Chapter 2.ppt

Chapter 2
Cost determination: The
costing of resource inputs

 Material is the first and most important element of cost. Material
simply means any commodity or substance which is processed in a
factory in order to be converted into finished product. Materials may
b raw material, components, tools, spare parts, consumable stores etc.
 Materials include both direct and indirect materials. Direct and
indirect materials purchased for stock purposes to be issued to
different jobs, work orders or departments as and when required are
known as stores
Materials

 Direct Materials : Materials which form a part of a finished
product are known as direct materials. For ex- leather used
making pair of shoes or yarn required for cloth are direct
materials.
 Indirect Materials : They cannot be treated as a part of finished
product because it cannot be conveniently and accurately allocated to
a particular unit of a product. For ex- nails used in making of shoes,
or button or threads used in stores etc.
Management accounting

 It can be defined as a comprehensive framework for the accounting
and control of material cost designed with the object of maintaining
material supplies at a level so as to ensure uninterrupted production
but at the same time minimizing investment of funds.
 It is the systematic control over the purchasing, storing, and using of
material so as to have the minimum possible cost of material. In
simple words, it is a system which ensures that right quality of
material is available in the right quantity at the right time and right
place with the right amount of investment.
Material Control

 1.Purchase Requisition
• A form known as ‘Purchase Requisition’ is commonly used
as a format requesting the purchase department to purchase
the required material.
• Normally the purchase requisition is issued by the Stores
Department when the quantity of the concerned material
reaches the minimum level
Procedures for Purchasing

 02. Select suitable suppliers
After the receipt of purchase requisition, the purchase
department places an order with a supplier, offering to buy
certain material at stated price and terms.
However before issuing the purchase order, quotations
may be invited from various suppliers for arriving at the
best deal
 03. Purchase order
purchase order is issued to the selected supplier. purchase
order is a legal document and it results into a contract
between the company and the supplier.
Con,t

Con,t
 04.Receiving the Materials
The receiving department performs the function of
unloading and unpacking materials which are
received by an organization.
 05. Approval of invoice
Approval of invoice indicates that goods are
purchased according to the purchase order have
been received and payments can be made for the
same amounts.

Con,t
 06. Making the Payment
After the invoice is approved the payment is made
to the supplier

Accounting for Stock
movement
 Material is being moved between different stages, and each
stage is being accounted for in the materials accounts.
When material moves from one department to another, the
material account is being debited. And when the material is
being moved out from each department after the process,
the material account is being credited.
 Stages through which material is being moved normally is
as below:

Con,t
 Supplier-Stores: Here, raw material is being purchased
and moved from suppliers’ warehouses to the company’s
stores.
 Stores-work in progress: Here, raw material is being
transferred from stores to the manufacturing process, i.e.,
goods are being processed. Thus, work in progress
account is being maintained at this stage.

Con,t
 Work in progress-Finished goods: At this stage,
work in progress goods are fully manufactured and
transferred to the finished goods department for
storage.
 Finished goods-customer: Here, finished products
are sold to the customer and transferred to the
customer’s place.

Con,t
 Therefore, there are certain stages through which
raw material is moved. While moving the raw
material, various costs and expenses are being
incurred. So, management has to take various
decisions regarding the reduction of costs. As a
result, the need for material control arises in the
manufacturing industry.

Selected Materials Accounting
Transactions
 Materials purchased from vendor.
Materials XX
Accounts Payable XX
 Materials issued to production.
Work in Process XX
Materials XX

Con,t
 Payment to vendor for invoice.
Accounts Payable XX
Cash XX
 Transfer finished work to finished goods.
Finished Goods XX
Work in Process XX

Con,t
 Sale of finished goods on account.
Accounts Receivable XX
Sales XX
Cost of Goods Sold XX
Finished Goods Inventory XX
 Collection of cash from customer.
Cash XX
Accounts Receivable XX

Determining the Cost of
Materials Issued
 In selecting the method to be used, the company
should review their accounting policies and the
federal and state tax regulations.
 The flow of materials does not dictate the flow of
costs.
– Flow of materials – the order that materials are issued for use
in the factory.
– Flow of costs – the order in which unit costs are assigned to
materials.

