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Chapter One

Cost Accounting Definition and Scope

Introduction- Cost accounting also known as costing takes it root from management accounting. It is therefore

important to understand the discipline called management accounting from which one can better appreciate

costing

Managerial Accounting Defined

Accounting is a broad discipline that has several sectors such as taxation, financial accounting, public sector

accounting as well as management accounting.

There is a branch of accounting that deals with providing vital information for decision making at the top

hierarchy of management. This division of accounting that has to do with providing quality information to

management for decision making purposes is termed as managerial accounting. Within this managerial

accounting is a branch called Costing or simply Cost Accounting

Cost Accounting Defined- It involves all the techniques and process of ascertaining cost. It is the process of

finding the value of resources used in production. It is the classifying, recording and appropriate allocation of

expenditure for the determination of the cost of a product or services.

It is the relationship of cost, proceeds, revenue or sales value.

Purpose of Cost Accounting

1) The main purpose of costing is to analyze and allocate the expenditure of a business in such a way that

it is possible to ascertain the cost of each product, job or contract or operation carried out.

2) To serve as a managerial tool and in this connection it provides management with the following:

a. A means of control over all cost.

b. A basis for formulating operating policies example to determine whether it is more

advantageous to make an article or to buy it readily made.

c. An efficient system of material control whereby the existence of excessive, inadequate,

obsolete, or slow moving stock are brought to the attention of management at the proper time.

d. The composition of total cost so that the selling prices can be effectively accepted to meet

prevailing competition.

e. A basis for the system of budgeting control and for the introduction of standard costing, the

important modern aids to efficient management.

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3) Distinguish unprofitable from profitable activities.

4) Indicate source of wastage or loss whether of time, material or in the usage of machinery or tools.

5) Provides information in order to facilitate comparison with the estimates or also comparison with

recorded cost at previous prices.

6) Provides a basis for the preparation of estimates and fixing selling prices.

7) Reveals the causes of increases or decreases in the profit shown by the financial accounts, in the

budgeted or other estimation of profits.

.

Cost Accounting & Managerial Account linked

It is an integral part of managerial accounting. Cost accounting provides detail analysis of the cost of products

and services activities and responsibility centers of an organization. Management accounting uses the end

results of cost accounting together with other vital information to provide a financial report for management to

make effective decisions.

Managerial accounting and financial accounting compared.

It is important to know that both managerial accounting and financial accounting belong to accounting yet

major difference exist as well as share common characteristics.

In most books when the two ( Financial accounting & Management accounting) branches of accounting are

compared costing could be used interchangeably with management accounting

Difference Between Financial Accounting And Management / Cost Accounting

Financial Accounting Managerial or cost Accounting

The financial accounting information is for the

general public

Managerial accounting information is for

insiders (top management)

Financial Accounting lays emphasis on the

past events

Emphasize is on the future progress and

development

It is compulsory to publish financial

Accounting information

Managerial accounting information may not be

published. Mostly held within the organization

It is prepared in line with generally accepted Its preparation does not need to follow any

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accounting principles (GAAP) GAAP

Legal requirement may be associated with

financial reports.e.g.As stated in the

companies` code of 1963 (179)

There may no legal requirement associated

with cost accounting recording

Only summarized data or information for the

entire organization is prepared

Detailed reports about each department

product/service etc are prepared

Similarities Between Financial Accounting And Managerial Accounting

They both use the same financial data

They both belong to the same discipline of accounting

They both provide necessary information for internal decision making in an organization.

QUESTION.

I. What are the major differences between financial and managerial accounting?

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Chapter Two

Elements of Cost & Classification of Costs

The following chart shows the various elements of cost and how they are classified.

Direct or Indirect Materials

The materials directly contributed to a product and those easily identifiable in the finished product are called

direct materials. For example, paper in books, wood in furniture, plastic in water tank, and leather in shoes are

direct materials. They are also known as high-value items. Other lower cost items or supporting material used

in the production of any finished product are called indirect material. For example, nails in shoes or furniture.

Direct Labor

Any wages paid to workers or a group of workers which may directly co-relate to any specific activity of

production, supervision, maintenance, transportation of material, or product, and directly associate in

conversion of raw material into finished goods are called direct labor. Wages paid to trainee or apprentices

does not comes under category of direct labor as they have no significant value.

Overheads

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Indirect expenses are called overheads, which include material and labor. Overheads are classified as:

Production or manufacturing overheads

Administrative expenses

Selling Expenses

Distribution expenses

Research and development expenses

Cost elements can be referred to as the various components which constitute a cost item.

The three principal elements of cost are:

(1) Material

(2) Labour

(3) Expenses.

A direct cost is a cost that can be traced in full to the product, service or department that is being costed.

Types of direct cost can be classified as;

Direct Material cost: This is any material, which goes into saleable product, or its use is directly essential

for the completion of that product and the amount paid is a direct material cost. Examples of direct material

are cloth in garments, leather in shoes, steel in machines, clay in bricks, timber in furniture, etc.

The important fact is that the accountant should be able to trace the material to a specific product or batch

of products.

Direct Labour Cost: Cost incurred or the Labour expended in converting the direct material into saleable

products by the composition, confirmation on condition of the product. Example, all wages for Labour that

can be allocated specifically to a particular product concern are called direct Labour costs. Example

includes wages paid to the baker in a bakery, wages paid to a lecturer in a teaching industry, wages paid

to the carpenter, shoe maker weaver tailor, etc.

Direct Expenses: Any cost other than direct material and direct Labour cost; the incurring of which results

in a benefit which can be traced directly to a particular product or batch of products. In other words, direct

expenses can be described as the expenses which are specifically incurred in connection with a particular

product, job or cost unit. Direct expenses are also known as chargeable expenses. Example includes hire of

special plant for a particular job, traveling expenses in securing a particular contract, cost of patent and

royalties, experimental costs, cost of drawings and designs, carriage paid for materials for a specific job,

etc.

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Indirect Cost: This is simply a cost that is not easily &directly identifiable with a particular cost object. Its

existence does not depend solely on what is being costed. It is also called Overhead charges. Or “on cost”

and it is that cost which for reasons cannot be definitely allocated to a particular unit or product. This

indirect cost includes all cost of indirect material, indirect Labour and indirect expenses. This can be

classified into production or factory overhead, administrative overheads, and selling and distribution

overheads.

Indirect materials: These are materials which cannot be directly allocated to with an individual cost units,

jobs or products. Example, sand paper, lubricating oil, bolts and nuts, soap, small tools, etc

Indirect Labour: Cost of Labour that cannot be directly attributed to a cost unit, product or job. In other

words, indirect Labour is not directly engaged in the production operations but only assist or help in the

production precess.Example, Supervisor’s salary, inspector, cleaner, clerk, watchman’s salary, etc.

Indirect expenses: All indirect cost other than indirect material and Labour are termed as indirect

expenses. example, rent and rates, depreciation, lighting and heating, advertising, insurance, carriage, etc.

The element of cost can be described diagrammatically and this is illustrated below:

Material = Direct Material + Indirect Material

+ +

Labour = Direct Labour + Indirect Labour

+ +

Expenses = Direct Expenses + Indirect Expenses

Prime Cost + Manufacturing Overheads = Production Cost

+

Administrative and Selling & Distribution Overheads= TOATAL COST

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Cost classification-

This is the process of grouping costs under common characteristics. It could also be defined as “the

arrangement of items in logical groups, having regard to their nature (subjective classification) or purposes

(objective classification).”Cost can be classified based on the following attributes as follows:

I. Function: Cost can be classified according to functional department. This cost is determined according

what work is being done and in which department the cost is being incurred. It could be incurred

during production called the production/manufacturing costs, if incurred in the planning and running of

an entity it is administration costs and if incurred when reaching out the company’s product to

customers it is marketing/selling and distribution costs

a. This examines costs incurred by each department (function) of the organization. Under this

classification, we have the following costs:

b. Production costs are the costs which are incurred in manufacturing a tangible item. it is by the

sequence of operations beginning with the supply of raw materials, and ending with the

completion of the product ready for warehousing as a finished goods item. Packaging costs are

production costs where they relate to ‘primary’ packaging (boxes, wrappers and so on).

c. Administration costs are the costs of managing an organization, that is, planning and

controlling its operations, but only insofar as such administration costs are not related to the

production, sales, distribution or research and development functions.

d. Selling costs, sometimes known as marketing costs, are the costs of creating demand for

products and securing firm orders from customers.

e. Distribution costs are the costs of the sequence of operations with the receipt of finished goods

from the production department and making them ready for dispatch and ending with the

reconditioning for reuse of empty containers.

f. Research costs are the costs of searching for new or improved products, whereas development

costs are the costs incurred between the decision to produce a new or improved product and the

commencement of full manufacture of the product.

g. Financing costs are costs incurred to finance the business such as loan interest.

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II. Nature: Classification of cost according to nature looks at the elements of costs. thus, cost may be

classified broadly into material, labour and expenses. Material may further be classified into direct and

indirect material. Labour and expenses may also be classified into direct and indirect.

III. Identifiably: This classifies cost into direct and indirect. This examines cost in order to determine their

identifiability or non-identifiability with a product, cost unit or cost centre.

Direct cost: This may be defined as a cost that arises solely from the existence of whatever is being costed

such a cost is that which can be charged directly to a particular unit, product or cost centre. (Job, contract,

process, etc) in which it is expended. The types of direct cost are:

Direct Material cost, Examples of direct material are cloth in garments, leather in shoes, steel in machines,

clay in bricks, timber in furniture, etc.

Direct Labour Cost. Example includes wages paid to the baker in a bakery, wages paid to a lecturer in a

teaching industry, wages paid to the carpenter, shoe maker weaver tailor, etc.

Direct Expenses Example includes hire of special plant for a particular job, traveling expenses in securing a

particular contract, cost of patent and royalties, experimental costs, cost of drawings and designs, carriage

paid for materials for a specific job, etc.

Indirect Cost: This is simply a cost that is not direct. Its existence does not depend solely on what is being

costed. It is also called Overhead charges. Or “on cost” and it is that cost which for reasons cannot be

definitely allocated to a particular unit or product. This indirect cost includes all cost of indirect material,

indirect Labour and indirect expenses. This can be classified into production or factory overhead,

administrative overheads, and selling and distribution overheads.

Indirect materials. Example, sand paper, lubricating oil, bolts and nuts, soap, small tools, etc

Indirect Labour: Example, Supervisor`s salary, inspector, cleaner, clerk, watchman`s salary, etc.

Indirect expenses.example, rent and rates, depreciation, lighting and heating, advertising, insurance,

carriage, etc.

IV. Behavior: Cost are classified according to how they react or vary with level of outputs, cost or sales.

Thus costs are classified according to whether they change directly with output, sales or cost or not.

Costs under this classification are as follows:

Variable Cost: This cost tends to vary directly with the volume of output and accordingly are

sometimes termed as direct cost that is they are costs that vary in direct proportion to the levels of

activity. All prime cost and variable overheads such as power, machinery repairs, indirect Labour and

indirect material.

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While the total cost of this varies with the volume of production the cost per unit remains the same. It

can be illustrated diagrammatically as follows:

Cost Total variable cost

Variable cost per unit

Fixed Cost: This are those which turn to be unaffected by variations in volume of output that is they

are costs that remain unchanged regardless of changes with the level of activity, they depend mainly on

the passage of time and accordingly are sometimes referred to as period costs. Example of period cost

is debenture interest, rent, rates and salaries of executives etc.

With fixed cost the total remains the same but the per unit figure decreases with an increase in volume,

this is because the same amount of overheads are spread over a large number of units as graphically

presented below:

Cost

Fixed Cost

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Cost

Per unit cost

The cost per unit remains the same at the various levels.

V. Control: Classification of cost by control means the grouping of costs according to the extent a

member of an undertaking will be able to influence cost. All costs that can be controlled or influenced

by that member is called controllable costs. Whilst costs that cannot be influenced by that member are

known as uncontrollable costs.

VI. Production: Here costs are classified into production and non-production cost. Production costs are

associated with the manufacturing of an organization’s products. Therefore all cost associated with

production of a product is called product cost.

VII. Period cost – These are cost associated with accounting Period but outside production- These are

cost appearing in the P& L account. they are re-occurring expenses which are incurred in the day to

day running of the entity. They are service cost incurred at the administration hence service overheads.

They aare non-production cost such as selling and distribution, rent and rates, printing & stationery etc

Decision making Costs: Are those costs which are relevant to decision making and these are called relevant

Costs: they are cost which arises as a direct consequence of a decision, thus, only costs which will differ under

some or all of the available opportunities should be considered. Relevant costs are also said to be `future cash

flow arising as a direct consequence of a decision. This means that costs or charges which do not reflect

additional cash spending are not relevant to decision making. Example, if a worker is paid 100 a month and is

expected to work for an additional task for 30 within the month, the 100 becomes an irrelevant cost whilst the

30 becomes a relevant cost. Examples of relevant cost are :

Differential Cost: Differential costs are the differences in costs between two alternative courses of action.

If option A will cost 400 and option b 480,the differential cost is 60,with option B being more expensive.

Incremental Costs: These are relevant costs which are simply the additional costs incurred as a result of a

decision taking.

Output

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Opportunity Cost: An opportunity cost is the benefit forgone by choosing one opportunity instead of the next

best alternative. Assuming a company owns a building which has been fully depreciated in the books of

accounts, yet it has a rental value of 10,000 per annum. Now if the company is considering the use of this

building for a special project, a charge in lieu of rent of 10,000 (opportunity cost) should be charged.

Replacement Cost: This is a cost incurred to replace an existing asset. In simple words, replacement cost is

the current market cost of replacing an asset.

Conversion Cost: This term is used to denote the sum of direct Labour and overhead costs in the production

of a product. It is the total cost of converting a raw material into finished product.

Irrelevant Costs: These are costs which if incurred will not have a direct consequence on any future decision.

Fixed costs are typical example of irrelevant costs. Examples of such costs are:

Committed and Discretionary Costs: Committed costs are fixed costs incurred in maintaining physical

facilities and management set up. Committed costs cannot be avoided in the short run. For example, salary of

the managing director, depreciation of plant and machinery. This is because they cannot be avoided in the short

run. Discretionary cost on the other hand is also a fixed cost that can be avoided in the short run by

management. Such costs are not permanent. Example, advertising, research and development cost, etc.

Sunk Cost: This is a cost used to describe the cost of an asset which has already been acquired and which can

continue to serve it’s present purpose, but which has no significant realizable value and no income value from

any other alternative purpose. Example, the cost incurred on the acquisition of a fixed asset, development cost

already incurred.

Notional cost or Imputed Cost: This is a hypothetical accounting cost to reflect the use of a benefit for which

no actual cash expense is incurred.Example,notional rent, thus,a company charging rent to their account as if

the building was rented from an outsider, even though, the building belong to the company, notional interest,

depreciation charge, etc.

Historical Cost: These are the costs which are ascertained after they have been incurred. Historical costs are

nothing but actual costs

Assignment

Students were asked to asquint themselves with costing terms hence were asked to classify the expenses below

to the appropriate cost terms making sure each term is used only once for that matter Candidates of cost

accounting were asked to use the appropriate costing terminology to explain the expenses incurred in Andes

manufacturer company, a company which is into mining in the Scandinavian city of Malmo

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1) The wages of the supervisor of Andes company is $2,300 per vehicle

2) Andes produce machinery for the mines. These machinery are made from special metals that cost

$6,400 per assembled.

3) Getting the gold sold is $1,000,200 per annum of meter reading.

4) The cost of changing raw mineral to become end product which the whites can wear occasionally is $

1,230 . The end product are moved from the factory to sales department by Obina at a monthly wages

of $ 500

5) The wear and tear cost of the machines used to make the mineral totals $ 7,390

6) The minerals are drilled by 5 guys at a wage cost of $2,700 per year.

7) For the year just ended 2015 Andes rent out the factory for $2,300,000 and therefore did not mine at all

8) The company spent $3,450 assessing the marketability of their product prior to establishing the

manufacturing Plant in the city.

9) The workers assembling the vehicles are supervised at a yearly salary $25,000 per vehicle.

10) Andes keeps her expatriate staff in quest rooms in the factory yet included rent as $1,500 per month in

it end of year accounts.

Question1

i) Write short notes and distinguish between the following:

a. Conversion cost & Production cost

b. Relevant cost &irrelevant cost

c. Cost unit and Cost per unit

d. Avoidable Cost uncontrollable cost

e. Sunk cost and Committed cost

f. Variable and semi-variable cost.

h Incremental and differential cost

ii)

The entire 2015 byear cost data of Andes mines is shown below.

Gross profit is at 20% in the year

Selling expenses………………………………………….140, 000

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Raw material (January 1)……………………………….90,000

Raw material (December 31)………………………………60,000

Utilities, factory…………………………………………………..36,000

Direct labour…………………………………………………………..150,000

Depreciation@ factor........………………………………………..162,000

Purchase of raw material……………………………………………750,000

Finished goods are transferred to the trading department at 25% profit

Insurance @ factory……………………………………………………40,000

Supplies @ factory……………………………………………………………15,000

Admin expenses…………………………………………………………………270,000

Indirect labour………………………………………………………………..300,000

Maintenance @ factory……………………………………………………...87,000

WIP January 1…………………………………………………………………….180, 000

WIP January 31……………………………………………………………………100,000

Finished goods January 1………………………………………………..260,000

Finished goods December ……………………………………………….210, 000

Management wants to know the performance of the entity for the year ending:

i. Manufacturing account

ii. And the profitability level

.

iii)What are major elements of product costs in a manufacturing company?

iv)Distinguish between the following

a. Direct Material & Indirect materials

b. Direct Labour & Indirect labour

c. Manufacturing overheads Prime cost

d) Product cost and a period cost.

