Cost Accounting An Introduction
Introduction • Cost is a measurement, in monetary terms, of the amount of resources used for the purpose of production of goods or rendering services. • Cost is the amount of actual or notional expenditure relating to a product, job, service, process or activity. • Cost is often used as a generic term to describe various types of costs. • Costing is the technique and process of ascertaining costs.
Introduction • 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 centers and cost units. It includes: • Collecting, classifying, recording, allocating and analyzing costs • Preparation of periodical statements and reports for ascertaining and controlling costs • Application of cost control methods • Ascertainment of profitability of activities carried out or planned. • Cost Accounting is the processing and evaluation of monetary and non-monetary data to provide information for internal planning, control of business operations, managerial decisions and special analysis.
Introduction • Cost Accountancy is the application of costing and cost accounting principles, methods and techniques to the science, art and practice of cost control and the ascertainment of profitability. It includes the presentation of information derived there from for the purpose of managerial decision making. • Objectives of Cost Accounting • To ascertain cost • To control cost • To provide information for decision making • To determine selling price • To ascertain costing profit
Advantages of Cost Accounting • Helps in ascertainment of cost • Helps in control of cost • Helps in decision making (make or buy, retain or replace, continue or shut down, accept or reject orders, etc) • Helps in fixing selling prices • Helps in inventory control • Helps in cost reduction • Helps in measurement of efficiency • Helps in preparation of budgets • Helps in identifying unprofitable activities • Helps in identifying material losses • Helps in identifying idle time, idle capacity • Helps in improving productivity • Helps in cost comparison
Essentials of a Good System • Suitability – to the nature of business • Tailor made system – to meet requirements of the business • Simplicity – easy to understand and simple to operate • Economical – to install and operate • Flexibility – to adapt to the changing business needs • Accuracy – must provide accurate information • Promptness – of information • Support of staff – must have staff co-operation and participation • Cost control – must ensure cost control in various fields • Clearly defined Cost Centers – least ambiguity • Detail – give relevant details but avoid unnecessary detail
Cost Concepts • Cost Unit – Is a unit of product, service or time in terms of which costs are ascertained or expressed. It is a unit of measurement. • Responsibility Centers – is the unit or function of an organization under the control of a manager who has direct responsibility for its performance. E.g. Cost Center, Revenue Center, Profit Center, Contribution Center, Investment Center. • Cost Center – Is a location, person or item of equipment for which costs may be ascertained and used for the purposes of cost control. • Types of Cost Centers: • Personal Cost Center – person or group of persons • Impersonal Cost Center – location or equipment • Production Cost Center – where actual production takes place • Service Cost Center – departments which render service to other cost centers • Cost Object – any product, service, process or activity for which a separate measurement of cost is required.
Cost Treatment • Cost Ascertainment is the process of determining actual costs after they have been incurred. • Cost Estimation is the process of determining future costs in advance before production starts, on the basis of actual past cost adjusted for anticipated future changes. • Cost Allocation is the process of charging the full amount of an individual item or cost directly to the cost center for which the item of cost was incurred. • Cost Apportionment is the process of charging the proportion of common items of cost to two or more cost centers on some equitable basis. • Cost Absorption is charging cost from cost centers to products or services by means of a pre-determined absorption rate.
Cost Audit • Cost Audit is the verification of cost accounts and a check on the adherence to the Cost Accounting plan. It comprises of verification of the cost records and ensuring that they adhere to the principles of cost accounting. • Purpose of Cost Audit are protective (examine undue wastage / losses to reflect realistic cost of production) and constructive (provide information for management decision making). • Items excluded from Cost Accounts – items of financial nature like Other Income, Finance Costs, Financial Accounting adjustments and appropriations. These include profit on sale of fixed assets / investments, interest income / expense, dividend / rent income, preliminary expenses written off, tax, cash discount, provision for doubtful debts, etc.
