Cost & Management Accounting

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1 The TVET First NATED Series offers students and lecturers a wide range of courses, written by lecturers, examiners and subject experts. Troupant/Macmillan have developed brand new books that cover the curriculum and that address developments in the various fields by bringing subject matter up to date. The books include: relevant and attractive illustrations activities Cost & Management Accounting N5 Cost & Management Accounting TVET FIRST NATED SERIES NATED Series N5 Cost & Management Accounting examples N5 Student s Book cost/managment acc N5-A4.indd 1 T Lakhan Student s Book TVET FIRST NATED SERIES new word definitions. 2015/08/28 4:01 PM

2 N5 Cost & Management Accounting Student s Book T Lakhan

3 Cost & Management Accounting N5 Student s Book T Lakhan, 2012 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, photocopying, recording, or otherwise, without the prior written permission of the copyright holder or in accordance with the provisions of the Copyright Act, 1978 [as amended]. Any person who does any unauthorised act in relation to this publication may be liable for criminal prosecution and civil claims for damages. First published in 2012 by Troupant Publishers [Pty] Ltd PO Box 4532 Northcliff 2115 Distributed by Macmillan South Africa [Pty] Ltd ISBN: Web PDF ISBN: It is illegal to photocopy any page of this book without written permission from the publisher. While every effort has been made to ensure the information published in this work is accurate, the authors, editors, publisher and printers take no responsibility for any loss or damage suffered by any person as a result of reliance upon the information contained herein. The publisher respectfully advises readers to obtain professional advice concerning the content. While every effort has been made to trace the copyright holders and obtain copyright permission from them, in some cases this has proved impossible due to logistic and time constraints. Any copyright holder who becomes aware of infringement on our side is invited to contact the publisher. Note: Any reference to Further Education and Training (FET) in this book should be taken to mean Technical and Vocational Education and Training (TVET). To order any of these books, contact Macmillan Customer Services at: Tel: (011) Fax: (011) customerservices@macmillan.co.za

4 Contents MODULE 1: INTRODUCTION 1 Unit 1.1: Fields of accounting....2 Unit 1.2: Management functions....4 Unit 1.3: Cost classification....9 Unit 1.4: Cost systems Unit 1.5: Unit, fixed, and variable costs MODULE 2: MATERIALS 39 Unit 2.1: Terminology Unit 2.2: Stock transactions Unit 2.3: Accounting entries MODULE 3: LABOUR 66 Unit 3.1: Influences on labour productivity Unit 3.2: Cost of labour Unit 3.3: Wage control Unit 3.4: Accounting entries MODULE 4: MANUFACTURING OVERHEADS 89 Unit 4.1: Classification of manufacturing overheads...90 Unit 4.2: Budgeted manufacturing overheads...92 Unit 4.3: Basis of allocation Unit 4.4: Actual manufacturing overheads Unit 4.5: Recovery of manufacturing overheads Unit 4.6: Accounting entries MODULE 5: ACCOUNTING SYSTEMS 113 Unit 5.1: Accounting systems used by manufacturing organisations Unit 5.2: The flow of transactions in an integrated system MODULE 6: FINANCIAL STATEMENTS 128 Unit 6.1: Financial statements GLOSSARY 138 BIBLIOGRAPHY 141 iii

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6 MODULE 1 INTRODUCTION At the end of this module, you must be able to: Describe the different fields of accounting and identify the most important differences. Demonstrate an understanding of the place and functions of: Financial accounting Cost accounting Management accounting. Define the four basic management functions. Identify qualitative and quantitative information needed for management decisions. Set objectives for short- and long-term decisions. Compile an organisational chart for a production concern. Describe the term cost. Describe the methods of accumulating and allocating cost data. Describe the terms: Prime product cost Conversion cost. Describe the periodic system briefly. Describe the perpetual system briefly. Describe the terms: Unit cost Fixed cost Variable cost. 1

7 Introduction Since you started studying accounting at school, you have been studying financial accounting, as contained in the accounting cycle in Figure 1.1 below: Figure 1.1: The accounting cycle UNIT 1.1: FIELDS OF ACCOUNTING Different fields in accounting focus on different areas. The main fields in accounting are: Financial accounting Management accounting. Financial accounting focuses on recording and maintaining the financial transactions in a business. Furthermore, it involves the preparation of financial statements (usually at the end of a financial period) to report on the financial results and position of a business. Management accounting is concerned with the provision of information to people within the organisation to help them to make decisions and improve the efficiency and effectiveness of existing operations (Drury, 2004: p. 7). 2

