 270 #!000 270 70 #70 #27 700 #!000 770 770 7=7 #!?00

#;0 #;0 700 #;0 ;00 #!000 KB,,, 6ne way distance E& 700 #00 %00 270 #000 #700 Tonne A ilometers #2!700 '!000 %!000 7!000 %0!000 %=!700 K)B000

A cost per tonne ilometre *.)

EB!777!000 O ;10*.JB2000

SE%1ICE COSTING O% INTE%NAL SE%1ICES

The service costing techni1ues and procedures used by service organi/ations can be used to cost the output of internal service departments. 9ut the 1uestion is why should we want to establish a cost for internal services provided by one department on behalf of anotherF

*.*

8ervice costing for internal services has two basic purposes) To control the costs in the service departments o 6nce cost per unit has been established! it can be compared with the target! budget or previous year<s figures for the purposes of control. To control the costs of the user departments in the following ways) o The overhead costs of the user department will be established more accurately. o The user department is discouraged to ma e wasteful use of the service departments. o The user department may be prompted to obtain a similar service e"ternally.

$.0

C0A&TE% SUMMA%Y 8ervice costing can be used by companies operating in a service industry and by service departments of organi/ations. Characteristics which distinguish a service from a product include) o Intangibility o 8imultaneity o Perishability o ,eterogeneity A common problem with service costing is that of identifying a suitable cost unit for costing purposes. As a result composite cost units are normally used. Total costs for the period Cumber of service units per period Cost per service unit

8ervice costing techni1ues are also used to establish costs for internal services which is a service provided by one department for another.

STUDENT:SEL TESTING SEL %E1IE2 3UESTIONS #. 2. %. '. 7. What is service costingF >#,ow is service costing applied >#.#&ention some features of services that distinguish them from products >#.%5ive e"amples of cost units commonly used in the service industry >#.'5ive reasons for costing of internal services >%.%-

E4AMINATION TY&E 3UESTIONS A transport business operates a fleet of #0 vehicles. 6perating data are as follows) Cost Item Purchase of vehicles >depreciated on a straight line basis over ' years @ehicle disposal value >after ' years:oad fund licence and insurance Tyres >? per vehicle and renewed every '0!000 m8ervicing >every #;!000 m(uel >consumption of # litre per %.2 m$rivers ># driver per vehicle@ehicle usage >in Eilometres%e>uired Calculate the total vehicle operating costs per ilometre. ;L000Unit o" measurement 700!000 20!000 ##!'70 #!070 %!270 7 B0!000 ?0!000 (or #0 vehicles per vehicle Per vehicle per year per tyre per vehicle service per litre per driver per year Per vehicle per year

CHAPTER 15 STANDARD COSTING

INT%ODUCTION This chapter introduces you to the concept of standards! an idea which is fairly common to many day to day activities. (or instance as a student of accountancy how many times have you heard your fellow students comment on the standard of tuition they are receiving. In a similar vain as a management accountant you can set a standard cost for products and services. This chapter loo s at the uses of standard costing! the standard setting process and review of such standards.

CONTENTS #. 2. %. '. 7. 8tandard cost. 8tandard costing. Types of standard. Preparation of standard costs. The need to review standards.

LEA%NING OUTCOMES After studying this chapter! you should be able to) $efine standard cost and standard costing. +"plain types of operations most suited for standard costing. *nderstand how standards are set. +"plain why standards should be continuously reviewed.

1.0

INT%ODUCTION

We shall start this chapter by defining the following terms) 1.1 8tandards 8tandard cost 8tandard costing STANDA%D

A standard is a benchmar measurement of resource usage! set in defined conditions. 1.) STANDA%D COST

A standard cost is the planned unit cost of the products! components or services produced in a period. The main uses of standard costs are in performance measurement! control! stoc valuation and in the establishment of selling prices.
<CIMA #fficial $erminolo%&'

A standard cost is built up using the following elements of cost) 1.* 2abour. &aterials. @ariable overheads. (i"ed overheads. STANDA%D COSTING

8tandard costing involves the establishment of predetermined estimates of the costs of products or services! the collection of actual costs and the comparison of the actual costs with predetermined estimates. The predetermined costs are nown as standard costs and the difference between standard and actual costs is nown as a variance. 8tandard costing was developed primarily for use in the manufacturing industry as a formal method for calculating the e"pected costs of products. It differs from general budgeting >which is normally concerned with the costs of sections of organisation-! because it focuses on the cost of what the organisation produces M the units costs.

1.$

20E%E S0OULD STANDA%D COSTING 9E USED

8tandard costing can be used in a variety of operations such as 4obbing manufacture! process manufacture and mass production. ,owever! the greatest benefit can be gained by operations that are highly repetitive where the average or e"pected usage of resources can be determined. It is therefore most suited to mass production and repetitive assembly wor . 1., COM&OSITION O STANDA%D COSTS

The composition of standard costs whether you are calculating the standard cost of a rubber washer! an aeroplane or ship replacement operation can be analysed into common elements. These are the same elements of cost that you have come across before in the earlier chapters) Direct costs $irect materials $irect 2abour $irect +"penses Indirect Costs @ariable overheads (i"ed overheads

#.; Traditionally these elements of cost are shown on a standard cost card li e the one below)

STANDA@D COST CA@D

$irect materials &aterial L &aterial D $irect 2abour 5rade A 5rade 9 @ariable Production overhead (i"ed Production overhead Total standard cost 7 gs I E20!000AEg %Egs I E#0!000AEg ;hrs I E#7!000A,r ?hrs I E20!000A,r #' ,rs I #0!000Ahr #' ,rs I 7!000Ahr ;C000 #00 %0 B0 #;0 #'0 =0 7B0

).0

DE%I1ING STANDA%DS

The responsibility for deriving standard costs should be shared between managers able to provide the necessary information about levels of e"pected efficiency! prices and overheads. ).1 SOU%CES O IN O%MATION O% STANDA%D SETTING E#ement o" cost &aterials price Source o" in"ormation $ata from suppliers :ecord of previous prices paid Anticipated cost inflation Anticipated demand for scarce supplies Production schedules and bul buying discounts 8easonality of prices Anticipated currency e"change rates Product specification Technical data from suppliers ,istorical data on 1uantities used in the past 6bservation of manufacture +stimates of wastage Huality of materials Production e1uipment Current pay rates Anticipated pay rises The e"pected effects of bonus schemes +1uivalent pay rates of other employers Changes in legislation 5rade of labour $ata on previous output and efficiency levels :esults of formal observations >wor study Anticipated changes in wor practices or productivity levels The level of s ills of employees to be used Accounting

&aterial usage

2abour rate

2abour hours

6verheads

).*

T0E USES O STANDA%D COSTING

Although standard costing has several uses! the two principal uses of standard costing are) To act as control device. To value stoc s and production.

