Chapter Two.
Cost Determination:
the costing of resource inputs
2.1. Materials
Accounting for stock(inventory) Movements: When
stock items are added to invoices and credit notes,
you'll see the stock levels and values update
automatically within the stock record.
Accounting records stock movements when stock is
bought and sold. Each stock movement has a type
which records whether stock was added or removed.
Cont------------------------
The accounting for inventory involves determining
the correct unit counts comprising ending
inventory, and then assigning a value to those
units.
The resulting costs are then used to record an
ending inventory value, as well as to calculate the
cost of goods sold for the reporting period.
Determination of optimum purchase
Quantities
The optimal order(purchase) quantity, also called
the economic order quantity, is the most cost-
effective amount of a product to purchase at a
given time. It's an important calculation, because
holding too much stock is expensive.
Not only are you tying up money you could be
using somewhere else, holding surplus stock may
result in unnecessary storage, administrative,
financing and insurance costs.
Cont--------------
Calculate Your Annual Usage:
Annual usage simply means how much of a product
you expect to sell in one year.
You can consult previous years' sales records or, if
you have not yet sold the product for a full year,
take the sales to-date and extend them to get a
projection.
For example, if you have sold 100 units over one
month, you could project 1,200 units sold over one
year.
Cont----------------
Calculate Your Annual Holding Cost Per Unit:
Your total annual holding cost is the amount it costs
you to keep the stock for one year.
The main component of your holding cost will be the
amount you pay to rent and operate storage space.
The only instance in which you should not include
these storage space costs is if you already have
unused space available.
If a space is currently unused, it does not cost you any
extra to fill that space.
Cont.--------------------
If you have taken a loan out to buy the stock, include
the interest you pay on the loan. Also include any
insurance premiums you pay on the stock. Add all
these costs together and divide the answer by your
annual usage to get your annual holding cost per
unit.
For example, imagine you sell 125 basketballs per
year, your storage space costs $2000 per year, you
pay $100 interest per year and a $50 annual
insurance premium. Your total holding cost is $2,150
and your annual holding cost per unit is $17.20.
Cont-----------------
Calculate Your Optimal Order Quantity :The formula
you need to calculate optimal order quantity is: [2 *
(Annual Usage in Units * Setup Cost) / Annual
Carrying Cost per Unit]^(1/2). Substitute each input
with your own figures. For example, imagine your
business sells 125 basketballs per year, your total
setup costs are $10 and your annual holding cost per
unit is $17.2. The equation would be: [2 * (125 * 10) /
17.2]^(1/2). Using this example, your optimal order
quantity for basketballs is 12.06, for an optimal order
quantity of 12 basketballs.
Identification of accounting for Stock
losses
Generally accepted accounting principles
say inventory losses should be dealt with on a firm's
income statement or other financial statements.
Because most losses are small and are normal
occurrences, it is usually sufficient to add the loss to
the cost of goods sold (COGS).
When there is a loss on the sale of a fixed
asset, debit cash for the amount received, debit all
accumulated depreciation, debit the loss on sale of
asset account, and credit the fixed asset.
Conti-----------------
1. The loss of stock should be valued at cost and
not at market price.
2. The closing stock should be valued at cost after
the considering the loss i.e. the closing figure should
be net of loss.
Losses of materials may arise during handling,
storage or during process of manufacture. Such
losses may be classified into two categories, i.e.
normal loss and abnormal loss. Normal loss is that
loss which has necessarily incurred and thus is
unavoidable.
Conti---------------------
Examples of normal losses :
− Loss by evaporation
− Loss due to loading and unloading
− Loss due to breaking the bulk, etc. Normal losses of
material cannot be completely avoided but may be
controlled to a limited extent.
Abnormal loss is that loss which arises due to
inefficiency in operations, mischief, carelessness, etc.
Conti----------------------
Examples –
− Theft or pilferage
− Breakage
− Fire, accident, flood, etc.
− Use of inaccurate instruments
− Improper storage, etc.
