Association of Accounting Technicians

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1 Association of Accounting Technicians Basic Costing Level 2

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3 Published by: Home Learning College 1 Hammersmith Broadway London W6 9DL Home Learning College Ltd 2013 Version 2.0 aat2_bcst_v2_ All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, transmitted or utilised in any form or by any other means, electronic, mechanical, photocopying, recording or otherwise without the written permission of the publisher. All product names and services identified throughout this book are trademarks and registered trademarks of their respective owners. They are used throughout this book in editorial fashion only and are for the benefit of such companies. No such usage, or the uses of any trade names, is intended to convey endorsement or other affiliation with the book. Home Learning College course materials are made available in electronic format for use by students of the College. All rights, including copyright and related rights and database rights, in electronic course materials and their contents are owned by or licensed to Home Learning College. In using electronic course materials and their contents you agree that your use will be solely for the purposes of completing a Home Learning College course. Except as permitted above you undertake not to copy, store in any medium (including electronic storage or use in a website), distribute, transmit or retransmit, broadcast, modify or show in public such electronic materials in whole or in part without the prior written consent of Home Learning College or in accordance with the Copyright, Designs and Patents Act 1988.

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5 Contents Introduction to Basic Costing (BCST) 1 Lesson 1 - Cost Classification Introduction 4 Accounting personnel 4 Financial accounting and management accounting 6 Cost allocation 10 Classifying costs 12 Lesson 2 - Cost Behaviour Introduction 22 Variable costs 22 Fixed costs 24 Stepped costs 25 Semi-variable costs 26 Using cost classification 28 Lesson 3 - Cost Coding Introduction 32 Cost codes 32 Numeric codes 32 Alphabetic codes 34 Alpha-numeric codes 35 Coding manual 36 Qualities of a good coding system 37

6 Lesson 4 Product Coding Introduction 40 Product cost 40 Total cost statement 41 Calculating cost using cost behaviour 42 Calculating unit cost at different levels of output 46 Lesson 5 Costing for Inventories Introduction 50 Inventory 50 Valuing inventories 51 Advantages and disadvantages of valuation methods 58 Lesson 6 Costing for Labour Introduction 62 Setting pay rates 62 Direct labour costs 63 Calculating gross pay 65 Comparing gross pay methods 77 Lesson 7 Manufacturing Accounts Introduction 82 Manufacturing accounts 82 Lesson 8 Budgeting Introduction 90 Budgets 90 Variances 92

7 Lesson 9 Spreadsheets Introduction 102 Format of spreadsheets 102 Entering data in spreadsheets 108 Assessment tasks 121

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9 Basic Costing Introduction to Basic Costing (BCST) The AAT Level 2 Certificate in Accounting consists of five separate units which should be completed in the following order: 1. Processing Bookkeeping Transactions (PBKT) 2. Control Accounts, Journals and Banking System (CJBS) 3. Basic Costing (BCST) 4. Computerised Accounting (CPAG) 5. Work Effectively in Accounting and Finance (WKAF) This is the Basic Costing unit and is therefore the third unit for you to study. It is written to AAT s AQ2013 syllabus specifications and is designed to be used in conjunction with Home Learning College s Virtual Learning Community (VLC). This unit focuses on using cost recording systems to prepare information relating to the income and expenditure of an organisation. You will learn how to make comparisons and identify differences between actual and expected figures, and communicate your findings using spreadsheets. Throughout the unit you will find the icons shown below. These highlight important items, reinforce essential points and provide helpful examtaking hints. Example this is an illustration of a learning point in the context of a real-life scenario. Key Learning Points the main items to learn and understand in a particular lesson. Exam Tip these call attention to information about potential pitfalls and essential information regarding the AAT assessment. 1

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11 Basic Costing LESSON 1 Cost Classification On completing this lesson you should be able to: Explain the nature of an organisation s business transactions in relation to its accounting systems Explain how materials, labour and expenses are classified and recorded Identify types of cost, profit and investment centres Classify cost information for materials, labour and expenses 3

12 Home Learning College Introduction Accounting is the system by which businesses are able to keep track of their money. This is important because a business that does not make a profit or that has insufficient cash to operate will go bankrupt. There are a number of different ways that businesses can record and monitor their activities and accounting is the term that covers the systems of recording, preparing and interpreting business transactions. Thus accounting is a primary source of information for owners and managers to enable them to monitor, plan and control the activities of the business. This lesson examines the essential features of two strands of accounting: financial accounting and management accounting. It introduces the concept of costs, their identification and ways of categorising them so that useful information is provided for management. There is a number of important accounting terms that will be used throughout this study text. As students progress through their studies these terms will become more familiar. However, there is a glossary at the back of the study text which can be referred to as necessary. Accounting personnel The number of people involved in accounting in a business will depend on the nature and size of the business. Many small businesses are run by just one or two people who are both the owners and the managers. In larger businesses there will be a specific chain of command and different accounting functions will be undertaken by different departments. A typical chain of command for a medium-sized business is shown overleaf. 4

13 Basic Costing Medium-sized business Typical accounting chain of personnel Finance Director Financial Accountant Management Accountant Book keeper Cost Accountant In larger businesses the managers are responsible for decision making and controlling activities on a day-to-day basis. The owners may not be involved at all in running the business but rather see the business as an investment opportunity. An example of this type of situation is a large limited company where the owners are the shareholders; those people who have bought shares in the company, and are hoping to receive dividends and make a profit when they sell their shares. Although the shareholders may attend a general meeting of shareholders once or twice a year, they are not involved in the day-to-day running of the company. Shareholders of large companies entrust the running of the company to directors who manage its resources and report regularly on its progress. The directors have overall responsibility but rely on departmental managers to provide them with sufficient useful information to enable them to make good decisions for the company s profitability and financial stability. The accounting systems provide financial information to managers and directors so that they can make business decisions. Accounting can be described as the process of identifying, measuring and communicating economic information to permit informed judgements and decisions by users of the information. (As defined by the American Accounting Association.) 5

