ACCT 219-Cost Accounting.pdf

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SCHOOL OF BUSINESS AND ECONOMICS

Department of Accounting, Finance& Investment

ACCT 219

COST ACCOUNTING

FREDRICK M.MUTEA

Open and Distance Learning InstructionalMaterial

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Published by Kenya Methodist UniversityP.O. BOX 267 – 60200, MERU

Email: [email protected]: 254 – 064 – 30301, 31146/0736752262

Cost AccountingACCT 219

© Fredrick Mutea 2014All rights reserved.

No part of this module may be reproduced, stored in any retrievalsystem or transmitted in any form or by any means, electronically,

mechanically, by photocopying or otherwise; without the prior writtenpermission of the author or Kenya Methodist University on that behalf

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TABLE OF CONTENTSLECTURE ONE....................................................................................................121.0 INTRODUCTION TO COSTACCOUNTING......................................................121.1 Lecture overview………………………………………………………………………………..121.2 Objective………………………………………………………………………………………...121.3 Definition and scope of costing accounting……………………………………………………..121.4 Relationship of cost and other disciplines………………………………………………………131.5 Distinction between financial accounting and cost accounting …………………………….…..151.6 Purpose of cost accounting…………………………………………………………………...…171.7 Summary………………………………………………………………………………………...201.8 Self-Assessment questions……………………………………………………………………....21

LECTURE TWO…………………………………………………………………………………222.0 COST CLASSIFICATION………………………………………………………………...….222.1 Lecture overview…………………………………………………………………………….….222.2 Objective………………………………………………………………………………......…….222.3 Classification of cost…………………………………………………………………..………..242.4 Cost statement………………………………………………………………………..…………302.5Work in progress…………………………………………………………………………………322.6 Summary…………………………………………………………………………………….…..342.7 Self-Assessment questions………………………………………………………………….…..36

LECTURETHREE.................................................................................................................393.0 COSTESTIMATION.......................................................................................................393.1 Lecture overview………………………………………………………………………….…….393.2 Objective…………………………………………………………………………………….…..393.3 Cost estimation.……………………………………………………………….…………….…. 393.4 High-low method……………………………………………………………..…………….…. 403.5 Regression analysis …………………………………………………………….………….….. 443.6 Visual fit…………………………………………………………………………………….…. 47

3.7 Engineering method…………………………………………………………….…..473.8 Account analysis…………………………………………………………………..…………….483.9 Learning curve theory…………………………………………………………………………...483.10 Summary……………………………………………………………………………………….483.11Self-Assessment questions………………………………………………………………….….49

LECTUREFOUR....................................................................................................................51

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4.0 MATERIALCOSTING...................................................................................................514.1 Lecture overview……………………………………………………………………………….514.2 Objective……………………………………………………………………………..………...514.3 Purchasing procedure and issue of materials…………………………………………………. 514.4 Store keeping and stock control………………………………………………………………. 544.5 Material Coding ………………………………………………………………………………. 564.6 Stock Recording and Inventory Control…………………………………………………….…. 56

4.7 Methods of valuing material issues……………………………………………………594.8 Stock levels…………………………………………………………………………….………..664.9 Summary………………………………………………………………………………..………694.10 Self-Assessment questions……………………………………………………………………..70

LECTURE FIVE...................................................................................................735.0 LABOR COSTING…………………………………………………………..…735.1 Lecture overview………………………………………………………………………………..735.2 Objective…………………………………………………………………………………...……735.3 Remuneration Methods…………………………………………………………………….….. 735.4 Incentive Schemes in Practice…………………………………………………………….…….755.5 Procedure for preparing a payroll…………………………………………………………….....77

5.6 Allocating of labour costs…………………………………………………………...795.7 Summary…………………………………………………………………………………….…..805.8 Self-Assessment questions……………………………………………………………………...80

LECTURE SIX……………………………………………………………….……826.0 OVERHEAD COSTING……………………………………………….…….. 826.1 Lecture overview……………………………………………………………...……………..…826.2 Objective………………………………………………………………………………..………82.6.3 Overhead ……………………………………………………………………………………….826.4 Bases of Absorption……………………………………………………………………………836.5 Service Departmental Costs……………………………………………………………………87

6.6 Absorption of Overhead………………………………………….…………………946.8 Summary……………………………………………………………………………………….1006.9 Self-Assessment questions…………………………………………………………………….100

LECTURE SEVEN………………………………………………………………1037.0 COSTING Systems……………………………………………………………1037.1 Lecture overview………………………………………………………………………………1037.2 Objective……………………………………………………………………………………….1037.3 Specific order costing …………………………………………………………………………1037.4 Accounting for Job Order Costing……………………………………………………………..1047.5 Job cost account……………………………………………………………………...………..1057.6 Batch costing…………………………………………………………………………………..1077.7 Summary………………………………………………………………………………..….….108

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7.8 Self-Assessment questions……………………………………………………………..……..109

LECTURE EIGHT……………………………………………………………….1108.0 CONTRACT COSTING………………………………………….…………..1108.1 Lecture overview………………………………………………………………………………1108.2 Objective…………………………………………………………………………………….....1108.3 Contract account…………………………………………………………………………….…1108.4 Features of contract accounting…………………………………………………………..……1118.5 Proforma contract account………………………………………………………….………...1138.6 Summary……………………………………………………………………………………....1178.7 Self-Assessment questions………………………………………………………..………..…117

LECTURE NINE…………………………………………………….……….….1199.0 PROCESS COSTING…………………………………………….….……….1199.1 Lecture overview…………………………………………………………………..……….....1199.2 Objective…………………………………………………………………………………..….1199.3 Nature of process costing……………………………………………………………………..1199.4 Valuation of work in progress…………………………………………………………………1209.5 Process losses……………………………………………………………………….…………1239.6 Allocation of joint cost………………………………………………………..….……………1289.7 Summary………………………………………………………………………..….………….1319.8 Self-Assessment questions…………………………………………………………………….131

LECTURE TEN…………………………………………………..……………..13310.0 VARIANCE ANALYSIS……………………………………………….….. 13310.1 Lecture overview……………………………………………………………………..….…13310.2 Objective……………………………………………………………………………………133

10.3 Purpose of variance analysis………………………………………………….13310.4 Material variance analysis…………………………………………………….13710.5 Labour variance analysis……………………………………………………..14010.6 Overhead variance analysis……………………………………………….….14210.7 Summary……………………………………………………………………………….….14910.8 Self-Assessment questions………………………………………………………………..150

LECTURE ELEVEN …………………………………………………………15411.0 STANDARD COSTING……………………………………………….…15411.1 Lecture overview……………………………………………………………………….…15411.2 Objective…………………………………………………………………………….……15411.3 Definition of budget………………………………………………………………………154

11.4 Budget as a tool of planning………………………………………………………………155

11.5 Budgeting preparation process……………………………………………………………157

11.6 Typical problems with budgeting…………………………………………………………160

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COURSE OVERVIEW

I welcome you to the study of Cost Accounting. In this course we shall study important concepts

and techniques needed by managers in planning, control, management and decision making in

business organization. The course has 11(eleven) lectures and each lecture takes one or more weeks

depending on the topic’s depth.inn addition, each has its own objectives that you should achieve. At

the end of every lecture, you will find a series of SAQs that are meant to help you to evaluate your

understanding of the concepts presented. You should attempt all the questions and activities once

you have finished studying the relevant work. A summary of each lecture is also provided at the

end with a list of further resources that you are expected to read and make notes from.

Kindly, make sure that:

You complete each lecture at a time before proceeding to the next one.

Refer to the suggested additional resources to get further information on each topic

Make notes as to simplify your study

Complete all activities and questions as you progress

Spend at least 3(three) hours to complete each topic for you to understand and apply the

knowledge and skills acquired

Once again welcome and let us begin. Good luck!!!!

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COURSE PURPOSE

This course is intended to equip you with knowledge; skills and attitudes that will enable

understand important concepts and techniques needed by managers in planning, control, management

and decision making in business organization.

Expected Learning Outcomes

By the end of the course, you should be able to:-

i. Explain the importance of costing in the management of organizations

ii. Apply costing techniques to account and accumulate input costs to various operating activities of

organizations

iii. Differentiate the different types of costing systems and their applications to different

organizations and situations

iv. Analyze an organization’s activities through budgetary control process.and responsibility

accounting in management of organizations.

Course Content

The course will cover: Introduction to cost accounting, cost estimation, material costing, labour

costing, overhead costing, costing techniques and variance analysis.

Teaching Methods

a) Tutorials

b) Class presentations

c) Discussions

Teaching Materials

a) Chalkboard

b) Instructional Materials

c) Research papers, projects etc.

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Assessment

a) Continuous Assessment Test(s) 40%

b) End of trimester examination 60%

Recommended Text Books:

1. Paresh, S. (2010). Cost Accounting. 3rd Edition, Tata McGraw-Hill, New Delhi.

2. T Lucy,T (2009) Costing. 9th Edition, Book Power, London

3. Saleemi,N.A (2009) Cost Accounting Simplified, N.A Saleemi Publishers, Nairob

4. Drury C., (2004) Management and Cost Accounting. 6th Edition, Book Power, London.

Text Books for further Reading:

Horngren C.T Sundrem G L and Stratton W. O; (2008), An introduction to Management Accounting,

Prentice Hall International Inc.

Other support materials: Various applicable manuals and journals; variety of electronic information

resources as prescribed by the lecturer

You will be expected to take responsibility of the learning process. The instructor will provide you

with the necessary support and facilitation in order to achieve the course objectives. You may be

expected to do assignments which will constitute 40% of the total marks. The final examination will

constitute 60% of the marks.

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SYMBOLS

Objectives

Activity

Key note

Summary

Self-Assessment Questions (SAQs)

Further Reading

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COURSE OUTLINE

Week Topics Content1 Introduction to Cost

Accounting1.1 Definition and Scope of Costing Accounting1.2 Cost and Management Accounting1.3 Relationship of Cost Accounting and Other

Accounting Disciplines1.4 Role of cost accounting

2 Cost Classification 2.1 Cost Classification2.2 Cost Behavior2.3 Costs Decision Making and Planning2.4 Cost Control and Cost Reduction2.5 Cost Statement

3 Cost Estimation 3.1 Account Analysis3.2 Engineering Estimates3.3 The Scatter Graph Method3.4 High-Low Method3.5 Statistical Cost Estimation

4 Material Costing 4.1 The Material Control Process4.2 Stocktaking4.3 Changes in Production and Purchasing

Systems4.4 Stock Recording And Inventory Control4.5 Pricing Issues And Stocks

5 Labour Costing 5.1 Remuneration Methods5.2 General Features of Incentive Schemes5.3 Incentive Schemes in Practice5.4 Trends in Labor Costing5.5 Labor Recording, Costing and Allied

Procedures6 CAT 17 Overhead costing 6.1 Overhead Absorption

6.2 Bases of Absorption6.3 Service Departmental Costs6.4 Overheads and Activity Based Costing.

8 Costing systems 7.1 Job costing7.2 Accounting for Job Order Costing

7.3 Job cost account7.4 Batch costing

9 Contract costing 8.1 Features of contract costing8.2 Contract costing and job costing8.3 Accounting procedures8.4 Proforma contract account8.5 Preparation of contractee account

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Week Topics Content10 9.0 Process costing 9.1 Job costing and process costing

9.2 Costing procedures9.3 Flow of cost in process costing9.4 Normal loss and abnormal loss9.5 Abnormal gain

11 10.0 Variance analysis 10.1Definition of variance analysis10.2The purpose of variance analysis10.3Material cost variances10.4Variable overhead variances10.5Fixed overhead variances

12 11.0 Standard costing 11.1 Introduction

11.2 Features of a budget

11.3Purpose of standard costing.

11.4 Element of a successful budget

11.3Budgetary control and standard13 End of year adjustments Revision

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LECTURE ONE

1.0 INTRODUCTION TO COST ACCOUNTING1.1 Lecture OverviewWelcome to cost accounting course. This course is important in every sector whethermanufacturing or service, and help in communicating financial information to management forplanning, evaluating and controlling performance, and also to assist management to make moreinformed decisions in line with changing environment. Costing as is normally referred is one of the

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courses that you will always need in all aspect of your life and profession. That why cost accountingis taught to all students irrespective of their profession and areas of specialization. It is thereforeimportant that as cost accounting students you understand the important concepts in this class. Thislecture will introduce you to “what we mean by cost accounting”.

1.2 Objectives

By the end of the topic, you should be able to:a. Define cost accounting

b. Outline the relationships of cost accounting to management accounting and financialaccounting

c. Describe the role of a cost accounting department in an organization

d. Describe the various cost classifications and prepare a cost statement

1.3 Definition of and Scope of Cost AccountingCost accounting is concerned with the ascertainment of costs. It is that part of managementaccounting which establishes budgets and standard costs and actual costs of operations, processes,departments or products and the analysis of variances, profitability or social use of funds”

Cost accounting identities, defines, measures, reports and analyses the various elements of directand indirect costs associated with producing and marketing goods and services. Cost accountingalso measures performance, product quality and productivity”

Cost accounting systematic process of collecting, summarizing and recording data regarding thevarious resources and activities in a firm so as to calculate the basis of production costs used infinancial accounting or making other relevant decisions in a firm

Cost accounting is broad and extends beyond calculating production costs for inventory valuation,which government-reporting requirements largely dictate. However accountants do not allowexternal reporting requirements to determine how they measure and control internal organizationsactivities. Cost accounting focus is shifting from inventory valuation for financial reporting tocosting for decision making.

The main objective of cost accounting is communicating financial information to management forplanning, evaluating and controlling performance, and also to assist management to make moreinformed decisions. Its data is used by managers to guide their decisions.

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1.4 The relationship of cost accounting and other accounting disciplines

Accounting can be described as a specialized information system that is used for purposes ofdecision making by the management of the organization and other users such as tax authorities,investors, creditors and the general public. Accounting is broadly divided into two:

i. Financial Accounting

ii. Management Accounting

1.4.1 Financial Accounting:

This is the analysis, classification, and recording of financial transactions and the ascertainment ofhow such information will be reported to the various users. It involves the development of general-purpose financial statements largely for external reporting. These statements are developed inaccordance with standards imposed by the public (through the professional accounting bodies suchas the Institute of Certified Public Accountants of Kenya – ICPAK and the International AccountingStandards Board – IASB) as well as the requirements of the Companies Act Chapter 486.

Conditions for effective costing systemCosting system must be simple, economical and practical. The conditions for an effective andsuccessful costing system include:-

1. Proper system of stores and stock control.2. Co-operation and co-ordination among the staff members.3. Proper and satisfactory wage procedures.4. Proper record keeping e.g. receipt of materials, issue of materials, labour hours worked,

wage calculations etc.5. The overheads must be recorded accurately and these must be charged to the respective

production departments.6. The cost accounting department must be established e.g. have cost accountants.7. The cost accounts and financial accounts should be maintained in such away that their

results can be reconciled easily.

Examples of information provided by a typical costing system and how it is used are given in thefollowing table and the following paragraphs.

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Information provided by costing system Possible uses by management

Cost per unit of production or service or fora process

As a factor in pricing decisions, productionplanning and cost control

Cost of running a section, department offactory

Organization planning, decisions onalternative methods, wages cost control

Wages costs for unit of production or perperiod of production.

Production planning, decisions onalternative methods, wages cost control

Scrap/rectification costs Material cost control, production planning

Cost behaviour with varying levels ofactivity

Profit planning, make or buy decisions, cost

Examples of costing information and uses

Activity 1.1

As you will realize as you go through this course, the characteristics of a good costaccounting system should be simple,economical and practical. Identify what may be hindering goodcosting systems in your organisation

An important part of the management task is to ensure that operations, departments, processes andcosts are under control and that the organization and its constituent parts are working efficientlytowards agreed objectives. Although there are numerous other control systems within anorganization, for examples production control, quality control, inventory control, the costing systemis the key financial control system and monitors and the results of all activities and all other controlsystems. The detailed analysis and location of all expenditures, the calculation of job and productcosts, the analysis of losses and scrap, the monitoring of labour and departmental efficiency andoutputs of the costing system provide a sound basis of information for financial control. Costaccounting and financial accounting Financial accounting can e defined as: „The classification andrecording of the monetary transactions of an activity in accordance with established concepts,principles, accounting standards and legal requirements and their presentation, by means of profitand loss account, balance sheets and cash flow statements, during and at the end of accountingperiod’ Financial accounting originated to fulfill the stewardship function of businesses and this isstill an important feature. Most of the external financial aspects of the organization, e.g., dealingwith accounts payable and receivables, preparation of final accounts etc., are dealt with by thefinancial accounting system. Of course internal information is also prepared, but in general it can besaid that financial accounting presents a broader, more overall view of the organization withprimary emphasis upon classification according to type of transaction rather than the cost and

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management accounting emphasis on the function, activities, products and processes and on internalplanning and control information.

1.5 Distinction between financial accounting and cost accounting.

Financial accounting and management are two interrelated facets of the accounting system. Theyare not exclusive of each other; they are supplementary in nature. Financial accounting provides thebasic structure for collecting data. The data collection structure is suitably modified or adjusted foraccumulating information for management accounting purpose. In a broader sense, managementaccounting includes financial accounting. A distinction is drawn between financial accounting andmanagement accounting since they differ in their emphasis and approaches. Some of thecharacteristics which distinguish management accounting and financial accounting are discussedbelow;.Focus. Financial accounting emphasizes the external use of accounting data. Managementaccounting on the other hand, utilizes accounting data for internal use. The major objective offinancial accounting is to prepare balance sheet and profit and loss account to inform shareholdersand others about the firm’s profitability and the state of its resources and obligations. The proposefor which management accounting collects and repots relevant information is to make decisions toensure optimum use of the firm’s resources.Principles. The accounting profession has developed certain principles foe preparing and presentingfinancial reports for external uses. Financial accounting adheres to these generally acceptedaccounting principles. This introduces consistency and meaningfulness of data for the investorspoint of view. They can make inter firm comparisons of performance and analysis performancetrend over years when some set of generally accepted principles are followed by all firms.Management accounting, in contrast, is not based on any set of accepted rules of principles. Everyenterprise, depending on its requirements for facts, evolves its own procedures and principles forpreparing reports for internal uses. The following should be relevant and aid management in makingdecisions.

Information. Financial accounting accumulates reports historical information to investors.Financial accounting reporting tell what has happened in the past. Through balance sheet and profitand loss account, to the investors is revealed the manner in which the resource entrusted by them tothe firm have been utilized. Management accounting, being a decision-making process, focuses onthe future. It analyses past data and adjusts them in the light of future expectations to make plans.

Need. Financial accounting is an outcome of statute. For example, in India under the companies Actto prepare balance sheet and profit and loss account for submission to shareholders and others. Thefinancial statements are generally required to be prepared in the formats prescribed by the law.Management accounting is the result of the management’s needs of information for makingdecisions. It is, therefore, optional. Management accounting functions would differ from firm tofirm. A firm may have a sophisticated elaborate and comprehensive system while another may havea partial system only.

Timing.Financial accounting adopts twelve months (one year) period for reporting financialperformance to shareholders and other investors. In contrast, management accounting reports are for

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shorter durations. Some companies in India prepare daily budgets. Monthly and quarterly reportsare quite common. Management accounting expenditure plans, for example, cover a longerduration.Coverage.While reporting the state of affairs of a company, financial accounting covers entireorganization. Financial statement show revenue, expenses, assets and equities of the firm as awhole. For management accounting purpose, however, organization is divided into smaller units, orcentres. These centres may be headed by responsible persons. Cost data and other information’s arecollected and reported by the centres. Thus, the data requirements of management accounting aremore specific.

Reporting. Financial statement-balance sheet and profit and loss account – are subject to theverification of statutory audit. Therefore, financial accounting stresses accuracy and precision ofaccounting data. Management accounting requires information promptly for decision-making.Continuous and speedy flow of approximate information is more useful than the precise, butdelayed information.

1.5.1 Management Accounting

Management accounting is defined as: ”The application of professional knowledge and skill in thepreparation and presentation of accounting information in such a way as to assist management in theformulation of policies and in the planning and control of operations of the undertaking”. Theprovision of information required by management for such purposes such as:a) Formulation of policies

b) Planning and controlling the activities of the enterprise

c) Decision taking on alternative courses of action

d) ]disclosure to those external to the entity

e) Disclosure to employees

f) Safeguarding assets

Management accounting uses both financial and cost information to advise management in planningand controlling the organization. The objectives of the various facets of accounting have been givenabove and differences. And the differences discussed. However, it must be realized that all formpart of the financial information system of an organization and in many organizations the variousfacets are totally integrated with no artificial divisions between them.

This is the part of accounting that provides special-purpose statements and reports to managementand other persons inside the organization. The information generated by management accounting istherefore for internal uses and is not guided by any standards or legal requirements. ManagementAccounting, unlike financial accounting, is proactive i.e. it is future-oriented. It is required inmaking decisions that affect the organization.

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In a nutshell, cost accounting enables a business to not only find out what various jobs or processeshave cost, but also what they should have cost. It indicates where losses are occurring before thework is finished and therefore corrective action can be undertaken.

From the foregoing discussion, it is then clear that cost accounting is very closely related to otheraccounting subjects especially management accounting. In fact, most people make no distinctionbetween management accounting and cost accounting, as the dividing line between the two isslimmer than thin!

1.5.2Relationship between cost accounting and management accounting

Referring to CIMA’s definition of cost accounting, we can see that cost accounting is a part ofmanagement accounting.

CIMA defines management accounting as “provision of information required by the managementfor such purposes as formulation of policies, planning and controlling the activities of theenterprise, decision taking on the alternative courses of action, disclosure to those external to theentity (shareholders and others), disclosure to employees and safeguarding assets. Cost accountingand management accounting have basically the same functions.

1.6 Purpose of cost accounting information

Cost ascertainmentCosts relating to materials, labour and overhead costs must be ascertained accurately. They shouldbe kept at minimum level possible.Disclosure of wastesThe costs incurred for the production of any commodity can be determined in advance in view ofthe past experience. If the actual costs are higher than the expected or standard costs, then thisexcessive cost can be analyzed e.g. it may be from wastage of raw materials, idle labour, timewastage etc.Decision makingCost accounting provides necessary information to the management for decision making e.g. whatgoods to produce and in what quantities.Cost controlMaterials costs, labour costs and overheads must be maintained at desirable levels. Cost accountingprinciples are used to eliminate unnecessary costs.. PlanningThe cost data and past experience are used to prepare and implement future plans e.g. expansion ofbusiness.Measurement of efficiencyDepartmental performance can be measured using the costs data. More efficient departments will begiven greater incentives and appropriate steps taken to improve the performance of less efficientdepartments.1.6.1 Settling selling pricesA business concern must ascertain its cost and then add its profit into cost of sales to avoid charginghigh or low prices which can bring negative effects.Evaluation of profitability

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Profitability can be measured in a number of ways e.g. profit as a percentage of sales, profitpercentage to capital employed, profit per unit of output etc.The profitability information serves as a guide to the management to make some strategic decisionsregarding the introduction of new products and increasing or decreasing the volume of production

a) Accounting for costs

This may be seen as a record keeping or score keeping role. Information must be gatheredand analyzed in a manner which will help in planning, control and decision making

b) Planning and Budgeting

This involves the quantification of plans for the future operations of the enterprise; suchplans may for the long or short term, for the enterprise as a whole or for the individualaspects of the enterprise.

c) The control of the operations of the enterprise

Control may be assisted by the comparison of actual cost information with that included inthe plan. Any differences between planned and actual events can be investigated andcorrective action implemented as appropriate

d) Decision Making

Cost accounting information assists in the making of decisions about the future operationsof the enterprise; such decisions making may be assisted by the information from costtechniques and cost-volume – profit analysis.

e) Resource allocation decisions

For example product pricing in determining whether to accept or reject jobs: This is basedon cost and revenue implications of the relevant decisions

f) Performance evaluation

Cost accounting information is used to measure and evaluate actual performance so as tomake a decision of the degree of optimality or efficiency of resource utilization.

1.6.2 The role of a cost accounting department in an organization

As part of their jobs, cost accountants interpret results, report them to management andprovide analysis that assist decision-making in the following departments:

a) Manufacturing

Cost accountants work closely with production personnel to measure and reportmanufacturing costs. The efficiency of the production departments in scheduling andtransforming materials into finished units is evaluated for improvements.

b) Engineering

Cost accountants and engineers translate specifications for new products into estimatedcosts; by comparing estimated costs with projected sales prices, they help managementdecide whether manufacturing a product will be profitable.

