Characteristics of Joint Products and Joint Cost:PART 3

Many products or services are linked together by physical relationships which necessitate simultaneous production. To the point of split-off or to the point where these several products emerge as individual units, the cost of the products forms a homogeneous whole.

The classic example of joint products is found in the meat packing industry, where various cuts of meet and numerous by products are processed from one original carcass with one lump-sum cost. An other example of joint products manufacturing is the production of gasoline, where the derivation of gasoline inevitably results in the production of such items as naphtha, kerosene, and distillate fuel oils. Other examples of joint products manufacturing are the simultaneous production of various grads of glue and the processing of soybeans into oil and meal. Joint product costing is also found in industries that must grade raw materials before it is processed. Tobacco manufacturers (except in cases where graded tobacco is purchased) and virtually all fruit and vegetables canners face the problem of grading. In fact, such manufacturers have a dual problem of joint cost allocation:

Materials cost is applicable to all grades
Subsequent manufacturing costs are incurred simultaneously for all the different grads.
The chief characteristic of the joint cost is the fact that the cost of these several different products is incurred in an indivisible sum for all products, rather than in individual amounts for each product. The total production cost of multiple products involves both joint cost and separate, individual products cost. These separable product costs are identifiably with the individual product and, generally, need no allocation. However, the joint production cost requires allocation or assignment to the individual products.

Definition and Explanation of By Products:
The term "by product" is generally used to denote one or more products of relatively small total value that are produced simultaneously with a product of greater total value. The product with the greater value, commonly called the "main product", is usually produced in greater quantities than the by products. Ordinarily, the manufacturer has only limited control over the quantity of the by product that comes into existence. However, the introduction of more advanced engineering methods, such as in the petroleum industry, has permitted greater control over the quantity of residual products. In fact, one company, which formerly paid a trucker to haul away and dump certain waste materials, discovered that the waste was valuable as fertilizer, and this by product is now an additional source of income for the entire industry.

Nature of By-Products:
The accounting treatment of by-products necessitates a reasonably complete knowledge of the technological factors underlying their manufacture, since the origins of by products may vary. By-products arising from the cleansing of the main product, such as gas and tar from coke manufacture, generally have a residual value. In some cases, the by product is left over scrap or waste, such as sawdust in lumber mills. In other cases, the by product may not be the result of any manufacturing process but may arise from preparing raw materials before they are used in the manufacture of the main product. The separation of cotton seed from cotton, cores and seeds from apples, and shells from coca beans are examples of this type of product.

By product can be classified into the following two groups according to their marketable condition at the split-off point:

Those sold in their original form without need of further processing.
Those which require further processing in order to be saleable.

Recognition of Gross Revenue Method--By Products Costing:

This method is typical non-cost procedure in which the final inventory cost of the main product is overstated to the extent that some of the cost belongs to the by product.

However this shortcoming is somewhat removed in procedure 4 (by product revenue deducted from the production cost), although a sales value rather than a cost is deducted from the production cost of the main product.

1.By-Product Revenue as Other Income:
To explain this procedure the following example is presented:

Example:
Sales (Main Product, 10,000 units @ $2) $20,000
Cost of goods sold:
Beginning inventory (1,000 units @ $1.5) $1,500
Total production cost (11,000 units @ $1.5) $16,500
-------
Cost of goods avail able for sale $18,000
Ending inventory (2,000 units @ $1.5) $3,000
-------
$15,000
--------
Gross profit 5,000
Marketing and administrative expenses $2,000
--------
Operating income $3,000
Other income: Revenue from sale of by-product $1,500
--------
Income before income tax $4,500
=====

2. By-Product Revenue as Additional Sales Revenue:
In this case, the income statement above would show the $1,500 revenue from sales of the by product as an addition to sales of the main product. As a result, total sales revenue would be $21,500, and gross profit and operating income would increase accordingly. All other figures would remain the same.