6ther use of standard costing include ).$ To assist in budget setting. To provide a prediction of future costs to be used in decision ma ing situations. To motivate staff and management by the provision of challenging targets. To provide guidance on possible ways of improving efficiency. TY&ES O STANDA%D Idea# standard3 a standard which can be attained under perfect wor ing conditions) no allowance is given for wastage! idle time and brea downs. Attaina'#e standard3 a standard which assume efficient levels of operation! but which include allowances for normal losses waste and machine down time. Current standard3 a standards based on current levels of efficiency in terms of allowances for brea downs! wastage! losses and so on 9asic standard3 a standard established for use over a long period of time from which a current standard can be developed. IM&ACT O STANDA%DS ON EM&LOYEE 9E0A1IO% Impact The employees may feel that the goals are unattainable and so they will not wor so hard. The employees are li ely to be motivated to wor harder as the standards are challenging but achievable

).,

Type of standard Ideal Attainable

Current 9asic

+mployees are unli ely to be motivated to do more than they are doing at the moment. +mployees are unli ely to be motivated by these standards which are easily achievable by employees. &%O9LEMS O SETTING STANDA%DS

).-

Common problems encountered in the standard setting process include) ).I ,ow to deal with inflation Who to set efficiency standards ,ow to incorporate the need for continuous improvement. %E1IE2ING STANDA%DS

&anagement should not thin that once standards are set they would remain useful forever. 8tandards must evolve to reflect the organisation<s changing methods and processes. Comparing out of date standards with actual results will provide misleading information. &any organi/ations have adopted the approach of revising standards whenever changes of a permanent and reasonably long3term nature occur. C0A&TE% SUMMA%Y A standard cost is an estimated unit cost built from each element of cost. 8tandard costing is primarily used to value production and stoc s and as a cost control tool. 8tandard costing is most suited to mass production and other repetitive operations. There are four types of standards namely ideal! attainable! current and basic. 8tandards should be revised when there is change of a permanent nature.

STUDENT:SEL TESTING SEL %E1IE2 3UESTIONS #. 2. %. '. 7. $efine a standard >#.#$efine standard cost >#.2$efine standard costing >#.%&ention some sources of information for preparing standards >2.#&ention four types of standards >2.'-

E4AMINATION TY&E 3UESTIONS (rom the following data prepare the standard cost card for one unit of the single product manufactured) $irect materials) #0 g of material L I E# ;00 per g =.7 g of material D I E2 700 per Eg $irect 2abour) Preparation #' hours I E% =70 per hour Assembly 7 hours I E7 000 per hour The budgeted total overheads for one year are)

Preparation department Assembly department

E<000 ?? #70

,ours 20!000 2'!000

The fi"ed overheads >included in the above figures- are E27 000 and E'? 000 respectively. The standard cost card should show sub totals for) Prime cost @ariable production cost Total production cost

CHAPTER 16 VARIANCE ANALYSIS

INT%ODUCTION ,aving introduced the concept of standard costing in the previous chapter! this chapter will deal with the computation of cost variances and e"planation of the possible causes of variances. CONTENTS #. 2. %. '. 7. @ariance accounting. 2abour variances. &aterial variances. 6verhead cost variances. Causes of variances. LEA%NING OUTCOMES After studying this chapter you will be able to) Enow what is meant by variance and variance analysis. *nderstand the relationship between variances. Calculate cost variances. +"plain the causes of variances.

1.0

1A%IANCE ANALYSIS

A variance is defined as) The difference between a planned! budgeted! or standard cost and the actual cost incurred. #.# @ariance analysis is defined as) The evaluation of performance by means of variances! whose timely reporting should ma"imi/e the opportunity for managerial action.
C h a r t o 7 c o < < o n v a r ia n c e s o p e r a t in g p r o 7 it v a r ia n c e T o t a l c o s t v a r ia n c e T y p e t it le h e r e T o t a l L a b o u r v a r ia n c e T o t a l M a t e r ia l ) a r ia n c e T o t a l v a r ia b le o v e rh e d v a r ia n c e E x p e n d it u r e ) a r ia n c e E 7 7 ic ie n c y ) a r ia n c e T o t a l , ix e d ; v e rh e a d ) a r ia n c e ) lu < e ) a r ia n c e C a p a c it y v a r ia n c e E x p e n d it u r e ) a r ia n c e T o t a l s a le s < a r g in v a r ia n c e ? a le s < a r g in p r ic e v a r ia n c e ? a le s < a r g in H u a n t it y ) a r ia n c e

8 a te v a r ia n c e

E 7 7 ic ie n c y ) a r ia n c e

P r ic e ) a r ia n c e

2 sage ) a r ia n c e

E 7 7 ic ie n c y v a r ia n c e

When actual results are better than e"pected results we have a favourable variance and when the actual results are worse than the e"pected results! we have an adverse variance #.2 @ariances can be divided into three main groups @ariable cost variance (i"ed production overhead variances 8ales variance >licentiate level material-

1.*

;EY ILLUST%ATION

The following e"ample will be used to illustrate the computation of all cost variances. Eipata manufacturing company produces a single product which is nown as Eiwaya. The product re1uires a single operation and the standard cost for this operation is presented in the following standard costs card.

STANDA@D COST CA@D

$irect materials &aterial L $irect 2abour 5rade A @ariable Production overhead (i"ed Production overhead Total standard cost 8tandard Profit Standard &rice 0.7 gs I E'0!000AEg E<000 20

2 hours I E20!000A,r 2 hours I E%!000A,r 2 ,rs I E%=!000Ahr

'0 ; =' #'0 ;0 )00

9udgeted output for Gune was 7!#00 units. Actual results for Gune were as follows) Production of '!?70 units was sold for E #!0'2.=7 million. &aterials consumed in production amounted to 2!%00 ilos at a cost of EB?.B million 2abour hours paid amounted to ?!000 hours at a cost of E#;2 million Actual variable overheads amounted to E2; million (i"ed over heads amounted to E'2% million %E3UI%ED This information will be used to define and calculate the following variances)

1.$0

TOTAL DI%ECT MATE%IAL COST 1A%IANCES The direct material cost variance is the difference between what the output actually cost and what it should have cost in terms of materials. T#$%& '()*+$ ,%$*)(%& +#-$ .%)(%/+*- = (Standard material cost per unit 0 Actual units produced) (Actual cost of materials) *sing the data above)

DI@?CT 9AT?@IAL AA@IANC? CALCULATION

8tandard material cost per unit Cumber of units produced Actual cost O Total material variance O E20!000 '!?70 units EB?!B00!000 >'!?70 " E20!000- M >EB?!B00!000; 1BK00B 000 <A=

1.$1

DI%ECT MATE%IAL &%ICE 1A%IANCE

This is the difference between the standard cost and the actual cost of the actual 1uantity of materials used or purchased. In other words it<s the difference between what the material did cost and what it should have cost. D()*+$ M%$*)(%& P)(+* V%)(%/+*- = (SP - AP) x QP where: SP = Standard Price AQ = Actual Quantity QP = Quantity Purchased

*sing the data above)

DI@?CT 9AT?@IAL ;@IC? AA@IANC? CALCULATION

8tandard material price per Eilo Huantity of materials purchased Cost of materials purchased &aterial Price @ariance O E20!000 '!?70 units EB?!B00!000 W'0!000 M >B?!B00!000A2%00-X " 2!%00 >'0!000 M '%!000- " 2!%00 ;-BK00B000 <A=

1.$)

DI%ECT MATE%IAL USAGE 1A%IANCE

This is the difference between the standard 1uantity of materials that should have been used for the number of units actually produced and the actual 1uantity of materials used valued at the standard cost per unit of material. D()*+$ M%$*)(%& U-%1* V%)(%/+*- = (SU AU) x SP here: SU = Standard Usa!e = "um#er of units produced x standard usa!e per unit AU = Actual Usa!e SP = Standard Price

