CHAPTER TWO

1.1. RESOURCE INPUT COST DETERMINATION

1.1.1. Material cost determination

International accounting standard (IAS 2), says that inventories shall be measured at
the lower of cost and net realizable value and outlines acceptable methods of
determining cost, including specific identification (in some cases), first-in first-out
(FIFO) and weighted average cost.

The cost of inventories shall comprise all costs of purchase, costs of conversion and
other costs incurred in bringing the inventories to their present location and condition.

1. Raw Material Cost: It includes the cost incurred by the company to acquire the raw
material required for the production of goods.
2. Indirect Tax: There are different types of indirect taxes which are included in the
invoice that is payable to the seller by the buyer of the goods. So, these costs also
form part of the direct cost of the company.
3. Discounts: There are different types of discounts offered by the supplier of the raw
material to the buyer, such as cash discounts, trade discount, and quantity discounts.
These discounts reduce the overall expense of the material and thus are subtracted
while calculating the direct material expense of the company.
4. Freight and Storage Charges: Cost incurred by the company for the freight and the
storage charged are included in this cost in case the same is included in the price as
per the invoice or can be easily prorated according to its units or weight.
5. Packing and the Container Charges: The expense incurred by the company for the
non-returnable material used for packing or for the containers used to get the material
from the supplier is included in the direct material expense of the company.

Illustration: From the information of the transaction given below for the company A
ltd. for October 2019, calculate the total direct material costs of the company for the
month ending on October 31, 2019.

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 The total cost of raw material purchased: $ 550,000
 Indirect taxes as mentioned in the invoice: $ 70,000
 Wages paid to the employees that are involved directly in the production activities of
the company: $ 150,000
 Packing and container charges paid, as mentioned in the invoice: $ 5,000
 Freight inward paid: $7,000

Solution: The total cost incurred by the company with respect to the raw material
along with the cost of other components incurred to purchase the material that is
related directly with the manufacturing of the different products of the company will
become part of the direct material cost of the company. In the case of the company A
ltd, all the expenses mentioned will be included in the direct material costs except
the cost incurred for paying the wages to the employees. Wages paid will be
considered while calculating the direct labor expense as they are related directly with
the manufacturing of the product of the company. Still, the same will not form the
part of the direct material expense.

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 550000+70000+5000+7000
=632000If the quantity material purchased is 10000 then unit material cost is
632000/10000=63.2

Inventory Control- By Setting Quantitative Levels

Re-order Stock Level •When to Order

Re-order Quantity/ EOQ •How Much to Order

Maximum Stock Level •Up to How much to stock

Minimum Stock Level •At least How much to stock

Average Stock Level •Stock normally kept

Danger Stock Level •Kept for emergency requirement

Buffer Stock •To mitigate sudden demand

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(i) Re-order Stock Level (ROL): This level lies between minimum and the
maximum levels in such a way that before the material ordered is received into the
stores, there is sufficient quantity on hand to cover both normal and abnormal
consumption situations
(ii) Re-Order Quantity: Re-order quantity is the quantity of materials for which
purchase requisition is made by the store department. While setting the quantity to be
re-ordered, consideration is given to the maintenance of minimum level of stock, re-
order level, minimum delivery time and the most important the cost. Hence, the
quantity should be where, the total of carrying cost and ordering cost should be
at minimum. For this purpose, an economic order quantity should be calculated.
Economic Order Quantity (EOQ): The size of an order for which total of ordering
and carrying cost are at minimum.

Ordering Cost: The costs which are associated with the purchase or order of
materials. It includes cost to invite quotations, documentation works like preparation
of purchase orders, employee cost directly attributable to the procurement of material,
transportation and inspection cost etc.

Carrying Cost: The costs for holding/ carrying of inventories in store. It includes the
cost of fund invested in inventories, cost of storage, insurance cost, obsolescence etc.

The Economic Order Quantity (EOQ) is calculated as below:

Annual Requirement (A) - It represents demand for raw material or Input for a year.

Cost per Order (O) - It represents cost of placing an order for purchase.

Carrying Cost (C) – It represents cost of carrying average inventory on annual basis.

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Assumptions underlying E.O.Q.: The calculation of economic order of material to
be purchased is subject to the following assumptions:

(i) Ordering cost per order and carrying cost per unit per annum are known and
they are fixed.
(ii) Anticipated usage of material in units is known.
(iii) Cost per unit of the material is constant and is known as well.
(iv) The quantity of material ordered is received immediately i.e. the lead time is
zero.

Illustration The John Equipment Company estimates its carrying cost at 15% and its
ordering cost at $9 per order. The estimated annual requirement is 48,000 units at a
price of $4 per unit.

