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.
Showing posts with label COST ACCOUNTING. Show all posts
Showing posts with label COST ACCOUNTING. Show all posts
Saturday, July 30, 2011
Wednesday, July 27, 2011
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.
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.
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.
Monday, February 7, 2011
Standard Costing
Standard Costing
A. Standard Cost--the anticipated cost of producing a unit of output
1. Recordkeeping--the standard cost is used by many companies to determine
inventory valuation and cost of goods sold for interim periods
2. Benchmark--the standard cost is used by many companies as a goal for
employees to strive to meet
3. Performance Evaluation--the standard cost is used by many companies to
evaluate employee performance and serve as an input into the planning
process
B. Variances--the difference between total actual costs incurred and the total
standard costs applied to the output produced during the period
1. Direct Materials
a. Computation--the difference between the actual direct materials
cost and the standard direct materials cost applied to production
can be divided into price and quantity components
1) Materials Price Variance--the materials price variance is equal
to the difference between the actual quantity of direct
materials purchased multiplied by the actual price for direct
materials and the actual quantity of direct materials purchased
multiplied by the standard price for direct materials
a) Favorable/Unfavorable--the materials price variance is
labeled as favorable if the actual price for direct
materials is less than the standard price for direct
materials and as unfavorable if the actual price for direct
materials is greater than the standard price for direct
materials
2) Materials Quantity Variance--the materials quantity variance is
equal to the difference between the actual quantity of direct
materials used in production multiplied by the standard price
for direct materials and the standard quantity of direct
materials allowed for the actual production multiplied by the
standard price for direct materials
a) Favorable/Unfavorable--the materials quantity variance is
labeled as favorable if the actual quantity of direct
materials used in production is less than the standard
quantity of direct materials allowed for the actual
production and as unfavorable if the actual quantity of
direct materials used in production is greater than the
standard quantity of direct materials allowed for the
actual production
b. Recording
1) Materials Price Variance--the materials price variance is
recorded when the direct materials are purchased
a) Materials--the materials account is debited for the actual
quantity of direct materials purchased multiplied by the
standard price for direct materials
b) Accounts Payable--the accounts payable account or the cash
account is credited for the actual quantity of direct
materials purchased multiplied by the actual price for
direct materials
c) Materials Price Variance--the materials price variance
account is debited/credited for the difference
2) Materials Quantity Variance--the materials quantity variance is
recorded when the direct materials are used in production
a) Work in Process--the work in process account is debited for
the standard quantity of direct materials allowed for the
actual production multiplied by the standard price for
direct materials
b) Materials--the materials account is credited for the actual
quantity of direct materials used in production multiplied
by the standard price for direct materials
c) Materials Quantity Variance--the materials quantity
variance account is debited/credited for the difference
c. Illustration--one unit of output should be manufactured using 3
pounds of direct materials; the standard direct materials cost is
$5 per pound; normal capacity is 100,000 units of output; during
the year 301,000 pounds of direct materials were purchased at a
cost of $5.10 per pound, and 290,000 pounds of direct materials
were used in producing 95,000 units of output
Actual Actual Standard Standard
Quantity Quantity Quantity Quantity
Purchased Purchased Used Allowed
x x x x
Actual Standard Standard Standard
_ Price _ _ Price _ _ Price _ _ Price _
1,535,100 1,505,000 1,450,000 1,425,000
(301,000 x 5.10) (301,000 x 5) (290,000 x 5) (95,000 x 3 x 5)
30,100 U 25,000 U
Materials Materials
Price Quantity
Variance Variance
Materials 1,505,000
Materials Price Variance 30,100
Accounts Payable 1,535,100
Work in Process 1,425,000
Materials Quantity Variance 25,000
Materials 1,450,000
2. Direct Labor
a. Computation--the difference between the actual direct labor cost
and the standard direct labor cost applied to production can be
divided into rate and efficiency components
1) Labor Rate Variance--the labor rate variance is equal
to the difference between the actual quantity of direct hours
multiplied by the actual rate for direct labor hours and the
actual quantity of direct labor hours multiplied by the
standard rate for direct labor hours
a) Favorable/Unfavorable--the labor rate variance is labeled
as favorable if the actual rate for direct labor hours is
less than the standard rate for direct labor hours and as
unfavorable if the actual rate for direct labor hours is
greater than the standard rate for direct labor hours
2) Labor Efficiency Variance--the labor efficiency variance is
equal to the difference between the actual hours of direct
labor multiplied by the standard rate for direct labor hours
and the standard quantity of direct labor hours allowed for the
actual production multiplied by the standard rate for direct
labor hours
a) Favorable/Unfavorable--the labor efficiency variance is
labeled as favorable if the actual quantity of direct labor
hours is less than the standard quantity of direct labor
hours allowed for the actual production and as unfavorable
if the actual quantity of direct labor hours is greater
than the standard quantity of direct labor hours allowed
for the actual production
b. Recording--both the labor rate variance and the labor efficiency
variance are recorded when the direct labor cost is incurred
1) Work in Process--the work in process account is debited for the
standard quantity of direct labor hours allowed for the actual
production multiplied by the standard rate for direct labor
hours
2) Wages Payable--the wages payable account or the cash account is
credited for the actual quantity of direct labor hours
multiplied by the actual rate for direct labor hours
3) Labor Rate Variance--the labor rate variance account is
debited/credited for the unfavorable/favorable labor rate
variance
4) Labor Efficiency Variance--the labor efficiency variance
account is debited/credited for the unfavorable/favorable labor
labor efficiency variance
c. Illustration--one unit of output should be manufactured in 4 direct
labor hours; the standard direct labor cost is $30 per hour; normal
capacity is 100,000 units of output; during the year 95,000 units
were produced in 385,000 direct labor hours at a cost of $30.40 per
direct labor hour
Standard
Actual Actual Direct
Direct Direct Labor
Labor Labor Hours
Hours Hours Allowed
x x x
Actual Standard Standard
_ Rate _ _ Rate _ _ Rate _
11,704,000 11,550,000 11,400,000
(385,000 x 30.40) (385,000 x 30) (95,000 x 4 x 30)
154,000 U 150,000 U
Labor Labor
Rate Efficiency
Variance Variance
Work in Process 11,704,000
Labor Rate Variance 154,000
Labor Efficiency Variance 150,000
Wages Payable 11,400,000
3. Manufacturing Overhead
a. Computation--the difference between the actual manufacturing
overhead and the standard manufacturing overhead applied to
production can be divided into spending, efficiency, and volume
components
1) Manufacturing Overhead Spending Variance--the manufacturing
overhead spending variance is equal to the difference between
the actual manufacturing overhead (the actual variable overhead
plus the actual fixed overhead) and the budgeted overhead for
the actual direct labor hours (the actual quantity of direct
labor hours multiplied by the standard rate for variable
overhead plus the standard cost for fixed overhead)
a) Favorable/Unfavorable--the manufacturing overhead spending
variance is labeled as favorable if the actual
manufacturing overhead is less than the budgeted overhead
for the actual direct labor hours and as unfavorable if the
actual manufacturing overhead is greater than the budgeted
overhead for the actual direct labor hours
2) Manufacturing Overhead Efficiency Variance--the manufacturing
overhead efficiency variance is equal to the difference between
the budgeted overhead for the actual direct labor hours and the
budgeted overhead for the standard quantity of direct labor
hours allowed for the actual production (the standard quantity
of direct labor hours allowed for the actual production
multiplied by the standard rate for variable overhead plus the
standard cost for fixed overhead)
a) Favorable/Unfavorable--the manufacturing overhead
efficiency variance is labeled as favorable if the budgeted
overhead for the actual direct labor hours is less than the
budgeted overhead for the standard quantity of direct labor
hours allowed for the actual production and as unfavorable
if the budgeted overhead for the actual direct labor hours
is greater than the budgeted overhead for the standard
quantity of direct labor hours allowed for the actual
production
3) Manufacturing Overhead Volume Variance--the manufacturing
overhead volume variance is equal to the difference between
the budgeted overhead for the standard quantity of direct labor
hours allowed for the actual production and the applied
overhead (the standard quantity of direct labor hours allowed
for the actual production multiplied by the standard
manufacturing overhead rate)
a) Standard Manufacturing Overhead Rate--the standard
manufacturing overhead rate is equal to the standard
quantity of direct labor hours allowed for the normal
capacity multiplied by the standard rate for the variable
overhead plus the standard cost for fixed overhead divided
by the standard quantity of direct labor hours allowed for
the normal capacity
b) Favorable/Unfavorable--the manufacturing overhead volume
variance is labeled as favorable if the budgeted overhead
for the standard quantity of direct labor hours allowed for
the actual production is less than the applied overhead and
as unfavorable if the budgeted overhead for the standard
quantity of direct labor hours allowed for the actual
production is greater than the applied overhead
b. Recording--the manufacturing overhead variances are recorded at the
end of the period
1) Manufacturing Overhead Application--manufacturing overhead is
applied to production when the direct labor hours are incurred
a) Work in Process--the work in process is debited for the
standard quantity of direct labor hours allowed for actual
production multiplied by the standard manufacturing
overhead rate
2) Manufacturing Overhead Variances--the manufacturing overhead
variances are recorded when the actual manufacturing overhead
and the applied manufacturing overhead accounts are closed at
the end of the period
a) Manufacturing Overhead Spending Variance--the manufacturing
overhead spending variance account is debited/credited for
the unfavorable/favorable manufacturing overhead spending
variance
b) Manufacturing Overhead efficiency Variance--the
manufacturing overhead efficiency variance account is
debited/credited for the unfavorable/favorable
manufacturing overhead spending variance
c) Manufacturing Overhead Volume Variance--the manufacturing
overhead volume variance account is debited/credited for
the unfavorable/favorable manufacturing overhead spending
variance
c. Illustrations
1) One unit of output should be manufactured in 4 direct labor
hours; budgeted variable overhead is $8 per direct labor hour;
budgeted fixed overhead is $7,600,000; normal capacity is
100,000 units of output; during the year 95,000 units were
produced in 385,000 direct labor hours, actual variable
overhead amounted to $3,100,000, and actual fixed overhead
amounted to $7,650,000
Budgeted
Budgeted Overhead
Overhead For
For Standard
Actual Direct
Direct Labor
Actual Labor Hours Applied
_Overhead_ _ Hours _ _Allowed _ _Overhead_
3,100,000 3,080,000 3,040,000 3,040,600