DI@?CT 9AT?@IAL USA>? AA@IANC? CALCULATION

8tandard &aterial price per Eilo Actual materials used 8tandard material usage per unit Cumber of units produced &aterial *sage @ariance O E20!000 2!%00 ilos 0.7 g '!?70 W>'!?70 " 0.7-3 2%00X " E'0!000 >2!'273 2!%00- " '0!000 E ;,B000B000 < =

1.,0

TOTAL DI%ECT LA9OU% COST 1A%IANCES

The direct labour cost variance is the difference between what the output actually cost and what it should have cost in terms of labour. T#$%& '()*+$ &%2#3) +#-$ .%)(%/+*- =
(Standard la#our cost per unit 0 Actual units produced) (Actual cost of la#our)

*sing the data above)

DI@?CT LA<OU@ COST AA@IANC? CALCULATION

8tandard 2abour cost per unit Cumber of units produced Actual cost O Total material variance O E'0!000 '!?70 units E#;2!000!000 >'!?70 " E'0!000- M >#;2!000!000; *)B000B 000 < =

1.,1

DI%ECT LA9OU% %ATE 1A%IANCE

This is the difference between the standard cost and the actual cost of the actual number of hours used. In other words it is the difference between what the labour did cost and what it should have cost. D()*+$ L%2#3) R%$* V%)(%/+*- = (S$ - A$) x A% here: S$ = Standard $ate A% = Actual %ours A$ = Actual $ate *sing the data above)

DI@?CT LA<OU@ @AT? AA@IANC? CALCULATION

8tandard 2abour rate per hour 2abour hours used Actual 2abour cost 2abour :ate @ariance O E20!000 ?!000 hours E#;2!000!000 W>E20!000 M >E#;2!000!000!000A?!000-X " ?!000 >20!000 M 20!270- " ?000 ;)B000B000<A=

1.,)

DI%ECT LA9OU% E

ICIENCY 1A%IANCE

This is the difference between the standard of labour that should have been used for the number of units actually produced and the actual number labour hours used valued at the standard labour hour rate. D()*+$ L%2#3) E44(+(*/+5 V%)(%/+*- = (S% - A%) x S$ here: S% = Standard %ours for actual production = "um#er of units produced x standard usa!e per unit A% = Actual %ours ta&en to produce the output S$ = Standard $ate per hour

DI@?CT LA<OU@ ?77ICI?NCB AA@IANC? CALCULATION

8tandard 2abour ,ours per unit Actual 2abour hours used 8tandard 2abour hours per unit Cumber of units produced &aterial *sage @ariance O E20!000 ?!000 ,ours 2 ,ours '!?70 W>'!?70 " 2-3 ?!000X " E20!000 >B!=003 ?!000- " E20!000 O ;*$B000B000 < =

1.-0

TOTAL 1A%IA9LE &%ODUCTION O1E%0EAD 1A%IANCE The difference between what the output should have cost and what it did cost in terms of variable production overheads. TOTAL 1A%IA9LE &%ODUCTION O1E%0EAD (Standard 'aria#le o(erhead cost per unit 0 Actual units produced) (Actual cost of 'aria#le production o(erheads)

*sing the data above)

TOTAL AA@IA<L? ;@ODUCTION OA?@=?AD COST AA@IANC? CALCULATION

8tandard @6, cost per unit Cumber of units produced Actual cost O Total @6, cost variance O E;!000 '!?70 units E2!;00!000 >'!?70 " E;!000- M >E2;!000!000; *B100B 000 < =

1.-1

1A%IA9LE O1E%0EAD E4&ENDITU%E 1A%IANCE

This is the difference between the amount of variable overheads that should have been incurred in the actual hours actually wor ed and the actual amount of variable overheads incurred.. V%)(%2&* 6)#'3+$(#/ #.*)7*%' *06*/'($3)* V%)(%/+*- = ()'*% x A%) - A'*% here: )'*% = )ud!eted 'aria#le *(erhead $ate A% = Actual %ours A'*% = Actual 'aria#le *(erhead $ate *sing the data above)

AA@IA<L? OA?@=?AD ?:;?NDITU@? AA@IANC? CALCULATION

9udgeted @ariable overhead rate per hour 2abour hours used Actual @ariable overhead Cost @ariable overhead e"penditure @ariance O E%!000 ?!000 hours E2;!000!000 >%!000 " ?000- M E2;!000!000 E2'!000!000 M E2;!000!000 ;)B000B000 <A=

1.-)

1A%IA9LE O1E%0EAD E

ICIENCY 1A%IANCE

This is the difference between the standard cost of the hours that should have been wor ed for the number of units actually produced and the cost for the units actually produced. V%)(%2&* O.*)7*%' E44(+(*/+5 V%)(%/+*- = (S% - A%) x )'*% here: S% = units A% = )'*% Standard %ours for actual production = "um#er of produced x standard usa!e per unit Actual %ours ta&en to produce the output = )ud!eted 'aria#le *(erhead $ate

AA@IA<L? OA?@=?AD ?77ICI?NCB AA@IANC? CALCULATION

9udgeted variable overhead rate per hour Actual 2abour hours used 8tandard 2abour hours per unit Cumber of units produced @ariable overhead +fficiency E%!000 ?!000 ,ours 2 ,ours '!?70 W>'!?70 " 2-3 ?!000X " E%!000

@ariance O

>B!=003 ?!000- " E%!000 O ;,B100B000 < =

TOTAL 7I:?D ;@ODUCTION OA?@=?AD COST AA@IANC? CALCULATION

8tandard (6, cost per unit Cumber of units produced Actual cost O Total (6, cost variance O 1.I0 E='!000 '!?70 units E'2%!000!000 >'!?70 " E='!000- M >E'2%!000!000;-$B100B 000 <A=

TOTAL I4ED O1E%0EAD 1A%IANCES

The difference between fi"ed overhead incurred and fi"ed production overhead absorbed. In other words it is the under or over absorption. TOTAL I4ED &%ODUCTION O1E%0EAD8 (Standard +ixed *(erhead ,ost per unit 0 Actual units produced) (Actual cost of +ixed Production *(erheads) *sing the data above) 1.I1 I4ED O1E%0EAD E4&ENDITU%E 1A%IANCE

This is the difference between the budgeted fi"ed overhead e"penditure and actual fi"ed overhead e"penditure. F(0*' 6)#'3+$(#/ #.*)7*%' *06*/'($3)* V%)(%/+*- = ()+*% - A+*%) here: )+*% = )ud!eted +ixed *(erhead A+*% = Actual +ixed *(erhead *sing the data above)

7I:?D OA?@=?AD ?:;?NDITU@? AA@IANC? CALCULATION

9udgeted (i"ed 6verhead Actual (i"ed 6verhead Cost E='!000 " 7!#00 E%==!'00!000 E'2%!000!000

(i"ed 6verhead +"penditure @ariance O 1.I)

E%==!'00!000 M E'2%!000!000 ;$,B-00B000 < =

I4ED O1E%0EAD 1OLUME 1A%IANCE

(i"ed 6verhead @olume @ariance is the difference between actual and budgeted productionAvolume multiplied by budgeted fi"ed overhead absorption rate per unit. F(0*' 6)#'3+$(#/ #.*)7*%' V#&3,* V%)(%/+*- = ()' - A') x )+*% here: )' = )ud!eted 'olume A' = Actual 'olume )+*% = )ud!eted +ixed *(erhead per unit