8 Cost accounting basically focuses on accumulating and calculating the production costs in a business, i.e. how much does it cost a business to produce the products they are producing to sell. It is very important for businesses to know the cost of its production so that it can determine its profit and sales. Cost accounting forms the link between financial accounting and management accounting. It uses the information generated by the financial accounting process to calculate the production costs in a business and presents this information to management, who will use it to make sound decisions regarding the business s future. In practice, cost accounting and management accounting are treated as a single discipline. Financial accountants determine what the costs and incomes of a business are and what profit or loss the business has made. Cost accountants determine what the costs of production are, i.e. how much it cost the business to produce the amount of finished goods they actually produced. They focus on reducing costs so as to maximise profits. Management accountants will take all this information and make good decisions about the business s future in order to maximise profits in the future. Users of information Users of financial information can be broken up into internal and external users. Internal users are those who are involved in the day-to-day running of the business, while external users are those who are not. Internal users Employees Managers Owners External users Banks Shareholders Potential shareholders Creditors Government Table 1.1: Internal and external users of information 3

9 Differences between financial accounting and management accounting Financial accounting Reports are prepared according to standards and GAAP Provides information for external users Reports on a business as a whole, e.g. shows the net profit of the business Reports on transactions that have already occurred (historical data), e.g. paid rates by cheque Data must be recorded to the nearest cent (accurate), e.g. the calculation and recording of depreciation Prepares general purpose financial statements, i.e. a set of financial statements will include all financial details about a business, i.e. its financial results and position and cash-flow position Management accounting No conformance to standards or legislation required Provides information for internal use Focus on departments/divisions of a business so that decisions can be made about them Reports are future-oriented (to make decisions about the business s future) Emphasis is not on monetary values but on other aspects to enable management to make decisions Prepares reports for a specific purpose, e.g. whether to buy a specific machine or not (capital budgeting/npv), or a production budget to determine how many units of a product to produce Table 1.2: Differences between financial accounting and management accounting UNIT 1.2: MANAGEMENT FUNCTIONS Four basic functions of management For any business to be successful, its management must perform various functions. The following figure shows the basic functions of management. Planning Planning involves the formulation of detailed plans and the preparation of various budgets in order to achieve the organisation s objectives. Planning is the starting point of all management functions. Everything starts with a plan. You may have heard of the saying: If you fail to plan, you are planning to fail. Control Planning Management functions Leading Organising So where does planning start? First and most importantly, managers must define their goals and objectives. They must know exactly what they want the business to achieve and in what time frames, for example, in three years, or in five years. Figure 1.2: Four basic management functions So the planning process starts with identifying objectives to be achieved. Thereafter, strategies are formulated to achieve these objectives. Planning is an estimate of what the business wants to achieve in the future. 4

10 For example, if the objective of a business is to increase profits by 20% in the next 12 months, then all plans must ensure that this objective is met, for example, by reducing telephone costs in the business by giving only managers codes to use the telephone. What do managers do after they have defined their goals and objectives? They must document ways and means of reaching these objectives. From a financial point of view, they must prepare various budgets. What is a budget? A budget is a financial plan detailing how management plans to achieve their objectives. For example, a sales budget will detail how many units of goods the business plans to sell in order to achieve an increase in profits of 20%. Now think about yourself. Why are you studying at college? Your goal is to get a job, specifically in the financial field. So you realised, or may have been advised, that you have to study a course in the financial field to achieve this. Have you noticed how your plan of studying a course in the financial field will help you to get a job in this field? If you had chosen to study nursing, it would not help you to get a job in the financial field. This is what we mean when we say that your plans must help you to achieve your objectives. Organising Organising involves assembling or arranging an organisation s activities and all its available resources in the best possible way to achieve its goals and objectives. Resources include human and physical and natural resources. A manager must determine the best or optimal combination of these resources in order to achieve the goals and objectives of management. Leading Leading involves inspiring, influencing and motivating people to share the vision of the organisation and in so doing, achieve its goals and objectives. In leading, a manager will provide the necessary knowledge, information, procedures, and possibly skills to employees. The manager s personality plays a crucial role in his or her leading function. It is essential for a manager to be an effective leader. Control Control involves comparing budgeted and actual results, investigating variances, and taking corrective action. This is an extremely important function. Managers can have the best plans, organise their resources optimally, and inspire and motivate their staff to achieve these goals and objectives. However, if they do not monitor and exercise control over the entire process, then the organisation can fail dismally! 5

11 The control function involves managers monitoring actions and activities to determine whether everything is going according to plan in order to achieve the goals and objectives of the business. This is achieved by comparing actual results to planned or budgeted results. If there is a difference, a manager must investigate the cause of, or reason for, the difference. After the manager has determined a difference or variance, he or she must take corrective action. This is extremely important. There is no point in understanding the reason an organisation has not achieved its objectives if action is not taken to correct this. Finally, management must evaluate the results of the control process and adjust their planning if necessary. It is possible that their plans were unrealistic and could not be achieved in the stipulated time frames and therefore need to be adjusted. Look at Figure 1.2, and notice how each management function is linked to another. Also notice how the control function goes back to planning. Information needed for management decisions Quantitative information The word quantitative comes from the word quantity. If you had to describe the quantity of something, you would describe it in numbers. Therefore quantitative information refers to measuring or calculating something, such as the profit of a business, its total expenses, its depreciation cost for the year, and so on. Management needs this quantitative information to help them in making decisions about various matters in the business. 6

