Introduction to cost accounting

CHAPTER 1INTRODUCTION TO COST ACCOUNTING

The need to properly plan, control and to make decision is the major task when it comes to cost accounting. Cost accounting is amanagement information system tool that helps to collect requireddata, analyzing the present and the future to fit into the various problems encountered by managers so as to enable them to plan, control and to make reformed decision.

Cost accounting can be defined as the collection, accumulation, classification, coding, analyzing, processing and recording of cost information to assist management in planning, control and decision making.

Therefore, for a good decision to be made in an organisation (i.e. selecting from various alternatives the best alternative), managers should be able to plan judiciously, hence the need for cost accounting. According to Chartered Institute of Management Accountant (CIMA), cost accounting is a branch of management accounting thatestablishes the budgeted costs, standard costs and the actual costs of products, processes, operations and departments for the analysis of variance, profitability and social use of fund.

Cost: a cost is defined by CIMA as the amount of expenditure (actual or notional) incurred on, or attributable to a specific thing or activity. It can also be defined as the total amount of expenditure incurred or yet to be incurred in the course of manufacturing a product or rendering a service.

Costing: this is the process of ascertainment or measurement of cost.

Purposes of cost accounting- the ascertainment of the cost of goods produced or services

provided- the confirmation of the cost of a department or work section- it aids the preparation of the financial statement- it is used for performance evaluation

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- the ascertainment of what revenues have been- to ascertain the future costs of goods and service- it is use for cost control- to determine the value of inventories of goods that are

still held in store at the end of a period- it is used for planning and decision making

Advantages of Cost Accounting

it helps to identify profitable and unprofitable products and services

it helps to identify efficient and inefficient methods and also helps management to take corrective measures to improveefficiency

it helps to generate comparative information on jobs, products, projects for effective control

it facilitates production control, this enhances production planning and scheduling

it facilitates stock control it facilitates accurate estimation of cost of various cost

units

Disadvantages of Cost Accounting The analysis of cost data involves some amount of expenses

and cost Some costing systems are complex and cumbersome to handle

and are thus not well understood by the managers who need tooperate the system

The production of basic data requires the filling of many forms, and sometimes, inaccurate data is provided.

Conditions Necessary for an Effective Cost Accounting System There must be co operation and coordination among all staff

members of the organisation There must be a proper system of store and stock control There must be an adequate payroll procedure There must be a sound plan for the collection of all

indirect cost


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A costing department or section should be established and the responsibilities and duties of the cost accountant must be clearly defined

The cost accounts and the financial accounts should be maintained in such a way that their results can be reconciled easily

Differences between Cost Accounting and Financial Accounting

COST ACCOUNT FINANCIAL ACCOUNTPeriod Daily, weekly,

monthly, quarterly,half yearly or yearly

Usually one year

Estimation This is done majorlyin cost account because cost accountpredict and estimatefor cost

Estimation is rare or do not exist

Rules and regulation The preparation of cost information does not adhere to any rule or regulations but majorly by the company’s guidelines

the preparation of financial information must be in line with GAAP, CAMA 1990 and ICAN pronouncements

Objectives It is usually for planning, control and decision making

It is usually for stewardship reporting

Detail Cost report are muchdetailed because it breaks down costs into different components

Financial reports shows only global figures

Users The report is used by the management i.e. internal users

The report is used by both the internaland the external users

Time focus It is historical, futuristic and

It is historical in nature


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predictive in natureCost benefit analysis

It is majorly carried out in cost accounting by comparing the cost of a decision with it benefits

This is not done in financial accounting

Dual concept Does not adhere strictly to the double entry principal

Adhere to the dual concept principal

Scope It is wide in scope It is narrow in scope

TERMS USED IN COST ACCOUNTING

Budgeted cost: This is a future cost or a predetermined cost collected before it is incurred on the aggregate or total units of production.

Standard cost: It is a future or a predetermined cost collected before it is incurred but based on the unit of an item of production.

Actual cost: These are costs that are collected based on historical data that is, costs that are already been incurred. Itis also known as a past cost.Variance: This is the comparison of the standard costs with the actual costs

Cost unit: This is the unit of the quantity of a product, process, operation and department in relation to which cost is ascertained. Once costs have been traced to cost centres, they can be further analysed in cost units. Examples of cost units include the following: guest per night, passenger per trip, mile,tonne/mile, patient/night e. t.

Cost centre: This is a product, item of equipment, location, or aperson in relation to which cost is ascertained and accumulated for cost control purposes


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.Relevant Cost and Irrelevant cost: For the purpose of decision making, costs can be classified according to whether they are relevant to a particular decision. Relevant costs are those future costs that will be changed by a decision.Irrelevant costs are costs that remain constant or the same whether or not a decision a decision is made. That is, they cannot affect decision.

Avoidable and Unavoidable Cost: Avoidable costs are those costs that may be saved by not adopting a given alternative, whereas unavoidable costs are not affected by whatever decision being considered. Only avoidable costs are relevant for decision purposes.

Controllable and Uncontrollable: Controllable costs are costs that can be influenced by the manager in charge of cost control, where as uncontrollable costs are costs that cannot be influencedby the manager in charge of cost control. That is, control cannotbe exercise on uncontrollable costs. Only controllable costs are relevant when making decision.

Opportunity Costs: An opportunity cost is a cost that measures the opportunity that is lost or sacrificed when the choice of onecourse of action requires that an alternative course of action isgiven up.

Sunk Costs: These are cost of resources already acquired where the total will be unaffected by the choice between various alternatives. They are costs that have been created by a decisionmade in the past and that cannot be changed by any decision that will be made in the future.

Incremental Costs and Marginal Cost: these are the additional cost resulting from a group of additional units of output, where as marginal cost is the additional cost of one extra unit of output.

Differential costs: these are the difference between the costs ofeach alternative action that is being considered.


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Product costs: These are costs that are identified with goods purchased or produced for resale. In a manufacturing concerned they are attached to the product and are included in the inventory valuation for finished goods, or for partly completed goods, until they are sold; they are them recorded as expenses and matched against sale for calculating profit.

Period costs: These are cost that are not included in the inventory valuation and as a result are treated as expenses in the period in which they are incurred.

Cost audit: cost audit is a detailed checking of the costing system, technique and accounts to verify its correctness and to ensure adherence to the objective of cost accounting. It is also refer to as an audit of efficiency of details of expenditure while the work is in progress.

Objectives of cost auditi. to determine and control costii. to provide data for making judgments and decisions on

various matters e.g. operation efficiencyiii. from management’s perspective, to detect errors, frauds

and misappropriation and hence, enhance efficiencyiv. from customers’’ perspective, to obtain more benefit if

the cost is reduced due to effective control implementation as a result of a cost audit

v. from shareholders’ view; to ensure that valuation of closingstock and work in progress are correct, hence, helps in the computation of more accurate profit figure

vi. from government view; to ensure that costs are reduced so that more tax will be paid by the company

NOTE! During cost audit, the cost auditor will place his/ her attention on the following records: record of materials, labour, overhead charges, depreciation, incomplete records, stores and spare parts records.


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CHAPTER 2 COST CLASSIFICATION AND CODING

Cost classification is the process of arranging or grouping costof related features according to the decree of their similaritiesfor easy collection. It can also be defined as the arrangement ofcost items into logical group having regard to their nature or thepurpose to be fulfilled.

TYPES OF COST CLASSIFICATIONThe following are the major cost classification:

1. Traceability Classification: This is where costs areclassified according to how cost can be traced to a particularproduct e.g. direct and indirect cost.

2. Element / Natural Classification : This is theclassification of cost according to the nature of the costincurred e.g. material cost, labour cost, overheads.

3.Behaviourial Classification : Here, costs are classifiedaccording to how they react to changes in activity level e.g.variable cost, fixed cost or semi-fixed cost.

4. Classification by Function : This is the classification ofcosts according to the functions it performs e.g. productioncost and non production cost.


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5. Controllability Classification : Here, costs are classifiedaccording to how controllable the costs are e.g. controllablecost and non controllable cost.

6. Planning/ Decision Making Classification: This is alsothe classification of cost for the purpose of planning,controlling and decision making e.g. historical cost, standardcost, sunk cost,budgeted cost.

COST CODING

Coding is the way the classification system is applied. A code isdefined as a system of symbols designed to be applied to aclassified set of item to give a brief accurate reference and tofacilitate entry, collation and analysis.

USEFULNESS OF CODING1. To identify unique items, materials and parts that cannot bedone from description.2. It is use to avoid ambiguity which could arise from usingdescription.3. It aids processing.4. It helps in reducing data storage i.e. it reduces the volumeof data than description5. It helps to save time.

FEATURES OF A GOOD CODING SYSTEMThe following are the features of a good coding system

1.Unique: each item should have only one code I .e. codeshould not be duplicated.

2.Clear Symbolization: code should consist of only eitheral numeric or all alphabetic characters.

3.Distinctiveness: code which represents different itemsshould as far as practicable look distinctive as error mayoccur if virtually identical codes describe different items.

4.Brevity: code should be as brief as possible consistentwith meeting the requirement s of the classification system.


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5.Uniformity: code should be of equal length and of the samestructure as this will make it easy to see whether anycharacter is missing.

6.Significant: this means that the actual code shouldsignify something about the item being coded.

7.Mnemonic: on occasions when an alphabetic system is usedthe actual code is derived from the items description orname.

QUALITIES OF GOOD COST ACCOUNTING INFORMATION For the cost accounting information provided to management toserve its role efficiently and effectively, it must posses thefollowing qualities;

1. Relevant: the information should be relevant to the usersand the purpose for which it is intended.

2. Timeliness: it should be supplied within the time it iscalled for. The cost accountant should know when managementis in need of the cost information and he should make itreadily available.

3. Reliable and Accurate: the cost accounting informationshould be accurate and produce in compliance with themanagerial guidelines.

4. Understandable: it should be easy to understand ascomplexity of language should be avoided.

5. Cost Effective: the benefits to be derived from such aninformation should outweigh it cost i.e. the cost ofgathering such a cost information should not outweigh thebenefit of such information.

6. Completeness: the information should fully disclose all whatit requires

7. Objective: all personal judgment or biasness should beavoided in preparing cost accounting report.


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Chapter 3COST BEHAVIOUR AND COST ESTIMATION TECHNIQUES

The term cost behaviour refers to the way and manner in whichcost react in respect to changes in activity level. Activitylevel refers to either output produced or hours worked. In thisregard the following costs are identified;

Fixed cost: a fixed cost is a cost that remains constantirrespective of the activity level i.e. the same amount isincurred at any activity level. By characteristic, a fixedcost is said to be constant in total but varies in unit.

Variable Cost: this cost tends to vary in direct proportionto changes in activity level. Unlike the fixed cost,variable cost varies in total but remains constant in unit.

Semi-Variable Cost: this contains but fixed and variableportion of costs, the fixed element and the variableelement of these costs are separated using cost estimationtechniques such as high and low point, regression analysis,scatter diagram e.t.c. examples of semi variable costincludes: maintenance cost, electricity bill, telephonebills e.t.c.

Step Fixed Cost: this is a fixed cost that only remainsconstant within a given range of activity level. It tendsto rise as output increases beyond a given level of output.

