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COSTING Kangwazi

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CHAPTER ONE
INTRODUCTION TO COST AND MANAGEMENT ACCOUNTING
1.1.
Basic definitions:
Cost: the amount of expenditure incurred on, or attributable to a given thing or the
resources consumed to accomplish a specified objective, or the value of a benefit
forgone in achieving a specific objective.
Cost object: this is any activity, operation, service or product for which we are trying to
ascertain the cost. Examples of cost objects could be a unit of product, e.g., a tablet
of soap, a unit of service, e.g., a one-way taxi hire, etc.
Cost unit: this is a basic measure or unit of production, service, time or a combination
of these in relation to which costs may be ascertained or expressed. Examples of cost
units include miles/hour, patient per day (for a hospital), cost/flight (for airlines) etc. it is
simply a unit at which costs are measured.
Examples of cost units in different industries
Industry sector
Cost unit
Brewing
Barrel
Brick-making
1,000 bricks
Coal mining
Tonne/ton
Electricity
Kilowatt hour (Kwh)
Engineering
Contract, job
Oil
Barrel, tonne, litre
Hotel/Catering
Room/meal
Professional services
Chargeable hour, job, contract
Education
Course, enrolled student, successful student
Hospitals
Patient day
Cost centre: this is a department, function or other unit within an organization to which
costs may be charged for accounting purposes. It is simply a centre where cost items
or elements are accumulated before they are analysed further to be transferred to
the cost objects. Examples of cost centres could be production departments,
administration departments, etc.
Cost driver: this is any factor which significantly determines or changes the cost of an
activity. For example, in purchasing, all the costs incurred in ordering depend on the
number of orders placed in that particular period. The number of orders therefore will
be the cost driver for the costs incurred by the activity of purchasing.
Cost pool: this is a collection or grouping of costs that are related on the basis of the
activities causing them and not on the basis of departments which incur them. For
example, a cost pool of “despatch costs” could be a collection of all costs incurred
on despatching activities. A cost pool may be related to a cost centre except that a
cost centre collects all costs incurred by it regardless of the activities behind the costs.
Cost accounting: This is part of management accounting which involves collecting,
recording and accumulating data and producing information about costs for the
products produced by an organisation and/or the services it provides.
Management accounting: It is the presentation of accounting information in such a
way as to assist management in the creation of policy and the day to day operation
of the undertaking. Management accounting is much broader than cost accounting
as it involves providing invaluable information to management for decision making.
Cost and/or management accounting is much concerned with assisting
management in the following ways:
a) Establishing cost of goods sold or services provided, cost of a department or
work station, as well as revenues from goods, services or departments. This
enables management to:
i.
Assess the profitability of products, services or departments
ii.
Set selling prices of products or services with regard to costs incurred
iii.
Value closing stocks (raw materials, work in progress and finished goods)
b) Estimating the future costs of goods and services through budgeting which is an
integral part of cost/management accounting
c) Making a comparison of actual costs incurred (or revenues earned) with what
was budgeted or expected through variance analysis.
d) Providing quality information to management in order to make sensible
decisions about costs and profits.
1.2.
Differences between management (Cost) accounting and financial accounting
Internal vs. External Uses
Management accounting focuses on providing information for internal users such as
supervisors, managers etc. Financial accounting concentrates on providing
information to both internal users and external users such as shareholders, creditors,
etc.
Emphasis on the Future
Management accounting provides information which is about the present and the
future whereas financial accounting information is mostly historical
Use of Generally Accepted Accounting Principles (GAAP) and other frameworks
Financial Accounting statements are prepared in accordance with GAAP (such as the
Accounting standards), as they provide consistency and comparability and are relied
on by outsiders for information regarding the company. Management Accounts on
the other hand, are not governed by GAAP or any other framework. Managers set
their own rules on the form and content of information. Whether these rules conform
to GAAP is immaterial.
2
Organizational Focus
Financial accounting is primarily concerned with the reporting on business activities of
a company as a whole. Management accounting, by contrast, focuses less on the
company as a whole and more on the parts or segments of a company. These
segments may be the product lines, sales territories, divisions, departments, etc.
Freedom of Choice
Financial accounting is mandatory for business organizations. Organisations are
compelled to maintain financial records as per various legal statutes like Companies
Act, Taxation Act, etc. By contrast, Management Accounting is not mandatory. There
are no regulatory bodies specifying what is to be done and how it is to be done and
presented. Thus in Management Accounting, the usefulness of the information is more
important than its requirement
1.3.
Classification of costs
Cost classification is the process of grouping costs according to their common
characteristics. The classification of costs can be done in the following ways:
1.3.1. Element
The costs are classified under the category of element based on the actual item that
brings about the cost. These costs are divided into three categories i.e. Materials,
Labour and Overheads (or other costs)
Materials are the principal substances that go into the production process and are
transformed into finished goods.
Labour refers to the human effort required to produce goods and services.
Other Expenses/ overheads: all other costs which are not materials or labour
The total cost of a product or service therefore consists of:
Cost of materials consumed + cost of wages and salaries of employees involved in
production or provision of service + cost of other expenses incurred in production
Example 1.1: Cost Classification-Element
A company incurred the following costs in the production of 200 units of product R:
Raw materials purchases
K69, 700
Labour cost (direct wages)
K6, 600
Other costs
K15, 000
After the production period, raw materials costing K5,900 were still in stock. Calculate
the total cost of producing one unit of product R.
3
Solution:
Based on element, the cost of a product will be made up of materials used, wages
(labour) and other expenses. Therefore the costs will be as follows:
Materials
(69,700 – 5,900)*
63,800
Labour
6,600
Other expenses
15,000
Total cost
85,400
Cost per unit = 85,400/200 = K427.00
*Materials used in production will be the difference between what was bought and
what is remaining as closing inventory.
1.3.2. Nature
This classification is based on how the cost relates to the product produced or service
provided. The costs can be directly or indirectly related to a product or service being
produced or provided.
Direct costs are those costs which are incurred for and may be conveniently identified
with or easily traced to a particular cost centre or cost object.
For example, wood is a direct material for furniture as it is directly associated with the
product, in this case furniture.
The aggregate of all direct costs is called Prime cost.
Indirect costs are those costs which are incurred for the benefit of a number of cost
centres or cost objects and cannot be conveniently identified with a particular cost
centre or object.
For example, in the production of furniture, electricity can be consumed but this cost is
not directly associated with furniture as it is incurred for a number of purposes in the
business.
The aggregate of all indirect costs is called Overhead cost.
The total production cost of a product or service is therefore the sum of prime costs
and overhead costs.
Example 1.2: Cost Classification-Direct and Indirect
Consider the following account balances for Piedmont Ltd:
1 January 2017
K
65,000
Nil
123,000
Direct materials inventory
Work in Process Inventory
Finished goods inventory
4
31 December 2017
K
34,000
Nil
102,000
Purchases of direct materials
128,000
Direct manufacturing labour
106,000
Indirect manufacturing labour
48,000
Indirect materials
14,000
Plant insurance
2,000
Depreciation-plant, buildings and equipment
21,000
Plant utilities
12,000
Repairs and maintenance of plant
8,000
Equipment leasing cost
32,000
Marketing, distribution and customer service costs
62,000
General and administrative costs
34,000
Required
a) Compute the prime cost for the year ended 31 December 2017
b) Compute the production overhead cost for the year ended 31 December 2017
c) The company always sells its products at a gross profit margin of 25%. Calculate
the amount of sales revenue made for the ended 31 December 2017
Solution
a) Prime cost:
Direct materials used in production (65,000 +128,000 – 34,000)
Direct labour cost
Total prime cost
b) Production overhead cost:
Indirect labour
Indirect materials
Plant insurance
Depreciation
Plant utilities
Repairs and maintenance
Leasing costs
Total production overhead costs
159,000
106,000
265,000
48,000
14,000
2,000
21,000
12,000
8,000
32,000
137,000
c) Sales revenue for the year
With a margin of 25%, sales revenue will be cost of sales x 100/75
Cost of sales is composed of:
Opening inventory of finished goods
123,000
Cost of production (265,000 + 137,000)
402,000
(102,000)
Less closing inventory of finished goods
423,000
Total cost of sales
Sales revenue = 423,000 x 100/75 = K564,000
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1.3.3. Function
This means grouping of costs according to the broad divisions or functions of a
business undertaking or basic managerial activities. According to this classification
costs are divided as follows:
Manufacturing and Production Costs: This category includes the total of costs incurred
in manufacture, construction and fabrication of units of production. The
manufacturing and production costs comprise of direct materials, direct labour and
factory overheads.