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Question.2

The following information has been taken from the accounting records of Wisconsin plc for last year:

Selling expenses………………………………………….140,000

Raw material (January 1)……………………………….90,000

Raw material (December 31)………………………………60,000

Utilities, factory…………………………………………………..36,000

Direct labour…………………………………………………………..150,000

Depreciation@ factor........………………………………………..162,000

Purchase of raw material……………………………………………750,000

Sales…………………………………………………………………………..2,500,000

Insurance @ factory……………………………………………………40,000

Supplies @ factory……………………………………………………………15,000

Admin expenses…………………………………………………………………270,000

Indirect labour………………………………………………………………..300,000

Maintenance @ factory……………………………………………………...87,000

WIP January 1…………………………………………………………………….180,000

WIP January 31……………………………………………………………………100,000

Finished goods January 1………………………………………………..260,000

Finished goods December ……………………………………………….210,000

Management wants the data organized in a better format so that financial statements can be prepared for the

year.

i. Prepare a schedule of cost of goods manufactured.

ii. Compute the cost of goods sold

iii. Using data as needed from above, prepare an income statement.

Question 3.

a) Establish the relationship between cost accounting and managerial accounting and illustrate with an example

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b) The following cost and inventory data for the just completed year are taken from the accounting records of

Somuah Company;

Advertising ……………………………………………………………………………….$100,000

Direct labour cost……………………………………………………………….........$90,000

Purchase of raw material………………………………………………………….$132,000

Rent factory labour…………………………………………………………………….$80,000

Indirect labour……………………………………………………………………………..$56,000

Sales commissions ……………………………………………………………………….$35,000

Utilities, factory……………………………………………………………………………..$9,000

Maintenance, factory equipment………………………………………………….$24,000

Supplies, factory………………………………………………………………………………$700

Depreciation, office equipment……………………………………………………..$8,000

Depreciation, factory equipment…………………………………………………….$40,000

Opening inventory:

Finished goods …………………………………………………………………..40,000

Raw material ………………………………………………………………12,000

W.I.P………………………………………………………………………………………20,000

Finished goods are transferred to the trading department at 20% mark-up

At year end 1/5 of total goods available for the year are still in store

Sales amounts to twice the cost of production of the company in the year:

Inventories end of year

Raw materials…………………………. $10,000

Work in progress……………………… $20,000

Required:

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i) Prepare the cost schedule of cost of goods manufactured in the year

ii) Prepare the cost of goods sold section of the company.

iii) Assess the profitability level of the entity for the year ending.

b) Explain in brief the following:

i) Product cost

ii) relevant range

iii) Distinguish between cost Centre and profit Centre

iv) Define direct and indirect wages. Enumerate the considerations that need to be given to any type of

labour to distinguish between direct and indirect wages

Question5

a) Explain briefly each element of total cost and give example to illustrate each element.

b) Classify the following labour costs as either direct or indirect and give reasons to support these.

1) The basic pay of direct workers (cash paid, tax and other deductions)

2) The basic pay of indirect workers

3) Overtime premium

4) Bonus payments

5) Employers National Insurance contributions

6) Idle time of direct workers

7) Work on installation of equipment

Answers to Question b

1) The basic pay of direct workers is a direct cost to the unit, job or process.

2) The basic pay of indirect workers is an indirect cost, unless a customer asks for an order to be carried

out which involves the dedicated use of indirect workers time, then the cost of this time would be a direct

labour cost of the order.

3) Overtime premium paid to both direct and indirect workers is an indirect cost, except in two particular

circumstances:

I. If overtime is worked at the specific request of a customer to get his order completed, the overtime

premium paid is a direct cost of the order.

II. If overtime is worked regularly by a production department in the normal course of operations, the

overtime premium paid to direct workers could be incorporated into the (average) direct labour hourly rate.

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4) Bonus payments are generally an indirect cost.

5) Employer’s National Insurance contributions (which are added to employees’ total pay as a wages cost)

are normally treated as an indirect labour cost.

6) Idle time is an overhead cost that is an indirect labour cost.

7) The cost of work on capital equipment is incorporated into the capital cost of the equipment.

c)It is a waste spending to install a costing system as it is an expense but not an investment. Comment

d)Define the following and illustrate each with an example.

i) Semi –variable cost

ii) Opportunity cost

iii) Relevant cost

iv) Fixed cost

v) Sunk cost

c). Compare and contrast the relationship between financial accounting and cost accounting.

Chapter Three

Behaviour and Estimation of Cost

Cost behavior is simply the way in which cost react or responds as and when level of activity changes. Level of

activity refers to the amount of work done, or the number of events that have occurred.

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The cost behavior pattern of any single item of expenditure might be described as:

i. Variable cost

ii. Fixed cost

iii. Semi-variable cost

iv. Step cost

Variable Cost: This cost tends to vary directly with the volume of output and accordingly are sometimes

termed as direct cost that is they are costs that vary in direct proportion to the levels of activity. All prime costs

are variable overheads such as power, machinery repairs, indirect Labour and indirect material.

While the total cost of this varies with the volume of production the cost per unit remains the same. It can be

illustrated diagrammatically as follows:

Cost Total variable cost

Variable cost per unit

A constant variable cost per unit implies that the price per unit of say, material purchased is constant, and that

the rate of material usage is also constant.

a) The most important variable cost is the cost of raw materials (where there is no discount for bulk

purchasing since bulk purchase discounts reduce the cost of purchases).

b) Direct labour costs are, for very important reasons, classed as a variable cost even though basic wages

are usually fixed.

c) Sales commission is variable in relation to the volume or value of sales.

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d) Bonus payments for productivity to employees might be variable once a certain level of output is

achieved, as the following diagram illustrations.

Non-linear or curvilinear variable costs

If the relationship between total variable cost and volume of output can be shown as a curved line on a graph,

the relationship is said to be curvilinear.

Two typical relationships are as follows

(a) (b)

GH₵

Cost GH₵

Cost

Volume of output Volume of output

Each extra unit of output in graph (a) causes a less than proportionate increase in cost whereas in graph (b),

each extra unit of output causes a more than proportionate increase in cost.

The cost of a piecework scheme for individual workers with differential rates could behave in a curvilinear

fashion if the rates increase by small amounts at progressively higher output levels.

Fixed Cost: This are those which turn to be unaffected by variations in volume of output that is they are costs

that remain unchanged regardless of changes with the level of activity, they depend mainly on the passage of

time and accordingly are sometimes referred to as period costs. Example of period cost is debenture interest,

rent, rates and salaries of executives etc.

With fixed cost the total remains the same but the per unit figure decreases with an increase in volume, this is

because the same amounts of overheads are spread over a large number of units as graphically presented

below:

Cost

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Fixed Cost

Semi-variable costs: Semi-variable costs are part fixed and part variable, and are sometimes called mixed costs

for this reason.

cost

VC

FC

QTY

For some cost items, the fixed and variable elements of cost can be identified separately

Examples of these costs include the following.

a) Electricity and gas bills

Fixed cost = standing charge

Variable cost = charged per unit of electricity used

b) Salesman’s salary

Fixed cost = basic salary

Variable cost = commission on sales made

c) Costs of running a car

Fixed cost = road tax, insurance

Variable costs = petrol, oil, repairs (which vary with miles travelled)

Other cost behavior/ patterns

Semi- Variable cost pattern.

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GH₵ GH₵

Cost Cost

(a) (b)

Volume of output Output

Graph (a) represents an item of cost which is variable with output up to a certain maximum level of

cost.

Graph (b) represents a cost which is variable with output, subject to a minimum (fixed) charge.

Exercise 1

Are the following likely to be fixed, variable or mixed costs?

a) Telephone bill

b) Annual salary of the chief accountant

c) The management accountant’s annual membership fee to ICA(GH), paid by the company.

d) Cost of materials used to pack 20 units product X into a box

e) Wages of warehouse

Cost Equation

Cost incurred by entities be it fixed,variable or a semi-variable it may call for the separation of cost into fixed

and variable costs.For the sake of analysis we assume cost relates to activity linearly ( y = mx+c) and the

following techniques are used to separate and predict future costs.

i. The High and low method;

ii. The scatter graph;

iii. Linear regression analysis;

Method 1

High and Low method

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By this method, a check is made of historical costs in previous accounting periods, and the costs in two

particular periods are selected for cost estimation, and the following steps are followed to separate the total

cost into fixed and variable;

The highest level of activity and the lowest level of activity are chosen and their corresponding cost incurred

are used to derive the cost equation

Example: the high-low method

DG Ltd has recorded the following total costs during the last five years.

Year output volume Total cost

Units GH₵

20X0 65,000 145,000

20X1 80,000 162,000

20X2 90,000 170,000

20X3 60,000 140,000

20X4 75,000 160,000

Required

Calculate the total cost that should be expected in 20X5 if output is 85,000 units.

Solution

Step 1 Period with highest activity = 20X2

Period with lowest activity = 20X3

Step 2 Total cost at highest activity level = 170,000

Total cost at lowest activity level = 140,000

Total units at high activity level = 90,000

Total units at low activity level = 60,000

Step 3 Variable cost per unit

= Total cost at high activity level – total cost at low activity level

Total units at high activity level – total units at low activity level

= 170,000 – 140,000 = 30,000 = £1 per unit

90,000 – 60,000 = 30,000

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Step 4 Fixed costs = (total cost at high activity level) – (total units at high activity level × variable cost

per unit)

= 170,000 – (90,000 × 1) = 170,000 – 90,000 = GH₵80,000

Therefore the cost in 20 X5 for output of 85,000 units are as follows.

£

Variable costs = (85,000 × 1) 85,000

Fixed costs = 80,000

165,000

The step-by-step guide has been covered in order that you fully understand the process involved.

Exercise 2

High-low method

The Valuation Department of a large firm of surveyors wished to develop a method of predicting its total costs

in a period. The following past costs have been recorded at two activity levels.

Number of valuations Total cost

(V) (TC)

Period 1 420 82,200

Period 2 515 90,275

The total cost model for a period could be represented as follows.

A TC = GH₵46,500 + 85V

B TC = GH₵42,000 + 95V

C TC = GH₵46,500 – 85V

D TC = GH₵51,500 – 95V

Exercise 3:

The costs of operating the maintenance department of a computer manufacturer for the last six years

have been given as follows:

Year Units produced Cost

GH ¢

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2001 340 2,260,000

2002 300 2,160,000

2003 380 2,320,000

2004 420 2,400,000

2005 400 2,300,000

2006 360 2,266,000

Required:

What cost should be expected in the year 2007 when output is expected to be 550 units?

Solution:

Units Cost Ghc

High 420 2,400,000

Low 300 2,160,000

120 240,000

Variable cost per unit = 240,000 /120 =Ghc 2,000

Using the coordinates at the highest output (420, 2400000) and substituting into the cost equation y = mx + c

where c is the fixed cost

2,400,000 = GH ¢2,000 @ 420 + c

Fixed cost = $1,560,000

Therefore the cost equation will be Y = 2,000X + 1,560,000$.

In 2007 at units 550. Y = 2,000(550) + 1,560,000 = 2,660,000$

NB -Where inflation makes the cost in each period impossible to compare, costs should be adjusted to the

same price level by means of a price level index.

Exercise 4:

Rise and Palm Ltd has recorded the following total costs during the last five months:

Month Output Total cost Average Price index

Units GH ¢

August 65,000 145,000 100

September 80,000 179,000 112

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October 90,000 209,100 123

November 60,000 201,600 144

December 75,000 248,000 160

What costs should be expected in January if output is 85,000 units and the average price level index is 80?

Solution:

Price levels should be adjusted to a common basis, say index 100

(a) Output Total Cost Cost at price level index = 100

Units GH ¢ GH ¢

High level 90,000 209,100 × 100 /123 =170,000

Low level 60,000 201,600 × 100/144 =140,000

30,000 30,000

Variable cost per unit = change in cost = GH ¢30,000 = Gh1

Change in activity 30,000

(b) Using y = mx +c

GH ¢

Total cost at 90,000 (index 100) = 170,000

Variable cost of 90,000 units @ GH ¢1 = 90,000

Therefore Fixed Cost = 80,000

The cost equation is therefore y = mx + c = 1x + ghc 80,000

Cost in January for 85,000 units will be: y= 1x85, 000 + 80,000 = 165,000ghc GH ¢

In January, pirce levels (index 180) = 165,000 × 180

100

= GH ¢ 297,000

Method 2

Scatter graph method and Line of Best fit Methods:

Information about two variables that are considered to be related in some ways can be plotted on a scatter

graph. A scatter graph is simply a graph on which historical data is plotted. For cost behaviour analysis, the

scatter graph would be used to record cost against output level for a large number of recorded `pairs` of data.

By plotting cost level against activity level on a scatter graph, the shape of the resulting figure might indicate

whether or not a relationship exists.

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In such a scatter graph, the y-axis represents cost and x-axis represents the output or activity level.

One advantage of a scatter graph is that it is possible to see quite easily if the points indicate that a relationship

exists between the variables, i.e. to see if any correlation exists between them.

It is not easy to measure the degree of correlation from a scattergrph.However, as will be seen later; there are

methods of calculating a numerical value for this.

Line of best fit:

A scatter graph can be used to make an estimate of fixed and variable costs, by drawing a `line of best fit`

through the band of points on the scatter graph, which best represents all the plotted points.

Y

X

Having drawn the line of best fit, we can use it to estimate fixed and variable costs.

The amount of fixed costs can be found by looking at the point where the graph intercepts the y-axis. In

other words, look at total costs when activity is 0, these must be all fixed costs called C

To calculate variable costs, take any two points on your line of best fit, and record the total cost and the

output level. Use these figures and your calculation of the fixed cost to estimate the variable cost.

variable cost per unit= change in cost / change in output level = (y2-y1) /(x2-x1) = a

Therefore the equation becomes y = ax + c

Method 3

Linear regression analysis (least square method)

Linear regression analysis or the “least squares method), is a statistical method of estimating fixed and variable

cost using historical data from a number of previous accounting period. As a technique, it is preferable to the

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scatter graph because it avoids the subjectivity of (visual) judgment and therefore analyses the historical data

more accurately.

Linear regression analysis is used to derive a linear cost function y = a + bx

where:

y = the dependent variable- total cost

x= the independent variable-the level of activity

a= the fixed cost

b= the variable cost per unit of activity

Historical data from previous periods, and adjusted to a common price level to remove inflationary differences,

so that a number of ‘readings’ exist for output volumes (x) and their associated costs (y). The aim is to provide

estimates of fixed cost (a) and unit variable cost (b) using these readings for X and Y.

A number of different formulae exist to calculate fixed cost (a), and the unit variable cost (b). It is most

unlikely that an examination question will test your ability to use any formula.

Nevertheless, you need to be aware of the linear regression analysis approach to cost estimation, and its

strengths and weakness.

It might therefore help to show how the technique is used. The formula used under this method will now be

used in the following illustrations;

Y = a + bx

where ,

n

xb

n

yna

xxn

yxxynb

22 )(

Or a= average of y – b average of x n= number of pairs of data for X and Y.

Illustration.

Suppose we have the following pairs of data about output and costs.

Month Output Cost

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‘000s of units GH₵ ‘000

1 20 82

2 16 70

3 24 90

4 22 85

5 18 73

Required:

using the least square regression method determine the fixed cost and the variable cost per unit and the

estimate the cost to be incurred in the 6 month if output is 25000 units.

Suggested solution

a) Workings

X Y XY X²

20 82 1,640 400

16 70 1,120 256

24 90 2,160 576

22 85 1,870 484

18 72 1,314 324

∑X = 100 ∑Y = 400 ∑XY = 8,104 ∑X² = 2.040

n= 5 (There are five pairs of data for x and y values)

28)5(

)100(6.2

5

400

6.2200

520

1000010200

4000040520

100)20405(

)400100()81045(

)( 222

n

Xb

n

Ya

XXn

YXXYnb

Where Y = total cost, in thousands of Cedis

therefore; Y= 28000 + 2.6 X

given an output level of 25000,

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Y= 28000+ 2.6 (25000)

Y= 28000 + 65000

Y= 93000

Assignment

Q1 Andes is a manufacturer of television set located in the industrial area in the Tema Accra Metropolis The following

table shows the number of units of televisions produced in a year and the total costs incurred.

Units produced total cost Ghc

10 5,200

15 5,500

20 6,500

25 6,500

30 7,500

35 8,500

120 8,800

Using graph:

i) Establish the cost equation of the company 9 Marks

ii) The units to be produced to incur a variable cost of Ghc 3,200 2 Marks

iii) The variable cost of production at activity level of 17units. 2 Marks

Using least square regression method:


ii) The units to be produced to incur a variable cost of Ghc 3,200 2 Marks

iii) The variable cost of production at activity level of 17units. 2 Marks

Tutorial Questions

Question1

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The data below shows the number of units of Toys sets produced and the total costs incurred by Asubonteng

Company located in the harbour city of Tarkoradi


5 2,000

10 2,500

15 3,000

20 3,250

25 3,500

30 3,750

Required:

Using graph:

i) Establish the cost equation of the Asubonteng company

ii) The units produced to incur cost of Ghc3, 100

iii) The variable cost of production at activity level of 14units.

Using the least square regression analysis:

i) Establish the cost equation of the Asubonteng company

ii) The units produced to incur cost of Ghc3, 100

iii) The variable cost of production at activity level of 14units.

Question2

a) Distinguish between variable cost and fixed cost

b) A professional consultant has been analyzing the performance of financial performance in order to control

cost. The table below gives the cost and its related services to clients.

Section

service

cost (y)

31 27 23 39 22 17 51 39 30 44

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Section

services

(x)

22 22 21 27 22 17 30 24 21 31

Required:

i. Represent the information in a scatter diagram

ii. Draw a line of best fit on the scatter diagram

iii. Find the least square regression equation of Y and X

iv. Interpret the regression equation best fit line.