12 Qualitative information The word qualitative comes from the word quality. If you had to describe the quality of something, you would describe it in words. Therefore qualitative information refers to descriptive information that helps management to make decisions. This information may refer, for example, to the aftersales service provided by a particular supplier, the reliability and reputation of a supplier, the quality of a product (even if it the cheapest), and so on. Setting of goals for decision-making As you have already noticed, the first function of management is planning. Before planning can commence, management must define or set their goals. To assist in the achievement of goals, we break them up into short-term and long-term goals, i.e. management must define which goals they can achieve in the short-term (taking not too long to achieve this) and which they can achieve in the long-term (this could be anything from nine months, or a year, to many years). Management must therefore take decisions to achieve their short-term and long-term goals. Short-term decisions Short-term decisions entail management making decisions about the business s day-to-day operations. They are therefore also called operating decisions. Examples of short-term or operating decisions include: Setting the selling price of products for the next financial period Budgeting for the next financial period The level of after-sales service that must be provided by the firm. Long-term decisions/strategic decisions Long-term decisions are decisions made by management that commit the business s resources for a lengthy or longer period of time. Examples of long-term decisions include: Producing a new product Entering into a new market Opening new, or closing existing branches. 7

13 Organisational chart An organisational chart is a diagrammatical representation of lines of authority and communications in a business. It clearly shows all employees who their immediate supervisor is (lines of authority) and therefore eliminates any confusion as to whom to report to (it aids in communication). It also shows employees who their peers are (employees on the same level). It usually depicts the various management functions (finance, sales, human resources, production, and so on) and their sub-divisions, as boxes linked by lines along which decisionmaking power travels downwards (from managers) and answerability travels upwards (from people on the lower levels). Names of managers and employees are captured in the relevant boxes so as to customise the chart and provide clarity on line management. Example 1.1 Draw the organisational chart of NTN Ltd, which has the following employees: Name of employee Mr A.C. Kerman Mr N.R. Hari Ms H.T.K. Buthelezi Ms F.S. Zwane Mr T. Singh Mr R. Mbatha Mr N.N. Botha Mr Z.J. Thwala Mr S. Shabangu Mr C.T. Moloi Ms E. Zita Ms G. Ray Suggested solution Designation/Job title Managing director Production manager Finance manager Sales manager Research and development manager Assembly manager Machinery department manager Management accountant Financial accountant Advertising manager Distribution manager Research and development assistant manager NTN Ltd Organisational Chart 8

14 Assessment activity 1.1 Cricket Manufacturers manufactures various types of bags. The business employs the following staff members: Name Portfolio in the company M. Dhoni Chief executive officer C. Gayle Financial manager S. Narine Production manager T. Dilshan Financial accountant R. Ponting Production supervisor G. Smith Cost accountant R. Cook Personnel manager Sales representatives S. Bond Marketing manager Prepare the organisational chart for Cricket Manufacturers. Clearly show the names of employees and their portfolios in the company. UNIT 1.3: COST CLASSIFICATION Definition of cost Costs are a necessary sacrifice incurred in order to deliver a product or service (Faul et al, 2001 p. 10). This sacrifice is usually measured in monetary value. Methods of accumulating and allocating cost data How does a business determine or calculate its costs? It must add up all the costs that it has incurred. To make this easy, various methods or approaches can be used to determine the costs in a business. Function In this method, costs for each functional area in a business are added together to get its total costs. Functional areas in a business include the finance, marketing, production, purchasing, sales, human resources, and other departments. Elements Costs are accumulated according to the elements of production cost. Remember the three elements of production cost are: Direct or raw materials Direct labour Manufacturing overheads. 9

15 The cost of each element is calculated and added to the others to determine the total cost of production. Direct materials are all those materials that are used in production and can be seen in, or traced to, the finished products, for example, the wood in a table, or the steel in a car. They are also called raw materials. We will refer to them as direct materials from this point onwards (materials are discussed in detail in Module 2). Direct labour is the wages paid to the labour that is used to make the finished products only, for example, the labour used to make tables (this is discussed in detail in Module 3). Manufacturing overheads are the indirect costs that are associated with production, for example, the cutting blade used to cut the logs of wood into the appropriate size for the tables, sandpaper used to sand down the tables, and so on. These are very important costs. If you did not use them on the product, it would not be complete. However, they are indirect, and you cannot see them in the final product (this is discussed in detail in Module 4). Example 1.2 The following information was extracted from OneUp CC: Direct materials R Direct labour R Manufacturing overheads R Calculate the manufacturing or production costs. Suggested solution Production cost = Direct materials + Direct labour + Manufacturing overheads = R R R = R Remember that any expense related to the factory (apart from direct material and direct labour), is a manufacturing overhead. Examples include depreciation on machinery, rent, water and electricity, rates and taxes, insurance, security guard s wages, telephone expenses, and any other costs involved in running the factory. Remember that any expense related to the office is a selling and administration cost. It has nothing to do with the factory, and is therefore not a product cost. 10