(385,000 x 8) (95,000 x 4 x 8) (380,000 x 8)
7,650,000 7,600,000 7,600,000 7,220,000
_ _ _ _ _ _ (380,000 x 19)
10,750,000 10,680,000 10,640,000 10,260,000
70,000 U 40,000 U 380,000 U
Manufacturing Manufacturing Manufacturing
Overhead Overhead Overhead
Spending Efficiency Volume
Variance Variance Variance
Standard Manufacturing Overhead Rate = (100,000 x 4 x 8 + 7,600,000) / 400,000
= 27
Work in Process 10,260,000
Applied Manufacturing Overhead 10,260,000
Applied Manufacturing Overhead 10,260,000
Manufacturing Overhead Spending Variance 70,000
Manufacturing Overhead Efficiency Variance 40,000
Manufacturing Overhead Volume Variance 380,000
Manufacturing Overhead 10,750,000
2) One unit of output should be manufactured in 5 direct labor
hours; budgeted variable overhead is $18 per direct labor hour;
budgeted fixed overhead is $6,000,000; normal capacity is
50,000 units of output; during the year 48,000 units were
produced in 244,000 direct labor hours, actual variable
overhead amounted to $4,400,000, and actual fixed overhead
amounted to $6,020,000
Budgeted
Budgeted Overhead
Overhead For
For Standard
Actual Direct
Direct Labor
Actual Labor Hours Applied
_Overhead_ _ Hours _ _Allowed _ _Overhead_
4,400,000 4,392,000 4,320,000 4,320,000
(244,000 x 18) (48,000 x 5 x 18) (380,000 x 18)
6,020,000 6,000,000 6,000,000 5,760,000
_ _ _ _ _ _ (240,000 x 24)
10,420,000 10,392,000 10,320,000 10,080,000
28,000 U 72,000 U 240,000 U
Manufacturing Manufacturing Manufacturing
Overhead Overhead Overhead
Spending Efficiency Volume
Variance Variance Variance
Standard Manufacturing Overhead Rate = (50,000 x 5 x 18 + 6,000,000) / 250,000
= 42
Work in Process 10,080,000
Applied Manufacturing Overhead 10,080,000
Applied Manufacturing Overhead 10,080,000
Manufacturing Overhead Spending Variance 28,000
Manufacturing Overhead Efficiency Variance 72,000
Manufacturing Overhead Volume Variance 240,000
Manufacturing Overhead 10,420,000
A. Standard Cost--the anticipated cost of producing a unit of output
1. Recordkeeping--the standard cost is used by many companies to determine
inventory valuation and cost of goods sold for interim periods
2. Benchmark--the standard cost is used by many companies as a goal for
employees to strive to meet
3. Performance Evaluation--the standard cost is used by many companies to
evaluate employee performance and serve as an input into the planning
process
B. Variances--the difference between total actual costs incurred and the total
standard costs applied to the output produced during the period
1. Direct Materials
a. Computation--the difference between the actual direct materials
cost and the standard direct materials cost applied to production
can be divided into price and quantity components
1) Materials Price Variance--the materials price variance is equal
to the difference between the actual quantity of direct
materials purchased multiplied by the actual price for direct
materials and the actual quantity of direct materials purchased
multiplied by the standard price for direct materials
a) Favorable/Unfavorable--the materials price variance is
labeled as favorable if the actual price for direct
materials is less than the standard price for direct
materials and as unfavorable if the actual price for direct
materials is greater than the standard price for direct
materials
2) Materials Quantity Variance--the materials quantity variance is
equal to the difference between the actual quantity of direct
materials used in production multiplied by the standard price
for direct materials and the standard quantity of direct
materials allowed for the actual production multiplied by the
standard price for direct materials
a) Favorable/Unfavorable--the materials quantity variance is
labeled as favorable if the actual quantity of direct
materials used in production is less than the standard
quantity of direct materials allowed for the actual
production and as unfavorable if the actual quantity of
direct materials used in production is greater than the
standard quantity of direct materials allowed for the
actual production
b. Recording
1) Materials Price Variance--the materials price variance is
recorded when the direct materials are purchased
a) Materials--the materials account is debited for the actual
quantity of direct materials purchased multiplied by the
standard price for direct materials
b) Accounts Payable--the accounts payable account or the cash
account is credited for the actual quantity of direct
materials purchased multiplied by the actual price for
direct materials
c) Materials Price Variance--the materials price variance
account is debited/credited for the difference
2) Materials Quantity Variance--the materials quantity variance is
recorded when the direct materials are used in production
a) Work in Process--the work in process account is debited for
the standard quantity of direct materials allowed for the
actual production multiplied by the standard price for
direct materials
b) Materials--the materials account is credited for the actual
quantity of direct materials used in production multiplied
by the standard price for direct materials
c) Materials Quantity Variance--the materials quantity
variance account is debited/credited for the difference
c. Illustration--one unit of output should be manufactured using 3
pounds of direct materials; the standard direct materials cost is
$5 per pound; normal capacity is 100,000 units of output; during
the year 301,000 pounds of direct materials were purchased at a
cost of $5.10 per pound, and 290,000 pounds of direct materials
were used in producing 95,000 units of output
Actual Actual Standard Standard
Quantity Quantity Quantity Quantity
Purchased Purchased Used Allowed
x x x x
Actual Standard Standard Standard
_ Price _ _ Price _ _ Price _ _ Price _
1,535,100 1,505,000 1,450,000 1,425,000
(301,000 x 5.10) (301,000 x 5) (290,000 x 5) (95,000 x 3 x 5)
30,100 U 25,000 U
Materials Materials
Price Quantity
Variance Variance
Materials 1,505,000
Materials Price Variance 30,100
Accounts Payable 1,535,100
Work in Process 1,425,000
Materials Quantity Variance 25,000
Materials 1,450,000
2. Direct Labor
a. Computation--the difference between the actual direct labor cost
and the standard direct labor cost applied to production can be
divided into rate and efficiency components
1) Labor Rate Variance--the labor rate variance is equal
to the difference between the actual quantity of direct hours
multiplied by the actual rate for direct labor hours and the
actual quantity of direct labor hours multiplied by the
standard rate for direct labor hours
a) Favorable/Unfavorable--the labor rate variance is labeled
as favorable if the actual rate for direct labor hours is
less than the standard rate for direct labor hours and as
unfavorable if the actual rate for direct labor hours is
greater than the standard rate for direct labor hours
2) Labor Efficiency Variance--the labor efficiency variance is
equal to the difference between the actual hours of direct
labor multiplied by the standard rate for direct labor hours
and the standard quantity of direct labor hours allowed for the
actual production multiplied by the standard rate for direct
labor hours
a) Favorable/Unfavorable--the labor efficiency variance is
labeled as favorable if the actual quantity of direct labor
hours is less than the standard quantity of direct labor
hours allowed for the actual production and as unfavorable
if the actual quantity of direct labor hours is greater
than the standard quantity of direct labor hours allowed
for the actual production
b. Recording--both the labor rate variance and the labor efficiency
variance are recorded when the direct labor cost is incurred
1) Work in Process--the work in process account is debited for the
standard quantity of direct labor hours allowed for the actual
production multiplied by the standard rate for direct labor
hours
2) Wages Payable--the wages payable account or the cash account is
credited for the actual quantity of direct labor hours
multiplied by the actual rate for direct labor hours
3) Labor Rate Variance--the labor rate variance account is
debited/credited for the unfavorable/favorable labor rate
variance
4) Labor Efficiency Variance--the labor efficiency variance
account is debited/credited for the unfavorable/favorable labor
labor efficiency variance
c. Illustration--one unit of output should be manufactured in 4 direct
labor hours; the standard direct labor cost is $30 per hour; normal
capacity is 100,000 units of output; during the year 95,000 units
were produced in 385,000 direct labor hours at a cost of $30.40 per
direct labor hour
Standard
Actual Actual Direct
Direct Direct Labor
Labor Labor Hours
Hours Hours Allowed
x x x
Actual Standard Standard
_ Rate _ _ Rate _ _ Rate _
11,704,000 11,550,000 11,400,000
(385,000 x 30.40) (385,000 x 30) (95,000 x 4 x 30)
154,000 U 150,000 U
Labor Labor
Rate Efficiency
Variance Variance
Work in Process 11,704,000
Labor Rate Variance 154,000
Labor Efficiency Variance 150,000
Wages Payable 11,400,000
3. Manufacturing Overhead
a. Computation--the difference between the actual manufacturing
overhead and the standard manufacturing overhead applied to
production can be divided into spending, efficiency, and volume
components
1) Manufacturing Overhead Spending Variance--the manufacturing
overhead spending variance is equal to the difference between
the actual manufacturing overhead (the actual variable overhead
plus the actual fixed overhead) and the budgeted overhead for
the actual direct labor hours (the actual quantity of direct
labor hours multiplied by the standard rate for variable
overhead plus the standard cost for fixed overhead)
a) Favorable/Unfavorable--the manufacturing overhead spending
variance is labeled as favorable if the actual
manufacturing overhead is less than the budgeted overhead
for the actual direct labor hours and as unfavorable if the
actual manufacturing overhead is greater than the budgeted
overhead for the actual direct labor hours
2) Manufacturing Overhead Efficiency Variance--the manufacturing
overhead efficiency variance is equal to the difference between
the budgeted overhead for the actual direct labor hours and the
budgeted overhead for the standard quantity of direct labor
hours allowed for the actual production (the standard quantity
of direct labor hours allowed for the actual production
multiplied by the standard rate for variable overhead plus the
standard cost for fixed overhead)
a) Favorable/Unfavorable--the manufacturing overhead
efficiency variance is labeled as favorable if the budgeted
overhead for the actual direct labor hours is less than the
budgeted overhead for the standard quantity of direct labor
hours allowed for the actual production and as unfavorable
if the budgeted overhead for the actual direct labor hours
is greater than the budgeted overhead for the standard
quantity of direct labor hours allowed for the actual
production
3) Manufacturing Overhead Volume Variance--the manufacturing
overhead volume variance is equal to the difference between
the budgeted overhead for the standard quantity of direct labor
hours allowed for the actual production and the applied
overhead (the standard quantity of direct labor hours allowed
for the actual production multiplied by the standard
manufacturing overhead rate)
a) Standard Manufacturing Overhead Rate--the standard
manufacturing overhead rate is equal to the standard
quantity of direct labor hours allowed for the normal
capacity multiplied by the standard rate for the variable
overhead plus the standard cost for fixed overhead divided
by the standard quantity of direct labor hours allowed for
the normal capacity
b) Favorable/Unfavorable--the manufacturing overhead volume
variance is labeled as favorable if the budgeted overhead
for the standard quantity of direct labor hours allowed for
the actual production is less than the applied overhead and
as unfavorable if the budgeted overhead for the standard
quantity of direct labor hours allowed for the actual
production is greater than the applied overhead
b. Recording--the manufacturing overhead variances are recorded at the
end of the period
1) Manufacturing Overhead Application--manufacturing overhead is
applied to production when the direct labor hours are incurred
