UNDERSTANDING COST

ACCOUNTING

LECTURE OUTLINE What is cost accounting Functions of CA Importance of CA Application of CA Element of cost Difference between CA and FA More about elements of cost Some formulas Classification of cost

FUNCTIONS OF CA Ascertainment of cost Controlling costs Fixing the selling price Determining sales Matching cost with revenue Profit planning Determining and controlling efficiency Facilitating the preparation of financial

statement Providing a basis for operating policy

IMPORTANCE OF CA TO BUSINESS CONCERNS Control of material cost Control of labour cost Control of overheads Measuring efficiency Budgeting Price determination

ELEMENT OF COST Cost object Cost centre Cost Cost unit Profit unit

A cost object is often a product or department for which costs are accumulated or measured. For example, a product is the cost object for direct materials, direct labor and manufacturing overhead. The factory maintenance department is a cost object for the cost of the maintenance employees and the maintenance supplies. Later the factory maintenance department costs will be assigned to products, which are also cost objects. 

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

COST OBJECT

COST CENTRE A cost center is often a department within a

company. The manager and employees of a cost center are responsible for its costs but are not responsible for revenues or investment decisions.

A manufacturer's cost centers include each of its production departments as well as the manufacturing service departments such as the maintenance department or quality control department. Other examples of cost centers include the human resource department, the IT department, the accounting department, and so on.

Differences between Financial Accounting, Cost Accounting & Management Accounting

DIRECT MATERIALS Direct materials are those that can be directly

identified a product . These materials become a major part of a product. These materials can be directly seen Examples limestone in chalk wood in furniture bricks in a house Direct materials are materials that can be easily

identified and related with specific products,jobs and processes

Direct material is also known as process material,prime cost material,production material,stores material,constructional material etc

DIRECT LABOUR Labour spent in converting raw materials into finished

good Example wages given to workers who convert raw

material into finished goods Direct labour is also called productive labour, process

labour, prime cost labour Following are considered as direct labour Labour engaged in the actual production of a product Labour engaged in assisting the manufacture by way of

supervision,maintainance,tool setting Inspectors and analysts spcially needed for production Dl can be easily identified and related with a specific

product ,job,process and activity Examples cost of a washer in dry cleaning, cost of a tailor

producing ready made garments---

DIRECT EXPENSES Expenses can be directly related to cost centres or cost

units are called direct expenses –expenses other than direct material and direct labout

Direct expenses are also known as chargeable expenses,prime cost expenses,productive expenses or process expenses

Examples cost of special drawings, design or layout Hire charge ,repairs and maintenance of special

equipments hired Excise duty Royalty Architect fees Cost of rectifying defective work Inward carriage ,freight charges

INDIRECT MATERIAL Materials that cannot be identified as part of a product

are called indirect material

Examples Cotton waste brooms Lubricants Cleaning materials materials for repairs and maintenance

Indirect material cannot be easily and conveniently identified and related with a particular product, job, process, activity e.g consumable stores, oil and waste printing and stationary used in factory,office,or selling or distribution department

INDIRECT LABOUR Wages that cannot be identified with a

product Paid to those workers who assist in production

/indirectly involved in production Examples : salary for supervisor salary for storkeepers salary for clerical staff directors fee salary of sales men and works manager It cannot be identified with a specific product,

job, process or activity

INDIRECT EXPENSES Expenses that are not directly identified

with a product are called indirect expenses

Examples factory rent factory insurance factory depreciation plant repair maintenance and insurance

OVERHEADS Indirect material+ indirect labour+

indirect expenses = overheads

Overheads are classified into 3 categories

Factory/works overhead heads Office and administration over heads Selling and distribution overheads

FACTORY OVERHEADS Expenses incurred in the production of

goods in a factory Indirect materials Indirect labour Indirect expenses

OVERHEAD -INDIRECT MATERIALS Grease Oil Lubricants cotton waste Small tools brushes for sweeping Cost of threads and nails Consumable stores Factory printing and stationary

FACTORY OVERHEADS-INDIRECT WAGES Salaries of factory manager, formen,

supervisors,clerks Salary of store keeper Salary and fees of factory directors and

technical directors Contribution to employees provident

fund,leave pay etcof factory employees

FACTORY OVERHEADS –INDIRECT EXPENSES Rent of factory bulidings and land Insurance/depreciation/repairs of factory