Assignment 2

Sunkwa Ltd produces wood from the amazon forest with finishing completed in a big plant located in the

wassa in the western corridors of Gold Coast. The following table shows the number of units of wood

completed and the total costs incurred.

Units of products Total cost ( ghc)

30 620

50 750

70 850

80 950

90 1,050

Management is interested in knowing the nature of their cost.

Using graph:


iii) Estimate using the graph the variable cost of production at activity level of 42 units. 2 Marks

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Chapter Four

Materials

The investment in stock is very important one for most businesses, both in terms of monetary value and

relationships with customers (no stock, no sale, loss of customer goodwill). It is therefore vital that

management establishes and maintains an effective stock control system and that they are aware of the major

costing problem relating to materials, that of pricing materials issues and valuing stock at the end of each

period.

Material costs are costs of commodities other than fixed assets introduced into a product or consumed in the

operation of an organization .It may also be described as all physical substances that go into the production of

goods and services. Examples of material costs are raw materials, factory supplies, component spare parts, etc.

Purchase requisition

A purchase requisition is a formal request for materials to be bought. It might be prepared by a member of the

stores staff or produced automatically by a computer system when the level of stock gets down to a pre-order

level.

PURCHASE REQUISITION Req. No

Department/job number: Date:

Suggested Supplier:

Requested by:

Latest date required:

Quantity Code

number

Description Estimated cost

Unit $

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Purchase order - It an order placed with a supplier for the purchase of goods. A copy is sent to the chosen

customers retained by the purchasing (buying) department.

Purchase/Confirmation

Our Order Ref: Date:

To:

(Address) Please deliver to the above address

Ordered by:

Passed and checked by:

Total Order Value £

Sub total

VAT(@7.5%)

Total

Authorized by ……………………..

Goods received note

It is a note which records details of goods received from a supplier. If the delivery is acceptable, the

storekeeper prepares a goods received note (GRN), an example of which is shown below.

Goods received note WAREHOUSE COPY

DATE: TIME: NO. 55565

OUR ORDER NO: WAREHOUSE A

SUPPLIER AND SUPPLIER’S ADVICE NOTE NO:

QUANTITY CAT NO. DESCRIPTION

RECEIVED IN GOOD CONDITION:

(INITIALS)

Purchase invoice

Purchase invoice is the invoice received from a supplier showing the description, quantity, unit price and the

total amount due.

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The bin card

A bin card is a simple record of receipts, issues and balances of stock in hand kept by the store keepers. Where

bin cards are used:

a) They are kept in the physical location where stores items are held.

b) There is a bin card for each store item and

c) The bin card is updated with issues of materials from stores and receipts of the items into stores

so that it should always show the current balance of the item in stock.

Bin card

Part code no----------------------- Location------------------------------

Bin number---------------------------- Store ledger no---------------------

Receipts Issues Stock

balance Date Quantity G.R.N

No.

Date Quantity Req. No.

The use of bin card is decreasing, partly due to the difficulty in keeping them updated and partly due to the

merging of stock recording and control procedures, frequently using computers.

Material requisition

A material requisition is a document that authorizes the storekeeper to release the goods and acts as a posting

medium to the stores ledger and bin card.

Materials requisition note

Date required----------------- Cost centre No/ Job No------------------

Quantity Item code Description £

Signature of requisitioning Manager/ Foreman------------------------- Date-----------

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Store Ledger

The stores ledger is the basis for stock control procedures.

Perpetual Inventory

Perpetual inventory is the recording as they occur of receipts, issues and the resulting balances of individual

items of stock in either quantity or value.

Methods of valuing (or pricing) material issues

The methods of pricing or valuing material issues are as follows:

(i) FIFO (first in firs out)

(ii) LIFO (last in first out)

(iii) Weighted average

(iv) Simple average

(v) Standard price method

(vi) Replacement method

(vii) Base stock method.

FIFO (First in first Out)

This method uses the price of the first batch (delivery) received for all issues until all units from this batch

have been issued after which the price of the next batch received becomes the issue price upon that batch being

fully issued the price of the next batch received is used and so on. This method ensure that materials are issued

at actual cost so no profits or losses will be incurred merely by adopting this price, it may be seen later on that

when estimates or approximations are used, a profit or loss of issue may be obtained.

Advantages of fifo

i) Realistic (that is) it assumes items are issued to shop floor in order of receipt.

ii) It is easy to operate

iii) Valuation of stock balance is a fair commercial value of stock.

iv) No profit or losses arise, that is value of issues after allowing for stock exactly equals cost of

purchase.

Disadvantages of fifo

i) If the price of material purchase fluctuates considerably, it involves a number of tedious

calculations, which may increase the possibility of errors.

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ii) Issued price may not reflect current economic values.

LIFO (last in first out)

This method use the price of the last batch received for all issues until all units from this batch have been

issued when the price of the previous batch received is used. Usually, however, a new delivery is received

before the first batch is fully issued in which case the new delivery price becomes the last in price and is used

for pricing issues until either the batch is exhausted or a new delivery is received. It must be not that:

a) The method can result in many batches being wholly or partly written off.

b) This is a book keeping method and or must not be confused with the physical methods of issue

by the storekeeper who will always issue the oldest stock first. This method also ensures that

materials are issued at actual cost.

Advantages Of Lifo

(i) It keeps value of issues close to current economic values.

(ii) Valuation of stock balance is very conservative.

(iii) No profit or losses arise.

Disadvantages Of Lifo

i) Tedious calculations and unfair comparison of job cost.

ii) Not realistic that is it assumes physical issue principle to be opposite of that actually followed.

iii) Valuation of stock balances may not be acceptable for corporation tax assessment.

Simple Average Method

This issued price or the average is obtained by adding all the prices paid on purchases or receipts to date and

dividing by the number of such prices. If the whole quantity in a consignment has been fully issued its price

must be excluded in finding the average. NB. To arrive at the value of stock on hand if there is a receipt of

goods, the value of the receipts should be added to the value of the stock on hand for the previous section, and

whenever there is an issue the value of the issue should be deducted from the value of stock on hand fro the

previous time to arrive at the value of stock on hand as at the current date. Under this method an approximated

figure may be obtained owing to the fact that the total of the prices paid for the material is divided by the

number of prices used in the calculation, materials are not therefore charged out at actual cost so profit and loss

may be incurred merely by adopting this price when evaluating materials charged to production.

Advantages Of Simple Average Method

i) It can be misleading.

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ii) Profits and losses can arise.

Weighted average

To get the weighted average price the total cost is divided by the total quantity to arrive at the value of stock on

hand whenever there are receipts or issues, the same principle as applied to the simple average should be

adopted. With this method, the profit or loss on issue may be incurred owing to the approximation of figures.

Advantages of weighted average

i) Although it is necessary to calculate the average price this is done only after each receipt and the

system tends to be simpler to operate than either LIFO or FIFO.

ii) It smoothens out fluctuations in purchase price.

iii) It gives acceptable figure for stock valuations.

Disadvantages of weighted average method.

i) Issues may not be at current economic values.

ii) Issue price may run to a number of decimal places.

Standard price method

This is a price which the management predetermines for a given period purchase invoices are valued in terms

of the standard price. All issues are then made at the standard price, the standard price will be set for each

material which can then be compared with the actual price paid, if the actual price exceeds the standard then a

loss will be realized. If the actual price is less than the standard, profit will be obtained. It must be noted that

the value of stock on hand is also made at the standard price.

Advantages of standard price method

i) The method is relatively easy to operate.

ii) It provides a check on the efficiency of the purchasing departments by seeing whether or not the

actual price exceeds standard.

iii) It eliminates price fluctuations from the cost thereby enabling satisfactory comparisons to be made.

iv) It does not change over the accounting period.

Disadvantages

i) It requires careful initial determinations.

ii) Profit and loss may arise (under full standard costing this is not a disadvantage)

iii) Issues may not be at current economic values.

iv) It disregards price trends.

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Replacement price

The principle of this method is that issues are priced either at replacement or realizable price at the date the

issue is made. It must be noted that the balances of units on hand are also valued at the replacement or

realizable price.

Advantages

i) The result of good or bad buying is disclosed.

ii) Issues are at current economic values.

iii) Calculations are simple.

Disadvantages

i) Difficult to be continually up to date with replacement prices.

ii) Profit or loss may arise.

iii) It is not at a traditional cost price.

Base stock method.

Under this method, it is assumed that the minimum stock of commodity, which must always by carried is in the

nature of a fixed asset as in practice it can never be realized while the business continues. This minimum stock

is therefore carried at original cost. The stock in excess of this figure will be treated in accordance with one of

the other methods.

Base stock is rather similar to FIFO in operation and suffers from the same disadvantage namely, calculations

and unfair comparison of job cost.

In stock valuation the stock will normally contain the minimum stock plus any of the latest purchases, which

have not been issued to production.

Illustration

The following information was compiled from the stock records of a company.

January 1 Received 1000 units at $1 per unit.

10 Received 260 units at $1.05 per unit.

January 20 Issued 700 units

February 4 Received 400 units at $1.15 per unit.

21 Received 300 units at $1.25 per unit.

March 16 Issued 620 units

April 12 Issued 240 units

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May 10 received 550 units at $1.10 per unit

May 25 Issued 380 units.

Required: calculate the value of closing stock, cost of goods sold using the following methods of valuing

materials issues.

(i) FIFO

(ii) LIFO

(iii) Simple average

(iv) Standard price assuming the standard price is $1.00

(v) Weighted average

(vi) Base stock method assuming the company keeps 1000 units of the January 1 purchases as a

buffer stock.

(vii)

Lifo

date receipts issuance balance

Jan. 1st

Jan. 10th

Jan. 20th

Feb. 4th

Feb. 21st

March 16th

April 12th

May 10th

May 25th

Qty

1000

260

400

300

500

Price

1.00

1.05

1.15

1.25

1.10

Amount

1000

273

460

375

550

Qty

260

440

700

300

320

80

160

380

Price

1.05

1

1.25

1.15

1.15

1.00

1.10

Amount

273

400

713

375

368

92

160

418

Qty

1000

1000

260

1260

560

560

400

560

400

300

560

80

400

400

500

400

Price

1.00

1.00

1.05

1.00

1.00

1.15

1.00

1.15

1.25

1.00

1.15

1.00

1.00

1.10

1.00

Amount

1000

1000

273

1278

560

560

460

560

460

375

560

92

400

400

550

400

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Closing stock

120

520

1.10

132

532

Purchase Ghc2,658

Closing stocks Ghc 532

COGS Ghc 2,126

Simple Average

Date Receipts Issues Balance

Qty Price Amt Qty Price Amt Qty Price Amt

Jan. 1 1000 1.00 1000 1000 1.00 1000

Jan. 10 260 1.05 273

1260 1.025 1273

Jan 20 700 1.025 718

560

1.025

574

Feb. 4 400 1.15 460

960 1.0875 1044

Feb. 21 300 1.25 375 1260 1.16875 1472

Mar.16 620 1.16875 724.63 640 1.16875 748

Apr.12 240 1.16875 280.50 400 1.16875 467.50

May10 500 1.10 550 900 1.134375 1020.94

May25 380 1.134375 431 520 589.88

Purchases = 2658

Less Closing stock = 589.88

2,068.12

weighted average



Jan 1 1000 1.00 1000 1000 1.00 1000

Jan 10 260 1.05 273 260 1.05 273

1000 1.00 1000

1260 1273

Jan 20 700 1.0103 707 560 566

560 566

Feb.4 400 1.15 460 560 566

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400 460

960 1026

Feb 21 300 1.25 375 960 1026

300 1.119 375

1260 1401

Mar 16 620 1.1119 689 640 712

Apr 12 240 1.1119 267 400 445

May 10 500 1.10 550 900 1.11 995

May 25 380 1.11 420 520 575

Purchases = 2658

Less: Closing stock 575

2083

standard price



Jan 21 1000 1.00 1000 1000 1.00 1000

Jan 10 260 1.05 273 1,260 1.00 1,260

Jan 20 700 1.00 700 560 1.00 560

Feb 4 400 1.15 460 960 1.00 960

Feb 21 300 1.25 375 1260 1.00 1260

Mar 16 620 1.00 620 640 1.00 640

Apr 12 240 1.00 240 400 1.00 400

May 10 500 1.10 550 900 1.00 900

May 25 380 1.00 380 520 1.00 520

Purchases =

Less: Cost of sales =

Closing stock =

base stock method



Jan 1 1000 1.00 1000 1000 1.00 1000

Jan 10 260 1.05 273 260 1.05 273

1000 1.00 1000

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1260 1273

Jan 20 700 1.00 700 560 573

Feb.4 400 1.14 460 400 460

960 1033

Feb 21 300 1.25 375 960 1033

300 375

1260 1408

Mar 16 200 1.00 200 100 1.00 100

260 1.05 273 240 1.15 276

160 1.15 184 300 1.25 375

620 657 640 751

Apr 12 240 1.14 276 100 1.00 100

300 1.25 375

400 475

May 10 500 1.10 550 100 1.00 100

300 1.25 375

500 1.10 550

900 1025

May 25 300 1.25 375 100 1.00 100

80 1.10 88 400 1.10 462

380 463 500 562

Purchases = 2658

Less: closing stock = 562

Cost of sales = 2096

NB – which ever method is used in valuing stocks you may get different values for cost of goods sold yet

the quantity sold should be the same

Assignment

A) Blessings Limited uses material called zola which is measured in kilogram for its production. In the

month of January, 2014, the following transactions in respect of the material occurred:

Jan.1 Opening inventory of 100 kg at GHS2 each

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Jan.2 Purchases 200kg@ GHS4 each

Jan.9 Issued 200kg

Jan.10 customers returned 150kg of Jan9 Issue. Stocks were of defect hence re-valued @ Ghc1.5

Jan.15 Purchased 400kg @ GHS3 each

Jan.19 Purchased 300kg @ GHS5 each

Jan 20 Issued 340kg

Jan.22 Issued 600kg

Required:

Prepare a store ledger account using

a) Weighted Average Method

b) FIFO Method

c) LIFO Method

to account for the closing inventory and cost of goods sold in the month of January, 2015.

b)

Phylis Ltd has the following transactions in respect of its goods during the month of Dec 2015.

Opening stock 78 units @ GH¢25

Dec 5 bought 250 units @ GH¢24

Dec 10 sold 175 units @ GH¢95



Dec 15 paid for printing GH¢7,200


dec 22 sold 140 units @ GH¢85

Dec 22 commission to sales Executives GH¢ 20,000



May 29 sold 115 units @ GH¢92

Additional information;

i. Cost of carting materials inwards was agreed at GH¢12 per unit of materials

ii. Out of the general administrative expenses of GH¢10,000 only GH¢2,900 had been paid during the

month of December

iii. The outstanding balance of GH¢7,100 was paid on the 20th February, 2016.

You are required to:

a. Write up the stores ledger card using FIFO and LIFO method of stock valuation.

` b) Prepare trading, profit and loss account for the period from 1st Dec to 31st Dec 2015 using method of

stock valuation

c) Show the balance sheet extract as at 31/12/2015

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Tutorial Question

Q1

The following is the summary of Ebony receipts and issues of material in a factory during December 2015.

Prepare Store Ledger according to LIFO Method.

December 2015

i. Opening balance 500 units @ GH¢25 per unit

ii. Issue 70 units

iii. Issue 100 units

iv. Issue 80 units

v. Received from supplier 200 units @ GH¢24.50 per unit

vi. Returned to store 15 units @ GH¢24 per unit

vii. Issue 180 units.

viii. Received from supplier 240 units @ GH¢24.75 per unit

ix. Issue 304 units.

x. Received from supplier 320 units @ GH¢24.50 per unit

xi. Issue 112 units

xii. Returned to store 12 units @ GH¢24.50 per unit

xiii. Received from supplier 100 units @ c25 per unit

Q2

The following information was extracted from the cost records of Somuah in relation to inventory ledger account

month of March 2015.

March 1 Balance brought forward 500 units @ GH¢5

March 5 Received 200 units @ GH¢6


March 10 Received 900 units @ GH¢7


March 15 Received 420 units GH¢5.50


March 22 Received 530 units @ GH¢8.50

You are required to cost the issue of the material and calculate the value of closing stock using

a. Last-In-First-Out (LIFO) method

b. Standard cost price of GH¢6.50

c. FIFO

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d. Weighted Average method

e. Simple Average method

Cost of holding stock or storage

The following costs are incurred in keeping materials in stock.

i) Capital cost: the cash tied up in stock as these stocks are acquired

ii) Space cost of renting a place for the stocks including providing the right conditions for the

inventory so as not to deteriorate.

iii) Equipment cost: The provision of equipments such as bin cards or tally cards, racks and material

holding equipments.

iv) Personnel cost: Employment of storekeepers and record clerks, security, etc.

v) Insurance: The cost of insuring the stocks.

vi) Deterioration: Some of the items may go bad.

vii) Obsolescence: Items becoming out of date or outmoded.

viii) Adverse fluctuations in market prices.

Stores control

Avoid the following when keeping inventory:

i) Overstocking: This involves holding stock more than required.

ii) Under stocking (Stock out): This is materials running out of stock. The possible consequence of

stock out are:

a. Wages and fixed cost incurred without any compensating output.

b. Loss of profits on lost sales.

c. Delivery delays resulting in concealed orders loss of goodwill or even penalty payments.

d. Greatly increased procurements cost: In an emergency prices and transport charges above

normal must be paid to obtain supplies quickly.

e. Production disorganization: Production must run smoothly to be efficient and disorganization

results in unnecessary through often hidden cost.

Various stocks Levels

i) Maximum stock level

ii) Minimum stock level

iii) Re-order level

iv) Re-order quantity

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Note however that such levels are not fixed once and for all; they must be adjusted as circumstances demand.