COST ESTIMATION TECHNIQUUES


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It should be noted that historical cost is not relevant fordecision making because it relates to past event. However,historical costs are useful / helpful in predicting the futurecost. Consequently, cost estimation techniques are thosetechniques adopted in order to predict the future cost. Apartfrom this, it is used to separate a mixed or a semi-variable costinto its variable and fixed components. Basically, there are five(5) methods of estimating cost;

High and Low Point/ Range Method : this methodmakes use of the highest and the lowest costs inconjunction with their respective activity level topredict cost. To arrive at the variable cost per unit,the difference between the highest and the lowest costis divided by the difference between the highest and thelowest activity level i.e.

Vc/unit= Highest cost – Lowest cost Highest cost – Lowest cost

Where cost function is Y= a + bxY= Total Costa= Total Fixed Costb= Variable Cost per unitx= Activity Level

Advantages of Range Methoda. It is relatively simple to operateb. It is a quick and inexpensive method of determining the

underline relationship between cost and activity level.

Disadvantages of Range Method a. It ignores any information between the twoextreme observations b. When the extreme points are not typical, thefunction calculated will reflect an abnormal cost function.

Regression Analysis Technique: this involves theuse of statistical techniques that is based onhistorical data. To arrive at the variable cost perunit, the basic regression analysis formulae of leastsquare will be used i.e. VC/ unit b = nExy - ExEy


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nEx2 – (Ex)2

FC a = Ey - bEx n n

Advantages of Regression Methoda. It produces a line of best fit that could be reproducedby anybody using the same data b. The simple modelcould be extended through the use of multiple regressionanalysis. c. It takes into cognizance all costs element when

estimating cost.

Disadvantagesa. A reasonable number of observations are required.b. A true relationship may not be linear but curvilinear.c. Cost estimated may not be reliable if the level of

activity we envisage does not fall within the range ofthe data observed.

SCATTER DIAGRAM; this technique involve the use of graphto predict cost. It provides a good visual picture ofcosts at different activity levels as both cost andactivity level will be plotted on the graph after whicha line of best fit is drawn. The fixed cost will bedetermined at the point at which the line of best fitcut across the Y axis and a slope of the line of bestfit represents the rate of variability i.e. vc/unit.

Vc/unit= C2 – C1 Q2 – Q1

AdvantageWhen compared with other techniques greater quantities ofhistorical data are used in the estimation.

DisadvantageIt is highly subjective because the line of best fit is drawnbased on personal judgment.

Account Analysis Method: this method of estimatingcost requires considerable subjective judgment when


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separating cost as accountants looks at the cost andguesses the likely type of cost behaviour. Accountanalysis technique is mostly used by accountants who arefamiliar with the costs within an account. Expenditurewill be classified into fixed, variable and semivariable cost and value will be assigned to each of theitems. Note: this method is useful and the only methodthat can be used to estimate cost when only one datapoint is used.

Advantages of Account Analysis Methoda. It is fast and inexpensiveb. It is simple and easy to understandc. It can be reversed regularly to account for changes

in cost structure or cost classification.

Disadvantages of Account Analysis

a. It is based on past/ historical datab. It rely on a single observation to determine the cost

functionc. Initial classification has considerable subjective

element.d. Separation of semi variable cost is arbitrary.

Engineering Method: this method is more appropriatewhere there are no historical costs to estimate thefuture cost, it is basically used for a new product. Inthis case, costs are estimated by examining thetechnological relationship between input and output.Estimate of materials, labour time and effort requiredare obtained from the engineers therefore, prices andrate are then applied to the physical measure to obtainthe cost estimate. However, this technique Is expensiveto operate in practise.

QUESTIONS ON COST ESTIMATION TECHNIQUES


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1. You have been asked to prepare an analysis between fixed andvariable costs in your department. The power cost does not seemto fit into either category easily. The following details are asfollows;

WEEK POWER COST # MACHINE HOURS1 3600 80002 3950 90003 3050 65004 3380 74005 3870 86006 4020 89007 2095 3700

You are required to:i. Separate the cost, finding the closest estimate of theelements using the high and low point method.ii. Estimate the total cost likely in week eight (8) if theexpected level of machine hour is 18000.

2. Production and cost data of Anu limited has been recorded overtwo years thus;

Last year Current yearProduction 60000 units 64000 unitsTotal cost #1,820,000 #1,961,400

Between last year and the current year, there has been 5% costinflation.Required:

i. Calculate the real fixed and variable cost.ii. Estimate what the total cost will be next year when it is

expected that there will be a 4% cost push inflation andoutput will be 90,000 units.

3. The following relates to Ayo plc from month 1- month 6 of 2010MONTHS VEHICLE MAINTENACE COST HOURS

1 13,600 2,1002 15,800 2,8003 14,500 2,2004 16,200 3,000


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5 14,900 2,6006 15,000 2,500

Using regression analysis technique, calculate;i. Variable maintenance costii. Fixed maintenance costiii. Estimate the maintenance cost for month 7 if the vehicle

is used for 2,800 hours.

4. The actual costs of Jos Manufacturing Limited for the month ofAugust 2009 are as follows:

#Direct material cost2,680Direct labour cost 3,990Supervising labour

300Factory rent and rate

700Fuel and power 1,140Costing office

670Maintenance 330Depreciation 1,200Miscellaneous 1,560

The production for the month of August was 220 units. Using theAccount analysis method, You are required to:

a. Determine the variable cost per unitb. Determine the total fixed costc. Determine what the cost will be in September if the

production is 500 units.

5. Lanso ltd kept the following records of output and totalcost for the past 6 months Months Output Total cost1 7,000 250,0002 8,000 230,0003 6,200 194,0004 7,700 222,0005 8,200 229,0006 7,800 212,000


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Estimate the cost equation in the form of Y= a + bx.

6. Dammy plc decides to relate total factory cost to directlabour hours in order to develop a cost volume formulae in theform of Y = a + bx. Twelve months observation are collected

Months Direct labour hours (000hrs) Cost(#”000)

January 9 15February 19 20March 11 14April 14 16May 23 25June 12 20July 12 20August 22 23September 7 14October 13 22November 15 18December 17 18

Using the scatter diagram, you are required to fit the line Y = a+ bx.

7. Paper plc has recorded the following total cost during thelast five years

REQUIRED:a. Estimate the cost equation in 2006when average price

level index will be 180b. What will be the resulting total cost in week 6, when

output will be 175,000 units.


YEAR OUTPUT(units)

TOTAL COST AVERAGEPRICE INDEXLEVEL

2001 97,500 362,500 1002002 120,000 448,000 1122003 135,000 522,750 1232004 90,000 504,000 1442005 112,500 620,000 160

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8. Ogechi ltd total factory overhead costs fluctuateconsiderably from year to year according to the number ofdirect labour hours worked in the factory. These costs athigh and at low level of activity for recent year are givenbelow;

Level of ActivityLow High

Direct labour hours 60,00080,000Total factory overhead cost #244,000#282,000The factory overhead cost above consists of indirectmaterials, rent and factory maintenance. The company hasanalysed the cost of 60,000 direct labour hours level ofactivity and has determined that at this activity level, thecost exists in the following proportions;

#Indirect materials (variable) 90,000Rent 100,000Maintenance 54,000

244,000

For planning purposes, the company wants to break down themaintenance cost into variable and fixed elements.Required:i. Determine how much of the #282,000 factory overhead

cost at the high level of activity above consist ofmaintenance cost

ii. By means of high and low point method of cost analysis,determine the fixed cost element for maintenance.

9. Teepee Company Ltd has the following total cost at threeactivity levels;Activity level (units) 8,000 12,000

15000Total cost (#) 204,000 250,000 274,000Variable cost per unit is constant within this activityrange and there is a step up of 10% in the total fixed costwhen the activity level exceeds 11,000 units.Required: using the high and low point method


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a. Calculate the variable cost per unit at the activitylevel above 11,000 units

b. Calculate the total fixed cost at the activity levelexceeding 11,000 units

c. Calculate the total fixed cost at the activity levelbelow 11,000 units

d. What is the total cost at an activity level of 10,000units?


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CHAPTER 4 COST ELEMENTS; MATERIAL COSTING

MATERIAL PRICING

The main objectives of material pricing include the following:1 To charge to production a fair cost of materials used2 To provide a satisfactory basis of valuation of inventory

Problems of Material Pricinga) constant changing prices for bought materialsb) The sensitivity of profit calculation to the pricing method

adopted where material forms a large part of total cost.c) Materials in store are subject to many delivery period and

different prices.d) The frequent impossibility of identifying items with their

delivery consignment.

Methods of Material PricingThere are various methods of valuing material; the followingmethods are recognized by (SAS) statement of AccountingStandard No_4:

i) First - in – first – out (FIFO)ii) Last - in – first – out (LIFO)iii) Weighted Average (WA)iv) Standard Cost or Price (SC)v) Specific or Unit Price (SP)vi) Simple Average (SA) vii) Based Stockviii) Replacement Priceix) Last Purchase Price (LPP)x) Adjusted Selling Price (ASP)

NOTE: The Standard however, lays more emphasis on there methodsnamely; FIFO,

LIFO & WAP


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FIFO: In this method, issues are valued at the oldest batch instock until all units of the batch have been issued when theprice of the next oldest is used and so on.

Advantagesa) It is based on actual costb) It is acceptable by the Inland Revenue Dept for tax

purposes.c) Stock Valuation is based on current price d) It represent a good stock keeping procedure whereby oldest

items are issued firste) It is recognized by IAS 2 and SAS 4 as a method to be used

in valuing stock.

Disadvantagesa) . In a period of inflation, product cost is undervalued /

understated and profit over stated while in deflationaryperiod, product cost are overstated and profit understated.

b) Product cost is based on the oldest price thus laggingbehind current economic values.

c) It renders cost comparison between jobs difficult as pricesvary from batch to batch.

LIFO Method: under this method, stocks are valued based on theassumption that stocks received last are issued first. Thisimplies that issues are priced at the most recent batchreceived and continue to be charged until a new batch isreceived.

Advantagesa) The price at which stocks are issued is actual cost b) Value of closing stock reflects the price levels ruling in

the early part of the period.c) Product cost are based on current priced) It provides a hedge against inflation

Disadvantagesa) It is not a favourable method in valuing stock as stated in

SAS 4


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b) It is cumber somec) Render cost comparison difficult.

Average Price Cost: - It gives result that are between LIFO andFIFO. This method is an applied in two ways depending upon theinventory system in used. Moving average unit cost should beused when perpetual inventory system is used & weighted averageunit cost for periodic inventory system.

Weighted Average :- this is a method of valuing stock at aweighted average price which is obtain by dividing the value ofstock in hand by unit of stock in hand. Issues will continue tobe priced at this price until anew batch is received and a new WAprice is calculated.

Advantages a) It is relatively easy to administerb) It evens out the fluctuation in price of materialsc) It is recognized by SAS 4 & IAS 2 for stocks valuation

purposedd) It is favoured by the Revenue for tax purposes.

Disadvantagesa) It is not an actual buying – in price except by coincidenceb) Issue may not be at current economic values c) Except care is taken, it usually involves decimals.

Simple Average: - Here, issues are made at a price which isthe simple average of the price of the different batches ofstock in hand. Simple average price is calculated at the timeof issues in contrast with WAP which is calculated when newbatch is received.

Characteristicsa) It is relatively more difficult to administer compare with

the WAP methodb) It is not an actual cost except by coincidence

Standard Cost Method: - This is a pre-determined price fixed onthe basis of a specification of a product or services. Standard


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price is used regardless of the actual purchased prices. Anydifference between the standard price and the actual price iscalled VARIANCE.