Material Cost Fundamentals
Material Cost • Material Cost can be Direct and Indirect • Direct Materials are those which can be identified with and directly allocated to the product, job or process. • Includes basic material and primary packing material • Indirect Materials are those which cannot be easily identified with and directly allocated to the product, job or process. • Includes stores, consumables, small value materials
Direct Material Cost • The total direct material cost includes: • Purchase price • Customs Duty, Excise Duty, VAT, CST, Octroi • Inward freight • Insurance • Directly attributable expenses like packing expenses, inspection, storage, delivery, etc • (Less) Volume or Trade Discounts • Rebates, Duty Drawback, MODVAT, Subsidies, etc • (Less) Cost of containers recovered on return
Objectives of Material Control • Avoid under stocking or shortages • Avoid over stocking and obsolescence • Ensure proper quality from reliable sources • Explore alternate sources and reduce cost • Reduce total cost of materials, including ordering and carrying costs • Avoid wastages and losses in storage and use • Maintain proper inventory records • Provide information for decision making
Requirements for Material Control • Proper co-ordination • Proper purchase system • Proper storage system • Proper issue system • Perpetual inventory system • Continuous stock taking system • Budgetary control system • Proper documentation • Proper accounting system • Proper reporting system
Documents for Materials • Purchase of Materials • Bill of Materials (BoM) • Purchase Requisition • Supplier Selection • Purchase Order • Goods Received Note • Inspection Note • Return of Rejected Material • Bill Passing • Making Payment to Supplier • Issue of Materials • Bin Card • Stores Ledger • Material Requisition • Material Return Note • Material Transfer Note
Material Losses • Waste – portion of raw material lost during processing or storage, having no recovery value • Arises due to shrinkage, evaporation, chemical reaction, etc • Scrap – incidental residue manufacturing operations usually of small amount and low value recoverable without further processing • Arises due to processing of material, defective or broken parts and obsolescence / abortion of development projects • Defective Work – work that has some imperfections which can be rectified by additional material or processing • Arises due to improper product design, bad raw material, poor workmanship, inadequate supervision, improper material handling, defective machinery or improper training • Spoiled Work – work that cannot be reconditioned or brought to standard and must be sold as scrap or “seconds” • Arises due to improper product design, improper machinery or process used, improper material quality or untrained operators • Normal Loss is charged to the particular job or as production overheads • Abnormal Loss is charged to Costing Profit & Loss Account
Controlling Material Loss • Proper product design • Proper selection of manufacturing process • Proper selection of machinery & equipment • Proper process control • Proper storage and material handling • Trained manpower • Proper record keeping • Proper control system having scientific standards • Proper reporting system • Defined accountability • Corrective action
Materials Issue Pricing • Cost Price Methods • FIFO (First In First Out) • LIFO (Last In First Out) • HIFO (Highest In First Out) • Base Stock Price • Average Price Methods • Simple Average • Weighted Average • Periodic Simple / Weighted Average • Moving Simple / Weighted Average • Notional Price Methods • Standard Price • Inflated Price • Replacement or Market Price • Weighted Average and FIFO Methods are used in Accounting
Inventory Control • Inventory is tangible property or assets held • for sale in the ordinary course of business or • in the process of production for sale or • for consumption in the production of goods or services for sale including maintenance supplies and consumables other than machinery spares • Inventory comprises of raw materials, stores & spares, work-in-process and finished goods • Inventory control includes planning, organizing and controlling purchase and storage to ensure availability in terms of quantity, quality, timeliness at least cost • Monitoring level of inventory with respect to production and sales • Releasing material in a systematic manner to ensure quality at least cost and reduce wastage / obsolescence • Analyze inventory levels and suggest optimal and alternate uses of material including value engineering • Ensure physical stock taking to avoid pilferage • Provide information for inventory valuation