3. By Product Revenue as a Deduction from the Cost of Goods Sold:
In this case, $1,500 revenue from the by product would be deducted from the $15,000 cost of goods sold figure, thereby reducing the cost and increasing the gross profit and operating income. The income before income tax remains at $4,500.

4. By Product Revenue deducted from Production Cost:
In this case, the $1,500 revenue from by-product sales is deducted from the $16,500 total production cost, giving a new production cost of $15,000. This revised cost results in a new average unit cost of $1.3625 for the main product. The final inventory will consequently be $2,725 instead of $3,000. The income statement would appear as follows:

Sales (Main Product, 10,000 units @ $2) $20,000

Cost of goods sold:
Beginning inventory (1,000 units @ $1.35) $1,350
Total production cost (11,000 units @ $1.5) $16,500
Revenue from sale of by product $1,500
---------
Net production cost $15,000
Cost of goods available for sale 12000units @1.3625 average cost
$16350
Ending inventory (2,000 units @ $1.3625) $2,725
-------
$13,625
----------
Gross profit $6,375
Marketing and administrative expenses $2,000
----------
Operating income $4,375
======

The preceding method required no complicated journal entries. The revenue received from by product sales is debited to cash or accounts receivable. In the first three cases, income from sales of by product is credited; in the fourth case, the production cost of the main product is credited.

Joint Products and Joint Product Cost PART 2

CRASH CLASSE OF CA MODULE D
COST ACCOUNTING
FOR STUDENTS IN KARACHI
0322-3385752



Definition and Explanation of Joint Products:

Joint products are produced simultaneously by a common process or series of processes, with each product processing more than a nominal value in the form in which it is produced. The definition emphasizes the point that the manufacturing process creates products in a definite quantitative relationship. An increase in one product's output will bring about an increase in the quantity of the other products, or vice versa, but not necessarily in the same proportion.

Definition and explanation of Joint Product Cost:
A joint product cost cay be defined as that cost which arises from the common processing or manufacturing of products produced from a common raw material. Whenever two or more different products are created from a single cost factor, a joint product cost results. A joint cost is incurred prior to the point at which separately identifiable products emerge from the same process.

Example:
For example, the production of coke, for which coal is the original raw material. In addition to coke as its major product, the process produces sulfate of ammonia, light oil, crude tar and gas. The greater quantity of gas is not sold but is used to fire the coke ovens and the boilers in the power plant. The coke ovens are the split-off point for cost assignments. The cost of each product consists of a pro rata share of the joint cost plus any separable or subsequent costs incurred in order to put the products into saleable condition.

COKE AND ITS ASSOCIATED PRODUCTS

COAL
(ORIGINAL RAW MATERIAL) → COKE OVEN
(SPLIT-OFF POINT) → COKE
(MAJOR PRODUCT) Plus Separable cost
→ COKE

→ SULFATE OF AMMONIA Plus Separable cost
→ SULFATE OF AMMONIA
→ LIGHT OIL Plus Separable cost
→ BENZOL
→ CRUDE TAR Plus Separable cost
→ TAR
→ COKE OVEN GAS Plus Separable cost
→ GAS

Characteristics of Joint Products and Joint Cost:

Many products or services are linked together by physical relationships which necessitate simultaneous production. To the point of split-off or to the point where these several products emerge as individual units, the cost of the products forms a homogeneous whole.

The classic example of joint products is found in the meat packing industry, where various cuts of meet and numerous by products are processed from one original carcass with one lump-sum cost. An other example of joint products manufacturing is the production of gasoline, where the derivation of gasoline inevitably results in the production of such items as naphtha, kerosene, and distillate fuel oils. Other examples of joint products manufacturing are the simultaneous production of various grads of glue and the processing of soybeans into oil and meal. Joint product costing is also found in industries that must grade raw materials before it is processed. Tobacco manufacturers (except in cases where graded tobacco is purchased) and virtually all fruit and vegetables canners face the problem of grading. In fact, such manufacturers have a dual problem of joint cost allocation:

Materials cost is applicable to all grades
Subsequent manufacturing costs are incurred simultaneously for all the different grads.
The chief characteristic of the joint cost is the fact that the cost of these several different products is incurred in an indivisible sum for all products, rather than in individual amounts for each product. The total production cost of multiple products involves both joint cost and separate, individual products cost. These separable product costs are identifiably with the individual product and, generally, need no allocation. However, the joint production cost requires allocation or assignment to the individual products.