Accounting Treatment
As a principle, all normal losses which are
necessarily incurred are treated as a part of the cost
and abnormal losses should not be included in the
cost. In order to absorb normal material losses in
cost, the rates of usable units are inflated so that
such losses are absorbed. Alternatively, normal
material loss is transferred to factory overhead.
However abnormal loss of material are charged to
Costing Profit and Loss account. Materials losses
may arise in the form of waste, scrap, spoilage or
defectives.
2.2. Labor
The difference between direct and indirect labor
Direct labor are those personnel that are directly
engaged in the manufacturing process of an entity.
Indirect labor are all other personnel of an entity who
work across departments but are not directly engaged
in the manufacturing process.
Conti--------------------
Types of labor remuneration Methods
Top 5 Methods of Remunerating Labor
Method # 1. Time or Day Rate System:
Method # 2. Straight Piece Work Rate System:
Method # 3. Time Rate v/s Piece Rate:
Method # 4. Incentives and Profit Sharing:
Method # 5. Bonus System:
Method # 1. Time or Day Rate System:
This is the most common system found in practice.
Under this the worker is paid an hourly, daily, weekly
or monthly rate of wages. Thus, his remuneration
depends upon the number of hours for which he is
employed and not upon the amount of his
production.
Conti------------
2. Straight Piece-Work System
The Straight Piece-Work System is the simplest
incentive method in which the rate per unit of
output is fixed, and the earnings of the worker are
computed by multiplying his total output by the
rate per unit. In other words, a system in which the
worker is paid according to the number of units
produced at a fixed rate per unit during a defined
period of time is called a straight piece-work system.
Here, the earnings of a worker depend directly on
his performance (measured in units).
Conti------------
In the case of a price-rate system, the worker
has to even go without the wages if the
output falls below the defined level of output.
Thus, in order to safeguard the interests of
the workers the straight piece-work system
is modified in one respect, i.e., the time-
rate of a worker is also guaranteed. This
means worker’s earnings are computed by
multiplying the time taken by per unit of time.
3. Time Rate v/s Piece Rate:
Time rate system pays the workers according to the
time spent in the factory. Piece rate system pays the
workers according to the units of output produced.
Time rate system emphasis on better quality of
output.
BASIS OF
DIFFERENCE TIME RATE SYSTEM PIECE RATE SYSTEM
Piece rate system is a
Time rate system is a method of method of wage payment to
wage payment to workers based on workers based on the
time spent by them for the quantity of output they have
MEANING production of output. produced.
Time rate system pays the workers Piece rate system pays the
NATURE OF according to the time spent in the workers according to the
PAYMENT factory. units of output produced.
Piece rate system gives
Time rate system emphasis on better emphasis on larger quantity
EMPHASIS quality of output. of output.
Time rate system does not Piece rate system
discriminate the workers and pays discriminates the workers
DISCRIMINATIO the same wages to efficient and and pays more wages to
N inefficient workers. efficient and skilled workers.
Time rate system requires strict Piece rate system requires
supervision to get required quantity strict supervision to get the
SUPERVISION of output. required quality output.
DETERMINATIO Piece rate system helps to fix
Time rate system helps maintain a Piece rate system does not
uniform flow of production and bring uniformity in the flow of
FLOW OF ensures an efficient use of production and causes an
PRODUCTION materials, tools and equipments. excessive wastage of inputs.
There is possibility of excessive There is a less chance of idle
IDLE TIME idle time. time in this system.
There is lack of incentive for It motivates the workers to
INCENTIVE efficient workers. produce more and earn more.
Control and Supervision is needed
CONTROL AND as the workers may not work Control and supervision are
SUPERVISION properly. comparatively less required.
Under this system, generally the Under this system, generally
STABILITY OF JOB employment is stable. the employment is unstable.
This method is suitable for the This method is suitable for
SUITABILITY workers who are slow. the workers who are fast.
CERTAINTY OF Under this system, the
AMOUNT OF Under this system, the amount of amount of wages is not
WAGES wages is certain. certain.
Under this system, the
Under this system, the workers workers want to take less
LEAVE want to take more and more leave. leave.