a) Work in Process--the work in process is debited for the
standard quantity of direct labor hours allowed for actual
production multiplied by the standard manufacturing
overhead rate
2) Manufacturing Overhead Variances--the manufacturing overhead
variances are recorded when the actual manufacturing overhead
and the applied manufacturing overhead accounts are closed at
the end of the period
a) Manufacturing Overhead Spending Variance--the manufacturing
overhead spending variance account is debited/credited for
the unfavorable/favorable manufacturing overhead spending
variance
b) Manufacturing Overhead efficiency Variance--the
manufacturing overhead efficiency variance account is
debited/credited for the unfavorable/favorable
manufacturing overhead spending variance
c) Manufacturing Overhead Volume Variance--the manufacturing
overhead volume variance account is debited/credited for
the unfavorable/favorable manufacturing overhead spending
variance
c. Illustrations
1) One unit of output should be manufactured in 4 direct labor
hours; budgeted variable overhead is $8 per direct labor hour;
budgeted fixed overhead is $7,600,000; normal capacity is
100,000 units of output; during the year 95,000 units were
produced in 385,000 direct labor hours, actual variable
overhead amounted to $3,100,000, and actual fixed overhead
amounted to $7,650,000
Budgeted
Budgeted Overhead
Overhead For
For Standard
Actual Direct
Direct Labor
Actual Labor Hours Applied
_Overhead_ _ Hours _ _Allowed _ _Overhead_
3,100,000 3,080,000 3,040,000 3,040,600
(385,000 x 8) (95,000 x 4 x 8) (380,000 x 8)
7,650,000 7,600,000 7,600,000 7,220,000
_ _ _ _ _ _ (380,000 x 19)
10,750,000 10,680,000 10,640,000 10,260,000
70,000 U 40,000 U 380,000 U
Manufacturing Manufacturing Manufacturing
Overhead Overhead Overhead
Spending Efficiency Volume
Variance Variance Variance
Standard Manufacturing Overhead Rate = (100,000 x 4 x 8 + 7,600,000) / 400,000
= 27
Work in Process 10,260,000
Applied Manufacturing Overhead 10,260,000
Applied Manufacturing Overhead 10,260,000
Manufacturing Overhead Spending Variance 70,000
Manufacturing Overhead Efficiency Variance 40,000
Manufacturing Overhead Volume Variance 380,000
Manufacturing Overhead 10,750,000
2) One unit of output should be manufactured in 5 direct labor
hours; budgeted variable overhead is $18 per direct labor hour;
budgeted fixed overhead is $6,000,000; normal capacity is
50,000 units of output; during the year 48,000 units were
produced in 244,000 direct labor hours, actual variable
overhead amounted to $4,400,000, and actual fixed overhead
amounted to $6,020,000
Budgeted
Budgeted Overhead
Overhead For
For Standard
Actual Direct
Direct Labor
Actual Labor Hours Applied
_Overhead_ _ Hours _ _Allowed _ _Overhead_
4,400,000 4,392,000 4,320,000 4,320,000
(244,000 x 18) (48,000 x 5 x 18) (380,000 x 18)
6,020,000 6,000,000 6,000,000 5,760,000
_ _ _ _ _ _ (240,000 x 24)
10,420,000 10,392,000 10,320,000 10,080,000
28,000 U 72,000 U 240,000 U
Manufacturing Manufacturing Manufacturing
Overhead Overhead Overhead
Spending Efficiency Volume
Variance Variance Variance
Standard Manufacturing Overhead Rate = (50,000 x 5 x 18 + 6,000,000) / 250,000
= 42
Work in Process 10,080,000
Applied Manufacturing Overhead 10,080,000
Applied Manufacturing Overhead 10,080,000
Manufacturing Overhead Spending Variance 28,000
Manufacturing Overhead Efficiency Variance 72,000
Manufacturing Overhead Volume Variance 240,000
Manufacturing Overhead 10,420,000
Friday, January 28, 2011
Economic Order Quantity (EOQ):
Economic order quantity (EOQ) is that size of the order which gives maximum economy in purchasing any material and ultimately contributes towards maintaining the materials at the optimum level and at the minimum cost.
In other words, the economic order quantity (EOQ) is the amount of inventory to be ordered at one time for purposes of minimizing annual inventory cost.
The quantity to order at a given time must be determined by balancing two factors: (1) the cost of possessing or carrying materials and (2) the cost of acquiring or ordering materials. Purchasing larger quantities may decrease the unit cost of acquisition, but this saving may not be more than offset by the cost of carrying materials in stock for a longer period of time.
The carrying cost of inventory may include:
Interest on investment of working capital
Property tax and insurance
Storage cost, handling cost
Deterioration and shrinkage of stocks
Obsolescence of stocks.
Formula of Economic Order Quantity (EOQ):
The different formulas have been developed for the calculation of economic order quantity (EOQ). The following formula is usually used for the calculation of EOQ.
A = Demand for the year
Cp = Cost to place a single order
Ch = Cost to hold one unit inventory for a year
* = ×
Example:
Pam runs a mail-order business for gym equipment. Annual demand for the TricoFlexers is 16,000. The annual holding cost per unit is $2.50 and the cost to place an order is $50.
Calculate economic order quantity (EOQ)
Calculation:
Underlying Assumptions of Economic Order Quantity:
The ordering cost is constant.
The rate of demand is constant
The lead time is fixed
The purchase price of the item is constant i.e no discount is available
The replenishment is made instantaneously, the whole batch is delivered at once.
Re-order Level or Ordering Point or Ordering Level:
Definition and explanation:
This is that level of materials at which a new order for supply of materials is to be placed. In other words, at this level a purchase requisition is made out. This level is fixed somewhere between maximum and minimum levels. Order points are based on usage during time necessary to requisition order, and receive materials, plus an allowance for protection against stock out.
The order point is reached when inventory on hand and quantities due in are equal to the lead time usage quantity plus the safety stock quantity.
Formula of Re-order Level or Ordering Point:
The following two formulas are used for the calculation of reorder level or point.
[ Ordering point or re-order level = Maximum daily or weekly or monthly usage × Lead time ]
The above formula is used when usage and lead time are known with certainty; therefore, no safety stock is provided. When safety stock is provided then the following formula will be applicable:
[ Ordering point or re-order level = Maximum daily or weekly or monthly usage × Lead time + Safety stock ]
Minimum Limit or Minimum Level of Stock:
The minimum level or minimum stock is that level of stock below which stock should not be allowed to fall. In case of any item falling below this level, there is danger of stopping of production and, therefore, the management should give top priority to the acquisition of new supplies.
Formula:
Minimum level or minimum limit can be calculated by the following formula:
[ Minimum limit or level = Re-order level or ordering point – Average or normal usage × Normal re-order period ]
Or the formula can be written as:
[ Minimum limit or level = Re-order level or ordering point – Average usage for Normal period ]
Maximum Level or Maximum Limit of Stock:
The maximum stock limit is upper level of the inventory and the quantity that must not be exceeded without specific authority from management. In other words, the maximum stock level is that quantity of material above which the stock of any item should not normally be allowed to go. This level is fixed after taking into account such factors as: capital, rate of consumption of materials, storage space available, insurance cost, risk of deterioration and obsolescence and economic order quantity.
Formula:
Maximum level or maximum limit can be calculated by the help of following formula:
[Maximum limit or level = Re-order level or ordering point – Minimum usage × Minimum re-order period + Economic order quantity]
Danger Level of Materials or Inventory Stock:
When danger level is reached, the try is made to purchase materials from the nearest possible source or place so that the workers and plant and machinery may not remain idle due to shortage of materials supplies.
Formula:
Danger level can be calculated by the help of the following formula:
[ Danger level = Average daily requirement × Time required to get emergency supply ]
Basic inventory decisions and EOQ
At the very basic level any firm faces two main decisions concerning the management of inventory: When should new stock be ordered and in what quantities? With regard to the order quantity, which minimises inventory related costs, we are familiar with the classical EOQ (economic order quantity) model. This remains the basic inventory model even when it is not applicable in real life business situations in most cases.
In inventory related literature, the answer to the question of when to order is given with reference to the ROP (reorder point), the point at which the replenishment order should be initiated so that the facility receives the inventory in time to maintain its target level of service. The ROP can be defined in terms of units of days or in units of inventory. In the static and deterministic model, the ROP is the simple multiplication of the number of lead days and the daily demand. It means that every time the inventory falls to the ROP level, an order must be initiated. And the order quantity is given by the EOQ model which is based on cost minimisation.
Figure 4.1 A simple deterministic inventory model based on fixed demand and fixed lead time
You are aware that the EOQ quantity is the balance between order and holding costs attached with the inventory. The order cost is made up of fixed and variable costs, whereas the holding cost consist of costs of insurance, taxes, maintenance and handling, opportunity costs and costs of obsolescence.
In your text
See Section 3.2.1 for a good discussion on the EOQ model.
The formula for EOQ or economic order quantity is well known:
Q is the order quantity per order.
K is the fixed set up cost which the warehouse incurs every time it places an order.
D is the demand per day.
h is the inventory carrying or holding cost per unit per day.
You will notice that your text highlights two important insights regarding the EOQ model. These are:
•Optimum order size is a good balance between the holding cost and the fixed order cost.
•Total inventory cost is related with order size, but the relationship is not very significant.
A discussion of the EOQ model would remain incomplete if the inherent assumptions on which the model is based are ignored. Bowersox (2001) explains that these major assumptions are:
•All demand is satisfied.
•The rate of demand is continuous, constant and known.
•Replenishment lead time is constant and known.
•There is a constant price of product that is independent of order quantity or time.
•There is an infinite planning horizon.
•There is no interaction between multiple items of inventory.
•There is no inventory in transit.
•There are no limits on capital availability.
The economic order quantity is a tool used in Operations Management to determine the most cost-effective purchase quantity. The variables within the formula are discussed in the article below.
The economic order quantity is used when goods or materials are purchased periodically.
The economic order quantity determines the appropriate number of product to order based on a number of different variables. The economic order quantity is the amount to purchase that will minimize the overall cost to the company. Small businesses do not have to compute this number on a regular basis, but understanding the logic behind the calculation can help your company make better purchasing decisions.
To begin, the different variables in the EOQ formula are; the annual demand of the product, the purchase cost per individual unit, the fixed cost per order, the order quantity and the holding cost of the product. By analyzing each of these variables, we can understand how it affects our purchasing habits and ultimately, our bottom line.
The annual demand for the product is an important piece to the puzzle. If it's a product that you use once or twice a year, you're probably not going to order it frequently or in large numbers. If it is a product that you use often, you may want to purchase in larger amounts to obtain a discount or arrange for frequent small deliveries with your supplier.
