CHAPTER ONE

INTRODUCTION

What is cost accounting?

Cost accounting is the part of management accounting concerned with gathering data about the costs of
products or services and the cost of activities. The cost accounting data is captured, stored and
subsequently analyzed to provide management information about costs. Information provided by cost
accounting systems is financial in nature; it may be forward looking, and used to provide information
about expected costs and profits in the future. More usually, cost accounting information is historical in
nature, and provides information about the actual costs of items and activities that have been incurred.

Cost accounting data is used to set standard costs which are used in preparing budgets. Other cost
accounting data relates to actual costs of products, services and activities. Standard costs are also used
to compare actual costs with expected costs of products, services and activities, and analyzing variances
between actual costs and expected costs for control purposes.

What is management accounting?

Management accounting is concerned with providing information to management about costs, sales
revenue and profits, so that managers are able to make well informed decisions. Management
accounting information is often prepared from an analysis of cost accounting data, although cost
estimates and revenue estimates may be obtained from sources other than the cost accounting system.

The purpose of management accounting is to provide detailed financial information to management, so

that they can plan and control the activities or operations for which they are responsible. Management
accounting information is also provided to help managers make other decisions.

What is financial accounting

A financial accounting system is used to record the financial transactions of the entity such as
transactions relating to revenue, expenditure, assets and liabilities. The financial accounting system
provides a record of the assets which an entity owns and the liabilities which it owes. It also provides a
record of the income the entity has earned and expenses it has incurred. This information is used to
prepare periodic financial statements aimed at informing the owners of the entity and other
stakeholders about the performance, financial position and cash flows of the entity over a given period.

While managers might also information in financial statements, the main purpose of financial
accounting is to provide information to various people external to the organization to enable them make
informed economic decisions.

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Differences between financial and management accounting
1. Financial statements are produced at the end of the financial year while management
information is required much more regularly throughout the year.
2. Management accounting information is more detailed than information provided in financial
statements.
3. Financial accounting information is historical while management accounting information
includes both historical and forward looking forecasts.
4. There is a statutory requirement for companies to produce annual financial statements while
there is no such requirement for management accounting information since management
accounting information is for internal use by managers.
5. Financial accounting information must be produced in compliance with accounting standards
while management accounting information is prepared to suit the information needs of the
managers.
6. Financial accounting information is required for external reporting while management
accounting information is for internal use by manager to assist them with planning and
controlling the activities of the organization.

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 CHAPTER TWO

CLASSIFICATION OF COSTS

The need to know about costs

Organizations produce products or provide services to customers. They therefore need to know:

(a) What has been the cost of goods produced, or services provided, or what has been the cost of a
department or work section? What have revenues been? Knowing about costs and revenues that are
being/or have been incurred and earned enables management to:

i. Assess the profitability of a product, a service, a department, or the organization in total;

ii. In some cases, set selling prices with some regard for the cost of sale
iii. Put a value to inventories of goods (raw materials, work in progress, finished goods) that are
held in store at the end of a period – for preparing a statement of financial position as at the
end of that period.

(b) What are the future costs of goods and services (and operations etc.) likely to be?

 Costing is an integral part of budgeting (planning) for the future.

(c) How do actual costs compare with budgeted costs?

 If an organization plans for its revenues and costs to be a certain amount, but they
actually turn out differently, the differences can be measured and reported.
Management can use these reports as a guide to whether corrective action (or control
action) is needed to sort out a problem revealed by these differences between
budgeted and actual results. This system of control is often referred to as budgetary
control.

(d) What information does management need in order to make sensible decisions about profits and
costs?

This information is important because:

 It helps an organization to plan for the future

 It helps an organization to compare actual costs with planned costs for control purposes
 It helps in ensuring that products and services are sold at a profit
 It helps to measure the amount of profit made by different products and also by the
organization as a whole.
 It helps to measure the value of inventories of raw materials, work in progress and finished
goods at the end of each accounting period.

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Classification of costs
Costs can be classified in different ways depending on the purpose for the classification.

Materials costs, labour costs and expenses

Costs can be classified according to their nature i.e. whether they are materials costs, labour costs or
expenses.

 Materials costs are costs of any items purchased from suppliers with the intention of converting
them into finished products or using them for any other purposes in the production of the
products, providing services or in carrying out any activities of the enterprise in the fairly short-
term future. These could be raw materials such as chemicals, metal, timber, cloth, detergents,
oils, lubricants, components, stationery, and other tangible substances that are used in the
course of the entity’s work. Materials costs do not include long term assets such as machinery,
equipment, motor vehicles, furniture etc.
 Labour costs are the costs incurred in remunerating people employed in all capacities for their
skill and effort provided to the work of the enterprise. These include wages, salaries, overtime
premiums, bonuses, shift allowances, pension contributions and any other benefits paid to
employees as part of their compensation for their skill and effort provided to the entity.
 Expenses are all other costs other than costs of materials and labour which are incurred by the
entity in carrying on its activities and operations. Examples of expenses are rent, rates,
electricity and water, depreciation, insurance, interest, charges for repairs by external
contractors etc.

Manufacturing costs and non-manufacturing costs

In a cost accounting system for a manufacturing organization, i.e. an organization which produces
tangible products, costs can be classified into two broad categories:

 Manufacturing costs (production costs); and

 Non-manufacturing costs (non-production costs)

Manufacturing costs or production costs are all costs incurred in acquiring raw materials and converting
them into finished products up to the time that the manufactured products are completed, and the
goods are either transferred into finished goods inventory awaiting sale or use, or delivered immediately
to the customer. Manufacturing costs include:

 The cost of raw materials, components, parts, and other materials purchased from suppliers and
used in the production of the goods that are manufactured, and other materials such as oils and
lubricants, cleaning materials etc used within the manufacturing function in support of the
activities carried out to manufacture the entity’s products.
 Labour costs of all employees working within the manufacturing function of the organization
whether directly involved in the actual manufacture of the products or working in other
capacities that support the manufacture of the entity’s products. For example the wages of

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 machine operators, wages and salaries of factory supervisors, the salary and other remuneration
of the factory manager, salaries and wages of clerks and other staff of the factory.
 Other expenses incurred in the factory such as rent and rates for the factory, insurance for the
factory building and machinery used in the factory, depreciation for machinery and equipment
used in the factory, power for running factory machines, lighting for the factory etc.

Non-manufacturing costs are all other costs which are not incurred within the manufacturing function
of the organization for example general administration and selling and distribution costs. The following
are the elements of non-production costs:

 Administration costs
 Selling and distribution costs (also called marketing costs)
 Finance costs

Administration costs are the costs of providing administration services for the entity such as human
resources management department costs, accounting department costs. They include:

 The salaries and wages of all employees working in the general administration department
 The costs of the space used by the administration department such as rent and rates for the
administration buildings
 Materials used in the administration department such as stationery, cleaning materials, and also
other costs such as travel and subsistence costs for the administration department, depreciation
of machinery, equipment and furniture for administration department etc.

Selling and distribution costs (Marketing costs) are the costs incurred in the selling and distribution of
goods and services to the entity’s customers. These costs include:

 Salaries, wages and commissions paid to sales and distribution employees of the organization.
 Advertising, sales promotion and other costs for creating awareness for the company’s products
or services and securing orders.
 Operating costs for vehicles used in delivering goods or services to customers e.g. insurance,
fuel, repairs and maintenance, depreciation etc.
 Any other costs incurred in the selling and distribution department.

Finance costs are costs incurred in financing the organization such as interest paid on loans obtained by
the organization, bank charges, discounts allowed etc. sometimes finance costs are included in
administration costs.

The importance of distinguishing between manufacturing and non-manufacturing costs

In a manufacturing business it is important to separate manufacturing costs from non-manufacturing

costs because manufacturing costs are product costs i.e. they form part of the cost of a product for
purposes of determining the cost of inventory and the production cost of goods sold while non-
manufacturing costs are not included in the costs of inventory and production cost of goods sold.

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At the end of each financial year there will be closing inventories of finished goods and partly finished
goods.

 Finished goods are goods which have been manufactured and completed during the financial
period but are not yet sold as at the end of the financial period (finished goods inventory). The
value of these goods must include all production costs incurred in manufacturing them.
 Partly finished goods or work in progress consists of goods which are still in the process of being
manufactured and are not completed by the end of the financial period. The cost of work in
progress should also only consist of production costs.

Some of the goods produced during the financial year are sold within the same year. Production costs
for any financial year must therefore be shared between:

 Goods produced and sold during the period

 Goods produced but not yet sold (finished goods inventory)
 Partly completed goods (work in progress)

Non-production costs must never be included in the cost of inventory.

Reporting profit for an accounting period

The profit or loss made in an accounting period is calculated in the statement for profit or loss. Profit or
loss is the difference between the revenue earned during the financial period minus all costs incurred
during that period. Manufacturing costs and non-manufacturing costs are shown separately in the
statement for profit or loss both in financial accounting and cost accounting because of inventory costs.
Production costs are only charged as expenses in the period in which the goods have been sold hence
the cost of closing inventories are subtracted from production costs for the period while the cost of
opening inventories are added in order to determine the production cost of goods sold during the
financial period being reported on. On the other hand, non-production costs are treated as period costs
and are charged as expenses in full in the financial period in which they have been incurred. This
differentiation in the treatment of production and non-production costs necessitates the differentiation
of the two categories of costs.

In summary, manufacturing costs are product costs and are only expensed in the period in which the
goods to which they relate are sold; on the other hand, non-manufacturing costs are period costs and
are charged as expenses in full in the period in which they are incurred. Such being the case it is
important that manufacturing costs are distinguished from non-manufacturing costs.

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 CHAPTER THREE

DIRECT AND INDIRECT COSTS

Cost object
A cost object is any activity for which a separate measurement of costs is desired. In other words, if the
users of accounting information want to know the cost of something, this something is called a cost
object. Examples of cost objects include the cost of a product, the cost of rendering a service to a bank
customer or hospital patient, the cost of operating a particular department or sales territory, or indeed
anything for which one wants to measure the cost of resources used.

Direct costs and indirect costs

Costs can be classified according to how they relate to a cost object. Some costs can be traced in full to a
specific cost object while some costs cannot be traced in full to the same cost object. Because some
costs can be related to a cost object directly while other costs cannot, costs can be classified as either
direct costs or indirect costs when they are being viewed in relation to a specific cost object. For
example, if a family organizes a birthday party for one of the children, the cost of drinks bought for the
party are a direct cost for the party because they can be traced in full to the party because they were
incurred as a direct consequence of holding the party; on the other hand, the rent for the house in
which the party was held cannot be traced in full to the birthday party because the rent was paid for
occupying the house for the whole month and would have been incurred even if the party was not held.
As far as the birthday party is concerned, the rent is an indirect cost. On the other hand, had the family
rented the house specifically for the party then the rent would be a direct cost of the party.

A Direct cost is a cost which is incurred as a direct consequence of carrying out an activity whose cost is
being determined and can be attributed entirely to that activity. To be a direct cost it must be capable of
being measured in relation to the cost object.

Example

Mr Phiri baked a wedding cake for a customer. He used materials such as flour and eggs costing K3,000,
he employed a chef to do the baking whom he paid K2,000 for the job, he hired a special baking pan for
baking the cake and paid hire charges amounting to K500. All these costs are direct costs of making the
cake because they were incurred entirely for baking the cake and can be attributed to the cake in full.

An indirect cost is a cost which cannot be attributed entirely to a cost object. In the example of Mr Phiri
above, he used some electricity for heating the oven in which the cake was baked, however, while
baking some electricity was also being consumed by his refrigerator and television set which were on at
the same time as the oven. Electricity was also being used for lighting different rooms in the house. At
the end of the month he paid K5,000 for electricity bill. This cost is not a direct cost for baking the cake
because the cost was not incurred entirely for baking the cake and cannot therefore be attributed

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directly to the cake. The cost of electricity is therefore an indirect cost as far as the cake is concerned as
a cost object.

Example 1

F Luso is a carpenter who makes furniture for different customers. During the month of January 2012 he
made furniture for five customers including a sofa set for K Muhama. The sofa set for Muhama
consumed materials costing K40,000; wages for carpenters who worked on the sofa amounted to
K15,000. Luso also paid rent for the carpentry shop for the month of January amounting to K75,000,
water and electricity bills for the month amounted to K6,000. He also paid K12,000 salary for the shop
supervisor and K30,000 wages for the shop clerk, cleaner and watchman. K3,000 was paid to a nearby
tailoring shop for making cushions for the sofa set.

Required

Which of the costs are direct costs for Muhama’s sofa set?

Solution

Direct costs of Muhama’s sofa set are:

Materials K40,000

Carpenter’s wages K15,000

Sub contracting cost for cushions K3,000

These are direct costs for Muhama’s sofa set because they were incurred specifically in making the sofa
set and can be attributed to the sofa set in full.

Indirect costs are:

Rent for the workshop K75,000

Water and electricity K6,000

Salary for supervisor K12,000

Other wages K30,000

These are indirect costs as far as Muhama’s sofa set is concerned because although they were incurred
in the course of work, they are not specifically attributable to Muhama’s sofa set.

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Example 2

Malindi Building contractors were hired to build a laboratory at Misesa primary school. Materials used
amounted to K4,000,000, wages of builders and carpenters amounted to K450,000, wages of the site
clerk amounted to K110,000, salary for site supervisor amounted to K200,000, electricity and water for
the site were K300,000. Hire charges for the concrete mixer used on the site were K80,000 and a sub-
contractor for electrical wiring and plumbing was paid K700,000. Head office costs were K20,000,000.

Required

Which of the costs are direct costs for the contract to build the laboratory?

Solution

Direct costs

Materials K4,000,000

Wages of builders and carpenters K450,000

Wages of site clerk K110,000

Salary of site supervisor K200,000

Electricity and water for the site K300,000

Hire of concrete mixer K80,000

Sub-contractor K700,000

All these costs are direct costs for the laboratory contract because they can be attributed in full to the
contract.

The head office costs of K20,000,000 cannot be fully attributed to the laboratory contract hence they
are indirect costs.

Elements of cost
As we saw in chapter two, all costs can be classified into three elements:

 Materials costs
 Labour costs
 Expenses

Each of these elements of cost can be classified as direct or indirect costs depending on how they relate
to a cost object. In a manufacturing environment, the cost object is usually the product which is being
produced. In relation to the product being produced, the three elements of cost can be summarized as
follows:

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Materials cost = Direct materials + Indirect materials
Labour cost = Direct labour + Indirect labour
Expenses = Direct expenses + Indirect expenses
Total cost = Prime cost + Overheads

Prime cost

Prime cost is the total of all direct costs of making a product i.e. direct materials plus direct labour plus
direct expenses.

Exhibit

One unit of product Q requires 3kg of material which costs K4 per Kg; 4 direct labour hours which are
paid at K2 per hour; K5 polishing cost which is sub-contracted to an expert polisher. The prime cost for
one unit of Q is:

Direct material (3Kg x K4) 12.00

Direct labour (4Hrs x K2) 8.00

Direct expenses 5.00

Prime cost 25.00

Direct Materials

Direct materials are materials that are consumed by a product directly or which are consumed directly in
providing a service. They are costs of materials which enter into and become constituent parts of the
product and are capable of being identified separately in the product costs. In making a dress, the cloth
used in making the dress is a direct material. In baking a cake, the flour used is a direct material.