Administrative Costs: This category includes costs incurred on account of planning,
directing, controlling and operating a company. For example, salaries paid to
managers and other administrative staff.
Selling and Distribution Costs: Selling costs are defined as the cost of seeking to create
and stimulate demand and of securing orders. Examples of selling costs are
advertisement, salesman salaries, etc., whereas, distribution costs are defined as the
cost of sequence of operations which begin with making the packed product
available for dispatch and ends with making it available to the consumers.
1.3.4. Behaviour
The basis for this classification is the behaviour (or response/reaction) of costs in
relation to changes in the level of activity or volume of production. The principle of
cost behaviour is that as the level of activity changes, costs will also change. On this
basis, costs are classified into four groups as follows:
Fixed Costs/ Capacity costs/ Period costs: Fixed costs are those which remain fixed in
total with increase or decrease in the volume of output or activity for a given period of
time or for a given range of output.
These costs are constant in total amount but keep decreasing per unit as production
level keep increasing.
Fixed Cost in Total and Fixed cost/unit
6
Variable Costs: Variable costs are those which vary in total directly in proportion to the
volume of output. These costs remain relatively constant per unit with changes in
volume of production or activity. Thus, variable costs fluctuate in total amount but
tend to remain constant per unit as production level changes.
Variable cost in total and per unit
Semi-variable Costs/mixed costs: Semi-variable costs are those which are partly fixed
and partly variable. They are the most common form of costs incurred by business.
The cost of production therefore will be the cost of Variable costs and the fixed costs.
The formula being 𝑇𝐢 = 𝑉𝐢 + 𝐹𝐢
Illustration
For example, the production cost of company G comprises a fixed cost of K5,000 per
year and variable costs of K7 per unit produced. Calculate the total cost at the
production quantities of 800 and 1200 units.
Solution
At the production of 800 units,
the variable costs will total (800 x7) =
The fixed costs will remain at
Total production cost
K5, 600
K5, 000
K10,600
At the production of 1,200 units, the variable costs will total (1200 x 7) =
The fixed costs will remain at
Total production cost will be
K8,400
K5, 000
13,400
The charts below illustrate the semi variable cost in total and per unit of output.
7
Semi-variable cost in total and per unit
Stepped costs: A stepped cost is a form of a fixed cost which changes its behaviour
when the level of activity exceeds a certain range (also called the relevant range).
This range provides a demarcation between the short and long runs. The stepped
costs remain constant for a certain period, and then they increase and remain
constant again, and increase again, and so on. The chart below demonstrates the
behaviour of such a cost.
Stepped costs
1.4.
The need for cost behaviour
Understanding the behaviour of the businessβ€Ÿ costs greatly helps the management in
planning the businessβ€Ÿ activities in view of the anticipated costs to be incurred. As
most business costs are a combination of fixed and variable costs (semi variable). It is
not possible to estimate a semi variable cost given a level of activity unless it (the semi
variable cost) is split into its separate elements of variable and fixed.
To split a semi variable cost into variable and fixed costs, a number of mathematical
techniques are applied. The three common ones being the High-Low method, the
scatter graph and the least squares method. In cost accounting, however, the high
low method is the most commonly used technique and it is discussed below:
High – low method: This method uses the highest and the lowest observations from a
set of past data to determine the fixed and variable cost element. Any measures
between the highest and lowest extremes are ignored.
The steps in high low method are summarised below:
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a) To estimate the fixed and variable elements of a mixed cost, records of costs in
previous periods are reviewed and the costs of two periods are selected:
i)
The period with the highest volume of output (high activity level), Q2
ii)
the period with the lowest volume of output (low activity level), Q1
b) The difference between the total cost of the high output and the total cost of the
low output (P2 – P1) will be the total variable cost of the difference in output
levels.
c) The difference in total costs (P2 –P1)) is divided by the difference in level of output
(Q2 – Q2) to get the variable cost per unit.
d) This unit variable cost is then substituted into the highest or lowest level to get the
fixed cost for the year (using the cost formula of TC=Qty(unit cost) + FC or FC = TC
–
Qty (cost per unit))
e) With variable cost and fixed cost calculated, the future period cost can be
estimated (using the same Cost formula) given the expected activity level.
Example 1.3
The following information relates to production months of an entity:
Total cost (K)
Production hours
Month 1
110,000
7,000
2
115,000
8,000
3 111,000 7,700 4
97,000 6,000
Estimate the total cost for month five if production hours are expected to be 7,500.
Solution:
ο‚’ Identify two observations, the highest (Q2) and lowest (Q1) in terms of activity (in
this case, hours)
Highest (Q2)
Lowest (Q1) Difference (Q2 -Q1)
Production hrs
8,000 hrs
6,000hrs
2,000hrs
Total cost
K115,000
K97,000
K18,000
Variable cost per hour
=
K18,000/2,000 = K9/hr
ο‚’ Substitute the variable cost/hr (K9/hr) in either of the two, highest or lowest
observations. Choosing the highest, the cost function will be:
115,000 (TC) = (8,000 hours x K9/hr) + FC
115,000
= 72,000 + FC
FC = 115,000 – 72,000 = K43,000
(Note that if the substitution is to be made in the lowest observation, the fixed
cost would still be the same)
ο‚’ With fixed cost of K43,000 and variable cost of K9/hr, the estimated total cost of
7,500 hrs will be:
TC
= VC + FC
= 7,500(9) + 43,000 = K110,500
This means that if the management plans to operate at 7,500 hours, they should be
prepared for a cost of K110,500.
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1.4.1. Limitations of the high low method
The high low method may not be a perfect way of estimating the future costs due to
the following drawbacks:
i.
It only considers the highest and lowest extremes ignoring the other levels
ii.
It assumes that the variable cost remains constant for all periods under review
iii.
It assumes that the fixed cost remains constant for all the periods under review
iv.
It only applies in the short run where costs can be classified as variable and fixed
but not in the long run.
1.4.2. Adjusting for inflation
As seen above, the high low method uses past data and as such costs in two different
production years may not be in a common form due to prevailing inflation levels. To
overcome this problem, it is appropriate to adjust all the costs for inflation so that a
comparison is made using only real figures and not the nominal ones.
For instance, if in 2016 the cost is K20,500 and in 2017 it was K22,550, one can easily
conclude that it was expensive to produce the products in 2017 than in 2016. This may
however, not be true if it is discovered that inflation level was at 110 in 2017. (110
means 10% above the base level of 100%).
This therefore calls for all figures to be adjusted to real terms by taking off the inflation
element. In this case, assuming 2016 is the base year, the costs will be:
2016
20,500 x 100/100 = 20,500
2017
22,550 x 100/110 = 20,500
It is now seen that there was no change in production cost except for inflation.
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Example 1.4. High-Low method with inflation
From the following information for the past 5 years, estimate the variable cost per unit
and fixed cost per year:
Year
2013
2014
2015
2016
2017
Output (units)
60,000
55,000
68,000
73,000
80,000
Total cost (K)
810,000
884,000
954,000
952,000
1,035,000
Inflation factor
100
104
106
112
115
Solution
Due to the inflation factors, the costs are to be adjusted to base 100 so that they can be
comparable:
Highest
Lowest
Output
82,000
55,000
Total cost
900,000*
850,000*
Variable cost per unit = K50,000/25,000 = K2 per unit
Fixed cost = 900,000 – 82,000(2) = K736,000
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Difference
25,000
50,000
CHAPTER TWO
COST OF PRODUCTION-MATERIAL COSTS
2.1.