LABOR UNION’S The labor union supports this The labor union does not
4. Profit sharing refers to various incentive plans:
introduced by businesses that provide direct or
indirect payments to employees that depend on
company's profitability in addition to employees'
regular salary and bonuses.
5. A bonus structure: is an employee incentive
program. These plans include rewards or incentives
beyond an employee's salary. They are a perk and
are conditional based on metrics being met or a
goal being complete. Each company's bonus
structure setup might look different depending on
its type and size.
2.3. Overheads
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.
Overhead may be defined as the cost of indirect
material, indirect labour and such other
expenses, including services, as cannot be
conveniently charged direct to specific cost
centres or cost units. It should be noted that
direct costs(materials, labour, etc.) are
associated with individual jobs or products.
Indirect expenses or overheads are not
associated with individual jobs or products; they
represent the cost of the facilities required for
carrying on the operations.
CIMA, London defines overhead as “Expenditure
on labour, materials or services which can not be
economically identified with a specific saleable
cost unit”.
In modern industrial undertakings, overheads are
a very large proportion of the total cost and,
therefore, good deal of attention has to be paid to
them. It will be a big mistake to pay attention only
to direct cost.
Overhead Cost Analysis
Generally overheads are classified on the following
basis:
(1) Functional analysis
(2) Behavioral analysis
1. Functional Analysis
Overheads can be divided into the following
categories on functional basis:
(a) Manufacturing or production or factory
overheads: Manufacturing overheads includes all
indirect costs
(indirect material, indirect labour and indirect
expenses) incurred for operation of manufacturing or
production division in a factory. It is also known as,
factory overheads, works overheads, factory cost or
works cost etc.
(b) Administration overheads: It is the sum of those
costs of general management, secretarial, accounting
and administrative services, which cannot be directly
related to the production, marketing, research or
development functions of the enterprise.
C. Selling and distribution overheads: Selling
overheads is the cost of seeking to create and
stimulate demand and of securing orders. It comprises
the cost to products of distributors for
soliciting and recurring orders for the articles or
commodities dealt in and of efforts to find and retain
customers. Distribution overhead is the expenditure
incurred in the process which begins with making the
packed product available for dispatch and ends with
the making the reconditioned returned empty
package, if any, available for re-use. It includes
expenditure incurred in transporting articles to central
or local storage.
(d) Research and development overheads:
Research overhead is incurred for the new
product, new process of manufacturing any
product. The development overhead is incurred
for putting research result on commercial basis.
2. Behavioural Classification
Based on the behavioual patterns, overheads can
be classified into the following categories:
(i) Fixed overheads
(ii) Variable overheads
(iii) Semi-variable overheads.
Fixed Overheads: Fixed overheads expenses are
those which remain fixed in total amount with
increases or decreases in volume of output or
productive activity for a particular period of time,
e.g. managerial remuneration, rent of building,
insurance of building, plant etc.
Variable Overheads: Variable overhead costs are
those costs which vary in total in direct proportion
to the volume of output. For instance, if the output
increases by 5%, the variable expenses also
increase by 5%. Correspondingly, on a decline of
the output it will also decline proportionately
Semi-variable Overheads/ Step Cost: These
overhead costs are partly fixed and partly variable.
They are known as semi-variable overheads because
they contain both fixed and variable element. Semi-
variable overheads do not fluctuate in direct
proportion to volume. Semi-variable expenses
usually have two parts—one fixed and other
variable. They are also called Step Costs It may
remain fixed within a certain activity level, but
once that level is exceeded, they vary without
having direct relationship with volume changes.
Methods of Segregating semi-variable costs into
fixed and variable costs :
Separation of semi-variable cost into fixed and
variable can be done by applying any of the
following methods:
(i) Graphical Presentation Method
(ii) Least square method
(iii) High and low points method
(iv) Analytical method
(v) Comparison by period or level of activity
method
(i) Graphical Presentation Method: Under this
method, a good number of observations in respect
of the total costs at different levels of activity or
output are plotted on a graph with the output on
the X-axis and their corresponding costs on the Y-
axis. Then by judgment a line of ‘best fit’ which
passes through all or most of the points is drawn.
