ACCA F2

Management Accounting

Chapter 1

The nature and purpose of management accountingThe nature and purpose ofmanagement accountingData and information.Planning, decision making and control.Responsibility centres.The role of management accounting.Data and informationData and information are different.Data consists of numbers, letters, symbols, raw facts, events and transactions which have been recorded but not yet processed into a form suitable for use.Information is data which has been processed in such a way that it is meaningful to the person who receives it (for making decisions).Good informationThe ACCURATE acronym:A AccurateC CompleteC Cost-effectiveU UnderstandableR RelevantA AccessibleT TimelyE Easy-to-use!Planning, decision making& control

Strategic, tactical and operational planning

Example

Solution

Responsibility CentresAn individual part of the business whose manager has personal responsibility for its performance.Managers to plan & control areas of performance on which they are measured. Responsibility Centre

Cost CentreProfit CentreInvestmentCentreRevenue Centre10Responsibility Centres

Type of cost centre ExamplesService location Stores, canteenFunction Sales representativeActivity Quality controlItem of equipment Packing machine11Responsibility centres - Examples

Practice questionsThe part of an organisation which generates revenues and for which costs are also collected is called:A)A cost centreB )A revenue centreC )A profit centre

2. A support department in an organisation, for which costs are collected, is called:A) A cost centreB )A revenue centreC )A profit centreC and A13Management Accounting vs. Financial AccountingFinancial accountingFinancial accounting is mainly a method ofreporting the results and financial position of a business. It is not primarily concerned with providing information towards the more efficient running of the business.Cost Accounting and Management Accounting

Management Accounting vs. Financial AccountingCost accountingCost accounting is concerned with the following.Preparing statements (e.g. budgets, costing)Cost data collectionApplying costs to inventory, products and servicesCost accounting is part of management accounting.Cost accounting provides a bank of data for the management accountant to use.Management Accounting vs. Financial AccountingManagement AccountingManagement accounting is the process of measuring and reporting information about economic activity within organizations, for use by managers in planning, performance evaluation, and operational control: Planning: For example, deciding what products to make, and where and when to make them.Performance evaluation: Evaluating the profitability of individual products and product lines. Operational control: For example, knowing how much work-in-process is on the factory floor, and at what stages of completion, to assist the line manager in identifying bottlenecks and maintaining a smooth flow of production.

Management Accounting vs. Financial AccountingManagement AccountingFinancial AccountingInformation mainly produced forInternal users, e.g. Managers and employeesExternal users e.g. Shareholders, creditors, lenders, banks, governmentPurpose of informationTo aid planning, control and decision makingTo record financial performance and position in a periodLegal requirementsNoYes (limited companies)FormatsNo set format managers decide on content & presentationLimited companies must produce financial accountsNature of informationFinancial & non-financialMostly financialTime periodHistorical & forward-lookingMainly an historical recordChapter Summary

Chapter 2

Types of cost and cost behaviour20Slide 21Slide 21The total cost of making a product or providing a service consists of the following:Cost of materialsCost of wages and salaries (labour costs)Cost of other expenses (rent, depreciation, electricity bills)Total product/service costs Slide 22Slide 22Direct and indirect costs A direct cost is a cost that can be traced in full to the product, service or department that is being costed Direct costs are made up of direct materials, direct labour and direct expenses An indirect cost is a cost which cannot be traced directly to the product, service or department. Indirect costs are also known as overheads Examples are indirect materials, indirect labour, indirect expenses, administration overhead, selling/distribution overhead

Direct Costs-Direct materialDirect material is all material becoming part of the product (unless used in negligible amounts and/or having negligible cost).Examples of direct material are as follows.(a) Wood in the production of a table or fabric in a shirt.(b) Primary packing materials like cartons and boxes.

Direct Costs-Direct labourDirect wages are all wages paid for labour (either as basic hours or as overtime) expended on work on the product itself.Examples are as follows.(a) Workers engaged in altering the condition or composition of the product.(b) Inspectors, analysts and testers specifically required for such production.(c) Foremen, shop clerks and anyone else whose wages are specifically identified.

Direct Costs-Direct expenseDirect expenses are any expenses which are incurred on a specific product other than direct material cost and direct wagesDirect expenses are charged to the product as part of the prime cost. Examples of direct expenses are as follows.The hire of tools or equipment for a particular jobMaintenance costs of tools, fixtures and so on, Royalty on production, Import duty, Excise duty Total direct costs are known as prime cost

Indirect costs An indirect cost is a cost which cannot be traced directly to the product, service or department. Indirect costs are also known as overheads Examples are indirect materials, indirect labour, indirect expenses, administration overhead, selling & distribution overhead

Indirect costsIndirect materials which cannot be traced in the finished product. e.g. material used in negligible amountsIndirect wages, meaning all wages not charged directly to a product. e.g. Wages of non-productive personnel in the production department e.g. supervisorsIndirect expenses (other than material and labour) not charged directly to production, e.g. Rent, rates and insurance of a factory, depreciation, fuel, power, maintenance of plant, machinery and buildings

Example Suppose that a furniture maker is determining the cost of a wooden table. The manufacture of the table has involved the use of timber, screws and metal drawer handles. These items are classified as direct materials .The wages paid to the machine operator, assembler and finisher in actually making the table would be classified as direct labour costs . The designer of the table may be entitled to a royalty payment for each table made, and this would be classified as a direct expense .Example Cont Other costs incurred would be classified as indirect costs . They cannot be directly attributed to a particular cost unit, although it is clear that they have been incurred in the production of the table. Examples of indirect production costs are as follows:Cost incurred Cost classification Lubricating oils and cleaning materials Indirect material Salaries of supervisory labour Indirect labour Factory rent and power Indirect expense

Direct and Indirect costsDirect costs : costs which can be directly identified with a specific unit or cost centreTotal of direct costs = Direct Materials + Direct labour + Direct expenses =Prime CostIndirect costs : costs which can not be directly identified with a specific unit or cost centreIndirect costs = Indirect Materials + Indirect labour + Indirect expenses =Overheads30Slide 31Slide 31Functional costs Costs can also be classified according to their function (a) Production or manufacturing costs. These are costs associated with the factory. Cost of oils used to lubricate production machinery, Protective clothing for machine operatives, Depreciation of factory plant and equipment, Salary of security guard in raw material warehouse(b) Administration costs. These are costs associated with general office departments. Salary of the secretary to the finance director, Cost of typewriter ribbons in the general office(c) Marketing, or selling and distribution costs. These are costs associated with sales, marketing, warehousing and transport departments. Fees to advertising agency, Motor vehicle licenses for lorries Classification in this way is known as classification by function. Expenses that do not fall fully into one of these classifications might be categorized as general overheads or even listed as a classification on their own (for example research and development costs).

Slide 32Slide 32Fixed and Variable Costs A fixed cost is a cost which is unaffected by changes in the level of activitySuch as rent of a building, business rates, salary of a directorA variable cost is a cost which tends to vary with the level of activitySuch as direct materials, direct labour, sales commissionCosts may also be semi-fixed or semi-variableSuch as an telephone bill which has a fixed standing charge and a variable cost per calls made Cost Behaviour variable costThe way in which costs vary at different levels of activityA cost that varies with the level of activity, e.g. Material cost

Cost behaviour Fixed CostsA cost that, within certain output and sales revenue limits, is unaffected by changes in the level of activity.

Cost behaviour Fixed CostsStepped Fixed Costs : A fixed cost which is only fixed within a certain level of activity. Once the upper level is reached, a new level of fixed costs becomes relevant. Warehouse costs(as more space is required, more warehouse must be purchased or rented). (a) Rent is a step cost in situations where accommodation requirements increase as output levels get higher.(b) Basic pay of employees is nowadays usually fixed, but as output rises, more employees (direct workers, supervisors, managers and so on) are required.(c) Royalties.