Maximum stock level

The maximum level of a given material is the maximum quantity that may be held in store. It is essentially an

uppermost limit that the buyer must ensure is not .In setting this stock level the following factors must be taken

into account:

MSL = ROL + ROQ– (Minimum Consumption x Minimum Re-order period)

Minimum stock level

This is the lowest level or quantity to which stock should fall. It is essentially a buffer stock that may not

normally be touched, in the event of any item falling to its minimum level management is immediately alerted

and acquisition of new supplies given top priority.

Minimum Stock Level (MSL) = ROL – (average consumption x average re-order period)

Re-order level

This is the point at which it is essential to initiate purchase requisitions for fresh supplies of the material. This

is the level at which a purchase requisition is made out, it lies between maximum and minimum levels and if

purchase action is taken when stock falls to this level new supplies will be received before stock falls to the

minimum level.

Re-order level (ROL) = Maximum consumption x maximum re-order period

Re-order quantity

This is the quantity to be re-ordered in normal circumstances; this is sometimes referred to as economic order

quantity. By setting this level, the buyer is saved the task of recalculating how much he should buy each time

he orders. He may of course disregard this quantity if he deems circumstance warrant it.

Illustration:

The following information is available in respect of material called DAMPA stocks .

Highest consumption 350 units per week

Lowest consumption 200 units per week

Re-order time 5 to 9 weeks

Re-order quantity 2,200 units

You are required to calculate:

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a) Re-order level

b) Minimum level

c) Maximum level.

i) Re-order level: it should be noted that in fixing the re-order level the worst possible expected conditions are

used. This should ensure that stock should not be exhausted at least in the short run.

Re-order level (ROL) = Maximum consumption x maximum re-order period

Maximum consumption = 350 units

Maximum re-order period = 9

ROL = 350 x 9

ROL = 3150 units.

ii) Minimum stock level: It should be noted that in fixing the minimum stock level the number or average

conditions are used. This should ensure that under normal conditions the “buffer stock” would not be required

for consumption.

Minimum Stock Level (MSL) = ROL – (average consumption x average re-order period)

= 3150 – (275 x 7)

= 3150 – 1925

= 1225 units

iv) Maximum Stock level: It should be noted that in fixing the maximum stock level the best possible

expected conditions are used, this should ensure that even if there is quick delivery from suppliers

and if there is also a low demand for materials stock should not rise higher than the maximum stock

level authorized.

MSL = ROL + ROQ – (Minimum Consumption x Minimum Re-order period)

ROQ = Re-order quantity = 2200

= 3150 – (200 x 5) + 2200

= 3150 – 1000 + 2200

= 4350 units.

Economic order quantity (EOQ)

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The economic order quantity (EOQ) is the order quantity which minimizes stock costs. The EOQ can be

calculated using a table, graph or formula.

Economic order theory assumes that the average stock held is equal to one half of the reorder quantity

(although as we saw in the last section, if an organization maintains some sort of buffer or safety stock then

average stock = buffer stock + half of the reorder quantity). We have seen that there are certain costs associated

with holding stock. These costs tend to increase with the level of stocks, and so could be reduced by ordering

smaller amounts from suppliers each time.

On the other hand, as we have seen, there are costs associated with ordering from suppliers: documentation,

telephone calls, payment of invoices, receiving goods into stores and so on. These costs tend to increase if

small orders are placed, because of larger number of orders would then be needed for a given annual demand.

The Economic Order Quantity can be derived by the formula below:

h

O

C

DCEOQ

2

Where 2= a constant

Co=cost of Ordering

D= annual Demand

Ch=Holding cost per unit per annum

Illustration 1:

i) New Life Limited uses material “K” for its regular production of smart soap.

Annual demand of material “K” is 7,500kg which was purchased at GH₵15.00 per kg of which 20% of

the purchase price was spent to keep a kilogram of the material in store per annum. It cost GH₵ 65 to make

an order.

Lead time is 5 days and there are 250 working days in the year of this company.

Required:

(a) Determine the Economic Order Quantity of material “K” (5Marks)

(b) What is the associated total inventory cost? (3Marks)

(c) How often should an order be placed for material “K”? (Optimum Order Cycle Time)

(2 Marks)

ii) The demand of a company product is about 300,000 units per month. It was estimated that it cost

GH¢4.8 to keep one unit of the product in stock for one year.

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The cost Accountant estimated that it will cost GH¢40 in administrative each time an order is to be placed.

Required:

a) Calculate the economic order quantity

b) Calculate the total inventory cost per annum

Illustration 2

a) Cantona produces and sells toys. The company sells 10,000 toys per month and that the demand for toys is

uniform throughout the year. It costs GH¢ 250 each time raw materials are ordered and carrying cost is

GH¢ 8 per unit of raw materials per day.

Required:

i) Determine the EOQ of raw materials

ii) Determine the inventory cost per year

Stock costs

Stock costs include purchase costs, holding cost, ordering costs and stock-out costs.

The costs of purchasing stock are usually one of the largest costs faced by an organization and, once obtained,

stock has to be carefully controlled and checked.

4.1.1 Reasons for holding stocks

To ensure sufficient goods are available to meet expected demand

To provide a buffer between processes

To meet any future shortages

To take advantage of bulk purchasing discounts

To absorb seasonal fluctuations and any variations in usage and demand

To allow production processes to flow smoothly and efficiently

As a necessary part of the production process (such as when maturing cheese)

As a deliberate investment policy, especially in times of inflation or possible shortages.

Holding costs

If stocks are too high, holding costs will be incurred unnecessarily. Such costs occur for a number of reasons.

a) Costs of storage and stores operations. Larger stocks require more storage space and possibly extra

staff and equipment to control and handle them.

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b) Interest charges. Holding stocks involves the tying up of capital (cash) on which interest must be paid.

c) Insurance costs. The larger the value of stocks held, the greater insurance premiums are likely to be.

d) Risk of obsolescence. The longer a stock item is held, the greater the risk of obsolescence.

e) Deterioration. When materials in store deteriorate to the extent that they are unusual, they must be

thrown away with the likelihood that disposal costs would be incurred.

Costs of obtaining stock

On the other hand, if stocks are kept low, small quantities of stock will have to be ordered more frequently,

thereby increasing the following ordering or procurement costs.

a) Clerical and administrative costs associated with purchasing, accounting for and receiving goods.

b) Transport costs.

c) Production run costs, for stock which is manufactured internally rather than purchased from external

sources.

Stock-out costs

An additional type of cost which may arise if stocks are kept too low is the type associated with running out of

stock. There are a number of causes of stock-out costs.

Lost contribution from lost sales

Loss of future sales due to disgruntled customers

Loss of customer goodwill

Cost of production stoppages

Labour frustration over stoppages

Extra costs of urgent, small quantity, replenishment orders

Objective of stock control

The overall objective of stock control is, therefore, to maintain stock levels so that the total of the following

costs is minimized.

Holding costs

Ordering costs

Stock-out costs

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Chapter Five

Labour

Just as management need to control stocks and operate an appropriate valuation policy in an attempt to control

materials costs, so too must they be aware of the most suitable remuneration policy for their organization. We

will be looking at a number of methods of remuneration and will consider the various types of incentive

scheme that exist. We will also examine the procedures and documents required for the accurate recording of

labour costs. Labour turnover will be studied too.

This is a major cost in most factories. Control of this cost is thus a chief objective of management be made by

a) Using direct labour cost as a basis for control. Direct labour is that labour associated directly with

the product being made since it can be easily identified and varies directly with the volume of

output, it can be readily ascertained and controlled.

b) Identify direct labour cost with the product, job or process.

c) Using direct labour cost as a basis for overhead application.

d) Determining indirect labour cost as an element in controlling the efficiency of different cost centers

or departments. Indirect labour is that labour which is not directly associated with the product and

which cannot be identified with.

Factors to be considered for effective labour control.

i) Production Planning: This includes product engineering, process engineering, planning, time and

motion studied, methods studied.

ii) Use of labour budget. This can be derived with the age of data from production planning.

iii) Use of labour standards, actual cost are compared with predetermined standards, the variances

computed and remedial action taken.

iv) Use of incentive schemes, efficiency report from departments help to ascertain the effectiveness of

such schemes, but beware of loss of quality or the product.

v) Labour performance report: This should cover both efficiency and utilization of labour.

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vi) Cost of clerical effort to achieve control, use could be of mechanical methods where possible such

as time recorders, punch cards, etc. to eliminate unnecessary clerical cost.

Labour turnover

This is the rate at which employees have employment and is evaluated by relating the number of

employees leaving during a period of time to the total or average numbers employed in the period i.e.

Labour turnover = Number of employees leaving who have to be replaced

Average number of employees during the period.

Reasons for labour turnover.

The reasons for labour turnover will be grouped into avoidable and unavoidable reasons.

The avoidable reasons for labour turnover are:

a) Redundancy: Due to lack of planning and foresight.

b) Dissatisfaction with wages.

c) Dissatisfaction with hours of work.

d) Relationship with superiors.

e) Relationship with other workers

f) Other reasons such as inadequate training, poor safety, precautions, improper promotion.

Unavoidable Reasons for Labour Turnover are:

a) Personal betterment.

b) Illness or accidents

c) Move from locality

d) Discharge i.e. unsuitable misconduct, bad time keeping.

e) Marriage, pregnancies, etc.

f) Retirement.

g) Death

h) Transport difficulties.

i) Other reasons such as housing etc.

Cost of labour turnover

It may be divided into preventive and replacement costs.

Preventive cost comprises:

a) Cost of personnel administration incurred in maintaining good relationships.

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b) Cost of medical services including check-ups for staff, etc.

c) Cost of welfare services including sports facilities, laundry services and canteen meals, etc.

d) Pension schemes, providing security to employees.

Replacement cost comprises:

a) Inefficiency of new labour

b) Cost of selection and replacement. Example, advertising, interview, clerical time spent on engagement,

paper work.

c) Cost of training new employees.

d) Loss of output due to delay in new labour becoming available.

e) Increase wastage and spoilage.

f) Accident frequency.

Labour remuneration system

The subject or remuneration rate and their determination are extremely complex. We will concern with the

most common methods used. For actual calculation of wages, the most commonly used methods are:

a) Basis of time spent (time work) in the factory day rate or day work or time rate.

b) Basis of production achieved or payments by results. That is piecework.

c) Either (a) or (b) supplemented by form of bonus or incentive scheme.

Time rate or day rate method

Flat time rate: The employee is paid on the basis of time engaged, the formula is:

Hours Worked x Rate per hour

Example using the formation labour, calculate wages under a day rate system.

Hourly rate Hours Worked Wagers per the periods worked

$1.20 per hour 8 $1.20 x 8 = $9.60

Advantages

1) Easy to compute (calculate) and understand.

2) Avoids frequent complex negotiations inevitable with most incentive schemes.

Disadvantages

1) No incentive for employee to do more than necessary this means constant supervision may be

required.

2) Efficient and inefficient employees are paid the same.

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3) There is direct incentive for employees to work slowly if uncompleted work results in overtime.

4) Since often employees wish to work overtime in order to increase their total weekly pay.

Circumstances under which day rate is applicable

Day rate is particularly suitable where:

a) Quality is more important than production.

b) Work is such that there is no basis for an incentive scheme. Example night watchmen.

c) Rate or production is outside the employees control example Oil refinery operation.

High day rate play or high time rate

The high day rate plan is a daily rate variant that aims to avoid the complications and negotiations involves

incentive scale and at the same time also avoid the lack of efforts that usually accompanies day rate works.

The same system of payment applies, the rate paid are higher than normal. It is possible to attract the best

workers in this way and obtain from them the higher level of production although greater supervision and

control is required.

Measured day work

As a bind of variation of this high wages plan, many firms have introduced what had been called measured day

work (MDW). The employer pays an agreed sum of wages under a specific level of performance, although the

worker does not have direct incentive to improve upon the level of performance initially fixed. It is claimed

that the better relationship establishment between management and employees more that offset any possible

draw in the level of output.

Payment by result schemes / incentives

An incentive scheme is a scheme that relates remuneration to performance though an occasional scheme aims

at improving punctuality or reducing material waste. The majority aims at increasing production. These form

into two groups:

1) Piece work scheme

2) Premium bonus scheme.

Straight piece work

Under this method the employee is paid under the basis of production. The formula

Is Wages = Units produced x rate per unit

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Illustration 1

In a particular job or work, the following factors apply:

Basic hourly rate = $0.80

Incentive on rate = 20%

Output is expected to be 12 units per hour.

Required:

a) Calculate the piecework rate.

b) The total amount to be paid on the total wage if 100 units were produced in an 8-hour day.

Solution:

Hourly rate = $0.80

Increase = 100 + 20% = 120

120 x 80

100

= $0.96

Rate per unit = 0.96

12 Total wages = 100 x 0.8

= $0.08 = $8

Illustration 2

Hourly rate = $1 per hour

Agreed production rate = 100 units per hour

Hours worked = 8 hours

Units produced = 1200 units

Required: Calculate his wage using the piecework method.

Solution:

Amount paid per unit = 1 = $0.01

100

Units produced = 1200

Wages = 1200 x 0.01

= 12.

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Illustration 3

Estimated time = 30 minutes

Basic time rate = 1.20 per hour

Allowed increase = 25%

Find the piece rate or rate per unit

Solution:

Enhanced (adjusted) time = 125 x $1.20 per hour

100

= $150

Rate per hour = $1.150 x 30

60

= $0.75 per unit.

Question:

Piecework

An employee is paid 5 per piecework hour produced. In a 35 hour week he produces the following output.

Piecework time allowed

per unit

3 units of product A 2.5hours

5 units of product B 8.0 hours

Calculate the employee’s pay for the week

Differential piece work

Simple piece work system offer no particular incentive for the very fast worker because he receives the same

per unit produced as the slower workers, various methods have been developed by which faster workers

receive a higher rate for all production when operating above a certain target level.

F.W. Taylor's scheme had two rates, one below normal time rate, the other well above them, Merricle later

modified this by introducing the intermediate levels of performance that is in this type of scheme the piece

work changes at different levels of efficiency.

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Differential piecework scheme offers an incentive to employees to increase their output by paying higher rates

for increased levels of production. For example:

Up to 80 units per week, rate of pay per unit = ¢1.00

80 to 90 units per week, rate of pay per unit = ¢1.20

Above 90 units per week, rate of pay per unit = ¢1.30

Employees should obviously be careful to make it clear whether they intend to pay the increased rate on all

units produced or on the extra output only.

Example: ¢0.01 per unit when efficiency is below 7 units an hour. ¢0.20 per unit when above 10 units an hour.

It should be appreciated that in such a scheme, it is important to distinguish between paying the increased rate

on all production or on only the excess production. Example if 11 units were produced under the above scheme

either the 11th unit only would be paid at ¢0.20 or all the 11.

Summary of piecework schemes

They enjoy fluctuating popularity.

They are occasionally used by employers as a means of increasing pay levels.

They are often seen to drive employees to work too hard to earn a satisfactory wage.

Careful inspection of output is necessary to ensure that quality doesn’t fall as production increases.

Piece work with guaranteed day rate / guaranteed minimum

Under this method a day rate is guaranteed so that if at any time piecework earning is lower than day rate, then

the day rate earning are paid instead. This avoids an employee being poorly paid on account of low production,

which arose through no fault of the employee. Example, poor materials, failure of machinery, waiting for work,

etc.

Disadvantages of Piecework

While the piecework is attractive on the grounds that performance and pay are directly linked piecework does

suffer from the following disadvantages:

a) Establishing piecework rate can involve protracted and expensive negotiations with the employees.

b) Establishing allowances that the management must give when the production falls due to matters

outside the control of employees. (Example shortage of materials or machine breakdown). It can also

involve complicated negotiations.

c) Piecework negotiations can lead to bad feelings between employees and management.

d) An error on the part of the rate fixer can prove very expensive.

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e) Piecework often involves a much more recording system than is required for straight day work.

f) Management is compelled to set up control systems to avoid abuse of the scheme.

Group bonus scheme

It is possible to arrange that a group of employees working together as a team example assemble work should

share out a bonus based on the result of the team efforts. The intention is to create a collective interest in the

work and each group enforces its own standards of efficiency, any who is an individualistic and want to work

faster than the others or anyone who cannot match the pace of the team are alike unwelcome as members of the

group.

Circumstances requiring group incentives

Despite the usual superiority of an individual incentive scheme, group incentive should be employed in the

following circumstances:

a) When work force flexibility is required some forms of work required employees to switch quickly from

job to job so that the individual performance cannot be measured although the groups performance can.

b) When teamwork is on a continuous production line basis so that extra production depends upon all

employees increasing their speed.

Computation of group bonuses.

The computation of rewarding efforts under a group incentive scheme falls into two parts:

a) Finding the group bonus.

b) Sharing the group bonus.

Example, standing production is fixed at 20 units per day and it is agreed that every 20% increase in

production, a bonus of $50 will be shared among the 20 members if time taken exceeds time allowed then there

is not time saved there is then no bonus and day rate only is paid for the time taken. There are three main types

of the scheme.

Payroll

This is a statement showing the earnings of employees, the various deductions such as SSF,workers dues, provident

fund income tax etc. and the resulting net income for a given period usually for a month.