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c) Systems design

Cost accountants are becoming more involved in designing computer integratedmanufacturing (CIM) systems and databases corresponding to cost accounting needs. Theidea is for cost accountants, engineers and system designers to develop a flexible productionprocess responding swiftly to market needs

d) Treasury

The treasurer uses budgets and related accounting reports developed by cost accountants toforecast cash and working capital requirements. Detailed cash reports indicate where thereare excess funds to invest or where cash deficits exist and need to be financed.

e) Financial accounting

Cost accountants work closely with financial accountants who use cost information invaluing inventory for external reporting and income determination purposes.

f) Marketing

Marketing involves the cost accountant during the product innovation stage, themanufacturing planning stage and the sales process. The marketing department developssales forecast to facilitate preparing a products manufacturing schedule. Cost estimates,competition, supply, demand, environmental influences and the state of technologydetermines the sales price that the product will be offered and will command in the market.

g) Personnel

Personnel department administers the wage rate and pay methods used in calculating eachemployees pay. This department maintains adequate labour records for legal and costanalysis purposes.

At this point, it cannot be over-emphasized that cost accounting is simply an informationsystem designed to produce information to assist the management of an organization inplanning and controlling the organisation’s activities. It also assists the management to makeinformed decisions so as to enable the organization to operate at maximum effectiveness andefficiently.

1.6.3 Role of Cost Accounting In business management

A system is a set of interdependent parts which together form a unitary whole that performs somefunctions. A number of sub systems make up the whole. In this context of the organization, amanagement information system may be seen as the overall system with a number of sub systemsincluding the cost and management accounting system that provide the information to managementfor purposes of planning, organizing, directing and controlling the organization’s activities so as toachieve corporate goals including profit maximization.

Information must be collected, processed and communicated in an organized manner if theobjectives of the enterprise are to be efficiently implemented and alternative strategies for theirimplementations examined, so as to select the best strategy.

Information may be non mutually exclusive in nature. This means that information gathered as partof the management information system may be used in two or more subsystems for differing

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purposes. An example of this information is with regard to the amount and location of work inprogress: (work in progress refers to partly completed units of products where a product passesthrough a number of operations and processes before being passed into finished goods store or tothe customer). Work in progress information may be used by:

a) Production planning department in order to monitor the progress of parts of an orderthrough the production process and to instigate action to speed up the completion of slowmoving parts of the order

b) Quality control department in comparing one batch of product with another inhighlighting the incidence of process losses and their location

c) Cost management department in the quantification and valuation of actual loses ascompared to the level originally allowed for in the business plan

d) Financial accounting department in the valuation of work in progress for balance sheetpurposes and for purposes of determining the cost of sales in the income statement.

Activity 1.1

Review ways in which you can use cost accounting in your home and organization i.e unitsdepartments, products and process.

1.7 Summary

(i) Cost accounting is concerned with the ascertainment and control of costs

(ii) The purpose of cost accounting is to provide detailed information for control, planning anddecision making.

(iii) To be of use, costing information must be appropriate, relevant, timely, well presented andsufficiently accurate for the purpose intended.

(iv) Cost accounting and management accounting are closely related.

(v) The emphasis of financial accounting is upon classification by type of transaction and type andtype of expenditure rather than the functional analysis of cost accounting.

(vi) Cost, financial and management accounting all contribute to the financial information system ofan organization and increasingly in practice are totally integrated.

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1.8 Self-Assessment Questions

1. Define cost accounting?

2. Give six examples of costing information and its uses

3. What is the relationship between costing, management accounting and financial accounting?

4. Describe the main purposes of cost accounting

5 Define the following terms

a) Cost Accounting

b) Financial Accounting

c) Management accounting

6 Briefly describe the purpose of Cost Accounting.7 Compare and contrast Cost Accounting and financial Accounting

1.9 Further Reading

1Paresh, S. (2010) “Cost Accounting” 3rd

Edition, Tata McGraw-Hill, New Delhi.

2. T Lucy,T (2009) Costing 9th Edition, Book Power, London

3. Saleemi,N.A (2009) Cost Accounting Simplified, N.A Saleemi Publishers, Nairobi

4.Drury C., (2004) “Management and Cost Accounting” 6th

Edition, Book Power, London.

LECTURE TWO

2.0 COST CLASSIFICATION

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2.1Lecture overviewTo this point am sure you have learnt what cost is and you are able to check the bills you pay toindentify some of these cost. Now is high time to take you through various methods of costclassification and the reason behind these classifications.

2.2 Lecture Objectives

By the end of this lecture, you should be able to:

(i) Define the term cost classification and the explain the rational

(ii) Describe the various cost classifications

2.1Terminologies

a) CostThis may be defined as: A cost is the value of economic resources used as a result of production ofany commodity or performing any service or The amount of expenditure (actual or notional)incurred on, or attributable to, a specified thing or activity.‟ At the simplest level, cost includes two components, quantity used and price, ie, Cost = quantity used x price Cost units The cost unit to beused in any given situation is that which is most relevant to the purpose of the cost ascertainmentexercise. This means that in any one organization numerous cost units may be used for particularparts of the organization or for differing purposes.

The main elements of costs are:a) Raw material

b) Labour

c) Overheads

b)Cost units –It is the quantitative unit of the product or service in relation to which costs are ascertained.The cost unit will be determined by the nature of the business enterprise. It may be

- An individual job, batch or contract- A unit of production expressed as a relevant quantity- A service is provided to the customer

Refers to a unit of quantity of produce, service or time in relation to which costs may be ascertainedor expressed. E.g. a kg of sugar, a meter of cloth, a liter of milk, a passenger seat, a patient bed; onelabour hour; a consulting hour etc.Mostly, costs are ascertained in terms of cost units e.g. cost of production per meter of cloth or costof providing service per patient bed in the hospital etc.

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c)Cost centreRefers to any particular part of enterprise e.g. a particular department; a function or items ofequipment in respect of which costs may be ascertained and related to cost units for control purpose.Cost per department is ascertained hence each department in an enterprise becomes a cost centre.

A CostCenter Framework/Approach in Cost Accounting

Cost accounting is based on the concept or framework of cost centers, i.e. all the costs incurredduring the production process have to be identified and accumulated around certain points of theproduction process, referred to as cost centers.

A cost center may be defined as ‘any point at which costs are gathered in order to control cost, fixresponsibility and enable costs to be recharged on an equitable basis. We will use a cost flowdiagram to illustrate the principles of a cost center framework

Each rectangular box represents a cost center. Each cost will be the responsibility of onemanagement member and will have costs charged to it and also costs recharged from it if such costsare incurred for purposes of offering a service to other cost centers.

Cost flow diagram of a typical manufacturing concern (Organization):

Note

!

There are three manufacturing centres (Making, Finishing and Packing). These are supportedby five support departments, namely Maintenance, Power, Administration, Selling and

ADMINISTRATION SELLING

POWER

FINISHEDGOODS

DISTRIBUTION

Cost of sales

MAKING FINISHING PACKING

MAINTENANCE

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Distribution. All the various costs incurred in those departments produce the cost of sale of thefinished product that is offered for sale in the market. It is possible that some departmentsreciprocally support each other, for example, in the above diagram, the power departmentprovides power to the maintenance department; in return, the maintenance department maintainsthe power department.

The departments can be viewed as cost centres as we can identify and accumulate costs inregard to them. Also, the finished products could be viewed as cost centres under the samelogic.

Importance of cost classification

Analysis of cost behaviour is important to all organizations for effective management. Thisis because many organizations have a unique cost structure. For example, fixed costsaccount for 60 – 80% of all hospital costs. However, unlike many organizations of this type,labour costs largely comprise the hospital’s fixed costs.

Labour costs unlike depreciation require a cash outflow. This is characteristic of labourintensive organizations. Capital-intensive organizations, on the other hand, have low labourcosts, e.g. computerized manufacturing organizations.

Some organizations e.g. hospitals allocate 10 –15% of their space for standby emergencyevents giving them built in idle capacity. This prevents them from enjoying advantages ofhigher profits that a capital-intensive organization realizes at higher volumes beyond thebreak-even volume. Thus the cost structure of healthcare institutions presents challenges toaccountants because of their labour intensive and capital-intensive characteristics

2.3 Classification of CostsClassification is the process of grouping costs recording to their common characteristics.Classification of cost is done in order to be concise of every cost incurred in the process ofmanufacture so that such costs can be accurately recorded, monitored and controlled. They arevarious ways of grouping cost:-

.

These different bases of cost classification are summarized in the diagram below:

Manufacturing/ Non-manufacturing

Fixed/Variable incremental/sunk

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Direct/indirect historic/opportunity

Cost BehaviourFunctional Classification

Avoidable/unavoidable

Controllable/Uncontrollable

Standard/actual

A) Functional classificationA business has to perform a number of functions e.g. manufacture, administration, selling,distribution and research. On this basis costs are classified into the following;

a) Manufacturing /production / factory cost This are costs related to themanufacturing process e.g. material cost, labour, cost and factory cost suchas rent, depreciation of machinery, power and lighting etc

b) Administrative costs include all expenditure incurred in formulatingpolicies, directing the organizations and controlling the operation of anundertaking such as audit fee, office rent, salaries etc.

c) Selling cost are costs of seeking to create and stimulate demand and toserve orders e.g. advertising, salaries and commission of salesmen etc.

d) Distribution expenses are cost incurred to avail the product to the finalconsumer. E.g. packing cost, carriage outward, warehousing cost etc.

e) Research and development cost this is the cost of searching new andimproved products and methods. E.g. wages and salaries of research staff, paymentto outside research organizations etc

B) Classification according to behaviour or variability

Cost behavior refers to the change in costs (increase or decrease) as the output level changes, i.e. aswe increase output, are the costs rising, dropping or remaining the same.

Cost Behaviour can be used to produce various classifications of costs such as:

a) Variable Costs Vs. Fixed Costs

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1) Variable costs:

Are costs that increase or decrease proportionately with the level of activity , i.e. that portionof the cost of an activity that changes with the level of output.

Costs

Variable Costs

0 Activity Level

Note that with variable costs, the cost level is zero when production is zero. The costincreases in proportion to the increase in the activity level, thus the variable cost function isrepresented by a straight line from the origin. The gradient of the function indicates thevariable cost per unit.

2) Semi variable costs

Are costs with both a fixed and variable cost component. The fixed component is thatportion which is constant irrespective of the level of activity. They are variable withincertain activity levels but are fixed within other activity levels, as shown below:

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Costs

Variable cost

Fixed

Cost

Activity Level

3) Fixed Costs

Are costs that do not change with of the level of output. It is also called autonomous cost, asit remains the same irrespective of the activity level as shown below.

Costs

Fixed Cost

Activity Level

The classification of cost into fixed and variable costs would only hold within a relevant rangebeyond which all costs are variable. The relevant range is the activity limits within which thecost behaviour can be predicted.

4) Semi Fixed Costs

Are costs with both a fixed and variable cost component. The fixed component is that portionwhich is constant irrespective of the level of activity. They are variable within certain activitylevels but are fixed within other activity levels, as shown below:

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Costs

Variable component

Semi

Variable cost

Fixed component

Activity Level

C) Product cost and period costa) Product cost is costs necessary for production and can not be incurred in case there is noproduction. They include; cost of direct materials, direct labour and some of the factory overhead.They are called production costs because they are included in the course of production.

b) Period costs are costs which are not necessary for production and they are written as expenses inthe period in which they are incurred. They are incurred for a time period and are charged to theincome statement for the period e.g. rent salary of company executives, travel expenses etc.

D Classification according to identifiability with the product

a) Direct costs are costs which are incurred for and may be conveniently identified with aparticular cost unit process or department such as direct labour, direct materials etc.

Direct costs consist of costs that can be directly attributed to a specific output,product or level of activity. Direct costs include direct raw materials and directlabour also called prime costs in aggregate.

PRIME COST = Direct Material Cost + Direct Labour Cost

b) Indirect costs are costs which can not be conveniently identified with a particularly cost unitprocess or department. They are general cost incurred for the benefit of a number of costunit or cost centres such as salary paid to a factory foreman.

Indirect costs are costs that will not be directly attributable to a specific product. They are regardedas overheads. Identification of overheads to specific products is done through cost allocation andapportionment. They include supervisors’ salaries, rent, electricity, depreciation of building etc.

E Classification according to controllability

a) Controllable costs are costs that may be directly regulated by a given level of managerialinfluence. E.g. variable costs are generally controllable by department heads.

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b) Uncontrollable costs are costs that cannot be influenced by the action of a specified member ofthe enterprise e.g. fixed cost like rent are generally uncontrollable.

F. Special cost for managerial decision making

a) Relevant costs are costs which changes from one decision to the next and as such relevant costwill be affected by the decision being made under different alternatives. In decision makingmanagement will be concerned with those costs that differ from one decision to another.

b) Sunk or irrelevant cost These are cost which have been already been incurred in the past andcannot be changed. They are relevant in decision making.

c) Incremental cost / differential costs This is an increase or decrease in cost as a result of analternative course of an action.

d) Marginal or variable cost It is the cost of producing an extra unit of a commodity.

e) Replacement cost This market value of replacing an existing asset.

f) Opportunity cost It is the sacrifice involved in accepting the alternative under consideration.

G. Classification according to time

a) Historical costs are costs ascertained after they have been incurred. They are the actual costswhich are only available after completion of the manufacturing process.

b) Predetermined costs They are future costs that are ascertained in advance of production on thebases of all specified factors affecting cost.

H Special cost for managerial decision making

a) Relevant costs are costs which changes from one decision to the next and as such relevant cost willbe affected by the decision being made under different alternatives. In decision making managementwill be concerned with those costs that differ from one decision to another.

b) Sunk or irrelevant cost These are cost which have been already been incurred in the past and cannotbe changed. They are relevant in decision making.

c) Incremental cost / differential costs This is an increase or decrease in cost as a result of analternative course of an action.

d) Marginal or variable cost It is the cost of producing an extra unit of a commodity.

e) Replacement cost This market value of replacing an existing asset.

f) Opportunity cost It is the sacrifice involved in accepting the alternative under consideration.

I. Classification according to time

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a) Historical costs are costs ascertained after they have been incurred. They are the actual costs whichare only available after completion of the manufacturing process.

b) Predetermined costs They are future costs that are ascertained in advance of production on the basesof all specified factors affecting cost.Concepts of Cost accounting Cost per unit this may be unit of a product service all time in relation towhich cost may be ascertained all expressed. There are the things that the business is set up to providewhich cost to ascertained. E.g. kilowatt in case of power consumption meals in case of a hotel passagesin case of transport. Profit centre `this may be defined as subdivision within an organization operatingon a self contained bases. Usually it will be a cost and an income earning subdivision hence producingprofit measurable as a return on capital employed.

Activity 2.1

Now that you have known the different type of cost classification, can you indentify the differentcost in an organization and group them in each of the classification learnt above

2.4 Cost statementThis means the presentation of cost data in the form of a statement. The statement shows costsincurred under appropriate headings.

Preparation of a cost statementA cost statement can be prepared to show:-

1. Production cost or factory cost.2. Total cost of sales.3. Total cost of sales; profit and sales. In this case, it may be known as income statement.

FORMAT Shs

Material cost xLabour cost xDirect expenses (if any) xPrime cost Xx

Production overheads shsFactory rent xPower xSupervision x

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Depreciation x xCost of goods manufactured xx

Administration overheads xSelling and distribution overheads xTotal cost of sales xProfit xSales xx

EXAMPLE IPrepare a cost statement from the following information.

ShsRaw materials 600,000Direct labour 160,000Factory rent 30,000Power 10,000Supervisor’s salaries 40,000Administration expenses 80,000Selling and distribution expenses 30,000

SolutionCost statement

ShsRaw materials 600,000Direct labour 160,000Prime cost 760,000

Factory overheads ShsFactory rent 30,000Power 10,000Supervision 40,000 80,000Cost of goods manufactured 420,000Administration expenses 40,000Selling and distribution expenses 15,000 55.000

475,000Total cost

EXAMPLE 2From the following information, prepare a cost statement.

ShsRaw materials 1,600,000Direct labour 700,000Factory rent 100,000Power 60,000Indirect wages 40,000Administration expenses 80,000Selling & distribution expenses 60,000

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Profit 25% of cost.

SolutionCOST STATEMENT

ShsMaterial cost 1600,000Labour cost 700,000Prime cost 1300,000

Factory overheads ShsFactory rent 100,000Power 60,000Indirect wages 40,000 200,000Cost of goods manufactured 2500,000Administration overheads 80,000Selling & distribution overheads 60,000

________Total cost of sales 2,640,000Profit (25% of cost) 66,000Sales 3300,000

2.5 Work In Progress (W.I.P)Work in progress refers to the cost of those items which remain incomplete at the end of a specificperiod. Thus are semi-finished goods. E.g. in the textile industry, thread is neither raw material norfinished good so it is considered as W.I.P.There may be opening and closing W.I.P. If the opening figure of W.I.P is greater than closing figurethen this difference is added to factory cost and vice versa.

Kemu ltd manufacturing company provides to you the following information for the month ofOctober 2014.STOCKS ON 1ST OCTOBER 2014

ShsRaw materials 800,000Work in progress 240,000Finished goods 400,000

STOCKS ON 31ST OCTOBER 2014Raw materials 700,000Work in progress 340,000Finished goods 460,000Purchases of raw materials for October 5,000,000Factory wages 1,600,000Salaries of supervisors 600,000

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Factory rent 200,000Power 100,000Sundry factory expenses 300,000Office salaries 260,000Sundry office expenses 140,000Salesmen’s salaries 360,000Sundry selling expenses 120,000Sales 10,000,000

REQUIRED1. Prepare a production cost statement2. Prepare a profit statement.

SolutionPRODUCTION COST STATEMENT

DIRECT MATERIALSOpening stock 800,000Purchases of raw materials 5,000,000

5800,000Less: closing stock (700,000)Cost of material used 5100,000Direct wages 1,600,000Prime cost 6,700,000

FACTORY OVERHEADS KshSupervisors salaries 600,000Factory rent 200,000Power 100,000Sundry factory expenses 300,000 (1200,000)

7,900,000

WORK IN PROGRESSOpening 240,000Closing (340,000) (100,000)Production for factory cost 7,800,000

PROFIT STATEMENTSHS (SHS)

Sales 10,000,000Less: cost of goods sold:Opening stock 400,000Add: production cost 7800,000

8200,000Less closing stock (460,000) 7,740,000Gross profit 2,260,000

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LESS: EXPENSESShs

Administration overheads 260,000Sundry office expenses 140,000 400,000SELLING & DISTRIBUTIONSalesmen’s salaries 360,000Sundry selling expenses 120,000 480,000 880,000Net profit 1,380,000

2.6 Summary

Cost may be classified as under:- Fixed and variable cost. Direct and indirect cost Cost classification by function.

Fixed and variable costFixed cost is the cost which is constant at various levels of output. I.e. it doesn’t change withchanges in output e.g. rent of premises, salaries to permanent employees etc.Variable cost is that cost which changes with the level of production. The change is direct e.g. costof raw materials, wages of factory workers lighting and heating charges etc.Direct and indirect costDirect cost is the cost which can be identified for the production of some specific goods e.g. rawmaterials and labour costs.Indirect cost is the cost which cannot be identified to the production of some specific goods e.g.indirect materials, indirect wages, electricity, water, rent and rates etc.Cost classification by functionThis consists of:-

a) Production cost e.g. cost of raw material, labour, factory rent etc.b) Administration cost e.g. office rent, depreciation of office machines etc.c) Selling and distribution cost – include all costs incurred to promote the sale of the goods

and deliver these goods to customers e.g. cost of advertisement, salesman’s commission,depreciation of delivery vans etc.

The Analysis of Total Costs.These include:-1. Prime costs i.e. Direct materials

Direct wages Direct expenses

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2. Production or factory costs. These include all prime costs plus overheads (production orfactory).3. Total cost of sales. These include production cost plus the other overheads e.g. administrationand selling and distribution.These are explained as under:-

Direct materials – consists of the raw materials used in a product and some component which areincorporated into the finished product.Cost of direct materials = opening stock + purchases – closing stockNB: 1. Transport charges on material purchased are added.

2. Returns of material purchased are deducted.Direct wages – are remuneration paid to factory workers for converting the raw materials intofinished goods. They also include remuneration of construction workers, machine operation etc.Direct expenses – Include any expenditure other than direct materials and direct wages incurred onthe production of some specific product. E.g. hire charges of equipment for the production of aspecific product, costs of designs or drawings etc.Prime cost = Direct material cost + direct labour costs + direct expenses (if any)Over heads – These are costs which cannot be identified to the production of any specific product.They are also called indirect expenses and include:-

1. Production or factory overheads.2. Administration overheads.3. Selling and distribution overheads.

Production overheads (factory or works overheads)These are factory expenses other than direct costsThey include:-

Indirect materials – that cannot be charged directly to the production of a specific product.It’s normally required for operating and maintaining the plant and equipment e.g.lubricating oil, spare parts for machinery etc. This is also called consumable materials.

Indirect wages – These are wages which are paid to those workers who are required tocomplete some process in respect of all the products e.g. factory supervision, wages ofmaintenance of staff like cleaners and repairers, store men’s wages etc.

Rent, rates, insurance, water, power and electricity charges for the factory. Depreciation of factory plant and machinery, depreciation of factory buildings, maintenance

and repairs of factory plant and buildings. Sundry expenses like canteen, entertainment and medical facilities provided to the workers.

Administration overheads.These are expenses incurred in providing control, direction and management of the enterprise. Theyinclude expenses related to secretarial, accounting and legal services. Others include:-

Rent, rates, insurance, water and electricity for the office. Salaries of office staff e.g. accountants, clerks etc. Depreciation of office furniture, office equipment and office buildings. Office stationery and maintenance cost of office equipment. Legal expenses e.g. fees of advocates. Financial expenses e.g. interest on loans bank charges etc.

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Selling and distribution expensesSelling overheads are the expenses incurred to secure orders and to increase sales of the enterprise.They also include:-

Advertisement expenses. Salaries of salesmen and commission of sales agents. Sales correspondence expenses and cost of preparing catalogue and price lists. Rent of salesrooms and offices, water and electricity expenses of salesrooms.

Distribution overheads are those expenses which are incurred on the movement of finished goodsfrom factory to warehouse and then in delivering these goods to the customers. These include:-

Transport charges (carriage outwards). Cost of maintaining delivery vans e.g. fuel insurance and repair charges. Salaries of delivery van drivers, mechanics and delivery clerks. Rent, rates, insurance, water and electricity charges of warehouse.

NB: total cost + profit (or minus loss) gives the selling price.


QUESTION ONE

What is meant by the tem „classification of costs‟? Explain various types of cost classifications. 2. Write short notes ona) Cost unitb) Cost centre

c) Profit centre

d) Cost behavior

a) Explain the difference between the following terms

i. Product cost and period cost

ii. Sunk cost and relevant cost

iii. Incremental and sunk costs

iv. Fixed and variable cost

v. Avoidable and unavoidable costs

vi. Controllable and uncontrollable costs

vii. Direct and indirect costs

b) What is the relevance of cost classification? Is it merely an activity for the

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sake of it? Explain

QUESTION TWO

Discuss the behavioural classification of costs, explaining all the terms

used therein.

QUESTION THREE

Discuss in detail what constitutes manufacturing costs as production costs, administrationcosts as well asselling and administration costs.

QUESTION FOUR

The functional classification of costs classifies costs as production costs,

administration costs as well as selling and administration costs.

Explain what constitutes these costs in detail.

QUESTION FIVE

Papermaking Ltd. Makes paper which is cut and packed before being transferred into the finishedgoods store. The paper is moved from department to department by a fork lift truck. Each pack offinished product contains one ream of paper. The paper is loaded onto wooden pallets beforedelivering to customers. The following cost information related to papermaking Ltd. For periodended 31st March 2014

Sh.Pulp 100,000.000Clay 40,000.000Wrapping paper (used in packing dept.) 3,500.000Spare knives for cutting machines 800.000Cleaning rags for machines 500.000Royalty payments 10,000.000Making dept. wages to packages 38,000.000Cutting dept. wages for machine crew 26,000.000Packing dept. wages to packages 20,000.000Fork lift truck driver wages 8,000.000Factory managers salary 11,000.000Wooden pallets 3,600.000Dispatch dept. wages 17,000.000Delivery vehicle driver wages 9,600.000Sales managers salary 17,500.000Advertising cost 16,500.000Sales office wages 18,500.000General Managers salary 30,000.000

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Production managers salary 21,500.000Maintenance fitter wages 25,000.000Maintenance workshop costs 17,000.000Maintenance engineers salary 18,000.000Administration salaries 45,000.000Electricity costs (See note 1) 18,000.000Administration office machine rental 1,000.000

Sundry other costs;Production 33,000.000Administration 42,000.000Selling 11,000.000Distribution 16,000.000

Note 1

Electricity is charged to each function area as follows; production 75%, administration 5%, selling5%, distribution 15%.