Cost behaviour Semi variable costsA cost with a fixed and a variable element, e.g. telephone charges with fixed line rental and charge per call

Cost behaviour Hi-low methodCosts are analysed into variable & fixed elements using the hi-low method.Step1 : Select high and low activity levels and their associated costs.Step 2 :Variable Cost per unit = cost at high level of activity-cost at low level of activity / High level of activity-low level of activityStep 3 : Find fixed cost by substitution using either the high or low activity level

Fixed cost=Total cost at activity level Total variable CostAnalysis of cost into fixed and variable elementsExample Output (units) Total costs ($) 200 7000 300 8000 400 9000Find the variable cost per unitFind the total fixed costEstimate the total cost if output is 350 unitsEstimate the total cost if output is 600 units

Example: The high-low method

DG Co has recorded the following total costs during the last five years.Year Output volume Total cost Units $20X0 65,000 145,00020X1 80,000 162,00020X2 90,000 170,00020X3 60,000 140,00020X4 75,000 160,000RequiredCalculate the total cost that should be expected in 20X5 if output is 85,000 units.High/low method with stepped fixed costs

Sometimes fixed costs are only fixed within certain level of activity and increase in steps as activity increases.The high/low method can still be used to estimate the fixed and variable costs.Adjustments need to be made for the fixed costs based on the activity level under consideration.Example: The high-low method with stepped fixed costsThe following data relate to the overhead expenditure of contract cleaners (for industrial cleaning) at twoactivity levels.Square meters cleaned 12,750 15,100Overheads $73,950 $83,585When more than 14,000 square meters are industrially cleaned, there will be a step up in fixed costs of $4700

Required Calculate the estimated total cost if 14,500 square meters are to be industrially cleaned.

Solution

Before we can compare high output costs with low output costs in the normal way, we must eliminate the part of the high output costs that are due to the step up in fixed costs: Total cost for 15,100 without step up in fixed costs = $83,585 $4,700 = $78,885 We can now proceed in the normal way using the revised cost above.Solution Sq Met $High activity 15,100 Total cost 78,885Low activity 12,750 Total cost 73,950 2,350 4,935Variable cost = $4,935 2,350 = $2.10 per square metreSolutionBefore we can calculate the total cost for 14,500 square metres we need to find the fixed costs. As the fixed costs for 14,500 square metres will include the step up of $4,700 we can use the activity level of 15,100 square metres for the fixed cost calculation: $Total cost (15,100 square metres) (this includes the step up in fixed costs) 83,585Total variable costs (15,100 x $2.10) 31,710Total fixed costs 51,875SolutionEstimated overhead expenditure if 14,500 square metres are to be industrially cleaned: $ Fixed costs 51,875Variable costs (14,500 X$2.10) 30,450 82,325High Low method with changes in the variable cost per unitSame data as the previous question.Additionally, a round of wage negotiations have just taken place which will cost an additional $1 per square metre. High Low method with changes in the variable cost per unitEstimated overheads to clean 14,500 square metres. Per square metre $Variable cost 2.10Additional variable cost 1.00Total variable cost 3.10

Cost for 14,500 square metres: $Fixed 51,875Variable costs (14,500 X $3.10) 44,950 96,825 ExampleAn organization has the following total costs at two activity levels:

Activity levels (units) 16,000 22,000Total costs ($) 135,000 170,000 Variable cost per unit is constant within this range of activity but there is a step up of $5,000 in the total fixed costs when the activity exceeds 17,500 units.

What is the total cost at an activity of 20,000 units? ,Variable cost pu = $5Total cost = $160,00048

Equation for the total cost function

Cost equations are derived from historical cost data. Once a cost equation has been established (using methods such as the high/low method which will be revised later in the course) it can be used to estimate future costs. In the exam, cost functions will be linear y = a + bx a is the fixed cost per period (the intercept) b is the variable cost per unit (the gradient) x is the activity level (the independent variable) y is the total cost = fixed cost + variable cost (the dependent variable).

Equation for the total cost function

Question 1: Total Cost FunctionsIf y = 8,000 + 40x

Please find the followings:(a) Fixed cost (b) Variable cost per unit(c) Total cost for 200 unitsQuestion 2: Total Cost FunctionsIf the total cost of a product is given as:Y = 4,800 + 8x

(a) The fixed cost is ?(b) The variable cost per unit is ?(b) The total cost of producing 100 units is ?Question 3: Total Cost FunctionsConsider the linear function y = 1,488 + 20x and answer the following questions.(a) The line would cross the y axis at thepoint(b) The gradient of the line is(c) The independent variable is(d) The dependent variable is(a) The line would cross the y axisat the point1,448(b) The gradient of the line is 20(c) The independent variable is x(d) The dependent variable is y53Question 4: Total Cost FunctionFixed costs $100,000.Variable costs per unit $5 for volumes up to 1,000 units.Volumes above 1,000 units receive 5% discount on all units.Required:Derive the two equations for the total cost function.Y = 100,000 + 5x for x1000Y = 100,000 + 4.75x for x>1000.54Cost UnitsA unit of product or service in relation to which costs are ascertained .Cost units can be developed for all kinds of organizations, whether manufacturing, commercial or public-service based. Industry sector Cost unitBrick-making 1,000 bricksElectricity Kilowatt-hourProfessional services Chargeable hourEducation Enrolled student Activity Cost unitCredit control Account maintainedSelling Customer callCost Object A cost object is often a product or department for which costs are accumulated or measured. For example, a product is the cost object for direct materials, direct labor and manufacturing overhead. The factory maintenance department is a cost object for the cost of the maintenance employees and the maintenance supplies. Later the factory maintenance department costs will be assigned to products, which are also cost objects.

A cost object can also be a customer, a machine, a group of machines, a group of employees, etc.Cost Card

Chapter 3

Business MathematicsExpected ValuesThe weighted average of a probability distribution, used in simple decision-making situations.EV = px Where p = probability of outcome occurringx = outcome.When using Expected Values :

Only accept projects if EV is positive

With mutually exclusive options, accept the one with the highest EV.Expected Values - Example

Expected Values - LimitationsExpected values :

Use past data and estimates, which may be inaccurate

Are not always suitable for one-off decisions as they are long-term average. The expected value might never occur for any single result

Do not take into account the time value of money

Do not take into account the decision makers attitude to risk.RegressionIf x is the independent variable and y the dependent variable, least squares regression finds the line of best fit through the scatter diagram.

y = a + bxWhere a is the y value when x is 0, and b is the change in y when x increases by one unit.Regression(Given)In the context of cost estimation :

y represents the total costx represents the production volume in unitsa represents the total fixed costsb represents the variable cost per unit

Correlation Coefficient(Given)r measures the strength of a linear relationship between two variables.

If r = 1 perfect positive correlationIf r = 0, no correlationIf r = -1, perfect negative correlation.-1 < r < 1

Correlation does not prove cause and effect it merely suggests it.Coefficient of determinationr shows how much of the variation in the dependent variable is dependent on the variation of the independent variable.E.g. If r = 0.95, r = 0.90 or 90%

This means that 90% of the variation in y (costs) is explained by the variation in x (level of output). Chapter 4

Accounting for MaterialsOrdering and Accounting for InventoryInventory control-Ordering, Receiving and issuing materials

Inventory control-Ordering, Receiving and issuing materials

Inventory control-PaperworkDocumentCompleted bySent toInformation includedPurchase Requisition formProduction departmentPurchasing departmentGoods requiredManagers authorisationPurchase order formPurchasing DepartmentSupplierAccounting (copy)Goods receiving department (copy)Goods requiredDelivery noteSupplierGoods Receiving DepartmentCheck of goods delivered against order form

Goods Received NoteGoods receiving departmentPurchasing departmentVerification of goods received to enable paymentMaterials requisition noteProduction departmentStoresAuthorisation to release goodsUpdate stores recordMaterials returned notesProduction DepartmentStoresDetails of goods returned to storesUpdate stores recordMaterials Transfer notesProduction Department AProduction Department BGoods transferred between departmentsUpdate stores recordsInventory control-Double entry

Slide 71Slide 71Inventory levels can be recorded in a variety of different waysBin cards - shows the level of inventory of an item at a particular stores location and is kept with the inventory Stores ledger accounts shows amounts received, amounts issued, amounts returned and the current balance in quantityFree inventory - what is really available for future useFree inventory is calculated as materials in inventory + materials on order materials requisitioned but not yet issued