Required:

1. What is the most economical number of units to order?

2. How many orders should be placed in a year?
3. How often should an order be placed?

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Solution

1. What is the most economical number of units to order?

Annual requirement = 48,000 units

Ordering cost = $9 per order
Carrying cost = 15% of per-unit cost
per unit cost = $4 per unit

2. How many orders should be placed in a year?

= Annual requirement / EOQ

= 48,000 units / 1,200 units
= 40 orders

4. How often should an order be placed?

Frequency of orders = No. of days in one year / No. of orders

= 360 days / 40 orders
= 9 days

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 1.1.2. EMPLOYEE (LABOUR) COST

Employee (Labor) cost: Benefits paid or payable to the employees of an entity,

whether permanent or temporary for the services rendered by them. Employee cost
includes payments made in cash or kind. Employee cost includes the following:

(i) Wages and salary;

(ii) Allowances and incentives;
(iii) Payment for overtimes;
(iv) Employer’s contribution to Provident fund and other welfare funds;
(v) Other benefits (leave with pay, free or subsidized food, leave travel concession
etc.) etc.
Classification of Employee (Labor) cost: Employee costs are broadly classified as
direct and indirect employee cost.

(a) Direct Employee (Labor) Cost

Benefits paid or payable to the employees, which can be attributed to a cost object
in an economically feasible manner. This can be easily identified and allocated to an
activity, contract, cost centre, customer, process, product etc.

(b) Indirect Employee (Labor) Cost

Benefits paid or payable to the employees, which cannot be directly attributable to
a particular cost object in an economically feasible manner.

Distinction between Direct and Indirect Employee Cost:

Direct employee cost Indirect employee cost

1. It is the cost incurred in payment 1. Cost incurred for payment of

of employees who are directly employee who are not directly

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 engaged in the production Engaged in the production

Process. Process.

2. Direct employee cost can be easily 2. Indirect employee cost is

identified and allocated to cost Apportioned on some

unit. appropriate basis.

3. Direct employee cost varies with 3. Indirect employee cost may not

the volume of production and vary with the volume of

has positive relationship with the production.

volume.

EMPLOYEE (LABOUR) COST CONTROL

Employee costs are associated with human beings. To control employee costs one has
to understand human behavior. Employee cost control means control over the cost
incurred on employees. Control over employee costs does not imply control over the
size of the wage bill; it also does not imply that wages of each employee should be
kept as low as possible.

The aim should be to keep the wages per unit of output as low as possible. This
can only be achieved by giving employees appropriate compensation to encourage
efficiency so that optimum output can be achieved in effective manner.

A well-motivated team of employees can bring about wonders. Each concern should,
therefore, constantly strive to raise the productivity of employee. The efforts for the
control of employee costs should begin from the very beginning. There has to be a
concerted effort by all the concerned departments.

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 Department Functions

1. Personnel Department i) On receipt of employee requisition from the

various departments it searches for the

required skills and qualification.

ii) It ensures that the persons recruited possess

the requisite qualification and skills required

for the job.

iii) Arranges proper training for the newly

recruited employees and workshops for

existing employees.

iv) Maintains all personal and job related

records of the employees.

v) Evaluation of performance from time to time

2. Engineering and Work i) Prepares plans and specifications for each

Study Department job.

ii) Providing training and guidance to the

employees.

iii) Supervises production activities.

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 iv) Conducts time and motion studies.

v) Undertakes job analysis.

vi) Conducts job evaluation.

3. Time-keeping i) Concerned with the maintenance of

Department attendance records i.e. time keeping and

ii) Time spent by an employee on various jobs

i.e. time booking etc.

4. Payroll Department i) The preparation of payroll of the employees.

ii) It disburses salary and wage payments.

5. Cost Accounting i) Accumulation and classification of employee

Department costs.

ii) Analysis and allocation of costs to various

cost centres or cost objects

Important Factors for the Control of Employee Cost

To exercise an effective control over the employee costs, the essential requisite is
efficient utilization of employee and allied factors. The main points which need
consideration for controlling employee costs are the following:

(ii) Assessment of manpower (iii) Control over time-keeping and time-

requirements. booking.
(iv) Time & Motion Study.

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(v) Control over idle time and overtime. (viii) Job Evaluation and Merit Rating.
(vi) Control over employee turnover. (ix) Employee productivity.
(vii) Wage and Incentive systems.

Collection of Employee Costs

The task of collecting employee costs is performed by the cost accounting department
which record separately wages paid to direct and indirect employee. It is the duty of
this department to ascertain the effective wages per hour in each department and to
analyze the total payment of wages of each department into:

1. The amount included in the direct cost of goods produced or jobs completed;
2. The amount treated as indirect employee and thus included in overheads; and
3. The amount treated as the cost of idle time and hence loss.
4. The amount treated as abnormal loss/ gain and to be transferred to profit and
loss account.
Through this process costs of various jobs are ascertained. Naturally, in this the
proper recording of time spent by the employees is essential.

