MA: COST ACCOUNTING CONCEPTS AND PRINCIPLES

COST ACCOUNTING CONCEPTS AND PRINCIPLES

BASIC DEFINITIONS AND COST CONCEPTS

(a) Cost: A cost may be defined as ‘the amount of expenditure (actual or notional) incurred on or attributable to a specified thing or activity.

(b) Cost Unit: This is a unit of product or service in relation to which costs are ascertained. The unit chosen is most relevant for the activities of the organization.

Examples:

Units of production Tables, TV sets, litres of paint, a job, a contract, a crate of beer, tonnes of cement.

Units of service Consulting hours, guest-nights, kilowatt hours, passenger-mile.

The primary classification of cost unit is as follows:
(a) direct cost; and

(b) indirect cost

(c) Direct Costs: These costs consist of direct materials, direct labour, and direct expenses which can be directly identified with a job, a product or a service.

Examples:
Direct materials   Raw materials used in the product; part and assemblies incorporated into the finished product; bricks, timber, cement, used on a contract

Director labour    Wages paid to factory workers for work that are directly related to production; salary paid to foreman.

Direct expenses Expenses incurred directly for a specific job, project or saleable service, for example, royalties paid on barrel of crude oil produced, tonnage of lime stone, etc.

The total of: Direct materials + direct labour + direct expenses = Prime cost

(d) Indirect Costs: These are materials, labour and expenses which cannot be directly identified with the product. These are also called overheads and can be classified into administration, finance, selling, distribution and production.
Note
Prime cost + overheads = Total cost

(e) Cost Centre: This is a production or service location, function, activity or item of equipment for which costs are accumulated (CIMA). Thus, in the cost centre coding system, costs are gathered together according to their incidence.

The gathering together of the indirect costs results in the establishment of the overheads relating to each cost centre which is an essential preliminary to spreading the overheads over cost units.

(f) Cost Allocation: To assign a whole item of cost, or of revenue, to a single cost unit, cost centre, account or time period (CIMA). It can also be defined as the allotment of costs that are directly identifiable with, incurred by a production or service cost centre.

(g) Apportionment: This process involves the sharing of indirect cost between two or more cost centres or units on the basis of benefit derived by them using relevant bases of apportionment. “To spread revenues or costs over two or more cost units, cost centers accounts or time periods”, (CIMA).

This process, which is common for indirect costs, involves the splitting or sharing of a common cost over the receiving cost centre on some basis which is deemed to reflect the benefits received. The following table gives examples of typical bases of apportionment.

Overhead Absorption: “A means of attributing overhead to a product or service based, for example, on direct labour hours, direct labour costs or machine hours” (CIMA). This is calculated thus:

Total cost centre overhead

Total units of base to be used

Conversion Cost: This is the term used to described the costs of converting materials purchased into finished or semi finished products. It is thus total production cost minus initial material input cost, that is, the sum of direct wages, direct expenses and absorbed production overhead.

Economists define conversion cost as total cost less material costs, that is, all overhead are included not just production overheads.

Added Value Or Value Added: This can be defined as “Sales value less the cost of purchased materials and services. This represents the value of an alteration in form, location, or availability of a product or service”, (CIMA).

Marginal Costing: Marginal costing can be defined as: “the accounting system in which variable costs are charged to cost units and fixed costs of the period are written-off in full against the aggregate contribution. Marginal costing is also known as ‘contribution approach’, and ‘direct costing’.

Its special value is in recognising cost behavior and, hence, assisting in decision making” (CIMA).

Arithmetically, Marginal cost is:

Direct material + Direct labour + Direct expense + Direct variable expense + Indirect variable expense.

The term marginal cost, at times, refers to the marginal cost per unit and also to the total marginal costs of a department or batch or operation. One can deduce its meaning from its context.

Cost Objects: A cost object is any activity for which a separate measurement of costs is desired. In essence, if the user of accounting information wants to know the cost of product/service, that service/product is called a “cost object”.

Examples are 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.

Avoidable Costs: These are savings in costs as a result of not altering or adopting a given alternative, for example, advert, insurance, donation, etc. Readers must note that only avoidable cost are relevant for decision making purposes. The decision rule is to accept those alternatives that generate revenues in excess of the unavoidable costs.

Unavoidable Cost: Are those costs that cannot be saved. Therefore unavoidable costs are irrelevant for decision making, for example, depreciation, security cost, etc.

Sunk Cost: This is a cost already incurred and therefore irrelevant to decision It is synonymous with historical or past cost, for example, salaries and wages paid, cost of machines already bought.

Relevant Cost: A relevant cost is a future cash flow arising as direct consequences of a decision.

Opportunity Cost: This is referred to as foregone alternative cost.

Incremental Cost (also known as differential cost) is the difference between costs and revenue for the corresponding items under which each alternative being considered.

Target Costing: “A product cost estimate derived by subtracting a desired profit margin from a competitive market price. It may be less than the planned initial product cost, but will be expected to be achieved by the time the product reaches the mature production stage” (CIMA).

Target costing is a market driven approach where market research establishes the performance requirements and target selling price required to gain the desired market share for a proposed product. The required profit margin subtracted from the target selling price to arrive at the target cost for the product is cost which in the long run must be met. Thus, accounting is driven by the requirements of the market place.

Costing System: This refers to a collection of procedures used in assigning cost to cost object. Typically, costing systems are classified as: direct costing system, traditional absorption costing system and activity output based costing systems.

INSTALLATION OF A COSTING SYSTEM

A costing system is not an arrangement which should be imposed on a business, rather it should be developed from a careful consideration of the business itself, and its special needs. It should, therefore, evolve out of the business and be adapted to it.

The aim should be to make the costing system as simple as possible and acceptable to the accounting staff. Obviously, to be of any value, it must produce helpful results promptly.

The following are essential to its success:

• There must be an efficient system of stores and stock control;
• There must be a well-designed wages procedure including the method of allocating labour cost to production;
• There must be a sound plan for the collection of all indirect expense (overhead) under suitable headings, and for its absorption to products or service departments on a predetermined basis;
• The cost and financial accounts should preferably be one integrated system. If not, the separate systems must allow for ease of reconciliation;
• Standard printed forms should be introduced wherever possible, giving the name and containing instructions as to what use is to be made of it; and
• The status of the cost accountant should be defined and his responsibilities and duties made clear. Adequate authority should be given to allow him access to all relevant records

MATERIAL COSTING – PURCHASING, RECEIPT AND STORAGE

Materials Control

Materials control involves the following procedures:

a) Stock control;

b) Purchasing;

c) Reception;

d) Storage; and

e) Issue to production.