 Direct materials include both raw materials and components used in making a product or
providing a service.
 Direct materials costs should be measurable in monetary terms. Some materials used in a
product may be in very small quantities such that their value per unit of the product made are
not measurable; for example, the cost of baking powder put in one cake is so small that its
monetary value cannot be determined. Such materials cannot be classified as direct materials
because their cost per unit of the product made cannot be determined.

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Direct labour

Direct labour refers to the skill and effort used entirely in the creation of the product or in providing a
service. The payment made as remuneration for such skill and effort is the direct labour cost for the
product or service. In a factory, the wages of employees who dedicate their skill and effort in operating
machines which produce the product, assembling the various components that make up the product,
putting finishing touches to the product etc constitute direct labour if these can be attributed in full to
the product. The wages of carpenters who make furniture in a furniture shop form the direct labour cost
for the furniture made. In a motor vehicle repair workshop the wages of the mechanics, panel beaters,
spray painters etc who work on the motor vehicles form the direct labour cost for repairing motor
vehicles, in a school the salaries of teachers form the direct labour cost for the school etc.

Direct expenses

Direct expenses are those expenses that can be attributed in full to a product or service. Direct expenses
may be difficult to determine where work involves manufacturing small items. Where work involves
large items direct expenses may exist e.g. the cost of hiring a crane for use at a building site, the cost of
hiring a hall in which a concert will be performed, the cost of a sub-contractor on a building contract etc.

Indirect costs (Overheads)

The total of all indirect costs is called overheads. Overheads are the sum of indirect materials, indirect
labour and indirect expenses.

Indirect materials

All materials which are used in the course of work but cannot be attributed in full to the product being
produced or service being provided are indirect materials. For example, oils and lubricants used in
machines, cleaning materials, coolants etc. Some materials are consumed directly by products but their
cost is so small that it is meaningless to attribute them to any specific product being made; such
materials are classified as indirect materials because they are not meaningfully measurable in respect of
any specific product.

Indirect labour

Indirect labour cost is the cost for remunerating workers whose work is not dedicated to the actual
production of the entity’s products or providing service. For example in a factory, wages paid to the
factory supervisor, cleaning staff, factory manager etc constitutes indirect labour because it cannot be
attributed directly to any products being made. All the wages and salaries of staff working in
administration, marketing and other departments not associated with the manufacturing function of the
organization are indirect labour.

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Indirect expenses

These are all other expenses of the organization which cannot be attributed to any product or service.
Examples of indirect expenses include rent, rates, electricity and water, insurance, repairs, maintenance,
depreciation, motor vehicle fuel and oils, travel and subsistence expenses etc.

Full cost

The full cost of a unit of product or service is its direct costs plus a proportion of overheads. The full cost
of a unit of product can be analysed as follows:

Direct material 12.00

Direct labour 8.00

Direct expenses 5.00

Prime cost 25.00

Production overhead 7.00 Production cost

Full production cost 32.00

Administration overhead 3.00

Non-production cost
Selling & distribution overhead 4.00 N
o
Full cost of sale 39.00
n
-
p
Note r
o
1. Prime cost plus a share of the production overheads form the full production cost or fully
d
absorbed production cost of the cost unit.
u
2. In cost accounting systems it is common practice to include production overheads in unit costs
c
and measure the full production cost per unit. However, administration and selling and
t
distribution overhead costs are not usually included in the cost of each unit. Instead, they are
i
treated in total as expenses for the period in which they are incurred as expenses and are
o
charged to the statement for profit or loss for that period.
n

c
o
s
t

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 CHAPTER FOUR

COST OBJECTS, COST UNITS AND COST CENTRES

Cost objects and cost units

Costs are always measured and related to some item or activity. It is not possible to talk about costs
without an object to which those costs relate. For example, we may want to know what the cost of
producing product Q is, or the cost of hosting a guest for one night etc. A cost object is any activity or
item for which a separate measurement of costs is desired.

A cost accounting system measures the cost of cost objects, and often presents the information as a cost
per unit of the cost object.

 A cost object is an item whose cost is measured

 A cost unit is a unit of the object whose cost is being measured. A cost unit is the basis for
measuring the quantity of the cost object; for example Illovo Sugar Corporation may measure its
product in tons i.e. one ton would be a cost unit for measuring the quantity of sugar produced
by the company; a law firm may measure the amount of work done for a client in terms of man
hours etc. A cost unit is therefore a unit of product or service for which cost is computed for
control purposes.

Management of an organization must select their cost objects and cost units carefully so that they are
able to obtain the cost information they desire. The following are examples of cost objects and cost
units:

Industry/Activity Cost object Cost unit

Car manufacturer Cars produced One car
Oil Driller Oil extracted One barrel
Coal miner Coal extracted One ton of coal
Audit firm Accounts audited Man hours
Hospital Cost of Patient admitted Cost per patient per day
Goods transporter Cost of transporting goods Cost/ton/Kilometer
Furniture manufacturer Sofa sets produced One sofa set
University Cost of teaching Cost per student

Exhibit

A furniture manufacturer produces two types of furniture, sofa sets and dining sets. In its cost
accounting system it has two cost objects, sofa sets and dining sets. The costing system measures costs
and revenues for each of the two cost objects. The costing system will also provide information about
the cost per one sofa set and also the cost per one dining set. These are cost units.

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Cost object Cost unit
Sofa sets Production cost per sofa set
Dining sets Production unit per dining set

Cost centre
A cost centre is a unit of an organization such as a department, a location, a piece of equipment, a
person; to which costs may be allocated for control purposes. In a cost centre, the manager is
responsible for the costs incurred and therefore needs information about those costs. A cost centre can
also be viewed as follows:

 A cost centre is a department, group of machines or activity that incurs costs

 The cost centre produces cost units
 Costs can therefore be traced to cost centres, and costs can be calculated for the units of output
or activity of that cost centre.

Example

The work of a printing company involves four activities; printing, collating, binding and trimming. Each
activity uses different type of machine and workers with different skills. If the printing company is very
large and is involved in printing large volumes of books, the company can separate the four activities
into distinct sections of its factory i.e.

1. Printing section
2. Collating section
3. Binding section
4. Trimming section

Each of these sections carries out distinct activities which incur costs. Each of these sections is therefore
a cost centre because it is possible to attribute costs to each of them separately according to the costs
being incurred by the activities each section carries out.

Cost centres and direct and indirect costs

Direct costs of a cost centre are those costs which can be attributed in full to that cost centre. For
example, the cost of materials used by a cost centre, the wages of all employees working in the cost
centre and all expenses incurred exclusively by the activities of the cost centre are direct costs for that
cost centre. Where the activities of a cost centre result in the production of cost units such as products,
some of the direct costs of the cost centre will be indirect costs to the cost units produced where these
cannot be traced in full to particular cost units produced.

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Example

J Amadu is a maintenance engineer allocated to the printing section of our printing company; his job
involves repairing and servicing the machines in the printing section. The wages paid to J Amadu are a
direct cost to the printing section. However, Amadu is not involved in the work of producing the
products manufactured in the printing section hence his wages are an indirect cost to the units of the
product produced in the printing section.

Let’s now assume that J Amadu is not allocated to the printing section but is allocated to the
maintenance section and his work involves repairing and servicing all the machines in all the sections of
the printing company. In this case, the wages paid to Amadu cannot be fully attributed to any of the
sections hence his wages are an indirect cost to the different sections whose machines he services.

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 CHAPTER FIVE

COST BEHAVIOUR AND COST ESTIMATION

The meaning of cost behavior

The term cost behavior refers to how costs change when the level of activity changes. Costs are incurred
when activities are carried out therefore we expect that costs will be different for different volumes of
activity. However not all costs change in the same way as the volume of activity changes. The volume of
activity may be:

 The number of units sold

 The number of units produced
 The number of labour or machine hours worked
 The number of processes carried out

The importance of knowing how costs behave

The work of managers involves planning and controlling the activities of an entity. Knowing how
different costs behave will help managers forecast costs at different levels of activity as part of the
planning process. When actual costs are incurred, they can be compared with the forecasts as part of
the control process. It is therefore important to know how different costs behave because this will help
managers project what the level of costs is likely to be at different levels of activity.

Classification of costs according to their behavior

Costs can be classified according to how they change relative to changes in the level of activities. The
most important classification of costs for purposes of cost estimation is to classify costs as fixed costs
and variable costs.

Fixed costs
Fixed costs are those costs which remain the same in total in a given period regardless of changes in the
volume of activity during the relevant period. Fixed costs are also called period costs because they are
incurred in relation to a period rather than to the volume of activity carried out during that period. Total
fixed costs increase with time.

A good example of a fixed cost is rent. Let’s assume that the rent for a factory is K150,000 per month. In
any month the cost of rent will be K150,000 whether the number of units produced in that month
increases or decreases. However, as the number of months increase total rent will increase e.g. rent for
two months will be K300,000 while rent for three months will be K450,000. As we can see from this
example, rent is a fixed cost per month but as the number of months increase the total cost of rent
increases. Fixed costs are therefore related to the period of time so that they increase in total as time
increases but they remain unchanged in any period even if the volume of activities in that period
changes.

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 Another example of a fixed cost is the salary of a worker who is paid a fixed salary per month. Let’s
assume that the supervisor in a factory is paid K80,000 per month as his salary. The monthly salary will
not change even if more units are produced in any month. However the total salary paid to the
supervisor will increase as the number of months increase so that in one year the cost of the
supervisor’s salary will be K960,000.

Look at the following table which shows the number of units of a product produced per month and two
costs incurred each month.

Month Units Cost A Cost B

produced K K
January 5,000 40,000 25,000
February 4,000 40,000 20,000
March 4,800 40,000 24,000
April 6,000 40,000 30,000
May 6,500 40,000 32,500

From this table we can see that cost A is a fixed cost because it does not change when the number of
units produced change. It remains the same each month regardless of changes in the volume of units
produced. On the other hand, cost B is not a fixed cost because it changes from month to month
depending on the number of units produced in each month.

If we plot total fixed cost on a graph against volume of output the graph will look as follows:

Total fixed costs

Output

The total fixed costs line will be a straight line parallel to the horizontal axis representing volume of
output because the fixed costs will be constant at all levels of output.

When a fixed cost is shared among the number of units produced, the cost per unit will decrease as the
number of units increase because the fixed cost is being shared among more units. Taking the example
of cost A above, when we divide the cost for each month by the number of units produced in that

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 month we shall see that the cost per unit will be higher when units in the month are low and lower
when the units in the month are more. See the following table:

Cost A
Units Cost A per unit
Month produced K K
January 5,000 40,000 8.00
February 4,000 40,000 10.00
March 4,800 40,000 8.33
April 6,000 40,000 6.66
May 6,500 40,000 6.15

If we plot fixed cost per unit on a graph, the fixed cost per unit line will be downward sloping from left to
right indicating that as the volume of output increases the fixed cost per unit reduces. The graph for
fixed cost per unit will therefore be as follows:

Fixed cost per unit

Output

Variable costs
Variable costs are costs which increase or decrease in the same proportion as the increase or decrease
in the volume of activity. The variable cost will increase by the same amount for each additional unit of
product produced. For example, if one unit of product Q consumes 3kg of material A which costs K2 per
kg, the cost of material A for one unit of product Q is K6. This means that for every additional unit of Q
produced the cost of material A will increase by K6. When we double the number of units of product Q
produced, the total cost of material A will also double etc. While the total variable cost will change in
the same proportion as the change in the number of units of the product produced, the variable cost per
unit remains constant. Let’s tabulate the cost of material A at different quantities of product Q
produced:

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 Units of Total Cost of
Q cost of material
Month produced material A per
A unit
K K
January 5,000 30,000 6.00
February 10,000 60,000 6.00
March 15,000 90,000 6.00
April 20,000 120,000 6.00
May 25,000 150,000 6.00

We can see from the table that:

i. In February the number of units produced was double the number of units produced in January.
The cost of material A in February is also double the cost of material A in January.
ii. In March the number of units produced was three times the number of units produced in
January and the cost of material A incurred in March was also three times the cost of material A
incurred in January.
iii. In April the number of units produced was four times the number of units produced in January
and the cost of material A incurred in April was also four times the cost of material A incurred in
January.

This is a characteristic of variable cost. When the level of an activity changes, its variable cost will change
by the same proportion as the change in the volume of the activity. On the other hand the variable cost
per each unit produced will remain the same. The variable cost for one unit of a product is also called
the marginal cost for that product.

If we plot total variable costs on a graph against output the graph will look as follows:

Total variable costs

Output

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 The curve for variable cost per unit will be a straight line parallel to the horizontal axis because the
variable cost per unit is constant at any level of output. The graph will look as follows:

Variable cost per unit

Output

Mixed cost
A mixed cost is also called a semi-variable cost or semi-fixed cost. This is a cost which is partly fixed and
partly variable. One component of the cost does not change when the volume of activity changes while
another component of the cost changes in the same proportion as changes in the volume of activity. A
good example of a mixed cost is where a salesperson is paid a fixed salary per month and in addition he
is paid a commission for every item he sells during the month. The monthly salary of the sales person
will consist of the fixed salary plus the commission. The fixed salary is fixed while the commission is
variable.

Exhibit

F Mukhito is a salesperson. He is paid a fixed monthly salary of K10,000 plus a commission of K50 for
every item he sells. What is the salary of Mukhito in the following months:

Month Units sold

January 100

February 80

March 110

R D C Neba MBA, BCom Page 20

 Solution

Month Fixed salary Commission Total salary

K K
January 10,000 100 x K50=K5,000 15,000
February 10,000 80 x K50 =K4,000 14,000
March 10,000 110 x K50 =K5,500 15,500

We can see that the monthly salary has a component which is fixed and a component which is changing.
The characteristic of a mixed cost is that it changes when the volume of activity changes but the change
in cost is not in the same proportion as the change in the volume of activity. Another characteristic of
the mixed cost is that as the volume of activity increases the cost per unit decreases because the fixed
component per unit of output becomes smaller as the volume of output increases.

Let’s look at the following tabulation:

Month Output Cost Cost per unit

January 1000 K7,000 K7.00
February 2000 K9,000 K4.50
March 4000 K13,000 K3.25
April 8000 K21,000 K2.63

This cost is a mixed cost because while it increases as output increases, the increase in cost is not in the
same proportion as the increase in output. In February for example, output increased two times over
the January output but the increase in cost was only by 1.28 times. Another indicator is that the cost per
unit reduces as output increases.

A Graph of a mixed cost would appear as follows:

K
Total mixed cost

Variable cost

Fixed cost

Output

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 Stepped fixed costs
A stepped fixed cost is a cost which:

 Is fixed within a limited range of activity; and

 Goes up or down in steps when the volume of activity rises above or falls below certain levels.

An example of a stepped fixed cost is where a company pays supervisors K50,000 each per month. The
company hires supervisors on temporary basis depending on the volume of production. One supervisor
supervises one shift. When output is less than 4,000 units per day only one shift is worked and only one
supervisor is hired. When output is 4001 to 7,000 units per day two shifts are worked and two
supervisors are hired. When output exceeds 7,000 units per day three shifts are worked and the
company hires three supervisors.

The graph for stepped fixed costs would be as follows:

Output

A stepped fixed cost could also be noted from the following tabulation

Output Cost
(units) K
0 5,000
1,000 5,000
2,000 5,000
3,000 7,000
4,000 7,000
5,000 7,000
6,000 9,000
7,000 9,000
8,000 9,000
9,000 12,000
10,000 12,000

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Cost estimation
Managers are often planning future activities and it is often necessary for estimates of costs to be made.
The estimated costs will depend on the behavior of the cost being estimated.