COACHING CLASSES FOR FIA-ACCA STUDENTS IN KARACHI

FA1 Recording Financial Transactions

MA1 Management Information

FA2 Maintaining Financial Records

MA2 Managing Costs and Finance

FAB Accountant in Business

FFA Financial Accounting

FMA Management Accounting

FAU Foundations in Audit


CONTACT NOW:

KHALID AZIZ
0322-3385752
COACHING CLASSES
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CA.MOD A,B,C,D
PIPFA
ACCOUNTING O/A LEVEL
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MICRO ECONOMICS & STATISTICS OF MA-ECONOMICS

By Products and Joint Products PART 1

CRASH CLASSES OF CA MODULE D
COST ACCOUNTING FOR STUDENTS IN KARACHI.
0322-3385752



Many industrial concerns are confronted with the difficult and often rather complicated problem of assigning costs to their by-products and joint products. Chemical companies, coke manufacturers, refineries, flour mills, coal mines, lumber mills, gas companies, dairies, canners, meat packers, and many others produce in their manufacturing or conversion processes a multitude of products to which some cost must be assigned. Assignment of costs of these various products enhances equitable inventory costing for income determination and financial statement purposes. An even more important aspect of by product and joint product costing is that it furnishes management with data for use in planning maximum profit potentials and evaluating actual profit performance.

Difficulties / Problems in Costing by Products and Joint Products:

By products and joint products are difficult to cost because a true joint cost is indivisible. For example, an ore might contain both lead and Zink. In the raw state, these minerals are joint products, and until they are separated by reduction of the ore, the cost of finding mining, and processing is a joint cost; neither lead nor Zink can be produced without the other prior to the split-off point.

The cost accumulated to the split-off point must be born by the difference between the selling price and the cost to complete and sale each mineral after the split-off point.

joint costs are frequently confused with common costs. However, there is a significant difference between the two: a joint cost is indivisible and common costs are divisible. Common costs are allocable among products or service. Because each of the products or services could have been obtained separately. Therefore, any shared costs of obtaining them can be allocated on the basis of relative usage of common facilities. For example, the cost of fuel or power may be allocated to products on the basis of production volumes or metered usage. The indivisibility characteristics of a joint cost is not always easy to comprehend, since in some cases a joint cost can be divided among joint products in accordance with a common cost causing characteristic. However the result of such a division is of limited use to management for decision making.

Because of the indivisibility of a joint cost, cost allocation and apportionment procedures used for establishing the unit cost of a product are far from perfect and are, indeed, quite arbitrary. The costing of joint products and by products highlights the problem of assigning costs to products whose origin, use of equipment, share of raw materials, share of labor costs, and share of other facilities cannot truly be determined. Whatever methods of allocation are employed, the total profit or loss figure is not affected--provided there are no beginning or ending inventories--by allocation costs to the joint products or by products, since these costs are recombined in the final income statement. However, a joint cost is ordinarily allocated to the products on some acceptable basis to determine product costs needed for inventory carrying costs. For this reason, there is an effect on periodic income, because different amounts may be allocated to inventories of the numerous joint products or by products under various allocation methods. In addition, product costs may be required for such special purposes as justifying selling prices before governmental regularity bodies. However, the validity of splitting a joint cost to determine fair regulated prices for joint products has been questioned by both accountants and economists.

Service Department Costing:

Difference between service department and operating department:

Most of the large organizations have both operating departments and service departments. The central purpose of the organization are carried out in the operating department. In contrast, service departments do not directly engage in operating activities. Instead, they provide services or assistance to the operating departments. Examples of operating departments include the surgery departments at hospitals, geography departments at universities, the marketing departments insurance companies, and production departments at manufacturing companies like Mitsubishi, Hewlett-Packard. Examples of service departments include Cafeteria, Internal Auditing, Human Resources, Cost Accounting, and Purchasing.