16 Example 1.3 The following information relates to North Value Manufacturers. The company is involved in the manufacture of wooden desks. Cost item Amount Salary of factory supervisor R Insurance: Factory buildings Office buildings R6 000 R7 000 Sales commission R3 000 Production wages R Depreciation: Office equipment Factory equipment R2 000 R5 000 Purchases of wood for the desks R Rent of office buildings R Factory electricity R Advertising costs R Carriage on sales R Salary of factory cleaner R Classify each cost item firstly as a production or selling and administration cost; and secondly, if it is a production cost, say whether the cost is direct or indirect. Write the amounts of the each cost item in the relevant column(s). Suggested solution Cost item Production Selling and Production administration Direct Indirect Salary of factory supervisor Insurance: Factory buildings Office buildings Sales commission Production wages Depreciation: Office equipment Factory equipment Purchases of wood for the desks Rent of office buildings Factory electricity Advertising costs Carriage on sales Salary of factory cleaner TOTAL R R

17 Product In this method, costs are accumulated according to each product being produced. For example, when building houses according to customers specifications, the cost of each house would be accumulated separately. If one customer wanted porcelain tiles in his house, the cost of those tiles would be added to the cost of his house only and not to other houses being built without porcelain tiles. Department Costs are accumulated according to the various departments in a business. Think about a factory making shirts. One shirt has to go through the cutting department (where the pattern is cut), then to the sewing department (where the shirt is stitched), then to the quality department (to check if the shirt is of the required quality), and finally to the packaging department. The costs incurred in each department are calculated and added together to determine the total cost for the business as a whole. Income Matching is one of the principles of GAAP, where costs are matched to corresponding income, for example, cost of sales is matched to sales. In this method, costs are matched to incomes and are added up to determine total costs. Volume In the volume method, costs are accumulated and allocated according to the volume produced (the number of units produced). For example, if the cost of producing 100 packets of soup is R1 000, then the costs associated with producing 500 packets of soup will increase accordingly. Prime product cost Think about the words prime or primary. Which school did you first attend? Primary school. So what does prime mean? It means first. Now think about production costs (direct material, direct labour, and manufacturing overheads). To manufacture (make) any 12

18 product, which two of the elements shown in the diagram below would you need first? Think about making a table. What would you need first? The wood (direct material) and labour to make the table (direct labour). Example 1.4 The following information was extracted from OneUp CC: Direct materials R Direct labour R Manufacturing overheads R Calculate the prime cost. Suggested solution Prime cost = Direct materials + Direct labour = R R = R Conversion cost Conversion comes from the word convert, which means to change or transform. What is being transformed? Direct or raw materials are being transformed into finished goods. For example, wood is being transformed or converted into tables. What is needed to convert direct materials into finished goods? Manufacturing overheads and direct labour. + = Example 1.5 The following information was extracted from OneUp CC: Direct materials R Direct labour R Manufacturing overheads R Calculate the conversion cost. Suggested solution Conversion cost = Direct labour + Manufacturing overheads = R R = R

19 Assessment activity 1.2 The following information relates to NTN Manufacturers: Direct material R Direct labour R Manufacturing overheads R Calculate the: a) Prime cost b) Conversion cost c) Production cost. Example 1.6 Refer to Example 1.3. Calculate the: a) Prime cost b) Conversion cost c) Production cost d) Manufacturing overheads. Suggested solution a) Prime Cost b) Conversion Cost = Direct materials + Direct labour = Direct labour + Manufacturing overheads = R R = R R = R = R c) Production cost d) Manufacturing overheads Add up the values in the Production cost column = R = R Add up the values in the Indirect production cost column Assessment activity 1.3 The following information relates to AA Producers: Direct materials R Direct labour R Factory rent R Insurance of office buildings R Factory electricity R Indirect materials R Indirect labour R

20 Calculate the: a) Manufacturing overheads b) Conversion cost c) Prime production cost d) Manufacturing cost. Assessment activity 1.4 Berry Ltd revealed the following cost data: Direct labour R Direct material R Indirect labour R Indirect materials R Factory rent R Office insurance R Factory electricity R Calculate the: a) Prime cost b) Conversion cost c) Production cost. Assessment activity 1.5 The following information was extracted from the records of Nina Ltd: Conversion cost R Prime cost R Manufacturing overheads R Calculate the: a) Direct labour cost b) Direct material cost c) Total production cost. 15