Stock Control

Management must give careful consideration to the stock levels to be maintained. This applies to:

• Raw materials;
• Bought-in components;
• work-in-progress; and
• Finished goods.

Decisions on stock holding will be influenced by:

1. Cash available;
2. Storage space available;
3. Storage costs such as premises costs, insurance of stocks and possibly interest on capital invested in stocks;
4. Delivery delays;
5. Risks of stock losses, that is, wastage, pilferage, and obsolescence;
6. Minimum ordering quantities imposed by purchasing policy;
7. Purchase ordering (procurement); and
8. Required service level to works or customer (whether it is essential that the stores shall be able to meet every requirement on demand, and if not what percentage of failure to meet demand can be tolerated).

Centralised Buying

In large businesses, buying is usually decentralised. In essence, each department is responsible for its own purchasing. However, most businesses operate a buying department, that is, centralised buying, which is usually a very satisfactory arrangement.

Advantages of centralised buying are;

• A firm policy can be initiated with regard to conditions of purchasing e.g. terms of payment;
• Standardisation of articles is facilitated;
• Expert buying staff are concentrated in one department;
• The number of people authorised to make purchase commitments is reduced; and
• Combined purchasing power may result in reduced prices of commodities.

Disadvantages of centrahsed buying are:

• The creation of a special department may lead to high administration costs;
• The purchasing procedure is much less flexible than that geared to special departments; and
• Bureaucracy may lead to sub- optimal decisions.

Store Records

Two records are usually kept on materials received, issued or transferred, namely:

• on the Bin cards, and
• in the stores ledger. The Bin cards are written up in the stores, but the stores ledger is usually kept in the profit centres or in the accounts office.

The advantages in this procedure are:

(a) The Storekeeper is required to do the minimum amount of clerical work;

(b) The accounting records are maintained more accurately and in
a better condition by an experienced stores clerk than by an assistant in the
stores; and
(c) The balances on the bin cards in the stores can be easily compared with the balances in the ledger.

Centralised Storage
The advantages of operating central stores as compared with sub-stores are as follows:

(a) Economy in staff and concentration of experts in one department;

(b) Reduced clerical costs and economy in records and stationery.

(c) Better supervision is possible;

(d) Staff become acquainted with different types of stores which is very useful. If anyone is absent from work;

(e) Better lay-out of stores;
(f) Stocks are kept to minimum, thus reducing storage space;

(g) Inventory checks facilitated;

(h) Fewer obsolete articles; and

(i) The amount of capital invested in stock is reduced.

The disadvantages are:

(a) Increased transportation costs;
(b) The stores may be situated at some distances from many
departments, thus causing inconveniences and delay;
(c) Breakdowns in transport or hold-ups in central stores may cause
production stoppages in departments; and
(d) Possible loss of local knowledge.

Periodic Stocktaking
Periodic stocktaking main objective is to find out the physical quantities of all types of materials, that is, raw materials, finished goods, work-in-progress, etc. at a given date.

Factors to be considered are:
(a) Staff should be adequately available to receive clear and precise instructions on the procedures.

(b) The stocktaking should be organised into clearly defined physical areas and the checkers should count or estimate all materials in the area.

(c) Technical assistance should be available to identify materials, etc. in order to avoid far greater errors that are possible because of wrong classification rather than wrong counting.

(d) Effort should be made to ensure that only valid stock items are included and that invalid items are identified and excluded.

(e) Stock sheets should be given random independent checks to verify their incorrectness.

(f) The quantities of each type of materials counted should be compared against the stock record to expose any gross errors which may be due to stocktaking errors or faults or errors in the recording system.

(g) The pricing and extension of the stock sheets, where done manually, should be properly checked. Where the pricing and value calculations are done by computer, the only action necessary would be to input quantities and stock and part numbers.

Continuous Stocktaking

In order to avoid some of the disruptions caused by periodic stocktaking and to be able to use competent and reliable staff, many organisations operate a system whereby a proportion of stock is checked daily so that over the year, all stock is checked at least once.

Where continuous stocktaking is adopted, it is invariably carried out by staff independent from the store officers.

Continuous stocktaking is essential when an organisation uses the Perpetual Inventory system. This is a stock recording system whereby the stock balance is shown on the record after every stock movement, either issue or receipt.

Continuous stocktaking is important to ensure that the perpetual inventory system is functioning correctly and that minor stock mistakes are corrected.

Changes in Production and Purchasing Systems

There are a number of changes that takes place in industry which alters dramatically the way products are made and the organisation of production. These changes naturally influence supporting activities such as purchasing and storage.

Just-In-Time (JIT) Systems

JIT systems aim at producing the required items, of high quality, at the time they are required. JIT systems are characterised by the pursuit of excellence at all stages with a climate of continuous improvement.

JIT systems were developed and considered as one of the main contributions to the success recorded by the Japanese manufacturing outfit.

Attributes of JIT are as follows:
(a) a move towards zero inventory,

(b) elimination of non-value added activities,
(c) an emphasis on perfect quality, that is, zero defects,

(d) short set-ups,

(e) a move towards a batch size of one,
(f) 100% on-time deliveries,
(g) a constant drive for improvement, and

(h) demand-pull manufacture.

It is these latter attributes which gave rise to the name of Just-in-Time. It is also relevant to say that production only takes place when there is actual customer demand for the product so JIT works on a pull-through basis which means that products are not made to go to stock.

Exception to this is the traditional manufacturing approach of production-push where products are made in large batches and moved into stock.

There are two aspects to JIT systems, JIT purchasing and JIT Production.

JIT Purchasing

This should match the usage of materials with the delivery of materials from external suppliers. This means that material stocks can be kept at near-zero levels. For JIT purchasing to work, it requires the following:
(a) Assurance that suppliers will deliver exactly on time.

(b) That suppliers will deliver materials of 100% quality and quantity so that there will be no rejects, returns and consequent production delays.