Material control and accounting
The stocks held in any organization are mostly in one or all of the following forms:
a) Raw materials
b)
Work in progress
c)
Spare parts/consumables
d)
Finished goods
The cost incurred on materials is just a component of total costs incurred in
manufacturing and therefore if the materials acquired by a business are not properly
recorded and controlled, the cost of a product may be higher or lower than the actual
cost incurred in terms of materials used.
The scope of stock control system is very wide and it covers the functions of ordering,
purchasing, receiving goods into stores, issuing and maintaining stock at the most
appropriate level.
For each kind of material, a separate record is kept on a bin card which shows in detail
the quantities of all receipts, issues to production and balance of that particular
material under the store keeperβ€Ÿs control, as shown below:
A sample bin card
12
As the bin card shows only the quantities, the stores ledger is as well prepared and this
shows in addition to the quantities, the monetary values of the materials received,
issued and outstanding in the stores as below:
13
Sample stores ledger card
2.1.1. Ordering, purchasing and receiving materials
The general hierarchical arrangement in most entities is that there is a central
purchasing department responsible for procurement and then a central warehouse
or stores which are responsible for receipting of goods and issuing to the
departments. In some instances, the purchasing department doubles as warehouse
department.
The purchasing department normally buys the materials when they are demanded
by the departments although in very few circumstances, materials are bought for
inventory.
ο‚’ When a department requires new materials, a purchase requisition is
completed by the department and sent to the purchasing department.
ο‚’ The purchasing department then draws a purchase order which is sent to the
supplier.)
ο‚’ The supplier delivers the consignment of materials and the store
keeper/receiving department signs a delivery note for the carrier. If the delivery is
acceptable, the storekeeper prepares a goods received note (GRN). See below:
14
A sample GRN
ο‚’ Where the purchasing department acquires materials for inventory purposes,
departments simply request for materials using a materials requisition note. This is
to request the stores/warehouse to issue the items to the department.
2.1.2. Issuing materials to departments
ο‚’ Materials can only be issued against a materials requisition note. Its purpose is
to authorize the storekeeper to release the goods which have been requisitioned
and to update the stores records.
ο‚’ Any unused materials which are returned to stores are recorded on the
materials returned note
ο‚’ When materials are being transferred from one department to another, they
are recorded in the materials transfer notes.
2.1.3. Stock taking
This involves counting the physical stock on hand at a certain date, and then
checking this against the balance shown in the clerical records. Two methods of
stock taking are as follows:
Periodic stock taking: this is usually carried out annually and the objective is to count
all items of stock on a specific date, for example, at the end of the financial year,
etc.
Continuous stock taking (or perpetual inventory): this involves counting and valuing
selected items of stocks on a daily basis or at frequent intervals. This system of stock
taking has the following advantages:
a)
The long and costly work of stock counting is avoided and the value of
materials can be obtained quickly for interim profit reporting.
b)
The disadvantages of excessive stocks are avoided.
c)
No operation stoppages required in order to carry out a complete
stock count.
15
d)
Discrepancies are readily discovered and localized, giving an
opportunity for preventing recurrence (repetition) in many cases.
Whatever stock taking method is employed, discrepancies might be identified, and
as such, the stores ledger card must be adjusted to reflect the true physical stock
count.
2.1.4. Stock control levels
a) Re-order level: The re-order level is that inventory level at which an order should
be placed to replenish (refill) the inventory. To estimate the re-order level, the
business has to estimate the maximum daily or monthly or weekly consumption of
the materials as well as the maximum lead time (the time lag between ordering
and receiving the materials)
Re-order level = (maximum lead time in days x maximum daily usage) +
Safety (buffer) Stock
Illustration
The annual consumption of material D in a business is 12,000Kg and it takes 7
days for the supplier to bring the materials ordered. In case of scarcity, the
business maintains a safety stock at a level of 120 Kg. Calculate the re-order
level. Assume a 300 day year.
Solution:
Re-order level = (7 x 12,000/300) + 120 = 400Kg. This means that if the materials in
the stores reach the level of 400Kg, a new order must be placed to ensure
continuity of operations.
b) Re-order quantity: this is the quantity of stock which is to be re-ordered when
stock reaches the re-order level.
Re-order qty = maximum level – (re-order level - minimum usage x minimum lead
time)
Illustration
The maximum stock level for material Y is set at 20,000 litres, the minimum daily
usage is 1,200 litres and it takes 8 to 14 days for material to be delivered. The reorder level is currently at 11,000 litres. Calculate the re-order quantity for material
Y.
Solution
Re-order Qty
= 20,000 – {11,000 – (1,200 x 8)}
= 20,000 – {11,000 – 9,600}
= 18,600 litres
c) Maximum level: this represents that level of stock above which the stock should
not be allowed to rise. It is to be fixed keeping in mind unnecessary blocking of
capital in stocks.
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Maximum level = re-order level + re-order quantity – (minimum usage x minimum
lead time)
Illustration
The re-order level of material Z is 2,000 Kg and the re-order quantity is 9,000 Kg.
the minimum daily usage is 400Kg and the minimum lead time is 6 days.
Calculate the maximum level for material Z.
Solution:
Maximum level = 2,000 + 9,000 – (400 x 6)
= 11,000 – 2,400
= 8,600 Kg
d) Minimum level: this represents a level of stock that draws management attention
to the fact that stocks are approaching a dangerously low level. Stocks should
not be allowed to decrease below this level.
Minimum level = re-order level – (average usage x average lead time)
Illustration
The re-order level of material L is 6,000Kg. The maximum daily usage is 800Kg and
the minimum daily usage is 300 Kg. It takes 6 to 10 days for the suppliers of
material L to deliver. Calculate the minimum level for material L.
Solution
Minimum level =
6,000 – (550 x 8)* = 1,600 Kg
*Explanation: Average usage = (800 + 300)/2, and average lead time = (6 + 10)/2
=8
e) Average level: this represents the average of the starting and closing levels of
stocks assuming a uniform (constant) pattern of stock usage.
Average level of stock = minimum level + ½ re-order quantity.
Illustration
If the minimum stock level and average stock level of raw material A are 4000
and 9000 units respectively, find out its „Re-order quantityβ€Ÿ.
Solution:
Minimum stock level of Material A = 4,000 units and average Stock level = 9,000
units
Since average stock level = Minimum Stock Level + ½ Re order quantity
Then ½ Reorder Quantity = 9000-4000 units = 5000 units
Therefore, Reorder Quantity = 10,000 units
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2.2.
The Economic Order Quantity (EOQ)
The reorder quantity shows how much is to be ordered whenever it is time to place
the order. However, it is not always necessary to order in large or small quantity
simply because the re-order quantity has been computed so. There are costs
involved with the quantity order and therefore a good balance has to be stricken
between too much and too little.
The recommended quantity to order is the EOQ which is the re-order quantity which
minimizes the total costs associated with holding and ordering stocks. It is the order
quantity where the sum of holding costs and ordering costs are equal and at a
minimum.
Ordering Costs: These include costs incurred in the following activities: requisitioning,
purchase ordering, transporting, receiving, inspecting etc.
Ordering costs increase with the number of orders; thus the more frequently
inventory is acquired, the higher the firm's ordering costs. On the other hand, if the
firm maintains large inventory levels, there will be few orders placed and ordering
costs will be relatively small. Thus, ordering costs decrease with increasing size of
inventory.
Carrying (or holding) costs: These are costs incurred for maintaining a given level of
inventory. They include storage, insurance, taxes, deterioration and obsolescence.
Unlike ordering costs, carrying (or holding) costs increase with increasing stock levels
and decrease with decreasing stock levels as seen in the graph below:
EOQ by graph
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Mathematically, the Economic Order Quantity (EOQ) can be ascertained by the
equation below:
2𝐢𝐷
𝐻
𝐸𝑂𝑄 =
√
Where C= cost of ordering, D = annual demand and H= holding costs.