21 Assessment activity 1.6 Use the following information of Chance Knitters Ltd to calculate the direct material cost. Conversion cost R Prime cost R Manufacturing overheads R Assessment activity 1.7 Outside Producers supplied you with the following information: Salary of factory supervisor R Insurance of factory buildings R Salesman s commission R Factory electricity R Depreciation of factory equipment R Salary of the office staff R Conversion cost R Prime cost R Calculate the direct material cost for Outside Producers for the period. Assessment activity 1.8 The following information relates to North Value Manufacturers. The company is involved in the manufacture of wooden desks. Cost item Salary of factory supervisor Insurance: Factory buildings Office buildings R Sales commission Production wages Depreciation: Office equipment Factory equipment Purchases of wood for the desks Rent of office buildings Factory electricity Advertising costs Carriage on sales Salary of factory cleaner

22 a) Classify each cost item firstly as a production or selling and administration cost. Secondly, if it is a production cost, say whether the cost is direct or indirect. Write the amounts of the each cost item in the relevant column(s). Copy the table below into your book and use it to answer this question. Cost item Cost behaviour Production cost Variable Fixed Direct Indirect Example: Factory rent b) Calculate the prime costs of the business. c) Calculate the conversion costs of the business. Assessment activity 1.9 The following information appeared in the books of Thula Bedding: Cost item Cleaning materials for the factory Maintenance of production equipment Factory insurance Direct material used Municipal rates and taxes: Factory Depreciation: Factory machinery Depreciation on delivery vehicles used to transport finished goods Direct labour used in the factory Office telephone Salary of factory security guard a) Classify each cost item firstly as a production or selling and administration cost. Secondly, if it is a production cost, say whether the cost is direct or indirect. Write the amounts of the each cost item in the relevant column(s). Copy the table below into your book and use it to answer this question. Cost item Cost behaviour Production cost Variable Fixed Direct Indirect Example: Factory rent b) Calculate the prime costs of the business. c) Calculate the conversion costs of the business. R 17

23 UNIT 1.4: COST SYSTEMS A cost system is a method of recording, processing and reporting on cost data. There are two types of cost systems, the periodic system and the perpetual system. Periodic system The periodic system is a recording system that calculates the inventory balance only at the end of each accounting period. The inventory has to be determined by counting it if we want to check the inventory balance. Perpetual system The perpetual system is a recording system that keeps track of inventory at all times. The Inventory account is increased whenever inventory is purchased or returned by clients, and decreased whenever inventory is sold or returned to suppliers. Concepts of job costing and process costing are very important in the perpetual system. Job costing In the job costing system cost data is recorded, processed, and reported per job. This system is used when heterogeneous products (products which are different from each other) are produced. Think about a dressmaker making wedding dresses. Each bride would want different items on her wedding dress.. Therefore, in order to calculate the total cost of each dress, the dressmaker would have to accumulate the costs for each dress separately. So how does the dressmaker calculate the total production costs for each dress? She must find the sum of the cost of the direct materials, direct labour, and overheads spent on each gown. Process costing Process costing is used for recording, processing, and reporting the costs of producing homogeneous products (products which are similar or identical to each other) which all go through the same processes in production, such as in a canning factory. Think about a factory canning jam. All the cans of jam will go through the same processes until they are complete and ready for sale. Costs are accumulated per process. UNIT 1.5: UNIT, FIXED, AND VARIABLE COSTS Period costs A period is time related. Period costs are those costs that are related to a particular period rather than a particular product. In a manufacturing concern, non-manufacturing costs, for example, advertising costs, are regarded as period costs. These costs are written off in the Income Statement in the period in which they occur. 18

24 Product costs Product or production costs are those costs that are incurred in the manufacturing of a product. They are related to the products being produced. Product or production costs include direct materials, direct labour, and manufacturing overheads. Relevant and irrelevant costs Relevant costs are those costs that are relevant to a particular decision, for example, if a business is evaluating the cost of buying a new machine, the cost of installing that machine is a relevant cost. Irrelevant costs are those costs that are not relevant to a particular decision. For example, if a business is evaluating the cost of buying a new machine, the cost of annual rates and taxes is an irrelevant cost in relation to that decision. Avoidable and unavoidable costs Avoidable costs are those costs that may be saved by not adopting a given alternative, whereas unavoidable costs cannot be saved (Drury, 2004 p. 38). These are also referred to as relevant and irrelevant costs. Sunk costs Sunk costs are costs that have already been incurred in the past. These costs cannot influence or affect any future decision as the expense for these costs has already been deducted and therefore cannot be changed. Opportunity costs Opportunity cost is a cost that measures the opportunity (chance) lost or sacrificed when the choice of one course of action requires an alternative course of action to be given up (Drury, 2004 p. 39). For example, you have R10 and you need to buy a loaf of bread and a litre of milk. If these items cost R10 each, then you have to make a choice between them and buy only one, because you have only R10. If you choose to buy the loaf of bread, then you have sacrificed the litre of milk. Therefore the opportunity cost of the loaf of bread is a litre of milk. Controllable costs Controllable costs can be controlled or influenced by a manager. It stands to reason that the manager should be held accountable for these costs. Uncontrollable costs Uncontrollable costs cannot be controlled directly. These are costs such as depreciation on machinery. If the method of depreciating production machinery in a business is 10% pa, then a manager cannot control this cost. Even if the factory uses machinery less often in a particular year, 10% will be written off as depreciation. 19