The assurance of suppliers is all-important and JIT purchasing means that the company must have good working relationships with her suppliers. This is usually achieved by doing more business with fewer suppliers and placing long term purchasing orders in order that the suppliers have assured sales and can plan to meet the demand.

JIT Production

JIT production, as earlier mentioned, works on a demand-pull basis and seeks to eliminate all wastes and activities which do not add value to products. It considers the lead times associated with making and selling a product. These include:
3.4 Inspection time

3.5 Transport time

3.6 Queuing time

3.7 Storage time

3.8 Processing time.
Of these, lead times, only processing time adds value to product whereas all others add cost.

The aim of ET systems is to convert materials to finished products with a lead time equal to processing time in order to eliminate all activities which do not add value. Away of emphasizing the importance of reducing throughput time is to express the above lead times as follows:

In using activity based system to identify and prioritise the need for cost reduction, many organisations have found it convenient to categorise activities as either value added or non value added.

Value added activity may be as an activity which customers
perceive as adding usefulness to the product or service they purchase.

Non-value added activity relates to an activity where there is an opportunity to reduce cost (cost reduction) without necessarily reducing the product’s service need to the customer.

Under the JIT pull system, components are not made until requested
by preceding process. Consequent upon this, there may be idle time at

certain work station but this is considered preferable to adding to work-in-progress inventory.

Implementation of JIT Production System

The following implementation stages are essential to achieve the targets of low inventories and on time deliveries.

(a) The production processes must be simplified and reduced to the barest minimum.

(b) JIT systems require quality awareness programmes, statistical checks on output quality and continual staff training.

(c) The layout of the factory must be rearranged so that the production process is separated away from a batch production functional lay-out. Conventionally, factory machines are grouped by function. Their movement from one area of the factory to another often stopping along the way in a storage area constitutes non-value adding activities.

(d) The employees must be fully involved. It is relevant to state that one of the most important behavioral implications of JIT is that the status quo is continually challenged and there is a never ending search for improvements.

Benefits of JIT
(a) It reduces the investment on inventory.

(b) Due to low-inventory storage, there will be savings in the space required.

(c) Higher quality would result in customer satisfaction due to better deliveries.
(d) Elimination of waste and inefficiency improves performance.

2.0 Due to the flexibility of JIT and the ability to supply small batches, companies are able to respond more quickly to market changes and satisfy market needs.

Materials Requirement Planning (MRP)

Materials requirement planning is a computerised approach for coordinating the planning of materials acquisition, information and production in enhancing smooth production flow.

MRP main feature are:

(a) Estimation of the quantity and timing of finished goods demanded by the customers.
(b) The system determines the requirements for each product into
its various components for efficient scheduling.
The operation of an MRP system requires the following:
(a) A master production schedule specifying both the timings and
quantities demanded.
(b) A Bill of Material file (BOM) which shows the breakdown of
each finished product into sub-assemblies components and raw materials.
(c) An inventory file containing the balance on hand, scheduled
receipts and numbers already allocated for each sub-assembly, component and
type of raw material.
(d) A master parts file containing planned lead times of all items
to be purchased and internally produced components.

MRP has evolved into MRP II which integrates material resources planning, factory capacity planning and labour scheduling into a single manufacturing control system.

 INVENTORY CONTROL

Inventory control is the system used in a firm to control its investment in stock. This includes:
(a) the recording and monitoring of stock levels;

(b) forecasting future demands; and

(c) deciding when and how many to order.

The objective of inventory control is to minimise, in total, the costs associated with stock. These costs can be categorised into three groups:

3.4.1 Carrying Costs or Holding Costs:

(a) Interest on capital invested in stocks.

(b) Storage charges (rent, lighting, heating, refrigeration, and air conditioning.

(c) Stores staffing, equipment, maintenance and running costs.
(d) Material handling costs.
(e) Audit, stocktaking, stock recording costs.
(f) Insurance and security.

(g) Deterioration and obsolescence.
(h) Pilferage, evaporation and vermin damage.

Costs of Obtaining or Ordering Stock

(a) Clerical and administrative costs of purchasing, accounting and goods reception
(b) Transportation costs

(c) Where goods are manufactured internally, the set-up and tooling costs
associated with each production run plus the planning, production control costs
associated with the internal order.

 Costs of Being Without Stock (Stock – out Costs)

(a) Lost contribution through the lost sale caused by the stock out.

(b) Loss of future sales because customers may go elsewhere.

(c) Cost of production stoppages caused by stock-outs of work-in-progress and raw materials.
(d) Extra costs associated with urgent, often small quantity, replenishment orders.

The basic reason why stocks are held in the first instance is to avoid stock out costs.

Benefits of a Good Inventory Control System

Benefits of a good inventory control system are:
(a) Ensures proper execution of policies covering procurement and use of materials and make possible rapid shifts in business to meet changes in market conditions

(b) Obtains economies through a reduction in needless variety of items carried in stock.

(c) Eliminates delays in production caused by non-availability of required materials and tools.

(d) Avoids over accumulation of inventories and tools and thereby maintain the minimum investment consistent with production needs and procurement policies.

(e) Reduces inventory losses caused by inadequate inspection of incoming materials, damage, deterioration, obsolescence, waste or theft.
(f) Provides “balanced – stores” records to serve as a reliable basis
for effective production planning, economical procurement, cost accounting and

preparation of financial reports.

Over-stocking are stocks which are excess to current needs and it results in capital being tied up unnecessarily and increased costs of storage and obsolescence. Under-stocking may result in costly production holdups, which may mean increased costs of goods. It also interrupts production, making machines and men idle and causing sales loss.

Economic Order Quantity

In economic order quantity a formula is applied to incorporate relationships between ordering/obtaining and holding costs and order quantities. It is the quantity to be ordered that would minimize both ordering cost and holding cost

Assumptions in Economic Order Quantity (EOQ) Model
(a) The rates of demand are known,
(b) Ordering cost is known and constant,

(c) Stockholding cost is known and constant,

(d) There is instantaneous replenishment, that is, the delivery is done once.

Nevertheless, the EOQ calculation is a useful starting point in establishing an appropriate reorder quantity.

The EOQ formula is given below and its derivation given in ‘Quantitative Techniques’, continuum.

ILLUSTRATION

Typical methods of calculating the major control levels: Reorder level. Minimum level and Maximum level are illustrated below using the following data:

 

Required:
(a) Calculate:
(i) Re-order level

(ii) Minimum stock level
(iii) Maximum stock level.