Points falling far behind the line are erratic and are
not considered for this purpose
(ii) Least square method: In this method ‘line of best
fit’ is drawn for a number of observations with the
help of statistical method. This method uses the linear
equation y=mx+c, where ‘m’ represents the variable
element of cost per unit, ‘c’ represents the total fixed
cost, ‘y’ represents the total cost and ‘x’ represents
the volume of output
(iii) High and low points method: Under this method
the output at two different levels i.e. high or low
point is compared with the amount of expenses
incurred at these different periods.
(iv) Analytical method: Under this method, the
degree of variability is estimated for each item of
semivariable expenses. For instance, some semi-
variable expenses may have 20% variability while
others may vary to the extent of 70%.
(v) Comparison by period or level of activity
method: Under this method output and expenses at
two levels are compared. Fixed overhead remain
fixed and variable overhead can be obtained by the
following formula:
Change in the amount of expenses
Change in activity or quantity
ALLOCATION AND APPORTIONMENT OF
OVERHEADS (DEPART-MENTALISATION OF
OVERHEADS)
Most of the manufacturing process functionally are
different and performed by different departments in
a factory. Where such a division of functions has
been made, some of the departments would be
engaged in actual production of goods while others
in providing services ancillary thereto.
For the efficient working, a factory is divided into a
number of sub-divisions. Such sub-divisions are
referred to as departments.
The departments in a factory can be broadly categorised into
the following types:
(i) Producing or manufacturing departments: A
manufacturing or producing department is one in which
manual/machine operations and other process of
production of articles or commodities take place. The
number of such departments will depend upon nature of
industry, type of work performed and the size of factory.
(ii) Service departments: These departments are not directly
engaged in production but they render special type of service
for the benefit of other departments.
(iii) Partly producing departments: In every organisation a
few departments such that it is not possible to place these
departments into a particular category, since they fall within
the purview of both categories, i.e. producing and service
Dept. departments.
ALLOCATION OF OVERHEADS
After having collected the overheads under proper standing
order numbers the next step is to arrive at the amount for
each department or cost centre. This may be through
allocation or absorption. According to the Chartered
Institute of Management Accountants, London, cost
allocation is “that part of cost attribution which charges a
specific cost to a cost centre or cost unit”. Thus, the wages
paid to maintenance workers as obtained from wages
analysis book can be allocated directly to maintenance
service cost centre. Similarly indirect material cost can also
be allocated to different cost centres according to use by
pricing stores requisitions.
APPORTIONMENT OF OVERHEADS
Apportionment refers to the distribution of overheads among
departments or cost centres on an equitable basis. In other
words, apportionment involves charging a share of the
overheads to a cost centre or cost unit.
CIMA, London has defined it as “that part of cost attribution
which shares costs among two or more cost centres or cost
units in proportion to the estimated benefit received, using a
proxy”. Apportionment is done in case of those overhead
items which cannot be wholly allocated to a particular
department. For example, the salary paid to the works
manager of the factory, factory rent, general manager’s salary
etc. cannot be charged wholly to a particular department or
cost centre, but will have to be charged to all departments or
cost centres on an equitable basis.
ABSORPTION OF OVERHEADS
Absorption of overheads refers to charging of
overheads to individual products or jobs. The
overhead expenses pertaining to a cost centre
are ultimately to be charged to the products,
jobs etc. which pass through that cost centre.
For the purpose of absorption of overhead to
individual jobs, processes or products,
overheads absorption rates are applied. The
overhead rate of expenses for absorbing them
to production may be estimated on the
following three basis.
(i) The figure of the previous year or period may be
adopted as the overhead rate to be charged on
production in the current year.
(ii) The overhead rate for the year may be
determined on the basis of the estimated expenses
and anticipated volume of production or activity.
(iii) The overhead rate for the year may be
determined on the basis of normal volume of
output or capacity of the business.