25 It stands to reason that a manager should not be held accountable for uncontrollable costs. Unit cost How much is a unit? One. Unit cost measures the cost of producing ONE unit. Example 1.7 The total cost of producing 100 chocolates is R200. Calculate the unit cost. Suggested solution Unit cost = R chocolates = R2 per chocolate Unit cost formula: Total cost No. of units produced Fixed cost Fixed costs are those costs which remain constant no matter how many units are produced. For example, if the rent expense is R per month, it does not matter if the business produces 1 unit or units, it must still pay its landlord R rent for the month. Variable cost Variable costs are those costs that vary or change in direct proportion to the number of units produced. Example 1.8 Wood (direct material) valued at R10 is needed to make 1 desk. Calculate the direct material cost if 50 desks are produced. Suggested solution Direct material cost for 50 desks = R10 50 desks = R500 Notice how the cost varied or changed when the number of units changed. When 1 unit was produced, the variable cost was R10. When the number of units increased to 50, the variable cost increased 50 times. 20

26 Unit cost and total cost It is important to understand how fixed and variable costs behave both in total and per unit. Think about total cost. When you find the total of something, does it become more or less? Now, do you think you would need to multiply or divide to calculate the total cost? Obviously you must multiply. What about unit cost? Unit means ONE, so you are calculating the cost of producing one unit. Is one the bigger or smaller number? So, when you are performing a calculation, would you multiply or divide to make the answer smaller? Obviously you must divide. Total cost Example 1.9 The following information relates to Summer Ltd: Calculate the total cost. Suggested solution Total cost = Total fixed cost + total variable cost = R R = R Total fixed cost R Unit fixed cost R10 Total variable cost R Unit variable cost Units produced R5 Total, and unit, fixed and variable costs The table below summarises how fixed and variable costs behave, both per unit and in total. Fixed Variable Per unit Changes Remains the same no matter how many units are produced Formula Total cost No of units produced Use original information to calculate: Total variable cost No of units produced If given in question, do NOT recalculate. In total Remains the same no matter how many units are produced Changes Formula Table 1.3 Use original information. If given in question, do NOT recalculate. Original unit variable cost x no of units produced 21

27 Example 1.10 The following information was extracted from the records of Majuba Manufacturers: Total fixed cost R Variable cost per unit R5 No. of units produced Calculate: a) The unit variable cost if units are produced b) The total variable cost if units are produced c) The unit fixed cost if units are produced d) The total fixed cost if units are produced e) The total cost if units are produced. Suggested solution a) Unit variable cost (UVC) You must ask yourself two questions: i. How does UVC behave, i.e. does it change or remain the same? It remains the same no matter how many units are produced ii. What is the formula to calculate UVC? Use original information to calculate. What is original information? The information given in the question is original information. Now go back to the original question. Is the UVC given? Yes, it is given, it is R5. Do you have to recalculate it? No! It is given! So it does not matter how many units are produced, the unit variable cost remains the same at R5. (Based on the example). b) Total variable cost (TVC) You must ask yourself the same two questions: i. How does TVC behave, i.e. does it change or remain the same? It changes in direct proportion to the number of units produced ii. What is the formula to calculate TVC? Unit variable cost x no. of units produced What is the unit variable cost? Remember that you got it from the original information. R units = R (Based on the example). c) Unit fixed cost (UFC) You must ask yourself the same two questions: i. How does UFC behave, i.e. does it change or remain the same? It changes when the number of units produced changes. If the total rent for a month is R (total fixed cost) and the number of units produced is 1 000, then the UFC is R10 000/1 000 = R10. However, if the number of units produced changes, then you will divide R by the new number of units produced and therefore the UFC will be different. 22

28 ii. What is the formula for calculating UFC? Total fixed cost/no. of units produced R10 000/2 000 = R5 (Based on the example). d) Total fixed cost (TFC) You must ask yourself the same two questions: i. How does TFC behave, i.e. does it change or remains the same? It remains the same no matter how many units are produced ii. What is the formula to calculate TFC? Get it from original information. What is original information? The information given in the question is original information. Now go back to the original question. Is the TFC given? Yes, it is given, it is R Do you have to recalculate it? No! It is given! So it does not matter how many units are produced, the total fixed cost remains the same at R (Based on the example). NB: All of the above are costs, so the answer must be expressed in rands, not units. In addition, notice how we divided for unit costs and multiplied for total costs (if a calculation was necessary). e) Total cost (TC) = TFC units = R R (calculated in (b)) = R Example 1.11 The following was extracted from the records of Nata Industries: Total fixed cost R Total variable cost R Number of frames produced Calculate the: a) Total fixed cost if frames were produced b) Unit variable cost if frames were produced c) Total variable cost if frames were produced d) Unit fixed cost if frames were produced e) Total cost if frames were produced. Suggested solution a) Before you start answering this question, ask yourself: How does total fixed cost behave? Does it change or remain constant? The answer is: It remains constant. Is the total fixed cost given in original information? Yes! Therefore no calculation is needed. The answer is R