Estimating variable costs

(1) If the variable cost per unit is known an estimate of variable costs involves multiplying the
planned volume of output by the variable cost per unit.

Exhibit

One unit of product Q requires 3Kg of material to be made. The cost of the material is K2 per Kg.
What is the estimated cost of making 1,000 units of product Q?

Solution

1,000 units x 3Kg x K2 = K6,000

(2) If the variable cost per unit is not given, it can be construed from the given information of
volume of activity and related cost.

Exhibit

The following data relates to production and materials costs for four months

Month Output Materials cost

(units) K
January 5,000 10,000
February 4,000 8,000
March 6,000 12,000
April 6,500 13,000

It is estimated that output for the month of May will be 7,000 units. What is the estimated materials
cost for May?

Solution

The first step is to determine whether the materials cost is a variable cost. If the cost per unit is
constant at all levels of output then we know that the materials cost is a variable cost. In this case
we find that the materials cost is a variable cost because if we divide the materials cost for each
month by the number of units produced in that month we find a unit cost of K2 which is constant.
We therefore know that materials cost in this case is a variable cost of K2 per unit.

To estimate the materials cost for May multiply the estimated output for May by K2

Estimated materials cost for the month of May is 7,000 units x K2 = K14,000

R D C Neba MBA, BCom Page 23

 (3) Variable costs can be estimated by determining the relationship between the variable cost and
the value of sales. Variable cost will always be a certain constant percentage of the volume of
activity and sales are a good representative of the volume of activity. We can know that a cost is
a variable cost if the cost is a constant percentage of sales at different sales levels. Consider the
following example:

Month Sales (K) Labour cost (K) Labour cost as

% of sales
January 200,000 120,000 60%
February 235,000 141,000 60%
March 180,000 108,000 60%
April 198,000 118,800 60%
May 250,000 150,000 60%

From this tabulation we can see that labour cost for each month is 60% of the sales value for the month.
Since labour cost is a constant percentage of sales value we know that labour cost is a variable cost and
that labour cost equals 60% of sales value. We can thus use this determined relationship to estimate the
labour cost for a future period.

Assume that the sales for June are expected to be K300,000. What is the estimated labour cost for June?

Solution

K300,000 x 60% = K180,000

Estimating fixed costs

Fixed costs are easy to estimate. Since we know that a fixed cost does not change at all levels of activity,
the estimated fixed cost for any volume of activity is the given amount of fixed cost at other levels of
activity.

Exhibit

Month Output (units) Rent (K)

January 10,000 70,000
February 15,000 70,000
March 8,000 70,000
April 12,000 70,000

What is the estimated cost of rent for the month of May when output is expected to be 14,000 units?

Since it is evident from the given data that rent is a fixed cost we know that the rent cost for May will be
K70,000.

R D C Neba MBA, BCom Page 24

Estimating mixed costs

Mixed costs are a little problematic because they contain a fixed element and a variable element. In
order to estimate mixed costs it is necessary to use past data to determine the values of the fixed and
variable elements of the given mixed cost. There are a number of techniques used to separate the fixed
and variable elements of a mixed cost. We shall consider these techniques in this section.

High/Low Method

The high/low method of analyzing mixed costs into their variable and fixed elements uses historical data
of activities and their associated costs. The method works as follows:

Step 1

From the given data select the highest level of activity and its associated cost, and the lowest level of
activity and its associated cost.

Step 2

Calculate the difference between the highest output and the lowest output in terms of quantity and
associated costs.

Step 3

Divide the incremental cost with the incremental quantity. The result is the variable cost per unit of
output.

Step 4

Pick one level of output and its associated total cost. Calculate the variable cost for that level of output
by multiplying the number of units with the variable cost per unit calculated in step 3. Then subtract the
resulting total variable cost from the total cost of the output. The resulting amount is the fixed element
in the mixed costs.

Exhibit

The following data relates to output and related overhead costs over a four months period:

Production
Month Output overhead
(units) K
January 5,000 65,000
February 4,500 62,500
March 6,000 70,000
April 7,000 75,000

R D C Neba MBA, BCom Page 25

Required

Calculate the variable and fixed elements in the mixed costs.

Solution

Output Production
(units) Overhead
K
High 7,000 75,000
Low 4,500 62,500
2,500 12,500

K12,500
Variable element =  K 5.00 per unit
2,500

We have now determined the variable cost per unit element of the mixed costs. The next step is to
determine the fixed element. To do this we choose any of the output levels, say 7,000 units. At 7,000
units the total cost is K75,000. The variable cost is 7,000 x K5.00 = K35,000. The fixed cost is K75,000-
K35,000 = K40,000.

Now we have determined the variable element and fixed element in the mixed costs. This information
can be used to estimate the cost for any level of output.

Exhibit

What is the overhead cost for producing 7,500 units?

Solution

K
Variable cost 7,500 x K5 37,500
Fixed cost 40,000
Total cost 77,500

The production overhead cost for 7,500 units is K77,500

High/low analysis when there is a step change in fixed costs

High/low analysis can be used even when there is a step increase in fixed costs between the low and the
high activity level, provided that the amount of the step increase in fixed costs is known.

The method of analysis to use depends on whether the step increase in the fixed cost is stated as a
money amount of cost, or whether it is stated as a percentage increase.

R D C Neba MBA, BCom Page 26

Where the step increase in fixed costs is given as a money amount

Where the step increase is given as a money amount, the high/low analysis can be approached from
either of two ways.

Approach 1

1. Select the high level of activity with its associated costs, and the low level activity and its
associated costs.
2. Add the step increase amount to the total cost of the low level activity
3. Do the high/ low analysis to find the variable cost per unit
4. Calculate the fixed cost element
5. The fixed cost element found is the fixed cost at the high level of activity.
6. To find the fixed cost element at the low level of activity subtract the step increase in fixed costs
from the fixed cost figure calculated in step 4 above.

Approach 2

1. Select the high level of activity with its associated costs, and the low level activity and its
associated costs.
2. Subtract the step increase amount from the total cost of the high level activity
3. Do the high/ low analysis to find the variable cost per unit
4. Calculate the fixed cost element
5. The fixed cost element found is the fixed cost at the low level of activity.
6. To find the fixed cost element at the high level of activity add the step increase in fixed costs to
the fixed cost figure calculated in step 4 above.

Exhibit

A company has the following costs at two levels of activity

Activity Total cost

(units) K
17,000 165,000
22,000 195,000

The variable cost per unit is constant over this range of activity, but there is a step in fixed costs and the
total fixed costs increase by K15,000 when the activity level equals or exceeds 19,000 units.

Required

Using high/low analysis, calculate the total cost of:

a) 18,000 units
b) 20,000 units

R D C Neba MBA, BCom Page 27

Finding the cost elements using approach 1

Activity Total cost

(units) K
High 22,000 195,000
Low 17,000 K165,000+K15,000 180,000
5,000 15,000

K15,000
Variable cost per unit =  K 3.00
5,000

To find fixed cost

K
Total cost for 22,000 units 195,000
Variable cost for 22,000 units 22,000x3 66,000
Fixed cost at high level activity (19,000units and above) 129,000

Fixed cost at low level activity (below 19,000 units) K129,000-K15,000 114,000

Finding the cost elements using approach 2

Activity Total cost

(units) K
High 22,000 K195,000-K15,000 180,000
Low 17,000 165,000
5,000 15,000

K15,000
Variable cost per unit =  K 3.00
5,000

K
Total cost for 17,000 units 165,000
Variable cost for 17,000 units 17,000x3 51,000
Fixed cost at low level activity (below 19,000 units) 114,000

Fixed cost at high level activity (19,000 units and above) K114,000 + K15,000 129,000

R D C Neba MBA, BCom Page 28

Finding the cost for 18,000 units

18,000 units are below 19,000 units hence the fixed cost is K114,000 so the total cost for 18,000 units is
as follows:

K
Fixed cost 114,000
Variable cost 18,000 x K3 54,000
168,000

Finding the cost for 20,000 units

20,000 units are above 19,000 units therefore fixed costs are K129,000. The total cost for 20,000 units is
therefore as follows:

K
Fixed cost 129,000
Variable cost 20,000 x K3 60,000
189,000

Where the step increase in fixed costs is given as a percentage amount

When the step increase in fixed costs is given as a percentage amount, the problem is a bit more
complex, and to use the high/low analysis we need a third figure for total cost at another level of activity
somewhere in between the high and the low amounts. The fixed cost should be the same for the in
between activity level and either the high or the low activity level. There are thus two possible scenarios
as follows:

Scenario 1

Fixed cost is the same between the in between activity level and the low activity level. The following
steps should be followed:

 Do the high/low analysis between the in between activity level and the low activity level to
determine the variable cost per unit and the fixed cost at the lower range of activities.
 To find the fixed cost at the higher range of activities multiply the lower range fixed costs by
1+% increase is costs.

Exhibit

A company has the following total costs at three activity levels:

R D C Neba MBA, BCom Page 29

Activity Total cost
(units) K
5,000 180,000
7,500 210,000
11,000 276,000

The variable cost per unit is constant over this range of activity, but there is a step fixed cost and total
fixed costs increase by 20% when the activity level is higher than 7,500 units.

Required

Estimate the total cost for 8,500 units.

Solution

Take note that 8,500 units is above 7,500 units therefore fixed costs at this level are higher than the
lower level by 20%. But the fixed costs at 5,000 units and 7,500 units are the same. We therefore do a
high/low analysis for 7,500 and 5,000 units as follows:

Activity Cost
(units) K
High 7,500 210,000
Low 5,000 180,000
2,500 30,000

K 30,000
Variable cost per unit =  K12
2,500

To find fixed costs at the lower range:

K
Total cost for 7,500 units 210,000
Variable costs for 7,500 units 7,500 x K12 90,000
Fixed costs 210,000-90,000 120,000

Fixed costs at high range (above 7,500 units) are 20% more than at the low range hence the fixed costs
at high range are K120,000 x 1.20 = K144,000

We can now calculate the estimated total cost for 8,500 units as follows:

R D C Neba MBA, BCom Page 30

 K
Fixed costs 144,000
Variable costs 8,500 x K12 102,000
246,000

Scenario 2

Fixed cost is the same between the in between activity level and the high activity level. The following
steps should be followed:

 Do the high/low analysis between the in between activity level and the high activity level to
determine the variable cost per unit and the fixed cost at the high range of activities.
 To find the fixed cost at the lower range of activities divide the higher range fixed costs by 1+%
increase is costs.

Exhibit

A company has the following total costs at three activity levels:

Activity Total cost

(units) K
5,000 180,000
8,000 240,000
11,000 276,000

The variable cost per unit is constant over this range of activity, but there is a step fixed cost and total
fixed costs increase by 20% when the activity level is higher than 7,500 units.

Required

Estimate the total cost for 7,000 units.

Solution

Take note that 7,000 units is below 7,500 units therefore fixed costs at this level are lower than the
higher range level by 20%. But the fixed costs at 8,000 units and 11,000 units are the same. We
therefore do a high/low analysis for 11,000 and 8,000 units as follows:

Activity Cost
(units) K
High 11,000 276,000
Low 8,000 240,000
3,000 36,000

R D C Neba MBA, BCom Page 31

 K 36,000
Variable cost per unit =  K12
3,000

To find fixed costs at the higher range:

K
Total cost for 11,000 units 276,000
Variable costs for 11,000 units 11,000 x K12 132,000
Fixed costs 276,000-132,000 144,000

Fixed costs at low range (7,500 units and below) are 20% less than at the high range hence the fixed
costs at low range are K144,000 ÷ 1.20 = K120,000

We can now calculate the estimated total cost for 7,000 units as follows:

K
Fixed costs 120,000
Variable costs 7,000 x K12 84,000
204,000

High/low analysis when there is a change in the variable cost per unit between the high and the low
levels of activity.

High/low analysis can also be used when there is a change in the variable cost per unit between the high
and the low levels of activity. The method to be used depends on whether the change in the variable
cost per unit is given as a money amount or as a percentage change.

Where the change is given as a money amount

Where the increase or reduction in variable cost per unit is given as a money amount, the total cost of
the high activity level should be adjusted by the amount of the increase or reduction so that total costs
for high and low amounts have the same basis for total variable costs.

High/low method can then be used in the normal way to obtain a variable cost per unit and a fixed cost
at the low activity level.

Once the variable cost per unit at the low level has been determined it is simply adjusted by the increase
or decrease to determine the variable cost per unit for the high activity level.

Exhibit

A company has the following materials costs at two activity levels:

R D C Neba MBA, BCom Page 32

 Material
Output Cost
(Units) K
10,000 70,000
15,000 88,800

The fixed costs are constant at all levels of output within this range. However, at output in excess of
12,000 units the variable cost per unit reduces by K0.40 per unit on all the additional units produced in
excess of 12,000 units.

Required

Calculate the total materials cost for producing 17,000 units using high/low method.

Solution

Step 1

Find the value by which the total cost of the 15,000 units are lower because the extra units above
12,000 units are at a lower variable cost per unit.

Out of the 15,000 units 3,000 units have a lower variable cost per unit (15,000 – 12,000)

The total cost for 15,000 units are lower by 3,000 x K0.40 =K1,200

Step 2

Calculate the total cost for 15,000 units if the variable cost per unit did not reduce by K0.40 for
additional units above 12,000 units.

i.e. K88,800 + K1,200 =K90,000

Step 3

Do high/low analysis using K90,000 as the total cost for 15,000 units

Materials
Output Cost
(units) K
High 15,000 90,000
Low 10,000 70,000
5,000 20,000

K 20,000
Variable cost per unit at low activity is  K 4.00
5,000

R D C Neba MBA, BCom Page 33

Fixed cost is found as follows: using 10,000 units level

K
Total cost for 10,000 units 70,000
Variable cost 10,000 units x K4 40,000
Fixed cost K70,000-K40,000) 30,000

Step 4

Find the variable cost per unit for additional units above 12,000 units.

Variable cost for additional units above 12,000 units is K4.00 – K0.40 =K3.60

Step 5

Calculate the total cost for 17,000 units.

The total cost for 17,000 units is now found as follows:

K
Variable cost for the first 12,000 units 12,000 x K4 48,000
Variable cost for the next 5,000 units 5,000 x K3.60 18,000
Total variable cost for 17,000 units 66,000
Add fixed cost 30,000
Total cost for 17,000 units 96,000

Where the change in variable cost per unit is given as a percentage

When the change in the variable cost per unit is given as a percentage amount, high/low analysis can
only work if three levels of activity are given so that two of the three levels are within the range where
the unit variable cost per unit is the same. The procedure is as follows:

Step 1

Do high/low analysis for the levels where the unit variable cost is the same. This will establish the unit
variable cost within that range.

Step 2

Calculate the fixed cost using the activity levels used in step 1.

Step 3

Adjust the unit variable cost established in step 1 to find the unit variable cost at the other range of
activity.

R D C Neba MBA, BCom Page 34

Step 4

Use the values calculated in step1 to step three to estimate the costs for the activity levels required in
the question.

Exhibit

A company has the following costs at three levels of activity:

Total
Output Cost
(Units) K
20,000 300,000
25,000 320,000
30,000 356,000

Fixed costs are constant over this range of activity, but there is a 10% reduction in the variable cost per
unit on all units produced when output is above 24,000 units.

Required

Calculate the cost for 22,000 units.