14 Home Learning College Financial accounting and management accounting It is important to recognise that there are a number of differences between financial accounting and management accounting. Financial accounting is concerned with how monetary amounts are divided into different categories and recorded in accounting records. It is also concerned with how that financial information is presented. It is important that the treatment and presentation of information is consistent from period to period so that the financial performance of the business can be assessed over time. Financial information can be presented in a number of different ways but the two main financial statements are the Statement of Profit or Loss and the Statement of Financial Position. The Statement of Profit or Loss is a statement that summarises the income (sales) earned by the organisation and the expenses incurred in making that income. It identifies the amount of profit or loss that the organisation has made during a specific period of time. If more income has been earned than expenses incurred then the organisation has made a profit. If more expenses have been incurred than income earned then the organisation has made a loss. A Statement of Profit or Loss is prepared for a specific period of time. For financial accounting purposes this is usually a year, however, some organisations choose to prepare financial statements monthly or quarterly as well as annually. The Statement of Financial Position lists the assets and liabilities of an organisation at a specific date in time. Students who have studied the Basic Accounting Units will already be familiar with assets and liabilities. Assets are items of value to an organisation and represent items owned, such as plant and machinery, or items owed to the organisation, such as customers who owe money for goods that have been supplied to them on credit. Liabilities are financial obligations of an organisation to persons or other organisations. These financial statements are prepared using historical information and their format is prescribed by statutory legislation. This means that all organisations will prepare the Statements of Profit or Loss and 6

15 Basic Costing Statements of Financial Position in the same way and using the same terminology. This enables comparison between organisations and consistency of presentation and measurement over time. The financial statements are prepared from the double entry bookkeeping system. This is the mechanistic process of recording business transactions in books of account so that income, expenses, assets and liabilities can be tracked and summarised. This allows owners and managers to identify how well the organisation is performing and to keep control over its finances. Financial statements are not only used by the owners and managers of an organisation but by other users outside the organisation itself. These other users include investors, lenders, debtors, creditors and government agencies. Management accounting is concerned with providing information for management so that it can carry out its functions of planning, control and decision making. Therefore, management accounting includes identifying, measuring, accumulating, analysing, preparing, interpreting and communicating information to management so that they can plan and control the organisation to ensure that resources are being used appropriately. They are not concerned with the every day recording of financial transactions for use in preparing statutory financial statements. Rather they gather information to enable the management to run the business efficiently. This is done using a management accounting system that categorises costs into various cost centres. Management accountants may undertake a vast range of different work that could include: Applying a range of different methods and techniques to enable them to ascertain costs. Analysing savings or inefficiencies and comparing these with previous experience or standards. Operating specific costing systems as a basis for identifying how profitable a product will be, valuing the inventory held by the organisation, analysing labour costs, controlling general production costs and determining appropriate selling prices. 7

16 Home Learning College Establishing budgets, calculating the standard (expected) cost of a product, identifying the actual costs of processes, activities or products and calculating and analysing differences occurring between expected costs and actual costs. Creating a reporting system that enables managers to take corrective action where necessary to control costs and provide information for decision making. Management accountants will work with historical data and use this to make estimates or forecasts of future data. The result is that management accountants may be called upon to produce a variety of types of information in a number of different formats. The key is that the information provided must be accurate, useful, relevant and timely to enable management to carry out their roles of planning, control and decision-making. Management accounting reports do not have any set format and are not required by legislation. This means that an organisation is free to prepare reports in whichever way will be most useful for their own purposes. The main differences between financial accounting and management accounting can be summarised as follows. Financial accounting Information is prepared primarily for external users Financial accounting is concerned with recording information using the principles of double entry bookkeeping The main financial statements are the Statement of Profit or Loss and the Statement of Financial Position Its purpose is to assess financial performance Data is stated in monetary terms, e.g. s Management accounting Information is prepared for internal purposes Management accounting is not concerned with day-to-day recording of financial information. Different organisations prepare different types of management reports Its purpose is to assist in decision making, planning and control Data may be stated in monetary or non-monetary terms, e.g. forecast sales volume in units 8

17 Basic Costing Financial accounts are prepared using historic data Financial accounts are normally prepared annually The format of financial accounts is prescribed by law Financial accounting requires costs to be analysed by function, such as production, administration, selling and distribution and finance Management accounting reports can use historic data or future forecast data Management accounting reports are prepared as and when they are required There is no set format for management accounting reports Management accounting will analyse costs according to element or behaviour to enable product costing, valuing of inventories, setting of selling price and management decision making Management accounting is also referred to as cost accounting and the systems used in an organisation for recording costs will be determined by the nature of the business being carried out. There are three main types of industry: manufacturing, service and retail. A manufacturing organisation is one in which products are made (manufactured) and then sold onto other businesses. These types of organisations need to maintain a store of raw materials and will usually have a supply of part-finished goods on the production line and finished goods waiting to be despatched to customers. Therefore, the costing system used will need to be able to value goods at any stage of the production process as well as value issues of raw materials to production. It will also need to be able to ascertain the direct labour cost of manufacture and allocate overheads to units of production. A service organisation is one that does not manufacture or resell finished goods but sells the services of its staff to customers. Accountancy practices are service organisations and offer a range of services to their customers which are carried out by their staff. Service industries do not have a requirement for a costing system that deals with inventories of raw materials, work in progress and finished goods in the same way as manufacturing industries. However, they will need to keep control of their staff costs and have a method of allocating staff time and costs to customers jobs to ensure that each job is profitable. 9

18 Home Learning College A retail organisation is one that purchases goods and then resells them on to customers at a profit. Again, they do not manufacture the product and would not need a costing system to keep track of raw materials and work in progress but they would need to keep track of the cost of goods held for resale. Most retail organisations have high fixed costs due to renting premises from which to operate their business. The mark up on cost to arrive at selling price needs to cover fixed costs if the organisation is to make a profit and therefore the costing system needs to provide management with relevant information. Cost allocation All organisations incur costs. A significant element of management accounting is the classification and analysis of those costs. It is important, therefore, to understand the use of terms such as cost unit, cost centre, profit centre and investment centre as these will feature in this unit and the management accounting units at Levels 3 and 4. Cost unit A cost unit is a single unit of output to which costs can be charged. A cost unit could be a product manufactured by an organisation. Examples would be a car, a telephone, a table or a computer. In service organisations a cost unit could be a mile travelled, a hotel room, a meal served in a restaurant or a dentist appointment. There are many different types of cost units that could be used, especially in a service industry. For example, a leisure centre may have cost units such as the attendance at the swimming pool, the members of the gymnasium or the snacks sold at the snack shop. Cost centres Costs also need to be allocated or charged to specific areas of a business and these are known as cost centres. A cost centre is any part of an organisation to which costs can be separately attributed. Cost centres can be as small as one person or one machine or they can be large with several resources allocated to them. It is important that costs 10