(b) Comment on four factors, which may have to be taken into accounts in setting the maximum stock level

(c) The company required 80,000 units per year which will be used at a constant rate. The purchasing manager is considering what size to be used. The holding cost is 20% of the purchase price. The cost per order is N2,500 while the purchase price is N24 per unit. Calculate Economic Order Quantity, using the formula.

SUGGESTED SOLUTION

(a) (i) Re-order level
Maximum usage x maximum re-order period

= 27,000 x 3 = 81,000 units

(ii) Minimum stock level
= Re-order level – (normal usage x normal re-order period)

= 81,000 – (24,600 x 2) = 31,800 units

(iii) Maximum stock level

= Re-order level + Re-order quantity – (minimum usage x minimum re-order period)
= 81,000 + 10,000 – (6,400 x 1.5)

= 81,400 units

(b) Factors to be considered in setting maximum level include:

(i) The availability of storage space

(ii) The nature of the stock material

(iii) Seasonal nature of the material

(iv) Lead time, that is length of period between placing and receiving orders.
(v) Rate of consumption of the material.

(c) Annual demand = D = 80,000

Holding cost = 20% x N24 = N4.8 = cc Ordering cost = C = N2,500

MATERIAL COSTING – PRICING ISSUES AND STOCKS

There is no point in detailed analysis of pricing systems for charging purposes unless the basic records are accurate and up to date. The system of issues, job recording, scrap records, material returns, material transfers, defective material returns, inspection records etc. must be continually monitored to ensure its relevance and accuracy.

Objectives of Material Pricing
There are two main objectives of material pricing:

(a) To charge to production on a consistent and realistic basis the cost of materials used; and
(b) To provide a satisfactory basis of valuation for inventory on hand.

Factors that affect Materials Pricing
Factors that affect materials pricing are:
(a) Frequent changes in prices for bought-in materials and components;

(b) The stock of any given material is usually made up of several deliveries which may have been purchased at different prices;

(c) The frequent impossibility (and undesirability from a costing view point) of identifying items with their delivery consignment; and

(d) The sensitivity of profit computations to the adopted pricing method where materials form a large part of total cost.

General Features of Pricing Systems

When an issue is made from Stores, the Materials Requisition would be passed to the cost department for pricing and an extension of appropriate ledger entries made:

Dr: Work-in-progress control A/C
(direct material issues)
Or

Overhead control A/C
(indirect material issues)

Cr: Store Ledger control A/C

To be able to use some of the pricing systems described below (For example, the FIFO and LIFO methods) the stock recording system has to be comprehensive enough not only to record overall quantities and prices, but also the number or quantity received in any one batch. This is so that issues can be nominally identified against batches which is necessary to establish the appropriate price to be charged.

Methods of Pricing Store Issues
(a) First in First out (FIFO)

Under this method, issues are valued at the price of the oldest batch in stock until all units of the batch have been issued when the price of the next oldest is used. In essence, as the issues are received, they are charged out to production.

(b) Last in First out (LIFO)

Under this method, issues are charged out at the price of the most recent batch received and continue to be charged until a new batch is received, that is, the last issues received are charged out first to production.

(c) Average price method

The average price method is a perpetual weighted average system where the issue price is recalculated after each receipt taking into account both quantities and value.

(d) Specific or unit price

The item issued can be identified with the relevant invoice where the actual cost can be charged. This is usually only possible with special purpose items bought for a particular job.

(e) Standard price
This is defined as:

“A predetermined price fixed on the basis of a specification of a product or service and of all factors affecting that price” (CIMA). A standard or planned price is an average price predicted for a future period and all issues/returns would be made at the standard price for the period concerned. It uses the expected purchase price as a standard.

(f) Replacement price

Under this method, issues are charged out at the buying price on the day of issue. There are many variants to this approach. For example, buying prices may be established by means of a price index or actual prices updated on a monthly basis.

(g) Base stock method

This is not strictly a method of valuing issues, it assumes that initial purchases were to provide a buffer or base stock and that this base stock should appear in all subsequent stock valuations at its original cost.

A disadvantage of the base stock method is that the resultant stock values could be totally unrealistic.

LABOUR COSTING

Personnel Engagement

Management will determine the optimum number of workers for each department. Adequate communication must exist between the personnel department, the factory and the wages office. The personnel department will maintain records of past and present employees and, in particular, should obtain reasons for all terminations of employment.

 Time Keeping for Control

It is important that good time keeping is enforced. This is usually affected by time clocks at the entrance to the factory or the individual departments.

Time Keeping for Accounting

It is essential to relate labour costs to individual jobs and processes and to achieve this, it is necessary for each worker to record the time he spends on each individual activity. The methods of time booking in existence are:
(a) Daily time sheet,
(b) Weekly time sheet,
(c) Job tickets,
(d) Job cards attached to each job, and
(e) Mechanical time booking.

The daily and weekly time sheets are prepared by the worker and should account for all working hours.
The job ticket may be completed by the worker or the cost office relating to one activity forming part of a job. As the activity is finished, the ticket is submitted to the cost office which summarises all the tickets relating to a particular job in order to ascertain the total costs thereof.

The job card actually circulates with the job and so it is not possible to ascertain labour costs until the job is completed and the card returned to the cost office. In some systems, the job card is returned weekly for cost control and is replaced by a ‘balance card’ for subsequent time records.

There are a number of mechanical devices available today with which workers can ‘clock’ their time to specific jobs.
An analysis of labour is required for costing purposes for the following categories of costs:
(a) production jobs, analysed by the numbers,
(b) indirect labour such as idle time or cleaning up,
(c) time taken setting up machinery analysed by job numbers.

LABOUR REMUNERATION

Just-In-Time JIT)

The modern forms of production organisation, such as Just-In-Time systems mean more and more workers will be paid time rates and will not have their pay dependent on individual output levels.

Time Based Systems

Basic System

Workers would be paid for the number of hours worked at a basic rate per hour up to say, 40 hours in a week. Time worked in addition to 40 hours would be treated as overtime and is usually paid at a higher rate, for example ‘time and a quarter’ (that is 11/4 x basic rate per hour) depending on the number of extra hours worked and when the overtime was worked.