Note 2

Maintenance costs should be totaled before a cost summary is prepared and charges to each functionmaking use of the maintenance service as follows; production 80%, administration 3%, selling 3%,distribution 14%.

Required

Prepare a cost summary for the period ended 31 March 19x4 analyzing costs intoprime costs, production costs and total cost.(Give all subtotals of classified costs).

2.7 Further Reading







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LECTURE THREE3.0Cost Estimation and Forecasting

3.1Lecture OverviewAfter you have learnt what cost is, and the different classification it is vital to have knowledge on thevarious techniques which can be used to separate mixed costs and to formulate linear predictionequation the equation is to be used to estimate and forecast future cost.

3.2 Lecture Objectives

By the end of this lecture, you should be able to:(i) Explain the terms cost estimation and forecasting‟ (ii) Describe the various methods of cost estimation

3.3 Cost estimation :

Cost estimation may be defined as ‘a study which attempts to predict the between costs and the activity levelor cost driver that causes those costs. In practice, managers frequently encounter such cost drivers (what is acost driver?) as machine hours, number of transaction, work cells, labour hours, and units of output e.t.c.

The cost estimating function is

y = a + bx,

Where

Y represents Total cost

a represents cost fixed component of the total cost

bx represents the variable costs component of the total cost

b represents the unit variable cost (this is the gradient of the equation)

x represents output level

This is the usual straight line equation you have been encountering in elementary mathematics.

Cost estimation is a procedure used to measure costs of various items used in the process of production.While cost forecasting is the process of accurately determining in advance the cost that will be incurredin the process of manufacturing a particular product over a given future period

There are various methods that can be applied by management accounts in cost estimation andforecasting.

3.3.1 The methods that can be used for this purpose are:-a) Accounts classification (separating mixed costs) entails the examination of accounts and regards andclassifying each item of expenditure into fixed, variable and semi variable. Although the method isquick and inexpensive and it is considerably subjective and inaccurate.

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b) Industrial engineering (cost estimation and forecasting) this is considered is the most scientificmethod of establishing a cost standard. Work study techniques are applied to determine levels of inputneeded to satisfy given levels of outputs. Those, inputs are then turned into standards in order toestimate product cost in the future.

Advantages1. It enables an organization to determine the most effective way to apply resources.

2. Standard can be set using efficient usage.

3. There is control of operation by comparing actual results with the expected results

Disadvantages1. It is costly to use as it involves experts.

2. It is not effective for controlling many types of overhead costs.

3. It is not easy to apply in non-manufacturing activities since relationship between cost and outputcannot be determined.

3.3.2 Methods of cost estimation

We will consider following cost estimation methods commonly utilized, namely:a) High Low Activity method

b) Account Analysis

c) Engineering Analysis

d) Visual Fit (Scatter graph) method

e) Simple linear regression analysis

f) Learning curve Theory

3.4 High – Low method

Here, cost estimation is based on the relationship between past cost and past level of activity. Variablecost is based on the relationship between costs at the highest level of activity and the lowest level ofactivity. The difference in cost between high and low activity level is taken to be the total variable costfrom which the unit variable cost can be computed by dividing it by the change in output level. This isindicated below:

Steps involvedi) Select highest and the lowest activity level.

ii) Select corresponding highest cost and lowest corresponding cost.

iii) Obtain the difference in cost and the difference in activity level.

iv) Divide the difference in cost by difference in activity to get the rate of variable cost.

v) Compute fixed cost by subtracting variable from total cost.

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vi) Formulate linear prediction equation

Total Variable Cost = Cost at high activity level – Cost at low activity level

Therefore,

Unit Variable cost = Variable cost = Cost at high level activity – cost at low level activityOutput Units Units at high activity level – units at low activity level

The variable cost per unit so calculated forms the ‘b’of the straight line equation mentioned earlier. Bysubstituting ‘ b’ into the equation, we can obtain ‘a’, the fixed cost.

Illustration 1

Based on performance, you have been provided with the following information regarding ABC Ltd forthe year ended 31 December 2004 :

Labour hours Service cost (Shs)

Highest activity level 800 200,000Lowest activity level 300 150,000

Required

Develop a total cost function based on the above data using the high-low method.

Solution

Unit Variable cost = Variable cost = Cost at high level activity – cost at low level activityOutput Units Units at high activity level – units at low activity level

Variable Cost Per Unit = Shs.200,000 – shs.150,000

800 hrs – 300 hrs

= Shs.50,000 = shs.100/hr

500 hrs

Therefore b = 100

To get the fixed cost a, substitute ‘b’ into the straight line equation as follows:

When labour hours (x) = 800, service cost (total cost, y) = shs.200,000

Therefore from the Straight Line equation, y = a + b x

200,000 = a + (100) 800

200,000 = a + 80,000

a = 200,000 – 80,000

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a = 120,000

Therefore fixed costs = shs.120,000

NB: Even if we used the 2nd set of labour hours and service costs, were would still get he same answer i.e.

When labour hours (x) = 300, service cost (total cost, y) = Shs.150,000.

Therefore 150,000 = a + 100(300)

a =150,000 – 30,000 = Shs.120,000

Therefore the cost equation is:

y = 120,000 + 100x

This equation can be used to estimate or predict the total costs : for example, when the activity level is say at1000 labour hours, then the total cost would be

Y= 120,000 + 1000(100)

=120,000 + 100,000

= Shs.220,000.

ILLUSTRATION 2

The production manager of Kemu ltd Company, is concerned abut the apparent fluctuation in efficiency andwants to determine how labour costs (in Sh.) are related to volume. The following data presents results ofthe 12 most recent weeks.

Week No. Units Produced(X) Labour Costs(Y)1 34 3402 44 3463 24 2874 36 2625 30 2206 49 4167 39 3378 21 1809 41 37610 47 29511 34 21512 24 275

Required:

Estimate the cost function using:The high low methodRegression analysis

Assume that the Company intends to produce45 units34 units next period

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Estimate the labour cost to be incurred.

SOLUTIONWe will first use the high-low method to establish the cost function.

High low method

Highest point X Y

416Lowest point 21 180Difference 28 236

Gradient/ slope = 236 = 8.4328

The function will be:

Y= a + bxWe can Substitute the lowest points (21,180)

180 = a + 8.43(21)

a = 2.97. This can be approximated to 3

The predicting equation is therefore Y = 3 + 8.43 x

i. if X=45 units

Y = 3 + 8.43*45= Sh.382.35

ii. 34 Y = 3 + 8.43(34)= Sh.289.62

Note:

The main problems of the high low method are:Reliability is lowIt Ignores all the other points except the highest and lowest which in most cases are outliners.

Advantages of the high low method1. It is easy to use.

2. The lowest and the highest item will cover the relevant range.

3. It takes into account possible extremes of cost.

Disadvantages1. It is not logical to use two points to represent all the points.

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2. The estimated cost function poorly describes the actual cost relationship.

3. Costs are not properly matched with the independent variable.

3.5 REGRESSION ANALYSIS

A regression equation identifies an estimated relationship between a dependent variable (the cost) and one ormore independent variables (the cost driver). When the equation includes only one independent variablethen it is referred to as simple regression and its form is:

Ỹ= a + bx

Where, Ỹ is the predicted value of Ya and b are Constantx is the cost driver

When the equation includes 2 or more independent variables, it is referred to as multiple regression and is ofthe form:

Y = a + b 1 x1 + b2 x2 + …….bn xn for n independent variables.

SIMPLE REGRESSIONRegression analysis determines mathematically the regression line of best fit. It is based on the principle thatthe sums of squares of the vertical deviation from the line established is the least possible

I.e. 2)ˆ( YY is minimised

where Y is the observed value of the dependent variableŶis the predicted value of Y

The equation can be solved by the use of normal equations and these are:

1. y = na + b (x)

xy = a (x) + b (x2)

From these normal equations:b = nxy – x y

nx 2– (x)2

a = Y - bxn n

Looking at illustration 2.1, then we first compute the sum of X, Y, XY, X2 and Y2

The table below shows these summations.

Week No. Units X) L.Costs(Y) XY X2 Y2

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1 34 340 11560 1156 1156002 44 346 15224 1936 1197163 24 287 8897 961 823694 36 262 9432 1296 686445 30 220 6600 900 484006 49 416 20384 2401 1730567 39 337 13143 1521 1135698 21 180 3780 441 324009 41 376 15416 1681 141376

10 47 295 13865 2209 8702611 34 215 7310 1156 4622512 24 275 6600 576 75625

430 3549 132,211 16234 1104005

Value of b can be calculated as follows:

b = 12(132211) - 430(3549) = 6.1012(16234) - (430) 2

a = 3549 - 6.10 ( 430) = 77.0812 12

Therefore the predicting function is Ŷ = 77.08 + 6.1X

b. i. If X = 45 units, then

Ŷ = 77.08 + (6.1 x 45)= Sh.351.58

ii. If X = 34 units, then

Ŷ = 77.08 + (6.1 x 34)= Sh.284.48

ILLUSTRATIONAssume that the company (in illustration 2.1) intends to spend Sh.400 on labour cost next period. Computethe number of units that the company may produce.

SOLUTIONNote:

Ŷ = a + bx is a regression of Y on X i.e. Y = f(x)

We require a regression of X on Y. i.e. X = g(Y) to answer the above question. The general format of theequation is:

X = a1 + b1 Y

47

b = nxy – x ynY 2– (Y)2

a = X - bYn n

b1 = 12(132,211) - (430 x 3549)12(1,104,005) - (3549)2

= 0.0926

a1 = 430 - 0.0926(3549)12 12

a1 = 8.3286

Therefore the predicting equation is X̂ = 8.33 + 0.093Y

Thus if the Company intends to spend Sh.400 on labour, the number of units to be produced will be:

X̂ = 8.33 + 0.093(400)= 45.56 units

Approximately 46 units

3.6 Visual fit (scatter graph method)

Cost estimation is based on past data regarding the dependent variable and the cost driver. The past dataon cost levels and the output levels) is plotted on a graph( called a scatter graph )and a line of best fit isdrawn as shown in the diagram . A line of best fit is a line drawn so as to cover the most points possibleon a scatter graph. Its intersection with the vertical axis indicates the fixed cost while the gradientindicates the variable cost per unit.

Illustration:

Assume a firm has total costs of 8m, 4m and 1m respectively when the output units are 400,000, 200,000 and

respectively. Estimate its cost equation using the visual fit method.

48

10

9

Dependant 8 X

Variable 7 X X X

(Total Cost) 6 X X X

5 X X X X X

4 X

3 X X X X X

2 X X

1m X

X2 X3

0 200,000 400,000

Independent Variable

(Output Level)

Per UnitCostVariableXXY-Y

XinChangeYinChange

Gradient

10XCostFixed

:Note

23

23

m

Variable cost = Change in cost = 8m – 4m = 20Per unit Change in activity level 400,000 – 200,000

Total cost equation y = 1m + 20 x

On the basis of the existing data, fixed cost is Shs 1m and the variable cost per unit is 20. On the basis of thedeveloped model, estimates can be made regarding future cost. When the activity level is 600,000 units, totalcost will be estimated as:

TC = 1M + 20 (600,000) = 1M + 12M = 13 M

3.7 Engineering method

This method is based on a detailed study of each operation where careful specification is made for materials,labour and equipment necessary to produce a product. It involves identifying the level of input required of anactivity in form of raw material and labour while total cost is based on the cost of each input. This approachis applicable where no past data exists. The main setback of the approach is that it requires a complexanalysis of all the constituents of an activity and the requirements of an activity in terms of costs detailedinto materials, labour, overheads and time

49

3.8 Account Analysis (Inspection of Accounts)

Using account analysis, the accountant examines and classifies each ledger account as variable, fixed ormixed. Mixed accounts are broken down into their variable and fixed components. They base theseclassifications on experience, inspection of cost behaviour for several past periods or intuitive feelings ofthe manager.

Activity 3.1

Using the knowledge acquired early in the unit think of a particular department in yourorganization and classify cost into variable and fixed cost and predict the cost to be incurred inthe next month.

3.9 LEARNING CURVE THEORY

The first time a new operation is performed both workers and operating procedures are untried but as theoperation is replaced the workers becomes more familiar with the work so that less hours are required. Thisphenomena is known as the learning curve effect.

This is also referred to as improvement curve theory. It occurs when new production methods are introduced,new product s (either goods or services) are made or when new employees are hired. It is based on theproposition that as workers gain experience in a task, they need less time to complete the job and productivityincreases.

The learning curve theory affects not only direct labour costs but also impacts direct labour related costs such assupervision, and direct material costs due to reduced spoilage and waste as experience is gained.

3.10 Summary

Cost estimation is a procedure used to measure costs of various items used in the process of production.While cost forecasting is the process of accurately determining in advance the cost that will be incurredin the process of manufacturing a particular product over a given future period

There are various methods that can be applied by cost accounting in cost estimation and forecastinga) High Low Activity method

b) Account Analysis

c) Engineering Analysis

50

d) Visual Fit (Scatter graph) method

e) Simple linear regression analysis

h)Learning curve Theory


QUESTION ONECB plc produces a wide range of electronic components including its best selling item, the Laser Switch.The company is preparing the budgets for Year 5 and knows that the key element in the Master Budget is thecontribution expected from the Laser Switch. The records for this component for the past four years aresummarised below:

Year 1 Year 2 Year 3 Year 4Sale (unit) 150,000 180,000 200,000 230,000

Sale revenue 292,820 346,060 363,000 448,800Variable costs 131,080 161,706 178,604 201,160Contribution 161,740 184,354 184,396 247,640

It has been estimated that sales in Year 5 will be 260,000 units.

Required:

As a starting point for forecasting Year 5 contribution, to project the trend, using linear regression;To calculate the 95% confidence interval of the individual forecast for Year 5 if the standard error of theforecastis £14,500 and the appropriate t value is 4,303, and to interpret the value calculated;To comment on the advantages of using linear regression for forecasting and limitations of the technique.

QUESTION TWOThe theory of the experience curve is that an organisation may increase its profitability through obtaininggreater familiarity with supplying its products or services to customers. This reflects the view thatprofitability is solely a function of market share.

Required:

Discuss the extent to which the application of experience curve theory can help an organisation to prolongthe life cycle of its products or services.

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3.12 Further Reading







52

LECTURE FOUR

4.0 Material costing

4.1Lecture Overview

The lecture is to introduce you to various methods of accounting for material issue from the stores andvaluation of closing stock .

4.2 Objectives

By the end of the topic, you should be able to:

(i) Describe the steps involved in purchasing of materials

(ii) Explain types of purchasing systems

(iii) Understand the principles of material control

(iv) Know the elements of storekeeping and stocktaking

4.3 PURCHASING PROCEDURE AND ISSUE OF MATERIALS

4.3.1 Material Control

This is the act of ensuring that the acquisition, storage, handling and usage of all types of materials

are fully controlled at all times.

Main aspects of material control include:-

1. Purchasing procedure

2. Receipt and inspection of materials

3. Storekeeping

4. Stores control

5. Issue of materials

6. Pricing of material issues

7. Allocation of material costs.

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4.3.2 Purchasing procedure (STEPS)

This involves acquisition of goods/services done by the purchasing department. Its importance

depends on the nature of business e.g. in a manufacturing business, the department is very important

than in service industry. Purchases control is exercised to ensure that goods are purchased at right

time of right quality and in right quantity. Over purchasing, under purchasing or purchase of inferior

quality goods have negative effects to the business.

Purchasing procedure adopted by various organizations include:-

1. Purchase requisitions

2. Letter of inquiry

3. Quotations

4. The purchase order

5. Receipt of goods

6. Rejection or return of goods

7. Invoice

8. Payments

9. Recording of purchases

4.3.3 Purchases requisitions

Refer to the written requests by all departments for goods required by them, to the purchasing

department. These requisitions contain the description of goods required, quantity required, and

time when required. These forms are signed by an authorized person of the department that needs

these goods. E.g. head of stores department, works manager etc.

Letter of inquiry

The purchasing department sends a letter of inquiry to various suppliers after receiving the purchase

requisitions.

Quotation

These are received from different suppliers in response to letter of inquiry.

The purchase order

After receiving the quotations the purchasing department selects the best supplier and issues a

purchase order. E.g. a L.P.O (local purchase order)

Receipt of goods

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Once the supplier receives the purchase order, he makes arrangements to deliver the goods. The

selling organization prepares and delivers the goods. The buying organization prepares and issues

goods received note and also signs the delivery note. Other documents involved in the receipt of

goods include advice note and a package sheet. Goods are mostly received by the stores

department.

If goods received are of inferior quality or not according to the description given in the purchase

order, then the receiving dept can refuse to accept them.

A rejection Note or goods returned note are issued.

Invoice – this is a claim of money by the supplier from the purchases for the goods supplied. It’s

send by the supplier to the buying firm.

Payment – After receiving the invoice, the buyer checks the amounts due to the supplier and once

satisfied he makes arrangements to remit money e.g. through a cheque. On receipt of the cheque or

cash, the supplier issues a receipt as a proof that transactions have been completed.

Recording stock- Goods purchased are recorded in the accounting books of any organization. The

entries in the cost are made from goods received notes while the financial entries are made from

invoices. Both entries should be reconciled.

4.3.4 ISSUE OF MATERIALS

Purchased materials are issued by the storekeeper to the respective departments on presentation of a

material requisition note.

Material requisition note

It’s an authorization to the storekeeper to issue raw materials, finished parts or other items of store.

It’s signed by a responsible person of the department e.g. foreman. The note contains the name of

department that needs this material, the details of materials required, the purpose for which the

material is required and signatures of the persons who prepare and authorize this requisition note.

Material issue note

It’s a document which is prepared by the store department containing the details of materials issued,

material requisition name; value of goods issued and signature of the persons receiving and

receiving the materials. This document is used by the costing department to prepare cost accounts.

Material return note

55

It’s a document used to return some materials to the stores department incase they were in excess. It

contains:-

Details of materials returned.

Reason for as return.

The job number to which it was originally charged.

Signatures of the person who returns from the department and the receiver in the stores

department.

Material transfer note

It’s a document used to transfer materials from one job to another job or from one department to

another department.

It is used by the stores and costing dept’s to charge the value of materials to the correct jobs.

4.4 Store - Keeping And Stock Control

4.4.1 Store Keeping

Store – keeping refers to keeping the store of materials and keeping the stores records. The stores

department receives materials; hold them centre they are required by the production department. It

also maintains records regarding receipts, issues and stock balances of materials.

Features of Effective and Good Storekeeping

1. Immediate location of materials

2. Speedy receipt and issue of materials.

3. Full identification of all materials at all times.

4. Keeping concept and up to date records of receipts, issues and stock balances of materials.

5. Protection of materials against pilferage and deterioration.

6. Protection of materials against fire and theft.

7. Economical use of storage space.

4.4.2 Types of Stores

o Centralized stores

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o Decentralized stores

o Imprest stores

Centralized Stores

Centralized system In this case the duty and responsibility of purchasing is done by one purchaser ispurchasing department.

b)

Reduces risk since purchasing is spread to many department.

ii) It is specialized in terms of specific material requirement.

iii) There is accountability.

iv) Less bureaucratic.

v) There are 6 minimum production breakdown due to the short time required in having the materials.N/B: The advantages of decentralized are the disadvantages of centralization

.

Decentralized Stores

These are stores where materials are held and issued by sub-stores in each department or branch.

The advantages are the disadvantages of centralized and vice versa.

. Decentralized system the duty and responsibility of purchasing is placed with individual branch departmentor geographical department. Advantages of centralized systemi) Less expensive since few activities are concentrated in one department.

ii) There is better control because of effective and efficient monetary.

iii) There is more accountability.

iv) There is bulk buying hence economies of scale are enjoyed.

v) Fewer staffs are employed.

vi) There is expertise in buying due to specialization.

N/B: The advantages of centralization are the disadvantages of decentralization. Advantage

decentralization

Activity 4.1

57

Visit your organization purchasing department and indentify which method of store system it has

adopted.

4.5 Material Coding

A code is defined as “a system of symbols designed to be applied to a classified set of items to give

a brief accurate reference facilitating entry, collation and analysis”.

Materials are coded for immediate identification. The coding may be in terms of sizes or models.

Purposes of Coding

To avoid ambiguity in description

To minimize length in description.

Principle of Coding

a) Certainty

b) Elasticity – flexibility

c) Brevity – brief

d) Memorization – easy and possible to remember and understand the code numbers.

e) Uniformity – equal length and same structure codes.

f) Exclusive – each item should have only one code and this code should not be used for

any other item.

4.6 Stock recording and inventory control

This refers to documents which give information regarding the movement of stock. These

documents include: - stores ledger and bin cards.

4.6.1 Stores Ledger

This is similar to the financial ledger. It contains three columns for receipts, issues and stock

balance in hand. Receipts and issues columns each have three columns for quantity, price and value

where as the balance column shows units and value columns.

58

STORES LEDGER

Date Receipts Issues Balances

G.R

note

NO

Qty Price Value M..K

note No

Qty Price Value Units Value

4.6.2 Bin Cards

A bin card is a stiff card which is kept where the relevant stock item is stored. Goods or materials

are stored in drawers, shelves or racks. A separate bin card is used for each kind of goods.

FORMAT

BIN CARD

DATE RECEIPTS ISSUES BALANCE REMARKS

G.R NO Qty M.R NO QTY QUANTITY

NB: GR. NO – Goods received note number.

MR NO – Material requisition note number.

Stock – Taking

59

Stock taking – means to check physically the stock items in order to ensure that stock quantities

shown on stock records and actual quantities are the same.

4.6.3 Systems of Stock Taking

Periodic StocktakingThe objective of periodic stocktaking is to find out the physical quantities of materials of all types at agiven date. This is a substantial task even in a modest organization and becomes difficult if notimpossible task in a large firm. The following factors should be considered:(i) Adequate number of staff should be available who should receive clear and precise instructions onthe procedures

(ii) Ideally the stock take should be done on a weekend so as not to interrupt with production

(iii) The stock take should be organized into clearly defined physical areas and the checkers shouldcount or estimate all materials in the area.

(iv) Adequate technical assistance should be available to identify materials, part no‟s etc. far greater errors are possible because of wrong classification than wrong counting.

(v) Great care should be taken to ensure that only valid stock items are included and their correctness.

(vi) The quantities of each material should be checked against the stock record to expose any grosserrors which may be due to stocktaking errors or faults or error in recording system.

(vii) The pricing and extension of stock sheets, where done manually, should be closely controlled.Frequently the pricing and value calculations are done by computer, the only action necessary being toinput quantities and stock and part numbers.

Continuous stock takingTo avoid disruptions caused by periodic stock taking and to be able to use better trained staff, manyorganizations operate a system whereby a proportion of stock is checked daily so that over the year allstock is checked at least once and many items particularly the major value of fast moving items, wouldbe checked several time. Where continuous stock taking is adopted, it is invariably carried out by staffindependent from the storekeepers. Continuous stock taking is absolutely essential when an organizationuses what is known as the perpetual inventory system. This is a stock recording system whereby thestock balance is shown on the record after every stock movement, either issue or receipt. With thissystem the balances on the stock record represent the stock on hand and the balances would be used inmonthly and annual accounts as the inventory system is functioning correctly and that minor stockdiscrepancies are corrected.

Just-in-time (JIT) systemsJIT were developed in Japan, notably at Toyota, and are considered as one of the main contributions toJapanese manufacturing success. The aim of JIT systems is to produce the required items, of highquality, exactly at the time they are required. JIT systems are characterized by the pursuit of excellenceat all stages with a climate of continuous improvement. A JIT environment is characterized by:a) A move towards zero inventory

b) Elimination of non-value added activities

60

c) An emphasis on perfect quality i.e. zero defects

d) Short set-ups

e) A move towards batch size of one

f) 100% on time deliveries

g) A constant drive for improvement

h) Demand- pull manufacture

Production only takes place when there is actual customer demand for the product so JIT works on apull-through basis which means that products are not made to go into stock. Benefits from JIT(i) Lower investment required in all forms of inventory

(ii) Space savings from the reduction in inventory and improved layouts.

(iii) Greater customer satisfaction resulting from higher quality better deliveries and greater productvariety

(iv) The buffers provided by traditional inventories masked other areas of waste and inefficiency,supplier unreliability and so on. Elimination of these problems improves performance dramatically.

(v) The flexibility of JIT and ability to supply small batches enables companies to respond more quicklyto market changes and to be able to satisfy market niches

Perpetual inventory – involves recording all receipts, issues and running balances on bin card

4.7 Methods of Valuing Material Issues

To determine the material cost of different jobs or products, materials issued must be valued.Valuation methods include.

a) First In, First Out (FIFO)b) Last In, First Out (LIFO)c) Weighted average

we will only consider FIFO, LIFOand Average Weight Cost methods.To show the recording in the stores ledger cards under each case, the following example is used.