Cost Flow Methods
 First – In, First – Out Method (FIFO)
– Assumes that materials used in production are costed at the
prices paid for the oldest materials and the ending inventory is
costed at the prices paid for the most recent purchases.
 Moving Average Method
–Material issued and the ending inventory are
costed at the average price. This average unit
price is computed every time a new lot of
materials is received and it continues to be used
until another lot is purchased.

Determination of optimum
purchase quantities
 The optimal order quantity, also called the economic order
quantity, is the most cost-effective amount of a product to
purchase at a given time. It's an important calculation,
because holding too much stock is expensive.
 Not only are you tying up money you could be using
somewhere else, holding surplus stock may result in
unnecessary storage, administrative, financing and
insurance costs.

 Economic order quantity (EOQ) is the order size that
minimizes the sum of ordering and holding costs related to
raw materials or merchandise inventories.
 In other words, it is the optimal inventory size that should
be ordered with the supplier to minimize the total annual
inventory cost of the business. Other names used for
economic order quantity are optimal order size and
optimal order quantity

 The two significant factors that are considered while
determining the economic order quantity (EOQ) for any
business are the ordering costs and the holding costs. A
brief explanation of both the costs is given below:
A.The ordering costs are the costs that are incurred every
time an order for inventory is placed with the supplier.
Examples of these costs include telephone charges,
delivery charges, invoice verification expenses and
payment processing expenses etc.

B.The holding costs (also known as carrying costs) are the
costs that are incurred to hold the inventory in a store or
warehouse. Examples of costs associated with holding of
inventory include occupancy of storage space, rent,
shrinkage, deterioration, obsolescence, insurance and
property tax etc.
NB:-The economic order quantity is the level of quantity
at which the combined ordering and holding cost is at the
minimum level.

 To calculate the optimal order quantity of raw materials the
following formula is used:
Q = √ 2DK/G
 Q = optimal order quantity
 D = annual demand quantity of the raw material in question
 K = cost of placing the order
 G = cost of storing one unit in the warehouse for a specific amount of
time

 EX. Let’s imagine there’s a company called OKk that
manufactures and distributes corks for wine producers in
its area. To satisfy its annual production of 10,000 units,
throughout the year, the business procures 2,000 units of
raw materials (cork oak). If each order costs Br.200,
including transportation expenses, and the cost of storing
the product is amounts to Br.3,000 a year, what’s the ideal
order amount?

 In this case, the optimal order quantity of the raw materials
would be solved from the square root of the formula
2*200*2000/3000, the result of which is 16 units .
Q = √ 2*2000*200/3,000 =16 units
 Therefore, the company should place annual orders of 16 units in
order to have the most appropriate number of units of cork oak to
produce cork, thereby avoiding the excessive storage of raw material
and potential stock-outs. So, the company should place 125 annual
orders of 16 units to procure the 2,000 units of cork oak.

Identification and accounting
for stock losses
 Stocktaking refers to the physical verification of stocks in a store
and checking the result against the book stocks. This may be done on
a continuous (more frequent) or periodic basis.
a. Continuous Stocktaking
This is the counting and valuing of physical stocks more frequently.
This involves a specialist team counting and checking a number of
stock items on daily basis, so that each item is checked at least once
a year. Valuable items with high turnover could be checked more
frequently.
b. Periodic Stocktaking
This is the counting and valuing of physical stocks at the end of an
accounting period, usually annually. This system is suitable where
low levels of stocks are carried.

Con,t
 The physical stocks counted in a store may be different
from the book stocks in the stock records. This discrepancy
must be investigated so as to prevent further occurrence.
The following may be the causes of stock discrepancies:
1.Poor record keeping such as omissions or over/under
statement of receipts and issues of stocks.
2.Theft or pilferage
3. Damages, deterioration or evaporation
4. Errors in stock count.