19 Basic Costing are capable of being identified with and allocated to that cost centre, whether it is based on location, function, activity or an item of equipment. Based on: A location A function Activity Cost centre examples: High street shop or a town or city Payroll department or sales department Painting or assembly Item of equipment Drilling Machine 1 or Lorry 3 Cost centres may be the same as departments within an organisation. A distance learning college may have a number of different departments which also correspond to cost centres, such as student enrolment, student support, individual course departments, finance and marketing. Costs are collected together in cost centres and this helps managers monitor and control those costs. The cost centres will normally be the responsibility of a departmental manager. Profit centres A profit centre is a part of an organisation to which both revenues and costs are allocated. There could also be several cost centres within a profit centre. An example of a profit centre would be a retail shop because it has both revenue and costs. Investment centres An investment centre is a profit centre. However, rather than performance being measured in terms of profit, it is measured by the return it achieves relative to the funds invested. Investment centres could include several profit centres and therefore are normally controlled by senior level managers. An investment centre manager will have some control over how resources are invested as well as responsibility for costs and revenues. 11

20 Home Learning College An example of an investment centre would be the headquarters of a large multi-national company or the treasury department of a local authority. Classifying costs There are many different types of businesses that undertake different types of activities. Each business will incur costs and these costs can be classified in a number of different ways depending on the nature of the business and its activities. Manufacturing businesses will have various departments which undertake different aspects of the production process and the supporting roles of selling and distribution. Different types of costs will be incurred in these departments. The following diagram shows how costs are incurred at different points in the business. Raw material Labour costs FACTORY Other production costs (overheads) Stores labour Non-production costs (overheads) STORES Goods to customer Selling and distribution costs Finance costs OFFICE Administration costs The factory is the area where the product is actually manufactured. The types of costs that might be incurred here are the raw materials used in the product, the labour used to assemble the product, machine costs, if 12

21 Basic Costing the process is mechanised, and other production costs, such as power or rent for the factory. The stores area is where the finished goods are kept until they are despatched to customers. Typical costs here will be rent, heat and light for the storage area and the labour costs for stores people. The office carries out a support function to the other departments providing accounting, administrative and selling services. Costs incurred here might be salaries of non-production employees, telephone and stationery costs, heat, light and rent for office buildings and a range of other administrative type costs. A similar diagram could be drawn for service businesses such as shops, educational establishments, transport companies or hotels. There will be different departments but they will all incur costs. It is important to understand that the cost structure within a manufacturing industry will be different from a cost structure within a service industry and so the costing systems will be different. To provide managers with suitable information for monitoring and controlling the organisation, all the costs incurred must be classified. There are three conventional methods for classifying costs: By element By nature, and By function The assessment for Basic Costing will expect students to be able to classify a range of costs by element, nature and function. This is a fundamental area of this unit. Classifying costs by element An organisation may incur a number of different types of cost and one way of classifying these costs is to split them into groups according to the type of expenditure. This is known as classifying by element. 13

22 Home Learning College The three groups under this system of classification are: Materials Labour Overheads Materials Materials costs are the costs of raw materials, components and other items purchased from suppliers. Labour Labour costs are the costs of employees and consist of wages and salaries. Overheads Overheads are also referred to as expenses. Under this system of classification they are any expenses other than materials and labour. In assessment tasks concerned with classifying costs by element, the terms overheads and expenses may be used interchangeably. The AAT assessment also assumes that all overheads are indirect. There is a category of direct expenses but this is outside the scope of this assessment. Example Classifying costs by element (1) A business manufactures wooden garden furniture. It incurs a variety of costs which include: Materials: Wood, screws and wood preservative. Labour: Wages for the employees who are directly involved in making the furniture and the salaries for the sales staff and the administrative staff who are responsible for selling the products and undertaking the day-to-day running of the business. 14

23 Basic Costing Expenses: All other costs incurred by the business, including motor expenses, rent, insurance, telephone, stationery and expenses incurred by office staff. Service organisations can also classify costs by element. Example Classifying costs by element (2) A business bus company incurs a variety of costs which include: Materials: Tyres, parts for repairing the buses, diesel. Labour: Wages for the bus drivers and salaries for the office support staff. Expenses: Rent of secure parking for the buses, heat, light, telephone and stationery costs for the office. This type of classification enables managers to see how the total costs of the business are split between materials, labour and overheads. This is important for controlling costs and helpful for decision making in terms of costing products or services and introducing new products or services. The salaries of non-production staff, such as office employees, are usually classified as overheads. This is not incorrect but they could equally be classed as labour costs and an organisation would select its own preference. AAT assessments seem to require any indirect labour costs to be classified as overheads and therefore when answering tasks that identify whether costs are material, labour or overheads, the best approach is to classify all direct labour costs as labour and all indirect labour costs as overheads. Classifying costs by nature The three elements of materials, labour and overheads can also be identified as direct costs or indirect costs. The classification of costs as either direct or indirect is referred to as classification by nature. 15

24 Home Learning College It is important to understand the difference between direct and indirect costs. A direct cost is one that can be directly attributable to a unit of production or a unit of service. Direct costs are related to a specific unit of production or unit of service. In a manufacturing organisation a unit of production might be one individual item or a batch of items. The identification of a unit of service might be more difficult but it could be a mile travelled for a bus company or a delivery company or a room occupied in a hotel. An indirect cost is a cost that is incurred during the production of a product or the performance of a service but which cannot be directly attributable to a unit of production or a unit of service. Indirect costs cannot be directly attributed to a cost unit and therefore they are initially taken to a cost centre. A cost centre is any part of an organisation where costs can be gathered together and could be described as a department. Examples of cost centres are warehouse/stores departments, maintenance departments and canteens. Under this type of classification, indirect costs are often grouped together and referred to as overheads. As mentioned earlier, materials, labour and expenses can be sub-divided into direct and indirect costs resulting in six categories: Direct materials Direct labour Other direct expenses These are any materials that become part of the final product. The material could be purchased specifically for the product or be a part-finished product that is passed from one department to another. All payments for labour that can be directly attributable to a unit of production are direct labour costs. These are any other costs that are directly incurred on a specific product but that do not fall into the category of direct materials or direct labour. An example might be the cost of drawings for a bespoke product. This category will not be assessed by the AAT. 16