It is important to say here that although workers’ pay is not related to output, this does not mean that output performance is not relevant and fundamental. It is normal practice to monitor output and performance closely by factory floor supervision and managerial control systems so that workers are paid for actually working and not merely attending or hanging around.

Advantages of time based system are:
(a) Easy to understand and administer

(b) Simplifies wage negotiations in that only one rate needs to be determined unlike the continuous complex negotiations over individual rates.

Disadvantages:
There is no incentive to increase output.
(b) All employees in the grade are paid the same rate regardless
of performance.

(c) It requires effective supervision.

High Day Rate System

This system is designed to provide a strong incentive by paying rates higher than the normal rates in exchange for above average output and performance. For the application of the rate system to be successful, it is necessary to ensure that the output levels are the result of detailed work studies and that there is agreement with the labour force and the unions involved on the required production level.

Merits of the High Day Rate System are:
(a) It attracts higher grade workers.
(b) It provides a direct incentive without the complications of individual piecework rates.
(c) It is simple to understand and administer.

Demerits of High Day Rate System are:

(a) It encourages agitation for better remuneration to attract the best workers.

(b) It brings about problems when the original target production figures are not met.

The system is also called ‘Measured Day Work’.

Common Bonuses in Time-Based Systems

In addition to the time rates outlined above, bonuses or extra payments are frequently made.

Example of bonuses are:

(a) Shift bonus: A worker agrees to work shifts particularly where rotating shifts are used, he receives an extra amount.

(b) Timekeeping bonus: A person’s timekeeping has been good over the week, a bonus may be paid.

(c) Continuous working bonus: The plant achieves continuous production without strikes, go slows or stoppages, necessitating a weekly bonus payment.

INCENTIVE SCHEMES

General Features of Incentive Schemes

Under this scheme, payments are related to output in some way or another. There are lots of variations. Some schemes apply to individuals while others apply to groups of workers. Some have a direct and immediate relationship to output whilst others are indirect In an organised and well planned system, both the firm and the employees can benefit.

The employee from the extra income arising from increased production, and the firm from the reduced overheads per unit of the increased production. Regrettably, not all schemes achieve this objectives. The following factors should be considered:

(a) Workers efforts should be taken into consideration and payment should be made without delay.

(b) Employees should be able to calculate their own bonus, hence, simple scheme should be introduced.

(c) Performance levels should be demonstrably fair, that is, they should be in reach of the average worker, working reasonably hard.

(d) There should be no artificial limit on earnings and earnings should be safeguarded when problems arise outside the employee’s control.

(e) The scheme should not be introduced until there has been full consultation and
agreement with employees and unions.

(d) Performance levels, rates, etc must be considered, so that it will be on for a reasonable length of life. Rapid changes especially artificial one curtail earnings and therefore, destroy trust and cause problems.

(g) Employees should be consulted and agreement reached before the implementation.

ADVANTAGES AND DISADVANTAGES OF INCENTIVE SCHEMES

Advantages

(a) It increases production, thereby increasing wages but also reducing overheads per unit, particularly where there are substantial fixed overheads.
(b) It enables a firm to remain competitive in inflationary periods.

(c) It improves morale by ensuring that extra effort is rewarded.
(d) It attracts efficient workers towards the opportunity of earning
higher wages.

Disadvantages

(a) There are problems in establishing performance levels and rates with frequent and continuing disputes.

(b) Some incentive schemes are expensive to administer and complex.

(c) Some group of workers, although relatively unskilled, may earn high wages through incentive schemes whilst others engaged on skilled work may become resentful when differentials are eroded.

Types of Incentive Scheme
(a) Individual Incentive Schemes

Incentive schemes which relate to an individual worker seem to be the more usual and successful, probably because of the immediate and direct relationship between effort and reward.

(b) Straight Piecework

The worker would be paid an agreed rate per unit for the number of units produced. On occasions, the number of operations would be the basis of payment, or where various types of articles are produced, a piecework time allowance per article would be set and the worker paid for the piecework hours produced.

(d) Group Incentive Schemes

It has been observed that individual based incentive schemes are common and successful but using group scheme will be much ideal in some type of business. Such businesses are:
(i) Road surfacing or local mining

(ii) Cars or domestic appliances.

Any of the incentive methods (piecework, differential piecework,
premium bonus systems, etc.) can be used, with appropriate adoption,

for group scheme. In addition, because of the wider scope of a group scheme, incentives based on cost savings, delivery dates, quality norms are used.

MERITS AND DEMERITS OF GROUP SCHEMES

Merits
(a) It engenders closer co-operation in the group and a team spirit.

(b) It is simple to administer, especially with recording of labour times, production rates etc.

(c) Support-workers, not directly associated with production, can easily be included in the scheme.
(d) It reduces the number of rates to be negotiated.

(e) It encourages more flexible working arrangements within the group.

Demerits
(a) It is less direct than individual schemes. Provision of some incentive is difficult.

(b) It causesfriction as itrewards bothefficient and less
hardworking members of a group with same bonus.
(c) It is difficult to obtain agreement on proportions of the bonus
which group members will receive.

Trends in Labour Costing

Labour costs were a major proportion of total cost in the past. This means that it was worthwhile carrying out a thorough analysis of labour costs and making the necessary detailed accounting entries. The position today is very different Factories are highly automated and labour is a small (and reducing) proportion of total cost. In these circumstances simpler costing systems are being used for labour with some companies eliminating direct labour accounting completely, and treating labour as part of overhead.

It is important to note that:

(a) Incentive scheme may increase the labour cost per unit but as long as the reduction in overhead cost per unit is sufficient, the scheme should be worthwhile.

(b) Incentive schemes are not only applicable to manufacturing. The Federal government is attempting to introduce ‘Performance Related Pay’ across the public sector and civil servants, local government officials, teachers and others are being targeted.

(c) It is a common costing practice to charge overtime wages above basic rate to overheads rather than direct wages. For example, if the basic rate is N4 per hour and overtime is paid at ‘time and a quarter’, then N4 per hour would be charged to direct wages and N1 per hour charged to overheads.