Con,t
 Stock Loss is simply the discrepancy/difference between actual
physical stock values compared to book value of stock. Stock loss
is normally incurred when stock is lost in a fire or stolen/pilferage.
Opening stock X
Add: Purchases X
Stocks Available for use X
Less: Stock issued/used (X)
Closing Stock X
Less: Physical stock value (X)
Stock Loss value X

Con,t
Ex. Mr. A is a sole proprietor and on 31 December 2015, he
valued his stock at Br.69,500. On 27 January 2016, his
shop was broken into and his stock was stolen with the
exception of stocks valued at Br.10,450 .The following
details are given during the month:
(a) Purchases received from 1 to 27 January 2016 amounted
to Br.31,500
(b) Stocks issued/used during the same period amounted to
Br.40,480 and all these stocks has been delivered before
the break-in.

Computation the stock loss actually stolen.
Opening Stock before stolen Br.69,500
Add: Purchases 31,500
Stocks available for use 101,000
Less: Stocks issued/used (40,480)
Original/Actual closing stock valuation 60,520
Less: Stock not stolen (10,450)
Cost of stock loss Br.50,070

Increase market share
year-over-year by at least
five percent
Planning
Planning is the detailed formulation of action to
achieve a particular end.
Setting
objectives
Identifying methods to
achieve those
objectives
Example
• Consider diversification
• Sell More to Current Customers
• Try Different Types of Channels
• Target a New Market Segment

Directing and motivating
 Directing and motivating involves coordinating diverse
activities and human resources to produce a smooth-
running operation.
 This function relates to the implementation of planned
objectives.
 Most companies prepare organization charts to show
– the interrelationship of activities, and the delegation of authority
and responsibility within the company.

Controlling
Controlling is the managerial activity of
monitoring a plan’s implementation and taking
corrective action as needed.
Compare
Actual
Performance
Expected
Performance

Controlling
 Controlling is the process of keeping the firm’s
activities on track.
 In controlling operations, management determines
–whether planned goals are being met, and
–what changes are necessary when there are
deviations from targeted objectives.

Decision Making
Decision making is the process of choosing among competing
alternatives.
 This managerial function is intertwined with planning and control
 manager cannot successfully plan or control the organization’s
actions without making decisions regarding competing alternatives
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Management Functions Review
Decision
Making
Controlling

Management Functions Review
– While managers are planning future operations, accountants will help
them by preparing budgets (financial plan) and special reports.
– While managers are executing what is planned, accountants will help them
in measuring, recording and properly classifying the transactions
completed by the management for the preparation of financial reports.
– While managers are assessing whether the planned activities are
implemented as intended the evaluation phase, accountants will help
managers in supplying performance evaluation reports which show the
planned target, the actual results, the variance (deviation of actual results
from the planned targets) and the possible causes for the variance.

Cost terminologies and
classification
To perform the three management functions effectively,
management needs information. One very important type of
information is related to costs. For example, questions such as
the following need answering:
– What costs are involved in making the product?
– If production volume is decreased, will costs decrease?
– What impact will automation have on total costs?
– How can costs best be controlled in the organization?

classification
 Accountants define cost as a resource sacrificed or
forgone to achieve a specific objective. It is usually
measured as the monetary that must be paid to acquire
goods and services. In the above definition there are two
important ideas included:-
a. Cost measures the use of resources in terms monetary
units. Cost measures the use of labor hours, materials,
machine hours and other inputs in terms of monetary units

classification
b. Cost measurement is related to a particular purpose or
activity. This purpose is referred to as a cost object. Cost
object is defined as anything for which a separate
measurement of costs is desired. To quite their decisions,
managers want to know how much a particular thing (such
as a product, services, machine or process) costs, we call
this thing cost object.

Manufacturing costs
Manufacturing consists of activities and processes
that convert raw materials into finished goods.
Manufacturing costs are usually classified as follows:
–Direct Materials
–Direct Labor
–Manufacturing Overhead

Manufacturing Costs:
Direct Materials
 Raw materials represent the basic materials and
parts that are to be used in the manufacturing
process.
 Raw materials that can be physically and
conveniently associated with the finished product
during the manufacturing process are termed
direct materials.