25 Basic Costing Indirect materials These are any materials that are used in the production process or service but that cannot be directly matched to a unit of product. An example is lubricant for machines. Indirect labour These are payments of wages and salaries made to personnel who are not involved directly in the manufacture of the product or the provision of the service. An example is the salary for a production supervisor. These are classified by the AAT as overheads. Indirect expenses These are expenses that cannot be directly identified with a product or service. An example would be electricity for lighting and heating. In a manufacturing environment the total of all of the direct costs of production is known as the prime cost and the total of all of the indirect costs of production is known as total overheads. Example Classifying costs by nature A company that manufactures metal filing cabinets might have the following costs: Direct materials: Indirect materials: Direct labour: Indirect labour: Metal sheets for the cabinet body, metal door handles and drawer runners. Cutting blades for the metal cutting machine. Wages for the employees who cut the metal sheets and assemble the filing cabinets. Salaries for the office staff who take customer orders and arrange for despatch of filing cabinets. Direct expenses: Hire of a specialist cutting machine for the manufacture of a one-off order to customer specifications. 17

26 Home Learning College Indirect expenses: Rent for the warehouse used to keep finished filing cabinets until they are despatched to customers. Classifying costs by function Costs can be classified according to their function. A function comprises activities that have a similar purpose. Within most organisations it is possible to divide costs into five different categories based upon their function: Production costs Selling and distribution costs These are costs that are incurred during the production process. Examples include raw materials, labour and packaging. These are also known as marketing costs and include all costs associated with creating a demand for a product and obtaining orders. Examples include advertising, sales, staff travel and salaries and delivery costs. Administrative costs These include the general costs for running an organisation. Examples include secretarial and accounting staff salaries. Finance costs Specialist costs These are the costs incurred in financing the business such as interest from bank overdrafts, loans and finance leases. These are costs that are not generally incurred but depend upon the particular nature of the business. An example of specialist costs are those incurred during the course of research and development. Research costs are those which relate to the search for new or improved products, while development costs are incurred during the creation of a new product ready for mass production. Selling and distribution costs, administrative costs, finance costs and specialist costs are known collectively as non-production costs because they are not directly incurred in the manufacture of products. Non-manufacturing organisations will not have a production function but may have an operations function that provides services to the 18

27 Basic Costing organisation. Some organisations may also have a training function where they require highly skilled staff whereas other organisations may include these costs within the administrative function. Each organisation will develop the functional headings that are most useful for its needs. An educational establishment or a hospital may use functional headings that match the activities carried out in different departments. Analysing costs according to their function can be useful for management to see which departments within the organisation are spending in excess of their budget or where cost savings are being made. Example Classifying costs by function A company that puts paint into cans might have the following functional costs: Production: Selling and distribution: Administration: Finance: Costs here will consist of raw materials such as paint and cans, labour costs for those involved directly in the canning process, depreciation and maintenance costs for the paint mixing machines and rent of the canning facility. Costs here will consist of warehousing, depreciation of delivery vans, wages of delivery drivers and sales personnel and advertising. These costs will be the support department s costs for accountancy and office administration, telephone costs, rent, heat and light of office buildings and salaries for office workers and management. Costs here will consist of bank interest associated with overdrafts and loans and interest on other financing arrangements such as hire purchase and finance leases. It is important to recognise that the same set of costs can be classified in a number of different ways and that an organisation will select the method that best suits their own information needs. 19

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29 Basic Costing LESSON 2 Cost Behaviour On completing this lesson you should be able to: Explain the nature of expenses and distinguish between fixed, variable and semi-variable overheads 21

30 Home Learning College Introduction Lesson 1 showed that the same costs can be classified in different ways dependent on their element, nature or function. The final type of cost classification is by behaviour. It is important to recognise that different types of costs behave differently when activity levels within the organisation change. This can have a significant effect on decision-making and therefore management accountants must be able not only to identify how costs behave, but also be able to use that information to produce forecasts and budgets. The main cost classifications are: Variable costs Fixed costs Stepped costs (sometimes referred to as step-fixed costs) Semi-variable costs This lesson is concerned with identifying and classifying costs according to their behaviour. Variable costs A variable cost is one that varies in direct proportion to the activity level. An example of a variable cost is a direct material cost. If one unit of production requires 1 kg of raw material then two units would require 2kg, three units would require 3kg and so on. The total variable cost is calculated by multiplying the variable cost per unit by the number of units. The following graph shows how the total variable cost increases steadily as the activity level increases. 22

31 Basic Costing Total variable cost 0 Level of activity When determining the behaviour of a particular cost it is necessary to have two different sets of data relating to that cost. If, when the cost is divided by the activity, the cost per unit is identical from both sets of data then it can be inferred that the cost can be classified as variable. Example Variable costs The cost of labour to manufacture 8,000 units is 54,000. What is the cost of manufacturing 7,600 units? In this case it is assumed that the cost of labour is the same per unit, however many units are made. Therefore the calculation is simply to divide the cost by its associated number of units and then multiply by the new number of units. Thus: 54,000 8,000 x 7,600 = 51,300 Examples of typical variable costs include: Materials used in the manufacture of a product or the provision of a service. Labour costs for manufacturing products or providing a service. Commission paid to sales staff. Fuel used by a transport company. 23

32 Home Learning College It is worth mentioning that direct costs may not always be true variable costs as a supplier may offer a discount for bulk purchasing. This means that as the activity level increases, the cost per unit will fall when order levels qualify for the discount. Fixed costs A fixed cost is one that is not affected by changes in the level of activity. In graphical terms fixed costs are represented as follows: Total fixed cost 0 Level of activity Rent is often used as an example of a fixed cost. If an organisation rents a warehouse then it will have to pay the same amount of rent whether one unit is produced and stored there or 15,000 units are produced and stored there. In reality, however, costs are only fixed over a specific range of activity. Using the example of a warehouse, assume that the warehouse had a storage capacity of 16,000 units. If the organisation produced and required storage for 16,500 units then another warehouse would be required which would increase the fixed cost. Since a fixed cost remains fixed over a set activity level, the fixed cost per unit decreases the greater the level of activity within that set activity range. 24

33 Basic Costing Example Fixed costs A company has fixed costs of 45,000. Calculate the fixed cost per unit if the company manufactures 80,000 units or if it manufactures 120,000 units. The fixed cost per unit if 80,000 units are manufactured is 45,000 80,000 = If 120,000 units are manufactured then the fixed cost per unit is 45, ,000 = Examples of typical fixed costs include: Rent of buildings. Advertising in trade publications. Salary paid to production supervisors (assuming it is not a stepped cost). Business rates paid to a local county council. Stepped costs Stepped costs are costs that are fixed over a relatively small range of activity and then step up to a new level of fixed cost for the next range of activity. An example of a stepped cost is production supervisors. It may be necessary to have one production supervisor for every ten production employees. Therefore once the number of production employees reaches eleven another production supervisor will be required. 25