,plant and machinery Muncipal taxes of factory building Power and fuel used in factories Factory telephone expenses

FACTORY OVERHEADExamples of factory overhead costs are:separate these into

material,labour,expense factory overhead Production supervisor salaries Quality assurance salaries Materials management salaries Factory rent Factory utilities Factory building insurance Fringe benefits Depreciation Equipment setup costs Equipment maintenance Factory supplies Factory small tools charged to expense Insurance on production facilities and equipment Property taxes on production facilities

OFFICE AND ADMINISTRATIVE OVERHEADS These expenses are related to the

management and administration of businesses.they are incurred in the direction and control of an undertaking

Examples Office printing and stationery Postage and stamps Cost of brushes and dusters Rent /insurance /taxes of office building Lightning ,heating, and cleaning Depreciation and repairs of office building Furniture,equipment

SELLING AND DISTRIBUTION EXPENSES incurred in the marketing of a

commodity ,securing orders for goods ,dispatching goods sold, or making efforts to find and retain customers

Indirect materials +indirect labor+indirect expenses in selling and distribution

SELLING OVERHEADS Indirect materials: catalogues, printing and

stationary, postage and stamps, cost of sample goods

Indirect wages: salaries of sales manager,clerks, sales men and technical staff, fees of sales director

Indirect expenses:advertising, bad debts, rent and insurance of showroom, legal charges incurred for recovery of debts, travelling and entertaintment expenses, expenses of sending samples, market research expenses

DISTRIBUTION OVERHEADSExamplesIndirect materials:cost of packing material,

maintenance of delivery van(oil,grease,spare parts)

Indirect wages:salaries of godown employees, wages of van drivers,wages of packers and dispatch staff

Indirect expenses:packing expenses, godown rent/rates/insurance, depreciation, repairoutward freight charges, other transport charges, other running expenses of delivery vans

CLASSIFICATION OF COSTS Grouping of costs according to their

common characteristics By nature By functions As direct and indirect By variability By controllability By normality

1.BY NATURE OR ELEMENT Material Labour Expenses

2.BY FUNCTIONS Under this classification the costs are divided

according to the function for which they have been incurred

Production cost Selling cost Distribution costs Administrative cost Research cost Development cost Preproduction cost Conversion cost=dw+de+production overhead for

converting raw material into finished stage or from one stage of production to the next

3.AS DIRECT AND INDIRECT4. BY VARIABILITY Fixed: Variable Semi variable:cost that are partly fixed

and partly variable in relation to output.thes costs dosent vary proportionately but simultaneously doesn’t remain stationary at all times e.g telephone bill,electricity bill,depreciation,repairs

5.BY CONTROLLABILITY Controllable costs Uncontrollable costs Uncontrollable costs are

business expenses that the manager doesn't have direct power over. A good example of an uncontrollable cost is insurance. A manager who runs a department on the factory floor does not have control over the liability insurance that the company buys. If several accidents happen within the company and the liability issuance increases, the manager shouldn't be penalized for the increased cost. Upper level executives usually set this insurance policy, so the factory floor manager doesn't have control over it.Depreciation is another example of an uncontrollable cost. Even though a factory floor manager has control over the machines, maintenance costs, and upkeep, depreciation and accelerated depreciation is rarely set at the manager level. Depending on how much equipment was purchased for the year, depreciation can also eliminate all profits from the department.

6.COSTS BY NORMALITY Normal costs:the cost that is normally incurred

at a given level of output in the conditions that level of output is normally attained. They are the sum of actual direct materials cost, actual labour cost and other direct expense. Example: repairs, maintenance, salaries paid to employees.

Abnormal costs:the costs that are not normally incurred at a given level of output in the conditions at which that level of output is normally attained  Example: destruction due to fire, shut down of machinery, lock outs, etc.