Illustration: assume ‘X’ an employee of ABC Co. gets the following emoluments
and benefits:

(a) Basic pay 10,000

(b) Position allowance 2,000
(c) Bonus 20% of salary and P.A.
(d) Other allowances 2,500
(e) Employer’s contribution to P.F. 10% of salary and P.A

‘X’ works for 2,400 hours per annum, out of which 400 hours are non-productive and
treated as normal idle time. You are required to COMPUTE the effective hourly cost
of employee ‘X’.

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 Per month (`) Per annum (`)

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 (A) Earning of Employee ‘X’:

Basic pay 10,000 120,000

Position Allowance 2,000 24,000

Bonus 2,400 28,800

Employer’s contribution to provident fund 1,200 14,400

Other allowances 2,500 30,000

(A) Total benefits 18,100 2,17,200

(B) Effective working hours (refer workings) 2,000 hours

(C) Effective hourly cost {(A) ÷ (B)} `108.60

Calculation of effective working hours: Annual working hours less Normal idle time
= 2,400 hours – 400 hours = 2,000 hours.

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 1.1.3. Manufacturing overhead cost

Overheads are the expenditure which cannot be conveniently traced to or identified with any
particular cost unit. Such expenses are incurred for output generally and not for a particular work
order e.g., wages paid to watch and ward staff, heating and lighting expenses of factory etc.
Overheads are also very important cost element along with direct materials and direct employees.
Often in a manufacturing concern, overheads exceed direct wages or direct materials and at times
even both put together. On this account, it would be a grave mistake to ignore overheads either
for the purpose of arriving at the cost of a job or a product or for controlling total expenditure.

Overheads are business costs that are related to the day-to-day running of the business. Unlike
operating expenses, overheads cannot be traced to a specific cost unit or business activity.
Instead, they support the overall revenue-generating activities of the business.

Overheads also represent expenses that have been incurred in providing certain ancillary
facilities or services which facilitate or make possible the carrying out of the production process;
by themselves these services are not of any use. For instance, a boiler house produces steam so
that machines may run and, without the generation of steam, production would be seriously
hampered. But if machines do not run or do not require steam, the boiler house would be useless
and the expenses incurred would be a waste.

Manufacturing overhead (MOH) cost is the sum of all the indirect costs which are incurred while
manufacturing a product. It is added to the cost of the final product along with the direct material
and direct labor costs. Usually manufacturing overhead costs include depreciation of equipment,
salary and wages paid to factory personnel and electricity used to operate the equipment.
According to IFRS (international financial reporting standard), manufacturing overhead should
be included in the cost of finished goods inventory and work in progress inventory on a
manufacturer’s balance sheet and in the cost of goods in income statement. Manufacturing
overhead costs are called indirect costs because it’s hard to trace them to each product. These
costs are applied to the final product based on a pre-determined overhead absorption rate.
Overhead absorption rate is the manufacturing overhead costs per unit of the activity (also called
as the cost driver) like labor costs, labor hours and machine hours.
Here are the types of costs that are included in manufacturing overhead.

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15
Indirect labor

Indirect labor is the cost to the company for employees who aren’t directly involved in the
production of the product. For example, the salaries for security guards, janitors, machine
repairmen, plant managers, supervisors, and quality inspectors are all indirect labor costs.
Cost accountants derive the indirect labor cost through activity-based costing, which involves
identifying and assigning costs to overhead activities and then assigning those costs to the
product.

For example, in activity based costing, every employee who is working in the manufacturing
facility but not directly involved in the manufacturing process, keeps a log on the amount of
hours spent on their job and from that the total cost is calculated and then the cost is assigned
to each product being manufactured.

Indirect materials
This cost is incurred for materials which are used in manufacturing but cannot be assigned to any
single product. Indirect material costs are mostly related to consumables like machine lubricants,
light bulbs, and janitorial supplies. Cost accountants spread these costs over the entire inventory,
since it is not possible to track the individual indirect material used. For example, in a
paper factory, the wood pulp used isn’t counted as an indirect material as it is primarily used to
manufacture paper. But the lubricant used to keep the machinery running properly is an indirect
cost incurred during the manufacture of paper.

Utilities
Utilities such as natural gas, electricity, and water are overhead costs that fluctuate with the
quantity of materials being produced. The might increase or decrease depending on the demand
for the product in the market. Since their usage isn’t constant, they’re included as variable
overhead costs. Accountants calculate this cost for the whole facility, and allocate it over the
entire product inventory.