ExampleMay 2 received 500 units at Ksh20 each” 8 received 300 units at ksh 22 each” 10 issued 400 units” 15 issued 200 units” 20 received 600units at Ksh25” 25 issued 300units” 27 received 200units at Ksh26

” 30 issued 100 units

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a) First In First Out (FIFO).The method assumes that the goods issued are those which have been longest on hand and that thoseremaining in stock represent the latest purchases or production.The stocks whose cost is to be carried forward were acquired or produced most recently.

NB: materials are issued at the cost price of that consignment which was received first. When thisconsignment is finished, then cost price of next consignment is finished, then cost price of nextconsignment is charged to value the materials issued.

This method is based on the assumption that stock purchased first is issued first. Prices of stockpurchased first are used to determine the cost or value of inventory issued. Closing stocks arecarried at the latest costs.

Advantages

1. It is a realistic system: oldest items are usually issued first out.

2. Unrealized profits or losses do not arise

3. It is easy to calculate if prices of materials don’t fluctuate

4. Closing stocks values reflect the latest costs thus tend to reflect the current market values.

5. It is acceptable to many tax authorities and is also consistent with accounting practices e.g.IAS/IFRS.

Disadvantages

1. It involves tedious calculations if the price of materials fluctuate from time to time

2. Product costs, based on the oldest material prices, lag behind current conditions especially ininflationary markets.

3. Comparison of one job with another may be difficult if materials are issued at different prices.

STORES LEDGER CARD

DATE RECEIPTS ISSUES BALANCES

62

G.RNO

QTY Price Value M.RNO

QUANTITY Price Value Qty Value

May 28

10

15

20

25

27

30

500300

600

200

2022

25

26

10,0006,600

15,000

5,200

400

200 100100

300200100

100

20

2022

2225

26

8,000

2,0002,200

4,4002500

2,600

500800

400

300200

800

600500700

600

10,00016,600

8,600

6,6004,400

19,400

15,00012,50017,700

15,100

500 units purchased on May 2, were first in and these must go first. These were issued as 400 unitson May 10 and 100unstis on May 15. These should be valued at Ksh20 per unit. 300 unitspurchased on May 8, were issued as 100units on May 15 and 200 units or May 25.

These must be valued at Ksh22 each unit. From 600 units purchased on May 20, 100units wereissued on May 25 and 100 units on May 30. These were valued at Ksh25 each. Now 600 units instock are valued as under:-400 units from May 20 purchases = 400x25 = 10,000200 units purchased on May 27 = 200 x 26 = 5,200

15,200

b) Last In, First Out (LIFO)

This method assumes that the goods issued on any particular date are those which were most

recently acquired and therefore stocks whose cost is to be carried forward are those which were

acquired earliest. The materials are issued at the cost price of that consignment which was received

most recently. The advantage of the method is that it reflects the current economic value of goods

charged to production.

Is based on the assumption that the stock purchased last is issued first. Stock valuation shouldtherefore be based on the prices ruling on the acquisition of the last stocks.

63

Advantages

1. Product costs tend to be based on current market prices and is therefore realistic.2. A charge to production is as closely related to current price levels as possible

Disadvantages

1. Stocks are valued at the oldest prices.2. It involves tedious calculations if the price of materials fluctuate from time to time.3. Comparison of one job with another may be unfair and difficult

Example

STORES LEDGER CARD

Date Receipts Issues BalanceG.RNo

Qty Price Value M.RNO

Qty Price Value Quantity Value

May 2” 8” 10

” 15” 20” 25” 27” 30

500300

600

200

Shs2022

25

26

Shs10,0006,600

15,000

5,200

400300100200

300

100

Shs

222020

25

26

Shs

6,6002,0004,000

7,500

2,600

500800

500400200800500700600

Shs10,00016,000

10,0008,0004,00019,00011,50016,70014,100

500 units were purchased on May 2 and 300 units on May 8. 400 units issued on May 10 must be

300 units from May 8, purchases and 100 units from May 2 purchases.

300 units are valued at Ksh22 each and 100 units at Ksh20 each. 200 units issued on May 15 will be

from first consignment because second consignment of May 8 is already finished. These must be

charged at Ksh20 each.

300 units issued on May 25 must be from last consignment of May 20 and these are charged at

Ksh25 each. 100 units issued on May 30 must be from last consignment of May 27 and these are

charged at Ksh26 each. Now 600 units in stock are valued as under:-

Ksh

100 units from May 27, purchases = 100x26 = 2,600

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300 units from May 20 purchases = 300x25 = 7,500

200 units from May 2 purchases = 200 x20 = 4,000

_____

14,100

C ) Average Weighted Cost Average

i. This method is a perpetual weighted average system where the issue price is recalculated after eachreceipt of stocks taking into account both quantities and money vale of the stocks received.

In this case stock used or unused is based on the average price per unit where the average price per unitis calculated as follows:

= Total value of stocks = Average Price Per Unit

No. of units of stock

= (Money value of old stocks + Money Value of New Stocks)

(Quantity of old stocks + Quantity of New Stocks)

This means weighted average price under this method, the total value of goods in stock is divided

by the number of units of stock. The resultant figure is weighted average price.

NB:

The method is simple and logical but it is not close to current value of goods.

Profit and loss may arise on the materials issued.

STORE LEDGER CARD

DATE RECEIPTS ISSUES BALANCEG.RNo

Qty Price Value M.RNO

Qty Price Value Quantity Value

May 2” 8” 10” 15” 20” 25” 27” 30

500300

600

200

Shs2022

25

26

Shs10,0006,600

15,000

5,200

400200

300

100

20.7520.75

23.94

24.53

8,3004,150

7,181

2,453

500800400200800500700600

10,00016,600

8,3004,150

19,15011,96917,16914,716

The formula for weighted average price is

= total value of goods in stock

65

No. of units

There for weighted average price is calculated as:

Date weighted average price

May 10 Ksh16,600 = Ksh20.75

800

May 15 Kshs 8,300 = Ksh20.75

400

May 25 Ksh19,150 = Ksh23.94

800

May 30 Ksh17,169 =Ksh24.53

Stock Control

This means making sure that the business has the right quantity of goods, in the right place and at

the right time. Stock level must be maintained at a reasonable level.

Objectives of Stock Control.

1. To ensure the availability of goods when required.

2. To account for the goods which have been purchased

3. To reduce storage costs as much as possible

4. To minimize the risks of deterioration, waste and theft

5. To maintain accurate records

To avoid over-stocking and under stockingCost Minimization through Economic Order Quality (EOD)There are four cost associated inventoryi) Purchase cost is the cost charged by the suppliers for the items purchased.

ii) Holding / carrying cost is the cost incurred as a result of having inventory item in the business. e.g. -Opportunity cost of capital tied up in stock

- Insurance and security cost - Refrigeration and conditioning - Ware housing changes. - Maintenance ofmachineryiii) Ordering cost is the cost of bringing stock items into the store. They include loading and off loadingcharges cost of purchasing department, transport etc.

66

iv) Stock out cost or shortage cost is the cost incurred as a result of not having inventory items in stock.E.g. production disruption which may lead to lower production, lost discounts cost of speeding up ordersand deliveries, lost customer good will.

Economic Order Quality (EOQ) This refers to the optimum number of units should be ordered everytime an order is made so as to minimize total stock cost. Assumptions / limitation of EOQ1. Replenishment is instantaneous (Q). There is no lead time. Lead time is the time taken betweenordering and delivery.

2. No safety stock.

3. Demand is known in advance and it is constant.

4. Purchasing cost and cost per order are constant i.e. there are affected by factors like discount.

5. Stock is replaced in equal batches.

6. Cost per order is constant irrespective of quality.

7. Stock holding / carrying cost is a function of average inventory.

8. No stock out cost.

Economic Order Quantity

This is the quantity at which the cost of having stock is minimum. The cost of having stock is

broken down into two:-

Holding costs which comprise:-

Cost of capital tied up

Warehousing

Deterioration

Obsolescence

Insurance

Ordering costs which comprise:-

Clerical costs

Telephone charges

Economic Order Quantity (E.O.Q) = 2CD

Where: P

C = delivery cost per batch

D = Annual demand for product

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P = Cost price per item

I = stock holding cost per annum (expressed as a fraction of stock value)

EXAMPLE

A company has an annual demand for material “p” of 25,000 tons per annum. The cost price per ton

is Ksh2, 000 and stock holding is 25% per annum of the stock value. Delivery cost per batch is

Ksh400.

Calculate the E.O.Q

E.O.Q = 2(400) (25,000)

25% of Ksh2000

= 2(400) (25,000)

500

= 40,000 = 200units

This means that 200units must be purchased at one time. If the batch size is more than or less than

200 units then stock holding and ordering costs will be higher

4.8 Stock Levels

Setting Material LevelsA business organization must not have too much of the stock or too little of it. Problems:a) Tie up capital in the stock.

b) There is risk of obsolesce

c) Costly in terms of storage facilities

On the other hand, having too little of the stock may have the following problemsi) Lost customer goodwill.

ii) Costly in terms of speeding up orders.

iii) Low production which may lead to losses.

Too low stock level or too high stock levels are not beneficial to an organization. Too low stock

level means production demands are not met resulting to loss of customers and profits reduction.

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High stock levels results in high storage costs, greater risk of deterioration of the stock hence

reduction in the enterprises profits.

Factors Affecting Stock Levels.

1. Availability

2. Lead time – refers to the period between the date of order and date of delivery. If lead time is

more then stock must be maintained at high level and vice versa.

3. Stock holding cost – high stockholding cost calls for low stock level and vice versa.

4. Consumption

5. Trade discount, - if the benefits of trade discount (due to bulk purchases) is greater than

stockholding cost, then stock level must be maintained at high level.

6. Durability.

Stock Level and its control

Management must make decisions about the control of stock levels with a view to minimizing the cost of thecompany while achieving more efficiency in the availability of material to fulfill planned usagerequirements. Consideration should be given to the following control levels:

a) Minimum stock level

b) Maximum stock level

c) Re-order level

d) Re order quantity (Note the re-order quantity is not necessary the EOQ)

a) Minimum stock level

This is the level below which stock should not fall. It is essentially a base (buffer) stock level. If stockfalls below this point, there is a danger of stockout.

Minimum stock level = Reorder level – (Normal consumption x normal reorder period)

b) Maximum stock level

This is the upper limit above which stock should not be allowed to rise. Each material to be kept in storemust have a maximum level and stock should not be allowed to go beyond this level

Maximum stock level = Re-order level +re-order Quantity - (Minimum consumption x minimum re-order period)

c) Re-order level

Is a point that lies between minimum and maximum stock levels at which purchase orders must beplaced to ensure that goods ordered are received before the minimum stock level is reached? It is thelevel of stocks at which replenishment must be made to avoid a stock-out.

Re-order level = maximum consumption X maximum re-order period

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d) Re-Order quantity

This is the quantity of stock ordered once the re-order point is reached. The quantity is such as tominimize stock costs taking into consideration the cost of holding stocks and making an order. This isalso regarded as the Economic Order Quantity (EOQ). It is computed as follows:

Where D is the annual demand (knits)

Co is the cost of making one order

Ch is the holding cost per unit per annum

ChODC2EOQ

Economic Order Quality (EOQ)

Define the EOQ model and the three methods of computing EOQ.

- Assumptions of the model.

Formulae of Stock Levels

Re-Order Level = Max: Consumption x Max. Re-order /lead time Period

Minimum stock level = RL – (NC x NRP)

Maximum stock level = MIN : SL – (MIN : C x MIN.RP)

A.S.L = Max stock + Min stock level

2

Where:

Max C = Maximum consumption

Min C = Minimum consumption

NC = Normal consumption i.e. average of max: C and Min C.

Max: RP – Maximum re-order period or lead period

Min: RP – Minimum re-order period

NRP – Normal re-order period

RQ – Re order quantity

Min: SL – Minimum stock level

Max: SL – Maximum stock level

EXAMPLE 1

70

Illustration

The following information was extracted from the books of Danex Holdings regarding itsstocks:

i. Reorder quantity 1,800ii. Reorder period 4 weeksiii. Maximum consumption 450 units/weekiv. Normal consumption 300 units/weekv. Minimum consumption 150 units/weekVi Maximum reorder period 5 weeksVii Minimum reorder period 3 weeks

Required

Determine the following stock levels for Danex Holdings:

i. Re-order level

ii. Maximum stock level

iii. Minimum stock level

Solution

i) Re-order level = Maximum consumption X maximum reorder period

= 450 units X 5 weeks = 2,250 units

ii) Maximum stock level = reorder level + reorder quantity-

(Minimum consumption X minimum reorder period)

= 2250 + 1800 – (150 X3) = 4050 – 450 = 3600 units

iii) Minimum stock level = Reorder level – (Normal consumption X

normal reorder period)

= 2,250 – (300 X 4) = 2250 – 1200 = 1050 units

4.9 Summary 700

71

From the costing perspective, the essentials of material purchase and control prior to actual use inproduction can be summarized as follows:

i. Materials of appropriate quality and specification should be purchased only when required andappropriately authorized.

ii. The suppliers chosen should represent an appropriate balance between quality, price and delivery.iii. Materials should be properly received and inspected.iv. Appropriate storage facilities should be provided and stock levels physically checked on a

regular basis.v. Direct material used in production should be charged to production on an appropriate and

consistent pricing basis.vi. Indirect material used in production and non production departments should be appropriately

charged to correct cost centre and included in the overheads of the cost centre.vii. The documentation, accounting system and controls at each stage should be well designed and

effectiveviii. Stock taking must be well organized to ensure that stock quantities on hand are available when

required.


QUESTION ONE

Assume the following purchases were made in Liz Ltd

Date of purchase Units purchased Price/unit1st January 500 1002nd January 600 2003rd January 800 400

Units used on 4th January are 900. Determine the value/cost of units used by using FIFO, LIFO and weightedaverage.

Required:

Determine the cost of units used and the value of the closing stocks using FIFO, LIFO and WeightedAverage.

QUESTION TWO

72

LATEX Ltd. are retailers who sell ceramic tiles. During the months of Jan to March 2012, there wereprice fluctuations. Due to the above problem the company had to adjust its selling prices.

The following transactions took place during the period.3 JAN Opening stock was 5,000 tiles valued at Sh 825,000.10 JAN Orders placed with the company increased, so extra tiles had to be

obtained from Mombasa. Therefore 22,000 tiles were purchased at a cost Sh 140each but in addition, there was a freight and insurance charge of Sh 5 per tile.

31 JAN During the month 20,0000 tiles were sold at a price of Sh 220 each.4 FEB A new batch of 14,000 tiles was purchased at a cost of Sh 175 per tile.28 FEB The sales for the month of August were 14,000 tiles at a selling price of Sh 230

each.1 MARCH A further 24,000 tiles were purchased at a cost of Sh 195 each.30 MARCH 27,000 tiles were sold during September at price of Sh 240 each.

The cost accountant of LATEX Ltd decided he would apply first-in-first-out basis and weighted averagemethods of material pricing for purposes of comparison.

Required:(i) A stores ledger account using the two methods and showing stock values at 30 MARCH 2012.

(14 marks)(ii) The trading accounts using each of the above methods.

QUESTION THREE

The following information is provided for material PQ 251. Maximum consumption = 12000 units

per week.

Minimum consumption = 8000 units per week

Reorder period or Lead time 4 - 6 wks

Re-order quantity 60,000 units

Required

1. Re –order level

2. Minimum stock level

3. Maximum stock level

4. Average stock level


73

1.Paresh, S. (2010) “Cost Accounting” 3rd






74

LECTURE FIVE

5.0 LABOUR COSTING

5.1Lecture OverviewLabour is the physical and mental energy applied by human beings in the process of manufacture of aproduct or service. It is important to understand how the cost of labour is accounted for in this process.This lesson introduces the learner to various method of labour costing.

5.2 Objectives

By the end of this lecture, you should be able to:(i) Know the main categories of remuneration

(ii) Understand the feature of time based systems (i) Know the main categories of remuneration

(ii) Understand the feature of time based systems

(iii) Know the features of Incentive schemes

(iv) Be able to distinguish between straight and differential piecework

(iii) Know the features of Incentive schemes

(iv) Be able to distinguish between straight and differential piecework

5.3 Remuneration Methods

Trends in Employment and Remuneration

At present Manual workers are paid by some form of incentive scheme. This overall percentage masksextremely wide variation from industry to industry. For example in general engineering around 80% ofthe workers are paid wholly or partly by some form of incentive scheme, whereas in process industriesthe figure is as low as 15%.There has been a general tendency for larger firms to move away from direct incentive schemes toschemes such as measured day work. There is also a tendency for workers to become salaried employeeswhich has clear costing implications as direct labor costs become more fixed in nature rather thanvarying with output.The trend evident in most parts of the world is that patterns of employment are changing from full timeemployment to part time employment. There is less job security and more self employment. In Kenya,the government is starting to move away from permanent employment schemes to renewable contractualschemes. The ultimate goal is to have a flexible employment system where demand for labor is matchedwith availability of work. However, this does not mean that full time employees will be eliminated.Companies will want to maintain a small core of full time employees with a large pool of part-timers or

75

contractors. In effect firms will be operating Just in Time system for labor. The new developments arenot without disadvantages as it may result into social oppressions, low and irregular earnings, and biaseddismissals in the pretext of no work or poor performance.

The two main categories of remuneration are:i. Time basedii. Remuneration related to output or performance.

Within these two categories there are innumerable variations some of which have general applicabilitywhilst others are of a local and specialized nature. Remuneration systems are frequently complex andadministratively cumbersome, but because the system is the result of negotiations, disputes anddisagreements over the years, attempts to rationalize and simplify are frequently met with hostility andsuspicion.The newer forms of production organization, such as Just In Time systems mean more and more workerswill be paid time rates and will not have their pay dependent on individual output levels. There are tworeasons for this: first, parts are only produced as and when required. This means that the repetitiveproduction of components that move into stock is avoided as one of the key objectives of JIT. Secondly,what counts in JIT is the output of the group (known as a production cell) as a whole. As a consequenceworkers have to be flexible and adaptable so that they can move from task to task according the demand.In such circumstances individual incentive schemes are of little or no value.In addition more and more wages and salaries, traditionally classified as overheads, are now beingtraced to product lines and classed as direct. Support functions are also grouped around specific productlines so that identification of costs is more direct. This has led to the development and use of activitybased cost system (ABC System)

Time Based Systems

Basic SystemAt the simplest level workers would be paid for the number of hours worked at a basic rate per hour upto, say, 40 hours per week. Time worked in addition to 40 hours would be classed as overtime and isusually paid at a higher rate.Although workers pay is not related to output, this does not mean that the output and performance isunimportant. Supervision and managerial control systems are employed so that workers are paid foractually working and not merely attending.Advantages

i. simple to understand and administerii. It simplifies wages negotiations because only the rate needs to be determined unlike incentive

schemes where negotiations are complicated.

Disadvantagesi. it has no real incentive to increase outputii. all employees in the same grade are paid the same rate regardless of performanceiii. constant supervision may be necessary

The time based systems are most appropriate for:i. Work where quality, safety, health care are all important e.g. tool making, nurses, signal operators

etc.

76

ii. Work where incentive schemes would be difficult or impossible to install e.g. direct labor, storesassistants, clerical work etc.

iii. Work where output is not under the employees control e.g. power station workers, teachers, etc.

High Day Rate Pay System

This is a time system which is designed to provide a strong incentive by paying rates well above normalbasic time rates in exchange for above average output and performance. For its successful application itis necessary to ensure that the output levels are the result of detailed work studies and that there isagreement from the labor force and the unions involved on the required production level. A typicalapplication of this system is on assembly line production in the car industry and in the domesticappliance manufacture.Advantages

ii. It is claimed to attract higher grade workers.iii. Provides a direct incentive without the complications of individual piecework ratesiv. Simple to understand and administer

Disadvantagesi. May cause other employers to raise their rates to attract better workers thus nullifying the original

effect.ii. Problems occur when the original target production figures are not met

5.4 Incentive schemes in practice (Premium Bonus Schemes )

Premium bonus is paid to the workers according to hours saved.

The employers assign some jobs to the workers to complete within a specific number of hours. If

the workers complete those jobs less than time allowed then there are some savings to the employer.

The workers are paid according to hours worked. The employer saves some money because they are

not supposed to pay the worker for the hours saved by them.

According to premium bonus schemes, the savings accruing to the employers out of time saved by

the worker should be shared between the employers and the workers. The premium bonus is paid to

a worker on the basis of his individual efforts.

The premium bonus schemes include:-

i. Halsey scheme

ii. Halsey – Weir schemes.

iii. Rowan – scheme

The formula for the workers total pay is:-

Day rate wage + bonus based on time saved.

Time saved (T.S) = time allowed (T.A) – Time taken (T.T)

77

Harsey Scheme

Bonus = ½ (time saved x wage rate)

Halsey – Weir

Bonus = 1/3 (time saved x wage rate)

Rowan: bonus = time taken x time saved x wage rates

Time allowed

Example 1

Total output of Mwangi for one week was 480 units. He was allowed 8 minutes per unit. He

completed these units in 52 hrs. His wage rate per hour is Ksh18.

Calculate his total wage according to:-

i. Halsey scheme

ii. Halsey – weir scheme

iii. Rowan scheme

Answer

Units completed = 480 units

Time allowed per unit = 8 minutes

Time allowed for 480 units = (8/60 x 480) hrs = 64hrs

Time taken = 52 hours

Time saved = (64-52) hrs = 12 hrs

Basic wage rate = Shs (52x18)

= Shs936

i) Halsey scheme:

Bonus = ½ x T.S x wage rate

= ½ x 12 x Shs18

= shs108

Total wage = basic wage + bonus

= shs936 + 108 = shs1044

Ii) Halsey weir scheme

Bonus = 1/3 x T.S x wage rate

1/3 x 12 x 18

78

= shs72

Total wage = basic + bonus

= 936 + 72

= Shs1008

Iii.)Rowan scheme

Bonus = T.T x T.S x wage rate

T.A

= 52 x 12 x18

64

= shs175.50

Total wage = basic + bonus

= 936 + 175.50

=Shs1, 111.50

5.5 Procedure for Preparing a Payroll

1. Calculate gross wage of each employee.

Gross wage = No of hrs worked x wage rate + over time hrs x over time wage rate

2. Calculation of income tax payable by each employee under the P.A.Y.E system.

3. Contribution regarding N.S.S.F, N.H.I.F etc are determined

4. Total deductions each employee is shown.

5. Calculation of net wages = Gross wage – Total deductions

6. Any advance taken by employees or loan repayments are subtracted to find out the wages

payable.

Example

From the following information, prepare a payroll for the month of May 2014.

Clock No. Name No of Hrs worked Rate of pay Advance paid

(shs)

MU1

MU2

MU3

MU4

Peter

Jane

Mathew

Eunice

180

200

190

210

Shs 200 per Hr

” 280 per Hr

” 240 per Hr

” 200 per Hr

5000

10,000

3000

1600

79

MU5

MU6

Joseph

Elizabeth

200

170

” 320 per Hr

” 260 per Hr

1600

10,000

Additional Information

1. Normal working hours per month are 180. Overtime payable for extra hours at the rate of

50% above normal pay rate.

2. P.A.Y.E to be deducted at the rate of 20% of gross wage.

3. N.S.S.F to be deducted Ksh200 for each employee.

4. N.H.I.F to be deducted Ksh400 for each employee.

PAYROLL – MAY 2014

S.No Name Total

hrs

worked

Rate Gross

wage

Deductions Net

wage

Advance Bal

P.A.Y.E NSSF NHIF Total

deductions

Shs Shs Shs Shs Shs Shs Shs Shs Shs

5011

5012

5013

5014

5015

5016

Alex

Robert

Wachira

Paul

Josphat

Mwangi

190

180

200

170

210

200

12

10

16

13

10

14

2,340

1,800

3,360

2,210

2,250

2,940

234

180

336

221

225

294

80

80

80

80

80

80

20

20

20

20

20

20

334

280

436

321

325

394

2,006

1,520

2,924

1,889

1,925

2,545

600

500

800

500

800

700

1,406

1,020

2,124

1,389

1,125

1,846

14,900 1,490 480 120 2,090 12,810 3,900 8,910

Workings

Gross wage Shs

1. Alex = 180hrs xshs12 = 2160

10hrs x shs 18 = 180 2,340

2. Robert = 180hrs x shs 10 1,800

3. Wachira = 180hrs x shs16 2,880

20hrs x shs24 480 3,360

80

4. Paul = 170hrs x Shs13 2,210

5. Josphat = 180hrs x shs10 1,800

30hrs x shs15 450 2,250

6. Mwangi = 180hrs xshs14 2,520

20hrs x shs21 420 2,940

NB: I. For overtime, payment is to be made at normal rate plus 50% of normal rate.