Example 2.1: Stock Control levels
Shagoon Ltd provides the following information in respect of material X:
Supply period:
5 to 15 days
Rate of consumption:
Average: 15 units per day
Maximum:
20 units per day
Yearly:
5000 units
Ordering costs are K20 per order
Purchase price per unit is K50
Storage costs are 10% of unit value.
Calculate the following
Re-order Qty (EOQ)
Reorder Level
Minimum level
Maximum level
Solution:
= 200 units
EOQ
Reorder level
=
maximum lead time x maximum daily usage
15 x 20
=
300 units
Minimum level
= reorder level – (average usage x average lead time)
300 - (15 x 10) =
150 units
Maximum level = reorder level + reorder quantity-(minimum usage x minimum
lead time)
300 + 200 –(10 x 5) = 450 units
When a business orders a quantity of Q and the annual demand is D,
𝐷
The cost of ordering for the entire year will be × π‘π‘œπ‘ π‘‘ π‘π‘’π‘Ÿ π‘œπ‘Ÿπ‘‘π‘’π‘Ÿ, and
𝑄
The cost of holding the inventory for the whole year will be:
𝑄
× π‘•π‘œπ‘™π‘‘π‘‘π‘–π‘›π‘” π‘π‘œπ‘ π‘‘ π‘π‘’π‘Ÿ 𝑒𝑛𝑖𝑑 π‘π‘’π‘Ÿ π‘¦π‘’π‘Žπ‘Ÿ
2
Remember that holding cost and ordering cost are always equal only when the
business is at EOQ.
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Example 2.2: Stock Control levels
A company uses a large quantity of salt in its production process. Annual consumption
is 60,000Kg over a 50week year. It costs K100 to initiate and process an order and
delivery follows two weeks later. Storage costs for the salt are estimated at K0.10 per kg
per year. The current practice is to order twice a year when stocks fall to 10,000Kg.
Required
a) Calculate the re-order level in Kg
b) Calculate the appropriate ordering quantity for the entity and calculate how
much cost will be saved if the company abandons its current strategy for the new
ordering strategy.
Solution
a) Re-order level
= max. weekly usage x maximum lead time
60,000/50 x 2
= 12,400Kg
b)
Appropriate ordering policy (EOQ)
= 10,954 Kg
Costs for the current policy (where ordering is made twice a year), are:
Ordering cost = 60,000/30,000 x 100
=
200
Holding cost =
30,000/2 x 0.1
=
1,500
Total cost
1,700
Costs for the new policy (the EOQ) are:
Ordering costs = 60,000/10,954 x 100
Holding costs = 10,954/2 x 0.1
Total cost
Cost saved then is K1,700 – K1,096 = K604
=
=
548
542
1,096
2.3.
Just-in-time (JIT) system
This is a new approach to operations planning and control based on the idea that
goods and services should be produced only when they are needed. They should
not be produced too early, so that inventories build up, nor too late, so that
consumers have to wait.
Under this system materials arrive exactly at the time they are needed for
production. The just-in-time (JIT) system is used to minimize inventory investment. The
principle is that materials should arrive at exactly the time they are needed for
production.
Because its objective is to minimize inventory investment, a JIT system uses no, or very
little, safety stocks. Extensive coordination must exist between the firm, its suppliers,
and shipping companies to ensure that material inputs arrive on time.
20
Failure of materials to arrive on time results in a shutdown of the production line until
the materials arrive. Likewise, a JIT system requires high-quality parts from suppliers.
When quality problems arise, production must be stopped until the problems are
resolved.
2.3.1. Benefits of JIT system in materials and cost control
a) Reduction in working capital investment in stocks
b) Reduction in materials handling, hence reduction of wastages.
c) More efficient ordering of materials
d) Fewer defective components supplied
e) There are minimal amounts of inventory obsolescence, since the high rate of
inventory turnover keeps any items from becoming old.
f) Since production runs are very short, it is easier to halt (stop) production of
one product type and switch to a different product to meet changes in
customer demand.
g) The very low inventory levels mean that inventory holding costs (such as
warehouse space) are minimized.
2.3.2. Disadvantages of JIT system in material and cost control
a) A supplier that does not deliver goods to the company exactly on time and in
the correct amounts could seriously impact the production process.
b) A natural disaster could interfere with the flow of goods to the company from
suppliers, which could halt production almost at once.
c) An expensive investment in information technology is required to link the
computer systems of the company and its suppliers, so that they can coordinate
the delivery of parts and materials.
d) A company may not be able to immediately meet the requirements of a
massive and unexpected order, since it has few or no stocks of finished goods.
2.4.
Stock (inventory) valuation
For purposes of reporting, both internally and externally, the value of inventory held
in a business must be ascertained at a given day of the year. The main methods
used to value the inventory used in production or value of inventory in stock include:
a) First In First Out (FIFO): This system assumes, for pricing purposes, that the first
materials to arrive in stock are the first ones to be sold or issued to production.
When the FIFO system is operated, the material cost charged to production is
high when prices are falling whereas in inflationary conditions; the material cost
charged to production is low.
Example 2.3: FIFO Valuation
From the information in the table below, Calculate the cost of materials that are
issued to production (or sold) on 5th and 24th June, and hence calculate the
value of the materials remaining in stock at 24th June.
Date
Receipts
Issues / Sales
21
Quantity
Unit cost
1 June
Balance
100
5
3 June
Receipts
300
4.8
5 June
Issues
12 June
Receipts
24 June
Issues
Quantity
Unit cost
220
170
Solution:
Cost of issues
Date of issue (or sale)
5th June
24th June
Cost of remaining materials
24th June
5.2
300
(100 x 5) + (120 x 4.8)*
(180 x 4.8) + (120 x 5.2)**
(50 x 5.2)***
Cost of materials
K1, 076
K1,488
K260
Explanations:
*Out of the first 220 materials that were issued or sold, 100 came from 1 June (at
K5 each) and the remaining 120 came from 3 June (at K4.8 each).
** Out of the 300 materials issued or sold, 180 were the ones remaining from 3
June (at K4.8 each), and 120 materials came from 12 June (at K5.2 each).
*** On 12 June, out of 170 materials, 120 materials were issued or sold on 24 June,
therefore 50 (170 – 120) are remaining in stock each having a cost of K5.2.
b) Average cost method (AVCO): This system assumes that all the materials are
issued at the average cost of the total inventory held regardless of the time they
were received. There are two ways of obtaining the average cost of materials
issued for production and these are:
Periodic weighted average where the average is based on the total cost paid
for all the materials acquired over a particular period, and;
Continuous weighted average where the average is determined the moment a
change arises either in the quantity or cost of the materials.
Using the above information of receipts and issues of materials, below is how the
average cost method is applied:
Periodic weighted average
ο‚’
Total value of materials received = (100 x 5) + (300 x 4.8) + (170 x 5.2) =
K2,824 ο‚’ Total quantity of materials received = (100 + 300 + 170) = 570 ο‚’
Periodic average = K2,824 / 300 = K4.95 per unit of material.
ο‚’
On 5th June the materials issued will cost 220 x 4.95 = K1,089
22
ο‚’
On 24th June, the materials issued will cost 300 x 4.95 = K1,485 ο‚’ The
materials in stock at 24 June will cost 50 x 4.95 = K247.50 Continuous average
ο‚’
By 5 June total cost of materials = (100 x 5) + (300 x 4.8) = K1,940 and
the
quantity of materials = 400. The average cost therefore is K1,940/400 =
K4.85. The cost of the issue on 5 June = 220 x 4.85 = K1,067.
ο‚’
By 24th June, the total cost of materials = (1940 – 1067) + (170 x 5.2) =
K1,757
and the total quantity of materials is (400 – 220 + 170) = 350. The
average cost therefore is K1757/350 = K5.02. The cost of issue on 24th June is
300 x 5.02 = K1,506
ο‚’
The closing stock on 24th June has a cost of 1757 – 1,506 = K251
2.5.