The purchase cost for individual unit is pretty straightforward. If an item cost thousands of dollars, we would expect to purchase it less frequently than an item that cost ten dollars. If the purchase price a unit increases, you may want to order it less frequently or wait until you have a customer commitment that requires the part.
The fixed cost per order is another key element, but it is often ignored in the purchasing process. Each time you place an order, it requires a fixed cost. You need to have an employee take the time to place the order. This may result from another employee taking the time to count the inventory and let your personnel know they need to order a product. Once an order is placed, there is the cost of tracking the order and receiving the order.
If these costs are high, you would want to order less frequently and in larger amounts. If your system is smooth, this fixed cost may be low and have a minimal impact on your purchasing habits.
The order quantity can be fixed or determined by your purchasing department. Sometimes lot sizes are fixed due to your supplier, and other times you have multiple pack sizes to choose from. If the order quantity is flexible, this is not too big of an issue. If the order quantity is large, depending upon your usage it can be costly to store. Understanding the order quantity versus your demand can greatly impact your purchasing decisions.
Finally, you need to consider the holding cost of the product. This can be difficult to calculate, especially for small businesses. The holding costs include the space the material is occupying as well as the labor to move it and count it in inventory. If your space is limited, your holding cost is high. As a result, you wouldn't want to have excess of a product that only gets used once or twice a year.
The EOQ formula can be easily found on the web. While it is not necessary for the small business to try and crunch these numbers, it is important that the small business understand the different variables and how they affect your company. If you understand the implications of the variables, you can find a nice balance that works best for your business.
In inventory related literature, the answer to the question of when to order is given with reference to the ROP (reorder point), the point at which the replenishment order should be initiated so that the facility receives the inventory in time to maintain its target level of service. The ROP can be defined in terms of units of days or in units of inventory. In the static and deterministic model, the ROP is the simple multiplication of the number of lead days and the daily demand. It means that every time the inventory falls to the ROP level, an order must be initiated. And the order quantity is given by the EOQ model which is based on cost minimisation.
Figure 4.1 A simple deterministic inventory model based on fixed demand and fixed lead time
You are aware that the EOQ quantity is the balance between order and holding costs attached with the inventory. The order cost is made up of fixed and variable costs, whereas the holding cost consist of costs of insurance, taxes, maintenance and handling, opportunity costs and costs of obsolescence.
In your text
See Section 3.2.1 for a good discussion on the EOQ model.
The formula for EOQ or economic order quantity is well known:
Q is the order quantity per order.
K is the fixed set up cost which the warehouse incurs every time it places an order.
D is the demand per day.
h is the inventory carrying or holding cost per unit per day.
You will notice that your text highlights two important insights regarding the EOQ model. These are:
•Optimum order size is a good balance between the holding cost and the fixed order cost.
•Total inventory cost is related with order size, but the relationship is not very significant.
A discussion of the EOQ model would remain incomplete if the inherent assumptions on which the model is based are ignored. Bowersox (2001) explains that these major assumptions are:
•All demand is satisfied.
•The rate of demand is continuous, constant and known.
•Replenishment lead time is constant and known.
•There is a constant price of product that is independent of order quantity or time.
•There is an infinite planning horizon.
•There is no interaction between multiple items of inventory.
•There is no inventory in transit.
•There are no limits on capital availability.
The economic order quantity is a tool used in Operations Management to determine the most cost-effective purchase quantity. The variables within the formula are discussed in the article below.
The economic order quantity is used when goods or materials are purchased periodically.
The economic order quantity determines the appropriate number of product to order based on a number of different variables. The economic order quantity is the amount to purchase that will minimize the overall cost to the company. Small businesses do not have to compute this number on a regular basis, but understanding the logic behind the calculation can help your company make better purchasing decisions.
To begin, the different variables in the EOQ formula are; the annual demand of the product, the purchase cost per individual unit, the fixed cost per order, the order quantity and the holding cost of the product. By analyzing each of these variables, we can understand how it affects our purchasing habits and ultimately, our bottom line.
The annual demand for the product is an important piece to the puzzle. If it's a product that you use once or twice a year, you're probably not going to order it frequently or in large numbers. If it is a product that you use often, you may want to purchase in larger amounts to obtain a discount or arrange for frequent small deliveries with your supplier.
The purchase cost for individual unit is pretty straightforward. If an item cost thousands of dollars, we would expect to purchase it less frequently than an item that cost ten dollars. If the purchase price a unit increases, you may want to order it less frequently or wait until you have a customer commitment that requires the part.
The fixed cost per order is another key element, but it is often ignored in the purchasing process. Each time you place an order, it requires a fixed cost. You need to have an employee take the time to place the order. This may result from another employee taking the time to count the inventory and let your personnel know they need to order a product. Once an order is placed, there is the cost of tracking the order and receiving the order.
If these costs are high, you would want to order less frequently and in larger amounts. If your system is smooth, this fixed cost may be low and have a minimal impact on your purchasing habits.
The order quantity can be fixed or determined by your purchasing department. Sometimes lot sizes are fixed due to your supplier, and other times you have multiple pack sizes to choose from. If the order quantity is flexible, this is not too big of an issue. If the order quantity is large, depending upon your usage it can be costly to store. Understanding the order quantity versus your demand can greatly impact your purchasing decisions.
Finally, you need to consider the holding cost of the product. This can be difficult to calculate, especially for small businesses. The holding costs include the space the material is occupying as well as the labor to move it and count it in inventory. If your space is limited, your holding cost is high. As a result, you wouldn't want to have excess of a product that only gets used once or twice a year.
The EOQ formula can be easily found on the web. While it is not necessary for the small business to try and crunch these numbers, it is important that the small business understand the different variables and how they affect your company. If you understand the implications of the variables, you can find a nice balance that works best for your business.
Wednesday, January 5, 2011
Controlling and Costing Materials Part 2
First In First Out (FIFO) - Materials and Inventory Costing Method:
Definition and Explanation:
The first in first out (FIFO) method of costing is used to introduce the subject of materials costing. The FIFO method of costing issued materials follows the principle that materials used should carry the actual experienced cost of the specific units used. The methods assumes that materials are issued from the oldest supply in stock and that the cost of those units when placed in stock is the cost of those same units when issued. However, FIFO costing may be used even though physical withdrawal is in a different order.
Advantages of First in First out (FIFO) Costing Method:
Advantages claimed for first in first (FIFO) out costing method are:
Materials used are drawn from the cost record in a logical and systematic manner.
Movement of materials in a continuous, orderly, single file manner represents a condition necessary to and consistent with efficient materials control, particularly for materials subject to deterioration, decay and quality are style changes.
FIFO method is recommended whenever:
The size and cost of units are large.
Materials are easily identified as belonging to a particular purchased lot.
Not more than two or three different receipts of the materials are on a materials card at one time.
Example:
This example is based on the following transactions:
February
(1)Beginning balance: 800 units @ $6 per unit.
(4)Received 200 units @ $7 per unit.
(10)Received 200 units @ $8 per unit.
(11)Issued 800 units.
(12)Received 400 units @ $8 per unit.
(20)Issued 500 units.
(25)Returned 100 excess units from the factory to the storeroom to be recorded at the latest issued price.
(28)Received 600 units @ $9 per unit.
Calculation for the above transactions would be as follows:
FIFO Costing Method
February:
01. Beginning balance
800 units @ $6
$4,800
04. Received 200 units @ $7 $1,400
10. Received 200 units @ $8 $1,600 $7,800
11. Issued 800 units @ $6 $4,800
Balance
200 units @ $7 $1,400
200 units @ $8 $1,600 $3,000
12. Received 400 units @ $8 $3,200 $6,200
20. Issued 200 units @ $7 $1,400
300 units @ $8 $2,400 $3,800
Balance
300 units @ $8 $2,400
25. Returned to storeroom 100 units @ $8 $800
28. Received 600 units @ $9 $5,400 8,600
Balance
400 units @ $8 $3,200
600 units @ $9 $5,400 $8,600
Disadvantages or Limitations of FIFO Method
FIFO method is definitely awkward if frequent purchases are made at different prices and if units from several purchases are on hand at the same time. Added costing difficulties arise when returns to vendors or to the storeroom occur.
Average Costing Method--Materials and Inventory Costing:
Definition and explanation:
Issuing materials at an average cost assumes that each batch taken from the storeroom is composed of uniform quantities from each shipment in stock at the date of issue. Often it is not feasible to mark or label each materials item with an invoice price in order to identify the used units with its acquisition cost. It may be reasoned that units are issued more or less at random as for as the specific units and the specific costs are concerned and that an average cost of all units in stock at the time of issue is satisfactory measure of materials cost. However, average costing may be used even though the physical withdrawal is an identifiable order. If materials tend to be made up of numerous small items low in unit cost and especially if prices are subject to frequent changes.
Advantages of Average Costing Method:
Average costing method has the following main advantages:
It is a realistic costing method useful to management in analyzing operating results and appraising future production.
It minimizes the effect of unusually high or low materials prices, thereby making possible more stable cost estimates for future work.
It is practical and less expensive perpetual inventory system.
The average costing method divides the total cost of all materials of a particular class by the number of units on hand to find the average price. The cost of new invoices are added to the total in the balance column; the units are added to the existing quantity; and the new total cost is divided by the new quantity to arrive at the new average cost. Materials are issued at the established average cost until a new purchase is recorded. Although a new average cost may be computed when materials are returned to vendors and when excess issues are returned to the storeroom, for practical purposes, it seems sufficient to reduce or increase the total quantity and cost, allowing the unit price to remain unchanged. When a new purchase is made and a new average is computed, the discrepancy created by the returns will be absorbed.
Example:
February
(1)Beginning balance: 800 units @ $6 per unit.
(4)Received 200 units @ $7 per unit.
(10)Received 200 units @ $8 per unit.
(11)Issued 800 units.
(12)Received 400 units @ $8 per unit.
(20)Issued 500 units.
(25)Returned 100 excess units from the factory to the storeroom to be recorded at the latest issued price.
(28)Received 600 units @ $9 per unit.
Calculations for the above transactions would be as follows
Average Costing Method Calculation Illustrated
01. Beginning balance 800 units @ $6 $4,800
04. Received 200 units @ $7 $1,400
Balance
1000 units $6,200 $6.20
10. Received 200 units @ $8 $1,600
Balance
12,00 units $7,800 $6.5
11. Issued 800 units @ $6.50 $5,200
Balance
400 units $2,600 $6.5
12. Received 400 units @ $8 $3,200
Balance
800 units $5,800 $7.25
20. Issued 500 units @ $7.25 $3,625
Balance
300 units $2,175 $7.25
Returned to storeroom 100 units $725
Balance
400 units $2,900 $7.25
28. Received 600 units @ $9 $5,400
Balance
1000 units $8,300 $8.30
Last In First Out (LIFO) - Materials and Inventory Costing Method:
Definition and explanation:
The last in first out (LIFO) method of costing materials issued is based on the premise that materials units issued should carry the cost of the most recent purchase, although the physical flow may actually be different. The method assumes that the most recent cost (the approximate cost to replace the consumed units) is most significant in matching cost with revenue in the income determination procedure.