(ii) P.A.Y.E is taken 10% of gross pay.

Activity 2.6

Finally, we have come up with a pay roll; do you see any linkages or relationships between the payroll and the payslip. Look at your pay slip and compare.

5.6 Allocation of Labour Costs.

Labour cost is allocated to respective jobs or products. Labour cost being a direct cost can be

identified and charged to the products which are produced by a specific worker. The allocation of

labour cost to the right jobs or products is required to ascertain the total cost of those jobs or

products.

Example

Simon worked 360 hours during the month of June 2012 and he was paid at the rate of Ksh200 per

hour. During the month he completed three jobs. The following additional information was

provided.

Job No of hrs

A 160

B 120

C 80

Calculate the labour cost chargeable to these three jobs on the assumption that these jobs were

completed only by Simon.

Answer

Total wages of Simon = 360hrs x shs200 = shs72000

Proportion of time for three jobs

81

A B C

160 120 80

OR 4: 3: 4

Therefore labour cost is apportioned as per these proportions.

Job A = shs72000x4/9 = shs800

” B = shs72000x3/9 = shs600

” C = shs72000x2/9 = shs400

5.7 Summary

In summary, the lecture aimed at explaining method of labour costing The two main categories ofremuneration are:

i. Time basedii. Remuneration related to output or performance


Illustration 1

Under a premium bonus scheme, workers received a guaranteed basic hourly minimum rate of pay plus abonus of 50% of the time saved. No payment is paid beyond the time allowed but the bonus which is paid atthe basic hourly rate is applicable to the accepted output only. No penalty is imposed on rejected output. Thefollowing details are available for the month of January 2003

Worker A B C

Time allowed per unit (hrs) ¼ 1/6 ½

Units produced 474 684 175

Units rejected 54 84 25

Time taken (hrs) 78 72 80

Basic Pay per hour (Kshs) 6 6 3

82

Required

From the above information calculate for each employee

a) Bonus hours and amount of bonus paid

b) Gross wages earned

c) Labour cost for each good unit sold

Illustration 2

Based on the data below you are required to calculate the remuneration of each employee as determined byeach of the following methods

i. Hourly rate

ii. Basic piece rate

iii. Individual bonus scheme where the employee receives the bonus in proportion of the time savedto time allowed

Name of employee Salmon Roala Pike

Units produced 270 200 220

Time allowed in minutes per unit 10 15 12

Time taken (hours) 40 38 36

Rate per hour (Kshs) 125 105 120

Rater per unit (Kshs) 20 25 24

5.9 Further Reading








83

LECTURE SIX

6.0 Overheads Costing

6.1 Lecture OverviewThis lecture introduce you to production overheads and methods of charging overheads to products,departments or processes.

6.2 Objectives

By the end of this lecture, you should be able to:i) Define overheads

ii) Describe methods of charging overheads to the final product

iii) Explain different types of overheads .

6.3 OVERHEADS

Overheads refer to “the total cost of indirect materials, indirect labour and indirect expenses”.

Indirect costs are those costs which cannot be identified to the production of some specific goods.

Overheads May Be Classified As:-

Production Overheads – include indirect materials, indirect wages, factory rent and rates,

depreciation of factory plant and other indirect expenses.

Administration overheads – e.g. office salaries, office rent depreciation of office equipments and

other office expenses.

Selling and distribution overheads e.g. advertisement, salaries of salesmen, rent of sales

warehouse, delivery van expenses, depreciation of delivery van and other sundry selling and

distribution expenses.

Over heads may also be classified as fixed overheads, sums fixed over heads or variable overheads.

Overhead Allotment

This means the charging of overheads to cost units or cost centers. This is done so as to ascertain the

total cost of a job as a product.

84

Stages of Overhead Allotment

Collection of overheads

Overheads analysis

Overhead absorption

Collection of Overheads

This involves accumulation of overheads in a specified period under separate heading.

These are collected from costing and financial accounting records e.g. indirect wages are obtained

from wages analysis book, indirect materials from stores requisitions etc.

Overhead Analysis

This is an analysis that charges overheads to cost centers. A cost centre is “a location, person or item

of equipment. (Or group of these) in respect of which cost may be ascertained and related to cost

units e.g. production department “A” is a cost centre. There are two ways of charging overheads to

cost centers via

Allocation of overheads.

Apportionment of overheads.

Allocation of overheads means to change those overheads to a cost centre which results solely from

the existence of that cost centre. E.g. salaries of supervisors of department “A” are expenses of this

department and must be charged to this cost centre only. This is possible only if:-

1. The cost centre has caused the overhead to be incurred and

2. The exact amount of the overhead is known.

Apportionment of overheads means to charge a cost centre a fair share of an overhead.

The overheads which are incurred for the organization as a whole must be charged to various cost

centers of the organization e.g. monthly rent shared among the departments in an organization in a

specified proportion.

Absorption of Overheads

This refers to the charging of overheads to cost units. The overheads of a particular cost centre are

absorbed into cost units produced during a specified period.

6.4 Bases of Apportionments.

85

The following bases are applied for apportionment of overheads to cost centers.

Basis of apportionment Overheads to which basis applies

1. Area Rent, rates, heat & light, depreciation of buildings, maintenance of

buildings, insurance of premises etc.

2. Book value Depreciation of plant & machinery, insurance of plant, repairs, and

maintenance.

3. No of employees Expenses of personnel office, canteen, welfare of staff, safety

measures, supervision etc

4. Weight of materials or

cost of materials used

Materials handling expenses, storekeeping, packages costs etc.

5. Technical estimates Power consumption, water usage, steel consumption etc

6. Sales revenue Advertisement, selling & distribution expenses etc.

7. Direct wages Staff training, provident, contributions etc

8. Machine hours or

labour hours

General overhead items

9. No of radiators Heating

NB: Appropriate basis of apportionment should be chosen. The basis should be equitable,

practicable, economical, reasonable and accurate.

Overhead Analysis Sheet

This sheet contains the following columns:-

1. Column 1 – shows the name of overhead to be allocated or apportioned eg rent, depreciation, etc.

2. Column 2 – shows the basis of apportionment or allocation.

3. Column 3 – shows the total amount of the overhead which is to be apportioned.

4. Column 4 – shows the No of total units in respect of any specific overhead eg area, book value

etc

5. Column 5 – shows the rate of overhead per unit.

Thus rate of – total overhead amt

Total no of units

86

6. Other columns depending on the No of departments or cost centre.

Example

The following information relates to a factory which has four departments.

A) Overhead shs

Rent 160,000

Repairs to plant 100,000

Depreciation of plant 80,000

Light & heat 40,000

Supervision 120,000

Repairs to buildings 60,000

B) Information in respect of four departments:

Departments

mixing boiling heating packing

Area in Sq meters 3000 2400 1600 1000

No of employees 70 50 50 30

Value of plant (shs) 1000,000 600,000 400,000

X2

Required: prepare an overhead analysis sheet showing clearly the basis of apportionment.

Overhead Analysis Sheet

Overhead Basis Amt

(shs)

Amt (shs) Rate/unit Dep. A Dep B Dep C Dep D

Rent Area 80,000 4000m2 Shs 20

per m2

30,000 24,000 16,000 10,000

Repair to

plant

Value of

plant

50,000 Shs1,000,000 Shs 0.05

per shs

25,000 15,000 10,000 -

Depreciation Value of 40,000 Shs1,000,000 Shs0.04 20,000 12,000 8,000 -

87

of plant plant per shs

Light & heat Area 20,000 4000m2 Shs per

5/m2

7,500 6,000 4,000 2,500

Supervision No of

employees

60,000 100

employees

Shs 600

per

employee

21,000 15,000 15,000 9,000

Repairs to

buildings

Area 30,000 4000m2 Shs7.5

per m2

11,250 9,000 6,000 3,750

280,000 114,750 81,000 59,000 25,250

WORKINGS

1. Total area = 1500 + 1200 + 800 + 500 = 4000m2

2. Total employees = 35 + 25 + 25+15 = 100

3. Total value of plant = shs (500,000 + 300,000 + 200,000)

= shs 1,000,000

4. Rent per Sq. M = shs80,000 = shs20 per m2

4,000

5. Repairs to plant per shs = 50,000 = Shs0.05

1,000,000

6. Depreciation of plant per shs. Shs40,000 = shs 0.04

Shs1, 000,000

7. Light and heat per m2 = shs 20,000 = shs 5

4000

8. Supervision per employee = shs 60,000 = shs600

100

9. Repairs to buildings per m2 = shs30,000 = shs7.5

4,000

10. Apportionment of rent e.g. Dep A = 1500 x shs20 = shs30,000

11. ” ” repairs to plant e.g. dep. B = 300,000 x shs0.05

= 15,000

88

12. Apportionment of depreciation of plant e.g. dep C = 200,000x shs0.04

= shs8,000

13.

14. Apportionment of light & heat e.g. dep D = 500 x shs5= shs 2,500

15. Apportionment of supervision e.g. dep A = 35 x shs 600 = shs21,000

16. Apportionment of repairs to buildings e.g. dep D = 500xshs7.5

= shs 3,750

6.5 Overheads of Service Departments

The overheads charged to service departments must be further charged to production departments.

Service departments are those which provide some services to the production departments. Service

departments are those which provide some services, to the production departments e.g. stores

departments, repairs department etc.

Example

A company operates a factory whose overheads for the year ending 31st Dec 2014 are as follows:-

Indirect Materials Shs Shs

Shop no 1 80,000

” 2 120,000

” 3 400,000

Tool room 24,000

Stores 32,000

Clerical services 12,000 308,000

Indirect Wages

Shop No 1 84,000

” 2 116,000

” 3 108,000

Tool room 74,000

89

Stores 30,000

Clerical services 44,000 456,000

Rent & rates 200,000

Insurance 40,000

Depreciation 600,000

Power 180,000

Light & heat 80,000 1,100,000

1,864,000

The following information is also provided.

Department’s area (m2) book value effective

Production of machinery H.P

(Shs)

Shop No 1 2000 10,00,000 100

Shop No 2 1,500 1,800,000 80

Shop No 3 3000 400,000

Service

Tool room 1000 600,000 20

Stores 1500 100,000 -

Clerical services 1000 100,000 -

10000 4,000,000 200

The service departments provide their services to production department as under:-

Service departments

Production departments Tool room Stores clerical

services

Shop No 1

Shop No 2

Shop No 3

30% 50% 30%

50% 30% 40%

20% 20% 30%

90

Required: prepare an overhead analysis sheet for the departments of the factory for the year ending

31st Dec 2014 showing clearly the basis of apportionment.

91

Overheads Basis Amount

(shs)

Units Rate

per

unit

Shop No

1

Shop No

2

Shop No

3

Tool

room

Stores Clerical

services

Indirect

material

Indirect wages

Rent & rates

Insurance

Depreciation

Power

Light & heat

Allocation

”Area

Bookvalue

”H.P

Area

154,000

228,000

100,000

20,000

300,000

90,000

40,000

-

500m2

2,000,000

2,000,000

100

5000m2

20

0.01

0.15

900

8

Shs

40,000

42,000

20,000

5000

75,000

45,000

8,000

Shs

60,000

58,000

15,000

9000

135,000

36,000

6,000

Shs

20,000

54,000

30,000

2000

30,000

-

12,000

Shs

12,000

37,000

10,000

3000

45,000

9,000

4,000

Shs

16,000

15,000

15,000

500

7,500

-

6,000

Shs

6,000

22,000

10,000

500

7500

-

4,000

Service Dept

overheads

apportioned

over

production

depts.

Tool room

Stores

Clerical

servicies

Technical

Estimate

”

”

Ratios

30:50:20

50:30:20

30:40:30

235,000

36,000

30,000

15,000

319,000

60,000

18,000

20,000

148,000

24,000

12,000

15,000

120,000

(120,000)

60,000

(60,000)

50,000

(50,000)

932,000 316,000 417,000 199,000 - - -

92

Service Departments Providing Service to Other Service Departments

When some service departments provide services to production departments as well to other

service departments then a part of the overhead cost of one service department should be charged

to other service department. E.g. assume the maintenance department provides some services to

the stores department and similarly, the stores department provides some services to the

maintenance department. In this case, the over head cost of the maintenance department should

be charged partly to the stores department and the over head cost of store department should be

charged partly to the maintenance department. Ultimately, the overheads of these service

departments must be charged to the production department only.

The methods of transferring the overheads of service departments to the production department in

respect of service departments providing services to other service departments include;

1) Repeated distribution or continued allotment method

2) Simultaneous equation

EXAMPLE 1

A manufacturing company has three production department and two service department.

Overheads of these departments for a period one as follows

Production Departments Shs

A 150,000

B 270,000

C 190,000

Service departments

X 30,000

Y 50,000

690,000

A technical assessment for the apportionment of the costs of the service department shows.

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NB.

DEPARTMENTS

A B C X Y

X 40% 20% 30% - 10%

Y 50% 20% 20% 10% -

You are required to show the total overhead chargeable to the three production department by

using the method known as continued allotment of apportioning service department costs

between the two service departments.

DEPARTMENTS

A B C X Y

Overhead 150,000 270,000 190,000 30,000 50,000

O.H of X apportioned 12,000 6,000 9,000 (30,000) 3,000

O.H of Y apportioned 26,500 10,600 10,600 5,300 (53,000)

O.H of X apportioned 2120 1060 1590 (5300) 530

O.H of Y apportioned 265 106 106 53 (530)

O.H of X apportioned 21 11 16 (53) 5

O.H of Y apportioned 3 1 1 - (5)

190909 287778 211313 0 0

I. The appropriate portion of the overhead of one service department is charged to the

other service department. E.g. 10% of the O.H of X department is charged to Y

department and so on. The process is continued until all the amounts are transferred to

production department.

II. The final overheads of the production department are equal to the total of O.H of all

departments i.e. 190,109 + 287,778 + 211,311 = 690,000

EXAMPLE 2.

A company has three production departments and two service departments. Overheads of these

departments for a specific period are as follows:-

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Production departments (shs)

P 25,000

Q 20,000

R 15,000

Service departments

A 10,000

B 7,800

77,800

The overheads of service center are charged out as under

DEPARTMENTS

P Q R A B

Service Dep: A 30% 30% 20% - 20%

Service Dep: B 40% 30% 20% 10% -

Required: show the total overhead chargeable to the three production departments by using

simultaneous equation methods.

Answer:

Let x = Total overhead of Dep ‘A’

Y = Total overhead of Dep ‘B’

Then X = 10,000 + 0.1y ------------ (i)

Y = 7,800 + 0.2x ------------- (ii)

Eliminate decimals by multiplying both equations by 10.

10x = 10, 0000 + y

10y = 78,000 + 2x

Re- arranging the equations:

10x – y = 10,000 -------------- (iii)

-2x + 10y = 78,000 ------------- (iv)

Multiply equation (iv) by 5 and add the result to equation (iii)

10x – y = 100,000

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-10x + 50y = 390,000

49y = 490,000

Y = 490,000 = 10,000

49

Substitute the value of y = 10,000 in equation (iii)

10x – 10,000 = 100,000

10x = 110,000

X = 11,000

Now, Let see apportion the value of x = 11,000 and y = 10,000 to the production

departments on the basis of agreed percentages.

PRODUCTION DEPARTMENTS

P Q R TOTAL

shs shs shs shs

Original O.H 25,000 20,000 15,000 60,000

Service Dep A 3,300 3,300 2,200 8,800

Service Dep B 4000. 3,000 2,000 9,000

Total 32,300 26,300 19,200 77,800

6.6 ABSORPTION OF OVERHEADS

Absorption of overheads means the charging of overheads to cost units. The overheads costs of a

cost centre are charged to cost units.

Overhead per cost units = total overheads

Units produced

The total overheads of a cost centre are established through allocation and apportionment of

overheads. The absorption of overheads is a process whereby the overhead is added to the direct

cost of each cost unit.

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In order to charge overheads to cost units, overhead absorption rate (O.A.R) is calculated.

The O.A.R is that rate at which overheads are charged to each cost unit.

6.6.1 Overhead Absorption Methods.

These are also referred to as bases of absorption they include:-

Method Formula to calculate O.A.R

Units of output

Direct labour hours

Direct machine hours

Percentage of material cost

Percentage of direct wages

Percentage of prime cost

Standard hours

Overhead

Units of output

Overhead

Total direct labour hours

Overhead

Total direct machine hours

Overhead x 100

Total direct material cost

Overhead x 100

Total direct wages

Overhead x 100

Total prime cost

Overhead

Standard hours

6.6.2 Choice of the Absorption Method

The method to be used should be selected according to the circumstances. It may be based on the

following factors.

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1. Units of output – appropriate when all the units produced are identical and involve

identical time and production process.

2. Direct labour hour – appropriate in those departments which are labour intensive.

3. Direct machine hour – appropriate in those cost centers where machines are used to great

extend in order to complete the production process.

4. Direct wages percentage – appropriate where wages paid are related to time.

5. Direct material percentage – suitable for those organizations when material cost represents

a large portion of total costs and where the material cost is significant factor.

6. Prime cost percentage: - most appropriate where each jobs material and labour cost

proportions vary to great extent. Standard hours – applicable in organizations where

standard costing technique is applied. Overheads are absorbed according to standard

hours.

Example

The following information is available from a manufacturing company:-

Total overhead shs600, 000

Total direct wages shs480, 000

Total direct material cost shs500, 000

Direct labour hours 75,000

Direct machine hours 50,000

Units of output shs750, 000

Calculate six overhead absorption rates.

Method Overhead O.A.R

Unit of output Overhead

Units of output

Shs600,000 = sh0.80 per unit

750,000

Direct labour hours Overhead

Direct labour

Shs600,000 = shs8 per labour

hour

75,000

Direct machine hour Overhead Shs600,000 = shs12 per

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Direct machine hours machine hr

50,000

Percentage of material cost Overhead x 100

Material cost

Shs600,000 x 100 = 120% of

500,000 material

cost

Percentage of direct wages Overhead x 100

Direct wages

Shs600,000 x100 = 125% of

direct

480,000 wages

Percentage of prime cost Overhead x 100

Prime cost

Shs600,000 x 100 = 61.2% of

prime

980,000 cost

6.6.3 Application of Absorption Rates

The overhead absorption rates are used to calculate the total cost of any particular job or cost unit.

Overhead absorption method is indicated in order to find out the total cost of a cost unit.

Example

The following information relates to the activities in a production department for a certain period.

Direct wages shs100,000

Direct materials shs200,000

Labour hours worked shs20,000

Machine hours used shs5,000

Total overhead chargeable to the department = shs150,000

On job number 1234 produced in the department during the period the relevant data was:-

Direct wages shs5,000

Direct materials shs12,000

Labour hours shs900

Machine hour’s shs250

Calculate the total cost of job No 1234 by five different methods of overhead absorption.

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Answer

Method Absorption rates

Direct labour hours shs150,000 = shs7.5 per machine hour

20,000

Direct machine hours shs 150,000 = shs30 per machine hour

5,000

Direct material percentage shs150,000 x100 = 75% of material cost

200,000

Direct wages percentage shs150, 000 x100 = 150% of direct wages

Shs100, 000

Prime cost percentage shs150,000 x 100 = 50% of prime cost

300,000

Total cost of Job Number 1234

Direct labour hours method shs

Direct materials 12,000

Direct wages 5,000

Prime cost 17,000

Over head = (900 x shs7.50) 6,750

(I.e. labour hours of this job x

labour rate per hour) Total cost 23,750

Direct machine hours method shs


Direct wages 5,000

Prime cost 17,000

100

Overhead (250xshs30) 7,500

(I.e. machine hours of this job x

Machine hour rate) Total cost 24,500

Direct material percentage method

Shs


Direct wages 5,000

Prime cost 17,000

Over head 75% of shs12, 000) 9,000

26,000

Direct wages percentage method

Shs


Direct wages 5,000

Prime cost 17,000

Overhead (150% of shs5, 000) 7,500

Total cost 24,500

Prime cost percentage method shs


Direct wages 5,000

Prime cost 17,000

Overhead (50% of 17,000) 8,500

Total cost 25,500

6.6.4 Under And Over-Absorption

Overheads are absorbed on predetermined rates in most cases. These are predetermined rates are

based on estimated (budgeted) production and estimated (budgeted) overheads.

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The actual overheads may be different than the estimated overheads. This results to under or over

absorption. If absorbed overheads are less than the actual overheads, this is known as under

absorption.

On the other hand, if the absorbed overheads are greater than actual overheads, this is known as

over absorption.

NB: The amount of under absorbed overheads should be added to total costs before the profit is

calculated. Over absorbed overheads are subtracted.

6.8 Summary

There should be a direct cause-effect relationship between consumption of overheads and thechosen cost driver. This relationship is not necessarily a short term one. Costs such as salariesmake up a significant portion of total overheads but are not easily adjusted in the short run. Thenumber and type of cost drivers chosen will depend on several factors such as:

i. the required accuracy of product costingii. The extend that a given cost driver captures the actual consumption of an activity by a

product.iii. The extend to which a cost driver can be related to many activities or cost pools. The cost

pool should be homogenous (fairly represented by one cost driver). Where this is notpossible the pool may need to be subdivided and numerous cost drivers used. (ofcourse this will complicate the system).

iv. The extend that one cost can be fairly applied to diverse products. For example if the costdriver, ‘number of inspections’ were used to trace inspection costs to products,distortions will occur if inspections take varying amounts of time for differentproducts.


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Example.

a) Equator garments Ltd manufactures custom-made suits tailored to the requirements of each

customer. They use predetermined overhead absorption rates in allocating overheads to each job.

In the cutting department the rate is based on direct labour hours and in the stitching department

the rate is based on machine hours. The management of equator garments ltd wants to set

overhead absorption rates to help in determining prices in the next financial year. The cost

accountant has provided the following budgeted data for the financial year:-

Cutting Stitching

Direct labour cost shs1, 200,000 shs750, 000

Factory overhead shs1, 500,000 shs1, 620,000

Direct labour hours shs60, 000 shs30, 000

Machine hours - shs40, 000

Required: calculate the overhead absorption rates for each department.

b) The following data relates to Job No. A4.

Cutting Stitching

Direct materials shs500 shs750

Direct labour hours shs30 shs10

Machine hours - shs20

Administration overheads are absorbed at 25% on factory costs. Profits mark – up is 33 1/3% on

costs.

Required: prepare a cost statement for Job A4 showing the price that will be charged to the

customer.

c) At the end of the year, the following data was obtained.

Cutting Stitching

Hours actually worked

Direct labour hours 68,000 30,000

Machine hours - 17,000

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Factory overhead cost incurred 1,600,000 760,000

Required: calculate the amount of under or over absorption of overhead for each department.








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LECTURE SEVEN

7.0 Costing Systems

7.1 Lecture Overview

This lecture is to introduce you to various methods of job order costing which is a form of specificorder costing which applies where the work is undertaken as per the customer’s specific requirements

.

7.2 Objectives

By the end of this lecture, you should be able to:(i) Explain the steps involved in activity based costing

(i) Define and explain the features of the various costing methods,(ii) Understand the environment under which the various product costing methods are applicable.(iii) Perform product costing computations.

7.3 SPECIFIC ORDER COSTING

This is a broad costing system, which is applicable where work jobs consist of separate jobs, batches orcontracts. Each job, batch or contract is a cost unit and in most cases, it is different from another. Eachorder made can be identified separately and the system is designed to find the cost of each order. Specificorder costing is subdivided into:

a) Job costingb) Batch costingc) Contract costing

7.3.1 JOB COSTING

This is a costing method which is applied when a job/cost unit is relatively of small size, is undertaken tofit the customer’s specifications and is of comparatively short duration: Each job moves through theoperations continuously as an identifiable unit. The method is usually adopted by businesses, whichreceives orders for work peculiar to the needs of individual customers.

a) Features of Job costingProduct is against the customer’s order and not on job stocksEach job has its own characteristics and requires special attention and skills.

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b) Procedures of Job Costing

The application of job costing method begins when a customer’s order is received. After accepting anorder, an individual work/job order number is assigned to each job for or separate order identification..Production order is then made giving authority for the job to start. A job cost account for each job is thenopened. In this account, all costs relating to that particular job are recorded and this account closed onlywhen the job is complete. After completion of the job, an invoice is prepared and served to the customer.

Materials for each job are made using material requisition forms Labour is charged on the basis of the amount of time used to complete that particular job as

recorded in time-keeping records. Overheads are charged on the basis of an predetermined overhead absorption rate.

Applied Overhead absorption rate = Budgeted Overheads ÷ Denominator valueThe Denominator value where the denominator value refers to units of some specified overheadabsorption base e.g. machine hours, direct labour hours.