TYPES OF COSTING Uniform costing

When firms in an industry agree to follow same costing technique for products ,proccess

Marginal costingOnly variable cost computed to find the effect of volume on production-fixed cost is excluded

Standard costingStandard costs are predetermined and then compared with actual. technique of cost control

Historical costingAscertainment of cost after they have been incurred

Direct costingThe practice of charging all direct costs to operations ,products to calculate profit

Absorption costingpractice of charging all costs ,both variable and fixed to operations and products or proccess or products

COST SHEET Cost sheet is a statement prepared to

show the various elements of costs, like prime cost factory cost ,cost of production and total cost

It is prepared at regular intervals like weekly,monthly,quarterly, yearly

Cost sheet also shows cost per unit of any product at any stage of production

FEATURES AND ADVANTAGES OF A COST SHEET Cost sheet shows total costs and cost per unit of

units produced Cost sheet shows total cost under different

classifications Cost sheet helps in the preparation of tender and

quotations It helps in the fixing of price It helps the manufacturer keep a close watch and

control over the cost of production It helps in eliminating/minimising the cost that

go towards increasing the cost of a product It acts as a guide to the manufacturer and helps

him formulating useful production policy

PREPARE A COST SHEETThe modern manufacturing company submitted the following

information on 31 march 1993Sales per year 275000Inventories at the beginning of the yearFinished goods 7000WIP 4000Purchases of materials 110000Materials inventory At the beginning 3000At the end of year 4000Direct labour65000Factory overheads were 60% of direct labourInventories at the end of the year

WIP 6000Finished goods 8000Other expenses of the yearSelling expenses 10% of salesAdministration expenses 5% of sales

QUIZ APRIL 17 20151. Answer the following questions2. Identify any two functions of cost accounting

(1)3. In what two aspects cost accounting differ

from financial accounting? (1)4. What are overheads?give two examples (1)5. How do direct material differ from indirect

material? (1)6. Give two examples of uncontrollable costs(1)7. How does cost sheet help businesses? (1)8. How do you calculate cost of production and

cost of goods sold? (1)

MATERIAL CONTROL/

INVENTORY CONTROL

WHAT IS MATERIAL CONTROL

It’s a way of regulating the purchase storage and use of materials

to ensure uniterrupted production and to minimize the investment of

funds in materials

OBJECTIVES OF MARERIAL CONTROL Regular supply of material Minimum possibility of overstocking and

understocking Minimum wastage Getting material at regular prices Avialability of up to date information

ESSENTIALS OF A GOOD MATERIAL CONTROL SYSTEM Quality of the material purchased must

depend on the product manufactured The price of the material should be

minimum The production process shouldnot be

interrupted for want of material Material shouldnot be understocked or

over stocked The loss and wastage of material should

be avoided during production Wastage of stored material should be

avoided

:STOCK REORDER LEVEL, PURPOSE & FORMULA Stock reorder level indicates to the

stock controller when it is necessary to reorder certain raw materials or components.

The purpose of using this stock reorder level is to enable management to ensure there is sufficient stocks to meet demands from the production department.

Formula=Maximum usage x Maximum lead time

Example 1: ABC Ltd. is a retailer of footwear. It sells 500 units of one of a famous brand daily. Its supplier takes a week to deliver the order.Reorder level =500x 7=3500The inventory manager should place an order before the inventories drop below 3,500 units (500 units of daily usage multiplied with 7 days of lead time) in order to avoid a stock-out

Example 2: ABC Ltd. has decided to hold a safety stock equivalent to average usage of 5 days. Calculate the reorder level.

Safety stock = 2,500 units (500 units of daily usage multiplied by 5 days).

Reorder level = 6,000 units (2,500 of safety stock plus 3,500 units based on 7 days of lead time).

LEVELS OF STOCK` Materials control means maintaining a

right level of stock by taking into account

The production requirements Financial resources of a business

This implies there is always a limit to minimum and maximum level of stock

MINIMUM STOCK LEVEL Minimum stock level is the minimum quantity of a

material must be kept in the store at all times. Material stock should not be allowed to fall down

below this level as it may interrupt the production due to non availability or shortage of the material.

Minimum stock level often called as safety stock as well.

There are factors needs to be considered in order to determine the minimum stock level, which is:

Lead time (time required for getting fresh delivery of material)

Rate of consumption of materials during the lead time.

Availability of substitute and re-order level.