An incentive scheme is any method of remuneration based on labour performance. Such incentive schemes may relate to individuals or groups.
(a) Profit sharing
(b) Co-partnership

(c) Benefits-in-kind

Labour Reports

Regular reports should be prepared to indicate the efficiency (or otherwise) of labour. These will include:
(a) Labour turnover report
(b) Comparison of labour time and costs with output
(c) Lateness reports

(d) Idle time reports
(e) Overtime reports.

Labour Cost Accounting
A brief description of the system is as follows:

(a) Clock cards (attendance records) are reconciled with time sheets (record of work done),

(b) The employee’s total ‘gross’ pay is credited to the payroll control account and debited either to the work-in-progress control account for the amount allocated to productive jobs, or to an overhead control for total non-productive time. Readers are referred to the general accounting entries under general features of Pricing Systems. The amount attributed to each individual job or overhead code will be charged to the appropriate job card or overhead analysis account – these being subsidiary records supporting the work-in-progress and overhead control accounts. There are a number of alternative methods of making these bookings in practice.

(c) Deductions from gross pay such as national insurance contributions, loan

refund and taxation will be debited to the payroll control account and credited to control or suspense accounts pending disbursements to the relevant authorities.

(d) The net wage paid to each employee will be credited to the cash account and debited to the payroll control account which is thus cleared,

Labour Turnover

(a) Ratio Calculation
The labour turnover ratio is calculated using the standard formula:

Number of Employees that left and Replaced x 100%

Average Number of Employees

This formula is one of several which could be used but is chosen because it is not affected by those leaving for whom no replacement is intended, for example, redundancy, natural wastage. The average number of employees thus remains fairly constant over the year, indicating quite clearly changes in the rate at which personnel are leaving.

(b) Costs of Labour Turnover

These include:

(i) Costs of filling the vacancy, such as advertising, interviewing costs;
(ii) Costs of training, for example, induction courses, supervisor time;

(iii) Loss of production due to the difference in skill between the trained employee and the trainee;

(iv) Higher scrap and wastage costs during initial training.

(c) Possible Remedies

Naturally, there is little that can be done to prevent employees leaving. Events such as illness or pregnancy are outside the immediate control of the company and can be classed as unavoidable. In order to reduce the avoidance loss to manageable proportions, possible courses of action are as follows:

(i) Personnel Selection Deployment Procedures

These should be reviewed in order to ensure that not only are suitable employees taken into the firm, but that every effort is made to fit them into the right job.

(ii) Training and Development

Revision of the training and development programmes are advised to ensure that employees have sufficient scope for promotion and personal betterment.

(iii) Remuneration

The number of firms paying highly competitive wages is on the increase. An investigation into the effect of possible wage increase is indicated.

(iv) Working Conditions and Welfare Facilities

A gradual decrease in the level of personnel can be traced in part to a lack of consideration on the part of management to the social needs of the employees.

Improvements in working conditions; welfare facilities and leisure activities can assist in the development of a more stable work force.

ILLUSTRATION

From data below, you are required to compute the total earnings of the three employees of Sangodiya Industries Limited for the month of July 2005.

Required: Calculate the gross pay for each of the employees based on the following methods:

(i) Halsey using 50% of time saved
(ii) Halsey – Weir

(iii) Rowan

SUGGESTED SOLUTION

DIRECT EXPENSES

Direct expenses are those costs other than materials or labour which can be identified directly with a particular cost unit. In many types of businesses, direct expenses will be insignificant and as a matter of convenience, all expenses will be treated as indirect.

In other instances, particularly where work is carried out at a number of sites, such as civil engineering, it will be possible to allocate the majority of the expenses directly to a particular cost unit.

Examples
(a) Plant hire, if the plant is hired to manufacture a specific cost unit.

(b) Sub-contracting, where the jobs are sent out for special work
(c) Travelling expenses to sites, particularly for contractors.

(d) Royalty payments as royalties are charged as a rate per unit.
(e) Salesmen’s commission as this is often based on the sales value of units.

 OVERHEADS

Overheads are those costs which cannot be related to an individual cost unit. They are identified, therefore, in the first instance with:
(a) Classification of cost in the ledger.
(b) Departments or cost centres where they can be controlled.

Overhead Charges
These can arise from the following:

(a) Material requisitions for small tools, consumable stores and other stock items which are not customarily identified with production jobs.
(b) Time sheets for labour bookings to non-productive work, idle time etc.

(c) Supplier: invoices for goods such as stationery and for service such as electricity, rent telephone charges etc.

(d) Petty cash vouchers for small disbursements.

Overhead Analysis
(a) Overheads are collected and analysed.
(b) Overheads are allocated to (identified with) production and service cost centres.

(c) Overheads are apportioned to (shared among) production and service centres.

(d) Service cost centre overheads are re-apportioned to productive cost centres.

(e) Cost units are charged according to the benefits they have received from each cost centre. This means that they are allocated on an equitable basis.

Allocation and Apportionment
Some overheads arise solely because of the existence of a particular cost centre. These overheads are direct, in view of the fact that, cost centre is concerned and can be allocated to it.

The majority of overheads are not caused solely by one cost centre and it is, therefore, not possible to allocate costs directly to individual cost centres. In these cases, it is only possible to apportion costs on a reasonable basis.

Bases of Apportionment

There are many bases for apportioning overheads and the choice of a suitable basis is largely a matter of common sense. Examples of overheads together with the manner in which they might be apportioned are:
(a) Cooling and heating costs – number of compressors and radiators in each cost center
(b) Rent-relative floor area in each cost centre

(c) Depreciation of machinery – capital values of machines.
(d) Canteen, Supervision, personnel – number of employees.

(e) Telephone costs- number of extensions
(f) Power- technical estimate.

Re-apportionment of Service Cost Centre Costs 

Having charged all overheads to individual cost centers (production and service), it is necessary to re-apportion all service costs center costs to the production. The following are examples of the service cost centres to be found in a typical engineering factory:
(a) Maintenance room

(b) Inspection
(c) Stores

(d) Canteen

(e) First aid
(f) Production.

The cost of the various departments will be apportioned to the productive cost centres on the basis of the benefit received by each cost centre.

Reciprocal Service Cost
Where there are a number of service departments, they may supply their

services to one another as well as to productive departments. Finding an equitable basis of apportionment may prove difficult because of the number of variable factors involved. One of the following methods can be applied:

(a) Simultaneous equation

(b) Repeated distribution

(c) Apportioning the costs of the service centre which received least benefits from other service centres first and then repeating the process until all service department costs are apportioned.