7.4 Accounting for Job Order Costing

1. (a) Direct materials

(i) Dr Stores ledger control A/c Cr Cash A/c – for cash purchasers X

(ii) Dr Stores ledger control A/c Cr Creditors A/c – for credit purchasers X

(b) Return of materials to suppliers

Dr Cash A/c or creditors control A/c X

Cr Stores ledger control A/c X

(c) Issue of materials from the store

Dr – W.I.P. Control A/c X

Cr stores ledger control A/c for direct materials. X

Indirect materials: Dr Factory overheads control A/c X

Cr Stores ledger control A/cX

2. Direct Labor

Dr W.I.P. Control A/c

Cr Cash A/c

3. Accrued Direct Wages

Dr W.I.P. Control A/c

Cr Wages Control A/c

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Indirect Wages

Dr Factory overheads control A/c

Cr Wages Control A/c

1. Production Overheads

(i) (not yet paid) Dr Factory overhead control A/c

Cr Expenses/Creditor control A/c

(ii) (When paid) Dr Expense/creditors A/c

Cr Cash A/c

Note

Overheads entries apply when there is an interlocking accounting system.

5. Finished goods transferred to the store:

Dr Finished goods stock control A/c

Cr W.I.P Control A/c

6. Sale delivery of finished goods to customers:

(i) On Credit: Dr Debtors control A/c Cr Sales A/c

(ii) In Cash: Dr Bank/Cash A/c Cr(Sales A/c

7. Cost of goods sold to customers:

Dr Cost of sales A/c

Cr Finished goods control A/c

8. (i) When there is over absorption of production overheads:

Dr Factory overheads control A/c

Cr P & L A/c

(ii) When there is under absorption of production overheads:

Dr P& L A/c

Cr Factory overheads control A/c

9. When there are non-manufacturing overheads:

Dr P & L A/c

Cr Non-manufacturing overheads control A/c or non-manufacturingoverheads/expenses are regarded as period costs & are therefore not changed ToW.I.P control A/c.

7.5 Job Cost Account

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Dr Cr

Direct materials issued from stock X Materials returned to the store X

Direct wages X

Materials transferred to other jobs

X

Production overheads absorbed X

Cost of completed jobs transferred tofinished goods A/c X

Materials transferred from other jobs X Balance c/d (Total cost of that job) XXX XX

Illustrations:

The following transactions were made by Z limited in the month of December.Direct Materials

8,000/= was bought on credit, out of these, materials worth 5,000/= were returned to the suppliers. 50,000/= was issued from the store Indirect materials issued amounted to 5,000/= Direct wages allocated to production amounted to 20,000/= Goods worth 200,000/= were sold Finished goods worth 100,000/= were transferred to the store. The cost of goods sold was 140,000/= Unpaid indirect expenses were 32,000/= Indirect wages allocated amounted to 15,000/= Non-manufacturing overheads incurred amounted to 20,000/= Overhead expenses charged to the jobs – 60,000/=

Required

a) Prepare the stores ledger control A/cb) Factory overhead control A/cc) W.I.P. control A/cd) Costing P & L A/c

Stores Ledger Control A/cCreditors (material) 8,000 Creditors control 5,000

W.I.P 50,000(Indirect materials)

Factory overheads 5,000

Factory Overheads Control A/cStores Ledger (material) 5,000 W.I.P 60,000Creditors (wages) 32,000

Incurred wages 15,000

P + LA/c

Overabsorption 8,000 _____

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60,000 60,000

W.I.P Control A/cStores Ledger (material) 50,000 Finished goods stock

control 100,000

Control (D wages) 20,000

Overhead expenses 60,000

Costing P and L A/cFinished goods control 140,000 Sales 200,000Non manufacturing Factor overhead 8,000Overheads 20,000 absorption

Costing profit 48,000

7.6 BATCH COSTING

This is a type of job costing that is used when production consists of limited repetitive work and definitenumber of item manufactured in one batch. A batch is defined as a cost unit consisting of a group ofidentical item in particular sizes and colors of shoes, toys, spare parts etc. The total cost incurred inproduction is spread on the number of units made when the batch is completed.

a) Procedures: Allocation of batch number Production order is made Creation of batch costs account Completion of the work and closure of the batch cost account Allocation of costs to individual units in the batch Determination of selling price/batch and unit.

Illustrations

The budgeted variable overheads of Githurai Ltd for the year 2001 are given as below:

Department Overhead(shs.) Absorption baseA 150,000 15,000 direct labour hoursB 200,000 25,000 direct labour hoursC 120,000 20,000 direct labour hoursD 300,000 30,000 machine labour hours


Selling and administering overheads are changed at 10% of total production costs while the profitmark up is 25 of total costs:

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An order for 2,000 units was received from a customer. The batch number of this order is 510.The following additional information in respect of this batch is provided below:

Direct materials – 87,000/= Direct Labor – Dept A (150 direct labor hrs) – 12shs. Direct labor hour.

o Dept B (40 direct labor hrs) @ 15shs. Per hr

o Dept C (60 direct labor hrs) @20shs. Per hr

o Dept D (100 direct labor hrs) @10shs. Per hr

A total of 50 machine hours were used in this job

Required

a) Calculated the total cost of the batchb) Cost/Unitc) Selling Price of the batchd) Selling Price unit

Solution

Githurai LimitedBatch 510Particulars Shs.

D Materials 87,000

D Labour: Dept A (150 x 12) 1,800

Dept B (40 x 50) 6000

Dept C (60 x 20) 1,200

Dept D (100 x 10) 1,000 4,600

Prime Cost 91,600

Variable Overheads: Dept A –15,000/15,000 x 150 1,500

Dept B – 200,000/25,000 x 40 320

Dept C – 120,000/20,000 x 60 360

Dept D – 300,000/300,000 x 50 500 2,680Total Production Cost 94,280

Selling and admin costs – 10% (94,280) 9,428

Total Costs 103,708

Mark-up: Mark-up @ 25% x 103,708 25,927

Cost/Unit = 103,708/2000 units = 51.854 Selling Price unit = 129,635/2,000 = 64.8175

7.7 Summary

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Job costing is also known as job order costing, it is that form of specific order costing which

applies where the work is undertaken as per customers specific requirements and each order is of

comparatively short duration.

In job costing every job can be identified clearly and have their own costs. Work in progress

depends upon the number of job in hand at the end of the period. each job is a separate

accounting unit, and separate job number or production numbers are allotted to each job.


1.What do you understand by job order costing? Under what condition, is it suitable

2.Explain the procedure involved in job order costing

.

7.9 Further Reading








111

LECTURE EIGHT

8.0 CONTRACT COSTING

8.1 Lecture OverviewThis is a form of specific order costing that is applied to relatively large cost units, which normally take aconsiderable length of time to complete e.g. building or construction works. Contract jobs are undertakenin accordance with specific requirements of contractee/Customer. Contracts may be distinguished fromjob orders by the following features:

The money value of a contract is much larger than that of a job order.

A contract consumes significantly larger amounts of resources than a job order. For a contract, special progress reports are usually made while in job costing, reports are made

after the completion of the job. For a contract, indirect costs are relatively smaller in relation to direct costs but the vice versa is

time for job order.

To second the progress of contract works, a special account known as a contract account is maintained.

8.2 Objectives

By the end of the topic, you should be able to:(i) Importance of contract costing in real-life situations

(ii) Understand the features of contact costing

(v) Describe the various stages and prepare contract accounts

8.3 CONTRACT ACCOUNTS

This is a form of specific order costing that is applied to relatively large cost units, which normally take aconsiderable length of time to complete e.g. building or construction works. Contract jobs are undertakenin accordance with specific requirements of contractee/Customer. Contracts may be distinguished fromjob orders by the following features:

The money value of a contract is much larger than that of a job order.

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A contract consumes significantly larger amounts of resources than a job order. For a contract, special progress reports are usually made while in job costing, reports are made

after the completion of the job. For a contract, indirect costs are relatively smaller in relation to direct costs but the vice versa is

time for job order.

To second the progress of contract works, a special account known as a contract account is maintained.

8..4 Features of contract accounting.

1. Direct expenses.

In addition to direct materials and direct labour, a high proportion of indirect expenses are

incurred. This includes hire charges of plant & machinery, site office expenses, site power usage

etc.

Most of the expenses are direct. Direct materials charged to a specific contract may be classified

as

1. materials issued from the store and

2. Materials purchased for a contract from the local market.

These materials are charged to the respective contract.

Incase of excessive materials, they are returned to the store and credited to the contract account.

The materials on site at the end of the accounting period are valued at cost and carried forward to

the next period.

Direct wages both paid and accrued are debited to the contract account.

2. Overheads.

Expenses like telephone, electricity, repairs, water etc are allocated to the respective contract

account. All other overheads incurred for the company as whole are apportioned on a suitable

basis to all contracts. The proper share of these overheads is charged to a specific contract.

3. Contract plant

The amount of plant used in a contract work is a key feature.

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This includes :cranes, trucks, mixers, lorries etc. if plant is on lease basis, then the leasing charges

are directly charged to the contract, on the other hand, if plant is purchased then this plant is

charged to that contract for which it was purchased.

At the end of the year or on completion of the contract, the contract account is credited with the

value of plant at that time. Thus the depreciation of plant is charged to the respective contract.

If the plant is moved frequently from one contract to another contract, then each contract is

charged the depreciation of the plant at a specific rate.

4. Subcontracts:

If the contractor assigns some work to sub-contractors e.g. electrical or plumbing work, the

amount paid to subcontractors is charged to the respective contract.

5. The contract price

This is the price agreed upon by the contractor and the contractee after the tendering process.

6. Architect’s certificate.The architect inspects the work done periodically and certifies the amount of work completed.

The contractor can claim the amount of work of work certified from the contractee. The architect

is appointed by the contractee.

7. Retention

A specific percentage of work certified is withheld by the contractee or client. This amount

withheld is known as retention money. The amount is paid to the contractor on the completion of

the contract.

The main purpose of this retention money is to ensure that the contract has been completed

according to the satisfaction of the client and all defects in the work have been rectified by the

contractor. If the contractor does not remove such defects, then the retention money is not

released by the contractee.

The retention money is shown as debtors in the books of the contractor.

8. Profits on uncompleted contracts.

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When a contract extends over a number of years, it may be necessary to take profit each year in

order to avoid wide fluctuations in annual profits.

The following rules are applied:

a) Take no profits on the very early stage of contract.

b) When the contract is in its maturity, then:

Amount of profit taken = 2/3 x notional profit x cash received

Value of work certified

c) When the contract is nearing its completion, then:

Amount of profit taken = notional profit x value of work certified

Contract price

NB: Notional profit = value of work completed - cost incurred to date.

8.5 Proforma contract account

This is a separate account that is opened and maintained for each contract undertaken for the purpose ofaccumulating cots. Each contract is given a number and all costs relating to that particular contract arerecorded in this account. A typical contract account is as shown below:

Contract No. XYZ AccountMaterials b/f x Materials returned to store xMaterials purchased x Materials c/d xDirect wages x Machinery c/d xIndirect wages x Balance c/d: Cost of work done xSubcontractors fees x

Cost of special plant x

Machinery/Plant b/f x

Cost of work done b/d x Value of work certified xNotional Profit x Cost of work done but not certified x

xx xx

Contract Costing TerminologyPrinciples of profit income recognition in contracts

The Notional Profit

It is a component of 2 items:

a) Profit taken = Notional profit x 2/3 x cash received/work certified

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This formula of calculating the part of national profit taken in the year is used when substantialcosts have been incurred on the contract but the contract is not near completion. But when thecontract is near completion the profit taken is calculated as:Profit taken = Estimated profit x cash received/contract price.Where Estimated profit = Contract price – Estimated total cost andEstimated total cost = Costs incurred to date and estimated future costs.

b) Profit not taken = refers to the part of the national profit that is not recognized in the currentperiod. It is profit carried forward to be recognized in the years that follow.

c) Retention MoneyThis is a portion of the value of work certified that is retained by the contractor to protect himselffrom faulty work that might be evident at the time of progress payments or at the completion ofthe contract. This amount is released after satisfactory performance under the contract.

Example.

Ideal construction company ltd won the contract for the construction of a multi story building at a

cost of sh.200 million. The data relating to the contract for the year ended 31st December 1998

were as under:

Sh (‘000’)

Materials issued to the site 80,000

Materials purchased locally 15,700

Direct wages: paid 5,800

Accrued 350

Plant purchased and installed 48,800

Direct expenditure:

Paid 1,780

Accrued 70

Established charges 180

Materials returned to store 850

Work certified 150,000

Cost of work not certified 3,800

Materials on site on December 31 5,330

Value of plant on Dec 31 41,500

The company had received from the client, payments amounting to sh. 126 million

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Required:

a) Prepare the contract account;

b) Prepare the contractee account;

c) Show how the various items will appear in the balance sheet as at dec 31 1998.

Answer.

CONTRACT ACCOUNT

Sh (‘000’) shs(‘000’)

Direct materialsIssued from store 80,000 Materials returned from store 850Purchased locally 15,700 materials on site c/d 5,330Plant installed 48,800 plant on site c/d 41,500

Cost to date c/d 105,000Direct wages: (shs)Paid 5,800Accrued c/d 350 6,150

Direct expensesPaid 1,780Accrued c/d 701,850Established charges 180

152,680 152,680Cost to date b/d 105,000 contractee A/c

Work certified 150,000cost of work not yet

Notional profit c/d 48,800 certified c/d 3,800153,800 153,800

Profit & loss A/c (w1) 27,328 notional profit b/d 48,800Profit provision c/d 21,472 _______

48,800 48,800Stock on site b/d 5,330 direct wages accrued b/d 350Plant on site b/d 41,500 direct expenses accrued b/d 70Cost of work not yetCertified b/d 3,800 profit provision b/d 21,472

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CONTRACTEE’S ACCOUNT shs.(‘000’)shs.(‘000’)

Work certified 150,000 bank A/c 126,000

_______ balance c/d 24,000

150,000 150,000

Balance b/d 24,000

BALANCE SHEET (EXTRACT)

Shs(‘000’) shs(‘000’)

Plant on site 41,500 accrued wages 350

Stock on site 5,330 accrued direct expense 70

Workings

(w1) calculation of profit:

Amount of profit taken = notional profit x 2/3 x cash received

Work certified

= 48,800 x 2/3 x 126,000

150,000

= shs. 27,328

Profit provision c/d = 48,800- 27,328

= sh. 21,472.

(w2) work in progress

Method 1 shs.(‘000’)

Cost to date 105,000

Add profit taken 27,328

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132,328

Less: cash received 126,000

W.I.P. 6,328

Method 2 shs.(‘000’)

Contractee’s A/c balance c/d 24,000

Add: cost of work not

yet certified 3,800

27,800

Less: profit provision 21,472

W.I.P. 6,328

8.6 Summary

Contract costing, which is otherwise called terminal costing, is adopted by those business undertakings which

undertake long-term contracts, eg builders and contractors,civil engineering firms, ship building companies etc

In case of contract costing,the cost of each contract is ascertained by charging the expenses attributable to each

contract.Most of the expenses are of direct type and only the general and administrative overheads have to be

apportioned.

The profits of contract costing are generally recognized on an annual basis as the work progresses.A contact

ledger is kept in which a separate account for each contract is opened.


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The following figures have been extracted from the records of China youn Ltd., for they yearended 31 Dec. 2013 in respect of an office block commissioned by the Outer City Grabbers Ltd:

Expenditure during 2013: kshPlant 150,000Wages, etc. 260,000Materials 330,000Sub-contract work 200,000Sundry Expenses 30,000Contract overheads 240,000Balances as at 31 Dec. 2013Plant 100,000Materials 50,000Accrued wages 60,000Other information kshValue of work certified during 2013 1,550,000Cost of work not certified during 2013 20,000Progress payments during 2013 1,100,000Progress payments receivable at 31 Dec. 2013 300,000Retentions during 2013 150,000

Required: (1) Contract A/C(2) Outer Cities Grabbers Ltd. (Contractee)(3) Architects’ Certificates A/C(4) Retentions A/C

8.8 Further Reading








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LECTURE NINE

9.0Process costing9.1 Lecture OverviewThis lecture is to introduce you to costing used by those concerns which manufacture articles ofuniform standards. These firms manufacture articles on a continuous flow basis.

9.2 Objectives

By the end of the topic, you should be able to:(i) Understand features and characteristics of process costing

(ii) Describe the valuation in work in progress

iii)Accounting Treatment of Spoilage Costs

iv)Allocation of joint cost

9.3 Nature of process costing

This is a costing method that is applied where there are standard operations with continuous production ofhomogeneous as identical units. Hence the output is the final product of a sequence of operations. In thistype of costing, costs are accumulated on the basis of process, and the cost per unit is arrived at bydividing the total process costs by the number of input of the next process and further materials can beadded at each stage production. Therefore cost per unit for the second and subsequent processes is acumulative cost for example, the cost per unit for the output transferred from9.0 process 2 is the cost ofproduction for both process 1 and 2 and not for process 2 above. The fact that the output for the firstprocess becomes the input for the next process means that the process costing procedure strives tomaintain the cost of each process product and charge that with the first process. The aim is to transfer thecost accumulated in the first process to the next process. This is illustrated below:

Process 1Shs Shs

Direct Material: 1,000 Transferred to

Direct Labour 500 Process 2: 3,000Overheads 1,500 3,000

3,000 3,000

Process 2Shs Shs

Transfer from Transfer to

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Process 1: 3,000 Finished Goods: 6,000Direct material 1,500

Direct labour 1,000

Overheads 500 ____

6,000 6,000

Examples of Industries where process costing is applied

Process Costing Procedure

1. The production factory is divided into a number of processes.2. An account is opened and maintained for each process.3. Each process account is debited with materials, labor, direct expenses and overheads apportioned

to the process.4. The output of a process is transferred to the next process input of that process.5. The finished output of the last process is transferred to the finished goods account.

9.4 VALUATION OF WORK IN PROGRESS

The concept of Equivalent units

Equivalent Units

This is a notional quantity of completed goods in the production process. It is a collection of workapplication (direct materials, direct labor and overheads) necessary to produce one complete unit ofoutput. They are the number of units that would have been produced during a period of all thedepartments’ efforts had resulted into completed units.The concept is used for purposes of translating the partially completed production into its completed unitsequivalent. This enables cost accountants to value the work-in-progress in an objective, consistent,reliable manner.

Illustration 1

Suppose there are 4,000 units of a product in ending inventory out of which 60% are fully completewhereas the remaining are 70% complete. What are the equivalent units of the product?

Solution: 60% x 4,000 = 2,400 units fully complete.

40% x 4,000 = 1,120 units –Equivalent units.Total Equivalent units = 3,520 unitsAssume we had total process costs of shs.7,040, then each unit would cost shs.7,040/3,520=shs.2

Illustration 2

Material A is added at the beginning of a production process. Labor and overheads are added continuouslyduring the production process. At the end of the process, 10,000 units were complete and 2,000 units were60% complete as per labor and overheads. The cost of raw materials used during the period amounted toshs.220,000, labour shs.150,000 and overheads shs.74,000. There was no opening inventory.

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Required

Determine the cost per unit of both the completed units, and the units in the ending inventory.Solution:

Physical Units Materials

Conversion (directLabour andoverheads

Completed 10,000 10,000 10,000Ending Inventory 2,000 2,000 1, 200

12,000 ______ _______

Equivalent Units 12,000 11,200

Cost for the Period 220,000 224,000

Cost per Equivalent Unit: Shs.18.33 220,000/1,200=sh18.33 224,000/11,200=sh20Total Cost/Equivalent Unit =18.33+sh.38.33

In the above illustrations, there is no opening work in process. When it exists, we need to adopt a methodof valuing it and incorporating it into the process accounts. The two main methods used for purposes ofvaluing the opening work in progress:

1. Weighted Average Method

2. First In First Out (FIFO) Method.Using these methods enables the cost of the opening work in progress to be appropriately assignedto the finished goods an the closing work in process.

a) Weighted Average

When this method is used, all costs of production are considered in assigning costs to inventory. Themethod puts together opening work in process inventory costs and cost of production. It mixes thecosts of previous period with those of current period in determining costs per unit.

Under this method, equivalent units are calculated as follows:Equivalent Units = Units completed and Transferred + Ending work in progress inventory: (% completion)Cost per Equivalent Unit = Previous Period costs + Current period costs

In beginning working processEquivalent units of work done.

Under weighted average approach, we do not distinguish the “units started and completed in the currentperiod” from the `units completed and transferred ` and the `Ending working period`

a) First In First Out (FIFO)

This method considers only those costs incurred during the current period. Equivalent units arecalculated as follows:

Equivalent Units= Units completed and transferred + (Units in ending W.I.P x % of completion –Units in beginning )

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X % of completion

Cost/Equivalent Unit = Current Costs

Equivalent Units

Carefully Note that FIFO distinguishes the “units started and completed in the current period” fromthe units completed and transferred. This is done by subtracting the “beginning W.I.P.” from the“units completed and transferred” and “the ending work in process”.

Illustration

The following work in progress account relates to the blending department of ABC Limited, a soft-drinks company for the month of January 2013. Raw materials were introduced at the start of thework while labour and overheads were incurred through-out the blending process.

Blending Department: W.I.P A/C

Particulars Shs Particulars Sh

Bal b/f = 5,000L (4/5) = 65,000 Completed and transferred out: 29,000L -

Raw materials added (30,000L) 125,000 Ending W.I.P (2/3) 6,000L -

Direct Labour 145,000

Factor Overheads 201,000


1. Beginning W.I.P. consists of the following:

- Raw materials shs.15,000

- Direct Labor shs.20,000

- Factory Overheads shs.30,000.

Required

Calculate cost/equivalent units using:

a) Weighted average

b) FIFO

Weighted AverageTotal PhysicalUnits

Materials Conversion

Completed Transferred Out: 29,000 29,000 29,999Ending W.I.P 6,000 6,000 4,000

______ ______ (2/3 X 6,000)

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35,000 35,000 33,000

Process Costs: In beginning Inventory: 15,000 50,000Current Costs: 125,000 346,000

140,000 396,000

Cost per equivalent Unit: Shs.140,000 Shs.396,000

35,000 33,000

= Shs.4 Shs.12

Total Cost per equivalent Unit: 4 + 12 = Shs.16

FIFO

Total Physical Units Materials Conversion

Beginning W.I.P 5,000 1,000 = (1/5 X 500)

Units started and completedduringThe current period= (2,900 – 5,000) 24,000 24,000 24,000Ending W.I.P 6,000 6,000 4,000 = (2/3 x 6,000)

35,000

Equivalent Units 30,000 29,000

Current Costs: 125,000 346,000

Cost/Equivalent Units 125,000 346,000

30,000 29,000

Total Cost Per EquivalentUnit:

Shs,16.10 = Shs.4.20 Shs.11.90

* Equivalent Units of 5,000 x (1 – 4/5) = 1,000 units was the work done in the period to complete thebeginning W.I.P.

Note that the previous period costs in the beginning W.I.P (Materials. shs.15,000 and converting –shs.50,000) have been excluded in *

9.5 PROCESS LOSSES

a) Most manufacturing processes result in some portion of the raw materials used not being convertedinto a reliable half hence losses. These losses may take the form of waste, scrap, rework, and spoiltunits.

Waste: are materials lost in the process, which are irrecoverable or have no recoverable value.

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Scrap: Material held after a productive process, which are irrecoverable or have no recoverablevalue.

Rework: These are finished goods that do not meet quality standards but which with someadditional work can be sold.

Loss: Refers to finished or partially finished units, which cannot be reworked or used for theirintended purpose. They may be discarded or sold for minimal value. There are two types ofspoilage;

- Normal Loss: is loss expected and unavoidable even under the most efficient systems ofproduction. Normal spoilage cost is normally included in product cost.

- Abnormal Spoilage: This is loss that is avoidable with efficient operating conditions. The cost isregarded as controllable and can be eradicated if due diligence and supervision are exercised. Thecost is normally treated as a loss and charged to profit and loss account.

b) Accounting Treatment of Spoilage Costs

1) Normal Spoilage Costs: These costs are assigned to the good output using two approaches:

(i) Omission Approach: Under this approach, the normally spoilt units are not included in thecalculation of equivalent units. This means that the cost of the normally spoilt units willautomatically be distributed to the good output. By excluding the normal spoilage in thecomputation to the good output, a lower figure will be derived. The weaknesses of thismethod are;

(a) The cost of normal spoilage is spread equally into the finished goods and theending W.I.P regardless of whether the ending W.I.P. has passed the inspectionstage or not.

b) It does not allow the manager to see the costs of spoilage because these costs arenot computed.

(ii) Recognition and Re-Assignment Approach In this approach, the normal spoilage isincluded in the equivalent units computation; further, the normally spoilt units will beassigned costs just like any other unit. The spoilage costs will then be reallocated to thesegood units that have passed the inspection point. The steps to follow under this method are:

(a) Compute equivalent units including normal spoilage.