Illustration 1

Question 2

A. The following data relates to BMX Limited for the month of December.

Names of Employees Hours Worked Rate/Hour Bonus

George 40 50 600

John 35 60 400

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Samuel 45 40 440

Afum 40 45 500

Addo 30 55 550

Additional information

(i) Rent allowance is 20% of basic wages

(ii) The SSF contribution is 5%. All employees are members of the fund

(iii) Income tax is 10%

(iv) Workers union dues is 1% of basic wages

( v) Provident fund contribution is also 5% of basic

You are required to prepare payroll for the month showing;

i. Basic wages

ii. Gross wages

iii. Total deductions

iv. Net wages

B. Explain two(2) factors you would consider when establishing an incentive scheme.

Solution

Employee Goerge John Samuel Afum Addo

Hours

Worked

40 35 45 40 30

Rate per

Hour

50 60 40 45 55

Basic

40 * 50

2,000

35* 60

2,100

45 *40

1,800

40* 45

1,800

30 * 55

1,650

Bonus 600 400 440 500 550

Rent

Allowance

20% *

Basic

400

420

360

360

330

Gross

Wages =

3,000

2,920

2,600

2,660

2,530

Deduction:

SSF 5%

of Basic

100 105 90 90 82.5

Providence 100 105 90 90 82.5

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Fund 5%

Basic

Income tax

10% Gross

less SSF &

Providence

fund

280

271

242

248

236.5

Union

Dues 1%

Basic

20 21 18 18 16.5

Total

Deductions

500 502 440 446 418

Net Wages 2,500 2,418 2,220 2,214 2,112

Assignment

a) The following data relates to Sgbodzo for the month of Dec 2015.

Names of Employees Rates per hour(ghc) Hours of work Bonus ghc

Thomas 45 55 760

Kwame Adu 45 56 430

Pimpong Samuel 53 45 440

Serwaa Akoto 40 45 550

James Obli 30 55 4 50

Additional information

i)Rent allowance is 17% of basic wages

ii)Car maintenance allowance is 15% of basic

iii) The SSF contribution is 10%.

(iv) Income tax is 12%

(v) Workers’ union dues is 6% of basic wages

( vi) Provident fund contribution is also 13% of basic

You are required to prepare payroll for the month showing;

v. Basic wages

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vi. Gross wages

vii. Total deductions

viii. Net wages

b) Elias, Siaw and Francis are employees in Franab Company Limited, producers of Plastic Chairs. Each

employee is remunerated using differential scales as follows:

Output Rate Per Unit (GH₵)

Up to 100 units 20

From 101 – 150 units 25

From 151 – 200 units 30

Above 200 units 35

In December, 2015 Elias, Siaw and Francis produced 90 units, 165 units and 240 units of plastic chairs

respectively.

Required:

Compute the wages payable to each of the employees for the month of Dec, 2015.

(9 Marks)

Chapter Six

Overheads

Overhead is defined as aggregate of indirect material cost, indirect wages and indirect expense.

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There are two(2) types of overheads namely Production overheads & other Overheads

Production overheads- These are indirect material, labour and other indirect expenses incurred during

production

Other Overheads – These are indirect material; labour and indirect expenses not linked with production

.These are normally period cost and are accounted for the income statement as operating expenses.

Indirect material cost is a cost of material, which may be incurred not because of particular of products, job,

service or the department. For example, a carpenter may purchase a crate of nails or quantities of polish not for

only one job but for several jobs. In view of this, the material cost may be termed indirect.

Indirect Labour (wages) may also be explained, as wages paid to a worker or workers whose services are not

directly connected with producing a particular job or service. Example, cleaners, supervisors, clerks, drivers,

etc.

indirect expenses are those expenses which are incurred not for any particular job service or department but

for the business in general and needs to be apportioned or shared to or absorbed by the cost centers or cost

units.

Classification:

Overheads are classified as either fixed overheads and Variable overheads Finally, it may also be grouped

into fixed and variable for its application in marginal costing.

In addition is variable overheads. The group of overheads, which vary in direct proportion to production, or

levels of activity in total but unit cost remains constant throughout all levels of production or level of activity.

Fixed overheads

Overheads, which does not change with the level of output or activity in total but rate per unit or hour, varies

adversely with level of activity.

Semi-variable overheads

This varies & proportionate to the change in levels of activity.

Illustration:

A company is producing at the following levels.

1 2 3 4

Level of activity 1000 1500 2000 2500

Total overheads 3000 3500 4000 4500

You are to find a) fixed cost

b) Variable cost element.

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Solution

Change in units = 500

Change in cost = 500

Cost per unit in variable overheads

= Change in overheads cost

Change in units

= 500 = £1

500

1 2 3 4

Total overheads 3000 3500 4000 4500

Total variable cost 1000 1500 2000 2500

Fixed cost 2000 2000 2000 2000

O/H allocation ,apportionment and absorption

(How to obtain total overheads for each department or cost center)

i) Cost Allocation: It will be explained as charging to a cost center those overheads that have been incurred or

to be incurred solely for the existences of that cost center. For instance, if certain overheads are incurred solely

because of the existence of a maintenance department.

ii)Cost Apportionment: This may be explained as sharing to a cost center a fair share of an overhead. There

are certain overheads, which are usually incurred or budgeted not for any particular cost center but for the

business in general. For instance insurance, rent, power and fuel consumed.

To determine the total overhead for each cost center, overhead incurred or budgeted for the whole organization

should be shared among the cost centers.

There are many basis that are used in sharing overheads.

Overhead cost basis of apportionment

a) Depreciation on building Area occupied by each cost center

b) Depreciation of plant and machinery Cost or written down value of plant and

machinery in each cost center

c) Lighting and heating Area occupied by each cost center or number

of lamps in each cost center or number of

electrical appliances.

d) Power Horse power consumed by each cost center.

However, in the absence of horsepower one

can use area occupied.

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e) Insurance on plant Value of plant in each cost center

f) Insurance on buildings Area occupied by each cost center

g) Employees salaries, wages, etc. Number of employees or total wages

h) Supervision Number of employees or total wages.

i) Telephone charges Number of calls made in each cost center

j) Shortage cost Number or requisitions handled or value of

materials stored.

k) Canteen expenses Number of employees.

Absorption of Overheads –This is the distribution of overheads and it inclusion in valuing the product or

service rendered. This is done after allocation and apportionment of overheads to the various cost centres.

Overhead analysis sheet

Usually all the information about the allocation and apportionment are presented in an overhead analysis sheet.

A sheet, which shows proportions of overheads, allocated and apportioned to each cost center.

Preparation of overhead analysis sheet

illustration

The Wutumi Limited is divided into four (4) cost departments or centers.

That is A, B, C as production departments and D as service department. The actual cost of a period is as

follows

A B C D

Indirect wages 50 100 175 -

Indirect materials 75 125 - 25

Maintenance wages 60 105 200 325

Other overheads as follows

£

Rent 100

Repairs of plants 600

Depreciation of plants 450

Depreciation of building 800

Light and heat 200

Supervision 1500

Fire insurance 600

Power 900

Employee liability 150

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The following information is available in respect of the departments

A B C D

Area occupied in square feet 1500 1100 900 500

Number of employees 20 15 10 5

Total wages £ 6000 4000 3000 2000

Value of plant £ 24000 18000 12000 6000

Value of store £ 15000 9000 6000 -

You are required to prepare an overhead analysis sheet by the most reasonable or equitable base.

1) Rent = £1000 2. Repairs to plant =£600

Base – Area occupied base = Value of plant

A = 1500 A = 24000

B = 1100 B = 18000

C = 900 C = 12000

D = 500 D = 6000

4000 60,000

A = 1500 X 1000 A =24000 X 600

4000 = £375 60,000 = £240

B = 1100 X 1000 B =18000 X 600

4000 = £275 60,000 =£180

C = 900 X 1000 C =12,000 X 600

4000 = £225 60,000 =£120

D = 500 X 1000 D =6000 X 600

4000 = £ 125 60,000 =£60

3) Depreciation of plant = £450 4) Depreciation of building =£800

Base = values of plant base = Area occupied

A = 24000 A = 1500

B = 18000 B = 1100

C = 12000 C = 900

D = 6000 D = 500

60,000 4000

A = 24000 X 450 A = 1500 X 800

60,000 = £180 4000 =£300

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B = 18000 X 450 B = 1100 X 800

60,000 = £135 4000 =£220

C = 12000X 450 C = 900 X 800

60,000 = £90 4000 =£180

D = 6000 X 450 D = 500X 800

60,000 = £45 4000 =£100

5) Light and heat = £200 6) Supervision = £200

Base – Areas Occupied Base–Number of employees

A = 1500 X 200 A = 20

4000 = 75

B = 1100 X 200 B = 15

4000 = 55

C = 900 X 200 C = 10

4000 = 45

D = 500 X 200 D = 5

4000 = 25 50

7) Fire Insurance £600 8) Power - £900

Base – Area Occupied Base – Area Occupied

A = 1500 X 600 A = 1500 X 900

4000 = £225 4000 = 338

B = 1100 X 600 B = 1100 X 900

4000 = £165 4000 = 248

C = 900 X 600 C = 900 X 900

4000 = £135 4000 = 202

D = 500 X 600 D = 5000 X 900

4000 = £75 4000 = 112

9) Employers Liability = £150

Base – Number of employee

A = 20 X 150

50 = 60

B = 15 X 150

50 = 45

C = 10 X 150

50 = 30

D = 5 X 150

50 = 15

Wutumi limited

overhead analysis sheet for the month

Cost Centres

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Item of overheads Basis A B C D

Indirect Wages

Indirect Materials

Maintenance Wages

Rent

Repairs to Plant

Depreciation of Plant

Depreciation of Building

Light and Heat

Supervision

Fire Insurance

Power

Employee Liability

Direct Allocation

Direct Allocation

Direct Allocation

Area Occupied

Value of Plant

Value of Plant

Area Occupied

Area Occupied

Number of employees

Area Occupied

Area Occupied

Number of Employees

50

75

60

375

240

180

300

75

600

225

338

60

100

125

105

275

180

135

220

55

450

165

248

45

175

--

200

225

120

90

180

45

300

135

202

30

--

25

325

125

60

45

100

25

120

75

112

15

2578 2103 1702 1057

Re-apportionment of service department

The need for re-apportionment

The main objective of analyzing overheads for each cost center is to determine the actual Overheads or what

should be the overheads for a particular cost center for control purposes. In view of this, any cost incurred or to

be incurred by the services department are to be charged to the production cost Centres to enable the total

overheads to be ascertained. It is therefore a principle in costing that total overheads of each department must

always be re-apportioned onto production department in the equitable base or ratios of services.

NB: In some examination questions, one may not be required directly to re-apportion but the type of question

may require the application of the above principle.

How to re-apportion

It is worth mentioning that each service dept may not render service for its own sake but for production

department. Thus the following guidelines must be well noted.

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What is the value of the services rendered by each service department to each production department. This may

be answered depending on the typed of service department. For instance a stores department service may be in

the form of issuing materials to each production department. However, since the service of certain department

may not be measurable, the services may be assessed by technical expects in percentages. That is service

department A may render 2% service to production department M and 30% to production department F.

Candidates must therefore note the tow main ways of identifying the value of service.

Find out whether there are any services between the service departments in the Organization. (Interlocking

Services)

This may also be determined by the determinations above. That is either the percentage (%) or any item of

service. Where service department has rendered a service to another service department then one has to clear

the interlocking service first.

Methods of clearing interlocking services

1. Repeated Distribution or Continuous Distribution method

2. Simultaneous equation or algebraic method

3. Reciprocal (try an error) or the repeated distribution method

4. Ignoring the fact that one service department services another. That is two –

Step Method

5. Specific Ordering

Illustration 1

Mr. Ofei has a manufacturing Company that comprises three production departments and two service

departments. The overhead costs for May were allocated as follows:

Production Departments A B C

6000 8200 9500

Service departments

Maintenance 3500

Personnel 4500

The cost of service department is apportioned as follows:

Maintenance department is apportioned on the basis of estimated units consumed.

Personnel department on the basis of total wages paid in the departments.

A B C Maintenance Personnel

Units Consumed 3000 800 500 --- 2500

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Total wages paid 3800 4500 1200 2600 2800

Required: Re-apportion the service departments cost using any reasonable method.

Solution

1) Repeated distribution Or Continuous Distribution Method.

With this method the first service department is closed off by apportioning its cost between all cost centers.

The total of the second service including the first service department cost also have to be apportioned until the

first round is completed.

This process may be continued until the remaining amount on the service department are insignificant.

A

B

C

X

Maintenance

Y

Personnel

Direct Allocation

1st Round X (3500)

Y (5795)

2nd Round X (1275)

Y (472)

3rd Round X (104)

Y (38)

4th Round X (8)

Y (2)

6000

1540

1796

561

146

46

12

4

0.9

8200

420

2144

153

175

13

14

1

0.7

9500

245

580

89

47

7

4

1

0.2

3500

----

(1275)

----

104

----

8

----

0.4

4500

1295

5795

(472)

----

(38)

----

(2)

----

10105.9 11120.7 10473.2

X = A = 3000 A) 3000 X 100 B) 800 X 100

B = 800 6800 = 44% 6800 = 12%

C = 500

Y = 2500 C) = 500 X 100 Y = 2500 X 100

6800 6800 =31% 6800 = 37%

Y = A = 3800 A) = 3800 X 100 B) 4500 X 100

B = 4500 12100 =31% 12100 =37%

C = 1200

X = 2600 C) 1200 X100 X = 2600 X 100

12100 12100 = 10% 12100 =22%

Simultaneous equation or algebraic method

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Total Overheads:

X = 3500 + 22% Y – (1)

Y = 4500 + 37% X – (2)

Rearrange X – 22% = 3500

Y – 37% = 4500

Step II X – 0.22y = 3500

Y – 0.37x = 4500

X – 0.22y = 3500 – (1)

- 0.37x +y = 4500 – (2)

Step III

1) X 0.37 0.37x – 0.81y = 1295

2) X 1 0.37x + y = 4500

1) + 2) 0.919y = 5795

y = 5795

0.919

y = 6305

Substitute x – o.22 (6306) = 3500

x – 1387 = 3500

x =3500 + 1387

x = 4887

A B C X Y

Direct allocation

Round (1) x (4887)

Y (6306)

6000

2150

1955

8200

586

2333

9500

342

631

Maintenance

4887

Personnel

6306

10,105 11,119 10,473

illustration 2

Suppose a company has two production departments and two service departments (stores and maintenance).

The following information about activity in a recent costing period is available.

Production departments Stores Maintenance

1 2 departments department

Overhead costs £10,000 £8,970 £10,000 £8,000

Value of materials req. £30,000 £50,000 --- £20,000

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Maintenance hours used 8,000 1,000 1,000 ---

a) Let S be the total stores department overhead for apportionment, after it has been apportioned

overhead from Maintenance.

b) Let M be the total of maintenance department overhead after it has been apportioned overhead

from Stores.

We can set up our equations as follows.

S = 0.1M* + £10,000 (1)

M = 0.25** + £8,000 (2)

* 10% x maintenance department overhead

** 20% x stores department overhead

Multiplying (2) by 5 gives us

5M = S + £40,000 (3), which can be rearranged so that

S = 5M – £40,000 (4)

Subtracting (1) from (4)

S = 5M – £40,000 (4)

S = 0.1M + £10,000 (1)

O = 4.9M – £50,000

M £50,000 = £10,204

4.9

Substituting in (1)

S = 0.1 x (£10,204) + £10,000

S = £11,020

These overheads can be apportioned as follows, using the percentages Note that the results is the same as that

obtained when using the reciprocal (repeated distribution) method.

Production Production

Dept A dept B Stores Maintenance

£ £ £ £

Overhead costs 10,030 8,970 10,000 8,000

Apportion stores total 3,306 5,510 (11,020) 2,204

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Apportion maintenance total 8,164 1,020 1,020 (10,204)

21,500 15,500 ---- ----

3) Trial and error method

This involves taking the highest amount of the service department and repeating the distribution

between only the service departments until the amount becomes insignificant, the total of the service

department is then apportioned to production Department.

Try an error

X y

Maintenance Personnel

Direct allocation 3500 (4500)

Y (4500) 22% 990 ----

(4490) ----

x (4490) 37% ---- (1661)

y (1661) 22% (365) ----

x (365) 37% ---- (135)

y (135) 22% (30) ----

x (30) 37% ---- (11)

y (11) 22% 2 ----

x (2) ---- (0.74)

4887 6307.74

Summary sheet

A B C

Direct allocation 6000 8200 9500

Apportionment x (4887) 2150 586 342

y (6308) 1955 2334 631

10106 11120 10473

4) Ignoring the fact that one service department

Services another or two step

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This involves the usual apportionments of each service departments cost with the respective

percentages but once a service department is apportioned any service rendered to any other service department

must be eliminated from the subsequent apportionment. The service department with greater percentage is

apportioned first.

A B C X Y

Direct allocation 6000 8200 9500 3500 4500

Apportionment x (3500) 1540 420 245 --- 1295

y (5795) 2303 2749 743 --- (1295)

9843 11369 10488 --- (5795)

Absorption of overheads

This is the practice by which overheads are charged to a product, process, job, batch, etc. It is at times called

recovery of overheads

How to compute the recovery or the absorption rates

To compute the recovery rate the following points must be noted

i) All recovery rates are based on estimates not actual it is therefore necessary to find out from every

examination question the budgeted overhead for the factory in general or for a department.

The basis of absorption:

The commonly used basis is by calculating the rate per activity given by:

Estimated or budgeted factory overheads / Estimated or budgeted activity volume

= Rate per level of activity

The budgeted activity volume may vary depending on the major activity of the entity upon which overheads

are incvurred. Normally they may include the following activities such as :

i) Direct Labour hours of work

ii) Direct Machine hours of work

iii) Labour cost

iv) Direct Material cost

v) Prime cost

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Meaning of the calculated rate: Assume the calculated rate is Ghc5, Ghc1, Ghc2 . This rate means for every

activity level actually worked for a particular job or department, that rate whether £5p, £1, £2, etc. should be

absorbed in production as overheads.

Illustration

Assume the rate of the company is calculated based on direct labour hours because the company is labour

intensive in production. If the rate per direct labour is £2.5, and the actual hours worked for job Ama is

600hours. The total overhead to be absorbed is 600 x £2.5 = £1,500. The rate is applicable in a circumstance

where direct labour forms a dominant factor of production that is labour intensive means of production as may

be the case in assembling or packing departments.