HOW TO CALCULATE Minimum stock level =reordering level-

(normal consumption x normal reorder period

Reordering level =maximum consumption x maximum reorder period

ILLUSTRATION Minimum Consumption………………………………….. 500 units Maximum Consumption…………………………………. 700 units Reorder period…………………………………………….. 15-20 Days Solution: There are three components in formula which is re-order level, normal consumption,

normal reorder period, initially we need to find our the value for this components as per the below calculation

Maximum consumption x Maximum reorder period = Reorder level 700 x 20 = 14000 units (Maximum consumption + Minimum consumption) / 2 = Normal

consumption ( 700 + 500 ) / 2 = 600 units (Maximum reorder period + Minimum reorder period) / 2 = Normal reorder

period ( 20 + 15 ) / 2 = 17.5 days Now we have all the component value to calculate the maximum level of

stock, let us have look: Minimum stock level = Re-order level – (Normal Consumption x Normal

reorder period) 14000 – (600 x 17.5)  = 3500 units

The main factors considered in fixing minimum level of inventory are

Information about maximum consumption and maximum delivery time to determine reorder level

Average rate of consumption for each inventory(normal consumption)

Average delivery period for each item ,this period can be calculated by averaging the max and min periods(normal reorder period)

MAXIMUM STOCK LEVEL It is the upper level of inventory The quantity must not exceed without

specific instruction from the management

This level is fixed after considering Rate of consumption Amount of capital needed and available Storage space available Insurance costs Risk of wastage

HOW TO CALCULATE Maximum level =reorder level

+reordering quantity –(minimum consumption x minimum delivery period)

Reorder level =maximum consumption x maximum delivery period

It also requires the figure of economic order quantity

ILLUSTRATION

Re-order quantity = 1000 unitsRe-order Level = 1500 unitsRe-ordering period = 4 to 6 daysDaily consumption = 150 to 250 unitsMaximum Level = ?

Solution,Maximum Level = Re-order level + Re-order quantity - (Minimum consumption x Minimum Re-ordering period)= 1500+1000(150 x 4)= 1900 units.

MAXIMUM LEVEL OF STOCK Maximum level is that level of stock, which is

not normally allowed to be exceeded. Beyond the maximum stock level, a

blockage of capital occurs The factory should not keep materials more

than the maximum stock level. It increases the carrying cost of holding unneccesary inventory

Maximum Level = Re-order Level + Re-order quantity - (Minimum consumption x Minimum Delivery Time)

AVERAGE STOCK LEVEL It is the normal stock level held by a

firm

Average stock level =minimum stock level +1/2(reorder quantity)

ECONOMIC ORDER QUANTITY Economic order quantity (EOQ) is the

order quantity of inventory that minimizes the total cost of inventory management

Two most important categories of inventory costs

ordering costs carrying costs. Ordering costs are costs that are incurred on

obtaining additional inventories. They include costs incurred on communicating the order, transportation cost, etc.

Carrying costs represent the costs incurred on holding inventory in hand. They include the opportunity cost of money held up in inventories, storage costs, spoilage costs, etc.

ORDERING COSTS AND CARRYING COSTS ARE QUITE OPPOSITE TO EACH OTHER

If we need to minimize carrying costs/holding cost we have to place small order which increases the ordering costs (as it increases the number of orders in a time period).

If we want minimize our ordering costs we have to place few orders in a year and this requires placing large orders which in turn increases the total carrying costs for the period.

We need to minimize the total inventory costs and EOQ model helps us just do that.

Total inventory costs = Ordering costs + Holding costs

By taking the first derivative of the function we find the following equation for minimum cost

EOQ = SQRT(2 × Quantity × Cost Per Order / Carrying Cost Per Order)

EXAMPLE ABC Ltd. is engaged in sale of footballs. Its cost per order is $400 its carrying cost unit is $10 per unit per annum. The company has a demand for 20,000 units per year. Calculate the order size, total orders required during a year, total carrying cost and total ordering cost for the year.

Solution EOQ=SQRT(2 xquantity x cost per order/carrying cost per

unit)

EOQ = SQRT(2 × 20,000 × 400/10) = 1,265 units Annual demand is 20,000 units so the company will have to place 16

orders (= annual demand of 20,000 divided by order size of 1,265). Total ordering cost is hence $64,000 ($400 multiplied by 16).

Average inventory held is 632.5 ((0+1,265)/2) which means total carrying costs of $6,325 (i.e. 632.5 × $10).