Solution

Note that unit variable cost is the same for outputs of 25,000 units and 30,000 units but different for
output of 20,000 units. High/low analysis must therefore be done for the 25,000 units and 30,000 units
range to determine the unit variable cost at that range of activity.

Total
Output cost
(units) K
High 30,000 356,000
Low 25,000 320,000
5,000 36,000

K 36,000
Variable cost per unit when output exceeds 24,000 units is  K 7.20
5,000

The fixed costs can now be calculated using the 25,000 to 30,000 units range. Let us use the 25,000 units
activity level. Remember that the variable cost per unit of K7.20 applies to all units produced and not
just the additional units (this is very clear from the question).

R D C Neba MBA, BCom Page 35

 K
Total cost for 25,000 units 320,000
Less variable cost for 25,000 units 25,000 x K7.20 180,000
Fixed cost 140,000

We should now calculate the cost for 22,000 units. But we are told that at levels of activity of 24,000
units and below the unit variable cost on all units produced is more than unit variable cost on all units
produced when activity level exceeds 24,000 units. The unit variable cost when output exceeds 24,000
units reduce by 10% therefore the unit variable cost at the higher level of activity is 90% of the unit
variable cost at the lower level of activity, hence K7.20 is equal to 90% of the unit variable cost at the
lower level of activity. The unit variable cost when output is 24,000 units and below is thus as follows:

K 7.20
 K 8.00
90%

The cost for producing 22,000 units is as follows:

K
Fixed cost 140,000
Variable cost 22,000 x K8.00 176,000
316,000

Linear regression analysis method

This is the second method of determining the variable and fixed elements in mixed costs for purposes of
estimating costs for different levels of activity. This method is statistical and uses all the data items
given. Linear regression analysis is based on the following equation:

Y=a+bx

Where:

Y =the total cost in a period

x = The number of units or volume of activity in the period

a = The fixed costs in the period

b = The variable cost per unit of output or unit of activity.

R D C Neba MBA, BCom Page 36

 nxy  xy
b=
nx 2  (x) 2

y x
a= b
n n

Where n is the number of data sets in our data.

To demonstrate how the linear regression analysis method works let’s consider the following example:

A company manufactures a single product. The following data relates to output and associated costs for
the months January to May 2012

Month Output Cost

(units) K
January 10 120
February 12 124
March 15 130
April 20 140
May 22 144

Required

Calculate the cost for producing 26 units.

Step 1

Draw up a table containing the following:

xy

x2

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 x y xy x2
10 120 1200 100
12 124 1488 144
15 130 1950 225
20 140 2800 400
22 144 3168 484
79 658 10606 1353
x y xy x 2

(5  10606)  (79  658) 1048

b= = =K2
(5  1353)  (79  79) 524

Our variable cost per unit is K2

Fixed cost is “a”

658  79 
a=   2   =131.6-31.6=K100
5  5 

our fixed cost is K100

Our equation for finding the cost for any level of activity can be given by substituting “a” with 100 and
substituting “b” with 2 as follows:

Y=100+2x

Therefore the cost for producing 26 units is:

100+(2x26)=K152

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 CHAPTER SIX

COST ACCOUNTING FOR MATERIALS

The purpose of cost accounting for materials

Cost accounting for materials has two main purposes:

(A) The first purpose is to determine:

i. The cost of raw materials, components and other supplies that are consumed as direct or
indirect materials
ii. The cost of goods manufactured by the business
iii. The value of any closing stocks, of raw materials, work in progress or finished goods.
(B) The second purpose of is to help with keeping the cost of stocks under control.

In order to fulfill these two purposes there must be very good systems for:

i. The identification of materials

ii. The ordering and receiving of materials
iii. The recording of materials movements
iv. The verification of physical materials held in stock
v. The control of quantities of stock held in store at any time
vi. The pricing of materials issued from stores

Identification of materials
It is very important that each item of stock held in store must be unambiguously identified. In order to
achieve this, stocks of materials must be classified and coded. Classification of materials ensures that
materials in the same class are kept in one location and can be clearly identified as a class. Coding
involves using code numbers to identify materials. The advantages of using code numbers are as follows:

 Codes avoid ambiguity because they can identify an item more precisely than a description.
 Codes are much shorter than descriptions. Using codes therefore saves time particularly when
completing written forms.
 Production efficiency is improved because errors of issuing the wrong materials to production
are minimized.
 Code numbers aid computerized processing
 Numbered code systems can be designed to be flexible, and can be expanded to include more
stock items as necessary.

The ordering and receipt of materials

Proper records must be kept of the physical procedures for ordering and receiving a consignment of
materials. A typical series of procedures might be as follows:

R D C Neba MBA, BCom Page 39

 a) When the quantity of materials in store has reduced to the level where a re-order is required,
the stores department issues a purchase requisition to the purchasing department. The
purchase requisition is a formal document authorizing the purchase department to order
replenishment stock. The purchase requisition will show:
i. The description, code number and quantity of the stock item required.
ii. The date required, and any special quality requirements and specifications.
iii. The job number or department to be charged with the cost of the goods if these are
required for a specific job or department.
iv. The signature of an authorized officer
b) Following the receipt of an authorized purchase requisition the purchase department will
initiate the stock procurement process following the laid down procurement policy of the
organization. Once a supplier has been identified, the purchase department will raise a purchase
order which is a formal request by the organization to the supplier to supply the materials
specified in the order. Copies of the purchase order must be sent to the accounts department
and the stores department.
c) The supplier delivers the consignment of materials to the stores department of the organization.
The consignment will be accompanied by a delivery note detailing what has been delivered. The
storekeeper will sign the delivery note as acknowledgement of receipt of the consignment once
he is satisfied that the materials are in order.
d) If the consignment is in order and thus accepted, the storekeeper prepares a goods received
note (GRN). The GRN will show:
i. The name of the supplier
ii. The date of receipt of the goods
iii. Quantities received of each stock item
iv. The purchase order number to which the receipt corresponds
v. The signature of the person receiving the consignment, confirming that the goods
received conform to the purchase order.
e) A copy of the GRN is sent to the accounts department where it is matched with the copy of the
purchase order. When the supplier’s invoice is received, the accounts department will check it
against the copies of purchase order and GRN before authorization for payment is made.

Recording stock levels

In the stores department, materials should be kept secure, and there should be systems, processes and
controls to prevent loss, theft, damage, and over or under stocking of materials. The stores department
should keep a record of the quantities of each item of material currently held in stock. In the cost
accounting department a separate record of inventories must also be kept for proper accounting of
materials.

The Bin Card

The bin card is a record of stocks maintained for each stock item by the stores department. Each stock
item will have its own bin card. A bin card shows the level of stock for each stock item at a particular
stores location. It is kept at the location where the stock item is kept. Every time new quantities of the

R D C Neba MBA, BCom Page 40

item are received the bin card is updated by the receipt and every time a quantity of the item is issued
out the bin card is updated with the issue. The balance of the quantity of the item showing on the bin
card must always agree with the physical quantity of the item in stock. A typical bin card would look as
follows:

BIN CARD
Item Code: Location:
Description: Sores Ledger number:
Bin number:
Receipts Issues Stock Balance
Date QTY GRN# Date QTY Req. #

The Stores record card

The stores record card is an inventory record kept in the cost accounting department. Each materials
stock item must have a stores record card. A stores record card is basically a ledger account; it may be a
card, a page in the stores ledger or an electronic account in a computerized cost accounting system. The
stores record card is a record which shows the quantities of a stock item currently held in stock, the
quantities received from suppliers, and the quantities issued out to operational departments. In
addition, the stores record card will show the cost of the materials currently held in stock, the cost of
materials received in stock and the cost of materials issued to each operating department. Also shown in
the stock record card are the stock control levels for the stock item and also the free stock balance. A
typical stores record card would be as follows:

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 STORES RECORD CARD
Item code: Maximum level:
Description: Minimum level:
Location: Re-order level:
Bin number: Re-order Qty:

Date Receipts Issues Current stock Pending Materials Free stock

Ref Qty Price Ref Qty Price Qty Value requisitions on order balance
K K K

Issues, transfers and returns of materials

In order for the cost of materials consumed to be correctly charged to jobs, issues of materials from
stores must be correctly documented. Additionally transfers of materials from one job to another and
returns of unused materials to stores must be correctly documented. Proper documentation of
materials movements will also ensure that stock records are up to date.

Materials issue note

Materials issued from stores must be made against a materials issue note. This document must record
not only the quantity of materials issued out of stores, but also the cost centre or job to which the
materials are issued and also the cost of the materials issued. This will ensure that the value of materials
issued is correctly charged to the right job or department. The materials issue note is also used to
update the stock balance for the stock item.

Materials transfer note

When materials previously issued to one job or cost centre are transferred from to another job or cost
centre, a materials transfer note should be issued to document the transfer. This should show both the
job and/ or department from which the materials are transferred and the job or department to which

R D C Neba MBA, BCom Page 42

the materials are transferred. This will ensure that jobs and departments are correctly charged with the
actual cost of the materials consumed by them.

Materials returned note

Where materials previously issued to a job or department are returned to stores, a materials returned
note should be issued to document the returns. This will ensure that the job or department is charged
only with the cost of materials it has actually consumed, and also that stock records are kept up to date.

Stock control
Stock control refers to the management task of providing a system whereby the stocks of raw materials,
work in progress and finished goods are controlled so that:

 The cost of holding stocks is kept under control

 The quantities of stocks held are under control
 The time taken between placing an order for fresh stocks and their eventual delivery into store
is kept under control.

The main objectives of stock control are:

 To maintain adequate stocks so that production stoppages due to stocks running out are
avoided. This will avoid customer dissatisfaction, increased costs of emergency action and loss
of revenue.
 To avoid holding excessive stock levels which ties up a lot of capital. Money tied up in stocks is
unproductive and leads to loss of the return which could have been earned had the money been
put to better use.
 To minimize materials costs

Systems of stock control

There are different systems of stock control which an organization can employ depending on the nature
of its inventories, the volume of the inventories and the value of the inventories. When deciding what
system of stock control to use, an organization must consider the cost of maintaining the system against
the benefits to be obtained from maintaining the system.

Perpetual inventory system

A perpetual inventory method involves knowing stock levels of items at all times. This method thus
requires that every receipt and issue of materials be recorded as it takes place. The system employs bin
cards and stores records cards which must be updated with each transaction as it takes place.

Under the perpetual inventory system it is necessary to ensure that stock records are in agreement with
physical stock balances at all times hence it is necessary to check the physical stock balances by

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continuous stocktaking and then comparing the physical stock balances with stock records so that any
errors are immediately corrected.

Advantages of perpetual inventory system

 Physical check for the annual stocktaking is unnecessary

 Disruptions caused by the annual stocktaking are avoided
 Regular skilled stock takers can be employed, reducing the likelihood of errors
 Errors are discovered early, making it easy to investigate them and make timely corrections
 The stock records are up to date hence the information required for control of stocks is more
reliable leading to greater stock control.

Disadvantages of the perpetual inventory system

The major disadvantage of the perpetual inventory system is that it is very rigorous and therefore
expensive. It is thus only suitable where stocks are of high value and fast moving.

Order cycling method

Under this system quantities on hand of each stores item are reviewed periodically e.g. every month.
For low cost items, a technique called 90-60-30 day technique could be used. This technique means that
when the stocks fall to 60 days’ supply, replenishment for 30 days’ supply is made so that the stock level
rises to 90 days’ supply. For high cost items, a more stringent stores control procedure is advisable so as
to keep down the costs of stock holding.

Two bin system

The two bin system of stock control is one whereby each stores item is kept in two storage bins. When
the first bin is used up an order is placed to replenish it. Meanwhile, the second bin will contain
sufficient quantities to last until the fresh delivery is received.

ABC System
Under system stocks are classified according whether they are expensive, middle cost range or
inexpensive. Selective controls are then applied to stores items according to their category. A more
elaborate system such as perpetual inventory is used for the expensive and middle cost range materials
and a less elaborate system is used for the inexpensive items.

Monitoring physical inventory

For reasons such as errors in recording receipts and issues of materials, omissions, damages, losses or
thefts, the stores records might not agree with the physical stock balances. For this reason physical stock
counts must be carried out so that comparisons can be made between physical stock balances and
stores records. There are two approaches to stocktaking:

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Periodic stocktaking

This is a system where stocktaking is carried our periodically e.g. once every quarter, once every half
year and at the end of the year.

Advantages:

 Work of storekeepers is only disturbed periodically when stocktaking is taking place.

 It is less costly because it avoids the necessity of reconciling physical stocks with stores records
on a daily basis.
 Stocktaking involves personnel from departments external to the stores department, this may
give assurance of the reliability of the physical quantities counted.
 High accuracy levels since all items in store are counted at the same time.
 Less damages since stocktaking is done only periodically

Disadvantages

 The value of stocks shown by stores records may be inaccurate due to undiscovered errors
 Errors in inventory take a long time to be discovered and corrected
 The stocktaking exercise requires the sores to be closed causing disruptions in work
 Loss of revenue during the stocktaking period because the stores are closed and no sales can
take place.
 Idle time costs in the production department because no materials can be obtained from stores
during stocktaking period.

Continuous stocktaking

This is a system whereby on a daily basis a number of stock items are counted and their physical
quantities compared with their book values. This system ensures that during the course of the year all
items are counted several times and any discrepancies discovered and corrected.

Advantages

 Errors are discovered early and corrections are therefore easy to make.
 Stores records are kept up to date because errors are continuously being corrected.
 It is a deterrent against theft by employees because they know that shortages will be discovered
early.
 Preparation of management accounts are facilitated because the stock values in the stores
records can be relied upon as accurate values of stock at any point in time.
 Physical check for the annual stocktaking is unnecessary
 Disruptions caused by the annual stocktaking are avoided
 Regular skilled stock takers can be employed, reducing the likelihood of errors

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Disadvantages

 Damages can result from regular handling of stock items

 Since stocktaking at the end of the year is not done some errors which occur during the period
between the last time the items were counted and the end of the financial period will exist in
the stock values. If these are material, stock values at the end of the year may be unreliable.
 It is costly to implement

Controlling material purchase quantities

Organisations that purchase and consume large quantities of materials should try to minimize the total
costs of materials. A total materials cost, for any item of material, consists of:

 The purchase cost of the material (purchase price)

 The cost of making purchase orders to purchase the material (ordering costs)
 The cost of keeping the item in stores (holding costs)

Ordering costs

Costs of making an order from suppliers consist of:

 The cost of placing an order such as costs of telephone calls made to suppliers, clerical work of
writing the orders and sending them to suppliers.
 The cost of transporting materials purchased from suppliers if these are paid by the buyer
 The cost of checking that materials received from suppliers are in order.

Holding costs

These include:

 The cost of storage space

 Interest foregone by tying up capital in inventories
 Losses from damages, obsolescence, deterioration, pilfering etc
 The costs of insurance and other security costs
 The administrative costs associated with keeping items in stores

The economic order quantity (EOQ)

If the price of materials is the same regardless of the size of the purchase order, the purchase quantity
that minimizes the total costs of ordering and holding materials is the economic order quantity (EOQ). If
a company purchases this quantity each time the stock item is replenished then the total of ordering
and holding costs will be minimized. The EOQ is calculated as follows:

2CD
EOQ =
h

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Where:

D = The annual demand for the materials

C= the cost of making one order

h =the cost of holding one unit of the material in store for one year

Exhibit

The demand for material Q per annum is 64,000 kilos. The cost of making one order is K250 and the cost
of holding one kilo of the material in stock for one year is K2. What is the economic order quantity for
material Q?