Various basis of calculating overhead absorption Rate

a. Direct labour hour rate = overhead cost / Direct labour Cost

b. Direct Machine hour rate = overhead cost / Direct machine hours

c. Direct wages cost percentage rate = Estimated overhead / direct wages cost

d. Direct material cost rate = Estimated overhead / Direct material cost

e. Production cost = Estimated overheads / Estimated production cost

f. Prime cost = Estimated factory overheads / Estimated prime cost.

g. Production hourly rate =Estimated overheads/Estimated production hours.

Exams Tips

a) Find out the budgeted overhead, which may or may not be given directly when not directly given the

information, may be given to enable one to find it.

b) Basis required using.

Illustration2

The estimated cost and operating data for four departments in LIWEWE Ltd for the upcoming year are

given below:

Departments

Bournvita Milo Human Resource Repairs

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Direct labour hours 60,000 30,000 40,000 20,000

Machine-hours 25,000 90,000 18,000 30,000

Direct material cost (Gh¢ 30,000 16,000 24,000 20,000

Direct Labour Cost (Ghc) 40,000 30,000 50,000 25,000

Overhead cost (Ghc) 432,000 270,000 384,000 300,000

Predetermined overhead rates are computed using the following bases in the four Departments:

Dept. Overhead rates based on

Bournvita Raw material cost

Milo Machine-hours

Human Resource Direct labour-hours

Repairs Prime cost

Required: Compute :

i) The predetermined overhead rate to be used in each Department

ii) Liwewe Ltd produces an item called CONSTANCE which passes through all the departments mentioned

above using 20,000 hours of machine and 12,000hrs of labour consuming Gh¢ 23,000 worth of material and a

labour cost of Ghc 5,000. Estimate the total overhead cost incurred on product CONSTANCE.

iii) Estimate the cost of producing CONSTANCE

Solution

i)

Dept Bournvita Milo Human Resource Repairs


Activity level Ghc 30,000 90,000 hr 50,000 hr Ghc 45,000

Rate (Overhead/activity L) 14.4 Ghc3/hr Ghc7.68/hr 6.67

ii)

Dept Bournvita Milo Human Resource Repairs Total

Rate 14.4 Ghc3/hr Ghc7.68/hr 6.67

Activity level 23,000 20,000 12,000 28,000

Overhead cost(Ghc) 331,200 60,000 92,160 186,760 670,120

iii) The cost of producing CONSTANCE:

Ghc

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Direct Material 23,000

Direct Labour 5,000

0/h 670,120

698,128

Illustration 3:

The following information relates to the activities of production departments for the month of May.

Budgeted: Estimated overhead 4800

Material estimated 2600

Labour hours 28000

Machine hours 19500

Direct wages 3500

On completion of Job KT50 the following information was obtained.

Material cost 350

Direct wages cost 285

Labour hours worked 1600

Machine hours 2200

a) You are required to calculate by different methods the overheads, which may be charged to the job.

b) Prepare a comparative cost statement to determine the selling price assuming that the company has

25% margin on sales.

c) Advise management on the basis of selling prices in (b) above

Solution

Material cost Direct wages Direct labour Machine hours Prime cost

% %

Estimated O/H 4800 4800 4800 4800 4800

Base 2600 3500 28000 19500 6100

185% 137% £0.17 p.a. £0.25 p.a. 79%

Computation of cost standard KT50

Direct material 350 850 350 350 350

Direct wages 285 285 285 285 285

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Prime cost 635 635 635 635 635

Overheads 648 390 272 550 502

1283 1025 907 1185 1137

Selling Price

Total 1283 1025 907 1185 1137

Add Profit 1/3 x C.P 428 342 302 395 379

Selling price 1711 1367 1209 1580 1516

c) Material cost percentage rate contributes the highest selling price thus it is economical to apply on the basis

of selling prices but this may be the most applicable method.

Illustration 4

The following figures have been extracted from the books of a manufacturing company. The following

information relates to Job A 100

Working Department £ Finishing Departments £

Material used 120 10

Direct wages 65 25

Direct labour hours 265 70

Machine hours 255 25

All jobs pass through the companies two departments.

Working Department £ Finishing Department £

Material used 6000 500

Direct wages 3000 1500

Factory overheads 1800 1200

Direct labour hours 12000 5000

Machine hours 10000 2000

a) You are required to: Enumerate four methods of absorbing factory overheads by Jobs showing the rates

for each department under the methods quoted.

b) Prepare a statement to show the different costs result for Job A 100 under any 2 methods referred to.

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Solution

Working Department Finishing Department

i) Material cost: Overheads 1800 1200

Direct material cost 6000 500

Rate = 1800/6000 = 0.3 1200 /500 = 2.4

ii) Wages cost: Overheads 1800 1200

Direct wages 3000 1500

Rate = 1800/3000 100 = .6 1200 / 1500 = .3

iii) Direct labour hours: Overheads = 1800 1200

Direct labour hours = 12000 5000

Rate = 1800/12000 = £0.15 per hour 1400 /5000 = £0.6 per hour

Statement of cost for job a 100

Direct labour hour rate Machine hour rate

Direct Material: W. Dept. 120 120

F. Dept. 10 130 10 130

Direct Wages: W Dept. 65 65

F. Dept. 25 90 25 90

Overheads: W. Dept. 39.75 45.90

F. Dept. 16.8 56.55 15.00 60.90

276.55 280.90

Workings:

Working Department Finishing Department

i) Direct labour: 0.15 x 265 0.24 x 70

= 39.75 =16.80

ii) Machine hour rate 0.18 x 255 0.6 x 25

= 45.90 =15.00

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Direct material cost 30/100 x 120 240/ 100 x 10

= £36 = £24

direct wages cost 60/100 x 65 80/100 x 25

= 39 = 20

Statement of cost for job a 100

Direct material cost Direct wages cost

Direct material W 120 120

F 10 130 10 130

Direct wages W 65 65

F 25 90 25 90

Overheads W 36 39

F 24 60 20 59

280 279

Assignment

The Sally Company Limited is divided into four (4) cost centers.

That is A, B, C as production departments and Repairs & Maintenance as service department. The actual cost

of a period is as follows

A B C Repairs & M’tenance

Ghc Ghc Ghc Ghc

Indirect wages 60 120 175 -

Indirect materials 75 125 - 25

Maintenance wages 60 150 200 325

Other overheads as follows:

Ghc

Light and heat 200

Supervision 1500

Power 900

Employee liability 150

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Rent 100

Repairs of plants 600

Depreciation of plants 450

Depreciation of building 800

The following information is available in respect of the departments

A B C Repairs & M’tenance

Total wages £ 6000 4000 3000 2000

Value of plant £ 24000 18000 12000 6000

Value of store £ 15000 9000 6000 -

Area occupied in square feet 1500 1100 900 500

Number of employees 20 15 10 5

Required

i) prepare an overhead analysis sheet by the most reasonable or equitable and estimate the overhead

cost incurred in each cost centre 10marks

Tutorial Questions

Question1

The following data are taken from a Jobbing company’s annual budget for a factory in which there are three

manufacturing departments.

Dept. A (£000) Dept. B (£000) Dept. C (£000) Total

Direct material 500 300 400 1200

Direct wages 300 125 450 875

Budgeted overheads 550 150 425 1125

Direct labour hours 150000 220000 140000 510000

Machine hours 200000 125000 175000 500000

During the year the completed Jobs include Job K 800, which passes through the following departments.

Dept. A Dept. B Dept. C Total

Direct material 780 155 100 1035

Direct labour cost 300 245 285 830

Machine hours 450 120 600 1190

Direct labour 650 365 1576 5959

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The company has 30% of factory cost of each job as gross profit.

Required:

a) Calculate the total selling prices of Job K 800 by using direct labour hour rate for dept. A, machine

hour rate for dept. B and direct wages percentage for dept. C.

b) Prepare comparative statement showing for each of the 3 methods above the total production cost

chargeable to Job K 800.

Question2

A company comprises 3 production cost centres and 2 service cost centres. Budgeted overheads for the year

commencing 1st July 2000 amount to £4900, 000 made up as follows:

Indirect Material Indirect Wages total

Allocated overheads £’000 £’000

Heavy machine shop P 260 764

P2 Light machine shop 330 896

P3 Assembling Shop 150 400

S1 Materials services 40 228

S2 Personal Services 20 132

800 2420 3220

Apportionable overhead

Rent and rates 300

Depreciation (machinery) 900

Insurance (machinery) 180

Insurance (building) 60

Power 120

Light and heat 120 1680

4900

Relative quantitative data have been converted into percentages as follows to facilitate apportionment.

Cost Centres

P1 P2 P3 S1 S2

Floor area 25 30 20 15 10

Book value of machine 35 45 15 5 -

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Power usage 40 45 10 5 -

Value of stores issues 40 50 10 - -

Number of employees 35 45 10 - -

Budgeted product capacity is:

P1 P2 P3

Machine hours (000) 600 800 -

Personnel hours (000) --- --- 45

Required:

a) Draw up a suitable columnar form and using appropriate basis distribute the budgeted overheads over

the five cost centres

b) Apportion the accumulated cost of the two service cost centres over the three production cost centres

using suitable basis.

c) Calculate an overhead absorption rate for each of the three production cost centres.

OVERHEAD ANALYSIS SHEET

Basis P1(000) P2(000) P3(000) S1(000) S2(000)

Indirect material Direct allocation 260 330 150 40 20

Indirect wages Direct allocation 764 896 400 228 132

Apportionment

Rent and rates Floor area 75 90 60 45 30

Depreciation

(Machinery)


Insurance

(machinery)


Insurance

(building)

Floor area 15 18 12 9 6

Power Power usage 48 54 12 6 -

Light and heat Floor area 30 36 24 18 12

b)

1570 1910 820 400 200

S1 Value of stores issue 160 200 40 - -

S2 Number of employees 40 90 40

1800 2200 900

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Calculation of overhead absorption rate for each production department.

c) P1 Overheads 1800 P2 Overheads 2200

Machine hours 600 machine hours 800

Machine hour rate = Overheads = 1800/ 600 Machine hour rate= Overhead= 2200 / 800

£3 per machine hour £2.75 per machine hour

P3 = overheads = 900

Personnel hours 45

Rate = overheads / Personnel hours = 900 / 45 = £20 per direct labour hours

Over and under absorption of overheads

Over or under absorption of overheads may be explained as the difference between amount of overheads

absorbed and the amount of actual overhead incurred.

Over absorption

This may be explained as the situation whereby the amount absorbed into product is more than the amount

actually incurred for producing that product.

In such a situation the over absorbed amount is termed a gain. It may be credited to overhead adjusted accounts

or overhead suspense accounts and finally written off to costing profit and loss account.

Under absorption

This occurs when the amount absorbed is less than the actual overhead incurred for producing a particular

product. The under absorbed amount is an expense to the company and finally written of to debit of Costing

profit and loss account.

Causes of over an under absorption

The main causes of over and under absorption are as follows:

1) Inaccurate budgets: Since one rarely is able to predict the future with absolute accuracy, the budgeted

overhead or the budgeted basis, that is direct labour hours produced, machine hours, etc. may not be absolutely

correct. As regards rates of absorption may also not be absolutely correct and consequently the actual overhead

incurred and overhead absorbed rarely coincides.

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2) Unavoidable Errors of budgeting.

Generally speaking budgeting has its own procedures and principles to be adopted. There are certain errors,

which are unavoidable in the course of budgeting and may lead to wrong estimates; one of these is

approximation of figures.

Illustration:

A factory has two production departments and three service departments as shown below. The budgeted

overhead for the year and actual overheads for 13 weeks ended 31st march 1997. with other relevant

information is as follows:

Budgeted for the year Actual for 13 weeks ended 31/3/97

Overheads £ £

Production Depts. D 84000 22000

E 91,000 24800

Service Depts. F 27000 7000

G 24000 6400

H 32000 7500

Direct labour hours Dept. D 84,000 22000

Direct wages Dept. E 110000 29000

The apportionment of service department’s overheads to production is on the following basis:

Department D (%) Department E (%)

Service departments: F 40 60

G 70 30

H 45 55

Required: Compile for each of the two production departments:

a) A statement of budgeted overheads with a calculation of the predetermined rate for overheads

absorption using :

i) Production departments D on direct labour hour basis.

ii) Production department E as percentage of direct wages

b) A statement of the total actual overheads incurred with overhead absorbed, using rates calculated in (a)

above. To show the over or under absorbed overhead

D E

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Direct allocation 84000 91000

Overhead: Department F 10800 16200

G 16800 7200

H 14400 17600

126000 132000

calculation of overheads.

Dept. D: Budgeted overhead 126000 Dept. E: Budgeted overhead 132000

Direct labour hour 84000 direct wages 110000

Rate = 126000 rate = 132000

84000 110000

= £1.5 = £120%

Overhead absorption

Department D = 1.5 x 22000 = £33000

E = 120% of 29000 = £34800

Statement of actual overhead and overhead absorbed.

Actual Overhead Overhead Absorbed over Absorption under absorption

Dept. D 32655 33000 345 -

E 35045 34800 245

Actual overhead

Dept. F 2800 4200

G 4480 1920

H 3375 4125

10655 10245

direct allocation 22000 24800

32655 35045

Example:

Samanshia Ltd has a budgeted production overhead of £150,000 and a budgeted activity of 75,000 direct

machine hours and therefore a recovery rate of £2 per direct machine hour.

Required

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Calculate the under-/over-absorbed overhead, and the reasons for the under-/over-absorption, in the following

circumstances.

a) Actual overheads cost 47,000 and 25,000 direct machine hours are worked.

b) Actual overheads cost 50,000 and 21,500 direct machine hours are worked.

c) Actual overheads cost 47,000 and 21,500 direct machine hours are worked.

Solution

a) £

Actual overhead 47,000

Absorbed overhead (25,000 x 2) 50,000

Over-absorbed overhead 3,000

The reason for the over absorption is that although the actual and budgeted labour hours are the

same, actual overheads cost less than expected.

b) £


Absorbed overhead (21,500 x £2) 43,000

Under-absorbed overhead 7,000

The reason for the under absorption is that although budgeted and actual overhead costs were

the same, fewer direct labour hours were worked than expected.

c) £


Absorbed overhead (21,500 x £2) 43,000

Under-absorbed overhead 4,000

Question 1

The estimated cost and operating data for four departments in Andes Ltd for the upcoming year are given

below:

Departments

Pepsodent Close-up Maxam Trident

Direct labour hours 60,000 30,000 40,000 20,000

Direct material cost (Gh¢ 30,000 16,000 24,000 20,000


Machine-hours 25,000 90,000 18,000 30,000

Direct Labour Cost (Ghc) 40,000 30,000 50,000 25,000

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Predetermined overhead rates are computed using the following bases in the four Departments:

Overhead rates based on

Maxam Raw material cost

Trident Machine-hours

Pepsodent Direct labour-hours

Close-up Prime cost

Required:

Compute :

i) the predetermined overhead rate to be used in each Department 6marks

ii) The Entity produces an item called Cinnamon powder which passes through all the departments mentioned

above using 22,000 hours of machine and 15,000hrs of labour consuming Gh¢ 33,000 worth of material and a

labour cost of Ghc 15,000. Estimate the total overhead cost incurred on product the cinnamon.

4marks

iii) Estimate the cost of producing Cinnamon 4marks

Chapter Seven

Marginal and absorption costing

Marginal costing is the accounting system in which variable costs are charged to cost units and fixed costs of

the period are written in full settlement against the aggregate contribution OR written against the P & L

account.

Marginal Cost of a product is that part of cost of one unit of product or service which would be avoided if that

unit was not produced, or which would increase in one extra unit when produced. (CIMA Official

Terminology)

Absorption costing – This is costing method that treats both variable cost and fixed cost of production as

product cost regardless of whether it is a variable cost of fixed cost. This is because all cost are considered in

determining the cost of the product .It is at times called full costing system

Practical reasons for using absorption costing

The main reasons for using absorption costing are for stock valuations pricing decisions and establishing the

profitability of different products.

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a) Stock valuations.

b) Pricing decisions. Many companies attempt to fix selling prices by calculating the full cost of

production or sales of each product, and then adding a margin for profit. In our example, the company

might have fixed a gross margin at 25% on factory costs, or 20% of the sales price, in order to establish

the unit sales price of £10. ‘Full cost plus pricing’ can be particularly useful for companies which do

jobbing or contract work, where each job or contract is different, so that a standard unit sales price

cannot be fixed. Without using absorption costing, a full cost is difficult to ascertain.

c) Establishing the profitability of different product. This argument in favour of absorption costing is

more contentious, but is worthy of mention here. If a company sells more than one product, it will be

difficult to judge how profitable each individual product is, unless overhead costs are shared on a fair

basis and charged to the cost of sales of each product.

Unit cost of a product –

The value (cost) incurred in the cost of production can now be assessed using the two different

approaches mentioned above.

Illustration-

Nana Adjoa Plc is a small company that produces a single product and has the following cost

information:

Number of units produced each year…………………5,000

Variable cost per unit: $

Direct material …………………………………3

Direct labour ………………………………….. 5

Variable manufacturing overhead……………...1

Variable selling & admin expenses……………….3

Fixed cost per year :

Fixed manufacturing o/h……………………30,000

Fixed selling and admin expenses……….12,000

Required

i) Compute the unit product cost under absorption costing

ii) Compute the unit product cost under variable costing

Solution

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Absorption costing $

Direct material ………………………….. .3

Direct labour …………………………….5

Variable manufacturing o/h ………………………….1

Total variable ……………………………………........9

Fixed manufacturing overhead (30,000/5,000).. 6

Unit product cost ……………………………….........15

Variable costing……………………………………$

Direct materials……………………………………3

Direct labour……………………………………….5

Variable manufacturing o/h………………………...1

Unit product cost…………………………………… 9

Nb ( the $30,000 fixed manufacturing overhead will be charged off in total against income as a period

expense along with the selling and administrative expenses.)