Actual and pre-determined overhead rate: The
overhead absorption rate may be computed either
based on actual cost or on the basis of estimated
cost:
Actual Overhead Rate
This is also known as historical overhead rate. This rate is
obtained by dividing the overhead expenses incurred during
the accounting period by the actual quantum (quantity/value)
of the base selected. This rate is determined as follows:
Actual overhead rate = Actual overhead for the period
Actual quantity or value of the base for the period
Pre-determined Overhead Rate
Pre-determined overhead rate is determined in advance of
the actual production and is computed by dividing
the budgeted overhead expenses for the accounting period by
the budgeted base for the period i.e.
Pre-determined overhead rate =Budgeted overheadfor period
Budgeted base for the period
Blanket and Multiple Overhead Rates
Blanket overhead rate refers to the use of one single or
general overhead rate for the whole factory. The blanket rate
is used in those factories :
(a) Where only one major product in continuous process is
being produced.
(b) Where several products are produced it can be applied
only if:
(i) all products pass through all departments; and
(ii) all products are processed for the same length of time in
each department.
This rate is calculated as follows: Blanket overhead rate =
Overhead Cost for the entire factory
Base for the period
When different rates are computed for each
producing department, service department, cost
centre, each product or product line, each
production factor, and for fixed overhead and
variable overhead, then they are known as multiple
rates. It is calculated as under:
Overhead rate = OC allocated and apportioned to
each cost centre
Corresponding base
OVER OR UNDER ABSORPTION OF
OVERHEADS
Overhead expenses are usually applied to production on the basis of
predetermined rates. The predetermined rates may represent
estimated, actual or normal costs. In either case, the amount of
expenses actually incurred and the amount of overheads applied to
production will seldom be the same.
Some difference is inevitable. If the actual expenses fall short of the
amount applied, there is said to be an over-absorption of overheads,
and, conversely, if the actual expenses exceed the amount applied to
production, it is a case of under-absorption. Such over or under-
absorption may also be termed as overhead variance, the amount of
over-absorption being represented by the credit balance on the
variance account, and, conversely, the amount of under- absorption
by a debit balance.
Treatment of under-absorption and over-
absorption of overheads
The treatment will depend on the causes that led to
under or over-absorption. The amount ascribable to
abnormal factors should be charged off to costing
profit and loss account, otherwise costs previously
arrived at should be adjusted.
The following are the main methods of disposal of
under or over-absorption of overheads.
Use of supplementary rates
Where the amount of under or over-absorption is
considerable, the cost of jobs or products is adjusted by
means of a supplementary rate. This rate is determined by
dividing the amount of under or over absorption by the base
that was adopted for absorption. This rate may be positive or
negative. The amount of under absorption is set right by a
positive rate while a negative rate is determined for adjusting
over-absorption. The amount of under/over-absorption at the
end of accounting period is adjusted in work-in-progress,
finished stock and cost of sales in proportion to direct labour
hours, or machine hours or the value of the balances in each
of these accounts by use of supplementary rate. The amount
so adjusted will be shown in the balance sheet as deductions
from the work-in progress and finished stock.
Writing off to costing profit and loss
account
Where the difference between actual or absorbed
overheads is not large, the simple method is to
write it off to the costing profit and loss account.
When there is under absorption due to idle
facility, the concerned amount is also written off in
this manner, likewise, when there was wasteful
expenditure due to lack of control also.
Carrying of overheads
The balance of under/over-absorbed overheads at
the end of the year is transferred to an overhead
reserve or suspense account and is carried forward
to the next year account for absorption. This method
is preferably applied when the normal business cycle
is more than one year and in the case of new
projects and schemes when the output is low in the
initial stages of production and can not bear the
entire share of overhead.
IAS 2 inventories on overhead allocations
IAS 2 is an
international financial reporting standard
produced and disseminated by the
International Accounting Standards Board
(IASB) to provide guidance on the valuation
and classification of inventories.
IAS 2 defines inventories as assets which are:
held for sale in the ordinary course of business,
in the process of production for such sale, or
in the form of materials or supplies to be consumed
in the production or rendering of services.