Indirect Materials
 Some raw materials cannot be easily associated with the
finished product. These are considered indirect
materials.
 Indirect materials
– do not physically become part of the finished
product, or
– cannot be traced because their physical association
with the finished product is too small in terms of
cost.
 Indirect materials are accounted for as part of
manufacturing overhead.

Direct Labor
 Direct labor is the work of factory employees
that can be physically and conveniently
associated with converting raw materials into
finished goods.
DIRECT LABOR

Indirect Labor
 The wages of maintenance people, timekeepers,
and supervisors are normally categorized as
indirect labor because their efforts have no
physical association with the finished product or it
is impractical to trace the costs to the goods
provided. Like indirect materials, indirect labor is
part of manufacturing overhead.

 Manufacturing overhead consists of costs that are indirectly
associated with the manufacture of the finished product. These costs
may also be defined as manufacturing costs that cannot be classified
as either direct materials or direct labor.
 Manufacturing overhead includes
– indirect materials;
– indirect labor;
– depreciation on factory buildings and machinery; and
– insurance, taxes, and maintenance on factory facilities.
Manufacturing Overhead

Product Costs
 Product costs (also called inventoriable costs) include
each of the manufacturing cost elements (direct materials,
direct labor, and manufacturing overhead). They are the
costs that are a necessary and integral part of producing
the finished product.
 These costs are not expensed (as cost of goods sold) under
the matching principle until the finished goods inventory is
sold.

Product Costs:
Prime and Conversion
 Direct materials and direct labor are often referred
to as prime costs due to their direct association
with the manufacturing of the finished product.
 Direct labor and manufacturing overhead are often
referred to as conversion costs since they are
incurred in converting raw materials into finished
goods.

Period Costs
 Period costs are identifiable with a specific time
period rather than a salable product.
 Period costs are deducted from revenues in the
period in which they are incurred.
 Period costs relate to nonmanufacturing, (thus,
noninventoriable) costs, and include selling and
administrative expenses.

All Costs
Product Versus Period Costs
Direct Materials
Direct Labor
Manufacturing
Overhead
Selling
Expenses
Administrative
Expenses
Prime
Costs
Conversion
Costs
Product Costs
Manufacturing Costs
(Go to Balance Sheet before
Income Statement)
Period Costs
Nonmanufacturing Costs
(Go straight to Income Statement)

Product Costs Versus Period
Costs
Product costs include
direct materials, direct
labor, and
manufacturing
overhead.
Period costs are not
included in product
costs. They are
expensed on the
income statement.
Inventory Cost of Good Sold
Balance
Sheet
Income
Statement
Sale
Expense
Income
Statement

Nonmanufacturing Costs
 Marketing and selling costs . . .
–Costs necessary to get the order and deliver the
product.
 Administrative costs . . .
–All executive, organizational, and clerical costs.

Variable and Fixed costs
How a cost will react to changes in the level of
business activity.
Total variable costs change when activity changes.
Total fixed costs remain unchanged when activity
changes.

Variable and Fixed costs
Behavior of Cost (within the relevant range)
Cost In Total Per Unit
Variable Total variable cost changes Variable cost per unit remains
as activity level changes. the same over wide ranges
of activity.
Fixed Total fixed cost remains Fixed cost per unit goes
the same even when the down as activity level goes up.
activity level changes.

Direct Costs and Indirect Costs
Direct costs
 Costs that can be
easily and conveniently
traced to a unit of product
or other cost objective.
 Examples: direct material
and direct labor
Indirect costs
 Costs cannot be easily
and conveniently traced
to a unit of product or
other cost object.
 Example: manufacturing
overhead

Opportunity Costs
 The potential benefit that is given up when
one alternative is selected over another.
• Example: If you were not attending college,
you could be earning Br.150,000 per year.
Your opportunity cost of attending college for one
year is Br.150,000.

Sunk Costs
 Sunk costs cannot be changed by any decision.
They are not differential costs and should be
ignored when making decisions.
• Example: You bought an automobile that cost
$10,000 two years ago. The $10,000 cost is sunk
because whether you drive it, park it, trade it, or
sell it, you cannot change the $10,000 cost.