Advantagesa) It is easy to useb) It provides a check on the purchasing deptc) It ensures comparison of cost between jobs or processd) It hardly changes over accounting period Disadvantagesa) Initial price determination need be carefully done b) Attention is not paid to price trend c) Cost & stocks valuation are not in line with current economic

values.

Replacement Price Method/ Market PriceUnder this method, issues are charged out at the buying price onthe day of the issue. It also values the closing stock at currentreplacement cost in the balance sheet.

Advantagesa) Simple to calculate b) Issues are priced at up to – date values

Disadvantagesa) Not accepted by the Revenue Boardb) There are major administrative problem in keeping

replacement price up to date.

Based Stock Method: - This is not strictly a method of valuingissues, It is assumed that initial purchases were to provide abuffer or base stock i.e. certain units among the first batch ofpurchase is regarded as not available for issue. Consequently, inevery stock taking, the buffer stock is always carried at itoriginal cost. Any units above the based stock can be priced byany method so desired. Base stock represents a permanentcommitment of resources like fixed assets.


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STOCK / INVENTORY CONTROL

Inventory control is the method of ensuring that the rightquantity and quality of the relevant stock is available at theright time and at the right place. Inventory can be of rawmaterials, work in progress or of finished goods awaitingdispatch.

Objectives of Inventory Control To avoid excessive stock level and tying up of capital To prevent scarcity or stoppages which could disrupt

production To relieve management of taking decision for every item

carried on stock The overall objective is to minimize in total the costs

associated with stock i.e. carrying cost, ordering cost andstock out cost

Factors Considered for Effective Stock Control Stock taking should be well organized There should be adequate receipt and inspection of materials There should be basis for pricing materials There should be adequate storage facilities Materials of quality should be ordered for only when needed Quality, price and other terms of delivery should be

properly taken into consideration when choosing supplier(s)

Purpose for Holding StockThere are three (3) reasons for holding stock and these are;

1. Transaction Motive: the purpose is to meet demand for thestock item where the size of demand is know with certaintyor replenishment of stock is immediate when stock outoccurs.

2. Precautionary Motive: this is where either or both thedemand for stock item or the re-supply or re-order isuncertain because of variation between one occasion and the


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next, there will be the need to avoid customersdissatisfaction and loss of sales, therefore, safety stocksmay be held to reduced the likelihood that the company runsout of supply.

3. Speculative Motive: here a decision may be taken to increasethe current stock level in anticipation of a price rise, soas to make a speculative profit.

Factors Influencing Stock Holding DecisionThe following are the various factors that can influence stockholding decision;

Amount of cash available Storage space available The storage cost Risk of stock losses Delivery delay Annual demand for stock

INVENTORY CONTROL SYSTEM

Perpetual Inventory System: This is a system of stock controlwhere records such as bin card, tally card, store ledger accounte.t.c. are kept as a perpetual record of receipt and issue ofmaterials.This system keeps a perpetual record of all stock transactionsupdate on a continuous basis.

Continuous stock taking: this is a method of stock taking wherestock items are counted at frequent interval on a randomrotational basis.

Bin Card: it records physical balance of units in store i.e. itrecords the issue and receipt of materials from the store and itrecords only the quantity of physical stock.


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Maximum Level... BIN CARDMaterial code…..Minimum level…. Bin card No …Description…. RECEIPT ISSUE

SBALANCE AUDIT

Date GRN Qty MRF No Qty Qty Date Initials

Store Ledger: it records both the physical balance of units instock and their valuations. It is located in the cost accountingdept.

Causes of Discrepancies between Bin Card and StoreLedger Card

Incorrect coding Evaporation, breakages, shrinkages e.t.c. Incorrect entries due to clerical and store keeper error Over/under issue of requisition not noted Parts and materials returned to store not documented

Advantages of Perpetual Inventoryi. likely errors are reduced by the use of skilled staffii. physical check for annual stocktaking is unnecessary

because of continuous stocktakingiii. disruption caused by annual stocktaking can be avoided

because of continuous stocktakingiv. discrepancies will be quickly detectedv. staff morale is increased and standard raised

Periodic Inventory System: This system does not require a day today record of inventory changes because cost of materials usedcannot be computed accurately until the end of the accountingperiod. Under this system, purchase orders are placed at fixedinterval of time and the quantity to be ordered on any occasionwill be decided by reviewing the trend of demand for or usage ofthe item(s) concerned.


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ABC Principle or Selective Approach: Under this system, controlof stock is maintained by classifying materials or item intoexpensive, inexpensive or middle cost range because of theadvantage of simplifying stores procedures without incurringunnecessary high cost. The segregation of materials for selectivestores control purposes may be done having the following in mind;(i) expensive and medium cost materials are subject to carefulstock control procedures to reduce costs i.e. items of high valuethough of little number are given priority to avoid a high loss,(ii) inexpensive materials can be stored in large quantities witha slow turnover period because the cost savings from carefulstore control does not justify the administrative effort neededto carryout the control. For better understanding of the ABCprinciple, an example is given below;

Group Units of Quantity Values #Percentage %A 10 7,00070B 30 2,50025C 60 500

5100 10,000

100

Reorder Level System: The stock levels in the bin card are meantto ensure effective control of materials in the store and toavoid excessive stock, wastages, work stoppages e.t.c. Thus; reorder level is the level of stock at which a furtherreplenishment order should be placed so as to avoid stock out. Itis given as;Re order Stock Level= Maximum usage x Maximum lead time

Other levels under the reorder level system can be defined asfollows;

a) Maximum Stock Level: This is the level in which stockshould not normally be allowed to rise; stock should not go


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beyond this level because it is the upper level of theinventory.

Maximum stock level= Reorder level + EOQ – (Minimum usage xMinimum lead time)

b) Minimum Stock Level: it is the level of stock in whichstock should not fall below because if stock should fallbelow this level, it will lead to stock out. It is alsorefer to as buffer stock or safety stock. It is the stockallowance to cover errors in forecasting demand during thelead time.

Minimum stock level= Reorder level – (Average usage xAverage lead time)

c) Average Stock Level: This is the maximum stock level plusminimum stock level divided by (2) two.

d) Lead Time/ Reorder Period: This is also called procurementtime, it is the period of time between ordering ofmaterials and when goods are available for use.

e) Reorder Quantity: This is also referred to as the EconomicOrder Quantity. This is the quantity that should be orderedat regular interval to minimize the total cost of order andholding of stock.

Economic Order System: This is the optimum quantity of rawmaterials that should be ordered at regular interval that willminimize the total cost of order and holding of stock. The costassociated with stock can be categorised into 3 groups viz:carrying/holding cost, ordering cost and stock out cost.

Carrying Cost: These are the costs of holding stock in the storeand it may be calculated as a percentage of purchase prices of anitem or material. Examples are;

Interest on capital invested in stock Material handling cost Storage charges (rent, lighting e.t.c.)


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Insurance Pilferages, evaporation deterioration, obsolescence e.t.c. Store staffing, equipment maintenance and running cost

( store administration cost) Store taking and recording costs

Ordering Cost: These are basically the cost of obtaining stockand examples are;

Transportation cost Set up and tooling cost Cost of stationary Clerical cost Salary of staff and overheads Cost of inspection

Stock out Cost: These are costs incurred when there areinsufficient stocks to meet customers’ requirement or order e.g.

Loss of future sales because of lack of patronage bycustomers

Loss of contribution or profit Cost of production stoppages caused by lack of work in

progress and raw materials Loss of goodwill Extra cost associated with urgent, often small quantity

replenishment order

ASSUMPTION OF EOQ

The following are the basic assumption underlying the operationof the economic order quantity (EOQ) model:

The annual demand is known with certainty The carrying cost is known and constant The ordering cost is known and constant The price per unit is known with certainty The replenishment of stock is made instantaneously Lead time is known with certainty Stock out is not allowed

EOQ METHODS


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The following methods are used to calculate the economic orderquantity (EOQ)

i. Formulae methodii. Tabular methodiii. Graphical method

Limitations of the EOQ Modela. The cost of purchasing and holding stocks is often difficult

to quantify with any accuracy. Consequently, even when theEOQ has been calculated, there is little certainty that theresult is particularly accurate

b. The actual optimum order quantity, is in fact, often muchmore crucially dependent on the storage space and facilitiesavailable, work load of purchase office, economics ofdelivery and overall convenience of all involved in thepurchase such that, it is only a potential savings of a fewnaira

c. The fact that in practice, the total annual stock cost isrelatively flat in the vicinity of the EOQ means that quitesignificant divergences from that quantity will result inonly minor cost increase. The EOQ then, is by no means acritical figure

EOQ with DiscountAs earlier discussed under the assumption of the EOQ model, thatone of it major assumption is that the price per unit is fixedand known with certainty, however, in a real life situation it ispossible for the price to fluctuate or varies. The variation inprice occurs only when there is discount resulting from bulkpurchases.

STORE LOCATION AND STORE LAYOUT


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Materials may be located in either a centralized or adecentralized store. A centralized store is a store wherematerials are kept in a central location or warehouse i.e.materials needed by each department, location or branches arekept in a central store for the whole organisation, while acentralized store is a store location where materials are kept ina departmental store.

Advantages of Centralized Store1. low level of stocks are maintained on the average2. low level of staff is required3. less risk of duplication4. stock taken is facilitated5. better supervision to ease stock level control6. security of stock are better maintained against fire,

thefts, flood e.t.c 7. reduction of capital invested on material8. there is better arrangement of store9. brings about specialization on the part of the staff

Disadvantages of Centralization1. local knowledge may be lost2. distant divisions, branches, departments, sections may

suffer from delay in supplies3. it brings about higher handling and transportation cost4. greater losses in the case of fire and natural disaster5. impart of breakdown in the system is highly felt by other

department6. skilled staff may not be available to give effect to

specialization

NOTE: the advantages of specialized store are the disadvantagesof decentralized store while the disadvantages of centralizedstore are the advantages of decentralized store.

STORE LAYOUT


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This is the way or manner in which stocks are arranged in thestore i e. the proper arrangement of store to ease the movementof materials in and out of the store.

Purposes of store layout

1. to reduce the cost of space occupied2. to bring about better usage space available3. to facilitate the location of individual materials4. to provide better positioning and removal of goods5. to reduce the burden that may be caused by weight of items

being placed/ removed

Possible arrangement within store

1. Keep heavy and bulky items near the point of receipt2. keep store materials of frequent request near the point of

dispatch 3. keep items of the same group on a single requisition4. store perishable goods in a highly ventilated area of the

store5. leave out enough space for the movement of heavy equipment

within the store

Elements of good store keeping

The following factors are essential for effective store keeping;1. ensuring correct and constant stock control level2. good location of materials in the store3. efficient and quick issue and receipt of materials4. organizing store checks either on a continuous or periodic

basis so as to ensure the provision of accurate stockfigures when required

5. availability of good storage facilities6. constant and regular determination of all materials and

tools at all times


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QUESTIONS ON MATERIAL COSTING

1. Calculate three control levels for a stock control systemhaving the following detailsAverage usage 3000 units per weekMinimum usage 2200 unit per weekMaximum usage 4200 units per weekRe order period 10 – 14 weeksEOQ 35,000 units

2. Daily consumption 130 – 180 unitsLead time 16 – 20 daysEOQ 4,800 units

Holding cost per unit #10

Require:a) Find the average stock levelb) What is the total cost of the base stock per annumc) Would your answer to (b) above differ, if the normal

daily consumption is 160 units?