Inventory control Slide 72Slide 72Inventory control Perpetual inventory is an inventory recording system where the records are updated for each receipt/issue of inventoryActual quantities of inventory may not agree to records therefore inventory counts requiredPeriodic inventory count - all items counted on specific date, usually the end of the accounting period Continuous inventory count each item counted at least once a year, generally requires a specialised team

Slide 73Slide 73Inventory levels Inventory is held for a number of reasonsTo ensure any unexpected demands can be metTo meet any future shortagesBulk purchasing discounts availableChapter 5

Order Quantities and Reorder LevelsHolding & Ordering CostsMinimise total of holding, ordering and stock-out costsEconomic Order QuantityThe EOQ minimises the total of holding, ordering & stock-out costs2C0DChEOQ = Where : D = demand p.a.C0 = Cost of placing one orderCh = cost of holding one unit per yearTotal Annual Cost = PD + (Co X D/Q)+ (Ch X Q/2)76EOQ

EOQA company uses components at the rate of 500 units per month, which are bought at a cost of $1.20 each from the supplier. It cost $20 each time to place an order, regardless of the quantity border.The total holding cost is 20% per annum of the value of inventory held.Required:How many components company should order and what will be the total annual cost ?

77EOQ with discount: A company uses components at the rate of 500 units per month, which are bought at a cost of $1.20 each from the supplier. It cost $20 each time to place an order, regardless of the quantity border.The supplier offers a 5% discount on the purchase price for order quantities of 2000 units. The current EOQ is 1000 units The total holding cost is 20% per annum of the value of inventory held.Required:Should the discount be accepted?Economic Batch QuantityThe EBQ is primarily concerned with determining the number of items that should be produced in a batch. 2C0DCh(1-D/R)EBQ = Where : Q= Batch sizeD = demand p.a.R=Annual production rateC0 = Cost of setting up a batch ready to be producedCh = cost of holding one unit per year79EBQThe following is relevant to item X:Production at a rate of 500 units per week.Demand is 10,000 units per annum, evenly spread over 50 working weeks.Set up cost is $2,700 per batch. Storage cost is $2.50 per unit for a year.Required:Calculate the economic batch quantity (EBQ) for item X.

SolutionAnnual production rate, R=500 x 50 =25,000 unitsAnnual demand rate = 10,000 unitsCost per setup Co = $2,700Cost of holding one item in inventory per year, Ch = $2.50EBQ = 2 x 2,700 x 10,000 2.5 (1-10,000/25,000) EBQ = 6,000 units

Inventory control levels

Inventory control levels can be calculated in order to maintain inventories at the optimum level. The three critical control levels are reorder level, minimum level and maximum level.Inventory control levels

Reorder level When inventories reach this level, an order should be placed to replenish inventories. The reorder level is determined by consideration of the following.The maximum rate of consumption The maximum lead time The maximum lead time is the time between placing an order with a supplier, and the inventory becoming available for useReorder level = maximum usage x maximum lead timeInventory control levels

Minimum level/Buffer Level This is a warning level to draw management attention to the fact that inventories are approaching a dangerously low level and that stock outs are possible.Minimum level = reorder level (average usage x average lead time)Maximum level This also acts as a warning level to signal to management that inventories are reaching a potentially wasteful level.Maximum level = reorder level + reorder quantity (minimum usage x minimum lead time)Inventory control levelsReorder quantityThis is the quantity of inventory which is to be ordered when inventory reaches the reorder level. If it is set so as to minimize the total costs associated with holding and ordering inventory, then it is known as the economic order quantityQuestion- Maximum inventory level

A large retailer with multiple outlets maintains a central warehouse from which the outlets are supplied.The following information is available for Part Number SF525.Average usage 350 per dayMinimum usage 180 per dayMaximum usage 420 per dayLead time for replenishment 11-15 daysRe-order quantity 6,500 units Based on the data above, what is the re-order level and maximum level of inventory?b) Based on the data above, what is the approximate number of Part Number SF525 carried as buffer inventory?AnswerMaximum inventory level = reorder level + reorder quantity (min usage x min lead time) =6,300 + 6,500 (180 x 11) =10,820units

Buffer inventory = minimum levelMinimum level = reorder level (average usage x average lead time) = 6,300 (350 x 13) = 1,750unitsChapter 6

Accounting for LabourDirect or Indirect Costs?Type of workerdirectly involved in making productsIndirect workers (Maintenance staff, supervisors, Canteen

Direct Labour cost Make up part of prime cost of a product, Basic Pay

Overtime Premium on specific job, at customers requestIndirect Labour cost General O/T premiumsBonus paymentsIdle timeSick payTime spent on indirect jobsIndirect Labour cost ALL COSTSDirect and Indirect Labour Vienna is a direct labour employee who works a standard 35 hours per week and is paid a basic rate of $12 per hour. Overtime is paid at time and a third. In week 8 she worked 42 hours and received a $50 bonus.Please find Basic pay for standard hours (DLC)Basic pay for overtime hours (DLC)Overtime premium (IDLC)Bonus (IDLC)420, 84, 28, 5090ExampleA company operates a factory which employed 40 direct workers throughout the four-week period just ended. Direct employees were paid at $4 per hour for 38 hours week. The total hours of the direct workers in the four- week period were 6,528. Overtime, which is paid at premium of 35%, is worked in order to meet production requirements. Employees deduction total 30% of gross wages. 188 hours of direct workers time were registered as idle.Calculate:Gross Wages, deductions, net wages, direct labour cost and indirect labour cost for the four-week period.

GW-26,739.20, Ded- 8,021.76, NP- 18,717.44, DLC-25,360, ILC-627.20+752=1379.20Productive time =6,528-188= 634091Solution

Solution

Remuneration MethodsTime Based SchemesTotal Wages = (hours worked * basic pay/hour) + (o/t hrs worked * o/t premium/hour)

Higher quality if workers are happy to spend longer on units to get them right; However, no incentive to improve productivity.

Piecework SchemesTotal Wages = Number of units completed * agreed rate per unit.

May involve a guaranteed minimum wage;May use a higher rate per unit once productivity target achievedHigher productivity at the expense of quality?Other Schemes e.g. Flat salary + bonus

Bonus Schemes (individuals or groups)Piecework SchemesA company operates a piecework system of remuneration, but also guarantees its employees 75% of a time-based rate of pay which is based on $19 per hour for an eight hour working day. Three minutes is the standard time allowed per unit of output. Piecework is paid at the rate of $ 18 per standard hour.If an employee produces 200 units in eight hour on a particular day. What is the employee guaranteed wages and gross pay for that day?200 u x 3 min = 600 min = 600/60 = 10 hours 10 h x 18 = $180Guaranteed ($19 x 8) = $152 = $152 x 75% = $114As gross pay exceeds the guaranteed minimum wages, the answer is 180

95Example A company operates a premium bonus scheme for its employees of 50% of the time saved compared with the standard time allowance for a job, at the normal hourly rate. The data relating to job 999 completed by an employee is as follows:Allowed time for the job 999- 12 hoursTime taken to complete job 999 10hoursNormal hourly rate of pay is $15.RequiredWhat is the total pay of the employee for job for 10 hours spent on job 999?

96Remuneration methods - examples

Question Weekly pay

Penny Pincher is paid 50c for each towel she weaves, but she is guaranteed a minimum wage of $60 for a 40 hour week. In a series of four weeks, she makes 100, 120, 140 and 160 towels.RequiredCalculate her pay each week, and the conversion cost per towel if production overhead is added at the rate of $2.50 per direct labour hour.Solution

Labour Turnover

Labour TurnoverAt 1st January a company employed 3,641 employees and at 31 December employees numbers were 3,735. During the year 624 employees choose to leave the company.