7I:?D OA?@=?AD AOLU9? AA@IANC? CALCULATION

9udgeted @olume Actual @olume 7!#00 *nits '!?70 *nits

9udgeted (i"ed 6verhead rate per E='!000 unit (i"ed 6verhead @olume @ariance >'!?70 M 7!#00 - " ='!000 O ;1JB,00B000 <A=

1.I*

I4ED O1E%0EAD 1OLUME E

ICIENCY 1A%IANCE

This is the difference between the standard cost of the hours that should have been wor ed for the number of units actually produced and the cost for the units actually produced. F(0*' O.*)7*%' E44(+(*/+5 V%)(%/+*- = (S% - A%) x )+*% here: S% = units A% = )+*% Standard %ours for actual production = "um#er of produced x standard usa!e per unit Actual %ours ta&en to produce the output = )ud!eted +ixed *(erhead $ate

7I:?D OA?@=?AD AOLU9? ?77ICI?NCB AA@IANC? CALCULATION

9udgeted (i"ed overhead rate per hour Actual 2abour hours used 8tandard 2abour hours per unit Cumber of units produced (i"ed overhead +fficiency @ariance O E%=!000 ?!000 ,ours 2 ,ours '!?70 W>'!?70 " 2-3 ?!000X " %=!000 >B!=003 ?!000- " %=!000 O ;-)BK00B000 < = 1.I$ I4ED O1E%0EAD 1OLUME CA&ACITY 1A%IANCE

The difference between budgeted hours of wor and the actual hours wor ed multiplied by the standard absorption rate. F(0*' O.*)7*%' .#&3,* +%6%+($5 V%)(%/+*- = (A% - )%) x )+*% here: )% = A% = )+*% )ud!eted hours to produce #ud!eted (olume Actual %ours ta&en to produce the output = )ud!eted +ixed *(erhead $ate

7I:?D OA?@=?AD AOLU9? CA;ACITB AA@IANC? CALCULATION

9udgeted Capacity Actual 2abour hours used 9udgeted (6, rate per ,our unit Cumber of units produced (i"ed overhead +fficiency @ariance O 7!#00 " 2 #0!200 ,ours ?!000 ,ours E%=!000 '!?70 >?!000 M #0!200- " E%=!000 O ;J1B$00B000 <A=

).0

T0E %EASON O% 1A%IANCES There now follows a list of possible cause of variances. This is not an e"haustive list and in an e"amination 1uestion you should review the information given and use your imagination and common sense to suggest possible reasons for variances.

1A%IANCE &aterial Price

A1OU%A9LE *nforeseen discounts received 5reat care in purchasing Change in material standard &aterial used of higher 1uality than standard &ore effective use made of material errors in allocating material to 4obs *se of wor ers at a rate of pay lower than standard The idle time variance is always adverse 6utput produced more 1uic ly than e"pected! because of wor motivation! better 1uality of e1uipment or materials +rrors in allocating time 4obs

AD1E%SE Price increase Careless purchasing Change in material standard $efective material +"cessive waste Theft 8tricter 1uality control +rrors in allocating material to 4obs Wage rate increase &achine brea down Con3availability of material Illness or in4ury to wor er 2ost time in e"cess of standard allowed 6utput lower than standard set because of lac of training! sub3standard material etc. +rrors in allocating time to 4obs Increase in cost of services +"cessive use of services Change in type of services used Production or level of activity less than budgeted

&aterial *sage

2abour :ate Idle Time

2abour +fficiency

6verhead +"penditure

8aving in costs incurred &ore economical use of services

6verhead @olume

Production or level of activity greater than budgeted

C5a!ter summar( @ariances measure the difference between actual results and e"pected results. The direct material total variance can be subdivided into the direct material price variance and the direct material usage variance. $irect material price variance are e"tracted at the time of receipt of materials! not time of usage The direct labour total variance can be subdivided into direct labour rate variance and direct labour efficiency variance. The variable production overhead total variance can be sub divided into variable production overhead e"penditure variance and the variable production overhead efficiency variance

The fi"ed production overhead total variance can be subdivided into e"penditure variance and volume variance. The volume variance can be subdivided into efficiency variance and capacity variance. STUDENT:SEL TESTING SEL %E1IE2 3UESTIONS #. What is variance analysis F>#.0 2. &ention the sub components of fi"ed overhead variance. >#.='%. &ention some causes of variances >'.0E4AMINATION TY&E 3UESTIONS DI%ECT MATE%IAL COST 1A%IANCES #. C 2td uses a standard costing system. The standard cost card for one of its products shows that the product should uses 'Egs of material 9 per finished unit and the standard price per Eg is E'!700. (or the month of April! the budgeted production level was #!000 units and the actual units made were #0'0 units. The actual material 1uantity of material 9 used was '!#00 Egs. The cost of the material 9 which was purchased was E#'.' million. %e>uired Calculate total material variances and analyse it into price and usage variances DI%ECT LA9OU% COST 1A%IANCES

2.

Z plc uses a standard costing system and has the following labour cost standard in relation to one of its products) ' hours direct labour I E;!000 per hour O E2'!000 $uring 6ctober 20L7! %!%70 of these products were made which was #70 units less than budgeted. The labour cost incurred was E=B!?B%!000 and the number of direct labour hours wor ed was #%!'70. %e>uired Calculate total labour variances and analyse it into rate and efficiency variances for the month of 6ctober. I4ED O1E%0EAD COST 1A%IANCES

%.

A company budgets to produce #!000 units of product + during august. The e"pected time to produce a unit of + is five hours! and the budgeted fi"ed production overheads is E20 million. The standard fi"ed production overhead cost per unit of product + will therefore be 7 hours I E'!000 >OE20!000-. Actual fi"ed production overhead e"penditure in august turns out to be E20!'70!000. The labour force manages to produce #!#00 units of product + in 7!'00 hours of wor . %e>uired Calculate the following fi"ed production overhead variances abcdeTotal variance. +"penditure variance. @olume variance. @olume efficiency variance. @olume capacity variance.

CHAPTER 17 COST BOOKKEEPING

Introduction This chapter introduces you to the concept of Cost 9oo eeping. This is a systematic way of recording cost accounting transactions in the boo s of accounts in order to facilitate the preparation of financial statements CONTENTS #. 2. %. '. Introduction The dichotomy The integrated system The interloc ing system

LEA%NING OUTCOMES After studying this chapter you should be able to) *nderstand the theory underlying cost boo eeping. :ecord systematically cost accounting transactions in cost ledger accounts. +ffectively carry out the double entry in the cost ledgers using integrated accounts and interloc ing accounts. $ifferentiate interloc ing accounts from integrated accounts.

1.0

INT%ODUCTION
Cost boo eeping is a systematic way of recording cost accounting transactions in the boo s of accounts in order to facilitate the preparation of financial statements relating to the calculation of profits or losses of products or services offered. The ey areas of cost accounting transactions are mainly those that relate to the elements of cost or principles of costing which are materials! labour and overheads. These three elements ma e up the total cost of a product or service.