Avoidable and Unavoidable Costs
 Avoidable costs are costs that will not
continue if an ongoing operation is changed or
deleted.
 Unavoidable costs are costs that continue even
if an operation is halted.

Standard cost, Budgeted cost
Actual Cost
 Standard cost refers to the pre-established or pre-determined cost
required to manufacture one product unit. It consists of an estimate
of the costs that are expected when producing a particular product.
The term standard cost refers to a specific cost per unit.
 Budgeted cost refers to costs in total given a certain level of activity.
 Actual Costs, on the other hand, are those realized during the period
and compared at the end of the period. This difference between the
standard cost vs actual cost is termed as Variance.

Cost Unit
 Cost Unit is defined as Unit of quantity of product, service or time in
relation to which costs may be ascertained or expressed. A cost unit
refers to the unit of quantity of product, service or time (or
combination of these) in relation to which costs may be ascertained
or expressed. A cost unit may be expressed in terms of number,
length, area, weight, volume, time, or value. The following are
examples of cost units applied in different industries:
 Electric Company-Cost unit per unit
 Transport Companies-Cost unit per kilometer
 Steel Companies-Cost unit per ton

cost center and profit center
 A cost center is a reporting unit of a business that is responsible for
costs incurred. An example of a cost center is the maintenance
department of a business, where its manager is only rated on the
amount of costs incurred to maintain facilities and equipment at a
predetermined level. Similarly, the accounting, finance, information
technology, and human resources departments are all treated as cost
centers.
 A profit center is a reporting unit of a business that is responsible for
profits generated. An example of a profit center is a subsidiary,
which is responsible for the amount of sales generated, as well as all
costs incurred. profit center is responsible for both its revenues and
costs.

Linear, curvilinear and step
functions
 A linear cost function is a mathematical method used by businesses
to determine the total costs associated with a specific amount of
production. This method of cost estimation can be done whenever the
cost for each unit produced remains the same no matter how many
units are produced.
 When that is the case, the linear cost function can be calculated by
adding the variable cost, which is the cost per unit multiplied by the
units produced, to the fixed costs. Performing this equation will give
the total cost for a production order, thus enabling businesses
to budget accordingly and make decisions on production amounts.

Con,t
 This is the function where the cost curve of a particular product will
be a straight line. Mostly this function is used to find the total cost of
"x" units of the products produced. For any product, if the cost curve
is linear, the linear cost function of the product will be in the form of
y = Ax + B
y = total cost
x = number of units produced
A = cost per unit
B = total fixed costs
 The total cost of producing two dresses is Br.130 , and the production
cost of 5 similar dresses is Br.190 . By assuming a linear cost
function, what is the cost of producing 8 such dresses?

Con,t
 Curvilinear costs increase at a non-constant rate as volume
increases. When volume and costs are graphed, curvilinear costs
appear as a curved line that starts at the graph origin (total cost is
zero when volume is zero) and increases at different rates.
 There exists a linear correlation if the ratio of change in the two
variables is constant. If we plot these coordinates on a graph, we will
get a straight line. There exists a curvilinear correlation if the change
in the variables is not constant. If we plot these coordinates on a
graph, we will get a curve.

Con,t
 Step costs are costs that do not change in direct proportion to
increasing levels of activity. In other words, step costs are constant
at a certain activity level but increase or decrease when an activity
threshold is met.
 Example. John operates a company that produces pens. A machine
costing Br.15,000 is capable of producing up to 1,000 pens. Assume
that there are no additional costs related to producing pens (no raw
materials, labor, etc.). As such, the cost of machinery is an example
of a step cost.

Con,t
 As shown in the above illustration, the cost of machinery closely
resembles steps. At a production of 500 or 750 pens, only one
machine is required. The total cost is, therefore, Br.15,000. However,
at the production of 1,500, the company must purchase an additional
machine to expand its production capacity.
 At a production of 1,500 pens, the total cost is Br.30,000 (Br.15,000 x
2 machines). Therefore, it is an example of a step cost: costs that are
constant at a certain level of activity and rise or decrease when a
certain activity threshold is met.

Chapter 2.ppt

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Chapter 2.ppt