34 Home Learning College The following graph shows how the cost increases in steps according to the increase in activity. Total stepped cost 0 Level of activity Semi-variable costs A semi-variable cost is one that contains two elements. One of the elements acts as a variable cost and the other element acts as a fixed cost. An example of a semi-variable cost is a telephone bill where there is a fixed element for line rental and a variable element for calls made. The graph below demonstrates the behaviour of semi-variable costs: Total semi-variable cost Variable element Fixed cost Fixed element 0 Level of activity 26

35 Basic Costing Examples of typical semi-variable costs include: Office salaries where there is a core of permanent staff and additional temporary staff are employed when activity levels rise. Payments to sales staff who have a basic salary plus commission based on units sold. Maintenance charges where there is a fixed basic charge per year plus a variable element depending on the number of call outs per year. Power costs such as electricity and gas where there is a fixed standing charge and a variable charge based upon usage. Total semi-variable costs are calculated as the variable element per unit multiplied by the number of units plus the fixed element. The behaviour of different costs can be determined where two sets of data are given relating to that particular cost. If the cost value divided by the cost units produces the same figure then the cost can be assumed to be variable. However, if the costs produced are different then the cost is likely to be semi-variable. If the cost is the same over different activity levels then the costs can be assumed to be fixed. Example Identifying semi-variable costs The cost of production expenses for a company has been calculated as 168,000 when 20,000 units are produced and 179,925 when 24,500 units are produced. To identify whether the production expenses are a variable cost the cost per unit produced needs to be calculated at each of the activity levels. 168,000 20,000 units = 8.40 per unit 179,925 24,500 units = per unit As these two figures are different, the production expenses are likely to be semi-variable costs. 27

36 Home Learning College Assessment tasks for Basic Costing may require the calculation of unit costs and total costs using variable, fixed and semi-variable cost information. Example Calculating semi-variable costs A cost incurred by a company has been found to act in a semi-variable manner. The variable element is 0.75 per unit and the fixed element is 3,000. Required Calculate the total cost incurred at production levels of 400 units and 650 units and the unit cost at each of the activity levels. Solution At 400 units the total cost will be: (400 x 0.75) + 3,000 = 3,300 The unit cost will be 3, units = 8.25 At 650 units the total cost will be: (650 x 0.75) + 3,000 = 3, The unit cost will be 3, units = 5.37 (to 2 dp) Using cost classification Lessons 1 and 2 have illustrated the different ways of classifying costs. When an organisation is selecting a classification system for costs they will need to consider how that information is to be used. The following table identifies which type of classification system might be used depending on the activities being undertaken. 28

37 Basic Costing Purpose Classification system Controlling costs By element materials, labour and expenses By function production, administration, selling and distribution Cost accounting Budgeting and decision-making By nature direct and indirect By function production, administration, selling and distribution By behaviour fixed, variable and semi-variable 29

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39 Basic Costing LESSON 3 Cost Coding On completing this lesson you should be able to: Explain different methods of coding data Classify and code information for materials, labour and expenses 31

40 Home Learning College Introduction The previous lessons were concerned with the detailed analysis of costs which is a part of cost accounting. To enable this type of detailed analysis it is necessary for costs to be coded so that they can be recorded in the accounting system correctly at source. This lesson examines different code systems that might be used in a cost accounting environment to facilitate easy and speedy access to information for planning and control purposes. Cost codes Most accounting systems are computerised and every cost item that is posted is given a code to enable it to be traced through the computerised system. The code can also be used to classify costs accurately and quickly based on the specific needs of the organisation. Invoices will be coded when they are received by the organisation and then the code will be used by the cost clerk when inputting the data into the computerised accounting package. A cost code is a system of letters and/or numbers which assist in classifying and analysing cost information. Different organisations will use different types of cost code systems designed to meet their own needs. Smaller organisations will tend to use less complicated coding systems than larger organisations. Codes can be numeric, alphabetic or alpha-numeric. Numeric codes Numeric codes are based on a system of numbers. Many codes are constructed around sets of numbers that are then combined to produce the final code. 32

41 Basic Costing Example Numeric cost codes A company uses sets of numbers in its cost code system. The first two digits represent the location of the company. The codes in use are: 91 London 92 Birmingham 93 Glasgow The next two digits represent the department. The codes in use are: 01 Administrative department 02 Production department 03 Selling department The final set of digits represents the type of cost. The codes in use are: 100 Raw materials 200 Direct labour 300 Production expenses 400 Non-production expenses 500 Selling expenses The cost codes for various costs can be determined as follows: Raw materials for production for the Birmingham factory is Sales persons salaries for Glasgow is The salary for the finance directors based in London is Remember that codes are built up from left to right. 33

42 Home Learning College Alphabetic codes Alphabetic codes are based on a system of letters. Alphabetic codes are often used to identify customers and suppliers as they can be more easily remembered than numbers. However, some organisations prefer to use alphabetic systems to code all of their transactions. The next example shows how codes can be derived from letters as easily as from numbers. Example Alphabetic cost codes A company uses sets of letters in its cost code system. The first two letters represent the location of the company. The codes in use are: LO BH GL London Birmingham Glasgow The next two letters represent the department. The codes in use are: AD PR SA Administrative department Production department Selling department The final set of letters represents the type of cost. The codes in use are: MAT Raw materials LAB Direct labour PRE Production expenses NPE Non-production expenses SLE Selling expenses 34

43 Basic Costing The cost codes for various costs can be determined as follows: Raw materials for production for the Birmingham factory is BHPRMAT Sales persons salaries for Glasgow is GLSASLE The salary for the finance directors based in London is LOADNPE Alpha-numeric codes Alpha-numeric codes contain both numbers and letters. These types of codes work on exactly the same principle as numeric and alphabetic codes. A company uses sets of letters and numbers in its cost code system. The first two letters represent the location of the company. The codes in use are: LO BH GL London Birmingham Glasgow The next two letters represent the department. The codes in use are: AD PR SA Administrative department Production department Selling department The final set of digits represents the type of cost. The codes in use are: 100 Raw materials 200 Direct labour 300 Production expenses 400 Non-production expenses 500 Selling expenses 35