1.1

Materia#s &aterials can be direct and indirect and can be raw materials! wor in progress and finished goods. (or direct materials we open in the cost ledger! stores control account or materials control account! wor in progress account and finished goods account. (or indirect materials we open the production overhead control account

1.)

La'our 2abour can be direct and indirect. (or direct labour! in the cost ledger we open the wages control account and the wor in progress accounts. (or indirect labour we open the production overhead control account. 1.* O+er5eads

All indirect costs are overheads. 6verheads can be production and non3 production .all overheads can be absorbed into products using various bases. We determine differences between actual overheads and absorbed overheads the results are over absorption or under absorption which increases or reduces the profits. The full double entry will be shown later. ).0 T0E DIC0OTOMY

In the accountancy profession! there are three accounting dimensions) financial accounting! cost accounting and management accounting. In the recent years! the three dimensions have been reduced to only two. that is financial accounting and management accounting. Cost accounting is now part of management accounting. &ost manufacturing businesses adopt one of the following systems of cost accounting)

iiiiiiiv).1

An independent system A reconciled system An integrated system An interloc ing system Inde!endent S(stem

In this system! no reconciliations are necessary between cost accounts and financial accounts. The two sets of accounts are ept separately. 8ome manufacturing businesses have adopted this system. ).) %econci#ed S(stem In this system! financial accounts are independently ept from cost accounts. 9oth sets of accounts each produces a profit figure. The profit figures produced must be reconciled 4ust as we reconcile the cashboo balance with a ban statement balance. The reconciliation can begin from the financial profit figure and end with cost accounts profit figure! additions and subtractions have to be made ta ing into account items in cost accounts and items not in cost accounts. This system is also common to the interloc ing system. *.0 INTEG%ATED SYSTEM

In this system! both financial accounts and cost accounts are lin ed together and presented as one set of accounts! the system uses one common system of input data. There is no need for the reconciliation since only one profit figure is arrived at. In this system there are resource accounts! accounts which record the cost of production items from the start of production wor through to cost of sales as mentioned above! sales account! and profit and loss account. 9y using the integrated system! savings in administration are made. The disadvantage is that the system is re1uired to serve two purposes i.e. e"ternal reporting and internal reporting and this disadvantage has been overcome by the use of computers.

*.1

E4AM&LE A 2T$ manufacturing company operating an integrated system had the following results for the year ended %#st $ecember 200;) 9alances at #A#A200;) :aw materials control Wor in progress control (inished goods control Transactions for the year were) &aterials purchased on credit &aterials purchased for cash $irect materials issued to production Indirect materials issued $irect wages incurred Indirect wages incurred Actual 8elling and administrative overhead Production completed and transferred to cost of sales Production cost of sales Credit sales $epreciation production e1uipment $irect and indirect wages paid ;000 #00 #0 ?0 #7 70 20 #2 #70 #?0 270 7 =0 ;000 27 '0 7;

Production overhead is absorbed at the rate of ?0 percent of actual direct wages. %e>uired Prepare the following ledger accounts) #. 2. %. '. 7. ;. =. ?. :aw materials control Wor in progress control (inished goods control Production overhead control Wages control 8elling and administrative overhead control Cost of sales Trading and profit and loss.

SOLUTION :AW &AT+:IA2 C6CT:62 ACC6*CT ;000 ;000 9alance bAd 27 Wor in progress control ?0 Creditors #00 Production overhead control #7 Cash #0 9alance cAd '0 #%7 #%7 W6:E IC P:65:+88 C6CT:62 ACC6*CT ;000 9alance bAd '0 (inished goods control :aw materials control ?0 9alance cAd Wages control 70 Production oAhead control '0 2#0 (ICI8,+$ 566$8 C6CT:62 ACC6*CT ;000 9alance bAd 7; Cost of sales Wor in progress control #70 9alance cAd 20; P:6$*CTI6C 6A,+A$ C6CT:62 ACC6*CT ;000 :aw materials control #7 Wor in progress control Wages control 20 $epreciation 7 '0 WA5+8 C6CT:62 ACC6*CT ;000 =0 Wor in progress control Production oAhead control =0

;000 #70 ;0 3 33 2#0

;000 #?0 2; 20;

;000 '0 3 3 '0

9an

;000 70 20 =0

9an

8+22IC5 AC$ A$&ICI8T:ATI@+ 6A,+A$ C6CT:62 AAC ;000 ;000 #2 Profit and loss #2 #2 #2

C68T 6( 8A2+8 ;000 (inished goods control #?0 #?0

Profit and loss

;000 #?0 #?0

T:A$IC5 AC$ P:6(IT AC$ 2688 ACC6*CT ;000 Cost of sales #?0 8ales3debtors 5ross profit cAd =0 270 5ross profit bAd 8elling and admin overheads #2 Cet profit for the year 7? I0 $.0 INTE%LOC;ING SYSTEM

;000 270 YYY 270 =0 333 I0

In an interloc ing system! cost accounts and financial accounts are ept separately but are put together through the use of a cost ledger control account or are reconciled by other means such as a reconciled system described above. A cost ledger control account is an account that represents financial accounts that are not in the cost ledger such as cash! receivables! payables etc. This system provides solutions to answers for internal reporting purposes and not e"ternal reporting. STUDENT:SEL TESTING SEL %E1IE2 3UESTIONS ;. $efine cost boo eeping =. +"plain fully the double entry for materials. ?. $escribe fully the treatment of production overheads and non production overheads in cost accounts. B. $efine e"plain and give an e"ample of an integrated system. #0. ,ow are e"penses dealt with in cost boo eepingF ##. $ifferentiate between cost accounts and financial accounts and also between interloc ing accounts and integral accounts. #2. +"plain fully the ey items that differentiate integral accounts from interloc ing accounts. #%. +"plain fully the double entry for the wages. #'. 6ver and under absorption are important to cost boo eeping for both integral and interloc ing accounts. +"plain.

#7. +"plain how depreciation affects cost boo E4E%CISES 3UESTION ONE F INTEG%ATED SYSTEM

eeping.

Prepare Gournal entries without narrations for the following list of transactions) #. 2. %. '. 7. ;. Purchases of raw materials on credit E20 000 :aw materials issued to production E#2 000 &aintenance materials issued E' 000 Cash paid for indirect production wages E#0 000 $epreciation of machinery used for production E; 000 Absorption of production overhead E? 000

3UESTION T2O F INTE%LOC;ING SYSTEM 5iven below are incomplete cost accounts for a period for which final accounts are to be prepared. &AT+:IA28 C6CT:62 AC6*CT ;000 9alance bAd ; 000 G2CA 5 ledger control 2= 000 9alance cAd ;000 #B 000 F

P:6$*CTI6C WA5+8 C6CT:62 ACC6*CT ;000 ;000 5.2edger control 27 000 G2CA F P.6.C6CT:62 F P:6$ 6.C6CT:62 F

P:6$*CTI6C 6@+:,+A$ C6CT:62 ACC6*CT. ;000 ;000 5.ledger control 2; 000 Production wages control F P.wages control F &.control F G69 2+$5+: C6CT:62 ACC6*CT ;000 20 000 Cost of sales