3. The following data relates to component B9Cost of raw material #10 per unitUsage of raw material 100 unitsMaximum re order period 30 daysMinimum re order period 20 daysCost of ordering material #400 per orderCarrying cost 10% per order


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Assume that each year consist of 48 working weeks of 5 daysper weekRequired: calculate

The order levelThe re order quantityThe minimum levelThe maximum levelThe average level

4. you are provided with the following information in respectof Paul plcRe order period 3 – 5 weeksMinimum consumption 300 units per weekRe order level 4500 unitsMinimum stock level 2100 unitsMaximum stock level 7200 unitsRequired: calculateRe order quantityNormal consumption

5. Ayo limited has the following data

Material cost per unit #100Present ordering level is in batch of 700 units, demand isconstant at 10 units a day for each of 250 working days in ayearOrdering cost per batch #600Carrying cost per unit 12 ½% of material cost

You are required to calculate:

EOQAnnual savings which would be made over the current policy

6. Jumbo and Brother currently order 2000 units of product GOTAat a time. It has decided that it may be better to use theEOQ method to establish an optimum re order quantity.Information regarding stock is as follows:


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Purchase price #30 per unitFixed cost per order #400Holding cost 8% of the purchase priceAnnual demand 24,000 units

Required:Calculate the current annual total stock costCalculate the EOQUsing your answer in (b) above, calculate the reverse annualtotal stock cost for product GOTA and also establish thedifference compared to the current ordering policy.

7. ABC motors, a car assembly plant buys battery from anoversea supplier at #20 per battery. Total annualrequirement are 25000 batteries at a rate of 100 per workingday. The following cost data are available

Desired annual return on stock investment #2Sundry carrying cost/unit per year 50kCost of purchase order include; clerical cost, stationary,telephone #50

Required:Prepare in tabular form the total annual relevant cost foreach of the following order size: 250, 500, 1000, 2000, 4000and 8000What is the EOQ for the batteries at ABC Motors and why?

8. The annual demand of a product by a company is 5000 units,ordering costs are #100 and the basic unit price is #5,carrying costs are 20% per annum. Discount are availablethus;

1200 – 1399 less 10%


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1400 – 1499 less 15%1500 – over less 20%What is the most economic quantity to order?

9. A retailer has an annual demand for a certain non perishablecommodity of 100 units. He buys from a wholesaler at a costof #5 per unit and the cost of ordering and receivingdelivery of a replenishment order is #25 each time. Itsstock holding cost is 25% of the average stock value peryear. Discount available;

Required; How many units should the retailer order per occasion andhow often should he order this quantity to minimize thetotal relevant cost?

What is the total stock cost?

Suppose the wholesaler offers 55 discounts on the purchaseprice per unit on orders between 300 and 1999. 10% discountson orders of 2000 or more. Determine whether the retailershould take advantage of either of the discount offered.

10. If the minimum stock level and average stock level ofraw material A are 4000 and 9000 units respectively, findout it re order quantity.

11. A company produces 7000 components of material needed.It annual demand is 5000 units, set up cost and carryingcost p.a. are #40 and #2 respectively. You are required tocalculate the company’s EOQ, total set up cost and the totalcarrying cost.

12. Jeje Nigeria enterprises has 100 bags of cements instore as at 1st July 2010. the transactions for the monthwere as follows:


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1st July 2010 opening balances 100 bags at #39 per bag 5th July 2010 received 100 bags at #41 per bag10th July 2010 received 200 bags at #50 per bag12th July 2010 issued 250 bags20th July 2010 received 400 bags at #58 per bag25th July 2010 issued 350 bags30th July 2010 issued 100 bagsYou are required to prepare store ledger account using;FIFO, LIFO and the Weighted Average Methods

CHAPTER 5

OVERHEAD COSTING

Apart from material and labour cost, overhead also represents a large component of production cost. Overhead should properly be accounted for so as to fully ascertain the cost of a product and service rendered.

Overhead cost relates to indirect cost (manufacturing) incurred in order to produce goods and services as well as direct cost (non manufacturing) incurred to get the goods sold. Overhead costs are costs that cannot be traced or specifically identified to a cost object but can only be allocated to cost centers, they are costs incurred in the course of manufacturing or services rendering but which cannot be traced directly to the products or services.

Cost object is any activity for which a separate measurement of costs is desired i.e. if the users of accounting information wantto know the cost of something; this something is called a cost object. Examples of cost objects include the cost of a product, the cost of rendering a service to a bank customer or hospital patient e.t.c

Classifications of overhead costs

Nature classification Functional classification


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Behaviourial classification Controllability classification Classification according to normality

Approaches to Overhead Costing

To fully allocate the appropriate share of overhead to products or services, the following approach can be used;Traditional/ Conventional ApproachActivity Based Costing (ABC)/ Modern Approach

TRADITIONAL COSTING SYSTEM

This system is use to absorb into a product cost using a predetermined rate. The traditional approach of was developed in the period when most of the organisation produced narrow range ofproducts in which similar operations, process were undertaken andsimilar proportions of overheads were consumed.

The traditional approach makes use of absorption costing to include in the total cost of a product an appropriate share of the organisation’s total overhead. Absorption costing is a methodfor sharing overheads between different products on fair basis.

Steps involves in the traditional approach

Collection of overhead cost/ expenses Allocation of expenses to production and service department Apportionment of expenses that cannot be allocated Reapportionment of service department overhead cost Absorption of the overhead of each production department

over the jobs completed during the period.

OVERHEAD ALLOCATION

Overhead allocation is the process of directly charging of overhead to a particular cost centre where it was incurred. An


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overhead can only be an allocated overhead if the overhead was incurred solely because of the existence of a particular cost centre.

Overhead that is direct to a particular cost centre but indirect to production is also known as an allocated overhead. For an overhead to be an allocated cost, two conditions must be me;The cost centre must have been the sole cause of the overhead,The exact amount of the overhead must be precisely known.

OVERHEAD APPORTIONMENT

This refers to the sharing of overhead cost that cannot be allocated to cost centre using fair basis. Some overhead are common to cost centre, and these overheads can only be distributeequitably using “proxy”. Proxy is the appropriate basis of sharing common overhead between cost centres according to benefits received.

BASIS OF OVERHEAD APPORTIONMENTOverhead Items Basis of ApportionmentRent, rate, depreciation of buildings, lighting and heating, buildings repairs

Floor area occupied or area square feet

Depreciation of equipment, insurance of equipment, maintenance of equipment

cost of the asset or NBV

Power Kilowatt or horse power or volume

Heating Number of radiatorLighting Number of bulb outletPersonnel office, wages and cost of office, administration, meal or canteen

Number of employees or labourhours worked in each department

Material handling Number of requisition or weight of material


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OVERHEAD REAPPORTIONMENT

This is the stage where the overhead apportioned to the service department is treated. The major concern in this stage is to ensure that the total overhead cost is fully charged to the production department only. It should be noted that, it is only the production department that is directly involved in the manufacturing of the products, therefore, all cost must be charged to it.

The service department is also a cost centre that can incur cost but all it cost must be charged back to the production departmentfor the full production cost to be calculated. There are three methods of reapportioning service cost;

a. Continuous Allotment/ Repeated Distribution MethodThis method assumes that the service cost centre provides reciprocal services to one another. An appropriate proportion of the cost of the first service department is apportion to all cost centres including other service cost centres, this is done continuously until all service cost centres are exhausted and the amount in the service cost centre become insignificant.

b. Simultaneous Equation Method: This method apportions the overhead cost of each service centre using the simultaneous equation formulae among the service centres before the secondary apportionment will be carried out.

c. Elimination Method/ Direct Method: This involves the apportionment of accumulated overhead cost in the service cost centre to the production cost centre that benefited from the services of a service cost centre. Once a service department cost has been apportioned, it is eliminated from further apportionment.

ABSORPTION OF OVERHEAD COST


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This is the process of bringing into a product cost an overhead cost. Overhead absorption is sometimes called overhead recovery. In order to ascertain the cost of a product, the overhead cost incurred must be added to the cost using a pre determined overhead absorption rate, this rate is calculated using the budgeted figures.

In order to arrive at the absorbed overhead, the predetermined rate calculated will be multiplied by the actual activity level; this figure will be compared with the actual result for the period to determine the over or under absorption of overhead cost.

OVERHEAD ABSORPTION RATE (OAR) = budgeted overhead Budgeted activity level

Overhead absorption rate is the rate at which overheads are addedto costs of a product.

Over/ Under Absorption of OverheadsSince absorption rate is based on the budgeted figure, and actualresults will be different from the budget. Due to the differencesbetween the budgeted and actual overhead cost and activity levels, the amount of overhead costs absorbed into production might exceed the actual overhead cost. When this happens, there is over absorption of overhead. But when the overhead cost absorbed into production cost is less than the actual overhead cost incurred, there is under absorption.

Treatment Of Over or Under Absorbed Overhead

When there is over absorbed overhead, them amount will be credited to the costing profit and loss account as an income thisis because production has been charged with more overhead cost than the actual overhead incurred.

Likewise, when overheads are under absorbed, the amount will be debited to the costing profit and loss account as an expense,


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this means that production has been charged with less overhead cost than the actual incurred.

Causes Of Over Absorbed or Under Absorbed Overhead Costs

i. Error in estimating overhead expensesii. Unanticipated changes in the production capacityiii. Seasonal fluctuation in overhead in some particular

industriesiv. Unexpected changes in the methods of productionv. Increase / decrease in the volume of production

BASIS OF ABSORPTIONProduction overhead costs are absorbed into product costs on a basis selected by the organisation. The most common bases of absorption are as follows:

i. A percentage of direct materials costii. A percentage of direct labour costiii. A percentage of prime costiv. A percentage of factory costv. A percentage of sales ( for selling and distribution

overhead) vi. A rate per labour hourvii. A rate per machine hourviii. A rate per unit

ACTIVITY BASED COSTING APPROACH

ABC analyses all activities to identify what drives the costs incurred, that is, what causes the cost to increase. ABC allocates overhead costs to cost pools based on the benefits received from various supporting activities. ABC seeks not only to allocate overheads to product costs on a more realistic basis than simply production volume, but also attempts to show the relationship between overhead costs and the activities that causethem.


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Cost pools are those activities upon which overhead costs are incurred.

Cost drivers are factors which cause a change in the cost of activities.

Examples of cost driversCosts Possible Cost Driver

1. Ordering costs Number of Order2. Material Handling Number of material movements or number

of production runs3. Maintenance Number of maintenance hours4. Production Scheduling Number of production runs5. Quality control Number of inspections6. Set ups Number of set ups or number of

production runs7. Despatching Number of dispatches

ABC is a modern approach that is mostly used by organisations that are into the production of wide range of products and it helps in cost reduction because it provides an insight into casual activities and allows organisations to consider the possibilities of outsourcing particular activities. The major difference between ABC and the traditional approach lies in the area of absorption, while ABC allocates overhead to cost units based on benefits derived from supporting or indirect activities,traditional approach allocates overheads using basis of absorption such as labour hours or machine hours.

Merits of ABC1. Many costs are driven by customers (delivery costs, after

sales service e. t. c.) but traditional cost accounting doesnot account for this.

2. ABC helps with cost reduction3. ABC can be used by service and retail organisations.4. With the increase in the complexity of manufacturing

processes, with wider rangers, and shorter life cycles, ABC takes into consideration these complexities with their multiple cost drivers.