44 Home Learning College The cost codes for various costs can be determined as follows: Raw materials for production for the Birmingham factory is BHPR100 Sales persons salaries for Glasgow is GLSA500 The salary for the finance directors based in London is LOAD400 Coding manual Once a code system has been devised it needs to be used throughout the organisation to ensure consistency. The person who undertakes the coding in large organisations is usually the coding clerk. They will use the master code list contained in the organisation s coding manual or policy documents. This is a very important role because the information obtained at the end of the process is only as good as the information entered. Therefore accurate reports require accurate coding of the source documents. The advantage of such a costing system is that once established it can be used to code costs and revenues incurred by the organisation to the depth of detail that they require. The code may be written on the face of the source document or there may be a more formal system of coding whereby the document is stamped with a rubber grid stamp that requires completion by the coding clerk. The grid may have spaces for the code, an authorising signature and the initials of both the coding clerk and the input clerk. The coding clerk will obtain information from a variety of sources to ensure that costs are coded, analysed and classified accurately according to the needs of the organisation. There are many different potential sources of information and the coding clerk will select the most appropriate one. The following table lists some of the possible sources of information. Students may not yet be familiar with all of the terms used in the table but they will be explained at different stages and in various units of the AAT qualification. 36

45 Basic Costing Sources of information for materials costs Sources of information for labour costs Suppliers product catalogues Time cards Purchase orders Payroll analysis sheets Goods received notes Job sheets Purchase invoices Material requisition sheets Income tax and National Insurance records Inventory records Job sheets Sources of information for expenses or overhead costs Sources of information for income Purchase invoices Sales orders Petty cash receipts Goods despatched notes Expense reclaim forms Sales invoices raised Cash book Cash receipts issued Petty cash book Bank paying in book Cheque book stubs Bank statements Bank statements Qualities of a good coding system If a coding system is to work well then there are a number of desirable qualities that it should have. Simple to understand and easy to use The more complicated a coding system is, the more likely it is that errors will be made when coding source documents. 37

46 Home Learning College Logical The code sequence should be logical so that similar items are grouped together. Timely The system should allow coding to be carried out within the timescales required by management. Comprehensive and flexible The coding system must enable every cost or revenue to be classified and should be flexible enough to permit the addition of new codes as and when required. Checking mechanisms The code should include a check digit where possible so that the computer can reject it if, for example, there are insufficient digits or letters entered. 38

47 Basic Costing LESSON 4 Product Costing On completing this lesson you should be able to: Calculate the direct cost of a product or service Calculate unit cost at different activity levels 39

48 Home Learning College Introduction An important role of management accounting is to identify all of the costs involved in manufacturing a product or offering a service so that the selling price can be set or the inventory valued. If the organisation wishes to make a profit then they must have accurate and timely advice regarding the costs of production. In addition, this information will be useful for budgeting for costs and revenues and ensuring that adequate resources are available when needed. This lesson covers the principles of building up the cost of a product or service. Product cost The calculation of the cost of producing one product or unit of service is undertaken through a series of steps. These steps assist with budgeting, ensuring that sufficient resources are available and establishing a selling price. Step 1: Identify the unit of output The unit of output will depend on the type of product being manufactured or the type of service being offered. A product might be a car or a coat or a pair of shoes. A unit of service could be a hotel room cleaned, a parcel delivered or a mile travelled. Step 2: Estimate the number of units of output for the period being considered When an organisation is forecasting the resources it may need for the next period of operations then it will usually begin by identifying the number of units of output it expects to be able to sell. This is the starting point for identifying the number of units that need to be manufactured. A period could be a week, a month, a quarter or a year depending on the organisation s requirements and operations. Step 3: Identify the direct costs associated with the unit of product or service The direct costs are those that can be directly identified with the product being manufactured or the unit of service being offered. The direct costs comprise direct materials, direct labour and direct expenses. 40

49 Basic Costing These direct costs, when added together, provide the total direct costs of the product or service and are known collectively as the prime cost. Step 4: Identify the indirect costs that will be incurred during the period The total cost of a product or service needs to include indirect costs. During this step all of the indirect costs or overheads are estimated for the period being considered. These will include indirect materials, indirect labour costs and indirect expenses. Step 5: Calculate the total costs for the time period associated with production or offering the services The total costs can be calculated as the total direct costs for the period plus the total indirect costs for the period. Step 6: Calculate the cost per unit of output or service The cost per unit can be calculated as: Total costs for the period Number of units for the period = cost per unit Total cost statement All of the costs incurred by an organisation can be gathered together and summarised in a total cost statement. Example Total cost statement Direct materials 25,000 Direct labour 34,000 Prime cost 59,000 Production overheads 44,000 Production cost 103,000 Non-production overheads Selling and distribution expenses 18,000 Administrative expenses 26,000 Finance expenses 3,000 47,000 Total cost 150,000 41

50 Home Learning College The total cost statement can also be used to calculate the cost per unit. Example Cost per unit (1) Assume that the total cost statement in the example above relates to the production of 300,000 units of output. Required Calculate the cost of one unit of output. Solution As all of the costs of production have been gathered in the total cost statement then the cost for one unit can be calculated as: 150, ,000 units = 0.50 per unit Remember that the total cost is always divided by the number of units. Calculating cost using cost behaviour The unit cost can also be built up using cost behaviour. This requires identifying whether the costs are variable or fixed. A variable cost is one that varies in direct proportion to the level of output. This means that every unit has the same quantity of material and labour. If the cost of the material and the labour rate remain stable then the variable cost per unit will be identical, irrespective of how many units are produced. Where there are production costs that are fixed then the cost per unit will depend on the number of units being produced. The method for calculating the fixed cost per unit is: Total fixed costs Number of units for the period = fixed cost per unit 42

51 Basic Costing The more units that are produced, the lower the fixed cost per unit will be. However, costs are only fixed within a specific range and once the output exceeds this range, the fixed cost per unit will increase. Example Fixed cost per unit A company forecasts its fixed costs for the next month as 12,000. If the company manufactures one unit of output then the fixed cost per unit will be 12,000. If the company manufactures 6,000 units then the fixed cost per unit will be 2.00 per unit. ( 12,000 6,000 units) If the company manufactures 16,000 units then the fixed cost per unit will be 0.75 per unit. ( 12,000 16,000 units) The cost per unit can be determined from the total cost of production or by building up the cost from its individual elements. Example Cost per unit (2) A single product has a variable material cost of 5.20 and a variable labour cost of 2.30 per unit of output. Fixed production costs are forecast to be 40,000 next month and the company has a budgeted monthly output of 20,000 units. 43