29 b) How does unit variable cost behave? It remains constant. Is it given in the original information? No, therefore use original information to calculate it. = Total variable cost number of units produced R = = R10 per frame c) How does total variable cost behave? It changes. = UVC number of units = R = R d) How does unit fixed cost behave? It changes. TFC = number of units R = = R3 per frame e) Total cost if frames are produced: = TFC + TVC (for frames) You have already calculated TVC for frames in c) above. You do NOT need to recalculate it! You also know that the TFC does not change. So: TFC = R and TVC = R Therefore: Total cost = R R = R Assessment activity 1.10 Milli Manufacturers had the following production costs for July 2012: Variable costs R Fixed costs R Units produced Calculate the: a) Fixed costs per unit if units were produced b) Total fixed costs if units were produced c) Variable cost per unit if units were produced. 24

30 Assessment activity 1.11 Crompton Manufacturers produce students desks. They provide you with the following information for the year ended May 2012: Total fixed cost R Unit variable cost R20 Number of desks produced Calculate the: a) Unit fixed cost if desks were produced b) Total fixed cost if desks were produced c) Total variable cost if desks were produced d) Unit fixed cost if desks were produced e) Calculate the total cost if desks were produced. Assessment activity 1.12 Lucky Manufacturers produces charm bracelets. The following information was supplied to you: Total variable cost R Total fixed cost R Number of bracelets produced Calculate the: a) Total fixed costs if bracelets were produced. Give a reason for your answer b) Unit variable cost if bracelets were produced c) Total cost if bracelets were produced. Assessment activity 1.13 Chance Producers manufactures kitchen bins. The following information was extracted from their records: Total fixed cost R Unit variable cost R15 Calculate the: a) Unit variable cost if units were produced. Give a reason for your answer b) Total fixed cost if units were produced c) Total variable cost if units were produced d) Unit fixed cost if units were produced e) Total cost units were produced. 25

31 Assessment activity 1.14 The following information was extracted from Doola Dala Manufacturers: Fixed costs R Variable costs R6 000 Production (units) 300 Calculate the: a) Fixed cost per unit if 600 units are produced b) Total fixed costs if units are produced c) Variable cost per unit d) Total variable cost if 700 units are produced e) Total cost if units are produced. Assessment activity 1.15 The following information relates to QRS Producers: Fixed cost R Variable cost R Number of units produced Calculate the: a) Total fixed cost if units are produced b) Total variable cost if units are produced c) Unit fixed cost if units are produced d) Unit variable cost if units are produced. Assessment activity 1.16 Plod Manufacturers produces ladies winter boots. The following data was extracted from their records: Fixed cost R Variable cost R Number of boots produced Calculate the: a) Unit fixed cost if boots are produced b) Unit variable cost if boots are produced c) Total fixed cost boots are produced d) Total variable cost if boots are produced e) Total cost if boots are produced. 26

32 Assessment activity 1.17 Storm Ltd manufactures security alarms. Their sales for June was units, the total variable costs were R50 000, and total fixed costs amounted to R The company has the capacity to produce between and units per year. Calculate the: a) Total cost per unit b) Total expected cost if the company were to produce and sell units per year. The Factory Remember that there are three different types of businesses, namely trading, service, and manufacturing businesses. The aim of every business is to maximise its profits. In order to calculate profits, you must know what your costs are. The focus of this subject is on manufacturing businesses. What happens in a manufacturing business? The business produces trading inventory and sells it at a profit. Irrespective of what product a business is producing, what would it need to produce? Think about a business producing tables or another producing cars, or yet another making shirts. All of these businesses would need: Direct or raw materials Direct labour Manufacturing overheads. These are the three elements of production cost. This is an extremely important concept and forms the basis of all studies in this subject. To calculate the total production costs, you need to find the sum of the three elements of production costs, which are direct or raw materials, direct labour, and manufacturing overheads. NB: Your lecturer will ask you what the three elements of production cost are at each lecture! Another word for production is manufacturing. So instead of being asked to calculate the total production costs, you could be asked to calculate the total manufacturing costs. Be careful, because there is a difference between manufacturing costs and manufacturing overheads. 27