Solution

2  250  64,000
EOQ =
2

= 4,000 kilo

Activity 1

A company uses 14,450 units of Material X each year, which costs K2.00 per unit. The cost of placing one
order is K125.00. The cost of holding one unit of the material in stock for one year is 10% of the
purchase cost.

What is the order quantity for Material X that will minimize annual costs?

Activity 2

The purchase cost of an item of stock is K60 per unit. In each three-month period, 5,000 units of the
item are used. Annual holding costs for this item are 8% of its cost. The cost of placing one order is K250.

Calculate the EOQ for the item of stock.

Inventory control levels

It is important for management to ensure that the company does not run out of materials (stock out)
because this will disrupt production and also cause the organization to make losses due to payments for
idle time, loss of revenue because sales are not made and loss of future revenue because customers will
go away and start buying from competitors. While making sure that the organization has adequate
stocks at all times it must avoid holding excessive stocks because this is also costly to the organization. In

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order to avoid running out of stocks and avoid holding excessive stocks it is necessary that management
should Know:

 When a new order for an item of material should be made to avoid running out of stock
 Whether the inventory level for each item of material appears too high or too low.

The following are the essential stock control levels which help managers to know when replenishment
for a stock item should be done to avoid stock outs and also to warn managers on whether the level of
stockholding appears too high or too low:

 Re-order level. This is the level of stock at which a further replenishment order should be
placed.
 Re-order quantity. The quantity of the replenishment order. Frequently, but not always, it is the
EOQ.
 Minimum level. This is also called the buffer stock or safety stock. It is a stock allowance to
cover errors in forecasting the lead time or the demand during the lead time. If stock level falls
to the minimum level before replenishment action has been taken then emergency
replenishment action should be taken to avoid stock out.
 Maximum level. This is the maximum desirable level of stock. If this level is exceeded it is an
indication to management that excessive stock is being held.

In order to calculate the above stock control levels an organization needs to know how long it takes for
stock items to be received from a supplier once a replenishment order has been made. The period of
time between the placing of an order and receiving the items in store ready for use is called the lead
time.

Calculating stock control levels

Re-order level

The reorder level is calculated as follows:

Maximum usage X maximum lead time

Minimum level

Re-order level – (average usage x average lead time)

Maximum level

Re-order level + reorder quantity – (minimum usage x minimum lead time)

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Exhibit

The following information relates to stock item Q

Average usage 100 units per day

Minimum usage 60 units per day

Maximum usage 130 units per day

Lead time 20 to 26 days

Re-order quantity 4,000 units

Required

Calculate the stock control levels for stock item Q

Solution

1. Re-order level = 130 units x 26 days = 3,380 units

2. Minimum level = 3,380 – (100 x (46  2) = 1,080 units
3. Maximum level = 3,380 + 4,000 – (60 x 20) =6,180 units

Pricing issues and stocks

There are two main objectives of pricing materials:

a) To charge the cost of materials consumed by products or departments on a consistent and

realistic basis.
b) To provide a satisfactory basis for the valuation of stocks on hand.

In practice the problem of pricing materials issued from stores to jobs arises from several factors:

 Rapidly changing prices for bought in materials and components

 The stock of any given material is usually made up of several consignments which were bought
at different prices
 The frequent impossibility of identifying items in stock with their consignments
 The sensitivity of profit calculations to the pricing method adopted particularly where materials
form a large part of total cost.

There are a variety of methods for pricing materials issues and an organization can adopt any method
which it deems most suitable to it. There is no one method which has all the advantages and for any
organization it is necessary to use the most appropriate system to fulfill its requirements most
satisfactorily.

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First in first out (FIFO)

Under this method it is assumed that the earliest consignment in stock at any particular point in time is
issued out first before later consignments. As a result of this assumption all issues at any particular time
are priced at the cost of the earliest consignment in stock at the time of issue.

Advantages

a) It is an actual cost system because it uses actual prices at which the materials were acquired.
b) It follows a common sense rationale that materials which were received first should be issued
out before materials which were received later.
c) Because actual costs are used, unrealized profits or losses do not arise.
d) Closing stocks are valued at the most recent prices hence the value of the asset of stock nearly
approaches current market values.
e) The method is recommended by IAS 2 for purposes of the preparation of financial statements
for external reporting.

Disadvantages

a) Product costs, being based on the oldest materials prices may lag behind current conditions
especially in times of rapidly increasing prices. This would result in profits being overstated.
b) The system is very involving because of the need to keep track of every consignment to ensure
that materials are priced according their right cost.
c) Comparison of costs between jobs is difficult because jobs may be charged with different
materials costs even where issues to the jobs were made on the same day.

Exhibit

A Company uses material Q in the production of its goods. Details of material Q for the month of
January 2012 were as follows:

1 Jan Opening stock 500 units @ K40 per unit

2 Jan Issues to production 300 units

3 Jan Purchases 2,000 units @ K42 per unit

6 Jan Issues to production 700 units

12 Jan Issues to production 1,000 units

15 Jan Purchases 3,000 units @ K44 per unit

20 Jan Issues to production 400 units

28 Jan Issues to production 1,800 units

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Required

i. Calculate the cost of materials issued to production during the month of January 2012
ii. Calculate the value of closing stock on 31 January 2012

Solution

To help us trace each issue to the right consignment it is important to prepare a table showing the
consignments. Each issue is then matched to its relevant consignment on FIFO basis as follows:

Opening
Stock Purchases Purchases
1-Jan 3-Jan 15-Jan
K40/unit K42/unit K44/unit
500 2000 3000
Issues
2 Jan 300 units -300
200
6 Jan 700 units -200 -500
0 1500
12 Jan 1,000 units -1000
500
20 Jan 400 units -400
100
28 Jan 1,800 units -100 -1700
0 1300

We can now calculate the cost of materials issued to production by costing each issue according to the
consignment out of which it has been made as follows:

Issue date Quantity Cost Cost

K K
2-Jan 300 40 12,000
6-Jan 200 40 8,000
6-Jan 500 42 21,000
12-Jan 1,000 42 42,000
20-Jan 400 42 16,800
28-Jan 100 42 4,200
28-Jan 1,700 44 74,800
178,800

The closing stock is 1,300 units @ K44 per unit = K57,200

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Last in first out (LIFO)

Under this method, issues are assumed to be made from the most recent consignment in stock at the
time the issue is made. As a result of this assumption all issues at any particular time are priced at the
cost of the most recent consignment in stock at the time of issue.

Advantages

a) It is an actual cost system because materials are issued at prices at which they were acquired.
b) Most recent costs are matched against current revenue to provide a better measure of profit.
Artificial profits are not reported because the cost of goods sold is more realistic especially in
times of inflation. In times when prices are falling artificial losses will not be reported.
c) If prices decline in future the need to write down values of inventory to the market value is
minimized because the inventories are already valued at lower prices.

Disadvantages

a) In times of inflation, inventory values are based on old prices and hence are understated. Where
inventories are substantial the low valuation may underestimate the financial position of the
business. On the other hand in times of falling prices inventory valuations may be overstated.
b) LIFO method does not reflect the rational storekeeping practice of issuing out materials in the
order in which they are received.
c) The method is very cumbersome to implement because of the need to trace each issue to the
consignment from which it was obtained.
d) The method is not accepted by IAS2 as a basis for valuing stocks for external reporting purposes.

Exhibit

A company uses material Z in producing its products. Issues from stores are priced on the LIFO basis. The
following data relates to January 2012:

1 Jan opening stock 400 units @ K30 per unit

4 Jan Purchases 1,000 units @ K32 per unit

6 Jan Issues 200 units

10 Jan Purchases 1,500 units @ K34 per unit

12 Jan Issues 500 units

15 Jan Issues 1,000 units

30 Jan Issues 300 units

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Required

i. Calculate the cost of materials issued in the month of January 2012

ii. Calculate the value of closing stock as at 31 January 2012

Solution

To be able to follow each issue to its correct consignment we need to draw up a table showing the
consignments and then match each issue to the right consignment on LIFO basis as follows:

Opening
stock Purchases Purchases
1-Jan 4-Jan 10-Jan
K30/unit K32/unit K34/unit
400 1000 1500
Issues
6 Jan 200 units -200
800
12 Jan 500 units -500
1000
15 Jan 1,000 units -1000
0
20 Jan 300 units -300
500

We can now calculate the cost of materials issues by costing each issue according to the unit cost of the
consignment from which it was obtained as follows:

Date of Unit Total

issue Quantity cost cost
K K
6-Jan 200 32 6,400
12-Jan 500 34 17,000
15-Jan 1000 34 34,000
20-Jan 300 32 9,600
67,000

Closing stock is made up of items from two consignments as follows:

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 Unit Total
Quantity cost Cost
K K
400 30 12,000
500 32 16,000
900 28,000

Weighted average method (AVCO)

Under this method, a weighted average of the items in stock is calculated and used to price issues from
stock. Every time a new consignment is received the weighted average issue price is revised accordingly.

Advantages

a) There is consistency in the cost of materials charged to jobs during a period instead of different
costs being charged depending on the batch from which the materials have been issued. This
makes the cost of different jobs more comparable.
b) The cost of materials charged to jobs is closely related to current market conditions because the
cost of materials charged automatically adjusts as new consignments acquired at new prices are
received. The value of closing inventories is also close to market values on the same basis.
c) The system is easy to implement because there is no need to trace each issue to a particular
batch.
d) Reported profits are not greatly affected by changing prices in times of inflation because the
cost of materials automatically adjusts to current conditions.
e) The method is recommended by IAS2 for external reporting purposes

Disadvantages

a) The issue prices are not verifiable to actual costs of materials since they are averaged.
b) When a large number of purchases are made at different prices the calculations of issue prices
becomes complicated.

Exhibit

A company uses Material P in producing its products. The company uses the AVCO method for pricing
issues of materials from stores. The following data relates to January 2012:

1 Jan Opening stock 400 units @ K10.00 per unit

3 Jan Purchases 1,000 units @ K10.28 per unit

4 Jan Issues 300 units

8 Jan Issues 400 units

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15 Jan Purchases 800 units @ K10.35 per unit

25 Jan Issues 650 units

Required

i. Calculate the cost of materials issued during the month of January 2012
ii. Calculate the value of closing stock at 31 January 2012

Solution

Once again, a tabulation of the movements in the stock item will help us determine the issue prices as
follows:

Date Details Quantity Unit

cost Amount
K K
1-Jan Opening stock 400 10.00 4,000
3-Jan purchases 1,000 10.28 10,280
1,400 10.20 w1 14,280
4-Jan Issue (300) 10.20 (3,060)
8-Jan Issue (400) 10.20 (4,080)
15-Jan purchases 800 10.35 8,280
1,500 10.28 w2 15,420
25-Jan Issue (650) 10.28 (6,682)
850 8,738

(W1)

K14,280
Issue price =  K10.20
1,400 Calculation of weighted average issue
price
(W2)

K15,420
Issue price =  K10.28
1,500

The cost of materials issued in the month of January 2012 is as follows:

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 Issue
Date Quantity price Cost
K K
4-Jan 300 10.20 3,060
8-Jan 400 10.20 4,080
25-Jan 650 10.28 6,682
13,822

The value of closing stock on 31 January 2012 is

850 units @ K10.28 = K8,738

The effect of the method of pricing issues of materials on reported profits

The method used to value the issue of materials from stores will affect the cost of goods sold hence the
reported profits. Different methods have different effects. Basically the effects on reported profits will
be as follows:

 Where FIFO is used, cost of goods sold will be low hence reported profits will be high.
 Where LIFO is used, cost of goods sold will be high hence reported profits will be low
 Where AVCO is used the profit reported will be in between FIFO and LIFO

Exhibit

Companies A, B and C buy and sell Item Q. Company A uses FIFO, Company B uses LIFO and Company C
uses AVCO. All the three companies had the following transactions during January 2012 in relation to
item Q:

1 Jan opening stock 400 units @ K20 per unit K8,000

2 Jan purchases 1,000 units @ K27 per unit K27,000

15 Jan Sales 800 units @ K40 per unit K32,000

Required

Calculate the gross profit made by each company in the month of January 2012

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Solution

Company A Company B Company C

K K K K K K
Sales 32,000 32,000 32,000
Opening stock 8,000 8,000 8,000
Add Purchases 27,000 27,000 27,000
35,000 35,000 35,000
Less closing stock (16,200) (13,400) (15,000)
Cost of goods sold (18,800) (21,600) (20,000)
Gross profit 13,200 10,400 12,000

As can be seen from the above results:

 Company A reports a high profit because it uses FIFO

 Company B which uses LIFO reports a low profit
 Company C which uses AVCO reports a profit in between A and B

It must be noted that the differences in reported profits are just a result of the timing of charging cost of
materials. They are not different in real terms. It is therefore important for an organization to choose
the method of valuing issues of materials which is the most suitable to its reporting needs.

Recording the movements of materials in the stores ledger card

This section illustrates how transactions for a stock item are recorded in the sores ledger card for the
item. We will demonstrate this by using fictitious data.

Exhibit

XY limited prices the issue of materials from stores using the FIFO method. The following data relates to
stock item Q in the month of January 2012.

1 January Purchases 1,000 units @ K10 per unit (GRN#123)

7 January Issues to production 300 units (Req 444)

10 January Issues to production 400 units (Req 448)

15 January Purchases 1,500 units @ K11 per unit (GRN#127)

20 January Issues to Production 300 units (Req 452)

25 January Issues to Production 600 units (Req 460)

Record the transactions in the stores ledger card for Item Q.

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 STORES LEDGER CARD
Item Code: Q 112D Max level :2,000 units
Description: Fabric Q 112D Min level: 100 units
Location: Main store Re-order level: 300 units
Bin #: 48 Re-order QTY: 1,500 units

Date Details Ref RECEIPTS ISSUES Stock

Unit Total Unit Balance
QTY Cost Cost QTY Cost Cost QTY Cost
K K K K K
1.01.12 Receipts GRN123 1,000 10.00 10,000 1,000 10,000
7.01.12 Issues Req444 300 10.00 3,000 700 7,000
10.01.12 Issues Req448 400 10.00 4,000 300 3,000
15.01.12 Receipts GRN127 1,500 11.00 16,500 1,800 19,500
20.01.12 Issues Req452 300 10.00 3,000 1,500 16,500
25.01.12 Issues Req460 600 11.00 6,600 900 9,900

Bookkeeping entries for materials

In the cost ledger the cost of materials issued out of stores are posted to control accounts depending on
the purpose to which the materials are issued as follows:

Usage of materials Control account to be debited

Direct materials Work in Progress Control Account
Indirect production materials Production overheads control account
Issues to Administration Administration Overheads control account
Issues to Selling & Distribution Selling & Distribution Overheads control account

Exhibit

During the month of January 2012 a company bought materials costing K1,500,000. Issues during the
months were summarized as follows:

 Direct materials issued K500,000

 Indirect production materials K200,000
 Materials issued to Administration K120,000
 Materials issued to selling & distribution K 80,000

Show postings to the cost ledger control accounts

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 Stores Ledger Control Account
Creditors 1,500,000 Work in Progress a/c 500,000
Production overhead control 200,000
Administration overhead control 120,000
Selling & Distribution overhead 80,000
Balance c/f 600,000
1,500,000 1,500,000
Balance b/f 600,000

Work in Progress Control Account

Stores Ledger 500,000

Production Overheads Control Account

Stores Ledger 200,000

Administration Overheads Control Account

Stores Ledger 120,000

Selling & Distribution Overheads Control Account

Stores Ledger 80,000

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 CHAPTER SEVEN

COST ACCOUNTING FOR LABOUR

Elements of labour cost

Labour costs consist of:

 The basic wages and salaries of employees

 Additional payments for overtime working
 Bonuses and other payments on top of the basic pay and overtime such as contributions made
by employers to the pension scheme of employees.