The costs incurred by service departments are usually allocated to the operating departments, and from the operating departments to the products and services. Many service departments also provide services to other service departments within organization. The cafeteria department, for example, provides food for all employees, including those assigned to other service departments. In return cafeteria department may receive services from other service departments such as from custodial services or personnel. Services provided between service departments are known as interdepartmental services or reciprocal services.

Several different methods are used to allocate costs of service departments to operating departments. Regardless of the allocation method that is ultimately selected, an allocation base must be selected for each service department.

Selecting Allocation Base:
Costs are ordinarily assigned to products and services by using a two stage process. In first stage, service department and other costs are allocated to operating departments. In second stage, the costs that have been assigned to operating departments are allocated to products and services. Here we will focus on the first stage, in which service department costs are allocated to operating departments.

In the first stage, service department costs are allocated to operating departments by using a unique allocation base for each service department. The allocation base that is used to allocate a particular service department's costs should "drive" those costs. For example, the number of meals served would commonly be used as the allocation base for cafeteria costs because the costs incurred in the cafeteria are driven to a large extent by the number of meals served. Ideally the total cost incurred in the service department should be directly proportional to the allocation base. If the allocation base increases or decreases by 10%, the service department cost should increase or decrease by 10% as well. Managers also often argue that an allocation base should reflect as accurately as possible the benefits that the various departments receive from the service department.

For example the most managers would argue that square feet building space occupied by each department should be used as the allocation base for janitorial services because both the benefits and costs of janitorial services tend to be proportional to the amount of space occupied by a department. A given service department's cost may be allocated using more than allocation base (see examples below). For example, data processing costs may be allocated on the basis of CPU minutes for mainframe computers and on the basis of number of personal computers used in each operating department.

In addition to explanation of how to select an allocation base, another critical factor should not be overlooked. The allocation base should be clear and straightforward and easily understood by the managers to whom the costs are being allocated.

Direct Method of Cost Allocation-Service Department Costing:

Definition:
Direct method is a cost allocation method under which any of the allocation base attributable to the service departments themselves is ignored; only the amount of the allocation base attributable to the operating departments is used in the allocation.

Explanation:
The direct method is the simplest of the three cost allocation methods. It ignores reciprocal or interdepartmental services (services provided by a service department to another service department) and allocates all costs of service departments directly to operating departments. Even if a service department (such as personnel department) provides a large amount of service to another service department (such as the cafeteria department), no allocations are made between the two departments. Rather all costs are are directly allocated to the operating departments, bypassing the other service departments. Hence the term direct method.

Example:
To provide an example of the direct method, consider Mountain View Hospital, which has two service departments and two operating departments as shown below:
Description
Service Department
Operating Department
Total

Hospital Administration Custodial Services Laboratory Daily Patient Care
Departmental costs before allocation
Employee hours
Space occupied square feet $360,000
12,000
10,000 $90,000
6,000
200 $261,000
18,000
5000 $689,000
30,000
45,000 $1,400,000
66,000
60,200

Hospital administration costs will be allocated on the basis of employee-hours and Custodial Services costs will be allocated on the basis of square feet occupied.
The direct method of allocating the hospital's service department costs to the operating departments is shown below:Description
Service Department
Operating Department
Total

Hospital Administration Custodial Services Laboratory Daily Patient Care
Departmental costs before allocation
Allocation:

Hospital administration costs (18/48, 30/48)*

Custodial service department costs (5/50, 45/50)**

Total costs allocation
$360,000


(360,000)



-----------
$0
======
$90,000





(90,000)
----------
$0
=====
$261,000


135,000


9,000
-----------
$405,000
======
$689,000


225,000


81,000
----------
$995,000
=======
$1,400,000







1,400,000
=======



*Based on the employee-hours in the two operating departments, which are 18,000 hours + 30,000 hours = 48,000 hours
**Based on the space occupied by the two operating departments, which is 5,000 square feet + 45,000 square feet = 50,000 square feet