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5. ABC is concerned with all overhead cost which goes beyond its “traditional factory floor boundaries”.

Criticisms

1. Implementation is problematic2. Cost of implementation and maintenance often outweigh it

benefits.3. Cost drivers are only limited to activity that is measurable

in quantitative terms and which can be related to productionoutput.

4. It still makes use of some measure of cost apportionment at the cost pooling stage for cost units like rent, rates and building depreciation.

OVERHEAD COSTING QUESTIONS

1. . De Law Manufacturing Company has four production departmentand three service department. Indirect labour and otherindirect cost for a typical month have been allocated as shown

The service department costs are allocated as follows: Grinding Blending Firing

Polishing Administration MaintenancePersonnel (%) 15 25 3020 5 5Administration (%) 10 30 4015 - 5Maintenance (%) 15 30 405 10 -


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In the Grinding and Firing department, an overhead rate permachine hour is used where as in the Blending and Polishingdepartment an overhead rate per direct labour hour is used.Machine hours are budgeted as 620 in the Grinding department and250 in the Firing department. Direct labour hours are budgeted as1,050 in the Blending department and 450 in the Polishingdepartment.

Required:a. Determine the total overheads for each of the production

cost centre using;i. Continuous allotment methodii. Elimination method

iii. Simultaneous equation methodb. Calculate the overhead recovery rates for each of the

production department

2. The following figures where extracted from the accounts ofPower Limited for the month of December, 2011;

# Indirect materials:

Production department X950 Y1,200

Z 200

Service department P 1,500 Q

400Indirect wages:

Production department X 900

Y 1,100 Z 300


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Service department P 1,000 Q650

Power and light6,000

Rent and rate2,800

Insurance on asset1,000

Meal charges3,000

Depreciation @ 6% on capital value of assetsFrom the following additional information, calculate the share ofoverhead cost to each cost centre;

Production department Servicedepartment

X Y Z P QArea sq (feet) 4000 4000 3000 2000

1000Capital value of asset (#) 100,000 120,00080,000 60,000 40,000Kilowatt hours 4,000 4,000 1,600

1,500 500Numbers of employees 90 12030 40 20

Using the continuous distribution method, reapportion the servicedepartment cost

X Y Z P QP (%) 50 20 20 - 10Q (%) 30 20 30 20 -

3. The Top Hotel Limited is developing a cost accounting system.Initially, it has been decided to create four cost centres;residential and catering are to deal directly with customerswhile house keeping and maintenance are internal service costcentre.


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The following overhead details have been estimated for the nextperiod;

Residential Catering House KeepingMaintenance Total

# # # # #Consumable materials 14,000 23,000 27,000

9,000 73,000Staff cost 16,500 13,000 11,500

5,500 46,500Rent and rate37,500Insurance 14,000Heating and lighting18500Depreciation on equipment37,500

227,000The following information is also available;

Residential Catering House KeepingMaintenance Total

Floor area 2,750 1,350 600300 5,000Value of equipment 350,000 250,000 75,000 75,000 750,000Number of employees 20 20 15 5 60

During the period, it is estimated that there will be 2,800 guestnights and 16,000 meals will be served. House keeping works 70% for residential, 30% for catering. Maintenance works 20% for housekeeping, 30% for catering and 50% for residentialYou are required to:a. Prepare an overhead statement showing clearly allocations and apportionments of each centreb. Calculate appropriate overhead absorption rate for residentialand catering


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c. Calculate the under/ over absorption of overheads if actual results where as follows;

Residential: 3,050 guest nights with overheads of #144,600Catering: 15,250 meals with overheads of #89,250

4. The following information relates to Simple Limited Departments: Casting Dressing

Assembly Production overheads (#) 112,50087,500 46,500 Expected

production hours 3,750 3,500 3,100During the year, actual results were as follows;

Department: Casting Dressing AssemblyProduction overheads (#) 114,658.50 91,437.50 47,197.50Production hours 3975 3640 3348

You are required to:i. Calculate OAR for the periodii .Calculate the under/ over absorption of overheads for each department for the period Briefly explain the following terms;i. Over and under absorptionii. Overhead absorption rateiii. Direct costiv. Historical cost

5. Ay limited has just presented to you the following data for theyear 2010 machine hours

10,000 direct labour hours18,000

#direct material cost 32,000

direct labour cost 40,000using the various basis of

absorption, calculate the overhead absorption rate given the budgeted overhead cost to be #36,000.


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6. Xans Nigeria limited is a manufacturer of beverages. the budgeted activity and cost data for the half year July to December 2009 were as follows: Direct labour hours 4,491,000

Direct wages (#) 2,240,000

Overhead:

Fixed (#) 2,208,000Variable (#) 3,400,000

The actual results for the six months were;Direct labour hours 4,300,000Direct wages (#) 2,560000Overhead:

Fixed (#) 2,040,000Variable (#) 3,860,000

The existing method of absorbing overhead is by a direct wages percentage rate. A proposal has been made to change the overhead absorption to a direct labour hours rate analysed into fixed and variable overhead.You are required to i. Under the present system, calculate a. Budgeted direct wages percentage rate of overhead absorption b. The absorbed overhead c. The over/ under absorbed overhead

ii. To calculate under the new proposed system ( i.e. using direct labour hour rate of absorption)

a. The budgeted direct labour hour rate of overhead absorptionb. The absorbed overheadc. The over or under absorbed overhead

7. Kasterlane limited has three production departments namely; spinning, weaving, and finishing. It also has two services


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department/ administration and store. The overheads applicable to each department following allocation and apportionment area;

Department #Spinning 325,000Weaving 280,000Finishing 400,000Administration 85,000Store 70,000Total 1,160,000

a. It is the policy of management to charge Store with 20 % of Administration costs and Administration with 25 % of Stores costs.

Required: using the continuous allotment method, compute the adjusted notional overheads the

TWO departments (round up figures to the nearest whole number)

b. it is also the policy of management to apportion Administration and Store overheads over the three production department using the following percentages;Administration Store Spinning Weaving Finishing

- 20% 40% 20%20%

25% - 20% 25% 30%Required;You are required to apportion the notional overhead for

administration and store computed in (A) above over the three production department

8. CFJ Networth manufactured 2 products MAXI and MIDI, it assignedall factory overhead cost to two production departments A and Bbased on machine hours and it uses direct labour hours to absorb overhead to individual products.For 2009, the firm budgeted #140,000 overhead cost for these operations:

Dept A Dept BMachine hours 4000 16000


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Direct labour hours 20000 10000

The following information relates to the firms operation for the month of January 2009;

Maxi MidiUnits produced and sold 280 1120Unit cost of direct material (#) 10 5Hourly direct labour wage rate (#) 2.5 2Direct labour hours in dept A/unit 2 2Direct labour hours in dept. B/unit 1 1

CFJ Networth is considering implementing an activity based costing system. It management accountant has collected the following information for activity cost analysis:

Activity Budgeted Overhead (#)Material movement 980Machine set up 56,000Inspections 82,320Shipment 700

140,000

Cost drivers Budgeted Qty Driver Consumption

Maxi MidiNo of production runs 350 150

200No of units 19600 200 800No of set ups 500 20

40No of shipments 250 50

100

Required;a. Calculate the unit cost per each of the two (2) products

under the existing method of absorbing overhead.b. Calculate the overhead per unit of the cost driver under the

proposed ABC system.


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c. Calculate the cost list of each of the two products under the proposed ABC system.

9. Plant Y produces about 100 products. Its largest selling product is A and its smallest product is B. relevant data is given below:

Product A Product B Total Units produce p.a. 50000 1000

500000Material cost per unit (#) 1.oo 1.00Direct labour per unit 15min 15minMachine time per unit 1 hour 1 hourNo of set ups p.a. 24 2 500No of purchase order for material 36 6

2800No of time material is handled 200 15

12000Direct labour cost per hour is #5

Overhead cost: #Set up 280,000Purchasing 145,000Material handling 130,000Machine 660,000

1,215,000Total machine hours are 600,000 hours.

You are required to calculate the cost per unit of product A and B using;

a. Traditional method if overhead absorption rate is based on machine hours

b. Activity based costing approach.

10. Product

Output

No. of prod. Runs

Machine hr/unit

DL hr/unit

Material cost/unit

Materialcomp./unit

P 50 6 4 4 60 16Q 50 8 8 8 150 10


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R 500 14 4 4 60 16S 500 20 8 8 150 12

Direct Labour is #7/HR. overhead costs are: short run = #16,500, long run are as follows; scheduling cost = # 15,360, set up cost=#7,200, material handling cost = #15,300

Required: calculate the production cost/ unit using1. traditional costing approach using machine hour to

absorb overheads2. using ABC approach using the following cost drive:a. short run variable cost= machine hourb. scheduling cost= no. of production runsc. set up cost= no. of production runsd. material handling cost = no. of material component

CHAPTER 6


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LABOUR COSTINGThe second element of cost of manufacturing a product is labourand since labour is a major cost in many organisation the controlof this cost must therefore be an important objective ofmanagement.Labour can be direct as well as indirect, direct labour is thatwhich can be charged to a specific cost units directly whileindirect labour is one which the direct allocation is notpossible i.e. labour cost cannot be traced directly to productionor to a specific cost unit.

CONTROL OVER LABOUR COSTProper employment and efficient utilization of labours are vitalfactors which determine the cost and quality of an organisation’sproduct as such there five departments in a large industrialorganisation that have control over labour costs:

1. Personnel Department: This department is responsible for therecruitment of labours, training of labours, discharging oflabours, transfer and promotion of employees. It ensures theremuneration of labours as well as provision of social andrecreational facilities.

2. Time Keeping Department: The time keeping department isprimarily concerned with:-

Recording of each workers time “in and out” of thefactory

Distinguishing between regular time and overtime Recording the time of each employee for each

department, operation and production order.Thus the time keeping department maintains two types ofrecords;a. Attendance Time Record: this record tells about the total

time spent by the workers in the factory.b. Job Time Record: this record tells about the time spent by

each worker on different jobs.

. 3. Engineering and Production Department: This departmenthelps in maintaining control over Working conditions and


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production methods for each job, department or process byperforming the following functions;

Preparation of plans and specifications for each jobscheduled for production

Making job analysis. Setting piece rate Making time or motion studies Maintaining safety and efficient working condition.

4. Pay Master Department: The pay master’s department isresponsible for making payment of salaries or wages toemployees. It performs the following functions;

It compute the wages earned by each worker It maintains permanent pay-roll record for each

employee It disburses salaries and wages payments It prepares the payroll for each department It verifies and summarises the time of each worker as

shown on the daily time card.

Prevention of Fraud in Wage Payment

The following are measures to be taken in order to preventpayroll fraud

i. Wages should be paid to workmen personally and not totheir fellow-worker.

ii. Ensure that individual employee’s insurance and taxdocument are in order, thus preventing ghost workersbeing shown on the payroll.

iii. Job card and time card should be dully checked andreconciled to know the accurate time spent by theworkers on a particular job.

iv. Insist on overtime or loans being properly authorizedbefore payment.

v. A system of cross check should be employed withindepartment to ensure accuracy of the wages paid toworkmen.

vi. Unclaimed wages should be properly accounted for.

5. Cost Accounting Department: A cost accounting department isresponsible for recording separately


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the entries in respect of wages paid to direct and indirectlabour. The direct labour costs are taken as basic or primecost of production and indirect labour cost as overheadexpense. The primary responsibility is to report to managementany loss of labour time, wastages and inefficiencies e.t.c.