Under the absorption costing method notice that all production costs, variable and fixed are included

when determining the unit product cost. Thus, if the entity sells a unit of the product and absorption

costing is being used, then $12 (consisting of $9 variable cost and $5 fixed cost) will be deducted on

the income statement as cost of goods sold. Similarly, any unsold units will be carried as inventory on

the balance sheet at $15

Under the variable costing method, notice that only the variable production costs are included in the

product cost .thus, if the company sells a unit of product, only $9 will be deducted as cost of goods

sold, and unsold units will be carried in the balance sheet inventory account at only $9.

Comparing the two (2) methods in estimating the product cost

i) Under the absorption method the product cost per unit is very higher as compared to the cost of the

product under the variable cost method.

ii)in the absorption costing fixed cost of production is considered when estimating the cost of the

product but in variable cost method fixed cost of production is eliminated.

iii) Gross profit is lower under the absorption cost method whilst the gross profit under the variable cost is

high.

Preparing income statements using absorption costing and variable costing.

The marginal production cost per unit of an item consists of the following:

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Direct material

Direct labour

Variable production overheads

Contribution:-It is referred to as the difference between the sales value and the marginal or variable cost of a

product.

Principles of Marginal Costing.

1. Period fixed costs are the same for any volume of sales and production (provided that the level of

activity is within the relevant range).

2. If the volume of sales falls by one item, profit will fall by the amount of contribution earned from the

item.

3. Profit measurement should therefore be based on an analysis of total contribution. Since fixed costs

relate to a period of time, and do not change with increases or decreases in sales volume, it is

misleading to charge units of sales with a share of fixed costs. Absorption costing is therefore

misleading and is more appropriate to deduct fixed costs from total contribution for the period to derive

a profit figure.

4. When a unit product is made, the extra costs incurred in it’s manufacture are the variable production

costs, fixed costs are unaffected, and no extra costs are incurred when output is increased.

Example:

A company produces a single product with the following budget:

Selling Price 10

Direct materials 3 per unit

Direct wages 2 per unit

Variable production overheads 1 per unit

Fixed production overheads 10,000 per month

The fixed production overhead is absorbed on the volume of 5,000 units per month. Show the operating

statement for the month, when 4,800 units were produced and sold under:

a) Marginal costing

b) Absorption

Assume that costs were as budget

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Solution:

a) Marginal Costing

Operating statement

Sales (4,800 @ 10) 48,000

Less marginal cost:

Direct materials (4,800 @ 3) 14,400

Direct wages (4,800 @ 2) 9,600

Variable production overhead (4,800 @1) 4,800 28,800

Contribution 19,200

Less Fixed cost 10,000

Profit 9,200

NB: The difference between sale value and the total variable cost is known as Contribution: This appears only

in the marginal costing statement.

b) absorption costing

In absorption costing statement, we have to adjust for under/over-absorbed fixed production overhead; no such

adjustments were necessary in the marginal costing statement.

Operating statement

Sales (4,800 @ 10) 48,000

Less Cost of sales:

Direct materials (4,800 @ 3) 14,400

Direct wages (4,800 @ 2) 9,600

Variable production overhead (4,800 @1) 4,800

Fixed production overhead (5,000 @ 2) 10,000 38,400

Operating margin 9,600

Under absorbed (w1) (400)

Operating profit 9,200

Workings 1:

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Fixed overhead incurred 10,000

Fixed overhead absorbed (4,800 units @ 2) 9,600

Under absorbed (400)

Marginal costing and stock valuation

In the above example, the operating profit is the same under both methods. That will not be so, however,when

production is more or less than sales,i.e.if stocks increases or decreases.

Stock valuation under marginal costing is based on variable production cost only. This is in contrast with

absorption costing where fixed production overheads are included in stock valuation using the predetermined

absorption rate. The following examples illustrate the effect of the different stock valuations on profit.

Activity 1:

Suppose that in the previous example, (company a) production was in fact 6,000 units, i.e. 4,800

Units sold and 1,200 units left in closing stock.

Prepare the profit statement for the month under absorption costing principles.

Solution:

Sales (4,800 @ 10) 48,000

Less Cost of sales:

Direct materials (6000 @ 3) 18,000

Direct wages (6000 @ 2) 12,000

Variable production overhead (6000 @1) 6,000

Fixed production overhead (6000 @ 2) 12,000

48,000

Less closing stock (1,200 @ 8) 9,600 38,400

Operating margin 9,600

Over absorbed fixed overhead (6,000 units@ 2)-10,000) 2,000

Operating profit 11,600

Activity 2:

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Now show the profit statement for the month under marginal costing principles.

Solution:

Sales (4,800 @ 10) 48,000

Less Cost of sales:

Direct materials (6000 @ 3) 18,000

Direct wages (6000 @ 2) 12,000

Variable production overhead (6000 @1) 6,000

36,000

Less closing stock (1,200 @ 6) 7,200 28,800

Contribution 19,200

Fixed production overhead 10,000

9,200

This will cal for the reconciliation of the two profits, i.e.11,600 (absorption) and 9,200 (marginal)

The difference in profit is due to the different valuations of closing stock. In absorption costing, the 1,200 units

of closing stock included absorbed fixed overheads of 2,400 i.e.(1,200 @ 2),which are costs carried over to the

next month and not charged against the profit. In marginal costing, all fixed costs incurred in the period are

charged against profit.

Recoinciliation of operating profit between absorption and marginal costing.

Profit as per Absorption Statement 11,600

Less over absorption 2,400

Profit as per Marginal profit statement 9,200

Assignmennt

Lawal company produces a single product with the following budget:

Ghc

Selling Price 10 per unit

Selling cost 3 per unit

Direct materials 3 per unit

Direct wages 2 per unit

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Variable production overheads 1 per unit

Fixed production overheads 10,000 per month

The fixed production overhead is absorbed on the volume of 5,000 units per month. Show the operating

statement for the month, when 4,800 units were produced and sold under:

i) Marginal costing 4marks

ii) Absorption 4 marks

iii) Reconcile the profit from i) & ii) above 3marks

Tutorial Questions

Q1

Atua Afari company produces and sells a single product, a wooden hand loom for weaving small items such as

scarves. selected cost and operating data relating to the product for two years are given below :

$

Selling price per unit……………………..50

Manufacturing costs:

Variable per unit produced:

Direct material,……………………11

Direct labour……………………….6

Variable o/h…………………………3

Fixed per year ………………………….120, 000

Selling and admin costs:

Variable per unit sold………………………5

Fixed per year……………………………….70, 000

Year 1 year 2

Units in beginning inventory…………..0 2,000

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Units produced during the year………10,000 6,000

Units sold during the year…………… 8,000 8,000

Units in ending inventory…………… 2,000 0

Required:

1) Assume the company uses absorption costing.

a) compute the unit cost in each year

b) prepare an income statement for each year

2) Assume the company uses variable costing.

a) compute the unit cost in each year

b) prepare an income statement for each year

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Chapter Eight

Job, Batch & Process Costing Systems

Job costing is system set in place to ascertain the cost of producing customized product. is ideally suited to

organizations that tend to supply goods and services on a project type basis where the customer’s individual

needs will largely determine both the cost and selling price. It is per customer request hence unique costing

system is set in place that addresses the specifications of the client. The cost records of each customer is kept

on Job cost sheet

Illustration 1 According to the factory Job Cost Ledger job number 84 has incurred the following prime cost.

Materials (direct) 30 kg at £6 per kg.

Wages (direct) Dept. A 18 hours at £1.75 per hour

Dept B 32 hours at £1.50 per hour

Budgeted overheads for the year based on normal capacity are as follows:

Variable Overheads: Dept. A £4500 for 9000 direct labour hours

Dept. B £12500 for 10000 direct labour hours

Fixed overheads: Total budgeted direct labour hours for both factories 22000

Total budgeted expenditure £28600

Required:

a) Calculate the cost of Job number 84.

b) Estimate the percentage of profits obtained if the price to the customer was £500.

Materials 180

Wages: Dept. A 31.50

Dept. B 48.00 79.50

Prime cost 259.50

Variable overheads Dept. A 9.00

Dept. B 40.00 49.00

Fixed overhead 28600 x 50

22000 65.00

373.50

profit 126.50

selling price 500.10

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126.50 x 100 = 34% or 33.5% = 373.50

Batch costing

This costing method is used by organizations involved in producing goods or providing services in batches,

such as a bakery producing loaves in batches, often use a variation of job costing, sometimes known as batch

costing.

Illustration:

The following data have been recorded for four batches in a period.

Batch A B C D

Output (Units) 250 60 200 120

Cost per batch: (£)

Direct Material 1650 750 2100 900

Direct labour 9200 1520 6880 2400

Labour hours 1150 190 860 300

The total production overhead for the period has been analyzed as follows:

£

Machine related cost 14600

Material handling and dispatch 6800

Stores 8250

Inspection/Quality Control 5850

Set – up Cost 6200

Engineering Support 8300

50000

Cost drives have been identified for the cost pools as follows:

Cost pool Cost Driver

Machine cost Machine hours

Material handling Materials – Movement

Stores Requisitions raised

Inspection Number of Inspections

Set – up Number of Set – ups

Engineering Support Engineering hours

The following cost driver volumes were recorded for the batches:

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Batch: A B C D Total

Machine hour per batch 520 255 610 325 1710

Material Movement 180 70 205 40 495

Requisition 40 21 43 26 130

Inspections 18 8 13 8 47

Set – ups 12 7 16 8 43

Engineering hours 65 38 52 35 190

Required: a) Calculate the batch and unit cost using traditional costing bases on a Barbour hours overhead

absorption rate.

b) The batch and unit costing using ABC (Activity base costing)

c) Compare the cost in a) and b) above.

d) Comment on the likely position, if the firm was cost plus pricing.

Solution:

a) Batch A B C D


Direct labour 9200 1520 6880 2400

Prime cost 10850 2270 8980 3300

Overheads 23000 3800 16952 6000

Total cost 33850 6070 26180 9300

Cost per unit 135.4 101.16 130.9 77.5

Activity base costing method

b) Batch A B C D


Direct labour 9200 1520 6880 2400

Prime cost 10850 2270 8980 3300

Overheads 16262 8138 16952 8655

Total cost 27112 10408 25932 11955

Cost per unit 108.45 173.47 129.66 99.62

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Working:

budgeted overheads = 50000 = 20 per DLHr

DLHr = 1150 + 190 + 860 + 300 =$ 2500per hr

Overheads = A 1150 x 20 = 23000

B 190 x 20 = 3800

C 860 x 20 = 17200

D 300 x 20 = 6000

Calculation of cost Drivers Rate.

Cost Driver Cost Driver Rate

Machine hours 14600 £ 8.54 per machine hour

1710

Material Movement 6800 £ 13.74 per material movement

495

Requisitions 8250 £ 63.46 per requisitions raised

130

Inspection 8250 £ 124.5 per inspection

47

Set – up 6200 £ 144.2 per number of set – ups

43

Engineering hours 8300 £ 43. 68 per engineering hour

190

Computation of unit cost using abc method

b) Batch A B C D


Direct labour 9200 1520 6880 2400

Prime cost 10850 2270 8980 3300

Overheads:

Machine hours 4441 2178 5209 2776

Material Movement 2473 962 2817 550

Requisition 2538 1333 2729 1650

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Inspections 2241 996 1619 996

Set – up 1730 1009 2307 1154

Engineering hours 2839 1660 2271 1529

Total overheads 16262 8138 16952 8655

Total cost 27112 10408 25932 11955

Total per unit 108.45 113.47 129.66 99.62

c) A B C D

Traditional Method ABC TM ABC TM ABC TM ABC

£ £ £ £ £ £ £ £

Cost per unit 135.4 108.45 101.16 173.47 130.9 129.66 77.5 99.62

d) There was a difference in the cost per unit because of the difference in overheads. The higher the overhead

the higher the cost per unit.

Illustration:

A company manufactures small assembles to order and has the following budgeted Overheads for the

year base on normal activity levels.

Departments Building Overheads Overhead absorption base

Blanking £ 18000 1500 labour hours

Machining £ 43000 2500 Machine hours

Welding £ 20000 1800 labour hours

Assembling £ 15000 1000 labour hours

Selling and administration overheads are 20% of factory cost.

An order for 250 assemblies type x 128 made as batch 5931 incurred the following cost. Materials

£ 3107

Labour 128 hours blanking shop at £5.25 per hour.

452 hours machining shop at £5.50 per hour.

90 hours welding shop at £ 5.25 per hour.

175 hours assembling shop at £4.80 per hour.

£525 was paid for the paid for the hire of special x-ray equipment for testing welds.

The time booking for the machine shop is 643-machine hour.

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Required: Calculate the total cost of the batch, the unit cost and the profit per assembly if the selling price was

£150 per assembly

Batch number 5931 statement of cost

Materials 3107

Labour: Blanking 672

Machining 2486

Welding 472.5

Assembling 840 4470.5

Direct Express 525

Prime cost 8102.5

Overheads:

Blanking 1536

Machinery 11059.6

Welding 999

Assembling 2625 16219.6

Factory cost 24322.1

Selling and Administration 20% 4864.42

Total cost 29186.52

Cost per unit = Total cost

= Total output

C. CPU = 29186.52 116.75

52

Selling price 150.00

Profit 33.25

Blanking 1800 = £ 12 per labour hour Machining 43000 = 17.2 per labour hour

1500 2500

Welding 20000 = 11.11 per labour hour Assembling 15000 = 15 per labour hour

18000 1000

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Process costing is a costing method used for vauing product where it is not possible to identify separate units

of production, or jobs, usually because of the continuous nature of the production processes involved. Thus

used in entities producing homogenous products where products are the same.

Process accounts

Where a series of separate processes is required to manufacture the finished the output of one process becomes

the input to the next until the final output is made in the final process. If two processes are required the

accounts would look like this.

Process 1 account

Units ¢ units ¢

Direct materials 1,000 50,000 Output to process 2 1,000 90,000

Direct labour 20,000

Production overhead 20,000

1,000 90,000 1,000 90,000

Process 2 account

Units ¢ unit ¢

Materials from Process 1 1,000 90,00 output to finished goods 1,000 150,000

Add materials 30,000

Direct labour 15,000


1,000 150,000 1,000 150,000

Note that direct labour and production overhead may be treated together in an examination question as

conversion cost.

Added materials, labour and overhead in process 2 are added gradually throughout the process. Materials from

process 1, in contrast, will often be introduced in full at the start of process 2.

The ‘units’ columns in the process accounts are for memorandum purposes only and help you to ensure that

you do not miss out any entries.

General format of Process account - it is a T account as shown below.

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Process Account

Unit Price/unit amount

Mat 5 4,000 20,000

Labour - - 70,000

O/heads - - 490,000

Ab’mal gain Y 145,000 145,000Y

Cost of input

Unit Price/unit amount

Normal loss 1 0 0

Output 3 145,000 435,000

Ab’mal loss 1 145,000 145,000

Cost of process

a) Candidates should understand that in a given process one cannot obtain for abnormal loss and abnormal

gain at the same time. One at a time but the above shows how they are accounted for in the process

account. Abnormal loss is given a cost, which is written off to the profit and loss account via an

abnormal loss/gain account.

b) Abnormal gain is treated in the same way as abnormal loss, except that being a gain rather than a loss;

it appears as a debit entry in the process account (whereas a loss appears as a credit entry in this

account).

c) The cost per unit of abnormal loss and abnormal gain are always the same. This is obtained by dividing

the the process cost by the expected good units.

Illustration 1

Suppose that input to a process is 1,000 units at a cost of £4,500. Normal loss is 10% and there is no opening

or closing stocks. Determine the accounting entries for the cost of output and the cost of the loss if actual

output were as follows.

a) 860 units (so that actual loss is 140 units)

b) 920 units (so that actual loss is 80 units)

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NB.

d) Normal loss is given no share of cost in all cases of preparing process account

e) The cost of output is therefore based on the expected units of output, which in our example amount to

90% of 1,000 = 900 units.

a) Output is 860 units

Step 1 Determine output and losses

If actual output is 860 units and the actual loss is 140 units;

Units

Actual loss 140

Normal loss (10% of 1,000) 100

Abnormal loss 40

Step 2 Calculate cost per unit of output and losses

The cost per unit of output and the cost per unit of abnormal loss are based on expected

output.

Costs incurred = £4,500 = £5 per unit

Expected output 900 units

Step 3 Calculate total cost of output and losses

Normal loss is not assigned any cost.

£

Cost of output (860 x £5) 4,300

Normal loss 0

Abnormal loss (40 x £5) 200

4,500

Step 4 Complete accounts

Process account

Units ¢ Units ¢

Cost incurred 1,000 4,500 Normal loss 100 0

Output (finished

Goods a/c) 860 (x£5) 4,300

Abnormal loss 40 (x £5) 200

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1,000 4,500 1,000 4,500

Abnormal loss account

Units ¢ Units ¢

Process a/c 40 200 profit and loss a/c 40 200

b) Output is 920 units


If actual output is 920 units and the actual loss is 80 units;

Units

Actual loss 80

Normal loss (10% of 1,000) 100

Abnormal gain 20


The cost per unit of output and the cost per unit of abnormal gain are based on expected

output.


Expected output 900 units

(Whether there is abnormal loss or gain does not affect the valuation of units of output.

The figure of 5 per unit is exactly the same as in the previous paragraph, when there

were 40 units of abnormal loss).

Step 3 Calculate total cost of output and losses

Normal loss is not assigned any cost.