Direct and indirect labour costs

In cost accounting a distinction is made between direct labour employees and indirect labour
employees.

 Direct labour employees are those employees who work directly on the goods and services
produced by the entity.
 Indirect labour employees are those employees who do not work directly on the goods and
services produced by the entity.

As a general rule, direct labour costs are the labour costs incurred with respect to the direct labour
employees. However, there are some exceptions to the general rule as follows:

o The cost of idle time.

Idle time is when employees are paid and are available for work, but are not doing any active
work due to one reason or another e.g. where materials are not available and workers cannot
work or machines are under repair and workers are waiting for the repair work to be completed
before they can start doing active work. The cost of idle time is classified as indirect labour cost
even if it relates to direct labour employees.

o Overtime premium

When hourly paid employees work more hours than their normal time, they are usually paid
overtime. The rate of overtime work is at a higher rate than the basic rate. The additional
amount in excess of the basic hourly rate is the overtime premium. Overtime premium is
classified as indirect labour cost even where it relates to direct labour employee. The only
exception is where the overtime was requested by a customer, in which case the overtime
premium is classified as direct labour cost.

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 Other costs of direct laboyur employees, which are classified as indirect labour cost are:

o Shift premium
o Sick pay
o Employer’s contribution to employees’ pension scheme

The labour cost of all other employees who do not work directly on the products or services produced
by the entity is classified as indirect labour cost.

Recording labour costs

In a cost accounting system there must be a system for relating the cost of labour to work that is done.
There are various ways in which labour time might be recorded, but the main methods are:

 Payroll records
 Time sheets or similar time records

Payroll records can be used to:

 Identify employees as direct labour or indirect labour employees

 Charge the labour costs of each employee to the department (cost centre) where he/she is
employed.

Payroll accounting involves computations of gross pay for each employee and computation of
deductibles such as PAYE, pension fund etc and calculating the net amount payable to the employee.
This therefore requires information relating to an employee’s attendance time, details of absenteeism,
hourly rates of pay or whatever other basis such as fixed weekly or monthly rate, and details of various
deductions.

Time sheets or similar time recording systems can be used within a cost centre to record the time spent
by each employee on different activities or tasks. Time sheets are not necessary where an employee
does the same work all the time. However, where an employee spends different amounts of time on
different tasks, time sheets are invaluable for allocating the cost of labour to different cost items.

Attendance records

Many organizations keep records of attendance for each employee. In some organizations each
employee has a clock card on which times are recorded when the employee enters the employer’s
premises and when the employee leaves the employer’s premises. The clock card records the total time
of attendance but does not show the time spent on specific jobs.

With the increased use of technology more and more recording systems are now electronic instead of
mechanical. Typically, electronic systems are based on the use of swipe cards i.e. a plastic card with a
magnetic strip similar to an ATM card.

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Time sheets

A time sheet is a record of how a person’s time at work has been spent. The employee fills out his/her
time sheet on a daily, weekly or monthly basis depending upon the policies of the organization. The
general objective is to reconcile all the time in attendance with time bookings either to jobs or
operations or to idle time. Time sheets are used as a basis for:

 Calculating a worker’s wages where these are based on time spent in attendance
 Allocate the labour cost to jobs, departments etc as the case may be.

Job cost card

A job cost card is a card that records the costs involved in a particular job. Job cards are used where the
organization carries out separately identifiable jobs usually to customer specifications. It is an important
document in a job costing system for ensuring that job costs are accurately captured and correctly
charged. On completion of a job, the job card will contain a full record of the times and quantities of
materials involved in the job or batch.

Controlling labour costs

Labour costs must be kept under control. There are various reasons why labour costs might be higher or
lower than expected. Three such reasons are:

 Labour turnover might be higher or lower than usual

 Labour efficiency might be better or worse than usual
 Idle time might be higher or lower than normal.

Labour turnover

Labour turnover refers to the rate at which employees are employed and leave the organization. Labour
turnover is a measure of the speed at which employees leave an organization and are replaced. It is
often calculated as:

Average annual number of leavers who are replaced

100
Average number of employees

The following are the costs of labour turnover:

 The cost of advertising for vacant positions created by employees leaving

 The cost of interviewing , choosing and taking on new employees
 The cost of training new employees
 The loss of efficiency whilst new employees are learning the job
 The effect on the morale of the existing work force when labour turnover is high, leading to a
loss of efficiency.

Typical causes of labour turnover are as follows:

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  Redundancy
 Dissatisfaction over prospects, pay, hours, conditions
 Lack of career structure
 Lack of training
 Personal advancement (seeking greener pastures)
 Marriage, pregnancy
 Retirement
 Discharge
 Move to another geographical area
 Changes in domestic circumstances

Some causes of labour turnover are not controllable by the organization. But for those causes which can
be controlled by the organization, each and every organization must put in place mechanisms for
controlling labour turnover.

Labour efficiency and utilization

Two other reasons why a work force might produce more or less output than expected are labour
efficiency and labour utilization.

Labour efficiency

The labour force of an organization is described as efficient if it produces more than the standard
amount of goods in a set period of time. If a labour force is efficient then it is working faster than
anticipated or producing more goods than anticipated in a set period of time. When a labour force is
producing less goods or is working more slowly than anticipated, it is described as inefficient. Labour
efficiency may be affected by:

 The grade of labour being employed. Lower grades may be less efficient than higher grades.
 The condition of the machines, tools or equipment being used by the workers
 The quality of materials being used by the employees in the production of goods
 The way the work processes are designed
 The quality of supervision
 Levels of motivation of the employees due to leadership style, conditions of work etc.

Labour efficiency or productivity is measured by the efficiency ratio which is calculated as follows:

S tan dard labour hours for actual output produced

 100
Actual hours worked in producing the actual output

The efficiency ratio is also called the productivity ratio.

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Exhibit-1

Company B produces a single product which has a standard direct labour time of 3 hours per unit.
During the first week of January 2012 the company produced 1,000 units of the product in 2,400 direct
labour hours.

Required

Calculate the productivity ratio

Solution

Std hours for 1,000 units is 1,000 units x 3hours = 3,000

Actual hours worked were 2,400 hours

3,000
Productivity ratio =  100 = 125%
2,400

This means that the workers were more efficient because in 2,400 labour hours they produced an
output which should have taken 3,000 labour hours to make.

Exhibit-2

Company B produces a single product which has a standard direct labour time of 3 hours per unit.
During the second week of January 2012 the company produced 1,000 units of the product in 3,750
direct labour hours.

Required

Calculate the productivity ratio

Solution

Std hours for 1,000 units is 1,000 units x 3hours = 3,000

Actual hours worked were 3,750 hours

3,000
Productivity ratio =  100 = 80%
3,750

This means that the workers were less efficient because in 3,750 labour hours they produced an output
which should have taken 3,000 hours to make.

When productivity ratio is greater than 100% the work force were more efficient than normal, on the
other hand, when the productivity ratio is less than 100% the work force were less efficient than normal.

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Labour utilization

Employees are not always engaged in active work during the time they attend the work place. Some of
the time may be spent on unproductive work e.g. when machines break down, when materials have run
out, when there are no jobs to work on etc. Some idle time is controllable by management e.g.

 By preventing machine break down through preventive maintenance

 By ensuring that materials do not run out through good inventory control systems
 Active marketing activities which ensure that more jobs are received from customers

Labour utilization refers to how much labour time is used on productive work compared to how much
available time was expected. Labour utilization is measured by the capacity ratio which is calculated as
follows:

Actual hours worked

Capacity ratio=  100
Budgeted hours

Exhibit

A company has a budgeted direct labour time of 3,000 hours a week. During week one of January 2012
the workers worked 2,400 hours.

Required

Calculate the capacity ratio

Solution

2,400
Capacity ratio =  100  80%
3,000

This means that only 80% of the available time was used on active work during the week.

Production volume ratio or activity ratio

The production volume ratio assesses how the overall production level compares to planned levels, and
is the product of the efficiency ratio and the capacity ratio. A ratio of greater than 100% indicates that
overall production is above planned levels and less than 100% indicates a shortfall compared to plans.

The production volume ratio is calculated as follows:

Actual output measured in s tan dard hours

Production volume ratio =  100
Budgeted production hours

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Exhibit

Company B produces a single product which has a standard direct labour time of 3 hours per unit.
Budgeted output per week is 1,000 units of the product. During the second week of January 2012 the
company produced 1,200 units.

Required

Calculate the production volume ratio

Solution

Std hours for 1,200 units = 1,200 x 3 hours =3,600 hours

3,600
Production volume ratio =  100  120%
3,000

This means that during the second week of January 2012 actual output was more than normal level by
20%.

Labour remuneration methods

The two broad methods of remuneration are:

 Time based
 Related in some way or another to output or performance

Time based systems

This is where employees are remunerated based on a time period worked. Many employees are paid a
fixed salary or wage per month, fortnight or week irrespective of the actual number of hours worked in
that period. Some employees are paid for every hour worked.

Where employees are paid per hour, there is a basic hourly rate for each employee. The organization
normally has a standard number of normal hours per week. Where an employee works more hours than
the standard normal hours for the period, the extra hours worked are overtime hours. In many
organizations the extra hours worked in excess of the normal hours are paid at higher rate.

Where an employee is paid per hour the basic pay is calculated as follows:

Basic pay = Basic hourly rate x number of hours worked.

Exhibit

A company pays its factory workers at a basic hourly rate of K40. The standard number of hours in a
week is 40 hours. During week 2 of January 2010 four employees worked as follows:

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Name of employee Hours worked
F Lajabu 38
J Kandikole 36
L Mwikhoma 45
T Muhaniwa 48

Required

Calculate the basic wages for each employee for week 2

Solution

Employee Hours worked Basic rate/hour Basic wages

K K
F Lajabu 38 40.00 1,520.00
J Kandikole 36 40.00 1,440.00
L Mwikhoma 45 40.00 1,800.00
T Muhaniwa 48 40.00 1,920.00

Overtime premium

When employees work more hours than the standard working hours for a period, it is often the case
that the extra hours are paid at a higher rate than the basic rate. The amount by which the overtime
rate exceeds the basic rate is called the overtime premium. For example:

Basic rate per hour is K40

Overtime rate is K60

Overtime premium is K60 – K40 = K20

The overtime rate is divided into two parts i.e. the basic pay and the premium so that the rate of K60 per
hour paid on overtime hours is made up as follows:

Basic pay/hour 40.00

OT Premium/hour 20.00

Overtime rate 60.00

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It is important to separate the basic pay and the overtime premium when calculating wages because the
treatment of the overtime premium is not the same as the treatment of the basic pay for cost
accounting purposes.

The basic pay for direct workers is classified as direct labour cost. On the other hand, the overtime
premium for direct workers is classified as indirect labour cost except where the overtime is requested
by a customer.

Exhibit

A company pays all its direct factory workers at a basic hourly rate of K60. Overtime is paid at 1.5 times
basic rate. The standard week for the company is 40 hours. During week 1 of January 2010 F Lajabu
worked 45 hours. Calculate the wages earned by Lajabu in that week.

Workings

Basic rate is K60 per hour

Overtime rate is K60 x 1.5 = K90 per hour

Overtime premium is K90 – K60 = K30

Calculating the wages of Lajabu

Wages
K
Basic Pay Total hours worked X Basic rate 45 hrs x K60 2,700.00
Overtime premium O/T hours x premium 5 hrs x K30 150.00
Total wages 2,850.00

By calculating the wages in this way we have separated the basic pay which is a direct labour cost from
the overtime premium which is an indirect labour cost.

Activity

Nthipela Limited pays all its direct factory workers a basic hourly rate of K50. Overtime is paid at basic
rate plus 25%. The normal working week for the company is 40 hours. The company has 200 direct
labour workers. During the first week of January 2012 the workers worked 9,000 hours. Calculate the
wages paid to the workers for the week.

Solution

Normal hours 40 hrs x 200 = 8,000 hours

Overtime hours 9,000 hrs – 8,000 hrs = 1,000 hours

Basic rate K50 per hour

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Overtime rate K50 x 1.25 = K62.50

Overtime premium K62.50-K50.00=K12.50

Calculating wages for First week of January 2012

Wages
K
Basic Pay Total hours worked X Basic rate 9,000 hrs x K50 450,000.00
Overtime premium O/T hours x premium 1,000 hrs x K12.50 12,500.00
Total wages 462,500.00

Piecework systems
Under piecework systems employees are paid a certain rate for the number of units of output produced.

Basic pay = number of units produced x rate per unit

Exhibit

A company pays its employees K40 for each unit of product produced. During week 3 of January 2012,
Anusa produced 300 units. What were his wages for the week?

Solution

300 units x K40 = K12,000

Piecework with a guaranteed minimum

Some companies employ a piecework system with a guaranteed minimum wage per period so that no
employee earns less than the guaranteed amount in any period. Under this system an employee who
has produced units of output which pay less than the guaranteed amount will receive the guaranteed
minimum amount while an employee whose output earns him more than the guaranteed amount is
paid for the actual units produced.

Exhibit

A company pays its direct labour workers K40 for each unit of good output produced. The policy of the
company is that there is a guaranteed minimum wage per week of K8,000. Calculate the wages of the
following employees in week 2 of January 2012.

J Banda 250 units

L Jere 300 units

D Gondwe 180 units

F Mwamadi 190 units

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Solution

Output(units) Rate/unit Based on output Actual Paid

K K K
J Banda 250 40.00 10,000 10,000
L Jere 300 40.00 12,000 12,000
D Gondwe 180 40.00 7,200 8,000
F Mwamadi 190 40.00 7,600 8,000

Differential piecework systems

Differential piecework schemes are aimed at encouraging workers to work hard and produce more units
of output. This is achieved because differential piecework schemes pay higher rates per unit when more
units are produced.

Exhibit

A company employs a differential piecework system for its direct labour workers as follows:

Production(units) Rate of pay per unit

K
0 – 100 40
101 – 200 45
More than 200 50

Calculate the wages of the following employees

J Phiri 80 units

L Jere 150 units

P Likongwe 215 units

Solution

J Phiri 80 x K40 = K3,500

L Jere

100 x K40 = K4,000

50 x K45 K2,250

K6,250

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P Likongwe

100 x K40 K4,000

100 x K45 K4,500

15 x K50 K 750

K9,250

Incentive schemes (Bonus schemes)

Employees are sometimes offered an incentive or bonus payment for improving their productivity, or for
achieving certain production targets during a period. The purpose of an incentive scheme for greater
productivity should be to:

 Increase total production output with the same number of employees; or

 Achieve the same total output volume, but in fewer hours of work.

A bonus scheme aims at sharing the benefits of higher productivity between the employer and the
employees so that there is mutual benefiting. This should give employees an incentive to achieve
productivity improvement. An incentive scheme may be based on:

 An individual’s performance, or
 The performance of a work group as a whole.

Individual incentive schemes

An individual bonus scheme rewards individual employees for working more efficiently i.e. where the
individual employee produces more in a given period of time or the employee exceeds set production
targets.