RECORDING OF LABOUR TIME AND WAGES COMPUTATION Various records are used to determine when an employee is atwork and the time spent on various activities. As such, thefollowing records can be used:a. Time sheet: These are documents filled by each employee,

detailing the employee’s activities and the time spent oneach activity. This may be completed on a daily or weeklybasis.

b. Clock Number: This is a number given to an employee onjoining the organisation and he is identified by this numbersuch that confusion are minimized as to who do what duty orjob.

c. Clock Card: This refers to a staff card that is insertedinto a clock at the gate and the time of insertion stamped.Each employee has his own clock card which he has to clockin on arrival at work and clock out when leaving thepremises.

d. Gate Time Keeping: This record the time when an employeeenters and leaves the organisation or company’s premises.

e. Job Card: This is a card created for each job which is meantto be filled by each employee. If any employee works on ajob, he records the time spent on that job on the job card.

f. Job Tickets: This constitutes an instruction to the workeras well as a means o booking his time.

g. Idle Time Card: This is used when a worker is engaged on nonproductive work and it is to ensure that the total recordedtime balances with the attendance clock cards.

Causes of Idle Time


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i. Productive Causes: Machine breakdown Power failure Waiting for work Waiting for tools and/ or raw materials Waiting for instructions

ii. Administrative Causes: Periods of depression (unable to utilize it full

capacity)iii. Economic Causes:

Seasonal fluctuation in demandiv. Abnormal causes:

Strikes Lock outs Flood Fire

WAGES COMPUTATIONThis computation is recorded on a payroll or wage sheet after allthe time keeping records have been prepared and certifiedcorrect. The payroll is a document which list all the employeesand shows the major details relating to their pay. Payroll can beused to determine the gross wages and the net wages.

Elements of Gross Wages Ordinary time earnings Overtime earnings Shift premium Bonus which may be on incentive schemes ( or piece of work

payment) Transport allowance Rent allowance Lunch allowance

It should be noted that only earnings that are traceable will beconsidered as part of prime cost.

METHODS OF REMUNERATIONThe following are the methods of remuneration;


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a. Time Based Method : under this method, labours are paid basedon the number of time they spent in the period. The time canbe measured in hours, days or months.

Hourly based- is calculated thus;wages = no of hrs worked x rate

per hr daily ate = no of daysworked x rate per day monthlyrate = fixed rate per month.

b. Output Based/ Piece Rate Method: under this method, wagesare paid as agreed for any unit of production. It can alsobe applied where various types of articles are produced anddifferent time is set for each article produced. Outputbased methods is common in industries like block makingindustries and it can be categorised into two; Straightpiece rate and differentiate piece rate.

Advantages of Output Based Useful where output for workers can be identified When attention is paid to the quantity of output rather

than quality The total labour cost per unit is accurately

ascertained It discourages idleness of workers

Disadvantages of Output Based The quality of output maybe sacrificed for the quantity It will increases supervision and inspection cost Fixing the equitable piece rate is a task of

considerable difficulty.

c. Piece Rate with Guaranteed Day Rate: It is a system adoptedto compensate employees on account of low production,leading to earning under piece rate being below the normal


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remuneration. If an employee’s earnings according to thepiece work are less than the normal Day Rate, he is paid theday rate instead of the piece rate.

PREMIUM BONUS SYSTEMThis system pays workers a normal day rate plus a bonus upon thedifference between the time actually taken for a job and the timeallowed. Many of these systems bear the name of the experts whooriginated the plan e.g. Halsey schemes and Rowan scheme. Underthese schemes, workers pay is made up of two components;

- a day rate amount based on hours worked- a bonus based on time saved in achieving the particular

level of output.

Halsey scheme formulaeTime actually worked multiplied by day rate plus bonus based ontime saved.Bonus = ½ x time saved x hourly rate.

Halsey weir formulaeThe proportion of time paid to works is 1/3Bonus = 1/3 x time saved x hourly rate.

Rowan SchemeBonus = Time taken x time saved x hourly rate

Time allowed

GROUP INCENTIVE SCHEME: This scheme is applied to a group ofworkers where work is carried out in group e.g. roadconstruction.

Advantages of Group Incentive Scheme supervision cost is reduced team spirit is encouraged among workers the rate to be negotiated is reduced output is increased


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not administratively clumsy

Disadvantages it may not encourage individual initiative as each member of

the group is paid the same bonus Efficient and inefficient employees are paid the same amount

of bonus.

PROFIT SHARING SCHEME AND CO PARTNERSHIP SCHEME: Profit sharingscheme is that where by a specific share of the company profit isis paid as an addition to normal wages.The co partnership is a development of profit sharing schemewhereby employees are issued with shares as bonus. The sharesthus entitle them to share in the company profit by right asshareholders.

BASIC PRINCIPLES OF A GOOD INCENTIVE SCHEMEi. The basis for calculating the bonus must be clear.ii. The payment must be closely related to the efforts put in.iii. There must be a clearly defined and attainable objective iv. There must be mutual agreement based on consultation betweenthe management and the workersv. There should not be a maximum ceiling on additional earningsunder the schemevi. Employees should not be penalized for matters beyond theircontrol.

OVERTIME PREMIUM / WAGESSometimes, workers have to work for an extra time over and abovethe normal hours of work. The time spent above the normal hoursof work is referred to as overtime. Hence, overtime premium isthe portion of the overtime pay over and above the basic rate ofpay. Overtime wage rates are expressed as time plus a fraction onin multiples of time.

Overtime work increases the cost of production significantlybecause as stated before, the hourly rate for overtime is higherthan the normal hourly rate. The rate at which overtime is paiddepend on whether those hours where worked during the week, atweekends or public holidays.


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Overtime wages can be taken as direct or indirect labour costdepending upon how it can be identify with specific jobs orproduction. Overtime is taken as a direct labour cost where it isnecessary to work overtime based on the specific request of acustomer so as to bring the completion period closet. But in acase where overtime hours is necessary with the intention ofincreasing the general output of the factory, the cost of suchovertime will be taken as an indirect cost charged to productionoverhead.

LABOUR TURNOVERThis is used to measure the extent at which employees leaves anorganisation. It is the rate at which employers’ losses and gainemployees. The rate may be high, normal or lower, a high turnoverrate might be harmful to the company’s productivity if skilledworkers are often leaving and the remaining working populationcontains a high level of novice workers, this will result intoincreased cost and low productivity. Therefore, the lower thelabour turnover rates the better for the organisation. Theformulae to measure the rate at which workers leave a particularorganisation is;

Number of employees leaving during the period x 100%Average number of employees

Before a conclusion can be drawn as to whether these ratescomputed is high or low, there must be a comparison between theLTR from previous periods, other businesses in the area or in theindustry as a whole.

CAUSES OF LABOUR TURNOVERThe reasons for labour turnover can be categorised into two (2);

1. Avoidable Causes Dissatisfaction with the job Lack of job security Dissatisfaction with remuneration Bad working condition Lack of incentive and promotional avenues Inadequate housing and medical facilities


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Odd hours of work Poor worker- supervisor relationship Lack of adequate recreational facilities Discrimination between one worker and the other Poor group relationship

2. Unavoidable Cause Personal betterment Redundancy due to seasonal nature of the business Retirement, death or disablement Discharged due to factors like; unsuitability,

negligence, incompetency, lateness, absenteeism and fordisciplinary reasons.

Domestic responsibility(s) i.e. to look after oldparents

Personal matters e.g. marriage, relocation, pregnancy,ill health e.t.c.

Note: Every organisation must ensure that employees leaving dueto avoidable causes should be prevented.

PREVENTION/ REDUCTION IN LABOUR TURNOVER RATEThe following are some of the ways in which managers can reducethe rate at which employees move in and out of the organisation;

- good safety and health measures should be in place - good working condition- job security- redundancy package- continuous or on the job training- personal and professional growth should be promoted- making employees fill involved by taking time to listen to

them- provision of necessary skills to perform their jobs- consider the introduction of high wage plan or some other

form of incentives

LABOUR REPLACEMENT COSTThe following are the costs associated with increased rate oflabour turnover;

- decrease in productivity


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- lowering the morale of the remaining employees- advertisement for personnel and interview expenses- training cost- machine breakdown- interview time- scrap and defective work during initial stages

JOB EVALUATION AND MERIT RATING

Job evaluation and merit rating are techniques of personnelmanagement that helps the management in the determination ofwage rates to be paid to workers and selecting the efficientwork force on the job.

Hence, job evaluation is concerned with measuring the demandthe job places on it holders. Job evaluation is a practicabletechnique designed to enable trained and experienced staff tojudge the size of one job relative to others; it does notdirectly determine pay level, but will establish the basis foran internal ranking of jobs.

Merit rating on the other hand is used for performanceappraisal. It appraises the performance of worker on the joband not off the job so as to know the differences in personalabilities and capabilities of workers. Unlike job evaluation,merit rating is carried out after the employee has been placedon the job.

Differences between job evaluation and merit rating Scope: job evaluation, evaluates the job and not the

job holder while merit rating appraises the person andnot the job

Time: job evaluation is made before the selectionprocedure starts with a view to select the personmatching with the requirement of the jobs while meritrating is always carried out after the employee hasbeen placed on the job; his performance is appraised onthe job and not off the job.


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Relative Value: job evaluation determines the relativeworth of the job while merit rating appraises therelative performance of the employee’s qualities so asto know the differences in personal abilities andcapabilities

Objective: the objective of job evaluation is todetermine the basic wage rates for each job in theorganisation while that of merit rating is to developworkers by evaluating their individual qualities ordeficiencies.

WORK STUDYThis involves the determination of the most efficientmeans of using input resources such as labour, materialand machinery. It is a technique for improving efficiencyand reducing waste in factories. Work study comprises ofmethod study and work measurement.

Method study: this is that part of work study which isaimed at establishing a correct method for a job orprocess to economize its human effort and make moreefficient use of men, materials, and machines. Theprocedure normally include the election of work to bestudied, relevant facts or method used, examining thefacts logically, developing a more effective method andinstalling and maintaining this method as a standardpractice.

Work measurement: this is the application of techniquesdesigned to establish the time for a qualified worker tocarry out a specific job at a defined level ofperformance. Although, method study can also determine themost effective use of man power, measurement is distinctin that, it aims to make improvements in labour planningand control, and through incentive schemes, the managingof organisation.


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Work measurement complements method study by examining thetimes that alternative method of carrying out a workassignment would take.

QUESTIONS ON LABOUR COSTING

1. Ayo, Bola and Shade work with Small plc which operates apremium bonus system of remuneration. They were each given aproduction target for an 8hours working day and they allachieved their targets as follows;

Ayo Bola shadeTime taken (hours) 61/2 6 51/2Wage rate per hour (#) 300 400 350

You are required to calculate the total wages payableto each of them under the following schemes; Halsey, Halseyweir and Rowan schemes.

2. you are required to calculate the remuneration of eachemployees using each of the following methods; (i) hourlyrate (ii) basic piece rate (iii) individual bonus schemewhere the employees receives a bonus in proportion of timesaved to time allowed.


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X Y ZUnits produced 540 400 440Time allowed (in min) per unit 10 15 12Time taken in hours 80 76 72Rate per hour (#) 2.5 2.10 2.40Rate per unit (#) 0.40 0.50 0.48

3. The following data are given to you in respect of 3 workers: P Q R # # #

Earnings per hour 20 30 40Overtime policy Time plus 1/3 Time plus ½Double timeActual hours (Dec., 2010) 190 180

170Basic working hours(Per each of 4 weeks) 40 40

40

Required: calculate the overtime payment for each employeein December 2010.