33 Example 1.12 Direct materials R Direct labour R Manufacturing overheads R Calculate the total manufacturing costs. Suggested solution Direct materials R Direct labour R Manufacturing overheads R R The diagrams below illustrate what happens in a factory: INPUTS 1. Direct materials 2. Direct labour 3. Manufacturing overheads PRODUCTION PROCESS OUPTPUT 1. Finished goods 2. Work-in-progress Figure 1.3: Summary of the production process So there are inputs in the production process, which are what is put INTO the production process. Direct materials, direct labour and manufacturing overheads are put INTO the production process or factory. Here, these inputs are transformed or changed into finished goods or work-in-process. These are therefore the outputs or what you get OUT OF the production process. Finished goods are those goods that are complete and ready for sale to customers. If a factory is producing tables, the finished goods are the tables that are ready for sale. Nothing must be incomplete (even if it is very small or minor), otherwise it is work-inprocess. 28

34 Work-in-process is therefore unfinished or incomplete work. At the end of a financial year, it can happen that there are some goods that have been started but are still not complete. Take the example of the tables not all the tables that were started during the year would necessarily be complete at the end of the year. But remember that some production costs have already been spent on these goods (even though they are incomplete), and they have entered the production process. Production Control account The Production Control account is a new account that you are introduced to in this subject. What is it, and why is it necessary in a manufacturing business? The Production Control account is the control account for production. Do you remember the Debtors or Creditors Control accounts you prepared in financial accounting? It is similar. The Production Control account is basically a summary of the production process or what happens in the factory. Look at Figure 1.3 above. Can you see the inputs on the lefthand side? And the outputs on the right-hand side? Notice that the inputs (what is PUT INTO the production process or factory) are on the debit side (left) and the outputs (what comes OUT of the production process or factory) are on the credit side (right). General Ledger of ABC Manufacturers DR Production Control CR Balance b/d Direct materials Direct labour Manufacturing overheads Finished goods Balance c/d (Work-in-process) Think about the Production Control account as a summary of what happens in the factory. The Balance b/d on the debit side of the Production Control account is the work-inprocess brought forward from the previous period. The Balance c/d on the credit side of the Production Control account is the work-inprocess from this period that will be carried forward to the next period. As we complete the next three modules, you will learn the accounting logic of recording these items on the debit and credit sides and balancing this account. ALL costs that are associated with the factory are manufacturing or production costs. All costs that are not direct labour or direct material, but associated with the factory, are manufacturing overheads. Remember your keyword here is factory. So long as the cost has factory in it, it is a manufacturing overhead (except direct materials and direct labour). Examples include factory electricity, factory rent, factory security guard s salary, and so on. 29

35 The office Production takes place in a factory. The main focus is on producing the final product. But materials must be ordered by telephone, fax or ; payment must be made for these materials; salaries of factory workers must be calculated and paid on time; insurance policies for inventory and the factory building must be paid; and telephone, electricity, and other utility costs must be paid for. When goods are produced, they must be sold. They must be advertised; telephone calls must be made and received from businesses who want to buy the goods; these goods must be delivered to buyers on time, and so on. So who does this? Office staff must be hired to do these tasks. However, because they are not doing tasks in the factory, all the costs associated with the office are classified as selling and administration costs. Look at the name of these costs carefully it comprises all the administration costs and all the costs associated with selling the finished goods, such as advertising the products, delivery costs, and so on. The keyword in these costs is office. All these costs are not production costs, but are classified as selling and administration costs. Some examples include: Office telephone Office rent Office electricity Depreciation on office machinery and equipment Office rates and taxes Office insurance Salaries of office staff Advertising Sales commission Delivery costs of finished goods. 30

36 Assessment activity 1.18 Various possible answers are provided for each question. Indicate the correct answer by writing the correct letter next to the question number, e.g. 21 A. 1. accounting places less importance on accuracy and more on other aspects than monetary value. a) Internal b) Financial c) Cost d) Management. 2. Organising, as one of the management functions, a) involves the comparison of actual performance with the original plans so that departure from plans can be identified and corrected b) is the process of putting together an organisation s human and other resources in such a way as to most effectively carry out established plans c) is the skill of influencing and inspiring performance d) is the development of objectives in an organisation and the preparation of various budgets to achieve these objectives 3. The following is classified as a short-term decision (operating decision): a) Investing in new plant or machinery b) Setting selling prices for the next financial period c) Renting or buying the premises of the business d) Opening up new branches or closing present branches 4. Rates and taxes of a company s factory land and buildings would be classified as cost: a) Prime b) Opportunity c) Period d) Product. Conversion costs refers to the combination of a) Direct material plus direct labour cost b) Direct labour plus manufacturing overheads c) Direct materials plus manufacturing overheads d) Production cost plus selling cost. 6. Period costs are a) The costs involved in the manufacturing of a product b) Used where the manufacturing process forms a cycle thus where the product goes through consecutive processes c) The costs associated with a given accounting period rather than a given product d) The costs involved with the purchasing of manufacturing materials. 31

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