Under LIFO procedures, the objective is to charge the cost of current purchases to work in process or other operating expenses and to leave the oldest costs in the inventory. Several alternatives can be used to apply the LIFO method. Each procedure results in different costs for materials issued and the ending inventory, and consequently in a different profit. It is mandatory, therefore, to follow the chosen procedure consistently.
LIFO Costing Method Example:
This example is based on the following transactions:
February
(1)Beginning balance: 800 units @ $6 per unit.
(4)Received 200 units @ $7 per unit.
(10)Received 200 units @ $8 per unit.
(11)Issued 800 units.
(12)Received 400 units @ $8 per unit.
(20)Issued 500 units.
(25)Returned 100 excess units from the factory to the storeroom to be recorded at the latest issued price.
(28)Received 600 units @ $9 per unit.
Calculations for the above transactions would be as follows
LIFO COSTING METHOD
February:
1. Beginning balance
800 units @ $6.00
$4,800
4. Received 200 units @ $7.00 $1,400
10.Received 200 units @ $8.00 $1,600 $7,800
11. Issued 200 units @ $8.00 $1,600
200 units @ $7.00 $1,400
400 units @ $6.00 $2,400 $5,400
Balance
400 units @ $6.00 $2,400
Received 400 units @ $8.00 $3,200 $5,600
20. Issued 400 units @ $8.00 $3,200
100 units @ $6.00 $600 $3,800
Balance
300 units @ $6.00 $1,800
25. Returned to storeroom 100 units @ $6.00 $600
28. Received 600 units @ $9.00 $5,400
$7,800
Balance
400 units @ $6.00 $2,400
600 units @ $9.00 $5,400
$7,800
The basic difference between the various applications of this costing method is the time interval between inventory computations. In this example of LIFO costing a new inventory balance is computed after each receipt and each issue of materials, with the ending inventory consisting of 1,000 units valued at $7,800. If, however, a physical rather than a perpetual costing procedure is used, whereby the issues are determined at the end of the period by ignoring day to day issues and by subtracting total ending inventory from the total of the opening balance plus the receipts, the ending inventory would consist of:
800 units @ $6 on hand in the beginning inventory
200 units @ $7 from the oldest purchase, Feb. 4
1,000 units, LIFO inventory at the end of February. $4,800
$1,400
-------
$6,200
=====
Both procedures are appropriate applications of the LIFO method, even though the cost of materials used and the ending inventory figures differ. Such a difference does not occur in FIFO costing method.
Regardless of the cost flow assumptions, this later procedure is particularly appropriate in process costing where individual materials requisitions are seldom used and the materials move into process in bulk lots, as in floor mills spinning mills, oil refineries, and sugar refineries. The procedure also functions smoothly for a company that charges materials to work in process from month end consumption sheets which provide the cost department with quantities used.
Advantages of Last In First Out (LIFO) Method:
The advantages of the last in first out method are:
Materials consumed are priced in a systematic and realistic manner. It is argued that current acquisition costs are incurred for the purpose of meeting current production and sales requirements; therefore, the most recent costs should be charged against current production and sales.
Unrealized inventory gains and losses are minimized, and reported operating profits are stabilized in industries subject to sharp materials price fluctuations.
Inflationary prices of recent purchases are charged to operations in periods of rising prices, Thus reducing profits, resulting in a tax saving, and therewith providing a cash advantage through deferral of income tax payments. The tax deferral creates additional working capital as long as the economy continues to experience an annual inflation rate increase.
Disadvantages of the LIFO Costing Method:
The disadvantages or limitations of the last in first out costing method are:
The election of last in first out for income tax purposes is binding for all subsequent years unless a change is authorized or required by the Internal Revenue Service (IRS)
This is a "cost only" method with no right down to the lower of cost or market allowed for income tax purposes. Furthermore, the IRS requires that when last in first out is adapted an adjustment must be made to restore any previous right downs from actual cost. Should the market decline below LIFO cost in subsequent years, the business would be at a tax disadvantage. When prices drop the only option may be to charge off the older (higher) cost by liquidating the inventory, however, liquidation for income tax purposes must take place at the end of the year. According to IRS regulations, liquidation during the fiscal year is not acceptable if the inventory returns to its original level at the end of the year. Interim external financial reporting principles impose a similar requirement when inventory is expected to be replaced by the end of the annual period.
LIFO must be used in financial statements if it is elected for income tax purposes. However, for financial reporting purposes, the lower of LIFO cost or market can be used without violating IRS LIFO conformity rules.
Record keeping requirements under this method, as well as FIFO, are substantially greater than those under alternative costing and pricing methods.
Inventories may be depleted due to unavailability of materials to the point of consuming inventories costed at older or perhaps the oldest prices. This situation will create a miss matching of current revenue and cost, sometimes companies using this costing method counteract this problem by establishing an allowance for replacement of the LIFO inventory account. Cost of goods sold is charged with current cost. The allowance account is credited for the access of the current replacement cost over the LIFO carrying cost for the inventory temporarily liquidated. When this inventory is replenished, the temporary allowance (credit) is removed and the goods acquired are placed in inventory at their old last in first out cost.
In standard number 411 "accounting for acquisition costs of materials, " the cost accounting standards board "CASB" precludes the use of LIFO except when applied currently on a specific identification basis. As a result, the use of this method, when an annual LIFO adjustment is made, is ruled out for government contracts to which CASB regulations apply.
The decision to adopt the last in first out method has had increased appeal in the last few years, due to an accelerated rate of inflation; however its adoption should not be automatic. Long range effects as well as short term benefits must be considered.
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Tuesday, December 28, 2010
Controlling and Costing Materials:Part 1
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Effective materials management is essential in order to (1) provide the best service to customers, (2) produce at maximum efficiency, and (3) manage inventories at predetermined levels to stabilize investments in inventories.
Successful materials management requires the development of a highly integrated and coordinated system involving sales forecasting, purchasing, receiving, storage, production, shipping, and actual sales. Both the theory of costing materials and inventories and the practical mechanics of cost calculations and record keeping must be considered.
Costing materials present some important, often complex, and sometime highly controversial questions concerning the costing of materials used in production and -he cost of inventory remaining to be consumed in a future period. In financial accounting, the subject is usually presented as a problem of inventory valuation; in cost accounting, the primary problem is the determination of the cost of various materials consumed in production and a proper charge to cost of goods sold.
Procedures for Materials Procurement and Use:
Although production processes and materials requirements vary, the cycle of procurement and use of materials usually involves the following steps:
Engineering and planning determine the design of the product, the materials specifications, and the requirements at each stage of operations. Engineering and planning not only determine the maximum and minimum quantities to run and the bill of materials for given products and quantities but also cooperate in developing standards where applicable.
The production budget provides the master plan from which details concerning materials requirements are eventually developed.
The purchase requisition informs the purchasing agent concerning the quantity and type of materials needed.
The purchase order contracts for appropriate quantities to be delivered at specified dates to assure uninterrupted operations.
The receiving report certifies quantities received and may report results of inspection and testing for quality.
The materials requisition notifies the storeroom or warehouse to deliver specified time or is the authorization for the storeroom to issue material to departments.
The materials ledger cards record the receipt and the issuance of each class of materials and provide a perpetual inventory record.
Accounting procedures for materials procurement and use involve forms and records necessary for general ledger financial accounting as well as those necessary for costing a job, process or department, and for maintaining perpetual inventories and other statistical summaries. The purchase requisition, purchase order, receiving report, materials requisition, bill of materials, scrap report, returned materials report, materials ledger cards, and summary of materials used are some of the forms used for materials control under a cost system. The purchases journal, the cash payments journal, the general journal, and the general ledger control accounts are also used.
The discussion here is not based on any particular type or size of industry. It is, rather a general description of the accounting and controlling procedure involved in the procurement and use of materials. To understand the detailed procedure of purchasing, receiving stocking, and using materials
First-in-First-Out (FIFO) Costing Method
Average Costing Method
Last-in-First-Out (LIFO) Costing Method
Other Methods-Month end average cost, last purchase price or market price at date of issue, and standard cost.
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Tuesday, April 13, 2010
Friday, March 5, 2010
BASIC CONCEPT OF COST ACCOUNTANCY
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1. DEFINITION: Cost Accountancy
Applications of Costing and Cost Accounting principles, methods and technique to the art, science and practice of cost control and ascertainment of profitability. It includes presentation of information derived there-from for the purpose of managerial decision-making’.
1.1 PRINCIPLES
• Maintaining Professional Competency, Integrity, Confidentiality and Objectivity
• Continuous development of knowledge & skill.
• Refrain from disclosing or misusing confidential information.
• Refrain from engaging in or supporting any activity that would discredit the profession.
• Communicate information fairly and objectively.
1.2 OBJECTIVE
• Application of right Methods or ways of correct cost findings at variant situations,
• Application of suitable Techniques of cost control and assessing operational profitability.
• Development of Art of presentation for quick and easy interpretation of performance.
• Enhancing Professional expertise to the best use of Management.
1.3 METHODS
Costing has been stated as method of classifying, recording and charging of cost to the products and services through appropriate and logical process or system depending on the nature of industry, Costing methods have been broadly divided into the following categories, viz.
1.3.1 JOB COSTING for jobbing industries engaged in production on specific order of customer and
1.3.2 PROCESS COSTING for process industries engaged in production of repetitive nature of products in a continuous process.
1.3.3 Variants of those broad methods of costing.
i) Contract or Terminal Costing: This is a variant of JOB Costing. This method is followed in huge single contract like, Building, Bridge, and Road etc. Separate accounts are being opened for different contracts.
ii) Batch Costing: This is an extension of Job costing. When a number of units of homogeneous type are produced in a batch, the said batch is being treated as a job. Cost arrived at for the batch as a whole in the card is divided by the number of units in that in order to arrive at the average cost per unit in that batch. Such method is followed in Cycle Industry.
iii) Single or output Costing: This is a method of costing being followed where the output is single like Coal Industry.
iv) Multiple/ Composite Costing: Different kinds components, sub-assemblies are produced in batches or through a continuous process for ultimate use in the main Job order. Different method of costing is applied for each segment and job costing for the main job undertaken as per specific order of the customer. Boiler industry is an example of application of such method
v) Operation Costing: This is an extension of Process Costing. In certain Process industries, when a process is divided into certain operations and Management need to have thorough costing of each and every operation for the purpose of control and decision-making. Food products and Chemical industry can be ideal examples for application of such costing.
vi) OPERATING COSTING for operating industries rendering services; viz., Transport Industries
2. COSTING TECHNIQUES
Besides such methods of assessment of cost of a job or a process, certain costing techniques followed for the purpose of cost control and management decision.