4. Clay product limited manufactures and sells a variety ofclay products. Management of the company is proposing anincentive scheme into its factory but is undecided on whatkind of scheme to introduce.

Below is an extract of payroll information with respect tofour of the company’s employees for July 2011

Name of employee Michael GeraldCynthia William

Actual hours worked 152 144 160136Wage rate per hour 45,000 30,00037,500 54,000Output produced in units

Product A 168 48 - 480


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Product B 288 304 - 1080Product C 368 - 200 -

The standard time per unit of each product is:Product Minutes AllowedA 6B 9C 15

Each minute earned is valued at $750 for pieceworkcalculations.

Required:a. Calculate the earnings of each employee using the

following methods:i. Guaranteed hourly rates (basic pay).ii. Piecework, but earnings guaranteed at 75% of basic

payiii. Premium bonus in which the employee receives (2/3)two third of time saved in addition to hourly pay.

c. State three advantages and three disadvantages ofindividual incentive schemes.

5. Remilekun works 60 hours with a team paid together as a

group. The team worked for a total of 1200 hours producing4500 units. Standard output is 3.2 units, normal pay is #5and the group operates the Halsey Weir scheme. CalculateRemilekun’s bonus payment under the incentive scheme and hergross pay.

6. Chukwu has for workers A, B, C and D. The four workers,works as a team and are paid on gross piece rate. They alsowork individually on day rate job. In a 44 hours week, thefollowing hours has been spent by A, B C and D on grouppiecework viz; A 40 hours, B 40 hours, C 30 hours and D 20hours. The balance of the time has been booked by eachworker on day work job. Their hourly rates are: A #0.50, B # 0.75, C #1 and D #1.


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The group piece rate is #1 per unit and the team hasproduced 150 units.Calculate the gross weekly earnings of each worker takinginto consideration that each individual is entitled toanother allowance of #20 per week.

7. Abyomi is paid by differential piecework and the scheme isas follows:

output up to 50 units per day #5 per unitadditional output between 51-70

units per day #6 per unitadditional output between 71-80 units per day #6.60 per

unit additional output between 81-100units per day #7.00 per unit His dailyoutput for a five day week were 68units, 83units, 59units,94units and 47units. What will be his gross pay for theweek?

8. The following information relates to production departmentof God’s power limited.i. Each production workers is paid on the basis of hoursworked x output produced according to the formulae:

Total Earnings= Hours worked x Rate/ hour x Output achieved+ overtime premium hours x rate

Expected output

ii. Production workers have basis week of 40 hours and abasis rate of #100 per hour.

iii. Overtime hours are payable on the basis of time and ¼iv. The standard time allowance is 10 minutes/unit producedv. During the month of January, 2011 (consisting of 4 weeks)

the following workers had the data


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Hours worked Unitsproduced

Mr. A Ahmeed 180 1,200Mr. John Obi 160 1,000Mr. T Kokumo 200 1,100

Required:a. calculate the total earnings for January, 2011

for each of the workerb. distinguish between production and productivity

using the data in the question to illustrate youranswer

9. Simple limited presents the following information whichrelates to a week work of three (3) of its workers

Mumu Ope AdamuWork issued (units) 400 600 120Time allowed (hours/unit) 0.2 0.10.4 Output rejected (units) 6090 40

The basic working week is 40 hours; the first 6 hoursovertime are paid time plus ½ and the next

10 hours at a time plus ¾. Hours worked by Mumu, Ope andAdam were 52, 45 and 40 respectively. Adam spent 8 hours onindirect work, these hours being included in the 40 hoursworked by him. The 3 employees basic hourly rates of paywere as follows: Mumu #30, Ope #40 and Adam 25.

Bonus is paid at ½ of the basic rate for all time saved. Thehigh rate of rejection was considered abnormal due to faultymaterials and it was agreed that all output should becredited for bonus purposes.

You are required to present in tabulated form for eachemployee:a. Number of bonus hours workedb. Basic wages including overtimec. Amount of bonus earned


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d. Gross wagese. Direct wages cost/unit accepted when overtime is worked:

i. regular throughout the year as company’s policyii. based on customer’s specific requirement

10. Jonathan limited had 4,500 employees on its payroll on1 January, and 4,800 employees on 31 December. During theyear, 940 employees left the company.

The company operates premium bonus scheme payable inDecember based on the hours worked in November. The timeallowed for the production in November was 864,000 hourswhile the time taken was 700,000 hours.

The company’s policy is to share the bonus equally among theemployees. No employee left the company in the last twomonths of the year. The wage rate per hour was Le 2,000.

Required:Calculate the labour turnover rate for the year.Calculate the bonus that will be paid to each employee usingHalsey, Halsey Weir and RowanList four unavoidable reasons for labour turnoverList four labour replacement cost

11. South limited pays a bonus to its employees based uponthe production achieved each month. Standard productiontarget is set at 960,000 units per month. A bonus of #0.40per unit is paid for any unit in excess of the normal outputfor each month. Distribution of the bonus is made on thefollowing points basis

Number of staff CadrePoints allowed2 Area Manager 1,0004 Production Engineers 80010 Production Supervisor 8002 Store Keeper 40010 Factory Office Worker 60


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200 Production Worker 80100 Non-production Worker 4010 Security Men 60

At the end of the month, actual production was 1,080,000units. You are required to calculate the amount payable tothe employees in the different groups (to the nearestnaira).

12. The detail below relates to the month of MarchTotal number of employees at the beginning of the month

201Number of employees who started during the month

3Number of employees leaving during the month 5

Calculate the labour turnover rate.

13. Dangote plc pays #1,200 to each of its employee permonth. The company estimated in January 2010 that if none ofthe present employees leaves, it will incur #720,000 at theend of the year for the salaries of employees throughout theyear. This is based on the fact that embargo has been placedon salary increase and no additional employees will beemployed.In the month of December, 2010, the actual salary paid atthe rate of #1,200 was #48,000; other employees had left theorganisation.

Required: calculate the labour turnover rate for the year.

14. People plc has the following labour turnover record forthe year ended 31 Dec, 2010

Departments A BC

Number of employees @ 1/1/x10 144 68212


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Employed during the year 28 1846Left during the year 22 1436

You are required to calculate the labour turnover rate foreach department. Which of the department has the highestlabour turnover rate?

15. At 1st January, a company employed 3,641 employees andat 31st December employees’ number were 3,735. During theyear, 624 employees chose to leave the company. What was thelabour turn over rate for the year?

16. A company operates a piecework system of remuneration,but also guarantees’ it workers 75% of a time-based rate ofpay which is based on #19 per hour for an eight hoursworking day. 3mins is the standard time allowed per unit ofoutput. Piecework is paid at the rate of #18 per standardhour. If an employee produces 200 units in eight hour on aparticular day. What is the employee’s gross pay for thatday?

CHAPTER 7 COST LEDGER ACCOUNTS


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Any costing system can be operated as an integral part of the general accounting system, and this is now commonly the case. It is necessary to segregate the cost accounting system from the financial accounting system. However, in cost accounting, the double entry principle in financial accounting is very much needed so as to understand the concept of cost book keeping in the cost accounting system.

Since cost accounting is very wide and detailed, it will be of great importance to properly maintain a costing system that is separated from the financial accounting system. Therefore there are two types accounting system which are;Integrated accounting system and interlocking or non-integrated accounting system

INTEGRATED ACCOUNTING SYSTEM

Integrated accounting system implies a system of accounting whereboth the cost and financial records are maintained in one set of books. It is a single comprehensive accounting system with no division between financial and cost accounting. It uses same basis for stock valuation, depreciation, e.t.c. and the need to reconcile cost profit and financial profit does not arise.

Basic requirements for integration of accounts

i. Determination of the degree of integration; management should decide about the degree of integration and there must be convinced of it advantages.

ii. A meaningful system of coding should be used so as to permit a meaningful consolidation and analysis of cost accounting and financial accounting information.

iii. Accounting staff should be properly trained.iv. Close coordination is required between staff dealing with

financial and cost information.v. Computerization of integrated accounting is highly needed.

Advantages of integrated system


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i. It avoids duplication of effort.ii. There is no need for the reconciliation of profitsiii. Simplification of accounting procedures which helps in

better control of operationiv. It save the administrative efforts of maintaining two

separate systemv. Centralization of accounting information is made possiblevi. Enough time is saved in getting information from the

accounting records for financial and cost purposes

Disadvantages of integrated systemInability to satisfy completely the requirement for external reporting e.g., where stocks are valued on the basis different from historical costs

INTERLOCKING ACCOUNTING SYSTEM

This is an accounting system whereby separate ledgers are maintained for the financial accounting system and the cost accounting system. It is a system in which the cost accounts are distinct from the financial accounts.

The two sets of accounts are being kept continuously in agreementby the use of control accounts or by reconciliation. This system is called cost ledger accounting system. The principal accounts in the system of interlocking accounts are:

a. Resources Accounti . material control accountii. Wages and salaries control accountiii. Production overhead control accountiv. Selling and distribution control account

b. Accounts which records the costs of production items from start of production through to Cost of sales:

i. work in progress control accountii. cost of sales control account

c. Sales Accountd. Costing profit and loss account


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e. Under/ over absorbed overhead accountf. Cost ledger control account.

COST LEDGER CONTROL ACCOUNT

This is maintained as a link between the two sets of accounts. Itis used to record all the accounts in the financial accounting books which are not included in the corresponding cost accountingbooks, e.g. fixed assets account, provision for depreciation, cash account, creditors account, debtors account, profit and lossreserves e.t.c. and other purely financial items.

CONTROL ACCOUNTS

This is a memorandum account, the balance of which reflects the aggregate balances of many related subsidiary accounts which are part of the double entry system. This means that when debit or credit entries are posted to individual ledger accounts, their total posted is posted to the control account, such that the balance of the control account should be equal to the total balances on the individual accounts.

RECONCILIATION OF COST AND FINANCIAL ACCOUNT

Whenever a company maintains separate cost and financial accounts, the cost profit will differ from the financial profit due to differences in the revenue and cost that are included in the respective profit and loss accounts. The following items may create differences between cost accounting and financial accounting profits:

1. Items appearing in the financial account but not in thecost account i.e. purely financial incomes and expenses;

Financial incomes include:i. interest receivedii. dividend receivediii. profit on sales of fixed assetsiv. discount received


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v. grant receivedvi. exchanged rate gainsvii. rent received

Financial expenses include:i. dividend paid ii. discount allowediii. loss on disposal of fixed assetsiv. donationsv. fines, penalties and leviesvi. Taxvii. Loss on investmentviii. Exchange rate lossesix. Interest paidx. Debenture interestxi. Bad debtxii. Preliminary expensesxiii. Goodwill written offxiv. Transfer to reserve

2. items that only appear in cost accountingi. notional charges like rent and interest on capitalii. under or over absorbed overhead

3. Differences between financial and cost accounts in the calculation of actual overhead cost incurred

4. differences in valuation of stocks

NOTIONAL CHARGES

These are expenses that do not involve the movement of cash because it is provided for by the owner of the business. There are two types of notional charges;

i. Interest on capital: this is the notional cost of capital tied down i.e. the provision of capital by the entrepreneur instead of borrowed capital or bank loan.

ii. Notional rent charge: this is a nominal charge rate raisedfor the use of owned premises.


