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 5 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 ππΆ = ππΆ + πΉπΆ 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 costs greatly helps the management in planning the businessβ 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: 8 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. 9 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. 10 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 11 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 keeperβs 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. 16 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. 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 17 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 18 Mathematically, the Economic Order Quantity (EOQ) can be ascertained by the equation below: 2πΆπ· π» πΈππ = √ 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, π· The cost of ordering for the entire year will be × πππ π‘ πππ πππππ, and π The cost of holding the inventory for the whole year will be: π × ππππππππ πππ π‘ πππ π’πππ‘ πππ π¦πππ 2 Remember that holding cost and ordering cost are always equal only when the business is at EOQ. 19 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 πΈπ₯ππππ‘ππ ππ π π‘ππππππ πππ’ππ πΈπππππππππ¦ π ππ‘ππ = π΄ππ‘ππ’π πππ’ππ × 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΄ππ‘π’ππ πππ’ππ πΆππππππ‘π¦ π ππ‘ππ = × 100% π΅π’ππππ‘ππ πππ’ππ ππ πππππππ‘π¦ πππ’ππ 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: ππ‘ππππππ πππ’ππ πππππ’ππ‘πππ ππππ’ππ πππ‘ππ = π΅π’ππππ‘ππ πππ’ππ × 100% Or alternatively; πππππ’ππ‘πππ π£πππ’ππ πππ‘ππ = πΈπππππππππ¦ πππ‘ππ x πΆππππππ‘π¦ πππ‘ππ 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£πππππ ππ’ππππ ππ ππππ£πππ ππππ’πππππ πππππππππππ‘ πΏππ = × 100% π΄π£πππππ ππ’ππππ ππ ππππππ¦πππ 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. πππ‘ππ ππ’ππππ‘ππ ππ£πππππππ ππ΄π = πππ‘ππ ππππ’ππ‘ ππ π‘ππ πππ 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 Yβs, 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 Xβs, 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