£

Cost of output (920 x £5) 4,600

Normal loss 0

Abnormal gain (20 x £5) (100)

4,500


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Process account

Units £ Units £

Cost incurred 1,000 4,500 Normal loss 100 0

Abnormal gain a/c 20 (x £5) 100 Output (finished

goods a/c) 920 (x£5) 4,600

1,020 4,600 1,020 4,600


Units £ Units £

Process a/c 20 100 profit and loss a/c 20 100

Question.

During a four-week period, period 3, costs of input to a process were £29,070. Input was 1,000 units, output

was 850 units and normal loss is 10%.

During the next period, period 4, costs of input were again £29,070. Input was again 1,000 units, but output

was 950 units.

There were no units of opening or closing stock.

Required

Prepare the process account and abnormal loss or gain account for each period.

Losses with disposal cost

As well as being able to deal with questions in which scrap or loss units are worthless or have a scrap value,

you must also be able to deal with losses which have a disposal cost.

The basic calculations required in such circumstances are as follows.

a) Increase the process costs by the cost of disposing of the units of normal loss and use the

resulting cost per unit to value good output and abnormal loss/gain.

b) The normal loss is given no value in the process account.

c) Include the disposal costs of normal loss on the debit side of the process account.

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d) Include the disposal costs of abnormal loss in the abnormal loss account and hence in the

transfer of the cost of abnormal loss to the profit and loss account.

4.2 Example: Losses with a disposal cost

Suppose that input to a process was 1,000 units at a cost of £4,500. Normal loss account is 10% and there are

no opening and closing stocks. Actual output was 860 units and losses which have a disposal cost.

Normal cost = 10% x 1,000 units. Therefore Abnormal loss = 900 -860 = 40 units.

Cost per unit = ¢ 4,500 + (100 x ¢ 0.90) = ¢5.10

900

The relevant accounts would be as follows.

Process account

Units ¢ Units ¢

Cost of input 1,000 4,500 Output 860 4,386

Disposal cost of Normal loss 100

normal loss 90 Abnormal loss 40 204

1,000 4,590 1,000 4,590


¢ ¢ Process a/c

204 profit and loss a/c 240

Disposal cost (40 x 0.90) 36

240 240

Valuing closing work in progress

When units are partly completed at the end of a period (and hence there is closing work in progress). It is

necessary to calculate the equivalent units of production in order to determine the cost of a completed unit.

In the examples we have looked at so far we have assumed that opening and closing stocks of work in process

have been nil. We must now look at more realistic examples and consider how to allocate the costs incurred in

a period between completed outputs (that is, finished units) and partly completed closing stock.

Some examples will help to illustrate the problem, and the techniques used to share out (apportion) costs

between finished output and closing stocks.

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Suppose that we have the following account for Process 2 for period 9.

Process account

Units ¢ Units ¢

Materials 1,000 6,200 Finished goods 800 ?

Labour and overhead 2,850 Closing WIP 200 ?

1,000 9,050 1,000 9,050

How do we value the finished goods and closing work in progress?

With any form of process costing involving closing WIP, we have to apportion costs between output and

closing WIP. To apportion costs ‘fairly’ we make use of the concept of equivalent units of production

Equivalent units

Equivalent units are notional whole units which represent incomplete work, and which are used to apportion

costs between work in process and completed output.

We will assume that in the example above the degree of completion is as follows.

a) Direct materials. These are added in full at the start of processing, and so any closing WIP will have

100% of their direct material content. (This is not always the case in practice. Materials might be added

gradually throughout the process, in which case closing stock will only be a certain percentage

complete as to material content. We will look at this later in the chapter).

b) Direct labour and production overhead. These are usually assumed to be incurred at an even rate

through the production process, so that when we refer to a unit that is 50% complete, we mean that it is

half complete for labour and overhead, although it might be 100% complete for materials.

Let us also assume that the closing WIP is 100% complete for materials and 25% complete for labour and

overhead.

How would we now put a value to the finished output and the closing WIP?

In step 1 of our framework, we have been told what output and losses are. However we also need to calculate

equivalent units

Statement of equivalent units

Materials Labour and overhead

Degree of Equivalent Degree of Equivalent

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Total units completion units completion units

Finished output 800 100% 800 100% 800

Closing WIP 200 100% 200 25% 50

1,000 1,000 850

In Step 2 the important figure is average cost per equivalent unit. This can be calculated as ff

Statement of costs per equivalent unit

Material Labour and overhead

Costs incurred in the period ¢6,200 ¢ 2,850

Equivalent units of work done 1,000 850

Cost per equivalent unit (approx) ¢ 6.20 ¢ 3.3529

To calculate total costs for Step 3, we prepare a statement of evaluation to show how the costs should be

apportioned between finished output and closing WIP.

Statement of evaluation

Materials Labour and overheads

Cost per Cost per

Equivalent equivalent Equivalent equivalent Total

Item units units Cost units units Cost cost

¢ ¢ ¢ ¢ ¢ ¢

Finished

Output 800 6.2 4,960 800 3.3529 2,682 7,642

Closing WIP 200 6.2 1,240 50 3.3529 168 1,408

1,000 6,200 850 2,850 9,050

The process account (work in progress or work in process account) would be shown as follows.

Process account

Units ¢ Units ¢

Materials 1,000 6,200 Finished goods 800 7,642

Labour and overhead 2,850 Closing WIP 200 1,408

1,000 9,050 1,000 9,050

5.3 Different rates of input

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In many industries, materials, labour and overhead may be added at different rates during the course of

production.

a) Output from a previous process (for example the output from process 1 to process 2) may be introduced

into the subsequent process all at once, so that closing stock is 100% complete in respect of these

materials.

b) Further materials may be added gradually during the process, so that closing stock is only partially

complete in respect of these added materials.

c) Labour and overhead may be ‘added’ at yet different rate. When production overhead is absorbed on a

labour hour basis, however, we should expect the degrees of completion on overhead to be the same as

the degree of completion on labour.

When this situation occurs, equivalent units, and a cost per equivalent unit, should be calculated separately for

each type of materials, and also for conversion costs.

5.4 Example: Equivalent units and different degrees of completion

Suppose that Columbine Ltd is a manufacturer of processed goods, and that results in process 2 for April 20X3

were as follows.

Opening stock nil

Material input from process 1 4,000 units

Costs of input: ¢

Materials from process 1 6,000

Added materials in process 2 1,080

Conversion costs 1,720

Output is transferred into the next process, process 3

Closing work in process amounted to 800 units, complete as to:

Process 1 material 100%

Added materials 50%

Conversion costs 30%

Required :Prepare account for process 2 April 20X3.

Solution

a) Statement of equivalent units (of production in the period)

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Process 1 Added Labour and

Input Output Total material materials overhead

Units Units Units % Units % Units %

4,000 Completed 3,200 3,200 100 3,200 100 3,200 100

Production

Closing stock 800 800 100 400 50 240 30

4,000 4,000 4,000 3,600 3,440

b) Statement of cost (per equivalent unit)

Equivalent production Cost per

Input Cost in units units

¢ ¢

Process 1 material 6,000 4,000 1.50

Added materials 1,080 3,600 0.30

Labour and overhead 1,720 3,440 0.50

8,800 2.30

c) STATEMENT OF EVALUATION (OF FINISHED WORK AND CLOSING STOCKS)

Number of Cost per

Equivalent equivalent

Production Cost element units units Total Cost

¢ ¢

Completed production 3,200 2.30 7,360

Closing stock: process 1 material 800 1.50 1,200

Added material 400 0.30 120

Labour and overhead 240 0.50 120

1,440

8,800

d) Process account

Units ¢ Units ¢

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Process 1 material 4,000 6,000 Process 3 a/c 3,200

7,360

Added material 1,080

Conversion costs 1,720 800 1,440

4,000 8,800 4,000 8,800

Valuing opening work in progress: FIFO method

Introduction

Account can be taken of opening work in progress using either the FIFO method or the weighted average cost

method.

Opening work in progress is partly complete at the beginning of a period and is valued at the cost incurred to

date. In the example in Paragraph 5.4, closing work in progress of 800 units at the end of April 20X3 would be

carried forward as opening stock, value £1,440, at the beginning of May 20X3.

It therefore follows that the work required to complete units of opening stock is 100% minus the work in

progress done in the previous period. For example, if 100 units of opening stock are 70% complete at the

beginning of June 20X2, the equivalent units of production would be as follows.

Equivalent units in previous period (May 20X2) (70%) =70

Equivalent units to complete work in current period(June 20X2)(30%) =30

Total work done 100

The FIFO method of valuation deals with production on a first in, first out basis. The assumption is that the

first units completed in any period are the units of opening stock that were held at the beginning of the period.

Example: WIP and FIFO

Suppose that information relating to process 1 of a two-stage production process is as follows, for August

20X2.

Opening stock 500 units: degree of completion 60%

Cost to date 2,800

Costs incurred in August 20X2 ¢

Direct materials (2,500 units introduced) 13,200

Direct labour 6,600


26,400

Closing stock 300 units: degree of completion 80%

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There was no loss in the process

Required : Prepare the process 1 account for August 20X2.

Solution

As the term implies, first in, first out means that in August 20X2 the first units completed were the units of

opening stock.

Opening stocks: work done to date = 60%

Plus work done in August 20X2 = 40%

The cost of the work done up to 1 August 20X2 is known to be ¢2,800, so that the cost of the units completed

will be £2,800 plus the cost of completing the final 40% of the work on the units in August 20X2.

Once the opening stock has been completed, all other finished output in August 20X2 will be work started as

well as finished in the month.

Units

Total output in August 20X2 * 2,700

Less opening stock, completed first 500

Work started and finished in August 20X2 2,200

(* Opening stock plus units introduced minus closing stock = 500 + 2,500 – 300)

What we are doing here is taking the total output of 2,700 units, and saying that we must divide it into two

parts as follows.

a) The opening stock, which was first in and so must first out.

b) The rest of the units, which were 100%, worked in the period.

Dividing finished output into two parts in this way is a necessary feature of the FIFO valuation method.

Continuing the example, closing stock of 300 units will be started in August 20X2, but not yet completed. The

total cost of output to process 2 during 20X2 will be as follows.

Opening stock cost brought forward 2,800 (60%)

Plus cost incurred during August 20X2

to complete x (40%)

Fully worked 2,200 units 2,800 + x

Total cost of output to process 2, FIFO basis y

2,800 + x + y

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Equivalent units will again be used as the basis for apportioning costs incurred during August 20X2. Be sure

that you understand the treatment of ‘opening stock units completed’, and can relate the calculations to the

principles of FIFO valuation.


STATEMENT OF EQUIVALENT UNITS

Total units Equivalent units of production

In August 20X2

O/S unit completed 500 (40%) 200

Fully worked units 2,200 (100%) 2,200

Output to process 2 2,700 2,400

Closing stock 300 (80%) 240

3,000 2,640


The cost per equivalent unit in August 20X2 can now be calculated.

Statement of cost per equivalent unit


Expected output 2,640 units

Step 3 Calculate total cost of output, losses and WIP

STATEMENT OF EVALUATION

Equivalent Valuation

Units

¢

Opening stock, work done in August 20X2 200 2,000

Fully worked units 2,200 22,000

Closing stock 240 2,400

4,500 26,400

The total value of the completed opening stock will be £2,800 (brought forward) plus £2,000

added in August before completion = £4,800.

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Process account

Units ¢ Units ¢

Opening stock 500 2,800 Output to process 2:

Direct materials 2,500 13,200 O/S completed 500 4,800

Direct labour 6,600 fully worked units 2,200 22,000

Production o’hd 6,600 2,700 26,800

Closing stock 300 2,400

3,000 29,200 3,000 29,200

Valuing opening work in progress: weighted average cost method

Introduction

An alternative to FIFO is the weighted average cost method of stock valuation which calculates a weighted

average cost of units produced from both opening stock and units introduced in the current period.

By this method no distinction is made between units of opening stock and new units introduced to the

process during the accounting period. The cost of opening stock is added to costs incurred during the period,

and completed units of opening stock are each given a value of one full equivalent unit of production.

7.2 Example: Weighted average cost method

Magpie Ltd produces an item which is manufactured in two consecutive processes. Information relating to

process 2 during September 20X3 is as follows.

Opening stock 800 units

Degree of completion: ¢

Process 1 materials 100% 4,700

Added materials 40% 600

Conversion costs 30% 1,000

6,300

During September 20X3, 3,000 units were transferred from process 1 at a valuation of £18,100. Added

materials cost £9,600 and conversion costs were £11,800.

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Closing stock at 30 September 20X3 amounted to 1,000 units which were 100% complete with respect to

process 1 materials and 60% complete with respect to added materials. Conversion cost work was 40%

complete.

Magpie Ltd uses a weighted average cost system for the valuation of output and closing stock.

Required Prepare the process 2 accounts for September 20X3.

Step 1. Opening stock units count as a full equivalent unit of production when the weighted average

cost system is applied. Closing stock equivalent units are assessed in the usual way.

Statement of equivalent units

Equivalent units

Total Process 1 Added Conversion

Units’ material material cost

Opening stock 800 (100%) 800 800 800

Fully worked units* 2,000 (100%) 2,000 2,000 2,000

Output finished goods 2,800 2,800 2,800 2,800

Closing stock 1,000 (100%)1,000 (60%) 600 (40%) 400

3,800 3,800 3,400 3,200

(* 3,000 units from process 1 minus closing stock of 1,000 units)

Step 2. The cost of opening stock is added to costs incurred in September, 20X3, and a cost per

equivalent unit is then calculated.

Statement of costs per equivalent unit

Process 1 Added Conversion

Material material costs

¢ ¢ ¢

Opening stock 4,700 600 1,000

Added in September 20X3 18,100 9,600 11,800

Total cost 22,800 10,200 12,800

Equivalent units 3,800 units 3,400 units 3,200 units

Cost per equivalent unit ¢6 ¢3 ¢4

Step 3. Statement of evaluation

Process 1 Added Conversion Total

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Material material costs cost

¢ ¢ ¢ ¢

Output to finished goods

(2,800 units) 16,800 8,400 11,200 36,400

Closing stock 6,000 1,800 1,600 9,400

45,800

Step 4. Process 2 account

Units ¢ Units ¢

Opening stock b/f 800 6,300 Finished goods a/c 2,800 36,400

Process 1 a/c 3,000 18,100

Added materials 9,600

Conversion cost 11,800 Closing stock c/f 1,000 9,400

3,800 45,800 3,800 45,800

Trial Questions

Q1

a) Liwewe Inc. processes Cocoa to finished product for various distributors .Two departments are

involved- Manufacturing and packaging. Data relating to Cocoa produced in the Manufacturing

department during September is given below.

Units of cocoa bags % Uncompleted

Work in process, September 1 ? 44%

Started into processing in September 840,000 -

Transfer to next department (Packaging) 780,000 -

Work in process September 30 220,000 85%

Required:

i) Estimate the units of Cocoa bags work in process on September 1st. 2marks

ii) Using the Weighted Average method estimate the equivalent units of production .3marks

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iii) Using the FIFO method estimate the equivalent units of production 5marks

b)

During the following month October, the following data was gathered on the manufacturing department of

Liwewe as follows :

Units Materials Labour Overhead

Work in process October 1…..220,000 $68,600 $30,000 $48,000

Units started in process…. 760,000

Units transferred out……. 790,000

Work in process, October 31…… ?

Cost added during June… -- $1,200,000 $ 720,000 $ 950,000

The beginning W.I.P inventory was 60 % complete with respect to materials and 70% complete with respect to

processing. The ending W.I.P inventory was 55% complete with respect to materials and 30 % complete with

respect to processing.

Required:

i) Estimate the work in process at end of month ( October ) 2marks

ii) Assume that the company uses only the weighted average method of accounting for units costs;

compute the equivalent units of production for the dept for the month of October.

5marks

iii) Determine the cost per equivalent unit for October. 7marks

Q2

Abigail Company manufactures and sells a single product. The following costs were incurred during the

company’s 2nd year of operations:

Variable cost per unit:

Production:

Direct materials……………. Ghc 20

Direct labour……………….. GHC 10

Variable manufacturing overhead…Ghc 4

Fixed cost per year:

Fixed manufacturing overhead Ghc 150,000

Fixed selling and admin exp Ghc 380,000

During the year the company produced 40,000 and sold 12,500 units. The selling price of the company’s

product is Ghc 75 per unit.

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Required:

i) Using the absorption costing method compute the unit product cost 2marks

ii) Using the absorption costing method prepare the income statement 4marks

iii) Using the variable costing method compute the unit product cost 2marks

iv) Using the variable costing method prepare the income statement 4marks

V) Reconcile the profit in ii) and iv) above 4marks

Q3

The following table shows the number of units of tuna produced and the total costs incurred.


100 40,000

200 45,000

300 50,000

400 65,000

500 70,000

600 70,000

700 80,000

Using the : a) least square regression analysis

i) Establish the cost equations of the company 8marks

ii) The units produced to incur cost of Ghc73,000 2marks

iii)The variable cost of production at activity level of 375units. 2marks

Q2

Asabea Company manufactures and sells a product. The following costs were incurred during the company’s

1st year of operations:

Variable cost per unit:

Production:

Direct materials……………. Ghc 12

Direct labour……………….. GHC 15

Variable manufacturing overhead…Ghc 5

Fixed cost per year:

manufacturing overhead Ghc 250,000

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selling and admin exp Ghc 280,000

During the year the company produced 50,000 and sold 20,500 units. The selling price of the

company’s product is Ghc 80 per unit.

Required:

i) Using the absorption costing method compute the unit product cost 2marks

ii) Using the absorption costing method prepare the income statement 4marks

iii) Using the variable costing method compute the unit product cost 2marks

iv) Using the variable costing method prepare the income statement 3marks

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