What was the labour turnover rate for the year?Labour Related RatiosLabour Efficiency Ratio= Expected hours to make actual output Actual hours takenLabour Capacity Ratio= Actual hours worked Hours budgetedLabour Production Volume Ratio= Expected hours to produce actual output Hours Budgeted

Example: Labour activity ratios

Rush and Fluster Co budgets to make 25,000 standard units of output (in four hours each) during a budget period of 100,000 hours.Actual output during the period was 27,000 units which took 120,000 hours to make.RequiredCalculate the efficiency, capacity and production volume ratios.SolutionEfficiency ratio = (27,000u x 4h) 108,000 x 100 = 90% 120,000hCapacity ratio = 120,000 hours x 100 = 120% 100,000hoursSolutionProduction volume ratio = (27,000u x 4h) 108,000h x 100 = 108% 100,000 The production volume ratio of 108% (more output than budgeted) is explained by the 120% capacity working, offset to a certain extent by the poor efficiency (90% x120% = 108%).Labour Related Ratios

Chapter 7

Accounting for OverheadsAbsorption costingCost Unit xStep1 : O/H allocated or apportioned to cost centres using suitable basesStep 2 : Service cost centres reapportioned to production cost centresStep 3 : Overheads absorbed into units of productionOverheadsOverhead is the cost incurred in the course of making a product, providing a service or running a department, but which cannot be traced directly and in full to the product, service or department.Overhead is actually the total of the followingIndirect materialsIndirect expensesIndirect labourOverheadsThe total of these indirect costs is usually split into the following categories.Production Selling and distributionAdministrationIn cost accounting there are two schools of thought as to the correct method of dealing with overheads.Absorption costing Marginal costing

Absorption costing: an introduction

The objective of absorption costing is to include in the total cost of a product an appropriate share of the organization's total overhead. An appropriate share is generally taken to mean an amount which reflects the amount of time and effort that has gone into producing a unit or completing a job.An organisation with one production department that produces identical units will divide the total overheads among the total units produced. Absorption costing is a method for sharing overheads between different products on a fair basis.Absorption costingA business needs to know the cost per unit of goods and services to value stockto fix a selling priceto analyze profitability

Absorption costingIn principle, the unit cost of material and labour should not be a problem, because they can be measured.Problem?It is overheads that present the real difficulty-in particular fixed overheads.e.g. If the factory cost $100,000 p.a. to rent, then how much should be included in the cost of each unit?

Absorption costingAllocation Allocation is the process by which whole cost items are charged direct to a cost unit or cost centre.Apportionment Apportionment is a procedure whereby indirect costs are spread fairly between cost centers.Overhead absorption Overhead absorption is the process whereby overhead costs allocated and apportioned to production cost centers are added to unit, job or batch costs. Overhead absorption is sometimes called overhead recovery. 114

Example: Overhead allocation

Consider the following costs of a company.Wages of the foreman of department A $200Wages of the foreman of department B $150Indirect materials consumed in department A $50Rent of the premises shared by departments A and B $300The cost accounting system might include three overhead cost centers.Cost centre: 101 Department A102 Department B201 RentOverhead costs would be allocated directly to each cost centre, i.e $200 + $50 to cost centre 101, $150 to cost centre 102 and $300 to cost centre 201. The rent of the factory will be subsequently shared between the two production departments, but for the purpose of day to day cost recording, the rent will first of all be charged in full to a separate cost centre.Absorption costing-Absorption of overheadsExample 1 (One product in a factory)X Plc produce desks.Each desk uses 3kg of wood at a cost of $4 per kg, and takes 4 hours to produce.Labour is paid at the rate of $2 per hour.Fixed costs of production are estimated to be $700,000 p.a..The company expects to produce 50,000 desks P.a.Calculate the cost per desk.`Absorption costing-Absorption of overheadsExample 2(more than one product) X plc produce desk and chairs in the same factory.Each desk uses 3 kg of wood at a cost of $4 per kg and takes 4 hours to produce.Each chair uses 2 kg of wood at a cost of $4 per kg, and takes 1 hour to produce.Labour is paid at the rate of $2 per hour.Fixed cost of production are estimated to be $700,000 p.a..The company expects to produce 30,000 desks and 20,000 chairs p.a..Overheads are absorbed on labour hours basisCalculate cost per unit of desks and chairsBlanket absorption rates and departmental absorption rates

A blanket overhead absorption rate is an absorption rate used throughout a factory and for all jobs and units of output irrespective of the department in which they were produced.Example, if total overheads were $500,000 and there were 250,000 direct machine hours during the period, the blanket overhead rate would be $2 per direct machine hour and all jobs passing through the factory would be charged at that rate.Blanket absorption rates and departmental absorption rates

Blanket overhead rates are not appropriate in the following circumstances. There is more than one department. Jobs do not spend an equal amount of time in each department.Blanket absorption rates and departmental absorption ratesIf a single factory overhead absorption rate is used, some products will receive a higher overhead charge than they ought 'fairly' to bear, whereas other products will be under-charged.If a separate absorption rate is used for each department, charging of overheads will be fair and the full cost of production of items will represent the amount of the effort and resources put into making them.Example: Blanket absorption rates and departmental absorption rates The Old Grammar School has two production departments, for which the following budgeted information is available.

Departments A B TotalBudgeted overheads $360,000 $200,000 $560,000Budgeted direct labour hours 200,000 hrs 40,000 hrs 240,000 hrs

Required: Find a single factory overhead absorption rate and departmental overhead absorption rate?SolutionIf a single factory overhead absorption rate is applied, the blanket rate/factory rate is:$560,000/240,000h = $2.33 per direct labour hour

If separate departmental rates are applied, Dep A=$360,000/200,000h =$1.80 per direct labour hourDep B =$200,000/40,000h = $5 per direct labour hour(Department B has a higher overhead rate of cost per hour worked than department A)

Example-ContNow let us consider two separate jobs.Job X has a prime cost of $100, takes 30 hours in department B and does not involve any work in department A.

Job Y has a prime cost of $100, takes 28 hours in department A and 2 hours in department B.What would be the factory cost of each job, using the following rates of overhead recovery?A single factory rate of overhead recoverySeparate departmental rates of overhead recovery123Example-ContSingle factory rate Job X Job Y $ $Prime cost 100 100Factory overhead (30 x$2.33) 70 70Factory cost 170 170

Example-ContSeparate departmental rates Job X Job Y $ $Prime cost 100 100Factory overhead: department A 0 (28x$1.80) 50.40department B (30 x$5) 150 (2x$5) 10.00Factory cost 250 160.40Example-ContUsing a single factory overhead absorption rate, both jobs would cost the same. However, since job X is done entirely within department B where overhead costs are relatively higher, whereas job Y is done mostly within department A, where overhead costs are relatively lower, it is arguable that job X should cost more than job Y. This will occur if separate departmental overhead recovery rates are used to reflect the work done on each job in each department separately.If all jobs do not spend approximately the same time in each department then, to ensure that all jobs are charged with their fair share of overheads, it is necessary to establish separate overhead rates for each department.More than one department in the factoryIn this situation we need first to allocate and apportion overheads between each department. We can then absorb the overheads in each department separately.Example 3 (more than one department) X plc produces desk and chairs. The factory has two departments, assembly and finishing.Each desk take 3kg of wood at $4 per kg and takes 4 hours to produce-3 hours in assembly and 1 hour in finishing.Each chair uses 2kg of wood at $4 per kg and takes 1 hour to produce-1/2 hour in assembly and in finishing, All labor is paid at the rate of $2 per hour.Fixed cost of production are estimated to be $700,000 pa, of this total , $100,000 is the salary of the supervisors-$60,000 to assembly supervisor and $40,000 to finishing supervisor.The remaining overheads are to be split 40% to assembly and 60% to finishing.The company expect to produce 30,000 desks and 20,000 chairs. Overheads are absorbed on labour hour basis. Calculate the cost per unit for desks and for chairs?Bases of apportionmentOverheadsBasisRent, rates, heating and light, repairs and depreciation of buildings