Several things should be carefully noted in this example. First, even though both the hospital administration department and custodial services department have recorded employee-hours. These employee hors are ignored when allocating service department costs using direct method. Under the direct method, any of the allocation base attributable to the service departments themselves is ignored; only the amount of the allocation base attributable to the operating departments is used in the allocation. Note that the same rules used when allocating the costs of the custodial services department. Even though the Hospital Administration and Custodial Service departments occupy some space, this is ignored when the custodial services costs are allocated. Finally, note that after all allocations have been completed, all of the departmental costs are contained in the two operating departments. These costs will be used to prepare overhead rates for purpose of costing products and services produced in the operating departments.

Advantages and Disadvantages of Direct Method:
Although the direct method is simple , it is less accurate than the other methods since it ignored interdepartmental services. This can lead to distorted product and service costs. Even so, many organizations use the direct method because of its simplicity.

Step Method of Cost Allocation:
Definition:
Step method is the method of allocating service department's costs to other service departments, as well as to operating departments, in a sequential manner. The sequence typically starts with the service department that provides the greatest amount of service to other departments.

Explanation:
Unlike the direct method, the step method provides for allocation of a service department's costs to other service departments, as well as to operating departments. The step method is sequential. The sequence typically begins with to department that provides the greatest amount of service to other service departments. After its costs have been allocated, the process continues, step by step, ending with the department that provides the least amount of services to other service departments.

Example:
To provide an example of the step method, consider Mountain View Hospital, which has two service departments and two operating departments as shown below:
Description
Service Department
Operating Department
Total

Hospital Administration Custodial Services Laboratory Daily Patient Care
Departmental costs before allocation
Employee hours
Space occupied square feet $360,000
12,000
10,000 $90,000
6,000
200 $261,000
18,000
5000 $689,000
30,000
45,000 $1,400,000
66,000
60,200

Hospital administration costs will be allocated on the basis of employee-hours and Custodial Services costs will be allocated on the basis of square feet occupied.
The step method of allocating the hospital's service department costs to the operating departments is shown below:
Description
Service Department
Operating Department
Total

Hospital Administration Custodial Services Laboratory Daily Patient Care
Departmental costs before allocation
Allocation:

Hospital administration costs (6/54, 18/54, 30/54)*

Custodial service department costs (5/50, 45/50)**

Total costs allocation
$360,000



(360,000)



-----------
$0
======
$90,000



40,000


(130,000)
----------
$0
=====
$261,000



120,000


13,000
-----------
$394,000
======
$689,000



200,000


117,000
----------
$1,006,000
=======
$1,400,000








1,400,000
=======



*Based on the employee-hours in custodial services the two operating departments, which are 6,000 hours + 18,000 hours + 30,00 hours = 54,000 hours
**Based on the space occupied by the two operating departments, which is 5,000 square feet + 45,000 square feet = 50,000 square feet

Example shows the treatment of step method of cost allocation. Note the following three key points about these allocations.

First, under the allocation heading in the solution you see two allocations, or steps. In the first step, the costs of hospital administration are allocated to another service department (Custodial Services) as well as to the operating departments. In contrast to the direct method, the allocation base for Hospital Administration costs now includes the employee hours for custodial services as well as for the operating departments. However, the allocation base still excludes the employee-hours for Hospital Administration itself. In both the direct and step methods, any amount of the allocation base attributable to the service department whose cost is being allocated is always ignored.
Second, looking again on the example, note that in the second step under the allocation heading, the cost of custodial services is allocated to the two operating departments, and non of the cost is allocated to Hospital Administration even though Hospital Administration occupies space in the building. In the step method, any amount of the allocation base that is attributable to a service department whose cost has already been allocated is ignored. After a service department's cost have been allocated, costs of other service departments are not reallocated back to it.
Third, not that the cost of Custodial Services allocated to other departments in the second step ($130,000) in example, includes the costs of Hospital Administration that were allocated to Custodial Services in the first step.