OVERHEAD ABSORPTION

Definition:

“A means of attributing overheads to a production service based, for example, on direct labour hours, direct labour cost or machine hours” (CIMA).

Having analysed overheads to productive cost centers, a fair share of these overheads is charged to each of the cost units passing through a cost centre. This process is termed ‘overhead absorption’. In order to absorb overheads into cost units, the process entails the computation of an overhead absorption rate. This is computed by the following formula:

Total cost centre overheads

Total units of base to be used

There are many bases for absorption. Some of them are as follows:
(a) % of Direct materials cost

(b) Direct labour hours
(c) % of Direct labour cost

(d) % of Prime cost

(e) Machine hours
(f) Units of output/production.

The absorption rate is normally based on budget cost and output figures.

Argument for Absorption Overheads

(a) The main argument for absorbing overheads costs is that they must be recovered if the firm is to make profit and the best way to recover overheads costs is to charge each department and ultimately, each product with a share of them,

(b) Another problem is the nature of the overheads which are charged to products. They will usually be combination of two different classifications:
(i) Those which vary with the level of output (variable overheads)

(ii) Those which remain at a constant level, regardless of the level of production (fixed overheads)

Pre-determined Overheads Absorption Rates

To obtain accurate costs, it is necessary to wait until the end of the accounting period to obtain the total costs and the total units of the base of absorption. In seasonal types of business, it will be necessary to wait for the end of an accounting cycle in order to obtain the necessary information.

In practice, it is not usually possible to wait until the end of an accounting period before preparing costing information and it is necessary to use estimated figures. Such estimates are termed “pre-determined overhead absorption rates” and are calculated in the following way:

Budgeted overheads for future period
Budgeted units of base for future period.

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Over And Under Absorption

With pre-determined overhead rates, it will almost always be found that actual overheads incurred differ from the amount of overheads absorbed. This over-or under-absorption may be caused by two factors:
(a) Difference between actual and budgeted overheads

(b) Difference between actual and budgeted units of base.

Blanket Absorption Rate

A blanket absorption rate is one which is applied to a whole factory Such a rate fails to distinguish between cost units which incur a large amount of overhead in mechanised processes and those which incur a smaller amount of overhead in manual processes. A blanket absorption rate can produce completely erroneous results.

Non-Production Overheads

The same principle with respect to production overheads shall also apply to non-production overheads.

(a) Selling overheads should not be absorbed into the cost of goods produced since the selling cost is part of administration overheads. The source documents for these entries are material requisitions [indirect materials], time sheet [non-productive time], the invoice analysis for purchase on credit and possibly, an analysis of petty cash payments. There will also be some overheads derived from internal calculation such as depreciation charges.

(b) The total factory overheads are analysed to cost centres on sheets sometimes called standing order numbers. This is a two way analysis, each standing order number containing a particular type of cost and analysing it across productive and service cost centres.

(c) Non-productive overheads are analysed on similar sheets called cost account numbers.

(d) The total of the standing order numbers are summarised into a departmental distribution summary and this in turn forms the basis for the computation of the overhead absorption rate of the department concerned.

(e) Overhead absorbed [applied] is entered on the individual job or process record and debited in total to the work-in-progress account. The corresponding credit can be made to the overhead control account.

(f) The individual job or process records may show only works cost, or percentage additions may be made for the non-productive overheads.

Depreciation

Depreciation charges are intended to represent the diminution in the value of a fixed asset due to use or lapse of time. Provision for depreciation may be calculated by any of the following methods:

(a) Straight-line: Under which the cost of an asset, possibly after deducting its forecast residual value, is written off by equal annual installments over its useful life. For example, an asset may have cost 5,000 and is expected to be used for five years after which it will be sold as scrap for 200. The annual depreciation charge will be:

N 5,000 – N 200 = N 960
5

(b) Reducing Installment: Under which depreciation is calculated each year at a fixed percentage of the residual asset value. For example, you are to depreciate the asset costing N5,000 at 15% per annum. In this case, the first year’s depreciation would be 15% x N5,000 = N750. The second year’s charge would be 15% x [N5,000 -750] = N637.5 and so on.

(c) Production unit: This is a method entirely based on use. An estimate is made of the number of units to be processed by a machine during its lifetime, and the cost of the machine is divided by that number of units to give a unit rate of depreciation. The depreciation charge for any year will be found by multiplying the number of units produced by the unit rate.

(d) Production hour: This is similar to the production unit method, but using the forecast number of working hours in the effective life of the machine instead of the number of units it will produce.

The maintenance of an asset register will facilitate the calculation of depreciation, provide continuous record of residual values, and enable depreciation charges to be allocated to cost centres.

Interest: This is usually omitted from costing records. It is advisable to bring interest into account in special report for decision making where it is significant.

Taxation: This should be considered in decision making when comparing alternative courses of action especially under investment appraisal.

ACTIVITY BASED COSTING [ABC]

This has developed to resolve the defects that conventional absorption costing absorbs support overheads into product costs. Traditionally all overheads were absorbed on production volume [measured as labour or machine hours] although, many support overheads vary, not with production volume, but with the range and complexity of production.

ABC is a recent approach to product costing, pioneered by Professors Kaplan and Cooper of Harvard University. ABC is aimed at using only cause and effect cost allocations. It is an attempt to reflect more accurately in product costs, those activities which influence the level of support overheads.

This includes such items as inspection, production planning, set-up tooling and other costs. Traditionally, all overheads were absorbed in production volume as measured by labour or machine hour.

Traditional volume related overhead absorption tends to over-cost products made in the long run and under cost products made in the short run. ABC seeks to overcome this problem in the following ways:
(a) short-term variable costs

(b) Long-term variable costs

(a) Short-term variable costs

ABC recognises that there could be several costs drivers wherever labour hours, machine hours and material costs are used in different proportions by products. In most organisations, there will only be a small proportion of overheads that can be classed as short-term variable costs.

(b) Long-term variable costs

These are overhead costs which do not vary with production volume but vary with other measures of activity, for example, costs for support activities such as stock handling, production scheduling to the range and complexity of the products manufactured.

ABC requires that these costs be traced to products by transaction based cost drivers. Most support overhead can be classified as longterm variable costs and thus traced to products using appropriate cost drivers such as making procurement order. In the traditional system, most of these would be classified as fixed.