Floor area occupied by each cost centerDepreciation, insurance of equipmentCost or book value of equipmentPersonnel office, canteen, welfare, wages and cost offices, first aid Number of employees, or labour hours worked in each cost centre Overheads Allocation and Apportionment Example 4X plc, production overheads costs for the period $Factory rent 20,000Factory heat 5,000Processing Dep-Supervisor 15,000Packing Dep-Supervisor 10,000Depreciation of equipment 7,000Factory Canteen expense 18,000Welfare cost of factory employees 5,000

There is also direct labour cost of $20,000. Processing Dep Packing Dep Canteen Cubic space (m) 50,000 25,000 5,000NBV equipment $300,000 $300,000 $100,000No. of employees 50 40 10Allocate and apportion production overheads costs amongst the three departments using a suitable basis.130Reapportionment of service cost centre overheadsExample 5Reapportion the canteen cost in example 4 to the production cost centers.Question- Apportioning service department overheads

Spaced Out Co has two production departments (F and G) and two service departments (Canteen and Maintenance). Total allocated and apportioned general overheads for each department are as follows. F G Canteen Maintenance$1,25000 $80,000 $20,000 $40,000 Canteen and Maintenance perform services for both production departments and Canteen also provides services for Maintenance in the following proportions. F G Canteen Maintenance% of Canteen to 60 25 - 15% of Maintenance to 65 35 - -Required: What would be the total overheads for production department G once the service department costs have been apportioned?100,050132 Fast Inc has two production departments (A and B) and two service departments (maintenance and stores). Details of next years budgeted overheads are shown below. Total ($)Central Heating 19,200Direct labour 8,000General Repair costs 9,600Machinery Depreciation 54,000Rent and rates 38,400Canteen 9,000Machinery insurance 25,000Direct Material 20,000Details of each department are as follows. A B Maintenance Stores TotalFloor area (m2) 6,000 4,000 3,000 2,000 15,000Machinery book value ($000) 48 20 8 4 80Number of employees 50 40 20 10 120Allocated overheads ($000) 15 20 12 5 52.133Service departments services were used as follows. A B Maintenance Stores TotalMaintenance hours worked 5,000 4,000 ---- 1,000 10,000Number of stores requisitions 3,000 1,000 ---- ---- 4,000Requireda) Allocate and apportion production overheads costs amongst the four departments using a suitable basis and reapportion the service department cost to production departments and finds the total overheads of production departments. B) In FAST incorporation there are two production departments A and B. Both departments are machine intensive. Department A use 10,000 machine hours and department B uses 12,000 machine hours. Find OAR for department A and B? 78,030 40,670 22,840 13,660

$127,058, $80,142134Example: The basics of absorption Athena Co makes two products, the Greek and the Roman. Greeks take 2 labour hours each to make and Romans take 5 labour hours. Athena Co estimates that the total overhead will be $50,000. Athena Co estimates that a total of 100,000 direct labour hours will be workedRequired: What is the overhead cost per unit for Greeks and Romans respectively if overheads are absorbed on the basis of labour hours?

135Example 7X plc produces one product-deskEach desk is budgeted to require 4 kg of wood at $3 per kg, 4 hours of labour at $2 per hour, and variable production overheads of $5 per unit.Fixed production overheads are budgeted at $20,000 per month and average production is estimated to be 10,000 units per month.The selling price is fixed at $35 per unit.There is also a variable selling cost of $1 per unit and fixed selling cost of $2000 per month.During the first two months X plc expects the following level of activity January FebruaryProduction 11,000 units 9,500 unitsSales 9,000 units 11,500 units

a) Prepare a cost card using absorption costing?b) Set out budgeted profit statement for the month of Jan and Feb?$27 puStandard GP $72,000 92,000Actual GP $74,000 91,000NP $63,000 $77,500136Over and under absorption of overheadsThe rate of overhead absorption is based on estimates (of both numerator and denominator) and it is a quite likely that either one or both of the estimates will not agree with what actually occurs. Reasons of under-/over absorbed overheads The overhead absorption rate is predetermined from budgeted estimates of overhead cost and the expected volume of activity. Under or over recovery of overhead will occur in the following circumstances Actual overhead costs are different from budgeted overheads.The actual activity level is different from the budgeted activity level.Both actual overhead costs and actual activity level are different from budget.

Hourly absorption rateY plc budgets on working 80,000 hours per month and having fixed overheads of $320, 000. During April, the actual hours worked are 78,000 and the actual fixed overheads are $315,000.

Calculate:a) the overhead absorption rate per hour.b) the amount of any over or under absorption of fixed overheads in April.

139Marginal CostingVariable production costs are included in cost per unit(i.e. treated as a product cost). Many businesses only want to know the variable cost of the units they make, as fixed costs treated as period cost. The variable cost is the extra cost each time a unit is made, fixed cost being effectively incurred before any production is started. Fixed costs are deducted as a period cost in the profit statement Variable production cost of a unit is made up of $Direct material XDirect Labour XVariable production OH XMarginal Cost of a Unit XContributionIt is the difference between selling price and all variable costs, including non-production variable costs.140Example 8X plc produces one product-deskEach desk is budgeted to require 4 kg of wood at $3 per kg, 4 hours of labour at $2 per hour, and variable production overheads of $5 per unit.Fixed production overheads are budgeted at $20,000 per month and average production is estimated to be 10,000 units per month.The selling price is fixed at $35 per unit.There is also a variable selling cost of $1 per unit and fixed selling cost of $2000 per month.During the first two months X plc expects the following level of activity January FebruaryProduction 11,000 units 9,500 unitsSales 9,000 units 11,500 units

a) Prepare a cost card using marginal costing?b) Set out profit statement for the month of Jan and Feb?Contribution 81,000 103,500Profit 59,000 81,500141A company commenced business on 1st March making one product only, the cost card of which is as follows $Direct labour 5Direct material 8Variable production overheads 2Fixed production overheads 5 20Fixed production overheads figure has been calculated on the basis of a budgeted normal output of 36,000 units per annum. The fixed production overhead incurred in March was $18,000 each month.Selling, distribution and admin expenses are Fixed $10,000 per monthVariable 15% of the sales valueThe selling price per unit is $35 and units produced and sold were:Production in March 2000 unitsSales in March 1500 units Prepare the absorption costing and marginal costing income statement for March.

Example: Marginal and absorption costing compared

Big Woof Co manufactures a single product, the Bark, details of which are as follows. Per unit $Selling price 180.00Direct materials 40.00Direct labour 16.00Variable overheads 10.00Annual fixed production overheads are budgeted to be $1.6 million and Big Woof expects to produce 1,280,000 units of the Bark each year. Overheads are absorbed on a per unit basis. Actual overheads are $1.6 million for the year.Budgeted fixed selling costs are $320,000 per quarter.Actual sales and production units for the first quarter of 20X8 are given below.January MarchSales 240,000Production 280,000There is no opening inventory at the beginning of January.Prepare income statements for the quarter, using(a) Marginal costing(b) Absorption costingAbsorption costingStep1 : Allocation is the charging of overheads directly to specific departments where they can be identified directly with a cost centre or cost unit.Apportionment is the sharing of overheads which relate to one department between those departments on a fair basis.Step 2 : Service department costs need to be reapportioned to the production departments, using a suitable basis linked to usage of the service.Step 3 : Costs within production cost centres are charged to a cost unit, using Overhead absorption rates (OAR) based on : Labour or machine hours% of direct labour cost....OAR = Budgeted overheads / Budgeted level of activityRe-apportionment

Over- or under-absorption of overheadsOverheads Absorbed = Actual labour hours * OAR per labour hourActual Overheads IncurredOverhead under- or over-absorbedActual overheads different from budgetActual activity level different from budgetLedger AccountingChapter 8

Marginal and Total Absorption CostContributionAbsorption & marginal costing and profitsABSORPTION COSTINGMARGINAL COSTINGValuing unitsTotal production costMarginal (variable) production costValuing inventoryOpening and closing stock valued at total production costOS and CS valued at marginal costFixed production overheadsCarried forward from one period to the next as part of the closing / opening stock valuation. Only hit profit when units are sold.FC charged in full against profit in the period in which they are incurredAdjusting for over- or under-absorptionYes in the income statementNone neededImpact of increase in inventory levelsGives higher profitGives lower profitImpact of decrease in inventory levelsGives lower profitGives higher profitInventory level constantSame profit under both systemsProfit Statements****ReconciliationMARGINAL COSTING PROFITIncrease in inventory * Fixed OARASORPTION COSTING PROFITAbsorption Vs Marginal

Breakeven or CVP AnalysisBreakeven or CVP AnalysisCost-volume-profit(CVP)/Breakeven analysis is study of the effects on future profit of changes in fixed cost, variable cost, sales price, quantity and mix .CVP analysis is a particular example of what if? analysis. A business sets a budget based upon various assumptions about revenues, costs, product mixes and overall volumes. 155Breakeven PointThe breakeven point which is the activity level at which neither profit nor loss.