Book keeping recording for materials
Materials held in stock are an asset and are recorded in the Statement of financial
position of a business. All materials are accounted for in the Materials or stores
control account. The well-known entries are as follows:
ο‚’
Opening balance of raw materials is a debit in the Materials control
account
ο‚’
Materials purchased are debited in the materials control account and
credited in the supplier or cash account (depending on whether they are
bought on cash or on credit)
ο‚’
Materials returned to stores are debited in materials control
ο‚’
Direct materials sent from stores to production are credited in the
materials control and debited in the Work in Progress (WIP) account
ο‚’
Indirect materials sent to production are credited in the materials
control and debited in the production overheads account.
ο‚’
Any materials written off or lost are credited in the materials control
and debited in the income statement as an expense
23
Example 2.4: The Stores Control Account
On 1 July, the total value of stocks held in store was K50,000. The following occurred
during July:
Materials purchased from suppliers on credit
120,000
Materials returned to suppliers
3,000
Materials purchased on cash
8,000
Direct materials issued to production department
110,000
Indirect materials issue to production
25,000
Materials written off due to discrepancy
1,000
Direct materials returned to stores from production
4,000
Prepare a materials control account for the month of July.
Solution
(The letters in brackets refer to the transaction)
______________________________________________________________________________________
Balance b/f
50,000
Suppliers (b)
3,000
Suppliers (a)
120,000
Work in progress (d)
110,000
Cash (c)
8,000
Production overheads (e)
25,000
Work in progress (g)
4,000
Profit and loss (f)
1,000
Balance c/d
43,000
182,000
182,00
24
CHAPTER THREE
COST OF PRODUCTION- LABOUR COSTS
3.1.
Direct Labour
Direct labour is that labour which is directly engaged in the production of goods
or services and which can be conveniently allocated to the job, process or
commodity unit.
For example, labour engaged in making the bricks in a kiln is direct labour
because charges paid for making 1,000 bricks can be conveniently allocated to
the cost of 1,000 bricks.
Normally, direct labour is paid for on the basis of hours the worker spent in the
production process. For instance, if the basic rate per hour is K700 and a worker
works for 15 hours, the labour cost in this case will be 700 x 15 = K10,500.
3.2.
Indirect Labour
Indirect labour is that labour which is not directly engaged in the production of
goods and services but which indirectly helps the direct labour engaged in
production. The examples of indirect labour are mechanics, supervisors, foremen,
watchmen, timekeeper, repairers and cleaners, etc.
The cost of indirect labour cannot be conveniently allocated to a particular job,
order, process or article. For example in a production factory, the wages of a
supervisor who oversees all the workers in all the production lines cannot be easily
identified with a particular product; therefore it is an indirect labour cost.
Though indirect, it still remains a production cost as long as it is incurred on
production related activity only that it is not considered directly but through
absorption (to be discussed later)
3.3.
Overtime
Normally, a worker is expected to work for a maximum given number of hours in a
day, week or month. If workers work beyond their normal working hours, the extra
hours (normally above the given maximum) are referred to as overtime.
This overtime is paid for at an additional cost premium (over and above the basic
rate for the normal hours).
For example, if the basic rate per hour for normal hours is K500 and any overtime is
paid at time and a half (that is 500 + 250), then if the normal hours are 40 and the
worker did 43 hours, the total wage will be calculated as follows:
Basic pay for all hours (43 x 500)
Overtime premium (3 x 250)
21,500
750
25
Total pay
The other presentation could be:
Pay for normal hours (40 x 500)
Pay for overtime hours (3 x 750)
22,250
20,000
2,250
22,250
N.B: The most recommended presentation is the first one because it shows the
overtime cost separately from the basic pay. You are therefore advised to use the
first one for labour cost recording and accounting purposes.
The overtime premium (in this case, the K750, and not the K2,250) is to be treated
as an indirect wage cost unless the overtime was specifically requested by the
customer for whom the work was done, in which case it will be a direct wage cost
for that particular job.
3.4.
Control of labour cost
Some of the techniques used to effectively control labour costs include the
following:
a)
Production planning: this involves the preparation of production
planning schedule in advance of production runs with supporting schedule of
man hour requirements.
b)
Labour budget and use of labour standards: a labour budget is simply
a cost estimate of expected labour to be used. A labour standard is a
benchmark (basis of comparison) set in place to represent the hours required
to complete one unit of product given certain conditions. This helps to
measure productivity by comparing actual time taken against an expected
time.
For example, if the standard (expected) hours to produce a unit of product is
7 hours but a worker has taken 10 hours, the reasons for the excess hours have
to be investigated.
c)
Labour performance reports: these reports signal whether control is
needed or not and should be produced periodically. A sample of labour
(employee) performance report form is illustrated below:
26
d)
Wage incentive schemes: Wage incentive refers to performance
linked compensation paid to improve motivation and productivity. It is the
monetary inducements offered to employees to make them perform beyond
the accepted standards. Workers will be more productive and more efficient if
they are sufficiently motivated.
Wage incentive schemes aim at the fulfillment of following objectives:
To improve the profit of a firm through a reduction in the unit costs of labour
and materials or both.
i)
To avoid or minimise additional capital investment for the expansion of
production capacity.
ii) To increase a worker's earnings without dragging the firm into a higher
wage rate structure regardless of productivity.
iii) To use wage incentives as a useful tool for securing a better utilisation
of manpower. Better production scheduling and performance control and
a more effective personnel policy.
3.5.
Measures of labour activity
The activities of workers in the production function can be assessed using the
following ratios.
a)
Efficiency/productivity ratio: this ratio shows the efficiency of workers
by comparing the actual hours taken to complete a given production against
the expected (or standard hours). It measures whether the production output
for a period in a production cost centre took more or less direct labour time
than expected
It is given by the formula:
27
𝐸π‘₯𝑝𝑒𝑐𝑑𝑒𝑑 π‘œπ‘Ÿ π‘ π‘‘π‘Žπ‘›π‘‘π‘Žπ‘Ÿπ‘‘ π‘•π‘œπ‘’π‘Ÿπ‘ 
𝐸𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑐𝑦 π‘…π‘Žπ‘‘π‘–π‘œ =
π΄π‘π‘‘π‘Žπ‘’π‘™ π‘•π‘œπ‘’π‘Ÿπ‘ 
× 100%
A
ratio above 100% means the workers are very efficient and this has to
be encouraged. On the other hand, it might mean that the expected or
standard hours were overstated.
b)
Capacity ratio: this ratio (also known as capacity utilisation ratio)
shows how much of the available labour capacity is being used. When
employees are working below capacity, it means the business will not fully
maximise its potential.
This is given the formula:
π΄π‘π‘‘π‘’π‘Žπ‘™ π‘•π‘œπ‘’π‘Ÿπ‘ 
πΆπ‘Žπ‘π‘Žπ‘π‘–π‘‘π‘¦ π‘…π‘Žπ‘‘π‘–π‘œ =
× 100%
𝐡𝑒𝑑𝑔𝑒𝑑𝑒𝑑 π‘•π‘œπ‘’π‘Ÿπ‘  π‘œπ‘Ÿ π‘π‘Žπ‘π‘Žπ‘π‘–π‘‘π‘¦
π‘•π‘œπ‘’π‘Ÿπ‘ 
c)
Production volume ratio: this ratio represents the actual output
measured in direct labour hours as a proportion of budgeted output. It is given
by the formula:
π‘†π‘‘π‘Žπ‘›π‘‘π‘Žπ‘Ÿπ‘‘ π‘•π‘œπ‘’π‘Ÿπ‘ 
π‘ƒπ‘Ÿπ‘œπ‘‘π‘’π‘π‘‘π‘–π‘œπ‘› π‘‰π‘œπ‘™π‘’π‘šπ‘’ π‘Ÿπ‘Žπ‘‘π‘–π‘œ =
𝐡𝑒𝑑𝑔𝑒𝑑𝑒𝑑 π‘•π‘œπ‘’π‘Ÿπ‘ 
× 100%
Or alternatively;
π‘ƒπ‘Ÿπ‘œπ‘‘π‘’π‘π‘‘π‘–π‘œπ‘› π‘£π‘œπ‘™π‘’π‘šπ‘’ π‘Ÿπ‘Žπ‘‘π‘–π‘œ = 𝐸𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑐𝑦 π‘Ÿπ‘Žπ‘‘π‘–π‘œ x πΆπ‘Žπ‘π‘Žπ‘π‘–π‘‘π‘¦ π‘Ÿπ‘Žπ‘‘π‘–π‘œ
A
ratio of more than 100%, say 120%, implies that the actual output,
measured in labour hours is more than the budgeted output by 20%.