9alance bAd

;000 F

&.control Wages control Prod.oAh control

#B 000 F F

9alance cAd

#0 000

8+22IC5 AC$ A$&ICI8T:ATI6C 6A,+A$ ACC6*CT ;000 ;000 5 ledger control #2 000 PR2 F Cost of sales F C68T 6( 8A2+8 ;000 G2CA F PR2 8RA 6A, account F 8A2+8 ACC6*CT ;000 F 5.2edger control 5+C+:A2 2+$5+: C6CT:62 ACC6*CT ;000 ##0 000 9alance bAd &.control account Wages control Production oAhead control 8RA 6Ahead 22 000 Cet profit

;000 F

PR2

;000 ##0 000

8ales

Closing balance

;000 2; 000 2= 000 27 000 2; 000 #2 000 F

?0J of the production wages incurred are charged directly to 4obs. Production overheads are absorbed at a predetermined rate of #70J of direct wages! and selling and administration overheads at #0J of sales. %e>uired a. b. c. 2ist characteristics of the cost accounting system which identifies the type of system being used. 2ist the missing amounts in the above accounts! determine the profit or loss for the period and list the balances to be carried forward to the following period. What is the purpose of a cost ledger control account in an interloc ing systemF

ANSWERS TO EXAMINATION TYPE QUESTIONS

C5a!ter 1 Huestion # Huestion 2 C5a!ter ) 3uestion one abcdefIndirect $irect Indirect Indirect Indirect Indirect C 9

3uestion t6o 0.1 A+oida'#e costs

Avoidable costs are specific costs of an activity or business which would be avoided if the activity or business did not e"ist. 0.) Una+oida'#e costs

*navoidable costs are costs which would be incurred whether or not an activity or sector e"isted. 0.% A cost centre is an area of a business > a department! location! or item of e1uipment- in relation to which costs may be ascertained for cost control and product costing. 8eparate production and service departments in a factory may each be a cost centre for e"ample. Alternatively! a department may consist of more than one cost centre where costs may be separately ascertained for each cost centre and an individual held responsible for the costs in each case. A cost unit is a 1uantitative unit of a product or service in relation to which costs are ascertained. In manufacturing! cost units will be units of output produced within production cost centres. If the manufacturing unit is on a 4ob order basis! the cost unit will be the individual 4obs for the customers. If the manufacturing

unit is a continuous process with output of homogeneous product! the cost unit will be a standardised 1uantity of output e"pressed in terms of units! weight or volume. 8imilarly in a service operation costs may be related to either individual 4obs or per unit of service such as cost per hour of service. C5a!ter *

Cost>E<000,igh activity 2ow activity Change @ariable cost per unit Activity '2 %% B ;'? B ;!=00 ;!072 ;'? O =2

(i"ed costs O Total cost 3 variable cost E<000 O ;=00 3 >=2 " '2- O *B-ITotal cost at =7 units O %;=; P >=2 " =7- O

KB0I-

Total cost at B0 units O %;=; P >=2 " =7- O

10B1,-

C5a!ter $ 3UESTION 18 9
Cost o" issues under t5e I O met5od Issue 700 #!000 #!;00 ?00 %!B00 @alue #!270 2!=70 '!'?0 2!%20 #0!?00

3UESTION )8 C

O?00A#200 " %'?0

Cost o" issues under t5e LI O met5od EQ000 Total :eceipts #;!%#0 2ess Issues #!200 B00 2!#00 #!700 %00 %!'?0 2!720

OB00A#;00 " ''?0

O%00A#;00 " ''?0

'!%70 ?'0 ##!#B0 ,B1)0

C#osing Stoc?

3UESTION *8 D
Cost o" issues under t5e A1CO met5od *nits Average price :eceipts 700 2.70 @alue EQ000 #!270

:eceipts :eceipts :eceipts Tota# Issue 9alance :eceipts Tota#

#!000 #!;00 #!200 $B*00 >2!#002!200 #!700 *BI00

2.=7 2.?0 2.B0 ).IJ 2.=? 2.=? 2.B0 ).J*

2!=70 '!'?0 %!'?0 11BK-0 >7!?'#;!##B '!%70 10B$-K

C5a!ter

3uestion8 1

C %eorder #e+e# E ma.imum Usage . ma.imum #ead time $)0 . 1, E -B*00

1 Ma.imum stoc? E reorder #e+e# G reorder >uantit( F <minimum usage . minimum #ead time= -B*00 G IB000 F <1J0 . 11= E 11B*)0 3uestion8 ) 9

Minimum stoc? #e+e# E %eorder #e+e# F <a+erage usage . a+erage #ead time= -B*00 F <*,0 . 1*= E 1BI,0 3uestion8 * ) 9

Z Z

) . ,,B000. $000 )00 G 10N . )00 ''0000000 220

#!'#'

C5a!ter 3uestion 1a

Chila 9asic 6ver time Premium 3 first % ,rs 6ver time Premium 3 ne"t 2 ,rs Total 9onus standard Time allowed >'0 min " =2Actual Time 8aving 9onus Pay Total Pay >'7 " B20>% " #A% " B20>2 " #A2 " B20'#!'00 B20 B20 '%!2'0

'? '7 % >% " B20 " =7J2!0=0 $,B*10

Cheta 9asic 6ver time Premium 3 first % ,rs 6ver time Premium 3 ne"t % ,rs Total 9onus standard Time allowed >'0 min " #??Actual Time 8aving 9onus Pay Total Pay >'; " B;0>% " #A% " B;0>% " #A2 " B;0''!#;0 B;0 B;0 ';!0?0

'= '; # ># " B;0 " =7J2!#;0 $JB)$0

Chulu 9asic >'' " B'0'#!%;0

6ver time Premium 3 first % ,rs 6ver time Premium 3 first 2 ,rs Total 9onus standard Time allowed >'0 min " '%2Actual Time 8aving 9onus Pay Total Pay

>% " #A% " B'0>2 " #A2 " B'0-

B'0 B'0 '%!2'0

70.' '' ;.' >;.' " B;0 " =7J-

'!7#2 $IBI,)

3uestion 1'
Cet pay computation 5ross Pay PAD+ CAP8A &u uba Pension Net &a( Chila '7!%#0 >#%!7B%>%!000>2!700)-B)1I Cheta '?!2'0 >#'!'=2>%!000>2!700)JB)-J Chulu '=!=72 >#'!%2;>%!000>2!700)IBK)-

3uestion 1c
Gournal +ntry Wages Account PAD+ CAP8A &u uba Pension 8alaries Control Tota# 1$1B*0) $: #'#!%02 C:

'2!%B# B!000 =!700 ?2!'## 1$1B*0)

9eing wages cost for the month

C5a!ter

So#ution 1.1 Answer is C

So#ution 1.) Answer is C So#ution 1.* Answer is A So#ution 1.$ Answer is 9 SOLUTION T2O a=
6verhead Analysis 8heet 6verhead Indirect &aterial Indirect Wages &anagers 8alaries $epreciation of machinery ,eating and 2ighting 9uilding insurance Insurance of &achinery :ent and rates Totals 9asis of apportionment $irect $irect Co of employees @alue of &achinery Area Area @alue of &achinery Area Total overhead Production departments 8ervice departments &achining Assembly 8tores &aintenance 2'7!000 #00!000 ?0!000 70!000 #7!000 2=7!000 B0!000 ;0!000 =0!000 77!000 =0!000 2#!000 2?!000 ##!200 B!?00 #70!000 #20!000 %0!000 3 3 70!000 #!270 #?!=70 #=!700 #2!700 27!000 ;27 B!%=7 ?!=70 ;!270 #00!000 ?0!000 20!000 3 3 =7!000 #!?=7 2?!#27 2;!270 #?!=70 BB0!000 '#'!=70 2='!270 #?%!=00 ##=!%00