Breakeven Point = Total Fixed Cost (in terms of number of units sold) Contribution per unit

Breakeven Point = Total Fixed Cost (in terms of sales revenue) C/S Ratio

Example The following information relates to product X $Selling price per unit 20Variable cost per unit 12Fixed cost 100,000Required:

a) Calculate the breakeven point in terms of number of units soldb) Calculate the breakeven point in terms of sales revenue.

C/S ratio/PV ratio/Contribution margin ratio

C/S ratio= Contribution PU = Total Contribution Selling price PU Total sales revenueExampleThe following information relate to product B. $Selling price per unit 20Variable cost per unit 12Fixed cost 100,000

Calculate the contribution to sales ratio.Margin of safety and target profitsThe margin of safety is the difference in units between the budgeted sales volume and the breakeven sales volume. It is sometime expressed as a percentage of the budgeted sales volume.It may also be expressed as the difference between the budgeted sales revenue and breakeven sales revenue expressed as a percentage of the budgeted sales revenue.

Margin of safety = Budgeted Sales Breakeven point sales (in terms of no. of units)

Margin of safety = Budgeted Sales Breakeven sales Budgeted Sales (as a % of budgeted sales)It means that at the current level of sales and with the company's current prices and cost structure, a reduction in sales of 3500, or 21.8%, would result in just breaking even.

159Example The following information relates to product X $Selling price per unit 20Variable cost per unit 12Fixed cost 100,000Budgeted sales for the period are 16,000 units.

Required:a) Calculate the margin of safety in terms of units.

b) Calculate the margin of safety as a % of budgeted sales.Target profitSometime an organization might wish to know how many units of a product it needs to sell in order to earn a certain level of profit or target profit.

Sales volume to = (fixed cost + required profit)achieve a target profit contribution per unit

Example Arrow ltd manufactures product A and wishes to achieve a profit of $20,000, the following information relate to product A $Selling price per unit 20Variable cost per unit 12Fixed cost 100,000Budgeted sales for the period are 16,000 units.

Required:Calculate the sales volume required to achieve a profit of $20,000.

Example the following information relate to product A $Selling price per unit 100Variable cost per unit 56Fixed cost 220,000Budgeted sales are 7,500 units.Required:a)Calculate the C/S ratio.b) Calculate the breakeven point in terms of units sold.c) Calculate the breakeven point in terms of sales revenue.d) Calculate the unit sales required to achieve the target profit of $550,000.e) Calculate the margin of safety (expressed as a percentage of budgeted sales).

Breakeven ChartThe Breakeven point can also be determined graphically using a breakeven chart.

The breakeven chart plots total costs and total revenues at different levels of output.

A breakeven chart has the following axis A horizontal axis showing the budgeted/actual sales/output (in terms of units)A vertical axis showing $ for sales revenues and costs

Drawing a breakeven chartThe breakeven chart is constructed as follows 1) Plot the fixed cost line as a straight line parallel to the horizontal axis. 2) Plot the sales revenue line from the origin. 3) the total cost line is represented by fixed cost plus variable costs. 4) Note the point at which the breakeven point and margin of safety occurs. 5) Breakeven point is the point where sales revenue is equal to the total costs. 6) Margin of safety is the difference between the breakeven point and the budgeted or actual sales.

Example

A restaurant selling 600 meals at $24. The meals cost $8 each to prepare.The restaurant also pays fixed cost such as rent of $8500 a week.Draw a breakeven chart?

QuantityFixed CostVariable cost $8 eachTotal costRevenue $24 each 0$85000$85000600$8500$4800$13,300$14,400166Breakeven Chart

ExampleThe budgeted annual output of a factory is 120,000 units. The fixed overheads amounts to $40,000 and the variable costs are 50c per unit.The sales price is $1 per unit.

RequiredConstruct a breakeven chart showing the current breakeven point and profit earned up to the present maximum capacity.

Contribution Breakeven ChartA variation on the traditional breakeven chart is the contribution breakeven chart. The main difference between the two charts are as follows,a) The tradition breakeven chart shows the fixed cost line whereas the contribution chart shows the variable cost line.b) Contribution can be read more easily from the contribution breakeven chart than the traditional breakeven chart.Contribution Breakeven Chart

P/ V Chart

Chapter 9

Relevant CostsRelevant Costs173Relevant Cash FlowsRelevant costs are future costs. A decision is about the future and it cannot alter what has been done already. Costs that have been incurred in the past are totally irrelevant to any decision that is being made 'now'. Such costs are past costs or sunk costs.Costs that have been incurred include not only costs that have already been paid, but also costs that have been committed. A committed cost is a future cash flow that will be incurred anyway, regardless of the decision taken now.Relevant Cash FlowsRelevant costs are cash flows. Only cash flow information is required. This means that costs or charges which do not reflect additional cash spending (such as depreciation and notional costs) should be ignored for the purpose of decision-making.Relevant Cash FlowsThe cost associated with one additional unit of production. also called marginal cost.Incremental cost is the overall change that a company experiences by producing one additional unit of good.

Differential costs and opportunity costs

Relevant costs are also differential costs and opportunity costs.Differential cost is the difference in total cost between alternatives.An opportunity cost is the value of the benefit sacrificed when one course of action is chosen in preference to an alternative.For example, if decision option A costs $300 and decision option B costs $360, the differential cost is $60.Example: Differential costs and opportunity costs

Suppose for example that there are three options, A, B and C, only one of which can be chosen. The net profit from each would be $80, $100 and $70 respectively.Since only one option can be selected option B would be chosen because it offers the biggest benefit.Profit from option B 100Less opportunity cost (ie the benefit from the most profitable alternative, A) 80Differential benefit of option B 20The decision to choose option B would not be taken simply because it offers a profit of $100, but because it offers a differential profit of $20 in excess of the next best alternative.

Relevant Cash Flows-Sunk costs-A sunk cost is a past cost which is not directly relevant in decision making.Example:An example of a sunk cost is development costs which have already been incurred. Suppose that a company has spent $250,000 in developing a new service for customers, but the marketing departments most recent findings are that the service might not gain customer acceptance and could be a commercial failure. The decision whether or not to abandon the development of the new service would have to be taken, but the $250,000 spent so far should be ignored by the decision makers because it is a sunk cost.

Relevant Cash FlowsCommitted costA cost which has not yet been paid, but an agreement, such as a purchase order or contract, has been made that the cost will be incurred.Discretionary fixed costs, for example, advertising and research and development costs can be thought of as being controllable because they are incurred as a result of decisions made by management and can be raised or lowered at fairly short notice.

Relevant Cash Flows

181Relevant Cash Flows - Materials

182Relevant Cash Flows - Labour

183Relevant Cash Flows - Labour

184Other Relevant CostsThe Relevant cost of overheads is only that which varies as a direct result of the decision taken.

Fixed AssetsRelevant costs are treated as if related to materialsIf P+M is to be replaced, then relevant cost = current replacement costIf P+M not to be replaced, then relevant cost is higher of :Sales proceeds (if sold)Net cash inflows arising from use of the asset (if not sold).

185Chapter 10

Dealing with Limiting FactorsSingle Limiting factor

A limiting factor is a factor that prevents a company achieving the level of activity it would like to. Scarce resources are where one or more of the manufacturing inputs needed to make a product are in short supply. 187Multiple Limiting factorLinear Programming is the technique used to establish an optimum product mix when there are two more resource constraints.