Example 3.1: Measuring labour activity.
A company budgets to make 25,000 standard units of output during a budget
period of 100,000 hours. Actual output was 27,000 units which took 120,000 hours.
The above three ratios are calculated as below:
ο‚’
Efficiency ratio =
4hours
Expected hours per unit = 100,000/25,000 =
Total expected hours = 27,000 x 4 = 108,000 hours
Actual hours = 120,000 hours
Efficiency ratio = 108,000/120,000 x 100% = 90%
ο‚’
Capacity ratio =
Actual hours are 120,000 hours
Budgeted hours are 100,000 hours
Capacity ratio = 120,000/100,000 = 120%
ο‚’
Production volume ratio= Expected (standard hours) = 108,000
28
Budgeted hours = 100,000
Production volume ratio = 108,000/100,000 = 108%
3.6.
Labour turnover
Labour turnover is a measure of the number of employees leaving or being
recruited in a period of time as a percentage of the total labour force.
π΄π‘£π‘’π‘Ÿπ‘Žπ‘”π‘’ π‘›π‘’π‘šπ‘π‘’π‘Ÿ π‘œπ‘“ π‘™π‘’π‘Žπ‘£π‘’π‘Ÿπ‘  π‘Ÿπ‘’π‘žπ‘’π‘–π‘Ÿπ‘–π‘›π‘” π‘Ÿπ‘’π‘π‘™π‘Žπ‘π‘’π‘šπ‘’π‘›π‘‘
𝐿𝑇𝑂 =
× 100%
π΄π‘£π‘’π‘Ÿπ‘Žπ‘”π‘’ π‘›π‘’π‘šπ‘π‘’π‘Ÿ π‘œπ‘“ π‘’π‘šπ‘π‘™π‘œπ‘¦π‘’π‘’π‘ 
Example 3.2: Labour Turn over
In a certain factory, the following data was gathered for the year:
Employees at the beginning of the year
72
Employed during the year
14
Left during the year
11
Employees at the end of the year
75
Calculate the labour turnover rate for the year
Solution
In this case, the labour turn over will be:
(14 + 11)/2
(72 + 75)/2
= 17%
This means that for every 100 workers in a year, 17 workers leave and need to be
replaced.
Management should do all it can to minimise labour turnover because it is significantly
costly.
3.6.1. Cost of Labour Turnover
The cost of labour turnover can be divided under two classes as follows:
Preventive costs: These are costs which are incurred to prevent excessive labour
turnover. The aim of these costs is to keep the workers satisfied so that they may
not leave the factory. These costs may include:
a)
Cost of providing good working conditions.
b)
Cost of providing medical, housing and recreational facilities to
workers.
c)
Cost of providing educational facilities to the children of the workers.
d)
Cost of providing Subsidised meals.
e)
Cost of providing safety measures against working conditions. Etc.
Replacement costs: These costs are associated with replacement of workers and
include:
a)
Cost of recruitment of new workers.
b)
Cost of training new workers.
c)
Loss of production due to interruption in production, and inefficiency of
new workers.
d)
Loss of profit due to loss of production.
29
3.6.2. Reduction of Labour Turnover
The following steps may be taken to reduce the labour turnover and its associated
costs:
a)
Paying satisfactory wages
b)
Offering satisfactory hours and conditions of work
c)
Creating a good informal relationship between fellow workers and
between supervisors and subordinates
d)
Offering good training schemes and a well-known transparent
promotion ladder
e)
Improving the content of jobs to create job satisfaction.
3.7.
Accounting for labour costs
All labour costs, whether direct or indirect are accounted for in the wages
control/labour account where all total wages paid are debited and credited in
the cash or bank account.
The labour costs must then be categorised into direct and indirect and all the
direct labour costs are then credited from the labour account and debited into
the Work in Progress (WIP) account, whereas all the indirect labour costs are
credited from the labour/wages control account but debited in the production
overheads account.
The summary below provides the journal entries for labours costs:
a) Total labour costs incurred or paid: Dr
Cr
b) Direct labour costs
c) Indirect labour costs
Dr
Cr
Dr
Cr
Wages/Labour Control account
Cash/Bank account
Work In Progress (WIP) account
Wages Control account
Production Overheads account
Wages Control account
Example 3.3: Labour cost bookkeeping
The following relates to labour costs for the month:
Direct workers
Basic pay for normal time
Overtime: basic wage
Premium
Shift allowance
Sick pay
Idle time
36,000
8,700
4,350
3,465
950
3,200
30
indirect
22,000
5,430
2,715
1,830
500
total
58,000
14,130
7,065
5,295
1,450
3,200
56,665
32,475
89,140
Prepare the wages control account for the month
Solution:
Bank (wages paid)
Wages control account
89,140
Work in progress
Production overheads
Indirect labour
Overtime premium
Shift allowance
Sick pay
Idle time
89,140
44,700*
27,430
7,065
5,295
1,450
3,200
89,140
*The only direct wage expense to go straight to the WIP account is the basic pay for
normal and overtime for direct workers. The overtime premium, shift allowance, sick
pay, and idle time were indeed paid to direct workers but the costs are not directly
related to any product, hence they are indirect labour costs.
31
CHAPTER FOUR
PRODUCTION COSTS-OVERHEAD ABSORPTION
4.1.
Introduction
Production overheads, by their nature cannot be identified or associated with a
particular product or service because they may be incurred for a number of
purposes and not just for the product being produced or service being provided.
Because of their indirect nature, overhead costs must be included to the cost of a
product or service by means of a systematic method or approach. Currently the
most popular approaches of dealing with overheads are the traditional approach or
Absorption Costing, and the Activity Based Costing (ABC).
When dealing with overheads using the absorption costing system, the costs are
taken into the product or service cost on the basis of volume of production where as
in Activity based costing, the costs are taken into the product or service cost on the
basis of activities causing the costs.
4.2.
Overhead absorption
Overhead absorption can be defined as the inclusion of fixed production overheads
into the cost of a product or service using a predetermined rate (called the
overhead absorption rate).
The overhead absorption rate (OAR) can be determined using a number of bases
which measure the volume of the business activities. Such bases may be but not
limited to direct labour hours, machine hours, total units produced, total direct
wages or total direct materials.
π‘‡π‘œπ‘‘π‘Žπ‘™ 𝑏𝑒𝑑𝑔𝑒𝑑𝑒𝑑 π‘œπ‘£π‘’π‘Ÿπ‘•π‘’π‘Žπ‘‘π‘ 
𝑂𝐴𝑅 =
π‘‡π‘œπ‘‘π‘Žπ‘™ π‘Žπ‘šπ‘œπ‘’π‘›π‘‘ π‘œπ‘“ 𝑑𝑕𝑒 π‘π‘Žπ‘ π‘’
Example 4.1: Full product costing
Product K requires 5Kg of materials which are bought at K89/Kg, 6 hours of direct
labour paid for at K35/hr. Fixed overheads are estimated to be K18, 000 and will be
absorbed on the basis of labour hours. If it is expected that 1,000 units of product K
will be produced, what is the total cost to produce one product of K?
Solution:
Total cost of one product
Direct Materials (5 x 89)
Direct labour (6 x 35)
Fixed overhead
Total cost
Explanation:
K
445
210
18*
673
32
*Since the fixed overheads are absorbed on the basis of labour hours, we need to
identify all the labour hours expected. In this case they are (1,000units x 6hours/unit)
= 6,000 hours. This means that the rate of absorption is (K18,000/6,000 hours) = K3/hr.