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COSTING TECHNIQUES AND DECISION MAKING TOOLS:MARGINAL AND ABSORPTION COSTING TECHNIQUES

Costing techniques refers to the various ways or alternative waysof presenting cost accounting information to management.Basically, there are two major ways in which this accountinginformation can be presented and these are; marginal costingtechnique and absorption costing technique.

MARGINAL VS ABSORPTION COSTING TECHNIQUE

In making short term, medium term or long term decision,management of organisation must adopt some tools that would aidbetter decision for the achievement of organizational goals.Therefore, these two techniques are expected to be appropriatelyused in short term tactical managerial decision making exercisethat would amount to efficient management of resource for theproduction of income, profit and wealth for the organisation.

Hence, marginal costing technique is a technique that presentscost information for managerial decision making and it has beendescribed by different name- direct costing or variable costing.It makes a distinction between fixed and variable cost ofproduction and shows at a glance the contribution made on adecision situation. Unlike absorption costing technique thattreats fixed production overhead (not fixed selling andadministration cost) as a product cost, marginal costingtechnique treats fixed production overhead cost as a period cost.A period cost is a cost that is written off immediately it isincurred and not absorbed into the product unit or job.Consequently, stock under marginal costing are valued using themarginal cost of production i. e variable cost.

Therefore, marginal costing can be define as the accountingsystems in which variable costs are charged to cost units and


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fixed costs of the period are written off in full against theaggregate contributions.

Features of marginal costing Simple to operate It treats variable cost as product cost and fixed cost as

period cost It classifies cost in variable cost and fixed cost i. e

behaviourial classification It does not use variable selling and variable

administration cost in valuing stock even if it classifiescost according to their behaviour

It is use for planning, controlling and decision making

Absorption costing technique on the other hand, is a costingtechnique that presents information to aid financial reporting.In this case, total cost incurred are classified into productionand non production cost for the purpose of reporting net profit.Under absorption costing concept, all costs which include fixedand variable costs are ultimately charged or allocated to costunit and total overheads are then absorbed according to a givenlevel of activity in order to ascertain the total cost of eachunit.

Absorption costing treats fixed production cost as part of theproduct cost which is also used in the valuation of stock.Absorption costing is also known as full costing technique asstocks are valued at their full cost which includes both fixedand variable production cost.A product cost is a cost that is added to the cost of a producti. e it is absorbed into the product unit and written off onlywhen the product is sold.

Features of absorption costing It uses both variable and fixed production cost in valuing

closing stock It classifies cost into their function All non production cost are treated as period cost It is use for stewardship reporting It is preferred for tax purposes


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Note: reconciliation statement the basic rule If stock levels are rising, ac profit > mc profit If stock levels are falling, ac profit < mc profit If opening and closing stock levels are the same, ac

profit= mc profit

CHAPTER 8

APPLICATION OF MARGINAL COSTING TECHNIQUE FORTACTICAL DECISION MAKING


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Decision making involves making a choice between two or morealternative courses of actions. Because the utmost objective ofevery producer lies in the maximization of profit, then thealternative chosen must be that which results in the highestcontribution to the organisation.When making decision, care must be taken as only those costs thatare relevant to the decision are been considered because decisionmaking is futuristic. Therefore, the knowledge of relevant andirrelevant cost is much needed when making decision.

Having examined the meaning of decision making, the next thing isto examine those areas of decision making where marginal costingshall be applied;

Product profitability Special offer Make or buy Product optimal mix Break even or cost volume profit (cvp) analysis Pricing decision

PRODUCT PROFITABILITYThis is a situation where the management of a company isconsidering discontinuing a product line or shutting down afactory or department permanently basically because it yieldsnegative profit. The decision to shut down however should not bebased on whether or not negative profit is made but rather,shutting down should be based on whether or not the division,factory or product line is making a positive or negativecontribution.

Qualitative factors in shutdown decision Loss of market share Loss of worker morale as it affects future productivity Loss of customer’s goodwill Effect of unemployment on the economy and society The effect of the entire organisation especially where the

product is being jointly demanded with some other products.

Decision rule:


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a. If the net contribution is positive, the segment should notbe closed or deleted. This is because the segment isactually contributing positively towards the recovery of thecompany’s general fixed overhead and profit.

b. In the case of a negative contribution, management will beadvice to close or delete the segment. This decision willthen increase the total profit of the organisation.

MAKE OR BUY DECISION

Business maybe faced with the decision whether to make componentfor their own product or to concentrate their resources onassembling the product thereby obtaining the component fromoutside suppliers. In coming up with the appropriate decision, itis necessary to compare the relevant cost of producing in-housewith the relevant cost of outsourcing.The relevant cost of internal production should include:

1. all variable manufacturing cost such as direct material,direct labour, direct expenses and variable productionoverheads

2. all attributable, avoidable or incremental fixed cost3. opportunity cost such as; benefit forgone for the use of

idle capacity

It should be noted that absorbed overhead as well asapportionment of general fixed overheads are irrelevant. However,the relevant cost of outsourcing should include:

1. The purchase cost.2. Any attributable fixed cost such as in-transit, storage

cost, carriage inwards, insurance e.t.c

QUALITATIVE FACTORS IN MAKE OR BUY DECISIONi. Trade secret relating to the product.ii. Technical know how in manufacturing the component must be

established.iii. The reliability of the supplier


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iv. Quality of the component to be supplied by the externalsupplier

v. Obsolescence of the facilities if buying persistvi. Alternative use of idle space of capacityvii. Reaction of the trade union when components are purchased

outside which may lead to workers redundancyviii. Consideration of the stability in the quoted price of

the component

PRODUCT OPTIMAL MIX

Optimal production or sales mix involves the allocation of afirm’s limited resources among various combination of output insuch a way that profit is maximized. When an organisation isfaced with scarcity of resources because the available resourcesare in short supply, then it will have to make a decision aboutwhat product mix it will produce. It volume of output and saleswill be constraint by the limited resources.

A scarce resources also known as limiting factor, budget factor,key resources, binding factor, governing factor, critical successfactor, constraint e.t.c. is that resources or combination ofresources whose non availability places a significant reductionon the company’s ability and capacity to expand output in orderto achieve its stated objective. Examples of limiting factorsinclude; raw material, labour hours, machine hours, finance,government policy, sales, demand e.t.c.

Optimal Product Mix Decision

This decision involves the process of identifying the appropriateproduction mix that will maximize the total contribution of theorganisation after the available limited resources must have beenjudiciously allocated among various competing product lines.However, the specific approach to be adopted in allocating thescarce resources will depend largely on the nature of the


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constraint. Under normal circumstances, it is possible toidentify two types of constraint situation viz;

i. Single constraint: this implies that out of variousfactors of production, only a resource is limited insupply. The approach of allocating the scarce resourceamong various product lines to maximize the overallprofitability through increased contribution is referredto as contribution per limiting factor.

ii. Multiple constraint: this represent where two or moreresources of an organisation are limited in supply. Thisdecision problem will require the application of linearprogramming technique.

SPECIAL OFFER DECISION

This is a decision situation that involves the acceptance orrejection of the production of a given output level for aspecific customer at a price that is usually below the marketprice. In order to accept or reject such offer, the organisationhas to compare the minimum price with the offer. The minimumprice is the lowest possible price an organisation must acceptfor performing a specific activity. It is the relevant cost ofproduction.

The minimum price is the amount that would be incurred to producethe given output level. When the organisation is working belowfull capacity level, the relevant cost would be the actual futurecost to be incurred on such job. But where it is operating atfull capacity, the relevant cost would also include thecontribution lost or forgone as a result of sacrificing someoutput for the required output of the offer.

Qualitative factors in accept or reject decision

i. Overstretching of existing capacity.ii. Effect on other customers if the offer is accepted at a

price below the existing market priceiii. Loss of customers’ goodwill where the offer is rejectediv. Government policy


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v. Inflation

BREAKEVEN ANALYSIS/ COST VOLUME PROFIT (CVP) ANALYSIS

Cost volume profit analysis otherwise known as breakeven analysisrefers to a technique that assists in decision making byemploying the marginal costing concept and is used to measure theeffect on profit as a result of changes in volume of activities,cost and price. It also facilitates planning in the sense thatCVP analysis could assist to predict future cost levels and saleas related to a range of level of activity.

BREAKEVEN POINTThe breakeven point is the sales volume at which total revenueequal total cost. It is the point of zero profit and zero loss.Any level of operation higher than the breakeven point will yielda profit, and any level of operation below the breakeven pointwill yield a loss. The significant of this point lies on thesignal it emits. It warns that if operation decline below thatlevel i. e the breakeven point, a loss will result.

MARGIN OF SAFTY

This is the difference between the breakeven point of sales,either units or values and the budgeted sales. Margin of saftymeasures the extent to which sales have to fall below thebreakeven point before a firm starts making loss. It serves as awarning signal to an organisation not to reduce sales otherwise,it would incur a loss.

MOS (units) = budgeted sales (units) – breakeven point of sales(units)MOS (value) = budgeted sales (value) – breakeven point of sales(units)

BASIC ASSUMPTIONS OF CVP

The basic assumptions associated with c-v-p technique are:Orefuwa Elizabeth ACA Page 83

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i. Selling price per unit is constant.ii. Variable cost per unit is constant.iii. Total fixed cost remains unchanged, regardless of

output.iv. Level of technology and efficiency remain unchangedv. There is no risk and uncertaintyvi. Volume is the only independent variable that affects

costvii. Profits are calculated on variable costing basisviii. Only one product is involved and in case of a

multi-product organisation, there is a constant salesmix

ix. All cost should be classified as either fixed orvariable cost

x. Semi- variable cost can be separated into both thevariable and fixed component

xi. A linear relationship exist between volume, revenueand cost

xii. Stocks are valued on marginal cost onlyxiii. Changes in opening stock and closing stock are

insignificantxiv. Variable cost varies proportionately with output

level

Usefulness of Breakeven Analysisi. It is used in budget planning.ii. It is used to determine selling price and volumeiii. It is used to determine the appropriate product mixiv. It is used for future estimation and control of cost and

profitv. It is used to quantify the effect of cost on programmes

APPLICATIONS OF THE C-V-P MODEL

a. To determine the breakeven point in unitsTotal Fixed Cost Contribution per unit

b. To determine break even point in sales value (#)Total Fixed Cost


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Contribution margin ratio (CMR)

c. To determine the number of units to sell to make a targetedprofit

Total Fixed Cost + Targeted ProfitContribution per unit

d. To determine the sales value in (#) required to achieve atargeted profit

Total Fixed Cost + Targeted ProfitContribution margin ratio

NOTE: Targeted profit is assumed to be profit before tax (PBT).However, if the targeted profit is profit after tax (PAT), thereis need to gross up the PAT using the formulae below;

PBT = Profit after Tax1- Tax rate

GRAPHICAL APPROACH TO BREAKEVEN ANALYSIS

Under the graphical approach, the accountant approach to breakeven analysis will be examined and which can be further dividedinto three approaches viz;

a. Traditional approach: in this case, only the total revenue,total cost and total fixed cost lines are relevant.

b. Contribution break even chart: here, the fixed cost line iseliminated while the variable cost line is introduced

c. Profit volume chart: this shows the relationship betweenprofit and sales at a given level of activity. One majoradvantage of profit volume chart over the two charts is thatit can be used to show the breakeven for a multi-productfirm.


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Introduction to cost accounting

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