'=
6verhead 9asis of apportionment O+er5ead Ana#(sis S5eet Total overhead Production departments &achining Assembly 8ervice departments 8tores &aintenance

Totals &aintenance 8tores Total

EQ000 BB0!000 3 3 KK0B000

EQ000 '#'!=70 72!=?7 #'#!2;B -0JBJ0$

EQ000 EQ000 2='!270 #?%!=00 70!'%B #'!0=; 7;!70= >#B=!==;*J1B1K3

EQ000 ##=!%00 >##=!%003 3

&achining 6ver heads &achine hours EQ000 ;0?!?0' #00!000

Assembly 6ver heads &achine hours EQ000 %?#!#B; ?0!000

6,A:

E ;.0B per hour

6,A:

E'.=; per hour

c=
Tota# costs "or Do' 4 EQ000 $irect &aterials Direct La'our &achining >E7!000 " #000 hrsAssembly O+er5eads &achining Assembly Tota# >'00hrs " E ;.0B>?00hrs " E '.=;2!'%; %!?0? 1IB)$$ >E7!000 " ?00 hrs2!000 7!000 '!000

C5a!ter Part >a-

J Part >bEQ000 #?0!000 3

A'sor!tion Cost Statement 8ales >B!000 L E206pening 8toc

Production cost >##!000 " E#2Closing 8toc >2!000 " E#2Cost of 8ales 5ross Profit >E#?0!000 3 E#0?!0006ther +"penses @ariable selling costs >E# L B!000(i"ed selling costs >E2 " #0!000*nder absorption >see wor ingNet &ro"it

#%2!000 >2'!000#0?!000 I)B000 >B!000>20!000'!000 $IB000 Margina# Cost Statement 8ales >B!000 L E206pening 8toc Production cost >##!000 " E?Closing 8toc >2!000 " E?@ariable Cost of 8ales @ariable selling costs >B!000 " #Total @ariable costs Contri'ution <;1J0B000:;KKB000= i.ed costs Production >#0!000 " '8elling >#0!000 " 2Net &ro"it EQ000 #?0!000 3 ??!000 >#;!000=2!000 B!000 ?#!000 KKB000 >'0!000>20!000*KB000

UnderAO+er a'sor!tion (i"ed Production 6, Absorbed overheads Actual overheads 6ver absorption EQ000 ''!000 '0!000 '!000

Part >cProfit :econciliation Absorption Cost Profit 2ess ) (Acosts in CAstoc &ro"it as !er margina# costing EQ000 '=!000 >?!000%B!000

C5a!ter

Traditiona# costing
Product *nits &atches 7!000 Candles =!000 9udgeted ,ours 2abour ,ours # 2 Total ,ours 7!000 #'!000 #B!000 9udgeted 6verheads 9udgeted ,ours E 2?7!000!000 #B!000 ;1,B000 !er 5our

6verhead Absorption rate O

6verhead Absorption rate O

O 6verhead absorbed per unit &atches Candles # " #7 2 " #7 #7!000 %0!000

'= Acti+it( 9ased Costing a!!roac5

Cost per driver computation 6verhead costs :elating to &achine activity :elating to production run set ups :elating to handling of orders EQ000 220!000 20!000 '7!000 2?7!000 Cumber of cost drivers 220003 machine hours 70 3 number of setups in the period =7 3 number of orders in the period Cost per $river E#0!000 per ,r E'00!000 per setup E;00!000 per order

6verhead costs per unit :elating to &achine activity :elating to production run set ups :elating to handling of orders Total costs &atches #0 " % " 7!000 '00 " #0 ;00 " #7 #70!000 '!000 B!000 #;%!000 Candles #0 " # " =!000 '00 " '0 ;00 " ;7 =0!000 #;!000 %B!000 #27!000

*nits Cost per unit >E<000-

7000 %2.;0

=000 #=.?;

C5a!ter

10 ; #=2!000 %%0!000 702!000 %?2!700 1B*J-B,00 77'!;00 1BK$1B100 Gob L#2' Materia# costs $irect &aterial issued from stores $irect returned to stores $irect &aterial transfers &aterial Cost &onth ; costs Total material costs La'our costs $irect 2abour hours :ate Per hour 2abour cost &onth ; costs Total labour cost &roduction o+er5ead $irect 2abour hours 6verhead absorption :ate Per hour 2abour cost &onth ; costs Total labour cost Gob L#2' ;B=!?00 Gob L#27 #!?BB!'00 >=00!000?;!000 #!2?7!'00 #!2?7!'00 2!%;' =00 #!;7'!?00 #!;7'!?00 Gob L#27 #!222!#00 2#=!000 >?;!000#!%7%!#00 #!%7%!#00 #!7#0 =00 #!07=!000 #!07=!000 Gob L#27 Gob L#27

So#ution 1 8alary cost per consulting hour >senior8alary cost per consulting hour >GuniorTotal 2abour cost 6verhead absorption rate per consulting hour Tota# cost Profit &ar up &rice "or t5e assignment So#ution ) a-

E2!000 " ?;hrs E#!700 " 220hrs E#!270 " %0;hrs

'0 J of #!%?;!700

;B=!?00 =22!000 #!'#B!?00 =?0 =00 7';!000 ;00!=;0 #!#';!=;0

=?0 #!200 B%;!000 #!0'#!;00 #!B==!;00 Do' 41)$ '!7''!#;0 B0?!?%2 7!'72!BB2

2!%;' #!200 2!?%;!?00 2!?%;!?00 Do'41), 7!===!000 #!#77!'00 ;!B%2!'00

#!7#0 #!200 #!?#2!000 #!?#2!000

b-

Tota# costs and !ro"its Total Production costs $istribution! selling R admin costs Total costs

8ales invoices &ro"it C5a!ter SOLUTION

Contract Price Cost to date +stimated future costs +stimated total costs +stimated total profit >aCost to date +stimated total costs EQ000 '70!000 2B7!000 =0!000 >%;7!000?7!000 2B7!000 %;7!000 L ?7!000 O

;!000!000 ,$IB00J

=!B00!000 K-IB-00

11

E<000

-JB-KK

>b-

Wor certified Contract Price

%00!000 '70!000

L ?7!000 O

,-B--I

C5a!ter a=

1)

&%OCESS ACCOUNT
$irect materials $irect 2abour Production overheads Tota#s ,0B000 *nits 70!000 E<000 2'!?00 #=!;00 #2!;00 ,,B000 (inished goods Closing WIP AA2oss CA2oss Tota#s *nits %0!000 #2!000 ;!000 2!000 ,0B000 E<000 %;!000 ##!000 =!200 ?00 ,,B000

'= A9C6:&A2 2688 ACC6*CT

Process account *nits ;!000 E<000 =!200 CashA9an PR2 *nits ;000 E<000 2!'00 '!?00