Techniques of Inventory Control • ABC Analysis • Economic Order Quantity (EOQ) • Stock Levels – minimum, maximum, reorder level, reorder quantity • Inventory Turnover Ratio • Slow and Non-Moving Items • Purchase, Storage and Issue Procedure • Two Bin System • Perpetual Inventory Records and Continuous Stock Verification • Budgetary System
ABC Analysis • A: 70% value, 10% items • B: 20% value, 20% items • C: 10% value, 70% items • Ensures control on high value items • Saves time and cost of monitoring • Reduces total investment in inventory • Facilitates faster decision making • Better utilization of resources • Better physical control of stock
Economic Order Quantity (EOQ) • Level at which the ordering and carrying costs are minimum. At EOQ, the ordering and carrying costs are equal. • Ordering Cost includes costs for placing an order, transportation, receiving goods and inspecting goods • Ordering Cost reduces with order size • Carrying Cost includes costs for storage space, handling materials, insurance, obsolescence and personnel. • Carrying Cost increases with order size • Dependent on periodicity and annual material consumption • EOQ determines quantity to be ordered at a given time
EOQ Technique • Assumes prior knowledge of annual usage, constant usage rate, constant ordering cost, constant carrying cost and zero lead / delivery time • EOQ can be determined by graphical, tabular or formula method • Find the level at which total of ordering and carrying cost is least or ordering cost equals carrying cost • EOQ = √(2AO / C) where A = Annual Consumption, O = Ordering Cost per order and C = Carrying Cost per order • EOQ = √(2AO/IP) where I = Inventory or Stock Holding Cost (as % of average stock value) and P = Price per unit • Economic Order Frequency (in days) = 365 / (Number of orders per year) • Total annual ordering and carrying cost at EOQ = √(2AOC)
Stock Levels • Maximum Stock Level is the maximum stock level that can be held in store. • It avoids cost of over-stocking such as costs for storage, investment, insurance and risk of obsolescence • Dependent on reorder level, reorder quantity, rate of consumption, reorder period, availability of funds and storage space, cost of storage, insurance, obsolescence, price fluctuation, etc • Formula: Maximum Level = Reorder Level + Reorder Quantity – (Minimum Consumption x Minimum Reorder Period)
Stock Levels • Minimum Stock Level is the level below which the stock should not be allowed to fall • Dependent on reorder level, rate of consumption and reorder period • Formula: Minimum Level = Reorder Level – (Normal Consumption x Reorder Period) • Reorder Level is the level of stock at which fresh replenishment order should be placed • Dependent on consumption rate, reorder period and minimum level • Formula: Reorder Level = Maximum Consumption x Maximum Reorder Period OR Minimum Level + (Normal Consumption x Reorder Period)
Stock Levels • Average Stock Level = Minimum Level + ½ Reorder Quantity OR (Minimum Level + Maximum Level) / 2 • Danger Level is the level at which only emergency material issue is done (normal material issue is stopped) • It is a level at which urgent ordering action is required • If Danger Level is below Minimum Level, urgent corrective action is required • If Danger Level is above Minimum Level, it calls for preventive action • Dependent on rate of consumption and reorder period • Formula: Normal Consumption Rate x Maximum Reorder Period for emergency purchases
Inventory Turnover Ratio • Indicates the speed with which inventory is consumed • A high ratio indicates fast moving stock, low ratio indicates slow moving stock • Inventory Turnover Ratio = Materials Consumed / Average Stock Held expressed in “times” • Materials Consumed = Opening Stock + Purchases – Closing Stock • Average Stock = ½ (Opening Stock + Closing Stock) • Days of Inventory = 365 / Inventory Turnover Ratio • Can be computed for stock categories to determine fast moving, slow moving, dormant or obsolete stock • Ideal level is determined with reference to level of other firms or the industry average
Other Techniques • Two Bin System – Bin has two parts, the smaller one for reorder stock level and the other for the remaining material • Issues are made from the larger bin, fresh order placed when it become empty, material used from smaller bin till replacement received and filled • Periodic Inventory System – Physical stock taking done periodically, requiring shut down • Records then physically reconciled • Perpetual Inventory System – Records updated at every receipt and issue • Done using bin cards and stores ledger • Continuous stock taking done by random checks of the bin cards and stores ledger