188Finding the solution Method 1

189Finding the solution Method 2

190Chapter 11

Job. Batch and Process CostingJob Costing

PROFIT can be a mark-up on cost, or a margin (%).Batch CostingPROFIT can be a mark-up on cost, or a margin (%).Introduction to process costing

Process costing It is a costing method used where it is not possible to identify separate units of production, or jobs, usually because of the continuous nature of the production processes involved. It is common to identify process costing with continuous production such as the following.Oil refining Foods and drinksPaper Chemicals Process costing may also be associated with the continuous production of large volumes of low-cost items, such as cans or tins.Features of process costing

The output of one process becomes the input to the next until the finished product is made in the final process.The continuous nature of production in many processes means that there will usually be closing work in progress which must be valued. In process costing it is not possible to build up cost records of the cost per unit of output or the cost per unit of closing inventory because production in progress is an indistinguishable homogeneous mass.Features of process costing

There is often a loss in process due to spoilage, wastage, evaporation and so on.Output from production may be a single product, but there may also be a by-product (or byproducts) and/or joint products.Framework for dealing with process costing

Process costing is centered around four keysteps. Step 1 Determine output and lossesStep 2 Calculate cost per unit of output, losses and WIPStep 3 Calculate total cost of output, losses and WIPStep 4 Complete accountsFramework for dealing with process costingStep 1 Determine output and losses. This step involves the following.Determining expected outputCalculating normal loss and abnormal loss and gainCalculating equivalent units if there is closing or opening work in progressFramework for dealing with process costingStep 2 Calculate cost per unit of output, losses and WIP. This step involves calculating cost per unit or cost per equivalent unit.Framework for dealing with process costingStep 3 Calculate total cost of output, losses and WIP. In some examples this will be straightforward; however in cases where there is closing and/or opening work-in-progress a statement of evaluation will have to be prepared.Framework for dealing with process costingStep 4 Complete accounts. This step involves the following.Completing the process accountWriting up the other accounts required by the question

Losses in process costing

IntroductionLosses may occur in process. If a certain level of loss is expected, this is known as normal loss. If losses are greater than expected, the extra loss is abnormal loss. If losses are less than expected, the difference is known as abnormal gain.

Losses in process costing

Normal loss is the loss expected during a process. It is not given a cost.Abnormal loss is the extra loss resulting when actual loss is greater than normal or expected loss, and it is given a cost.Abnormal gain is the gain resulting when actual loss is less than the normal or expected loss, and it is given a 'negative cost'.

Losses in process costing

Since normal loss is not given a cost, the cost of producing these units is borne by the 'good' units of output.Abnormal loss and gain units are valued at the same unit rate as 'good' units. Abnormal events do not therefore affect the cost of good production. Their costs are analyzed separately in an abnormal loss or abnormal gain account.

Losses in process costingExample: abnormal losses and gains

Suppose that input to a process is 1,000 units at a cost of $4,500. Normal loss is 10% and there are no opening or closing stocks. Determine the accounting entries for the cost of output and the cost of the lossif actual output were as follows.(a) 860 units (so that actual loss is 140 units)(b) 920 units (so that actual loss is 80 units)SolutionStep 1 Determine output and lossesIf actual output is 860 units and the actual loss is 140 units: UnitsActual loss 140Normal loss (10% of 1,000) 100Abnormal loss 40Step 2 Calculate cost per unit of output and lossesThe cost per unit of output and the cost per unit of abnormal loss are based on expected output. Cost incurred = $4,500 = $ 5 pu Expected output 900 units SolutionStep 3 Calculate total cost of output and lossesNormal loss is not assigned any cost. $Cost of output (860 x$5) 4,300Normal loss 0Abnormal loss (40 x $5) 200 4,500Solution Step 4 Complete accounts PROCESS ACCOUNT Units $ Units $Cost incurred 1,000 4,500 Normal loss 100 0 Output (finished goods a/c) 860 ($5) 4,300 Abnormal loss 40 ($5) 200 1,000 4,500 1,000 4,500Step 1 Determine output and lossesIf actual output is 920 units and the actual loss is 80 units:UnitsActual loss 80Normal loss (10% of 1,000) 100Abnormal gain 20Step 2 Calculate cost per unit of output and lossesThe cost per unit of output and the cost per unit of abnormal gain are based onexpected output.Expected outputCosts incurred=900 units$4,500= $5 per unit(Whether there is abnormal loss or gain does not affect the valuation of units ofoutput. The figure of $5 per unit is exactly the same as in the previous paragraph,when there were 40 units of abnormal loss.)Step 3 Calculate total cost of output and losses$Cost of output (920 $5) 4,600Normal loss 0Abnormal gain (20 $5) (100)4,500Step 4 Complete accountsPROCESS ACCOUNTUnits $ Units $Cost incurred 1,000 4,500 Normal loss 100 0Abnormal gain a/c 20 (x $5) 100 Output 920 (x $5) 4,600(finished goods a/c)1,020 4,600 1,020 4,600208Solution Step 4 Complete accounts ABNORMAL LOSS ACCOUNT Units $ Units $Process account 40 200 Income statement 40 200 . 40 200 40 200Example: Abnormal losses and gains again

During a four-week period, period 3, costs of input to a process were $29,070. Input was 1,000 units, output was 850 units and normal loss is 10%. During the next period, period 4, costs of input were again $29,070. Input was again 1,000 units, but output was 950 units. There were no units of opening or closing inventory.RequiredPrepare the process account and abnormal loss or gain account for each period.Solution

Step 1 Determine output and lossesPeriod 3 UnitsActual output 850Normal loss (10% x 1000) 100Abnormal loss 50Input 1,000SolutionPeriod 4 UnitsActual output 950Normal loss (10% x 1000) 100Abnormal gain (50)Input 1,000SolutionStep 2 Calculate cost per unit of output and lossesFor each period the cost per unit is based on expected output. = Cost of inputExpected units of output = $29,070/ 900 units = $32.30puSolutionStep 3 Calculate total cost of output and lossesPeriod 3 $ Cost of output (850 x $32.30) 27,455Normal loss 0Abnormal loss (50 x $32.30) 1,615 29,070Period 4 Cost of output (950 x$32.30) 30,685Normal loss 0Abnormal gain (50 x $32.30) 1,615 29,070Solution Step 4 Complete accounts PROCESS ACCOUNTPeriod 3 Units $ Units $Cost incurred 1,000 29,070 Normal loss 100 0 Output (finished goods a/c @$32.30) 850 27,455 Ab Loss @$32.30 50 16,15 1,000 29,070 1,000 29,070215Solution Step 4 Complete accounts PROCESS ACCOUNTPeriod 4 Units $ Units $Cost incurred 1,000 29,070 Normal loss 100 0 Abnormal gain a/c Output (finished @$32.30 50 1,615 goods a/c @$32.30) 950 30,685 Ab Loss @$32.30 1,050 30,685 1,050 30,685216Solution Step 4 Complete accounts ABNORMAL LOSS ACCOUNT Units $ Units $Period 3 Period 4Abnormal loss 50 1,615 Abnormal gain in 50 1,615 in process A/c process A/C . 50 1,615 50 1,615SolutionA nil balance on this account will be carried forward into period 5.If there is a closing balance in the abnormal loss or gain account when the profit for the period is calculated, this balance is taken to the income statement. an abnormal gain will be a credit to the income statement and an abnormal loss will be a debit to the income statement.Losses with scrap value