Since each product requires 6 labour hours, then each product will get a share of
(K3/hr x 6hrs) = K18.
Example 4.2: Computation of OARs
A production process passes through three stages/departments, all of which are
cost centres. The information relating to a period is as follows:
Department allocated OH
machine Hrs (budget) labour Hrs(budget)
A K56,000
16,000
nil
B
K48,000
nil
24,000
C K32,000
1,000
1,000
The estimated production is 16,000 units. Department A is machine intensive and the
department B is labour intensive. The absorption rate for department C is based on
level of production. Each product requires 1 machine hour in department A and 1.5
labour hours in B.
Calculate the overhead absorption rate for each of the three departments and the
total overhead cost to be incorporated in the production cost of the product.
Solution
Using the above information, the absorption rates will be as follows:
Dept A (basis is machine hrs)
56,000/16,000 machine hrs = K3.5/machine hr
B (basis is labour hours)
48,000/24,000 labour hours = K2/labour hr
C(basis is production volume) 32,000/16,000
products
=
K2/unit
of
production.
This means that the overheads per unit produced will be:
Department: A
1 hour x K3.5 /hr
=
B
1.5 hours x K2/hr
=
K3
C 1 unit x K2/unit
=
K2
K3.5
K8.5
The K8.5 will be added to the prime cost per unit to get the total cost per unit of a
product.
NB: The basis of absorption depends on the nature of the department. If it is more
machine intensive, machine hours could be the most appropriate basis and if it is
labour intensive, labour hours make a good basis. Otherwise, you will have to be
advised as to which basis to use in the departments.
4.3.
Costing procedures
The stages involved in assigning overhead costs to a product or service are as
follows:
33
4.3.1. Cost allocation
This is a process where cost items are charged direct to a cost centre. The cost is (or
will be) incurred for a particular cost centre or department. In this case, the
overheads are directly attributable to a particular department (not products) and as
such they just have to be assigned to where they belong. For instance, if
department A incurs overheads of K400,000, it will simply be allocated these
overheads as they are easily traced to the department.
However, there are some overheads that are incurred for the business as a whole
and cannot be easily associated with a single department. In such a situation, the
next stage follows.
4.3.2. Cost apportionment
This is the process where cost items or cost centre costs are divided between several
other cost centres in a fair proportion. What determines the proportion is the arbitrary
usage of the cost incurred by each department concerned.
The table below provides a suggestion (not a rule) of the bases to use when
apportioning various overheads to centres:
Overhead
Suggested basis
Rent ,rates, repairs, lighting and Floor area occupied by each cost
depreciation of buildings or factory
centre or department.
Depreciation, insurance of equipment
Cost or book value of equipment
Personnel office, canteen, welfare, etc Number of employees in each cost
centre
Heating etc
Volume of space occupied by each
centre
There are no strict rules of choosing the basis of apportionment but reasonableness
and fairness should prevail when determining the bases. For instance, it may not be
reasonable to apportion depreciation cost based on number of employees in the
department. The most reasonable basis could be the value of equipment in the
department as depreciation is based on the value.
Example 4.3: Overhead allocation and apportionment
The following production overheads were incurred by an entity:
Indirect materials: Dept A
3,000
Dept B
2,500
Dept X
500
Dept Y
750
Indirect labour
Dept A
400
Dept B
750
Dept X
600
Dept Y
180
Factory depreciation
1,000
34
Factory repairs and maintenance
Factory office costs
Depreciation of equipment
Insurance of equipment
Heating
Lighting
Canteen
600
1,500
800
200
390
100
900
14,170
Information relating to the production departments A and B; and service
departments
X and Y is as follows:
Dept A
Dept B
Dept x
Dept Y
Floor space
(sq m)
1,200
1,600
800
400
Volume (cub m)
3,000
6,000
2,400
1,600
Number of employees
30
30
15
15
Book value of equipment (K) 30,000
20,000
10,000
20,000
Hours used from X
100
70
30
Hours used from Y
50
10
20
Show how the overheads will be apportioned to the four departments A, B, X
and Y.
Solution:
(See explanations below)
Item
basis
A
B
X
Y
Indirect materials
allocated
3,000
2500 500
750
Indirect labour
allocated
400
750
600
180
Factory depreciation
floor area
300
400
200
100(a)
Factory repairs
floor area
180
240
120
60(b)
Factory office costs
no. of employees 500
500
250 250(c)
Equip depreciation
book value
300
200
100 200(d)
Insurance of equip
book value
75
50
25 50(e)
Heating
volume
90
180
72 48(f)
Lighting
floor area
30
40
20 10(g)
Canteen
no. of employees 300
300
150 150(h)
5,175
5,160 2,037 1,798
Explanations:
a) The term factory represents all the infrastructure or premises within which
the business is situated, that is, the buildings within. The area of the whole
factory is 4,000m2. Department A will therefore get a proportion of 1,200/4,000
of K1,000; B will get a share of 1,600/4,000 of K1,000; etc.
b)
Factory repairs will be shared on the same basis of floor space or area.
A will then get 1,200/4,000 x 600; etc.
c)
Factory office costs will be apportioned on the basis of number of
employees. Total number of employees is 90. A will therefore be apportioned
30/90 x 1500; etc.
35
d) Depreciation of equipment will be apportioned on the basis of book value of
equipment. Total book value is K80,000. A will get a proportion equal to
30,000/80,000 of 800; etc.
e) Insurance of equipment will also be apportioned using book value of equipment.
Department A gets 30,000/80,000 of K200, etc.
f) Heating cost will be apportioned on the basis of volume and the factory has got
a total volume of 13,000m3. Department A will be apportioned 3,000/13,000 of K390,
etc.
g) Lighting will be apportioned based on floor area and therefore A will get
1,200/4,000 of K100.
h) Canteen costs will be apportioned based on number of employees and
Department A will get a share of 30/90 of K900.
4.3.3. Re-apportionment of service costs:
Our main goal is to get the cost of production and production departments should
be our areas of focus. But as we see in the above example, two other departments,
X and Y are not involved in production but some overheads have been apportioned
to them. We need now to transfer those overheads to the production centres A and
B where absorption takes place. This is called re-apportionment of costs to
production centres from service centres.
The service centre costs can be re apportioned to the production centres using any
of the following methods:
Direct Method:
This is where the costs of service departments are directly apportioned to production
departments without taking into account any service rendered by one service
department to another service department. This can be done by estimating how
much of the overheads in the service centres must be transferred to production
centres but not to another service centre. It is assumed in this case that the service
centres are not servicing each other.
Example 4.4. Re-apportionment using the direct method
Continuing from the above analysis sheet in example 4.3 you are requested to
reapportion the service costs to the production costs using the following basis:
Service X
Service Y
Production A
40%
80%
Production B
60%
20%
Solution
A
B
X
Y
Apportioned costs
5,175
5,160
2,037
1,798
X- Re-apportioned
815 1,222
(2,037) - Y- Re-apportioned 1,438
360
(1,798)
7,428
6742
This shows that the total overheads in X of 937 have been shared by A and B in the
given proportions or percentages. (40% of 937 goes to A and 60% goes to B, and so
on)
36
Repeated (continuous) distribution method:
Under this method, the re-apportionment goes on continuously, using the
appropriate bases until the service costs become equal to zero or become
negligible. The emphasis is mostly on how each department benefits from a
particular service centre. With this approach, it is acknowledged that a service
centre can service another service centre in addition to serving the production
centres.
Example 4.5: Re-apportionment using continuous distribution
Continuing from the above analysis sheet in example 4.3, reapportion the service
costs to production centres using continuous distribution method.