Labour Cost Fundamentals
Meaning • Essential factor of production • A human resource that participates in the process of production • Two Categories – Direct & Indirect Labour • Labour Cost controlled by: • Personnel Department • Engineering / Work Study Department • Time Keeping Department • Payroll Department • Cost Accounting Department
Labour Cost Control • Manpower requirement assessment • Time and Motion Study • Job Evaluation and Merit Rating • Labour Productivity • Wage Systems • Incentive Systems • Time Keeping and Time Booking • Labour Turnover • Casual and contract workers
Time Keeping • Statutory attendance record • Maintain discipline and punctuality • Payroll preparation • Ascertain Overtime • Ascertain Idle Time • Ascertain Labour Cost • Provide basis for apportionment • Control Labour Cost • Maintained using Attendance Register / Muster, Token / Disc Method and Time Clocks / Clock Card
Time Booking • Records time spent by each worker on various jobs / orders / processes • Methods: • Daily Time Sheet • Weekly Time Sheet • Job Card or Job Ticket • Time and Job Card • Labour Cost Card / Circulating Job Card • Piece Work Card
Labour Turnover • Rate of change in the composition of labour force due to retirement, resignation or retrenchment • Defined as the number of workers left or replaced or both in relation to the average number of workers • Turnover due to personal, avoidable and unavoidable causes • Cost of Labour Turnover consists of Preventive Cost and Replacement Cost • Preventive Cost – personnel administration, medical & health care, welfare measures, wage & retirement benefits • Replacement Cost – personnel department expenses, training of new workers, initial inefficiency, initial breakages and defectives, time lag in recruitment,
Labour Turnover Measurement • Measurement by Separation Rate Method, Replacement Rate Method, Flux Method • Separation Rate Method: Number of Separations / Average Number of Workers x 100 • Replacement Rate Method: Number of Replacements (not normal additions) / Average Number of Workers x 100 • Flux Method: (Number of Separations + Replacements) / Average Number of Workers x 100 OR (Number of Separations + Accessions i.e. all Recruitments) / Average Number of Workers x 100
Types of Labour Cost • Overtime Cost: • Customer requested, charged to specific job • For increased production, charged to total production • Abnormal overtime, charged to Costing P&L Account • Idle Time: • Normal Idle Time, charged to the product • Abnormal Idle Time, charged to Costing P&L Account • Casual Workers, charged to specific job or as production overhead based on work done • Out-Workers (who do the work in their premises) normally supply based on piece rate • Outside Workers (outdoor duty) should be monitored to ensure adequate time booking
Types of Labour Cost • Attendance Bonus are part of wages and treated accordingly • Shift Premium, charged same as Overtime Cost • Fringe Benefits are part of wages and treated accordingly • Apprentice Wages, charged as production overhead • Holiday / Vacation Pay, charged as overhead or accounted in an inflated rate • Leave with pay, accounted in an inflated rate • Employer’s contribution to employee insurance, charged as production overhead
Incentive Wage Plans • Premium Bonus Plan - Halsey Plan, Halsey Weir Plan, Rowan Plan, Barth Plan • Differential Piece Work - Taylor System, Merrick System • Combination of Time and Piece Work - Emerson’s Efficiency Plan, Gantt Task and Bonus Plan, Points Scheme (Bedeaux Plan, Haynes Plan), Accelerated Premium Plan • Group Incentive Plans – Priestman’s Production Bonus, Rucker Plan, Scalon Plan, Towne Gain Sharing Plan, Budgeted Expenses Bonus • Incentives for Indirect Workers • Profit Sharing • Co-Partnership
Premium Bonus Plans • Halsey Plan: standard time fixed for each work, guarantees hourly wages for actual time taken, bonus of 50% paid if time saved Earnings = Time Rate Wages + Bonus = Actual Time Taken x Time Rate + 50% (Time Saved x Time Rate) • Halsey – Weir Plan: same as Halsey Plan except bonus is 33⅓% compared to 50% in Halsey Plan • Rowan Plan: same as Halsey Plan except bonus is a proportion – (Time Saved / Time Allowed) x Actual Time Taken x Time Rate • Barth Plan: Designed for trainees, beginners and slow workers. Earnings = Time Rate x √(Standard Hours x Time Taken)