52 Home Learning College Required Calculate the total cost of production and the unit cost assuming an output of 20,000 units next month. Show each element of the product cost separately. Solution It is probably easier to start with the unit cost because the two variable costs are already provided. The fixed cost per unit is then calculated as the total budgeted fixed costs divided by the budgeted output. Materials (given) 5.20 Labour (given) 2.30 Fixed costs ( 40,000 20,000) 2.00 Unit cost 9.50 The total production cost can be calculated in a similar way. This time the variable costs need to be multiplied by the output. Materials (20,000 x 5.20) 104,000 Labour (20,000 x 2.30) 46,000 Fixed costs (given) 40,000 Total cost 190,000 To check whether the unit cost is correct the total cost can be divided by the output. In some instances the information on the material and labour costs may be given in total, requiring a calculation to arrive at the unit cost. These calculations are a little more complicated. If the total quantity of materials is provided for a specific output level and the cost per unit of material given, then the actual quantity per product 44

53 Basic Costing will need to be calculated before the cost can be identified. The method for calculating this is simply to divide the quantity of material by the number of units of output. This will provide the material quantity per product that can then be multiplied by the cost per unit of material. Example Calculating material quantity per unit A company manufactures a single product. It has identified that for an output level of 9,000 units it requires 11,700 litres of material at a cost of 3.00 per litre. To find the material cost per unit, the quantity of material per unit needs to be identified. This is calculated by dividing the quantity of material by the number of units being manufactured. Thus: 11,700 litres 9,000 units = 1.3 litres per unit The cost per litre has been provided and therefore the material cost per unit of output is calculated as: 1.3 litres x 3.00 = 3.90 Exactly the same procedure can be undertaken if total labour hours are provided and the hourly rate given. However, a further complication would occur where the total quantity and the total cost are provided. This situation requires an additional step in the calculation. Example Calculating labour cost per unit A company manufactures a single product. It has identified that for an output level of 9,000 units it requires 5,400 labour hours at a total labour cost of 45,360. Before the labour cost per unit can be calculated, two additional pieces of information need to be identified: the labour hours for producing one unit and the hourly labour rate. The labour hours per unit are calculated in the same way as the material quantity in the previous example, by dividing the total labour hours by the output: 5,400 hours 9,000 units = 0.6 hours per unit 45

54 Home Learning College The second piece of information required is the hourly labour rate. This can be calculated by dividing the total labour cost by the number of labour hours: 45,360 5,400 hours = 8.40 per hour The cost per unit can now be calculated by multiplying the hours per unit by the hourly rate: 0.6 hours x 8.40 = 5.04 per unit Calculating unit cost at different levels of output The final section of this lesson is concerned with calculating the cost per unit at different levels of output when the costs are classified by element. The key points to remember are that fixed costs remain the same for each level of output and that the variable cost per unit will remain the same. Where the total variable cost is given relating to a specific level of output then the variable cost per unit can be calculated by dividing the cost by the output. Total variable costs output = variable cost per unit Once the variable cost per unit has been identified it can then be multiplied by whichever output level is required. Example Cost per unit (3) The fixed cost of producing 4,000 units has been identified as 16,000 and the total variable cost for the same number of units is 20,800. If the company wants to calculate the total cost and unit cost for an output level of 5,000 units then the following calculations are necessary. The fixed cost will remain the same, however the unit cost will decrease because more units are being produced. At an output level of 5,000 units the fixed cost per unit is: 16,000 5,000 =

55 Basic Costing The variable cost per unit at an output of 5,000 units will be the same as that at 4,000 units. Thus: 20,800 4,000 units = 5.20 However the total variable cost will change as this will now be: 5.20 x 5,000 units = 26,000 The costs at both output levels can be summarised: Units Fixed costs Variable costs Total costs Unit cost 4,000 16,000 20,800 36, ,000 16,000 26,000 42, A similar exercise can be undertaken at any output level provided that the fixed costs remain constant across the range being considered. 47

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57 Basic Costing LESSON 5 Costing for Inventories On completing this lesson you should be able to: Classify different types of inventory as: Raw materials; Part-finished goods (work in progress); Finished goods Calculate inventory valuations and issues of inventory using these methods: First in first out (FIFO); Last in first out (LIFO); Weighted average 49

58 Home Learning College Introduction This lesson examines the nature and valuation of different types of inventories. Materials is a costing term that relates to a number of different items that may be purchased by an organisation: Raw materials used in the manufacture of products, e.g. steel for use in the manufacture of cars. Components used in the manufacture or assembly of products, e.g. an electrical switch for using within an electrical device being manufactured by the organisation. Goods bought for resale, e.g. bread bought by a small grocery store for onward sale to its customers. Goods bought for use (consumption) within the organisation, e.g. stationery and printing ink used by the organisation. At any point in time most organisations will hold inventories of these items ready for use in the manufacturing process or in the day-to-day trading activities. Inventories are sometimes referred to as stocks. Inventory Inventory is a term covering goods held by an organisation. These are often sub-categorised as: Raw materials Part-finished goods (work in progress) Finished goods Raw materials, including components, are items that have been purchased for use in the manufacturing process. They will be incorporated into the final product. 50

59 Basic Costing Work in progress consists of part finished goods. This type of inventory occurs when an organisation has a production line where products are assembled as they travel down the line. At any point in time there will be a number of partly assembled products and these are classed as work in progress. It is also possible to have work in progress in a service industry. Finished goods are products that are finished and ready for sale to customers. These could be items that have been manufactured or items bought for resale by a trading organisation. Valuing inventories One of the roles of a management accountant is to value the inventories held at a particular point in time. This could be at the end of a month, a quarter or a year, depending on the needs of the organisation. An accurate valuation is essential because it is needed to calculate the cost of the goods that have been sold during the period and thus to calculate the profit earned by the organisation. If the valuation is inaccurate then the profit levels will be under or overstated. Many organisations have much of their financial resources tied up in inventory which can only be released once those products are sold. Thus maintaining adequate levels of inventory, without incurring high storage costs or having high financial resources tied up in slow moving inventory, is an important part of managing an organisation effectively and efficiently. Many organisations carry out regular inventory counts (also known as stocktakes) to identify the physical levels of each item held at a point in time. The inventory can then be valued as follows: number of items x cost per item = inventory value at cost The costing system of the organisation will be used to identify the cost per unit. The general rule for valuing inventory is that it can be valued either: At cost this is the cost actually incurred in purchasing or manufacturing the product, or At net realisable value this is the actual or estimated selling price less any further costs that need to be incurred before the product can be sold. 51