2.1. a) Standard Costing: This is a technique to assess standard cost of the product, recording the actual, comparing the actual with that of the standard, finding out the variation with reasons for ultimate control or revision of standard, if necessary. This technique can be well use of in cases standard and repetitive nature of work having all kinds of standard facilities.
2.2. b) Marginal Costing: This is a technique to assess marginal cost (Prime Cost and variable overhead) of products and contribution there-of by deducting marginal cost from sales. Fixed cost is kept away from cost structure. Profitability of each product is assessed through a ratio of contribution to sale (P/V ratio). The main idea behind this technique is assessment of true profitability of each product. Arbitrary distribution of fixed overheads, in absence of suitable bases makes it difficult to calculate correct profitability of the various products. Cost Accountants can assist management in various decision making areas like ‘Optimum product mix, pricing, make or buy and a host of other decisions in day to day business in a competitive world.
2.3. c) Uniform Costing: This is a technique of cost control by applying method of costing uniformly in various production units of homogeneous type so that it makes possible to compare the product-wise cost incidence of each unit. This is a technique to control cost through ‘Inter firm comparison’.
2.4. d) Differential Cost Analysis: This is a technique applied to find out optimum capacity utilization by comparing incremental revenue with that of differential cost at different level of capacity. This is a contribution of Cost Accountant in managerial decision- making where there is a limitation of Marginal Costing.
3. COST ACCOUNTING
As defined, Cost Accounting is a process of accounting for the cost from the point at which it is incurred or committed to the establishment. Cost accounting necessarily starts from the same original sources like vouchers and primary document. Cost accounts relates to the operational side of the business. It classifies accounting information and records, arranges and interprets such expenses by the cost elements like materials, labour and expenses.
As in the case of general accounting system, transactions relating to factory operations, to be finally reflected in cost accounts, are recorded in the books of original entry. Summaries of these books are initially journalized and posted in the general ledger, which contains control accounts and subsidiary books.
In Ordnance factories PRINCIPAL LEDGER with 30 heads serves the purpose of Cost Accounting.
4. Activity Based Costing
A latest technology incorporated by many organizations with their scientific and updated cost accounting system. ABC has its’ genesis in the growing incidence of indirect expenditure in the manufacturing operations with the increasing trend of management cost consciousness to ensure its’ survival in the global competition.
This is, specifically, a process of distribution of indirect cost amongst the various products and services more accurately and scientifically.
4.1. What it aims
• Overcome the problem of inaccurate cost findings and cost reporting due to wrong selection of bases of cost distribution.
• Identification of no value added activities and improvement in performance and activities.
• Cost cutting and down-sizing (Indirect cost).
• Activity based Budgeting.
• Target Costing
1. DEFINITION: Cost Accountancy
Applications of Costing and Cost Accounting principles, methods and technique to the art, science and practice of cost control and ascertainment of profitability. It includes presentation of information derived there-from for the purpose of managerial decision-making’.
1.1 PRINCIPLES
• Maintaining Professional Competency, Integrity, Confidentiality and Objectivity
• Continuous development of knowledge & skill.
• Refrain from disclosing or misusing confidential information.
• Refrain from engaging in or supporting any activity that would discredit the profession.
• Communicate information fairly and objectively.
1.2 OBJECTIVE
• Application of right Methods or ways of correct cost findings at variant situations,
• Application of suitable Techniques of cost control and assessing operational profitability.
• Development of Art of presentation for quick and easy interpretation of performance.
• Enhancing Professional expertise to the best use of Management.
1.3 METHODS
Costing has been stated as method of classifying, recording and charging of cost to the products and services through appropriate and logical process or system depending on the nature of industry, Costing methods have been broadly divided into the following categories, viz.
1.3.1 JOB COSTING for jobbing industries engaged in production on specific order of customer and
1.3.2 PROCESS COSTING for process industries engaged in production of repetitive nature of products in a continuous process.
1.3.3 Variants of those broad methods of costing.
i) Contract or Terminal Costing: This is a variant of JOB Costing. This method is followed in huge single contract like, Building, Bridge, and Road etc. Separate accounts are being opened for different contracts.
ii) Batch Costing: This is an extension of Job costing. When a number of units of homogeneous type are produced in a batch, the said batch is being treated as a job. Cost arrived at for the batch as a whole in the card is divided by the number of units in that in order to arrive at the average cost per unit in that batch. Such method is followed in Cycle Industry.
iii) Single or output Costing: This is a method of costing being followed where the output is single like Coal Industry.
iv) Multiple/ Composite Costing: Different kinds components, sub-assemblies are produced in batches or through a continuous process for ultimate use in the main Job order. Different method of costing is applied for each segment and job costing for the main job undertaken as per specific order of the customer. Boiler industry is an example of application of such method
v) Operation Costing: This is an extension of Process Costing. In certain Process industries, when a process is divided into certain operations and Management need to have thorough costing of each and every operation for the purpose of control and decision-making. Food products and Chemical industry can be ideal examples for application of such costing.
vi) OPERATING COSTING for operating industries rendering services; viz., Transport Industries
2. COSTING TECHNIQUES
Besides such methods of assessment of cost of a job or a process, certain costing techniques followed for the purpose of cost control and management decision.
2.1. a) Standard Costing: This is a technique to assess standard cost of the product, recording the actual, comparing the actual with that of the standard, finding out the variation with reasons for ultimate control or revision of standard, if necessary. This technique can be well use of in cases standard and repetitive nature of work having all kinds of standard facilities.
2.2. b) Marginal Costing: This is a technique to assess marginal cost (Prime Cost and variable overhead) of products and contribution there-of by deducting marginal cost from sales. Fixed cost is kept away from cost structure. Profitability of each product is assessed through a ratio of contribution to sale (P/V ratio). The main idea behind this technique is assessment of true profitability of each product. Arbitrary distribution of fixed overheads, in absence of suitable bases makes it difficult to calculate correct profitability of the various products. Cost Accountants can assist management in various decision making areas like ‘Optimum product mix, pricing, make or buy and a host of other decisions in day to day business in a competitive world.
2.3. c) Uniform Costing: This is a technique of cost control by applying method of costing uniformly in various production units of homogeneous type so that it makes possible to compare the product-wise cost incidence of each unit. This is a technique to control cost through ‘Inter firm comparison’.
2.4. d) Differential Cost Analysis: This is a technique applied to find out optimum capacity utilization by comparing incremental revenue with that of differential cost at different level of capacity. This is a contribution of Cost Accountant in managerial decision- making where there is a limitation of Marginal Costing.
3. COST ACCOUNTING
As defined, Cost Accounting is a process of accounting for the cost from the point at which it is incurred or committed to the establishment. Cost accounting necessarily starts from the same original sources like vouchers and primary document. Cost accounts relates to the operational side of the business. It classifies accounting information and records, arranges and interprets such expenses by the cost elements like materials, labour and expenses.
As in the case of general accounting system, transactions relating to factory operations, to be finally reflected in cost accounts, are recorded in the books of original entry. Summaries of these books are initially journalized and posted in the general ledger, which contains control accounts and subsidiary books.
In Ordnance factories PRINCIPAL LEDGER with 30 heads serves the purpose of Cost Accounting.
4. Activity Based Costing
A latest technology incorporated by many organizations with their scientific and updated cost accounting system. ABC has its’ genesis in the growing incidence of indirect expenditure in the manufacturing operations with the increasing trend of management cost consciousness to ensure its’ survival in the global competition.
This is, specifically, a process of distribution of indirect cost amongst the various products and services more accurately and scientifically.
4.1. What it aims
• Overcome the problem of inaccurate cost findings and cost reporting due to wrong selection of bases of cost distribution.
• Identification of no value added activities and improvement in performance and activities.
• Cost cutting and down-sizing (Indirect cost).
• Activity based Budgeting.
• Target Costing
Wednesday, January 20, 2010
Cost Accounting : An Introduction
Cost Accounting : An Introduction
If you set up a small manufacturing unit, say manufacturing of packing boxes, a problem will
arise what price of each box you should quote to the buyer. Many factors are considered while fixing the price of a product/item such as competitors’ price etc. One of the basic factors is the cost of its production. Cost is essential not only to fix price but also to ascertain the margin of profit.
Knowledge of the cost determination is also necessary to keep a check on the cost of product/control on wastages, etc. The accounting used to study the various aspects of cost is known as cost accounting. In this lesson, you will learn about meaning, importance, limitations etc. of cost accounting.
OBJECTIVES
After studying this lesson, you will be able to:
_ state the meaning and scope of cost accounting;
_ explain the objectives of cost accounting;
_ differentiate between cost accounting and financial accounting;
_ state importance of cost accounting;
_ explain limitations of cost accounting.
MEANING AND SCOPE OF COST ACCOUNTING
Cost accounting is the process of determining and accumulating the cost
of product or activity. It is a process of accounting for the incurrence and
the control of cost. It also covers classification, analysis, and interpretation
of cost. In other words, it is a system of accounting, which provides the
information about the ascertainment, and control of costs of products, or
services. It measures the operating efficiency of the enterprise. It is an
internal aspect of the organisation. Cost Accounting is accounting for cost
aimed at providing cost data, statement and reports for the purpose of
managerial decision making. The Institute of Cost and Management
Accounting, London defines “Cost accounting is the process of accounting
from the point at which expenditure is incurred or committed to the
establishment of its ultimate relationship with cost centres and cost units.
In the widest usage, it embraces the preparation of statistical data,
application of cost control methods and the ascertainment of profitability
of activities carried out or planned”.
Costing includes “the techniques and processes of ascertaining costs.” The
‘Technique’ refers to principles which are applied for ascertaining costs of
products, jobs, processes and services. The `process’ refers to day to day
routine of determining costs within the method of costing adopted by a
business enterprise.
Costing involves “the classifying, recording and appropriate allocation of
expenditure for the determination of costs of products or services; the
relation of these costs to sales value; and the ascertainment of profitability”.
Scope of Cost Accounting
The terms ‘costing’ and ‘cost accounting’ are many times used
interchangeably. However, the scope of cost accounting is broader than that
of costing. Following functional activities are included in the scope of cost
accounting:
1. Cost book-keeping: It involves maintaining complete record of all costs
incurred from their incurrence to their charge to departments, products
and services. Such recording is preferably done on the basis of double
entry system.
2. Cost system: Systems and procedures are devised for proper accounting
for costs.
3. Cost ascertainment: Ascertaining cost of products, processes, jobs,
services, etc., is the important function of cost accounting. Cost
ascertainment becomes the basis of managerial decision making such
as pricing, planning and control.