(b) Assign costs to all units including normal spoilage.

(c) Reassign normal spoilage costs to good output.

2) Abnormal Spoilage Costs

These costs do not add any production benefit to the company and are treated as accountinglosses. The costs are written off directly as losses for the period in which they occur.

Illustration

Mombasa Limited manufacturer a product through two departments. The following is the data inrespect of department for the month of January:

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Beginning W.I.P. (25% complete as to conversion): 10,000 units

Costs for beginning W.I.P:

Transferred in Shs.82,900

Conversion costs Shs.42,000

Units started in the current period. 70,000 units

Current costs: Transferred in Shs.645,100

Conversion Shs.612,500

Additional Materials*

Units completed and transferred: 50,000 units

Units in ending W.I.P (95% complete as to conversion) 20,000 units

Spoilt Units 10,000 units


1. Normal spoilage is 10% of all good units that pass inspection

2. Inspection occurs when production is 80% complete.

3. Conversion costs are incurred evenly through-out the process.

Required

Prepare a process cost report using

(a) Weighted Average

(b) FIFO

Apply both the recognition re-assignment approach in dealing with the spoilage.

Solution

Mombasa Limited.

Process Cost Report (Dept 2)

Weighted Average Approach

Physical Units PhysicalUnits

Transferred In AdditionalMaterials

Conversion

Beginning W.I.P. 10,000

Units started in CurrentPeriod

70,000

Units to Account for 80,000

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Equivalent Units:

Finished Goods: 50,000 50,000 50,000 50,000

Ending W.I.P 20,000 20,000 20,000 19,000

Normal Spoilage @ 10%

(50,000 + 20,000): 7,000 7,000 - 5,600 - (80%x70)

Abnormal Spoilage:

(10,000 – 3,000) 3,000 3,000 - 2,400 - (80%x30)

Equivalent Units 80,000 80,000 70,000 77,000

Cost Determination Total Cost Transferred In AdditionalMaterials

Conversion

Beginning W.I.P 124,900 82,900 - 4,200

Current Costs 1,908,600 645,100 651,000 612,500

Costs to Account for: 2,033,500 728,000 651,000 645,500

Divided by Equivalent Units 80,000 70,000 77,000

Cost per equivalent Unit Shs.26.90 Shs.9.30 Shs.9.30 Shs.8.50

Cost Assignment Transferred In Cost: 7,000 x 9.10 = 63,700

Normal Spoilage Added Material: 7,000 x - = -

Conversion Costs: 5,600 x 8.50 = 47,600

Normal Spoilage costsrecognized

111,300

(and to be assigned)

Finished Goods Costs Excluding Normal Spoilage: 50,000 x 26.90 = 1,345,000

Normal spoilage costs assigned: 50,000 x 111,300 =

70,00079,500

1,424,500

Ending W.I.P: Excluding Normal Spoilage:

Transferred in costs = 20,000 x 9.1 = 182,000

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Additional Material = 20,000 x 9.3 = 186,000

Conversion Costs = 19,000 x 8.5 = 161,500

Normal Spoilage costs = 20,000 x 111,300 =70,000

31,800

561,300

Abnormal Spoilage:

Transferred in costs = 3,000 x 9.10 = 27,300

Additional Material = = -

Conversion Costs = 2,400 x 8.5 = 20,400

47,700

Costs Accounted for 2,033,500

Mombasa Limited, Process Cost Report

Weighted Average Method (Omission Approval)

Physical Units: Total Transferred In Material Conversion

Beginning W.I.P 10,000

Started and Transferred 70,000

Units to account for 80,000

Equivalent Units

Finished Goods 50,000 50,000 50,000 50,000

Ending W.I.P 20,000 20,000 20,000 19,000

Normal Spoilage 7,000 - - -

Abnormal Spoilage 3,000 3,000 - 2,400

Units Accounted for 80,000 73,000 70,000 71,400

Cost Flow Total Costs

Beginning W.I.P. 124,900 82,900 - 42,000

Current costs 1,908,600 645,000 651,000 612,500

Cost to Account for: 2,033,500 728,000 651,000 651,500

Cost per equivalent unit 28.44 9.97 9.3 9.167

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Cost Assignment:

Finished Goods: 50,000x28.44 1,422,000

Ending W.I.P: Transferred in: 20,000 x 9.97 = 199,460

Materials: 20,000 x 9.30 = 186,000

Conversion: 19,000 x 9.167 = 174,173 559,663

Abnormal Spoilage: Transferred in: 3,000 x 9.97 = 29,919

Conversion: 2,400 x 9.167 = 22,000

51,919

Total Costs Accounted for 2,033,552

9.6 ALLOCATION OF JOINT COSTS

When two or more products of relatively high value emerge simultaneously from a single process, they arecalled joint products. The process that gives rise to these products is called a joint process and the costsinvolved are referred to as joint product costs. Joint products are not separately identifiable as individualproducts until their split off point. Split-off point is the point at which joint products become separateentities or are individually identifiable.

Allocation of joint costs involves assigning the costs of the joint process to the products emerging at thesplit off point. Any costs beyond the split off point are referred to as separable costs.

Methods Used to Allocate Joint Costs

1) Physical/Unit Measure

2) Constant gross margin rate

3) Net realizable value.

1) Physical Measure/Unit

Joint costs are allocated to the joint products according to the ratio of physical measurement of theoutputs at the split off point.

2) Constant Gross Margin Rate

This method assumes that each product contributes an equal percentage of gross profit for every shilling ofsales. It works back from gross margin to the joint costs allocation. It involves the following steps:

(i) Calculate the overall rate of gross margin for al the products

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(ii) Multiply the computed overall rate by the sales of every product to obtain the grossmargin of the product.

(iii) Deduct the gross margin from the sales value of the product to determine the total costsfor each product.

(iv) Deduct separable costs from the total costs to obtain joint costs allocated.

3) Net Realizable Value

Under this method, joint costs are allocated according to the net realizable*

Net Realizable Value = Ultimate Sales Value – Separable Costs.

Illustration

A company produces three products, Y1, Y2, and Y3 in the same process. The data below reflectsaverage monthly results:

Y1 Y2 Y3

Monthly output (kg) 40,000 20,000 20,000

Sales Value at split off (shs.) 0 30,000 105,000

Sales Value after Split off 45,000 100,000 155,000

Costs of further processing 20,000 40,000 65,000

The joint costs were Shs.100,000

Required

Allocate the joint cost using the three methods used to allocate joint costs.

Solution

(i) Physical/Measurement/Unit Method

Y1 Y2 Y3 TOTAL

Physical Output: (Kg) 40,000 20,000 20,000 80,000

Proportion 50% 25% 25%

Joint costs allocated 50,000 25,000 25,000

(ii) Constant Gross Margin Rate Method

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Total Sales Value after slit-off: Y1 = 45,000

Y2 = 100,000

Y3 = 155,000

300,000

Less: Total Costs:

Joint Costs: 100,000

Further Processing Costs: Y1 20,000

Y2 40,000

Y3 65,000 (225,000)

75,000

Costs Allocated To: Y1 Y2 Y3 TOTAL

Sales Value: 45,000 100,000 155,000

Less Gross Margin (11,250) (25,000) (38,750)

Total Costs 33,750 75,000 116,250

Less Separate Costs (20,000) (40,000) (65,000)

Joint Costs Allocated : 13,750 35,000 51,250 100,000

(iii) Net Realizable Value/Method

Net Realizable Value = Ultimate Sales Value – Separable Costs

Y1 Y2 Y3 TOTAL

Ultimate Sales Value: 45,000 100,000 155,000

Less: Separable Costs (20,000) (40,000) (65,000)

Net Realizable Value: 25,000 60,000 90,000 175,000

Proportion on Net Realizable Value 14% 34% 52%

Allocation of Joint Costs: 14,000 34,000 52,000 100,000

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9.7 Summary

Process costing is used to determine the cost of a product at each operation, process, or stage ofmanufacture. This method of costing is used in industries engaged in the manufacture of paints,simple chemicals, textiles, steel etc

Manufacturing operation or process is continuous when the arrangement of plant and machineryis such that the production of an item of standard nature continues for a long period of timewithout any stoppages


QUESTION ONE

A company produces three products, A1, A2, and A3 in the same process. The data below reflectsaverage monthly results:

A1 A2 A3

Monthly output (kg) 80,000 40,000 40,000

Sales Value at split off (shs.) 0 60,000 210,000

Sales Value after Split off 90,000 200,000 210,000

Costs of further processing 40,000 80,000 130,000

The joint costs were Shs.200,000

Required

Allocate the joint cost using the three methods used to allocate joint costs.

7.9 Further Reading

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134

LECTURE TEN

10.0VARIANCE ANALYSIS

10.1 Lecture OverviewThis lecture equip you with practical pointers to the causes of off-standard performance so thatmanagement can improve operations, efficiency, utilize resources more effectively and reduce costs.

10.2 objectives

By the end of this lecture, you should be able to:(i) Know what is meant by variance and analysis and its purpose(ii) Understand the relationship of variances(iii) Be able to calculate basic material, labour, and overhead variances

10.3 Purpose of variance analysisThis section describes how material, labour and overhead variances are calculated and what causes each ofthose variances. A chart is also provided to describe how the variances add up to translate to a profitvariance.

In a typical organization, the planning process starts with a budget followed by actual performance. Thebudget will usually be based on standard costs of the desired output units. But how does a budget actualperformance relate?

Budgets are followed by performance

Performance leads to preparation of a performance report, which compares the budgeted performanceand the actual performance, and therefore determines whether there is a favourable (F) orunfavourable (U) variance. These variances are exceptions, thus the performance report (Variancereport) is an exceptions report.

Variance signals those areas that require managerial attention and these are usually areas withproblems. These variances lead to investigation in those problems areas and the appropriate correctiveaction is determined, recommended and later on implemented.

!Variance reporting concentrates on both favourable and unfavourable variances. Usually,

unfavourable variances are punished on the responsible persons while favourable variances arerewarded. However, this is a rule of thumb but not always the case. Remember that anunfavourable variance might arise due to factors beyond the employee’s or manager’s control, in

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which case you can’t punish that person: rather, you need to explain the unfavourable variance interms of the uncontrollable factor of alternatively adjust the standard to incorporate the changedcircumstances. The same case can be argued for favourable variances.

a) Variance Analysis Defined

Variance analysis can simply be defined as the process of analyzing the difference between thestandard cost and the actual cost (this difference is called the variance) into its constituent parts. Thecauses of variances are determined and management can take appropriate measures.

b) Why Perform Variance Analysis?

Variance analysis is aimed at obtaining practical pointers to the causes of off-the –standardperformance so that management can improve operations, increase efficiency, utilize resources moreeffectively and reduce costs. For this to be achieved, the following need to be met:

A simple standard costing system that is easily well understood by everyone in the organization. Fast and timely reporting of variances at the point of incidence so as to attach responsibility for

favourable or unfavourable variance. Rapid management action to correct adverse (unfavourable) variances and encourage favourable

variances. Utmost commitment to the process of setting standards and performance evaluation by all

managers and employees.

However, not all variances are identified and acted upon. Only those types of variances, which fulfillthe cost control needs of the organization and meet performance evaluation purposes of the entity areidentified, calculated and acted upon. Thus, the only criterion for the calculation of a variance is itsusefulness to the organization: if it is not useful for management purposed, then it should not becalculated!

c) Attaching the Variance to Responsible Persons

In calculating variances, the calculations need to be detailed enough so that the responsibility for thevariance can be assigned to a particular individual. This is necessary because it would be almostimpossible to control costs if the responsibility for a certain variance is spread between manymanagers since each of them will “pass the buck” or refuse to accept personal responsibility for thevariance.

For example, the material cost variance can be analyzed into usage variance and price variance. Theusage variance is the responsibility of the foreman or production manager using those materials, whilethe price variance is the responsibility of the purchasing manger.

The above example illustrates how variance analysis is utilized to attach responsibility for costvariances to individuals. Such individuals cannot claim that they are not responsible for the variancesarising. However, to be able to attach such responsibility, the costs must be controllable by theconcerned individuals!

Due to tendency of budgetary control and standard costing variance analysis responsibilities toindividuals, it is usually referred to as responsibility accounting. But where departments are

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interdependent, then responsibility accounting may not be straight forward due to inefficiencies orefficiencies brought in from other departments.

d) Relationship between variances

We cannot over emphasize the central aim of variance analysis as outlined in the above paragraphs:i.e. To assign responsibility for a particular variance to a specific individual, assuming there isadequate independence between departments and the managers have full control of their departmentsso that they can be held fully responsible for the resulting variances.

Variance analysis subdivides the total difference between the budgeted profit and actual profit for theperiod into the detailed difference. This is illustrated in the figure below. Each of the managersresponsible for each of the detailed variances can then he held responsible. But remember that onlythose variances useful for management controls are calculate.

At this point it is critical to understand that every variance has two aspects, a price aspect and a quantityaspect: these two aspects combine to produce a cost variance. This is illustrated below:

COST ELEMENT PRICE VARIANCE QUANTITY VARIANCEDirect Labour Rate EfficiencyDirect Materials Price UsageVariable Overheads Expenditure EfficiencyFixed Overheads Expenditure volume

For example, direct labour cost = Direct labour+ Direct LabourVariance Rate Variance Efficiency Variance

Also, Direct Material cost = Direct Material + Direct LabourVariance Price variance usage variance

Etc.

Note that the operating profit variance, it follows, is then the sum of all the cost (labour, material, variableoverheads, fixed overheads) variances and sales variances. Remember that the operating profit variance issimply the difference between the budgeted and actual profit. You then need to note that budgeted figuresdo not form part of the double entry system, and thus the budgeted profit variance does not enter theledger accounts. The other reason why the operating profit variance is not entered in the ledgers is that itis a resultant figure i.e. a sum of all the other variances.But all the other variances are entered into the ledger system and form part of double entry. We will seelater how these variances are treated in the accounts

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Variance Chart:

Operating profitVariance

TOTAL COST VARIANCE TOTAL SALES MARGINVARIANCE

Direct wagesTotal Variance

Direct MaterialsTotal Variance

VariableOverheadVariance

Fixed OverheadVariance

Ratevariance

EfficiencyVariance

PriceVariance

UsageVariance Volume

Variance

ExpenditureVariance

EfficiencyVariance

Expenditure

Variance

MixVariance

YieldVariance Capacity

VarianceEfficiencyVariance

SalesMarginVariance

Sales MarginVariance

SalesVolumeVariance

Sales Mix

Variance

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!Carefully note that when prices are being charged to production, this can be done at the actual or

standard price. For purposes of making variances analysis useful, instant and easily understood, we willassume that the process of production changes the costs to production units at the standard costs. Whenunits are changed with standard costs, it is now very easily to compare the standard cost with the actualcosts and compute the variance immediately: consequently, the responsibility for the variances can also beassigned immediately and corrective measures implemented.

We will look at variances in the following order:a) Direct Material Total Varianceb) Direct Labour Total Variancec) Variable Overhead Total Varianced) Fixed Overhead Total Variance.

For purposes of our calculations, we will assume the following basic data for company ABC limited:

The standard cost for the production of a radio cassette model called stereo F262 is as follows:

Inputs Standard quantity Standard price (shs)Direct materials: 3 kg 4.00Direct labour: 2.5 hrs 14.00

During the month, 6,500 kg of raw materials were purchased at shs.3.80 per kilo and all of it was used toproduce 2000 units of finished products. Also, 4,500 hours of direct labour time were used at a total costof shs.64,350.

10.4 Direct Materials Total Variance

Direct materials total variances refers to the difference between the standard direct material cost of theactual production volume and the actual cost of the direct material. The direct materials totalvariances is a sum of two sub-variances, namely,

i.Direct Material Price Variance, andii.Direct Material Usage Variance.

i. The Direct Material Price Variance Refers to the difference between the standard price and theactual purchase price for the actual quantity of materials. It can be calculated at the time ofpurchase or time of usage. The latter is specific to the quantity of material utilized in production.But generally, in the calculation of direct material price variance, the quantity purchased is used asthe basis of the variance.

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Diagrammatically, the direct material price variance can be illustrated as follows:

Direct Material Price Variance

Actual Quantity of Actual quantity of Direct MaterialDirect Material Purchased x Purchased x Standard PriceActual Price

The above diagram can be summarized in the form of an equation as follows:

Direct material = (Actual Quantity x Actual Price) – (Actual Quantity x Standard Price)Price Variance

= (AQ.AP) – (AQ.SP)

Factoring out the actual quantity from the equation, we get,Direct Material Price Variance = AQ (AP – SP)

From the above equation, it is clear that the direct material price variance is as a consequence of the actualpurchase price of direct materials being different from the standard p rice of the direct materials.

ii. Direct Material Usage (Efficiency) Variance: Refers to the difference between the actual quantityused and the standard quantity specified for the actual production, all valued at the standard purchaseprice.

Again this is represented as follows diagrammatically;

Direct Material Usage Variance

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Actual Quantity x Standard Price Standard Quantity x Standard Price

The above diagram can be represented as follows using equations:

Direct Material = (Actual Quantity x Standard Price) – (Standard x Standard

Price Usage Variance Quantity

= (AQ x SP) – (SP x SP)

Factoring out the standard price (SP) from the above equation gives us the following equation:

Direct material usage variance = (AQ – SQ) SP

It is again clear that the direct material usage variance arises due to the production department using morematerials than expected (the standard).

Recap: The above two direct material price variances can now be summarized as follows:

Actual Purchase Quantity x Actual Price Price Variance DirectLess: MaterialActual Purchase Quantity x Standard Price TotalActual Purchase Quantity x Standard Price VarianceLessStandard Quantity used for the X Standard Price Usage VarianceActual Production

From our basic data first before the beginning of the discussion on variances, we can calculate:

i. Direct Materials price variance = (AQ X AP) – (AQ X SP)= (6,500 X 3.80) – (6,500 X 4)= 6,500 (3.80 – 4)= Kshs.1,300 Favourable

The variance is favourable since we used less costs than the standard cost.

Direct Materials usage variance = (AQ X AP) – (SQ X SP)

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= (6,500 X 3.80) – (6,000 X 4)= 24,700 – 24,000= 700 Unfavourable

Note that the above equation (total materials variance) agrees with the following:

Total Materials Variance = Price Variance + Usage (Efficiency) Variance= 1300 (Favourable) + 2000 (Unfavourable)= Kshs.700 unfavourable.

Tutorial Note Please make sure you follow the basics of the calculation of the direct material variancescalculations so that you can effectively follow the following variances sections.

10.5 Direct Labour Total Variance

This is the difference between the standard direct labour cost and the actual direct labour cost incurredfor the production achieved. It is a sum total of the direct labour rate variance and the direct labourefficiency variance.

Direct Labour Rate Variance: This is the difference between the actual direct labour rate and thestandard direct labour rate for the total hours worked.Using an equation, this can be shown as follows;

Direct labour rate = Actual labour x Actual Actual x StandardVariance hours Rate - Labour Hours Rate

= (AHrs x AR) – (AHrs x SR)

= A HRs (AR – SR).

It is clear from the above equation that the direct labour rate variance arises due to the actual rate paid forthe actual labour hours worked differing from the standard rate that was expected to be paid for thoselabour hours.

Direct Labour Efficiency Variances This is the difference between the standard hours allowed for theactual production achieved and the hours actually worked, all valued at THE standard labour rate. Usingan equation, this can be shown as follows:

Direct labour = Actual labour x Standard - Standard x StandardEfficiency Variance hours Rate Labour Hours Rate

= (AHrs x SR) – (SHrs x SR)

Factoring SR out of the equation we get

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Direct Labour efficiency variance = SR (AHrs – SHrs).

Thus, the direct labour efficiency variance arises due to the actual hours used in production varying fromthe standard hours expected to have been used.

NB: The direct labour efficiency variance is also called the direct labour usage variance.

Recap:

Actual Labour Hours x Actual Rate Rate Variance Total DirectLess: Labour varianceActual Labour Hours x Standard RateActual Labour Hours x Standard Rate Efficiency VarianceStandard Labour hours x Standard Rate

From our basic data, we can calculate the labour variances as follows:i. Labour Rate Variance = (AH x AR) – (AH x SR)

= AH (AR – SR)

NB: AH x AR = Shs.64,350 Labour Rate Variance = 64,350 – (4,500 x 14)

= Shs.1,350 Unfavourable.

The rate is unfavorable because we spent more than expected.

ii. Labour Efficiency (usage) variance: = (AH X SR) – (SH x SR)= (AH – SH) SR= (4,500 – 5,000) 14= 7,000 Favourable

The variance is favourable because we spent less than the expected cots.

Note: Total Labour Variance = Rate Variance + Efficiency Variance= 1,350 (Unfavourable) + 7,000 (Favourable)= Shs.5,650 Favourable.

Developing and Insight into Material and Labour Variance

The calculation of material and labour variances is not enough; we need to know how the variance couldhave typically occurred in the first place, and whether there is any connection between one cause of thevariance to another. For example, a higher price of materials could have resulted in an unfavourable directmaterial price variance: but, due to the high quality (though high priced) input materials; this could haveled to a favourable efficiency variance!

The above paragraph leads to an important question. What typically causes variances of direct labour anddirect materials? This question is answered in the sections that follow.

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Typical Causes of Material Variances

Price Variancesa) Paying higher or lower prices than planned.b) Losing or gaining quantity discounts by buying in smaller or larger quantities than planned.c) Buying lower or higher quality than planned.d) Buying substitute material due to unavailability of planned material.

Usage (Efficiency) Variancesa) Greater or lower field from material than planned.b) Gains or losses due to use of substitute or gather/lower quality than planned.c) Inefficiency or efficient machinery.d) Grater or lower rate of scrap than anticipated.e) Poorly trained workers or extremely high quality labour.

Typical Causes of Labour Variances

Labour Rate Variances

a) Higher rates being paid than planned due to wage (increase) awards.b) Higher or lower grade of workers being used than planned.c) Payment of unplanned overtime or bonus.

Labour Efficiency Variances

a) Use of incorrect grade of labour e.g. poorly trained personnel.b) Poor workshop organization or supervision.c) Incorrect materials or machine problems.d) Use of better quality laboure) Increase labour or decrease labour efficiency.

10.6OVERHEAD VARIANCES

Introduction

This section will describe how the variable overhead total variance and the fixed overhead total variancescalculated. You can recall the overheads refer to production costs that cannot be categorized as directsince they cannot be directly traced to an individual unit of production.

It is necessary to recall that overheads are absorbed into costs by means of Predetermined OverheadAbsorption Rates (OAR). The overhead absorption rate is predetermined as follows:

LevelActivityBudgeted

periodfor thecostsoverheadBudgetedOAR

The activity level so budgeted could be expressed as units, weight, sales etc: but the most useful conceptof the activity level is the standard hour. Thus, the total overhead absorbed = OAR x Standard hours ofproduction.

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Where the standard costing system uses Total absorption costing principles (where both fixed and variableoverheads are absorbed into production costs), the total overheads absorbed can be sub-divided into FixedOverhead Absorption Rates (FOAR) and Variable Overhead Absorption Rates (VOAR).

Thus,Fixed Overhead Absorbed = FOAR x Standard hours of productionVariable Overhead Absorbed = VOAR x Standard hours of production.Total Overheads Absorbed = (FOAR + VOAR) x Standard hours of production

But where the standard marginal costing principles are utilized by the standard costing system, onlyvariable overheads are absorbed into production costs and thus only variances relating to variableoverheads arise. This makes overhead variance analysis a bit easier in this case.

Again for purposes of our illustrations in overhead variance analysis, we will assume the following basicdata for company ABC Ltd in the production of a radio cassette model Stereo F262:

Budget for December 2003; Shs.Fixed Overheads 11,480Variable Overheads 13,120Labour Hours 3,280 hoursStandard Hours of Production 3,280 hours

Actual Results for December 2003 Shs.Fixed Overheads 12,100Variable Overheads 13,930Actual Labour Hours 3,150/hoursStandard Hours of Production 3,280 hours

Note

Based on our budget above, the predetermined overhead absorption rates can be computed as follows:

.Shs.7.5/hrShs.4Shs.3.5VOARFOAROARTotal

Shs.4/hhrsstd3,280

Shs.13,120

LevelactivityBudgeted

OverheadsVariableBudgetedF.O.A.R

Sh.3.5/hhoursstd3,280

Shs.11,480

Levelactivitybudgeted

overheadsfixedBudgetF.O.A.R

Total OAR = FOAR + VOAR = Shs.3.5 + Shs.4 = shs.7.5/hr.