Reciprocal Method of Cost Allocation-Service Department Costing:
Definition:
Reciprocal method is a method of allocating service department costs to other departments that gives full recognition to interdepartmental services.

Explanation:
The reciprocal method gives full recognition to interdepartmental services. Under the step method, only partial recognition of interdepartmental services is possible. The step method always allocates costs forward never backward. The reciprocal method, by contrast, allocates service department costs in both directions. The reciprocal allocation requires the use of simultaneous equations. This method is also known as algebraic method and simultaneous equations method.

Under this method the true cost of the service departments are computed first with the help of simultaneous equations and these are then distributed to producing departments on the basis of given percentage or ratio. Remember that true cost of the service department means the cost of the service department which includes original cost of the department plus the share of the other service department. The main advantage of this method is to have an accurate distribution in a single step in the distribution summary.

Example:
A company has two service and two producing departments. The two service departments serve not only to producing departments but also to each other. The departmental estimates for the next year are as follows.

Producing departments:
A
B
Service departments:
X
Y

50,000
40,000

10,000
8,800


The service departments costs are to be distributed as under:
Cost of X : 50% to A, 40% to B, and 10% to Y
Cost of Y : 40% to A, 40% to B, and 20% to X


Required:
Transfer the service departments costs to each other and to producing departments.


Solution:
Now we solve the given illustration first using the simultaneous equation method as follows:

Original costs of service departments:

X = Rs.10,000
Y = Rs. 8,800

After getting the share from distribution of service departments:

X = Rs. 10,000 + 20% Y
Y = Rs. 8,800 + 10% X

By putting the value of Y in equation (1)

X = Rs. 10,000 + 20%(Rs.8,800 + 10%X)
X = Rs. 10,000 + 1760 + 0.2X
X – 0.02X = Rs. 10,000 + Rs.1,760
0.98X = Rs. 11,760
X = 11760 / 0.98
= Rs. 12,000

By putting the value of X in equation (2)

Y = Rs. 8,800 + 10%(Rs. 12000)
Y = Rs. 8,800 + Rs. Rs. 1,200
= Rs. 10,000


Distribution Summary

Department
Producing Service

Original costs
Distribution of service department costs:
X
Y

Total departmental overheads
A
Rs
50,000
6,000
4,000
-------
60,000
=====
B
Rs
40,000
4,800
4,000
------
48,800
=====
X
Rs
10,000
(12,000)
2,000
-------
Nil
=====
Y
Rs
8,800
1,200
(10,000)
-------
Nil
=====


Use of Reciprocal Method:
This method is rarely used in practice for two reasons. First, the computations are relatively complex. Although the complexity issue could be overcome by use of computers, there is no evidence that computers have made the reciprocal method more popular. Second, the step method usually provides results that are a reasonable approximation of the results that the reciprocal method would provide. Thus, companies have little motivation to use the more complex reciprocal method.

COACHING CLASSES FOR FIA STUDENTS

FA1 Recording Financial Transactions

MA1 Management Information

FA2 Maintaining Financial Records

MA2 Managing Costs and Finance

FAB Accountant in Business

FFA Financial Accounting

FMA Management Accounting

FAU Foundations in Audit

CONTACT NOW:

KHALID AZIZ
0322-3385752

Pricing Products and Services

Pricing is not a problem for some businesses. They make products or provide a service that is in competition with others, identical products or services for which a market price already exists. Customers will not pay more that this price, and there is no reason to charge less. Under these circumstances, the company simply charges the prevailing market price. Markets for basic raw materials such as farm products and minerals follow this pattern.

Here we are concerned with the more common situation in which a company is faced with the problem of setting its own prices. Clearly, the pricing decision can be critical. If the price is too high, customers will avoid purchasing the company's products. If the price is set too low, the company's costs may not be covered.

the usual approach in pricing is to mark up cost. A product's markup is the difference between its selling price and its cost. The markup is usually expressed as a percentage of cost. This approach is called cost plus pricing because the predetermined markup percentage is applied to the cost base to determine a target selling price.