Exhibit

An employer pays its direct factory workers an hourly rate of K50. Employees who complete jobs in less
time than the set standard time for the job are paid a bonus equal to half the time saved. During week 1
of January 2012 J Alabi worked on jobs with standard time of 40 hours. Alabi completed the jobs in 30
hours.

Required

Calculate the bonus payable to J Alabi in week 1

Solution

Time saved = 40 hours – 30 hours = 10 hours

Bonus = 10 hours ÷ 2 х K50 = K250

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Assuming that Alabi worked only 30 hours during week 1, his total wages would be as follows:

Basic pay 30 hours x K50 K1,500

Bonus K 250

Total wages K1,750

Advantages of individual bonus schemes

 An individual is directly rewarded for his own hard work

 Individual workers are motivated to work harder
 The morale of an employee may be improved because his extra effort is rewarded
 Highly skilled and hard working employees will be attracted to the employer because of the
prospect of earning higher wages.

Disadvantages of individual bonus schemes

 The scheme can only work where individual effort is capable of being measured reliably
 It can encourage unhealthy competition among workers thereby adversely affecting team work
 Employees who are naturally slow will not benefit from the scheme leading to low morale
among such employees
 It can compromise quality of output where employees try to work too fast
 The rate of accidents can increase where the work involves using potentially dangerous
machines.

Group bonus schemes

Group bonus schemes involve making bonus payments to groups of employees rather than individual
employees. These schemes are suitable where productivity is a result of concerted group effort rather
than individual effort. Group incentive schemes can be classified into two categories:

 Collective schemes where all employees of the organization are paid a bonus because the
organization as a whole has performed well. So where an organization has made a profit which
is higher than what was anticipated the organization may pay a bonus to share some of the
extra profit with the employees.
 A collective bonus scheme where a limited group of employees are rewarded for the better
performance of their work group. For example where a department has exceeded its production
targets in a certain period a bonus might be paid to all members of the department.

Advantages

 It encourages closer cooperation among workers and fosters team work

 It is administratively simpler to administer with less recording of labour times, production rates
etc.

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  Support workers not directly associated with production can easily be included in the scheme
 May encourage more flexible working arrangements within the group.

Disadvantages

 It is less directly related to an individual’s effort hence it may not give a direct incentive for
employees to work harder
 Less hardworking members of the group are rewarded equally with hardworking ones which
may cause dissatisfaction among hardworking members.
 The basis for sharing the bonus may be difficult to determine. Some employees are more senior
than others etc. It is thus difficult to obtain an agreement on proportions of the bonus to give to
different group members.

Cost book keeping entries for labour

In the cost ledger accounts labour costs are entered as follows:

Direct labour Debit Work in progress control account

Indirect factory labour Debit Production overhead control account
Administration wages and salaries Debit Administration overhead control account
Selling and distribution salaries Debit Selling & distribution overhead control account

Exhibit

Labour costs for Kachimanga Limited for January 2012 were as follows:

Basic wages for direct workers 500,000

Overtime premium for direct workers 180,000

K400,000
Wages of other factory workers 220,000

Administration salaries and wages 375,000

Selling and distribution salaries 245,000

Total 1,520,000

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 Wages control account
Work in progress control a/c 500,000
Production overhead control a/c 400,000
Administration overhead control a/c 375,000
Selling & distribution overhead control a/c 245,000

Work in progress control account

Wages control a/c 500,000

Production overhead control account

Wages control a/c 400,000

Administration overhead control account

Wages control a/c 375,000

Selling and distribution overhead control account

Wages control a/c 245,000

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 CHAPTER EIGHT

COST ACCOUNTING FOR OVERHEADS

Introduction
Overheads are all the indirect costs for an organization. Some overheads are incurred in the production
of goods or provision of services of the organization; such overheads in a manufacturing company are
incurred in the factory. These overheads are product costs. Some overheads are incurred in non-
production departments of the organization e.g. in administration and marketing departments.

As we have already learned direct costs differ from indirect costs because direct costs can be traced in
full to cost units while indirect costs cannot. Such being the case, direct costs are charged directly to cost
units. On the other hand, indirect costs cannot be charged directly to cost units because they cannot be
directly attributed to cost units.

In cost accounting a problem arises of how production overheads should be dealt with since although
they are indirect costs, they are incurred in the process of producing the products of the organization
and they are therefore product costs. A way must be found for dealing with indirect costs of production.
There are two approaches to cost accounting:

 Marginal costing
 Absorption costing

Under marginal costing no attempt is made to incorporate fixed production overheads into the cost of
producing the products. Instead fixed production overheads are treated as period costs and are charged
as expenses in the period in which they are incurred together with the costs incurred in the non-
production departments.

Under absorption costing however, all production overheads are incorporated into the production cost
of products so that the production cost of one unit of a product includes both the direct costs of
production and a proportion of production overheads.

In this chapter we are going to learn the process through which production overheads are incorporated
into the production costs of products, jobs and services.

Absorption costing
Absorption costing is a method of costing in which overhead costs are added to the cost of cost units,
and a full cost is calculated. The full cost of an item is the prime cost plus a share of overhead costs.
Absorption costing is based on the idea that the cost of a product or service should be:

 Its direct costs (direct materials, direct labour and direct expenses)
 Plus a share of overhead costs

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Absorption costing is therefore a system of costing in which a share of overhead costs is added to direct
costs, to obtain a full cost. This might be:

 A full production cost, or

 A full cost of sale

An absorption costing system might be used to decide the full production cost of the product, so that
only a share of production overheads is added to product costs. Administration overheads and selling
and distribution overheads are simply charged as an expense in the period in which they occur. In some
costing systems, a share of administration and selling and distribution overheads might be added to the
full production cost, to obtain a full cost of sale. However, it is not common practice to calculate a full
cost of sale, because it has only limited value as management information.

Absorption costing is of particular importance in the valuation of inventories for work in progress and
finished goods. This is so because IAS2 inventories, requires that the cost of goods sold and the value of
inventories for finished goods and work in progress should include a fair share of production overheads
for purposes of financial accounting and financial reporting.

Stages in absorption costing

In a system of absorption costing, each item of overhead cost is charged either:

 To a cost centre, or
 As a general expense.

The overhead costs which are charged to cost centres are those which can be attributed in full to
specific cost centres. Those overhead cost items which cannot be attributed in full to specific cost
centres are charged as a general expense.

The cost centres might be:

 A cost centre in the production function (production overheads)

 A cost centre in administration (administration overheads)
 A cost centre is sales and distribution (sales and distribution overheads)

The cost centres in the production function might be:

 A department engaged directly in production work (a production cost centre), or

 A department providing services to production department e.g. stores, maintenance, boiler
house, quality control etc.

The stages in the process of absorbing overheads to products relate to the overhead costs incurred in
the production function of an organization and are as follows:

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Stage 1-Overhead allocation

There are some overheads which are incurred by specific cost centres in the organisation. These costs
are fully attributable to specific cost centres; they are thus charged directly to the cost centres to which
they relate. Overhead allocation therefore involves charging specifically attributable overheads to the
cost centres to which they relate. For example, indirect materials costs, indirect labour costs, and
indirect expenses which are incurred by a specific department or section of a factory are charged to that
department or section, those which are attributable to administration and selling and distribution
departments are allocated to those departments. This is a fairly straightforward process since such costs
can be easily identified with the cost centre.

Stage 2-Overhead apportionment

Some overhead costs incurred in the organisation are not directly attributable to any specific cost centre
within the organisation. Good examples of such costs are rent, cost of power for driving machines,
lighting and heating, and similar costs which relate to the organisation as a whole and not to specific
cost centres of the organisation. These cost items are initially charged as general expenses.

Overhead apportionment involves sharing these general overheads to all the cost centres within the
organisation which are seen to be benefiting from these costs. The general overheads relating to the
production function must further be shared by the cost centres within the production function, both
production cost centres and service cost centres.

The sharing of the general overheads must be based on a basis which equitably reflects the
consumption of such costs by each cost centre. The following are some of the bases for apportioning
general overheads to cost centres:

Cost Apportionment basis

Rent and rates Floor area
Insurance for buildings Floor area
Insurance for machines Value of machines
Depreciation for buildings Floor area
Depreciation for machines Value of machines
Power for driving machines Capacity of machines e.g. Kilowatts
Lighting and heating Floor area
Personnel costs Number of employees
Stores costs Number of materials requisitions
Maintenance costs Maintenance hors
Canteen costs Number of employees

Each cost centre is given a share of an item of cost on a proportionate basis e.g. the floor area occupied
by the cost centre relative to total floor area. The following example demonstrates how general
overheads are apportioned to cost centres.

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Exhibit

The following information relates to the overhead costs for the factory of Fojamuheni Limited

Production departments Service departments

Machine
shop Assembly Stores Maintenance Total
K K K K K
Indirect materials 80,000 60,000 30,000 50,000 220,000
Indirect labour 45,000 70,000 18,000 22,000 155,000
Factory rent and rates 100,000
Factory power 200,000
Insurance for factory building 28,000
Insurance for factory machines 32,000
Depreciation for factory buildings 40,000
Depreciation for factory machines 120,000
Factory lighting and heating 18,000
913,000
Other information
Floor area (sqM 4,500 6,750 9,000 2,250 22,500
Value of Machines (K) 24,000,000 12,000,000 4,000,000 40,000,000
Capacity of machines (Kilowatts) 360 120 120 600

Required

Apportion the general overhead costs to the various cost centres on the most equitable basis.

Solution

Each cost item will be shared using the following formula

a
D
b

Where:

D = the total cost of the overhead item

a=the amount of the basis attributable to the cost centre (e.g. floor area occupied by the cost centre)

b= The total basis for the whole factory (e.g. total floor area for the factory as a whole)

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e.g. Factory rent and rates will be shared on the basis of floor area

Total cost for rent and rates is K100,000, this is D

Machine shop share

a=Floor area occupied by machine shop is 4,500 sqm

b=Total floor area 22,500sqm

4,500
Share for machine shop is  K100,000  K 20,000
22,500

Production departments Service departments

Machine
shop Assembly Stores Maintenance Total
Basis K K K K K
Indirect materials Allocated 80,000 60,000 30,000 50,000 220,000
Indirect labour Allocated 45,000 70,000 18,000 22,000 155,000
Factory rent and rates Floor area 20,000 30,000 40,000 10,000 100,000
Factory power Capacity 120,000 40,000 - 40,000 200,000
Insurance for factory building Floor area 5,600 8,400 11,200 2,800 28,000
Insurance for factory machines Value of machines 19,200 9,600 - 3,200 32,000
Depreciation for factory buildings Floor area 8,000 12,000 16,000 4,000 40,000
Depreciation for factory machines Value of machines 72,000 36,000 - 12,000 120,000
Factory lighting and heating Floor area 3,600 5,400 7,200 1,800 18,000
373,400 271,400 122,400 145,800 913,000

Stage 3-Reapportionment of service cost centre costs to production cost centres

The costs accumulated in the service cost centres are part of the production overheads which must be
incorporated into the production costs of the products. There is a problem, however, because the
products are not produced in the service cost centres hence it is difficult to find a link between the
products and the service cost centres which can form the basis for absorbing the costs to the products.
It is necessary therefore that the service cost centre costs should be shared to the production cost
centres so that all factory overheads should reside in the cost centres where the products are actually
made. This will enable costs to be absorbed into products because a link between the products and the
production cost centres is easier to determine.

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Direct method

Under this method service cost centre costs are apportioned to production cost centres only. Any
services between service cost centres are ignored. This method is suitable where the amount of services
between service cost centres is negligible. For functional purposes, it is my opinion that this method
should only be used where service cost centres do not give services to each other.

Specific order of closing method

This method should be used where one service cost centre gives a significant amount of services to
another service cost centre in addition to services it gives to production cost centres. The procedure
should be to share the costs of the service cost centre which gives a significant amount of services to
other service cost centres first. The service cost centre which gives the least amount of services to other
service cost centres should be shared last and its costs should be shared to production cost centres only.

Exhibit

ABC limited has two production departments, machine shop and assembly, and two service
departments, stores and boiler house. The situation after the initial allocation and apportionment of
overheads is as follows:

Production Departments Service Departments

Machine Boiler
Shop Assembly Stores House Total
K K K K K
Overhead costs 200,000 90,000 60,000 40,000 390,000

Service deparments
Stores 60% 30% 10%
Boiler house 70% 30%

Required

Apportion the service cost centre costs to production departments

Solution

Stores department provides services to Boiler house but does not receive any services from Boiler
house; the costs of stores department should therefore be shared first on this basis. The costs of stores
department should be shared to all departments including Boiler house. The costs of boiler house
including the share it receives from stores should be shared to production departments only. The
process is as follows:

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 Production Departments Service Departments
Machine Boiler
Shop Assembly Stores House
K K K K
Overhead costs 200,000 90,000 60,000 40,000
Stores 60% 36,000 30% 18,000 (60,000) 10% 6,000
46,000
Boiler house 70% 32,200 30% 13,800 (46,000)
268,200 121,800 - -

Continuous apportionment method

This method is suitable where all service departments give services to each other in addition to giving
services to production departments. Under this method the apportionment of service departments is
done repeatedly until the amount of overheads in the last service department becomes so small that it
is insignificant; at that point the remaining amount is shared to production departments only. The
method is demonstrated in the following exhibit:

Exhibit

ABC limited has two production departments, machine shop and assembly, and two service
departments, stores and maintenance. The situation after the initial allocation and apportionment of
overheads is as follows:

Production Departments Service Departments

Machine
Shop Assembly Stores Maintenance Total
K K K K K
Overhead costs 200,000 90,000 60,000 40,000 390,000

Service deparments
Stores 60% 30% 10%
Maintenance 50% 30% 20%

Required

Apportion the service cost centre costs to production departments

R D C Neba MBA, BCom Page 81

 Production Departments Service Departments
Machine
Shop Assembly Stores Maintenance
K K K K
Overhead costs 200,000 90,000 60,000 40,000 390,000
Stores 60% 36,000 30% 18,000 (60,000) 10% 6,000
- 46,000
Maintenance 50% 23,000 30% 13,800 20% 9,200 (46,000)

Stores 60% 5,520 30% 2,760 (9,200) 10% 920

Maintenance 50% 460 30% 276 20% 184 (920)

Stores 60% 111 30% 55 (184) 10% 18

Maintenance 50/80 11 30/80 7 (18)

265,102 124,898 390,000

Algebraic method

This method is suitable where there are two service departments which give services to each other in
addition to giving services to the production departments. It should not be used where there are more
than two service departments.

The first step is to formulate equqtions representing the total costs for each service department after
each service department has received its share of the costs from the other service department. The
result is that we shall have two simultaneous equations which are then solved to calculate the total
amount of costs for each service department. The calculated amounts are then apportioned directly to
the production departments.