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It is also notable from our budget that the budgeted labour hours and the budgeted standard hours ofproduction are the same: this is the normal planning basis, which assumes that the actual labour hours willbe the same as the standard hours actually produced. This would imply that efficiency is as initiallyplanned so that no efficiency variances would arise. However, this is rarely the case in practice andtherefore the efficiency variances in overhead variances analysis.

Start Note:

The total overhead variance can be broken down into its two constituent parts, namely:i. The variable overhead variance, and

ii. The fixed overhead variance

We will look at each of these individually.

i. Variable Overhead VarianceThis is the difference between the actual variable overheads warned and the variable overheadsabsorbed. It can therefore be described as the underabsorbed or overabsorbed variable overheads.

The variable overhead expenditure variance is made up of two components, namely:a) The variable overhead expenditure variance,b) The variable overhead efficiency variance

The variable overhead expenditure variable is the difference between the actual variable overheadsincurred and the allowed variable overheads based on the actual hours worked. This is calculated asfollows:

Variable Overhead = Actual Variable - (Actual Labour Hours x V.O. A. R).Expenditure variance Overheads

The variable overhead efficiency variance is the difference between the allowed variable overheads andthe absorbed variable overheads and the absorbed variable overheads. This is calculated as follows:

V.O.A.RxProduction

ofHoursStandard

V.O.A.Rxhours

LabourActual

VarianceEfficiencyOverheadVariable

Shs.1,010 (U)

ii. Fixed Overheads Variance

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This is defined as the difference between the standard cost of fixed overheads absorbed in the

production achieved (whether completed or not), and the fixed overheads attributed and charged to

that period.

This is in fact the over or under absorbed overheads for the period under consideration.

The fixed overhead volume variance has two main components namely:

Fixed overhead expenditure variance, and

Fixed overhead volume variance

The fixed overhead expenditure variance is the difference between the budget cost allowance for

production for a specified control period and the actual fixed expenditure attributed to and charged to

the period. It is therefore the difference between the actual and budgeted fixed overheads.

The fixed overhead volume variance is the difference between the standard cost absorbed in the

production achieved and the budget cost allowed for the period. It arises due to the actual production

volume differing from the planned: this is in turn caused by volume differing form the planned: This

is in turn caused labour efficiency variance and or capacity variance (hours of working being less or

more than planned). The fixed overhead efficiency variance, and

The fixed overhead capacity variance.

The fixed overhead efficiency variance is the portion of the fixed overhead volume variance which is

the difference between the standard cost absorbed in the production achieved whether completed or

not, and the actual labour hours worked. (valued at the standard hourly absorption rate).

Recap:

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The above discussion can be summarized as follows:

Actual expenditure on

Fixed overheads Fixed overhead

Less: Expenditure Variance

Budgeted fixed overheads

Less: Capacity Variance Fixed

Actual Labour Hours x F.O.A.R Fixed overhead Overhead

LESS: Volume Variance Variance

Standard Hours of x F.O.A.R Efficiency variance

Production

Referring to our basic data, we can calculate the fixed overhead variances as follows:

Fixed Overhead Expenditure Variance:

= Actual Fixed Overheads – Budgeted Fixed Overheads

= Shs.12,100 – Shs.11,480 = Shs.620 (Unfavourable)

Fixed Overhead Capacity Variance:

= Budgeted fixed Overheads – (Actual Hours x F.O. A. R)

= Shs.11,480 – (3,150 x 3.5) = Shs.455 Unfavourable

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Fixed Overhead Efficiency Variance:

= (Actual Hours x F.O.A.R) – (Standard Production Hours x F.O.A.R)

= (3,150 X 3.5) - #,230 X 3.5) = Shs.280 Favourable.

Fixed Overhead Volume Variance

= Fixed Overhead Capacity Variance + Fixed Overhead Efficiency Variance.

= 455 (U) + 280 (F) = Shs.175 (Unfavourable)

Fixed Overhead Variance

= Fixed Overhead Expenditure Variance + Fixed Overhead Volume Variance

= Shs.620 (Unfavourable) + Shs.175 (Unfavourable)

= Shs.795 (Unfavourable).

The approach described so far is the most commonly used especially for examination. Another

purpose that the student should be confident enough with so far for further insights, the student could

proceed to the following section.

QUESTION THREE

Beauty Products Ltd. Are manufactures of a body lotion that is sold to retailers in packages of 24 one-quarter litre bottles. In the month of July, 750 packages were produced and sold. Details regardingproduction costs are given below:

Shs

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Sales (750 packages @ Sh.360 each) 270,000

Production costs:

Direct materials:

Material A – 15,000 litres @ Sh.1.60 per litre 24,000

Material B – 16,500 litres @ Sh.2.90 per litre 47,850

Labour – 3,200 hours @ Sh.15 per hour 48,000

Overheads 70,000

189,850

80,150

Gross profit

Operating expenses

Packaging costs – 750 packages @ sh.20 15,000

Administrative costs 55,000

NET PROFIT 10,150

Beauty Products had budgeted to produce and sell 1000 packages for the month of July. At this productionlevel they anticipated a net profit of sh.90,500 as shown below:

Shs

Sales (1000 packages @ Sh.365 each) 365,000

Production costs:

Direct materials:

Material A – 15,000 litres @ Sh.1.50 per litre 22,500

Material B – 16,500 litres @ Sh.3.00 per litre 54,000

Labour – 4,000 hours @ Sh.13.80 per hour 55,200

Overheads: based on 150% labour costs 82,800

214,500

150,000

Gross profit

150

Operating expenses:

Packaging costs – 1000 packages @ sh.15 15,000

Administrative costs (all fixed) 45,000

NET PROFIT (budgeted) 90,500

Required

a) Prepare a flexible budget profit and loss statement for the production level achieved for BeautyProducts Ltd. For the month of July

b) Determine the effect (favourable or unfavourable) that the failure to achieve the target sales of 1000units in July had no budgeted profit for each of the following items show your calculations)

i. Salesii. Materials

iii. Material A and Material Biv. Labourv. Overheads

vi. Packaging materialvii. Administrative costs

c) Explain briefly TWO other major factors (apart from the failure to achieve target sales) which arecauses of the difference between budgeted and actual profit. (Calculations are not necessary)

10.7 Summary

The above discussion of variable overhead variances can be summarized as follows:

Actual Variable Overheads IncurredLess: Variable OverheadsActual Labour hours x V.O.A.R. Expenditure Variance Total Variable

Overheads VarianceActual Labour Hours x V.O.A.R Variable OverheadsLess: Efficiency Variance.Standard Hours of Production x V.O.A.R

Using our basic data, we can then calculate the variable overheads variances as follows:

i. Variable Overhead = Actual Variable - (Actual labour hours x V.O.A.R)Expenditure Variance Overheads

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= Shs.13,930 – (3,150 x 4)= Shs.13,930 – Shs.12,600= Shs.1,330 Unfavourable

The variance is unfavourable because we spent more than allowed.

ii.

V.O.A.RxProduction

ofHoursStandard

V.O.A.Rxhours

LabourActualVarianceEfficiencyOverheadVariable

= (3,150 x 4) – (3,230 x 4)= Shs.12,600 – Shs.12,920= Shs.320 Favourable

The variance is favourable because we spent less than the standard cost.

Note

The total variable overheads variances= Variable Overhead Expenditure Variance + Variable Overhead Efficiency Variance

= Shs.1,330 (U) + Shs.320 (F) = Shs.1,010 (U)

This can also be directly obtained by calculating the difference between the actual variable overheads cotsincurred and the production cost absorbed in variance overheads;

i.e. shs.13,930 – (3,230 x 4) = Shs.13,930 – Shs.12,920=


QUESTION FOUR

For a product the following data was given:

Standards per unit of product:

Direct material 4 kilogrammes at Sh.0.75 pr kilogramme

Direct labour 2 hours at sh.1.60 per hour

Actual details for a given financial period:

Output produced in units 38,000

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Direct materials: Shs

Purchased 180,000 kilogrammes for 126,000

Issued to production 154,000 kilogrammes

Direct labour 78,000 hours worked for 136,500

There was no work-in-progress at the beginning or end of the period.

You are required to

a) Calculate the following variances:

(i) Direct materials costs;(ii) Direct materials price, based on issues to production;(iii) Direct material usage;(iv) Direct wages cost;(v) Direct wages rate;(vi) Direct labour efficiency;

b) State whether each of the following cases, the comment given and suggested as the possible reason forthe variance, is consistent or inconsistent with the variance you have calculated in your answer to (a)above, supporting each of your conclusions with a brief explanatory comment.

Items in

a.

(i) Direct materials price variance; the procurement manager has ignored the economic orderquantity and, by obtaining bulk quantities, has purchased material at less that the standardprice;

(ii) Direct materials usage variance: material losses in production were less than had beenallowed for in the standard;

(iii) Direct wages rate variance: the union negotiated wage increase was Sh.0.15 per hour lowerthan expected;

(iv) Direct labour efficiency variance: the efficiency of labour was commendable.

QUESTION FIVE

Maridadi People Ltd., an exclusive cosmetic business, manufactures a popular perfume, known as Jasho,which it sells in bottles, thorough its retail shops for Sh.2,000. During the latest quarter ending 30September 20X1, the company budgeted to make a profit of Sh.875,000 before deducting fixed overheadsamounting to Sh.400,000. The standard cost per bottle is shown below:

Shs

Materials - 10 Kg @ Sh.50 per Kg 500

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Labour - 10 hours @ Sh.60 per hour 600

Variable factory overheads 200

Marginal cost per bottle 1,300

Fixed factory overheads 320

Total cost per bottle 1,620

Factory overhead costs (variable and fixed) are absorbed into products on the basis of direct labour hours.

Actual results for the quarter as follows:-

Shs

Sales - 1,100 bottles 2,365,000

Raw Materials (14,000 Kg) 784,000

Labour (15,000 work hours) 997,500

Variable factory overhead incurred 320,800

Fixed factory overheads incurred 441,700

Production in the quarter amounted to 1300 units. Out of the total raw materials purchased, 2000 Kg. Arestill in stock. There were no operating balances of raw materials or finished goods stocks. It is the policyof the company to value all stocks at standard cost.

Required

a) Calculate the following variances; indicting clearly whether they are favaourable (F) or unfavourable(U): -

i. Material price and usage.

ii. Labour rate and efficiency

iii. Variable factory overhead over or under absorbed

iv. Sales price and sales margin quantity.

b) Independently calculate the operating profit variance; and explain its significance.

c) Why should management investigate favourable significant variances?


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LECTURE ELEVEN

11.0 BUDGET AND BUDGETARY CONTROL

11.1 Lecture OverviewWelcome once again to learn on budgeting, It is one of the primary objectives of cost accountingto provide useful information to management for planning and control. Budgeting acts as a toolfor both planning and control.

11.2 Objectives

By the end of the topic, you should be able to:(i) Define budgeting

(ii) Understand the application of budgeting

(iii) Budgeting as a tool of management planning and control

(iv) Type of budgets

11.3 Definition of a budget.

A budget is a quantitive expression of a plan of action prepared in advance of the period which it

relates:-

Generally, it’s defined as “A plan expressed in Money, It is prepared and approved prior to the

budget period and may show income, expenditure and the capital to be employed. It may be

drawn up showing intermental effects on former budgeted or actual figures or be compiled by

zero based budgeting” - By: T. Lucy.

A budget may be prepared for the business as a whole, for departments, for functions such as

sales and production, or for financial and resources items such as cash, capital, expenditure,

manpower, purchase etc.

Advantages of a budget.

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The general objective of a budget is to set some target to be achieved in a specific period, mainly

the advantages include:

(i) It provides clear guidance for managers and supervisors and is the major way in which

organizational objectives are translated into specific tasks and objectives related to

individual managers.

(ii) It helps to improve communication and co-ordination among the management and

employees.

(iii)These are used to determine and evaluate the performance of the business enterprise.

(iv)It helps to clarify the authority and responsibilities of the departmental manager and other

staff members.

(v) Because of the “exception principal” which is at the heart of budgetary control,

management time can be saved and attention directed to areas of most corners.

(vi)It’s a tool for planning.

(vii) Involving lower & middle management with the preparation of budgets & the

establishment of clear target against which performance can be judged is a form of

Motivating factor.

11.4 Budget as a tool of planning.

Budgeting is a procedure which helps to achieve the targets of the organization more adequately.

It helps to plan in advance and implement these plans.

Reasons why budget is a planning tool include.

a) It helps to formulate the policy of a business.

b) It helps to co-ordinate the activities of a business e.g. production plan is based on sales

budget.

c) It helps proper control of an organizations activities in orders to achieve the targets of it’s

budgeted plans.

Budgetary Control.

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Budgetary control is a management technique which is adopted to control the business more

effectively.

As defined by the institute of costal management Accountant (I.C.M.A), budgetary control refers

to:-

“The establishment of departmental budgets relating the responsibilities of executives to the

requirements of a policy and the continuous comparison of actual with budgeted results either to

secure by individual action the objectives of that policy or to provide a firm basis for its revision”

Budget differs from budget control in that, a budgetary control in that, a budget is a standard with

which to measure the actual achievement of people, departments, firms e.t.c. whereas. Budgetary

control is the planning in advance of the various functions of a business so that the business as a

whole can be controlled.

Objectives of Budgetary control

i) to formulate the policy of the business

ii) To co-ordinate the activities of the business in order to achieve a specific target.

iii) To control each function so that the best possible results may be achieved.

Budget committee

Normally large organizations have budget committee comprising of:

i) The chairman – a senior members of the management e.g. C.E.O

ii) Departmental heads

iii) Budget officer

The budget committee formulates the general procedure of the budget preparation and

approves the budget for a specific period. The functions of the budget officer involve.

a) To issue the institution to various departments in respect of submitting budget estimates.

b) To receive and check budget estimate

c) To assist the departmental managers to the budget committee for the approval of budgets

d) To co-ordinate for the proper implementation of budgets.

e) To submits to the budget committee, the report relating to budget and actual results.

Budget Manual:

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This is a rule book which lays down the budgeting procedures, organizational structure,

designations of responsibilities and budget time table

The Budget Period

The budget is prepared for a specific period e.g.

i) Period Budgets

ii) Continuous budgets

Period budget cover a fixed period of time e.g. 6 month, 1 year, 5years e.t.c. if the period is

long, then the period is divided into shorter period often called control periods.

Conditions budget is a process whereby budgets for a year are continuously extended by

another period i.e. one quarter or half year. The quarter or half year just ended is dropped and

next quarter or half year is included. This process is also called rolling budgeting.

Limiting Factor/Key Factors/ Principal Budget Factor.

This is that factor which, at any given time, effectively limits the activities of an organization.

This may be limited demand, limited production capacity, labour shortage, materials shortage,

less space or lack of finance.

Because such a constraint will have a pervasive effect on all plans and budgets, the limiting

factor must be identified and its effect on each of the budget carefully considered during the

budget preparation process.

Budget Centre’s.

This is a section of an entity for which control may be exercised and budget prepared.

This may be a cost centre, a group of cost centers or it may coincide with a profit centre.

11.5 Budgeting Preparation Process (Stages)

1. Budget committee – meeting.

2. Derivation of key fore casts.

3. Preparation of quantity budgets with appropriate managers (e.g. Unit of materials

required, units to be produced or sold, No of labour hours required e.t.c)

4. Check feasibility and adherence to policies of quantity budgets.

5. Amendments to quantity budgets.

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6. Produce financial budgets.

7. Produce master budget.

8. Submission of budget to chief executive or board of directors for approval or

amendments.

9. Publish agreed budgets for ensuring period.

10. Recording of actual results.

11. Actual/ budget comparison and identification of variances.

12. Reporting to budget holders and senior management.

13. Variance investigation – variance and their causes provide the link between budgetary

control and budgetary planning.

14. Developing solutions to problems revealed by budgetary control.

Master Budget.

This is a summary of al other budget and includes also a budgeted profit and loss account and a

balance sheet; it shows the overall picture of the budgeted targets for the next period.

It contains various subsidiary or functional budgets.

A functional budget is one which relates to any of the functions of an enterprise. This may

include:-

a) Sales budget.

b) Production budget.

c) Purchase budget.

d) Production cost budget.

e) Selling and distribution cost budget.

f) Cash budget

g) Budgeted profit and loss account and balance sheet.

Cash Budgeting.

This is prepared to show the expected cash receipts and cash payments in next few months or one

year period.

Functions Of A Cash Budget.

(i) To ensure that cash is available for revenue expenditure.

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(ii) Indicate when, where and how much cash will be needed and whether this is

permanent or temporary.

(iii) Preserve liquidity throughout the year.

(iv) Reveal surplus cash for investments or expansion of facilities.

(v) Guide management on financial capital expenditure internally or externally.

The cash budget is affected by the:-

(i) Expansion or contraction of the investment in fixed assets.

(ii) Increase or decrease in stocks and debtors.

(iii) Rate of inflation anticipated.

(iv) Policy decision like credit control, dividends and taxation.

Fixed And Flexible Budgets.

A fixed budget is defined as “a budget which is designed to remain uncharged irrespective of the

volume of output or turnovers attained”. It is a budget for a single level activity.

A flexible budget is a “budget which is designed to adjust the cost according to actual level of

activity attained.

The process by which this is done is by analyzing cost into their fixed and Variable elements so

that the budget may be “flexed” according to the actual activity. This is shown in marginal

costing.

The main objective of a flexible budget is to provide an instrument of control. The actual results

should be compared with flexible budgets of the activity level achieved. This helps the

management to evaluate the performance of the organization.

Forecasting And Budgets.

The budgets are prepared on the basis of future. Forecasting without accurate and reliable

forecasting, it is not possible to achieve the targets of an organization.

Forecasting on sales volume and prices, wage rates, materials availability and their prices,

overhead expenses, inflation rates e.t.c are very crucial.

Forecasting techniques includes:-

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Regression analysis – Least squares method.

Time series analysis.

Exponential smoothing approach.

These are covered in statistics and Quantitative Techniques.

Benefits And Problems Of Budgeting.

The benefits of budgeting are related to the advantages of budgets already discovered. Other

benefits include:

(i) The integration of budgets makes it possible better cash and working capital

management.

(ii) Better control of current operations is helped by regular, systematic, monitoring and

reporting of activities.

(iii) Provided there is proper participation, goal congruence is encouraged and motivation

increased.

11.6 Typical Problems Which May Arise With Budgeting.

(i) Variances are just as frequently due to changing circumstances and poor forecasting as

due to managerial performance.

(ii) Budgets are developed round existing organization structure which may be in

appropriate for current conditions.

(iii) The existence of well documented plans may cause inertia and lack of flexibility in

adopting to change.

(iv) Badly handled budgetary systems with undue pressure or lack of regard to behavioral

factors may cause antagonism and may lower morale.

Zero Based Budgeting (ZBB)

ZBB is defined as “A method of budgeting whereby all activities are re-evaluated each time a

budget is formulated, each functional budget starts with the assumption that the functions does

not exist and is at zero cost. Increasments of cost are compared with the increaments of benefits,

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culminating in the planning maximum benefit for a given budgeted cost” – CIMA it’s thus, a cost

– benefit approach.

Activity Based Budgeting (ABB)

Also called activity cost management, is a planning and control system which seeks to support

the objective of continuous improvement.

The method recognizes that it is activities which causes cost and is a more focused method of

budgeting.

Examples;

1. Oshal Ltd manufactures two types of products for the printing industry. Budgeted sales of the

products, known as P and Q for 2014are.

Product Quantity Price (Shs)

P 3,000 80

Q 7,000 70

Stocks of these products were as under:-

Product Opening Stock Closing Stock

P 2,000 units 1,500 units

Q 1,800 units 2,500 units

Required:

(i) Prepare sales budget.

(ii) Prepare production budget.

i. Sales Budget.

Product Quantity Sale Price per unit (Shs) Sales Value

P 3,000 80 240,000

Q 7,000 70 490,000

730,000

ii. Production Budget.

Product

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P Q

Sales (Units) 3,000 7,000

Increase (Decrease) in stock (500) 700

Units to be produced 2,500 7,700

Example 2

The following information was extracted from the books of Box Ltd, a company which started

trading one year ago.

2014.

Month Sales (Shs) Purchases (Shs)

April 150,000 100,000

May 160,000 110,000

June 160,000 90,000

July 170,000 90,000

August 200,000 80,000

September 200,000 130,000

October 180,000 140,000

November 180,000 60,000

December 200,000 60,000

The Following Additional Information Is Available:

1. Cash in hand at the end of May 2014 will be Shs. 180,000.

2. 60% of the sales proceeds are received in the current month, 30% in the following months and

the balance is received two months after sale.

3. Suppliers are paid one month after delivery of goods.

4. Corporation tax for 2013 amounting to Shs. 20,000 will be paid on 31st September, 2014.

5. Contractor’s retention monies amounting to Shs. 50,000 will be paid on 30th June, 2014.

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6. The share holders at their last Extraordinary general Meeting increased the share capital by

Shs. 70,000 and the first call of Shs. 40,000 will be received in October, 2014.

7. In October, 2014, the company is due to receive Shs. 20,000 as compensation for a civil suit.

8. The monthly administration expenses amounting to Shs. 33,000 include factory depreciation

charge of Shs. 4,000 and preliminary expenses of Shs. 3,000.

9. Office equipment worth Shs. 13,000 will be paid for in November, 2014.

Required:

Prepare a cash budget for the period 1st June to 31st December, 2014.

CASH BUDGET

June July August Sept Oct Nov Dec

Receipts:

Balance b/f

Receipts from sales (w2)

Share Capital

Compensation received

Total Receipts

Less:

Payments:

Payments to creditors (w1)

Administration expenses

Corporation tax

Retention money

Office equipment

Balance c/f

Shs.

180,000

159,000

-

-

Shs.

153,000

166,000

-

-

Shs.

203,000

187,000

-

-

Shs.

274,000

197,000

-

-

Shs.

345,000

188,000

40,000

20,000

Shs.

437,000

182,000

-

-

Shs.

440,000

192,000

-

-

339,000 319,000 390,000 471,000 593,000 619,000 632,000

110,000

26,000

-

50,000

-

90,000

26,000

-

-

-

90,000

26,000

-

-

-

80,000

26,000

20,000

-

-

130,000

26,000

-

-

-

140,000

26,000

-

-

13,0000

60,000

26,000

-

-

-

186,000 116,000 116,000 126,000 156,000 179,000 86,000

153,000 203,000 274,000 345,000 437,000 440,000 546,000

Workings:

1) Supplies are paid one month after the delivery of goods e.g may purchases will be paid on

June, June on July and so on.

165

2) Receipts from sales

a) June Shs b) July shs.

60% of June Sale = 96,000 60% of July sales = 102,000

30% of May sale = 48,000 30% of Sept sales = 48,000

10% of April Sale = 15,000 10% of May sale = 16,000

159,000 166,000

c) August shs d) September shs.

60% of Aug sales = 120,000 60% of Sept sales =120,000

30% of July sales = 51,000 30% of Aug sales = 60,000

10% of June sales = 16,000 10% of July sale = 17,000

187,000 197,000

(e) October shs.

60% of Oct sales = 108,000

30% of Sep sales = 60,000

10% of Aug sales = 20,000

188,000

(g) December shs

60% of Dec sale = 120,000

30% of Nov sales = 54,000

10% of Oct sales = 18,000

192,000

3. The monthly administration expenses are shs. 33,000 which include factory depreciation

charge of shs. 4,000 and preliminary expenses of shs. 3,000. these two charges (i.e shs. 7,000

= 3,000 + 4,000) do not include cash payments so cash paid every month is shs. 26,000 i.e

(shs. 33,000 – 7,000)

(f) November shs.

60% of Nov sales = 108,000

30% of Oct sales = 54,000

10% of Sep sales = 20,000

182,000

166

11.7 Summary

Budget can be explained as a financial and/or quantitative statement, prepared and approved prior to a

defined period of time, of the policy to be pursued during that period for the purpose of attaining a

given objective.

. 11.8 Self-Assessment Questions

A company has a cash balance of ksh 27,000 at the beginning of March and you are required to

prepare a cash budget for March, April and May having regard to the following information.

1. Creditors give 1 month credit.

2. Salaries are paid in the current month.

3. Fixed costs are paid one month in arrears and include a charge for depreciation of ksh

5,000 per month.

4. Credit sales are settled as follows: 40% in month of sale, 45% in next month and 125 in

the following month. The balance represents bad debts.

Cash Credit Purchases Salaries Fixed

Month sales Sales over heads.

(ksh) (ksh) (ksh) (ksh) (ksh)

167

January 74,000 55,200 9,000 30,000

February 82,000 61,200 9,000 30,000

March 20,000 80,000 60,000 9,500 30,000

April 22,000 90,000 69,000 9,500 32,000

May 25,000 100,000 75,000 10,000 32,000








ACCT 219-Cost Accounting.pdf

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