Selling price = Cost + (Markup × Cost)

For example, if a company uses a markup of 50%, to the costs of its products to determine the selling price. If a product costs $10, then it would charge $15 for the products.

Two key issues must be addressed when the cost plus approach to pricing is used. First, What cost should be used? Second, how should the markup be determined? Several alternatives approaches are considered here, starting with the generally favored by economists.

Price Elasticity of Demand--Economists' Approach to Pricing:

If a company raises the price of a product, unit sales ordinarily falls. Because of this, pricing is a delicate balancing act in which the benefits of higher revenues per unit are traded off against the lower volume that results from charging higher prices. The sensitivity of unit sales to changes in prices is called the price elasticity of demand. Click here to read full article.

Absorption Costing Approach to Cost Plus Pricing:

The absorption costing approach to cost plus pricing differs from the economists' approach (price elasticity of demand) both in what costs are marked up and in how markup is determined. Under the absorption costing approach to cost plus pricing, the cost base is the absorption costing unit product cost rather than variable costing. Click here to read full article.

Target Costing:

Target costing is the process of determining the maximum allowable cost for a new product and then developing a prototype that can be profitably made for that maximum target cost figure. Click here to read full article.

Time and Material Pricing in Service Companies:

Some companies--particularly in service industries-- use a variation of cost plus pricing called time and material pricing. Under this method, two pricing rates are established--one based on direct labor time and other based on the cost of direct materials used

Definition and Explanation of Time and Materials Pricing:
Some companies--particularly in service industries-- use a variation of cost plus pricing called time and material pricing. Under this method, two pricing rates are established--one based on direct labor time and other based on the cost of direct materials used. This pricing method is used in repair shops, in printing shops, and by many professionals such as physicians and dentists. The time and material rates are usually market determined. In other words, the rates are determined by the interplay of supply and demand and by competitive conditions in the industry. However, some companies set the rates using a process similar to the process followed in the absorption costing approach to cost plus pricing. In this case, the rates include allowances for selling, general and administrative expenses; other direct and indirect costs; and a desired profit. This page will show how the rates might be set using the cost-plus approach.

Time Component:
The time component is typically expressed as a rate per hour of labor. The rate is computed by adding together three elements:

The direct costs of the employee, including salary and fringe benefits.
A pro rata allowance for selling, general, and administrative expenses of the organization.
An allowance for a desired profit per hour of employee time.
In some organizations (such as a repair shop), the same hourly rate will be charged regardless of which employee actually works on the job; in other organizations, the rate may vary by employee. For example, in a public accounting firm, the rate charged for a new assistant accountant's time will generally be less than the rate charged for an experienced senior accountant or for a partner.

Material Component:
The material component is determined by adding a material loading charge to the invoice price of any materials used on the job. The material loading charge is designed to cover the costs of ordering, handling, and carrying materials in stock, plus a profit margin on the materials themselves.

Example of Time and Material Pricing:
To provide a numerical example of time and material pricing, consider the following:

Quality Auto Shop uses time and material pricing for all of its repair work. The following costs have been budgeted for the coming year:

Repairs Parts
Mechanics' wages $300,000
Service manager--salary 40,000
Parts manager--salary $36,000
Clerical assistant--salary 18,000 15,000
Retirement and insurance--16% of salary and wages 57,280 8,160
Supplies 720 540
Utilities 36,000 20,800
Property taxes 8,400 1,900
Depreciation 91,600 37,600
Invoice cost of parts used 400,000

Total budgeted cost

The company expects to bill customers for 24,000 hours of repair time. A profit of $7 per hour of repair time is considered to be feasible, given the competitive conditions in the market. For parts, the competitive markup on the invoice cost of parts used is 15%.

The following schedule shows the calculation of the billing rate and the material loading charge to be used over the next year.