Scrap is 'Discarded material having some value.'Loss or spoilage may have scrap value.The scrap value of normal loss is usually deducted from the cost of materials.The scrap value of abnormal loss (or abnormal gain) is usually set off against its cost, in an abnormal loss (abnormal gain) account.Losses with scrap valueAs the questions that follow will show, the three steps to remember are these.Step 1 Separate the scrap value of normal loss from the scrap value of abnormal loss or gain.Step 2 In effect, subtract the scrap value of normal loss from the cost of the process, by crediting it to the process account (as a 'value' for normal loss).Step 3 Either subtract the value of abnormal loss scrap from the cost of abnormal loss, by crediting the abnormal loss account.Losses with scrap value 3,000 units of material are input to a process. Process costs are as follows.Material $11,700Conversion costs $6,300Output is 2,000 units. Normal loss is 20% of input.The units of loss could be sold for $1 each.Required: Prepare appropriate accounts.Losses with scrap valueStep 1 Determine output and lossesInput 3,000 unitsNormal loss (20% of 3,000) 600 unitsExpected output 2,400 unitsActual output 2,000 unitsAbnormal loss 400 unitsLosses with scrap valueStep 2 Calculate cost per unit of output and losses $ Scrap value of normal loss 600Scrap value of abnormal loss 400Total scrap (1,000 units x $1) 1,000Cost per expected unit = $(11,700-600)+ $6,300 2,400 = $7.25Losses with scrap valueStep 3 Calculate total cost of output and losses $Output (2,000 x $7.25) 14,500Normal loss (600 x$1) 600Abnormal loss (400 x $7.25) 2,900 18,000Solution Step 4 Complete accounts PROCESS ACCOUNTPeriod 3 Units $ Units $Cost incurred 1,000 29,070 Normal loss 100 0 Output (finished goods a/c @$32.30) 850 27,455 Ab Loss @$32.30 50 16,15 1,000 29,070 1,000 29,070225Solution Step 4 Complete accounts PROCESS ACCOUNTPeriod 4 Units $ Units $Cost incurred 1,000 29,070 Normal loss 100 0 Abnormal gain a/c Output (finished @$32.30 50 1,615 goods a/c @$32.30) 950 30,685 Ab Loss @$32.30 1,050 30,685 1,050 30,685226Process Costing - FeaturesFind a cost per unitValue Closing StockProcess Costing Losses & GainsSteps for answering questionsWIP Equivalent UnitsWIP Equivalent UnitsAVCOFIFO2 MethodsOpening Inventory Values are added to current costs to provide overall average cost per unitOpening WIP Units are completed first.Process Costs in the period allocated between : Opening WIP unitsUnits started & completed in periodClosing WIP UnitsLosses part way through production

Joint and by-products

Joint and by-products

Accounting TreatmentChapter 12

Service and Operation CostingService & operation costingSuitable Cost UnitsServicePossible Cost UnitHotelCost per guest per nightTransportCost per passenger mileCollegeCost per studentHospitalCost per patient day / cost per procedure

Service Cost Analysis

Labour may be the only direct costOH likely to be absorbed using labour hoursChapter 13

BudgetingBudgets and Budgeting A quantitative expression of a plan of action prepared in advance. It sets out the costs and revenues that are expected in future periods.Budgeting is a process to construct a quantitative model of how our business might perform financially if certain strategies, events and plans are carried out. PurposePurpose of BudgetingCo-ordinating ActivitiesPlanning for the futureControlling CostsPerformance EvaluationAuthorisation of expenditureMotivationCommunication of targetsComponents of the Budget

Planning for The Future It can provide the basis for detailed sales targets. It can provide staffing plans. It can be a document to buy and maintain inventory levelsit can be use to set production PlansIt can be used for cash investment/borrowing, capital expenditures (for plant assets, etc.), and on and on243Performance Evaluation Budgets provide benchmarks against which to compare actual results and develop corrective measures.

Controlling Costs It can be used to control costs because standards are set in advance for each expenditure and managers are aware about the limits. Authorization of Expenditure Budgets give managers pre approval " for execution of spending plans.

Communication of Targets A budget document is a best way to communicate targets to the departments of organization Like: sales, Purchase, Finance, manufacturing, Store and so onCo-ordinating ActivitiesA comprehensive budget usually involves all segments of a business. As a result, representatives from each unit are typically included throughout the process.

Motivation

It gives a forward looking guidance to managers and employeesBudgets don't guarantee success, but they certainly help to avoid failure. Without a budget, an organization will be highly inefficient and ineffective.

Slide 251A budget has two main roles to compel planning and to establish a system of controlPlanning Force management to look aheadEstablish formal system of communicating plans and ideas usuallyCo-ordinate activitiesQuantify an organisations objectivesFunctions of a budget 1Slide 252Functions of a budget 2ControlCompare with actual resultsProvide a framework for responsibility accountingMotivate employees to improve their performanceSlide 253Computers are used in budgeting to process large amounts of data and recalculate changes in key variablesThey can also be used to evaluate different options and carry out what if analysisSpreadsheets and programs are usedComputers and budgeting 1 Slide 254Spreadsheets Advantages Forecasting different projections can be inputTax the tax associated with various options can be easily calculatedProfit projections figures can be changed to deal with a variety of options and their associated profitEasy to use Excel can be learnt quickly and is easy to share with others in the organisation Computers and budgeting 2Slide 255Computers and budgeting 3Spreadsheets Disadvantages Danger of corruption of data or variablesCannot incorporate qualitative factors Minor errors can creep in the output is only as good as the input Slide 256Flexible budgets 1 Fixed budgets are budgets which are set for a single activity level. Master budgets are fixed budgetsFlexible budgets are budgets which, by recognising different cost behaviours patterns, change as activity levels changeSlide 257Flexible budgets 2To prepare a flexible budget:Decide whether costs are fixed, variable or semi-variable Split semi-variable costs using the high/low methodCalculate the budget cost allowance for each item = budgeted fixed cost* + (number of units variable cost per unit)*** nil for variable cost ** nil for fixed cost

Slide 258Behavioural effects of budgets/motivation 1 Budgets as targetsCan standards and budgets, as targets, motivate managers to achieve a high level of performance?There are a number of ways in which standards can be set:Ideal standards are de-motivating because adverse efficiency variances are always reported.Low standards are de-motivating because there is no sense of achievement in attainment, no impetus to try harder.Slide 259Behavioural effects of budgeting/motivation 2A target must fulfil certain conditions if it is to motivate employees to work towards it:Sufficiently difficult to be challengingNot so difficult that it is not achievableAccepted by employees as their personal goal

Slide 260Behavioural effects of budgeting/motivation 3Decision makingOrganisational goals = employees goalsGoal congruenceIf managers goals organisational goals leads to dysfunctional decision makingA well-designed control system can help to ensure goal congruence continuous feedback prompting appropriate control action should steer the organisation in the right directionSlide 261Behavioural effects of budgeting/motivation 4 There tend to be three budget setting styles: Imposed (from the top down)Participative (from the bottom up)NegotiatedSlide 262Behavioural effects of budgeting/motivation 5Imposed approach AdvantagesEnhance co-ordination between strategic plans and divisional objectivesLess time-consumingDisadvantagesImposed so can be de-motivationalLower-level initiatives may be stifledDoes not suit some employeesSlide 263Behavioural effects of budgeting/motivation 6 Participative approachAdvantagesMore realistic budgetsCo-ordination, morale and motivation improvedIncreased management commitment to objectivesDisadvantagesMore time-consumingBudgetary slack may be introducedDoes not suit some employeesSlide 264Behavioural aspects of budgeting/motivation 7In practice final budgets are likely to lie between what top management would really like and what junior managers believe is feasibleSlide 265Behavioural aspects of budgeting/motivation 8An important source of motivation to perform well (to achieve budget targets, to eliminate adverse variances) is being kept informed This will mean being kept informed about how actual results are progressing compared with target.The information feedback about actual results should have the qualities of good information.Clear and comprehensive reportsSignificant variances highlighted for investigationTimely reportsSlide 266Behavioural aspects of budgeting/motivation 9ExampleA production manager may be encouraged to achieve and maintain high production levels and to reduce costs Particularly if a bonus is linked to these factors. Such a manager is likely to be highly motivated. The effect on the organisation, with the need to maintain high production levels, could lead to slow-moving inventory This could result in an adverse effect on cash flowPrincipal Budget FactorThe first thing is to decide where to start. For most companies starting point will be a sales budget. Once it has been decided how many units the company