Tota#s

100

IB)00

Tota#s

100

IB)00

2or?ings W# Cost &er Unit ;C000

0.70 0.'0 0.%0 1.)0

).1.1.1 E>ui+a#ent Units

Cost E#ement &aterial 2abour 6verheads Tota# (inished 6utput %0!000 %0!000 %0!000 AA2oss ;!000 ;!000 ;!000 Closing WIP #2!000 ?!000 ;!000 Total '?!000 ''!000 '2!000

Tota# Costs ;C000

2'!000SS #=!;00 #2!;00

SS E2'!?003 ?00 beings scrap value of normal loss W2

1a#uation o" C#osing 2or?:In:&rogress Cost E#ement &aterial 2abour 6verheads Tota# 1a#uation o" inis5ed Goods Cost E#ement &aterial 2abour 6verheads Tota# E>ui+a#ent Units F 2I& %0!000 %0!000 %0!000 Cost !er unit ;C000 0.7 0.' 0.% 1a#ue ;C000 #7!000 #2!000 B!000 *-B000 E>ui+a#ent Units F 2I& #2!000 ?!000 ;!000 Cost !er unit ;C000 0.7 0.' 0.% 1a#ue ;C000 ;!000 %!200 #!?00 11B000

W%
1a#uation o" a'norma# Loss Cost E#ement &aterial 2abour E>ui+a#ent Units F 2I& ;!000 ;!000 Cost !er unit ;C000 0.7 0.' 1a#ue ;C000 %!000 2!'00

6verheads Tota#

;!000

0.%

#!?00 IB)00

C5a!ter

1*
*nits Costs EQ000 '!000 ;!'00 7!200 ##!;00 #=!'00 2B!000 >;00>B00%!'00 2?!#00

Process costs $irect materials $irect 2abour Total Prime Costs (actory overhead >#70J of E##.;mTotal Process Costs 2ess 9y3product salesSS Goint costs to be apportioned

SS Cote the treatment of the sales value of the by3product which has been deducted from the process costs. aA!!ortionment o" /oint costs using 1o#ume EQ000 2700L %B!=00 O 2B!#B# C %!'00 E '00L %B!=00 O %!'00 700L %B!=00 O %!'00 '!;=#

7!?%?

Tota# costs a!!ortioned

*KBI00

2or?ings "or sa#es +a#ues at t5e s!#it:o"":!oint Product Huantities in Eg 8elling price per Eg Ewacha 2!700 #0!#;0 C '00 #2!;'7 E 700 ;!='0 J Tota# sa#es +a#ue at s!#it:o"":!oint

EQ000 27!'00 7!07? %!%=0 %%!?2?

bA!!ortionment o" /oint costs using re#ati+e sa#es +a#ues at s!#it:o"" EQ000 L 27!'00 L E2?!#00 O 20!;;2 %%!?2? D 7!07? %%!?2? %!%=0 %%!?2? L E2?!#00 O %!%0;

L E2?!#00 O

'!#%2

Tota# costs a!!ortioned

)JB100

C5a!ter

1$

Cost Item $epreciation of vehicles W>700!0003 20!000-A#0 X A ' :oad fund licence and insurance Tyres >?0!000A'0!000- " ? " #070 8ervicing >?0!000-A#;!000 " %270 (uel >?0!000A#0- " 7 $rivers Tota# Eilometres per year Cost !er ;i#ometre

EQ000 =!700 ##!'70 #;!?00 #;!270 '0!000 %;!000 #2?!000

?0!000 1.-0

C5a!ter

1,

Standard Cost Card Direct materia#s

+ Costs + #(%!!! #1%$0! "&%$0!

#0 g of material L I E#!;00 per g =.7 g of material D I E2!700 per Eg &aterial cost $irect 2abour) Preparation #' hours I E%!=70 per hour Assembly 7 hours I E7!000 per hour &rime Cost The budgeted total overheads for one year are) @ariable 6verheads Preparation #' hours I E%!#70 per hour Assembly 7 hours I E'!270 per hour 1aria'#e &roduction Costs (i"ed 6verheads Preparation #' hours I E#!270 per hour Assembly 7 hours I E2!000 per hour

0 %0!! 0%!!! $$%0!! 112,2 0

&&%#!! #% 0! (0%"0! 1**,.00 #$%0!! #!%!!! $%0!!

Tota# &roduction Cost

20 ,100

2O%;INGS
Total (i"ed 6, 27!000!000 '?!000!000 ,ours 20!000 2'!000 @ariable ;%!000!000 #02!000!000 6, rate per ,our #!270 2!000

Preparation Assembly (i"ed Production 6, Preparation Assembly

??!000!000 #70!000!000 Cost 27!000!000 '?!000!000

@ariable Production 6, Preparation Assembly

Cost ;%!000!000 #02!000!000

,ours 20!000 2'!000

6, rate per ,our %!#70 '!270

C5a!ter

1-

SOLUTIONS ONE F Direct Materia# Cost 1ariances

Tota# materia# cost +ariance Actual units 8tandard cost per unit >'!700 " '8tandard material cost Actual material cost @ariance EQ000 #!0'0 #?!000 #?!=20 #'!'00 '!%20

Materia# &rice +ariance E <S& : A&=A3 >'!700 3 #'!'00!000A'!#00- " '!#00 O EQ000 '070(

Materia# Usage 1ariance E <S3 : A3= . S& W>#0'0" '- 3 '!#00X " '!700

2=0(

T2O F Direct La'our Cost 1ariances

Tota# #a'our cost +ariance Actual units 8tandard cost per unit 8tandard labour cost Actual labour cost @ariance EQ000 %!%70 2'!000 ?0!'00 =B!?B% 70=

La'our %ate +ariance E <S% : A%=A0 >;!000 3 =B!?B%!000A#%!'70- #%!'70 O EQ000 ?0= (

La'our e""icienc( 1ariance E <S0 : A0= . S% W>%!%70" '- 3 #%!'70X " ;!000

3%00

T0%EE F i.ed O+er5ead Cost 1ariances

Tota# i.ed o+er5ead +ariance Actual units 8tandard cost per unit 8tandard labour cost Actual labour cost @ariance EQ000 #!#00 20!000 22!000 20!'70 #!770

E.!enditure 1ariance 9udgeted +"penditure Actual +"penditure +"penditure @ariance E!000 20!000 20!'70 >'70-

1o#ume 1ariance Actual @olume >*nits9udgeted @olume >*nits9udgeted :ate per unit >EQ0001ariance <;L000= #!#00 #!000 20 )B000

1o#ume 1ariance E""icienc( 8tandard ,ours O ##00 units I7 hours Actual ,ours 7!700 7!'00

8tandard :ate per ,our >EQ0001ariance <;L000=

' $00

1o#ume Ca!acit( E""icienc( Actual ,ours 9udgeted ,ours O #000 units I7 hours 8tandard :ate per ,our >EQ0001ariance <;L000= 7!'00 7!000 ' 1B-00

Inde"
A Abnormal gain ##B! #22! #2%! #27! #2=! 207 Abnormal loss #2#! #2%! #2'! #2; Absorption;=! ;B! =%! =?! =B! ?0! ?2! ?%! ?'! ?=! B2! #?%! #B'! #B7! #B; Absorption costing =?! =B! ?2! ?%! ?'! ?=

Activity 9ased Costing #B; Avoidable cost C C,APT+: #

?;! ??! B7! B;! #2! #?; 207