Exhibit

ABC limited has two production departments, machine shop and assembly, and two service
departments, stores and maintenance. The situation after the initial allocation and apportionment of
overheads is as follows:

R D C Neba MBA, BCom Page 82

 Production Departments Service Departments
Machine
Shop Assembly Stores Maintenance Total
K K K K K
Overhead costs 200,000 90,000 60,000 40,000 390,000

Service deparments
Stores 60% 30% 10%
Maintenance 50% 30% 20%

Required

Apportion the service cost centre costs to production departments

Solution

Define equation

Let the total cost for Stores be X

Let the total cost for maintenance be Y

X = 60,000 + 0.20Y (1)

Y = 40,000 + 0.10X (2)

Rearrange equations so that like terms are together

X – 0.20Y = 60,000 (3)

-0.10X +Y=40,000 (4)

Eliminate one unknown and solve for X and Y

Let us eliminate Y. To do this we first multiply the whole of equation 3 by 5 (this is because to make
0.20Y into 1 Y we must multiply it by 5). Equation 3 now becomes:

5X-Y=300,000 (5)

Add equation 5 and 4 to eliminate Y and calculate the value of X

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 5X -Y = 300,000
-0.10X +Y = 40,000
4.9X = 340,000

340,000
X=  69,388
4.9

The total cost for Stores is thus K69,388

Find the cost for maintenance by substituting K69,388 for X in equation 3.

69,388 – 0.20Y = 60,000

69,388-60,000 = 0.20Y

9,388 = 0.20Y

9,388
Y=  46,940
0.20

The total cost for maintenance is therefore K46,940

Apportion the calculated values for stores and maintenance to the production departments according to
the percentages given.

Machine
% Shop % Assembly Stores Maintenance Total
K K K K K K
Overheads 200,000 90,000 60,000 40,000 390,000
Stores 69,388 60% 41,633 30% 20,816
Maintenance 46,940 50% 23,470 30% 14,082
265,103 124,898 390,001

Stage 4- Calculation of overhead absorption rates (recovery rate)

Once the production overheads have been accumulated into the production cost centres the next step is
to calculate the overheads absorption rates. The overhead absorption rate is the rate used to charge
overheads for each department to products or jobs carried out in that department. Each production
department will have its own rate except where the organization uses a blanket rate for the factory as a
whole.

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The overhead absorption rate is calculated as follows:

Total allocated and apportioned overhead cos ts

Total Output for the period

Measurement of the total output for the period

1. Units of output

Where a company produces identical products the total output is the quantity of units
produced. When this is the case the overhead absorption rate is calculated as a rate per unit.

Exibit

A Company produces a single product, product Q. The product is produced in three production
departments: Fabricating, Assembly and Finishing. During the 2012 year budgeted output is
15,000 units of Q. Budgeted production overheads after allocation and apportionment are as
follows:

Fabricating Department K67,500

Assembly Department K48,750

Finishing Department K79,200

Required

Calculate the overhead absorption rate for each of the three departments

Solution

K 67,500
Fabricating Department  K 4.50 per unit
15,000 units

K 48,750
Assembly Department  K 3.25 per unit
15,000u units

K 79,200
Finishing Department  K 5.28 per unit
15,000 units

What do these rates mean?

These rates mean that every unit of product Q produced will be charges production overheads
from each of the three departments equal to those rates. For example assume that one unit of

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 product Q consumes K25 direct materials and K18 direct labour. The full cost of production for
one unit of product Q is as follows:

K K
Direct material 25.00
Direct labour 18.00
Prime cost 43.00
Production overhead
Fabricating 4.50
Assembly 3.25
Finishing 5.28
13.03
Production cost per unit 56.03

Where a firm produces products which are not identical total output cannot be measured in units of
product because it is not rational to do so. In such cases it is necessary to find a measure which can be
used commonly for all products produced by the organization. The most common measures of output
are as follows:

 Direct labour hours

 Machine hours

The following are also used as measures of output

 Direct labour cost

 Direct materials cost
 Prime cost

2. Direct labour hour rate

A direct labour hour rate is an overhead absorption rate based on a standard direct labour hour.
A standard direct labour hour is a measure of output; it represents the estimated number of
units of a product which can be produced in one direct labour hour under normal conditions.
Each product a firm produces has its own standard direct labour hour. It is therefore possible to
state the volume of units of a product produced in terms of standard direct labour hours. Such
being the case, where a company produces a number of different products, total output can be
stated in standard direct labour hours by simply calculating the standard direct labour hours for
each product and adding them together. For example:

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 A company produces two products P and Q. One unit of P has two standard direct labour hours
while one unit of Q has 3 standard direct labour hours. Let’s assume that the company produced
1,000 units of P and 1,200 units of Q. Total output in standard direct labour hours is as follows:

Direct
labour
hours
Product P 1,000 x 2 2,000
Product Q 1,200 x 3 3,600
5,600

Exhibit

A company produces two products X and Y. One unit of X has 3 standard direct labour hours
while one unit of Y has 2 standard direct labour hours. Budgeted output for 2012 is 5,000 units
of X and 7,000 units of Y. Budgeted production overheads for 2012 are K174,000. Calculate the
direct labour hour rate.

Solution

Step 1 is to calculate total output in standard direct labour hours as follows:

Standard
direct labour
Product hours
X 5,000 x 3 15,000
Y 7,000 x 2 14,000
29,000

Step 2 is to calcuate the overhead absorption rate by dividing the overhead cost by the number
of standard direct labour hours.

K174,000
The Direct labour hour rate is  K 6.00 per direct labour hour
29,000

This means each unit of the products produced by the company will be charged K6.00 for each direct
labour hour it is estimated to consume. In our case, products X and Y will be charged production
overheads per unit of output as follows:

One unit of X 3 std hours x K6 = K18

One unit of Y 2 std hours x K6 = K12

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A direct labour hour rate is a suitable rate for absorbing production overheads in a department which is
labour intensive i.e. a department whose work involves a lot of labour rather than machines. Where a
department has more direct labour hours than machine hours you must use the direct labour hour rate
for absorbing production overheads for example:

Production department Z has 60,000 direct labour hours per annum and 12,000 machine hours per
annum. What should be the basis for absorbing the overheads for department Z into products?

Answer: Direct labour hour rate.

Example

Nkwepele Limited produces two products Mpwesa and Nthudza. These products are manufactured in
three production departments: Machining, Assembly and Finishing. The following information is given:

Direct labour hours per unit of product:

Machining Assembly Finishing

Mpwesa 3 2.5 1
Nthudza 2 1.5 2.2

Budgeted output:

Mpwesa 7,000 units

Nthudza 4,000 units

Budgeted Production overheads:

Machining K101,500

Assembly K99,875

Finishing K33,970

Required

i. Caclulate the direct labour hour rate for each department

ii. Calculate the production overheads chargeable to one unit of each product

Solution

Step 1-calculate total direct labour hours for each department

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 Machining Assembly Finishing
Hours Hours Hours
Mpwesa 7,000 x 3 21,000 7,000 x 2.5 17,500 7,000 x 1 7,000
Nthudza 4,000 x 2 8,000 4,000 x 1.5 6,000 4,000 x 2.2 8,800
29,000 23,500 15,800

1. calculate direct labour hour rates

K101,500
Machining  K 3.50 / direct labour hour
29,000 hours

K 99,875
Assembly  K 4.25 / direct labour hour
23,500 hours

K 33,970
Finishing  K 2.15 / direct labour hour
15,800 hours

2. Calculate the overhead cost chargeable to one unit of each product

Dept Mpwesa Nthudza

K K
Machining 3 hrs x K3.50 10.50 2 hrs x K3.50 7.00
Assembly 2.5 hrs x K4.25 10.63 1.5 hrs x K4.25 6.38
Finishing 1 hr x K2.15 2.15 2.2 hrs x K2.15 4.73
23.28 18.11

3. Machine hour rate

A machine hour rate is an overhead absorption rate based on a standard machine hour. A standard
machine hour is a measure of output; it represents the estimated number of units of a product
which can be produced in one machine hour under normal conditions. Each product a firm produces
has its own standard machine hour. It is therefore possible to state the volume of units of a product
produced in terms of standard machine hours. Such being the case, where a company produces a
number of different products, total output can be stated in standard machine hours by simply
calculating the standard machine hours for each product and adding them together. The procedure
for calculating standard machine hours is exactly the same as that for calculating standard direct
labour hours.

A machine hour rate is a suitable rate for absorbing production overheads in a department which is
machine intensive i.e. a department whose work involves the use of machines more than labour. Where

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a department has more machine hours than labour hours you must use the machine hour rate for
absorbing production overheads for example:

Production department Z has 60,000 machine hours per annum and 12,000 direct labour hours per
annum. What should be the basis for absorbing the overheads for department Z into products?

Answer: Machine hour rate.

Exhibit

A company produces two products A and B in two production departments, machine shop and
assembly. The following data is given:

Machine hours per unit

Machine shop Assembly

Product A 3 2

Product B 4 6

Production overhead K310,500 K175,000

Budgeted output

Product A 5,000 units

Product B 3,000 units

Required

Calculate the machine hour rate for each of the two departments

Solution

The first step is to find total machine hours for each department as follows:

Machine
shop Assembly

Product A 5,000 units x 3hrs 15,000 5,000 units x 2hrs 10,000

Product B 3,000 units x 4hrs 12,000 3,000 units x 6hrs 18,000
27,000 28,000

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 Calculation of machine hour rate

K 310,500
Machine shop  K11.50 per machine hour
27,000 hours

K175,000
Assembly  K 6.25 per machine hour
28,000 hours

4. Percentage of Direct labour cost method

Direct labour cost can be used as a basis for absorbing production overheads in a labour
intensive department. It can be used where it is difficult to determine the number of direct
labour hours for products.

The overhead absorption rate is calculated as a percentage of direct labour cost.

Exhibit

The production overhead for Department Q is K480,000. The direct wages for the department
amount to K400,000. Calculate the overhead absorption rate as a percentage of direct labour
cost.

Solution

K 480,000
Absorption rate =  100  120%
K 400,000

What does this rate mean?

This rate means that the amount of production overhead chargeable to any product which is
produced in department Q will equal to 120% of the direct labour cost of that product
consumed in department Q.

Example

Let’s assume that product Z is produced in department Q. The direct labour cost incurred by one
unit of Z in department Q is K40. The production overhead chargeable to one unit of Z in
department Q is:

K40 x 120% =K48

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 5. Percentage of Direct materials cost method

Under this method the overhead chargeable to a product is a percentage of the direct materials
cost of that product. The overhead absorption rate is expressed as a percentage of direct
materials cost.

Exhibit

The direct materials cost for department D is K600,000. The production overhead for
department D is K480,000. The overhead absorption rate based on direct materials cost is:

K 480,000
 100  80%
K 600,000

This means that the amount of overhead chargeable to any product produced in department D
will equal to 80% of the department D direct material cost consumed by that product.

Example

Product P consumed K50 direct materials in department D. What is the amount of overhead for
department D which is chargeable to product P?

Solution

K50 x 80%=K40

6. Percentage of Prime cost cost method

Under this method the amount of overhead cost chargeable to products is calculated as a
percentage of the prime cost of the product in that department.

Exhibit

The following are the production costs for production department Z

Direct materials K108,000

Direct labour K112,000

Production overhead K165,000

What is the overhead absorption rate as a percentage of prime cost?

Solution

Prime cost is (direct materials + direct labour)=K108,000+K112,000=K220,000

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 K165,000
Overhead absorption rate is  100  75%
K 220,000

This means that for any product which is produced in department Z the production overhead for
department Z chargeable to that product will equal to 75% of the prime cost of that product
incurred in department Z.

Example

Product A is produced in department Z. Its direct material and direct labour costs incurred in
department A are K50 and K60 per unit respectively. What is the amount of department Z
production overhead chargeable to one unit of product A?

Solution

Prime cost for product A in department Z is K50+K60=K110

The department Z production overhead chargeable to one unit of product A is:

K110 x 75% = K82.50

Using overhead absorption rates to charge overheads to products, jobs etc

Once overhead absorption rates have been calculated they are used to charge production overheads to
products, jobs, and services in order that a proportion of production overheads should be incorporated
into the product costs. The following examples demonstrate this.

Exhibit 1

A company produces three products P, Q and R in two production departments, machine shop and
assembly. The company uses full absorption costing system.

The following are the specifications per unit of each product

Machine
shop Assembly
Machine hours
Product P 4 1
Product Q 3 0.5
Product R 5 2
Direct labour hours
Product P 1.5 3.5
Product Q 1 5.5
Product R 1.2 4

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Direct materials:

Product P 6 Kilo @ K12 per kilo

Product R 3 Kilo @ K16 per Kilo

Product Q 4 Kilo @ K10 per Kilo

Total Production overheads for the year

Machine shop K232,000

Assembly K147,200

Output for the year in standard hours

Machine shop 58,000 machine hours

Assembly 64,000 direct labour hours

Direct labour is paid at the rate of K8 per hour in machine shop and K6 per hour in assembly.

Required

Calculate the full production cost for one unit of each of the three products.

Solution

Step 1 is to calculate the overhead absorption rates for the two production departments

K 232,000
Machine shop: Machine hour rate  K 4 per machine hour
58,000 machine hours

K147,200
Assembly: Direct labour hour rate  K 2.30 per direct labour hour
64,000 direct labour hours

The next step is to calculate the full production cost of the three products as follows:

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 Product P
K K
Direct material 6 kilo x K12 72.00
Direct labour
Machine shop 1.5 hrs x K8 12.00
Assembly 3.5 hrs x k6 21.00
33.00
Prime cost 105.00
Production overhead
Machine shop 4 hrs x K4 16.00
Assembly 3.5 hrs x K2.30 8.05
24.05
Production cost 129.05

Product Q
K K
Direct material 3kilo x K16 48.00
Direct labour
Machine shop 1 hrs x K8 8.00
Assembly 5.5 hrs x k6 33.00
41.00
Prime cost 89.00
Production overhead
Machine shop 3 hrs x K4 12.00
Assembly 5.5 hrs x K2.30 12.65
24.65
Production cost 113.65

R D C Neba MBA, BCom Page 95

 Product R
K K
Direct material 4kilo x K10 40.00
Direct labour
Machine shop 1.2 hrs x K8 9.60
Assembly 4 hrs x k6 24.00
33.60
Prime cost 73.60
Production overhead
Machine shop 5 hrs x K4 20.00
Assembly 4 hrs x K2.30 9.20
29.20
Production cost 102.80

Exhibit 2

A company produces two products Mpwesa and Tongole in two production departments, Fabricating
and Assembly.

The following information is for the year ending 31 December 2014:

Fabricating Assembly

Machine hours 50,000 -

Direct wages K120,000 K670,000

Production overheads K475,000 K301,500

Production overheads are absorbed on the machine hour rate basis in Fabricating department, and as a
percentage of direct wages in the Assembly department.

The following are the specifications for one unit of each product:

Fabricating Assembly

Machine hours

Mpwesa 4 -

Tongole 2.5 -

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 Fabricating Assembly

Direct wages

Mpwesa K40.00 K78.00

Tongole K30.00 K110.00

Direct materials

Mpwesa K120.00

Tongole K235.00

Required

Calculate the full production cost for one unit of each product.

Solution

First step is to calculate the overhead absorption rate for each department as follows:

K 475,000
Fabricating:-Machine hour rate  K 9.50 per machine hour
50,000 machine hours

K 301,500
Assembly:-Percentage of direct wages  100  45% of direct wages
K 670,000

Calculating production cost for one unit of each product:

Mpwesa
K K
Direct material 120.00
Direct wages
Fabricating 40.00
Assembly 78.00
118.00
Prime cost 238.00
Production overhead
Fabricating 4 hrs x K9.50 38.00
Assembly K78 x 45% 35.10 73.10
Production cost 311.10

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 Tongole
K K
Direct material 235.00
Direct wages
Fabricating 30.00
Assembly 110.00
140.00
Prime cost 375.00
Production overhead
Fabricating 2.5hrs x K9.50 23.75
Assembly K110 x 45% 49.50 73.25
Production cost 448.25

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