Cont.--------------------------------
IAS 2 requires that those assets that are considered
inventory should be recorded at the lower of cost or
net realisable value. Cost not only includes the
purchase cost but also the conversion costs, which
are the costs involved in bringing inventory to its
present condition and location, such as direct labour.
IAS 2 also allows for the capitalisation of variable
overheads and fixed overheads so long as the fixed
overheads are allocated on a systematic and
consistent basis and in respect to usual output levels.
Where output is lower than expected the resultant excessive
overhead should be considered an expense and not
capitalised but when output is abnormally high the fixed
overhead allocated to each unit must be decreased so as not
to overvalue the inventory.
In the event of there being multiple products produced from
one process, such as a main product and a by-product,
where the costs are not clearly separated, the costs should
be allocated “on a rational and consistent basis”,[1] such as
based on the market value of each unit once the two
products become separate.
IAS 2 does not allow for the capitalisation of:
(a) the cost of abnormal levels of waste,
(b) storage costs where the storage is not part of the
production process,
(c) administrative costs, (d) selling costs.
IAS 2 allows for two methods of costing, the
standard technique and the retail technique. The
standard technique requires that inventory be
valued at the standard cost of each unit; that is,
the usual cost per unit at the normal level of
output and efficiency. The retail technique values
the inventory by taking its sales value and then
reducing it by the relevant gross profit margin.
Where items of inventory are not ordinarily
interchangeable or where certain items are
earmarked for specific projects, these items are
required to have their specific costs identified
and assigned to them individually.
IAS 2 also requires the use of the
First-in, First-out (FIFO) principle whereby those
items which have been in stock the longest are
considered to be the items that are being used
first, ensuring that those items which are held in
inventory at the reporting date are valued at the
most recent price. As an alternative, costs of
inventories may be assigned by using the
weighted average cost formula. The value of
inventories must be recorded at the lower of cost
or net realizable value. Where net realizable
value drops to below the cost of inventory the
loss is to be recognized as an expense in the
period in which the drop of value occurs.
2.4. Recording of costs and schedule of
Costs of products
Product costs may appear in any of three
inventory accounts as well as the cost of goods
sold account. Which accounts are used depends
upon the stage of product production and
whether the product has been sold.
This is most complex for a company that
manufactures the product that it sells. In that
case, the product costs are recorded in the
following accounts as they proceed through the
production process.
Asset Accounts (Balance Sheet)
Raw Materials Inventory Account - Record the cost
of materials not yet put into production. The raw
materials used to produce the product are recorded
here.
Work-in-Process Inventory Account - Record the cost
of products that are in production but not yet
complete. This will include direct materials used,
direct labor invested in production, and
manufacturing overhead.
Finished Goods Inventory Account - Record the costs
of products that are complete and ready to sell.
These are known as Cost of Goods Manufactured.
They include all of the costs that were previously
recorded in the Work-in-Progress Inventory Account.
Expense Account (Income Statement)
Manufacturing companies employ three schedules to
prepare an income statement for a manufacturing
company, in the following order:
Schedule of raw materials placed in production, which
shows cost of direct materials added to work-in-
process inventory and cost of indirect materials added
to manufacturing overhead
Schedule of cost of goods manufactured, which shows
cost of goods completed and transferred out of work-
in-process inventory into finished goods inventory
Schedule of cost of goods sold, which shows cost of goods sold and
transferred out of finished goods inventory into cost of goods sold
Note: Merchandising companies do not use a schedule of raw materials
placed in production or a schedule of cost of goods manufactured, and
they use a merchandise inventory account instead of a finished goods
inventory account. Further, they use the term net purchases instead of
cost of goods manufactured. They often include the schedule of cost of
goods sold in the income statement rather than presenting it separately.
The company will apply the following cost flow equation to determine
the costs in each schedule:
beginning balance (BB) + transfers in (TI) - transfers out (TO) = Ending
balance (EB)
Ultimately, this information will be used to determine the cost of goods
sold amount on the income statement for manufacturing companies.
Note: Merchandising companies do not calculate the raw materials
placed in production or cost of goods manufactured. They purchase
goods for sale. This is a net purchases expense on the income
statement.
End of chapter two