(c) Fixed costs Using
ABC, these are classified as costs which do not vary, for a given

time period with any activity indicator. An example would be the salary of the Managing Director. Research conducted by Kaplan and Cooper (1992) suggests that these are a relatively small proportion of the total costs.

COST POOLS AND DRIVERS

Cost Pools

Cost pools can be defined as “The point of focus for the cost relating to a particular activity in an activity-based costing system” (CIMA).

There are difficulties in choosing realistic cost drivers Kaplan and Cooper (1992) warns:

“There are no simple rules that pertain to the selection of cost drivers. The best approach is to identify the resources that constitute a significant proportion of the products and determine their cost behaviour If several are long-term variable costs, a transaction based system should be considered”

Cost Drivers

“Any factor which causes a change in the cost of an activity e.g. the quality of parts received by an activity is a determining factor in the work required by that activity and therefore affects the resources required. An activity may have multiple cost drivers associated with it” (CIMA).

It may be decided that an activity based system is required then the appropriate cost drivers are chosen and the costs associated with each activity are gathered together in cost pools.

Cost pools are similar in principle to cost centres in traditional system. Costs are pooled, or collected, on the basis of the activity that drives the costs regardless of conventional departmental boundaries. For example, if the cost driver is a number of set-ups, then all costs relating to activity of setting-up will be pooled together.

Cost pools are not necessarily related to departmental boundaries nor do they include all the activity of a single department as the cost drivers may differ for the various activities carried out within the same department.

Selecting Cost Drivers

Basically, there should be a direct cause relationship between the consumption of overheads and the chosen cost driver. There should be a causal relationship between the amount of resource use, and therefore, the level of cost, and the volume of the selected cost driver.

The relationship is not necessarily a short-term one. This is because salaries and related personnel costs make up a significant proportion of most support overheads and these costs are not easily adjusted in the short-run, hence; Kaplan (2001) defines it as ‘long-run variable costs’.

Factors that affect Cost Drivers
The factors that most likely affect cost drivers are;

(a) Accuracy

The greater the level of accuracy required of product costing, the more the cost drivers.

(b) Correlation

The more closely a cost driver correlates with activity use, the fewer distortions in products cost and the fewer cost drivers.

(c) Homogenity

The cost pool should be homogenous. It can fairly be represented by one cost driver. Where this is not possible, the pool may need to be sub-divided and numerous cost drivers used and the resultant effect make the system more complex and costly to administer.

(d) Inspection

This is the extent that one cost can be fairly applied to diverse products. If the cost driver, ‘number of inspections’ was used to trace Inspection costs to products, distortions will be introduced. If inspections take varying amounts of time for different products, inspection hours may be a better cost driver or there may be a need for several cost drivers to trace cost fairly.

Cost Drivers used in Practice

Conventionally, the cost pools and cost drivers chosen must suit the organisation, the products or services and the objectives of the ABC system. As a consequence, they will vary from organisation to organisation and there are, no universally applicable examples.

Example of Cost Driver Calculation and Use

An organisation introduced ABC and has separated its main activities into reasonably homogenous cost pools. Cost drivers have been selected for each pool.

(j) It provides realistic product costs most especially in Advanced Manufacturing Technology [AMT] factories where support overheads are a significant proportion of total costs.

(k) It enhances the tracing of overheads to the product. In modem factories, there are a growing number of non-factory floor activities. ABC is concerned with all activities.
(l) It recognises activities which cause cost, and not products.

(m) It focuses attention on the real nature of cost behaviour and helps in reducing costs and identifying activities which do not add value to the product.

(n) It also recognises the complexity and diversity of modern production by the use of multiple cost drivers, many of which are transaction based rather than based solely on production volume.

(o) It provides a ‘reliable indication of long-run variable product cost which is relevant to strategic decision making.

(p) It is flexible to trace costs to processes, customers, areas of managerial responsibility, as well as products costs.

(q) It also provides useful financial measures, for example, cost driver rates and non-financial measures – transaction volumes.

Demerits of ABC
These include:

(c) the preference for particular cost drivers – it is a simplistic assumption that a chosen cost driver is an adequate summary measure of complex activities.

(d) the assumption of a direct linear relationship between the usage of a cost driver and the amount of overheads. It is widely known that very few costs are truly variable, whether in the short or long term.

(e) the issue of common costs – it is difficult to attribute costs to single activities; hence, some costs support several activities.

(f) tracing difficulties – It is not always apparent which product should carry the traced overhead.
(g) Complexity – A full system having numerous cost pools and cost drivers is more complex and consequently more expensive to operate. This need not be a problem provided that the benefits outweigh the costs.

ACTIVITY BASED ACCOUNTING [ABA]

Activity Based Accounting is a new approach to internal accounting. It focuses on analyzing, recording, controlling and reporting on the costs and wider performance of activities rather than the conventional emphasis on merely the costs of departments and cost centres.

Activity based accounting includes:
(i) Activity Based Costing [for product costing],
(b) Activity Based Budgeting or Activity Cost Management [for cost planning and control] and
(c) Activity Performance Measurement [for performance monitoring using both financial and non-financial indicators].

All these approaches are covered in detail later in the study pack. It has strong behavioural influences and is widely used to promote cost reduction and increase efficiency

CONCLUSIONS

Cost accounting system largely focuses on the analysis of past costs and operations. The prime cost is the addition of the total direct material plus direct labour plus direct expenses while the total indirect costs is referred to as overhead.

Overheads are determined by defining cost centres and then allocating and apportioning costs to the cost centres using bases of apportionment which are deemed to reflect the benefits received. These overheads are spread over cost units by adopting overhead absorption rates usually based on labour or machine hours.

Where all costs whether variable or fixed are included in production costs, the system is “absorption costing” and where fixed costs are excluded from production costs and charged as period costs, the system is referred to as “marginal costing”.

The major material pricing systems are FIFO, LIFO, replacement price, weighted average price and standard price.

ABC collects overheads into cost pools and traces these to products using cost drivers with overhead being long term variable costs that vary more with product complexity and diversity than production volume.

Cost pools are homogeneous and are single cost drivers that relate directly to the amount of resources used.

ABC has strong behavioral influences and is widely used to promote cost reduction and increase efficiency.