TIME AND MATERIALS PRICING

Time Component: Repairs Parts: Material Loading Charge
Total Per Hour* Total Percent**
Cost of mechanics' time:
Mechanics' wages $300,000
Retirement and insurance (16% of wages) 48,000
--------
Total cost 348,000 $14.5
For repairs--other cost of repair service. For parts--cost of ordering handling, and storing parts:
Repairs service manager--salary 40,000
Parts manager salary $36,000
Clerical assistant salary 18,000 15,000
Retirement and insurance (16% of salaries) 9,280 8,160
Supplies 720 540
Utilities 36,000 20,800
Property taxes 8,400 1,900
Depreciation 91,600 37,600
-------- ---------
Total cost 204,000 8.50 120,000 30%
-------- --------
Desired profit:
24,000 hours × $7per hour 168,000 7.00
15% × $400,000 60,000 15%
------- ------- ------- -------
Total amount to be billed $720,000 $30.00 $180,000 45%
====== ===== ====== ====
*Based on 24,000 hours
**Based on $400,000 invoice cost of parts. The charge for ordering, handling, and storing parts, for example, is computed as follows: $120,000 cost / $400,000 invoice cost = 30%

Note that the billing rate, or time component, is $30 per hour of repair time and the material loading charge is 45% of the invoice cost of parts used. Using these rates, a repair job that requires 4.5 hours of mechanics time and $200 in parts would be billed as follows:

Labor time: 4.5 hours $30 per hour $135
Parts used:
Invoice cost $200
Material loading charge: 45% $200 90 290
-------- ------
Total price of the job $425
=====


Rather than using labor hours as the basis for calculating the time rate, a machine shop, a printing shop, or a similar organization might use machine-hours.

This method of setting prices is a variation of the absorption costing approach. As such, it is not surprising that is suffers from the same problem. Customers may not be willing to pay the rates that have been computed. If actual business is less that the forecasted 24,000 hours and $400,000 worth of parts, the profit objectives will not be met and the company may not even break even.

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ATTENTION COMMERCE STUDENTS

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Double Entry System of Bookkeeping:

The double entry system of bookkeeping owes its origin to an Italian merchant named Lucas Pacioli who wrote the first book on double entry bookkeeping entitled "Decomputis et Scripturis". It was published in Venice in 1544. All modern methods of accounting are simply adaptation of the system invented by that ancient pioneer.

Definition and Explanation:
The double entry theory of bookkeeping can be defined as the system of recording transactions having two fundamental aspects - one involving the receiving of a benefit and the other to giving the benefit - in the same set of books.

In this theory, as the two fold aspects of each transaction are recorded, the name "double entry" has been given to this system.

Every transaction involves two fold aspects e.g., an aspect of receiving and an aspect of giving. One who receives is a debtor (Dr) and one who gives is a creditor (Cr). Under the double entry system, both the aspects of giving and receiving are recorded in terms of accounts. The account which receives the benefit is debited and the account which gives the benefit is credited. It is the ultimate result of this system that every debit must have corresponding credit and vice versa and on any particular day the total of the debit entries and the credit entries on the various accounts must be equal.

Advantages of Double Entry System:
The main advantages of double entry theory of book keeping are as follows:

Trial balance can be drawn up on any day to prove the arithmetical accuracy of record.

The nominal sides of transactions being recorded: it is possible to prepare Trading and Profit and Loss Account from which the Gross Profit and Net Profit made by the business during a particular period can be easily ascertained.

As all personal accounts of debtors and creditors as well as real accounts are kept, it is possible to prepare Balance Sheet.

The transactions being recorded in the most scientific and systematic way gives the most reliable information of business.

It prevents fraud by rendering any alteration in any account more difficult.

It enables the trader to compare the different items, such as sales, purchases, opening stock and closing stock of one period with similar items of preceding period and the trader may thus know whether his business is progressing or not.

Disadvantages of Double Entry System:
The following are the main disadvantages of this system:

This system requires the maintenance of a number of books of accounts which is not practical in small concerns.

The system is costly because a number of records are to be maintained.

There is no guarantee of absolute accuracy of the books of accounts inspite of agreement of the trial balance.

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