4. Cost Analysis: It involves the process of finding out the causal factors
of actual costs varying from the budgeted costs and fixation of
responsibility for cost increases.
5. Cost comparisons: Cost accounting also includes comparisons between
cost from alternative courses of action such as use of technology for
production, cost of making different products and activities, and cost
of same product/ service over a period of time.
6. Cost Control: Cost accounting is the utilisation of cost information for
exercising control. It involves a detailed examination of each cost in
the light of benefit derived from the incurrence of the cost. Thus, we
can state that cost is analysed to know whether the current level of costs
is satisfactory in the light of standards set in advance.
7. Cost Reports: Presentation of cost is the ultimate function of cost
accounting. These reports are primarily for use by the management at
different levels. Cost Reports form the basis for planning and control,
performance appraisal and managerial decision making.
Objectives of cost accounting
There is a relationship among information needs of management, cost
accounting objectives, and techniques and tools used for analysis in cost
accounting. Cost accounting has the following main objectives to serve:
1. Determining selling price,
2. Controlling cost
3. Providing information for decision-making
4. Ascertaining costing profit
5. Facilitating preparation of financial and other statements.
1. Determining selling price
The objective of determining the cost of products is of main importance
in cost accounting. The total product cost and cost per unit of product
are important in deciding selling price of product. Cost accounting
provides information regarding the cost to make and sell product or
services. Other factors such as the quality of product, the condition of
the market, the area of distribution, the quantity which can be supplied
etc., are also to be given consideration by the management before
deciding the selling price, but the cost of product plays a major role.
2. Controlling cost
Cost accounting helps in attaining aim of controlling cost by using
various techniques such as Budgetary Control, Standard costing, and
inventory control. Each item of cost [viz. material, labour, and expense]
is budgeted at the beginning of the period and actual expenses incurred
are compared with the budget. This increases the efficiency of the
enterprise.
3. Providing information for decision-making
Cost accounting helps the management in providing information for
managerial decisions for formulating operative policies. These policies
relate to the following matters:
(i) Determination of cost-volume-profit relationship.
(ii) Make or buy a component
(iii) Shut down or continue operation at a loss
(iv) Continuing with the existing machinery or replacing them by
improved and economical machines.
4. Ascertaining costing profit
Cost accounting helps in ascertaining the costing profit or loss of any
activity on an objective basis by matching cost with the revenue of the
activity.
5. Facilitating preparation of financial and other statements
Cost accounting helps to produce statements at short intervals as the
management may require. The financial statements are prepared generally
once a year or half year to meet the needs of the management. In order
to operate the business at high efficiency, it is essential for management
to have a review of production, sales and operating results. Cost
accounting provides daily, weekly or monthly statements of units
produced, accumulated cost with analysis. Cost accounting system
provides immediate information regarding stock of raw material, semifinished
and finished goods. This helps in preparation of financial
statements.
DIFFERENCE BETWEEN FINANCIAL ACCOUNTING AND
COST ACCOUNTING
After studying financial accounting and cost accounting, you can understand
the difference between these two accounting systems. Therefore, difference
between financial accounting and cost accounting is as follows:
Table 27.1 Differences between financial accounting and cost accounting
Basis Financial Accounting Cost accounting
(i) Objective It provides information about It provides information of
the financial performance and ascertainment of cost to control
financial position of the cost and for decision making
business. about the cost.
(ii) Nature It classifies records, presents It classifies, records, presents,
and interprets transactions in and interprets in a significant
terms of money. manner the material, labour and
overheads cost.
(iii) Recording It records Historical data. It also records and presents the
of data estimated/budgeted data. It
makes use of both the historical
costs and pre-determined costs..
(iv) Users of The users of financial The cost accounting information
information accounting statements are is used by internal management
shareholders, creditors, at different levels.
financial analysts and
government and its agencies,
etc.
(v) Analysis of It shows the profit/ loss of the It provides the details of cost and
costs and organisation. profit of each product, process,
profits job, contracts, etc.
(vi) Time period Financial Statements are Its reports and statements are
prepared for a definite period, prepared as and when required.
usually a year.
(vii) Presentation A set format is used for There are not any set formats for
of information presenting financial presenting cost information.
information.
In spite of the above differences, both financial and cost accounting are in
agreement regarding actual cost data and product costing analysis. Values
of stock and cost of goods produced and sold are the main examples. For
the preparation of the position statement, financial accountant receives the
necessary data from the cost accountant.
Importance of Cost accounting
The limitation of financial accounting has made the management to realise
the importance of cost accounting. The importance of cost accounting are
as follows:
1. Importance to Management
Cost accounting provides invaluable help to management. It is difficult
to indicate where the work of cost accountant ends and managerial
control begins. The advantages are as follows :
Helps in ascertainment of cost
Cost accounting helps the management in the ascertainment of cost of
process, product, Job, contract, activity, etc., by using different techniques
such as Job costing and Process costing.
Aids in Price fixation
By using demand and supply, activities of competitors, market condition
to a great extent, also determine the price of product and cost to the
producer does play an important role. The producer can take necessary
help from his costing records.
Helps in Cost reduction
Cost can be reduced in the long-run when cost reduction programme
and improved methods are tried to reduce costs.
Elimination of wastage
As it is possible to know the cost of product at every stage, it becomes
possible to check the forms of waste, such as time and expenses etc.,
are in the use of machine equipment and material.
Helps in identifying unprofitable activities
With the help of cost accounting the unprofitable activities are
identified, so that the necessary correct action may be taken.
Helps in checking the accuracy of financial account
Cost accounting helps in checking the accuracy of financial account
with the help of reconciliation of the profit as per financial accounts
with the profit as per cost account.
Helps in fixing selling Prices
It helps the management in fixing selling prices of product by providing
detailed cost information.
Helps in Inventory Control
Cost furnishes control which management requires in respect of stock
of material, work in progress and finished goods.
Helps in estimate
Costing records provide a reliable basis upon which tender and
estimates may be prepared.
2. Importance to Employees
Worker and employees have an interest in which they are employed. An
efficient costing system benefits employees through incentives plan in
their enterprise, etc. As a result both the productivity and earning
capacity increases.
3. Cost accounting and creditors
Suppliers, investor’s financial institution and other moneylenders have
a stake in the success of the business concern and therefore are benefited
by installation of an efficient costing system. They can base their
judgement about the profitability and prospects of the enterprise upon
the studies and reports submitted by the cost accountant.
4. Importance to National Economy
An efficient costing system benefits national economy by stepping up
the government revenue by achieving higher production. The overall
economic developments of a country take place due to efficiency of
production.
5. Data Base for operating policy
Cost Accounting offers a thoroughly analysed cost data which forms the
basis of formulating policy regarding day to day business, such as:
(a) Whether to make or buy decisions from outside?
(b) Whether to shut down or continue producing and selling at below
cost?
(c) Whether to repair an old plant or to replace it?
INTEXT QUESTIONS
Write against each of the following indicating the party i.e. management,
employees and creditors, benefitted from cost accounting :
1. Using budgetary control and standard costing, costing used to control
material cost, labour cost, etc.
2. Installation of an efficient costing system results in the increase in
productivity and earnings capacity.
3. Studies and reports submitted by the cost accountant enables judging
the profitability and prospects of the enterprise.
4. It enables to check the wastage in term of time and expenses.
LIMITATIONS OF COST ACCOUNTING
Like other branches of accounting, cost accounting is not an exact science
but is an art which has developed through theories and accounting practices
based on reasoning and common sense. These practices are not static but
changing with time. Cost accounting lacks a uniform procedure. There is
no stereotyped system of cost accounting applicable to all industries. There
are widely recognised cost concepts but understood and applied differently
by different industries. Cost accounting can be used only by big enterprises.
The limitations of cost accounting are as follows:
_ It is expensive because analysis, allocation and absorption of overheads
require considerable amount of additional work.
_ The results shown by cost accounts differ from those shown by financial
accounts. Preparation of reconciliation statements frequently is necessary
to verify their accuracy. This leads to unnecessary increase in workload.
_ It is unnecessary because it involves duplication of work. Some
industrial units are functioning efficiently without any costing system.
_ Costing system itself does not control costs. If the management is alert
and efficient, it can control cost without the help of the cost accounting.
Therefore it is unnecessary.
WHAT YOU HAVE LEARNT
_ Cost accounting is the process of determining and accumulating the cost
of product or activity.
_ There is a relationship among information needs of management, cost
accounting objectives, and techniques and tools used for analysis in cost
accounting. Cost accounting has the following main objectives:
Determining selling price,
Controlling cost
Providing information for decision-making
Ascertaining costing profit
Facilitating preparation of financial and other statements.
_ Difference between Financial accounting and Cost accounting:
After studying financial accounting and cost accounting, you can
understand the difference between these two accounting systems.
Objective Nature
Recording of data Accounting system
Users of information Analysis of costs and profits
Presentation of information
_ Importance of Cost accounting
Importance to Management:
Importance to Employees
Cost accounting and creditors
Importance to National Economy
_ Limitations of cost accounting
It is expensive
The results shown by cost accountant differ from those shown by
financial accountant.
It is unnecessary because it involves duplication of work.
TERMINAL QUESTIONS
l. State the meaning and scope of cost accounting.
2. Explain the objectives of cost accounting.
3. Differentiate between cost accounting and financial accounting
4. What is the importance of cost accounting in a production unit?
5. State the limitation of cost accounting.
If you set up a small manufacturing unit, say manufacturing of packing boxes, a problem will
arise what price of each box you should quote to the buyer. Many factors are considered while fixing the price of a product/item such as competitors’ price etc. One of the basic factors is the cost of its production. Cost is essential not only to fix price but also to ascertain the margin of profit.
Knowledge of the cost determination is also necessary to keep a check on the cost of product/control on wastages, etc. The accounting used to study the various aspects of cost is known as cost accounting. In this lesson, you will learn about meaning, importance, limitations etc. of cost accounting.
OBJECTIVES
After studying this lesson, you will be able to:
_ state the meaning and scope of cost accounting;
_ explain the objectives of cost accounting;
_ differentiate between cost accounting and financial accounting;
_ state importance of cost accounting;
_ explain limitations of cost accounting.
MEANING AND SCOPE OF COST ACCOUNTING
Cost accounting is the process of determining and accumulating the cost
of product or activity. It is a process of accounting for the incurrence and
the control of cost. It also covers classification, analysis, and interpretation
of cost. In other words, it is a system of accounting, which provides the
information about the ascertainment, and control of costs of products, or
services. It measures the operating efficiency of the enterprise. It is an
internal aspect of the organisation. Cost Accounting is accounting for cost
aimed at providing cost data, statement and reports for the purpose of
managerial decision making. The Institute of Cost and Management
Accounting, London defines “Cost accounting is the process of accounting
from the point at which expenditure is incurred or committed to the
establishment of its ultimate relationship with cost centres and cost units.