Physical costs
These costs include the physical items which are essential for manufacturing. They usually
include the cost of the property where the manufacturing is taking place and its depreciation,

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 purchasing new machines, repair costs of new machines and other similar costs. Accountants
calculate this cost by either the declining balance method or the straight line method. In the
declining balance method, a constant rate of depreciation is applied to the asset’s book value
every year. The straight line depreciation method is used to distribute the carrying amount of a
fixed asset evenly across its useful life. This method is used when there is no particular pattern to
the asset’s loss of value.

Financial costs
Financial overhead consists of purely financial costs that cannot be avoided or canceled. They
include the property taxes government may charge on your manufacturing unit, audit and legal
fees, and insurance policies. These costs don’t frequently change, and they are allocated across
the entire product inventory.

Fixed, variable and semi-variable overheads

Manufacturing overhead is classified into different parts based on its behavior. Some overhead
costs change with the amount of output produced, while others don’t. This creates three types of
overhead cost based on behavior:

1. Fixed overhead costs: These costs don’t fluctuate based on the manufacturing output.
2. Variable overhead costs: These costs are dependent on the output.
3. Semi-variable overhead costs: These costs are partially variable and partially fixed.
Fixed overhead costs
These overhead costs don’t fluctuate based on increases or decreases in production activity or the
volume of output generated during manufacturing. These overhead costs aren’t influenced by
managerial decisions and are fixed within a specified limit based on previous empirical data.
They include equipment depreciation costs during manufacturing, rent of the facility, land used
for inventory, and depreciation of the facility.

Variable overhead costs

These overhead costs vary in proportion to the volume of output generated. They’re directly
affected by the volume of the output produced or stored. They include shipping expenses,
advertising and marketing costs for the product, and electricity used during manufacturing.

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Semi-variable overhead costs
Semi-variable overhead costs are partially variable and partially fixed in nature. Since they
contain both a fixed and variable component, it doesn’t change directly in proportion to the
manufacturing output. For example, telephone charges, repairs and maintenance of the
equipment etc.

How to calculate manufacturing overhead cost?

You can calculate manufacturing overhead cost either as a total for the entire production facility,
or on a per-unit basis:

Determining total manufacturing overhead cost

To determine your total manufacturing overhead cost, you need to add up all of the overhead
costs for your manufacturing facility. Let’s look at an example: A company made 10,000
bicycles in 2018. Here is the breakdown of overhead expenses incurred at their manufacturing
facility in 2018:

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To calculate the total manufacturing overhead cost, we need to sum up all the indirect costs
involved. So the total manufacturing overhead expenses incurred by the company to produce
10,000 units of cycles is $50,000.

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How to Calculate Overhead Absorption Rate
The amount of indirect costs that are assigned to goods and services is known as overhead
absorption. The indirect costs are not directly traceable. Overhead absorption is required by both
GAAP and IFRS for external financial reporting.

The overhead is attributed to a product or service on the basis of direct labor hours, machine
hours, direct labor cost etc. The overhead absorption rate is calculated to include the overhead in
the cost of production of goods and services. It’s used to define the amount to be debited for
indirect labor, material and other indirect expenses for production to the work in progress.

There are several methods for calculating the absorption rate.

1. Percentage on Direct Material Method

The direct material cost is one of the primary components for product cost. Under this method,
the absorption rate is based on the direct material cost. To calculate this, divide the overheads by
the estimated or actual direct material costs.

Percentage on Direct Material Cost = Overhead / Direct Material Costs x 100

2. Direct Labour Cost Method

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The estimated or actual cost of labor is calculated by dividing overhead by direct wages and
expressed as a percentage.

Direct Labor Percentage = Overhead / Direct Wages x 100

3. Prime Cost Percentage Method

The prime cost is the sum of direct labor and direct material costs of a business. To calculate the
prime cost percentage, divide factory overhead by prime cost.

Prime Cost Percentage = Overheads / Prime Cost x 100

4. Labour Hours Method

The labor hour rate is calculated by dividing the factory overhead by direct labor hours.

The formula is:

Labor Hour Rate = Overheads/ Labor Hours

Machine Hour Rate

Machine hour rate is calculated by dividing the factory overhead by machine hours.

Machine Hour Rate = Overheads/ Machine Hours

5. Sale Price Method

Under this method, budgeted overheads are divided by the sale price of units of production.

Sale Price = Overheads/Sale Price of Production Units

Self test questions

1. How can we control raw material inventories?

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2. How can we determine the labor cost?

3. How can we determine the cost raw materials?

4. How can we determine manufacturing overhead cost?

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