Solution:
the departments are enjoying the services of service centres X and Y as follows:
A
B
X
Y
Services of X (in hours)
100 (50%)
70 (35%)
30 (15%)
Services of Y (in hours)
50 (62.5%)
10 (12.5%)
20 (25%)
Below is how the repeated distribution works (starting with service centre with higher
costs, in this case X)
A
B
X
Y
Apportioned costs
5,175.00
5,160.00
2,037
1,798.00
X (2,037 in the ratio100:70:30)
1,019.00
712.95
(2,037)
305.55
6,194.00
5,872.95
2,103.55
Y (2,103.55, ratio 50:10:20)
1,314.72
262.94
525.89
(2,103.55)
7,508.72
6,135.89
525.89
X (525.89 in ratio100:70:30)
262.95
184.06
(525.89)
78.88
7,771.67
6,319.95
78.88
Y (78.88 in ratio 50:10:20)
49.30
9.86
19.72
(78.88)
7,820.97
6,329.81
19.72
X (19.72 in ratio 100:70:30)
9.86
6.90
(19.72)
2.96
7,830.83
6,336.71
2.96
Y (2.96 in ratio 50:10:20)
1.85
0.37
0.74
(2.96)
7,832.68
6,337.08
0.74
To this end the remaining overhead costs of K0.74 in department X could as well be
ignored as negligible and therefore the final overhead costs will be K7,832.68 for A
and K6,337.08 for B. (you may wish to continue with the distribution if in your opinion
the K0.74 is material).
37
Linear algebra method:
Under this method, simultaneous equations are applied after considering how the
service centres are serving the production departments.
Firstly, we need to establish the proportion of service the service centres are
providing to the other centres (or to themselves in extreme cases). These proportions
will help to create the linear equations to be used in re-apportioning the costs
To understand the development of the linear equations, the analysis is redrawn here
for reference:
A
B
X
Y
Apportioned overheads
5,175
5,160
2,037
1,798
Dept X (proportion of hours used)
50%
35%
15%
Dept Y (proportion of hours used)
62.5%
12.5%
25%
-
Points to note:
ο‚’
Out the 200 hours of X, 30 hours (or 15%) are used by Y
ο‚’
Out of 80 hours of Y, 20 hours (or 25%) are used by X
ο‚’
This means that the overheads to be apportioned from X will be 2,037
plus 25% of Yβ€Ÿs, that is X = 2,037 + 0.25Y (equation 1).
ο‚’
This also means that the overheads to be apportioned from Y will be
1,798 plus 15% of Xβ€Ÿs, that is Y = 1,798 + 0.15X (equation 2).
These two equations can then be solved algebraically to give the actual values of X
and Y to be taken by A and B.
Solving for X and Y, the values become Y = K2,185.51 and X = K2,583.38.
The cost of X (2,583.38) will then be apportioned to A and B as 50% to A and 35% to B
and that of Y (K2,185.51) will be apportioned to A and B as 62.5% to A and 12.5% to
B.
The total overhead cost for Department A and Department B will therefore be:
A
B
Apportioned overheads
5,175.00
5,160.00
Share of X (50%, 35%)
1,291.69
904.18
Share of Y (62.5%, 12.5%)
1,365.94
273.19
7,832.63
6,337.37
4.3.4. Overhead absorption or recovery
This is where costs of cost centres are added to unit, job or process to come up with
a complete cost of production using the bases already explained above.
For example, using the results from the linear algebra method, if in Department A the
overheads were to be absorbed on the basis of labour hours and in B on the basis of
machine hours; and given 4,000 labour hours in A and 3,000 machine hours in B, then
the absorption rates would be as follows (using the final overhead amounts):
A
B
Overhead cost
K7,832.63
K6,337.37
Basis
4,000 labour hours
3,000 machine hours
38
OAR
K1.96/labour hr
K2.11/machine hour
This means that if one product spends 4 hours in department A and 9 hours in B, the
total overhead cost for one product would be:
In Department A
(4 hours x K1.96/hr)
7.84
In Department B
(9 hours x K2.11/hr)
18.99
26.83
4.4.
Over/under absorption of overheads
The rate of absorption (OAR) is based on estimates of costs and activities (budgets)
and therefore the actual fixed overheads absorbed are not always equal to the
fixed overheads incurred over the production period.
It must be noted here that in absorption costing, the cost of a product is that which
has been absorbed and not that which has been incurred. Take for instance,
overhead cost incurred of K42 but due to the OAR in use of say K8/hour, if the
product uses 6 hours, then the cost of the product will be 6 x 8 = 48 (absorbed), and
not the actual cost incurred of K42.
4.4.1. Under absorption
This occurs when the actual overheads absorbed into the production costs are
lower than the actual overhead cost incurred.
For instance, absorbing K10,000 into the cost of the product but actually incurring
say K15,000. The difference of K5,000 is an under absorption (meaning that the
production has absorbed less overheads than what has been incurred in making it)
The under absorption of overheads is an expense in the income statement of the
business.
Example 4.6: Under-absorption
The budgeted overhead costs for a period are K28,000 for a budgeted machine
time of 4,000 hours. If actual overheads incurred are K31,500 for 4,200 machine
hours. Calculate the under absorbed overheads.
Solution
ο‚’
From the budgeted information, the pre-determined absorption rate
(OAR)= 28,000/4,000 = K7/hour.
ο‚’
Multiplying the K7/hr with the actual hours worked, we get the
absorbed overheads of K29,400.
ο‚’
Since the overheads incurred (31,500) are greater than the ones
absorbed (K31,500), there has been an under absorption of K2,100.
4.4.2. Over absorption
This occurs when the actual overheads absorbed into the production cost are
greater than the actual overhead costs incurred.
For instance having absorbed K13,000 into a cost of a product but having incurred
only K10,000. The difference of K3,000 in this case is the over absorption (meaning
39
that the product has absorbed more overheads than what has been incurred in
making it)
The over absorption of overheads is an income in the profit and loss account
(income statement) of the business.
Example 4.7: Over-absorption
Budget
Overheads
K148,750
Labour hours
8,500
Calculate the overheads over absorbed.
Actual
K146,200
9,200
Solution
ο‚’
The pre-determined overhead absorption rate is 148,750/8,500 = K17.5
/hr (it is always based on budgets)
ο‚’
The actual overheads absorbed are K17.5 x 9,200 = K161,000
ο‚’
Since the overheads incurred (146,200) are less than the one absorbed
(161,000), there has been an over absorption of K14,800.
4.5.
Plant wide (Blanket) absorption rates
As discussed above, every production centre is assigned its own overhead
absorption rate. However, most businesses prefer to use a plant wide absorption rate
which is used for all products regardless of the departments they go through in the
production process.
A blanket overhead absorption rate is a rate used throughout the factory and for all
the jobs, and units of output irrespective of the department in which they were
produced.
To illustrate the use of blanket rates, let us look at the illustration below:
Department 1
Budgeted overheads
K360,000
Budgeted direct labour hrs
200,000 hrs
Department 2
K200,000
40,000hrs
In this case the overhead absorption rate per department will be:
Department 1
K360,000/200,000
=
K1.8/labour
Department 2
K200,000/40,000 = K5/labour hour.
Total
K560,000
240,000hrs
hr
On the other hand, if the blanket overhead absorption rate were to be used, the
rate would be (560,000/240,000) = K2.33/labour hour.
Now let us see how the two approaches determine the overhead cost of a product.
Assume that a product spends 4 hours in department 1 and 6 hours in department 2.
Using the departmental absorption rate, the overhead cost of the product will be:
Department 1
(4 hours x 1.8/hour) = 7.2
Department 2
(6 hours x 5/hour) = 30.0
40
Total overhead cost/unit
37.2
Alternatively, if the blanket absorption rate is used, the overhead cost for one unit
will be (10 hours x K2.33/hr) = K23.3.
A blanket overhead rate is not a satisfactory method of allocating overheads in a
situation where a factory consists of a number of different production centres and
the products consume cost centre overheads in different proportions.
4.6.
Accounting for overheads
The following are some of the basic accounting entries required for overheads:
ο‚’
All production overhead costs incurred are debited in the production
overheads account.
ο‚’
All overheads absorbed are credited from the overheads account and
debited in the WIP account.
ο‚’
Any under absorbed overheads are credited from overheads account
and debited in the profit and loss account as an expense
ο‚’
Any over absorption is debited in the overheads account and credited
in the profit and loss account as an income.
41
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