In the widest usage, it embraces the preparation of statistical data,
application of cost control methods and the ascertainment of profitability
of activities carried out or planned”.
Costing includes “the techniques and processes of ascertaining costs.” The
‘Technique’ refers to principles which are applied for ascertaining costs of
products, jobs, processes and services. The `process’ refers to day to day
routine of determining costs within the method of costing adopted by a
business enterprise.
Costing involves “the classifying, recording and appropriate allocation of
expenditure for the determination of costs of products or services; the
relation of these costs to sales value; and the ascertainment of profitability”.
Scope of Cost Accounting
The terms ‘costing’ and ‘cost accounting’ are many times used
interchangeably. However, the scope of cost accounting is broader than that
of costing. Following functional activities are included in the scope of cost
accounting:
1. Cost book-keeping: It involves maintaining complete record of all costs
incurred from their incurrence to their charge to departments, products
and services. Such recording is preferably done on the basis of double
entry system.
2. Cost system: Systems and procedures are devised for proper accounting
for costs.
3. Cost ascertainment: Ascertaining cost of products, processes, jobs,
services, etc., is the important function of cost accounting. Cost
ascertainment becomes the basis of managerial decision making such
as pricing, planning and control.
4. Cost Analysis: It involves the process of finding out the causal factors
of actual costs varying from the budgeted costs and fixation of
responsibility for cost increases.
5. Cost comparisons: Cost accounting also includes comparisons between
cost from alternative courses of action such as use of technology for
production, cost of making different products and activities, and cost
of same product/ service over a period of time.
6. Cost Control: Cost accounting is the utilisation of cost information for
exercising control. It involves a detailed examination of each cost in
the light of benefit derived from the incurrence of the cost. Thus, we
can state that cost is analysed to know whether the current level of costs
is satisfactory in the light of standards set in advance.
7. Cost Reports: Presentation of cost is the ultimate function of cost
accounting. These reports are primarily for use by the management at
different levels. Cost Reports form the basis for planning and control,
performance appraisal and managerial decision making.
Objectives of cost accounting
There is a relationship among information needs of management, cost
accounting objectives, and techniques and tools used for analysis in cost
accounting. Cost accounting has the following main objectives to serve:
1. Determining selling price,
2. Controlling cost
3. Providing information for decision-making
4. Ascertaining costing profit
5. Facilitating preparation of financial and other statements.
1. Determining selling price
The objective of determining the cost of products is of main importance
in cost accounting. The total product cost and cost per unit of product
are important in deciding selling price of product. Cost accounting
provides information regarding the cost to make and sell product or
services. Other factors such as the quality of product, the condition of
the market, the area of distribution, the quantity which can be supplied
etc., are also to be given consideration by the management before
deciding the selling price, but the cost of product plays a major role.
2. Controlling cost
Cost accounting helps in attaining aim of controlling cost by using
various techniques such as Budgetary Control, Standard costing, and
inventory control. Each item of cost [viz. material, labour, and expense]
is budgeted at the beginning of the period and actual expenses incurred
are compared with the budget. This increases the efficiency of the
enterprise.
3. Providing information for decision-making
Cost accounting helps the management in providing information for
managerial decisions for formulating operative policies. These policies
relate to the following matters:
(i) Determination of cost-volume-profit relationship.
(ii) Make or buy a component
(iii) Shut down or continue operation at a loss
(iv) Continuing with the existing machinery or replacing them by
improved and economical machines.
4. Ascertaining costing profit
Cost accounting helps in ascertaining the costing profit or loss of any
activity on an objective basis by matching cost with the revenue of the
activity.
5. Facilitating preparation of financial and other statements
Cost accounting helps to produce statements at short intervals as the
management may require. The financial statements are prepared generally
once a year or half year to meet the needs of the management. In order
to operate the business at high efficiency, it is essential for management
to have a review of production, sales and operating results. Cost
accounting provides daily, weekly or monthly statements of units
produced, accumulated cost with analysis. Cost accounting system
provides immediate information regarding stock of raw material, semifinished
and finished goods. This helps in preparation of financial
statements.
DIFFERENCE BETWEEN FINANCIAL ACCOUNTING AND
COST ACCOUNTING
After studying financial accounting and cost accounting, you can understand
the difference between these two accounting systems. Therefore, difference
between financial accounting and cost accounting is as follows:
Table 27.1 Differences between financial accounting and cost accounting
Basis Financial Accounting Cost accounting
(i) Objective It provides information about It provides information of
the financial performance and ascertainment of cost to control
financial position of the cost and for decision making
business. about the cost.
(ii) Nature It classifies records, presents It classifies, records, presents,
and interprets transactions in and interprets in a significant
terms of money. manner the material, labour and
overheads cost.
(iii) Recording It records Historical data. It also records and presents the
of data estimated/budgeted data. It
makes use of both the historical
costs and pre-determined costs..
(iv) Users of The users of financial The cost accounting information
information accounting statements are is used by internal management
shareholders, creditors, at different levels.
financial analysts and
government and its agencies,
etc.
(v) Analysis of It shows the profit/ loss of the It provides the details of cost and
costs and organisation. profit of each product, process,
profits job, contracts, etc.
(vi) Time period Financial Statements are Its reports and statements are
prepared for a definite period, prepared as and when required.
usually a year.
(vii) Presentation A set format is used for There are not any set formats for
of information presenting financial presenting cost information.
information.
In spite of the above differences, both financial and cost accounting are in
agreement regarding actual cost data and product costing analysis. Values
of stock and cost of goods produced and sold are the main examples. For
the preparation of the position statement, financial accountant receives the
necessary data from the cost accountant.
Importance of Cost accounting
The limitation of financial accounting has made the management to realise
the importance of cost accounting. The importance of cost accounting are
as follows:
1. Importance to Management
Cost accounting provides invaluable help to management. It is difficult
to indicate where the work of cost accountant ends and managerial
control begins. The advantages are as follows :
Helps in ascertainment of cost
Cost accounting helps the management in the ascertainment of cost of
process, product, Job, contract, activity, etc., by using different techniques
such as Job costing and Process costing.
Aids in Price fixation
By using demand and supply, activities of competitors, market condition
to a great extent, also determine the price of product and cost to the
producer does play an important role. The producer can take necessary
help from his costing records.
Helps in Cost reduction
Cost can be reduced in the long-run when cost reduction programme
and improved methods are tried to reduce costs.
Elimination of wastage
As it is possible to know the cost of product at every stage, it becomes
possible to check the forms of waste, such as time and expenses etc.,
are in the use of machine equipment and material.
Helps in identifying unprofitable activities
With the help of cost accounting the unprofitable activities are
identified, so that the necessary correct action may be taken.
Helps in checking the accuracy of financial account
Cost accounting helps in checking the accuracy of financial account
with the help of reconciliation of the profit as per financial accounts
with the profit as per cost account.
Helps in fixing selling Prices
It helps the management in fixing selling prices of product by providing
detailed cost information.
Helps in Inventory Control
Cost furnishes control which management requires in respect of stock
of material, work in progress and finished goods.
Helps in estimate
Costing records provide a reliable basis upon which tender and
estimates may be prepared.
2. Importance to Employees
Worker and employees have an interest in which they are employed. An
efficient costing system benefits employees through incentives plan in
their enterprise, etc. As a result both the productivity and earning
capacity increases.
3. Cost accounting and creditors
Suppliers, investor’s financial institution and other moneylenders have
a stake in the success of the business concern and therefore are benefited
by installation of an efficient costing system. They can base their
judgement about the profitability and prospects of the enterprise upon
the studies and reports submitted by the cost accountant.
4. Importance to National Economy
An efficient costing system benefits national economy by stepping up
the government revenue by achieving higher production. The overall
economic developments of a country take place due to efficiency of
production.
5. Data Base for operating policy
Cost Accounting offers a thoroughly analysed cost data which forms the
basis of formulating policy regarding day to day business, such as:
(a) Whether to make or buy decisions from outside?
(b) Whether to shut down or continue producing and selling at below
cost?
(c) Whether to repair an old plant or to replace it?
INTEXT QUESTIONS
Write against each of the following indicating the party i.e. management,
employees and creditors, benefitted from cost accounting :
1. Using budgetary control and standard costing, costing used to control
material cost, labour cost, etc.
2. Installation of an efficient costing system results in the increase in
productivity and earnings capacity.
3. Studies and reports submitted by the cost accountant enables judging
the profitability and prospects of the enterprise.
4. It enables to check the wastage in term of time and expenses.
LIMITATIONS OF COST ACCOUNTING
Like other branches of accounting, cost accounting is not an exact science
but is an art which has developed through theories and accounting practices
based on reasoning and common sense. These practices are not static but
changing with time. Cost accounting lacks a uniform procedure. There is
no stereotyped system of cost accounting applicable to all industries. There
are widely recognised cost concepts but understood and applied differently
by different industries. Cost accounting can be used only by big enterprises.
The limitations of cost accounting are as follows:
_ It is expensive because analysis, allocation and absorption of overheads
require considerable amount of additional work.
_ The results shown by cost accounts differ from those shown by financial
accounts. Preparation of reconciliation statements frequently is necessary
to verify their accuracy. This leads to unnecessary increase in workload.
_ It is unnecessary because it involves duplication of work. Some
industrial units are functioning efficiently without any costing system.
_ Costing system itself does not control costs. If the management is alert
and efficient, it can control cost without the help of the cost accounting.
Therefore it is unnecessary.
WHAT YOU HAVE LEARNT
_ Cost accounting is the process of determining and accumulating the cost
of product or activity.
_ There is a relationship among information needs of management, cost
accounting objectives, and techniques and tools used for analysis in cost
accounting. Cost accounting has the following main objectives:
Determining selling price,
Controlling cost
Providing information for decision-making
Ascertaining costing profit
Facilitating preparation of financial and other statements.
_ Difference between Financial accounting and Cost accounting:
After studying financial accounting and cost accounting, you can
understand the difference between these two accounting systems.
Objective Nature
Recording of data Accounting system
Users of information Analysis of costs and profits
Presentation of information
_ Importance of Cost accounting
Importance to Management:
Importance to Employees
Cost accounting and creditors
Importance to National Economy
_ Limitations of cost accounting
It is expensive
The results shown by cost accountant differ from those shown by
financial accountant.
It is unnecessary because it involves duplication of work.
TERMINAL QUESTIONS
l. State the meaning and scope of cost accounting.
2. Explain the objectives of cost accounting.
3. Differentiate between cost accounting and financial accounting
4. What is the importance of cost accounting in a production unit?
5. State the limitation of cost accounting.
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