60 Home Learning College Whichever of the two costs is lower is the one that must be used in financial statements to value the inventory. Methods of valuing inventories Costing requires that raw materials are given a value when they are either issued to production or sold to customers. Issued to production is a traditional accounting term which simply means that the items have been taken out of inventory and have entered the production process. It is important to understand that the methods for valuing inventory are not the same as the physical movement of inventory. They are simply a way for an organisation to allocate a cost to the item being issued or sold. A vegetable shop may physically sell its products on a first in first out basis to prevent vegetables perishing and becoming unsaleable, however, for the purpose of its cost accounts, it may value those sales using the weighted average method. In large manufacturing organisations there will usually be a stores department that maintains records of each item of inventory held. These are known as inventory record cards or stores ledger records and they will hold information on the part and the dates, quantities and prices of receipts into stores and the issues out of stores. Example Stores ledger card Stores ledger cards differ from organisation to organisation but most of them hold the following information. Date Receipts Issues Balance Total Total Total Quantity Cost cost Quantity Cost cost Quantity Cost cost 52

61 Basic Costing Many organisations now use computer packages to keep track of their inventories rather than manual records. By using this type of stores ledger an organisation can easily identify how many items it should have in inventory and the cost at which those items were purchased or issued. Items are usually issued at their purchase price but costs vary over time and therefore an organisation needs to decide how to value both its issues to production and the balance of inventory when costs are changing. There are three common methods for valuing issues to production and the value of inventory held at a particular point in time: 1. First In First Out (FIFO) 2. Last In First Out (LIFO) 3. Weighted Average Cost (AVCO) First in First Out (FIFO) This method uses the oldest or first cost prices for issuing items from stores. This means that the remaining inventory items are valued at the most recent prices. Example Valuing inventories using FIFO Gold Ltd uses raw material RM3 in its manufacturing process and uses the FIFO method of valuing inventories. It has recently made the following purchases: 1 April each 5 April each These receipts will be recorded in the stores ledger record as follows: 53

62 Home Learning College Date Receipts Issues Balance Qty Cost Total cost Qty Cost Total cost Qty Cost Total cost No. No. No. 1 Apr Apr , On 10 April 120 units of RM3 are issued to production. The valuation of this issue assumes that the oldest cost is used first. Therefore the issue will be valued as follows: units 1, The remaining inventory will consist of 40 units valued at 12 each (70 units less 30 units issued) = The stores ledger record will now show the following: 54

63 Basic Costing Date Receipts Issues Balance Qty Cost Total cost Qty Cost Total cost Qty Cost Total cost No. No. No. 1 Apr Apr , Apr , The balance on 10 April should be the balance on 5 April less the issue made on 10 April. Remember that if an assessment task just provides the quantity and the total price then the cost per item can be calculated by dividing the total cost by the quantity. Last in First Out (LIFO) This method uses the most recent or last cost prices for issuing items from stores. This means that the remaining inventory items are valued at the oldest cost prices. Example Valuing inventories using LIFO Using the previous example for Gold Ltd, assume now that the company uses the LIFO method of valuing inventories. On 10 April 120 units of RM3 are issued to production. The valuation of this issue assumes that the latest cost is used first. Therefore the issue will be valued as follows: 55

64 Home Learning College units 1, The remaining inventory will consist of 40 units valued at 10 each (90 units from 1 April less 50 units issued) = The stores ledger record will now show the following: Date Receipts Issues Balance Qty Cost Total cost Qty Cost Total cost Qty Cost Total cost No. No. No. 1 Apr Apr , Apr , Weighted Average Cost (AVCO) This method uses an average cost to value issues from stores and the remaining inventory items. The average cost is calculated as: Total cost of goods in stores Number of items in stores = weighted average cost 56

65 Basic Costing A new weighted average cost has to be calculated every time purchases of raw materials are made. Example Valuing inventories using AVCO Using the previous example for Gold Ltd, assume now that the company uses the AVCO method of valuing inventories. The stores record before the issue shows the following: Date Receipts Issues Balance Qty Cost Total cost Qty Cost Total cost Qty Cost Total cost No. No. No. 1 Apr Apr , On 10 April 120 units of RM3 are issued to production. The valuation of this issue will be based on the average cost of items held in the stores. This cost is calculated as: 1, units = per unit Therefore the issue cost will be calculated as 120 units x = 1, The remaining inventory will consist of 40 units also valued at each = The stores ledger record will now show the following: 57

66 Home Learning College Date Receipts Issues Balance Qty Cost Total cost Qty Cost Total cost Qty Cost Total cost No. No. No. 1 Apr Apr , Apr , Assessment tasks will expect students to be able to explain the three different ways of valuing raw material inventory and be able to calculate the value of an issue to production and the remaining inventory balance using each of the three methods. Whichever method an organisation selects they must use the same method consistently from period to period. Advantages and disadvantages of valuation methods Each method has its advantages and disadvantages. These are listed overleaf for information but are unlikely to be assessed in the Basic Costing Unit. 58

67 Basic Costing FIFO Advantages Reflects the usual pattern of use of most inventory the oldest items are used or sold first. Relatively simple to use and calculate Profits are higher when prices are rising. Disadvantages Changing prices make it difficult for managers to make comparisons. As profits are higher taxes are higher. Issues use out of date price. Closing inventory is valued at the latest prices. LIFO Advantages Issues are at up-to-date prices. As issues are at up-to-date prices, managers are more aware of the current price. Relatively simple to use and calculate. Disadvantages Changing prices make it difficult for managers to make comparisons. Few items have LIFO as their actual pattern of use. When inventories fall to low levels, the issues may be at prices that are many years old. Not acceptable for tax purposes in many countries (including the UK.) 59

68 Home Learning College AVCO Advantages Relatively simple to use and calculate separate batches for each purchase do not have to be tracked. Price fluctuations are smoothed out. Disadvantages Several decimal places are often required for unit prices junior staff may find this perplexing. Changing prices make it difficult for managers to make comparisons. Prices used for issues and valuations may not reflect prices in the world outside. When prices are rising the issue price will lag behind current prices. 60

69 Basic Costing LESSON 6 Costing for Labour On completing this lesson you should be able to: Use these methods to calculate payments for labour: Time rate; Piecework rate; Bonuses 61

70 Home Learning College Introduction One of the cost classifications is labour costs. These are the costs involved in employing people and are known collectively as wages and salaries. There are a number of factors that affect how pay rates are set by organisations and different ways of calculating payments due. This lesson is concerned with classifying and calculating labour payments using basic (time rate), overtime, piecework and bonus payments. Setting pay rates There are a number of different factors that affect how an organisation determines the pay rates for its employees. These factors include local and national considerations as well as statutory regulations. The following factors need to be considered: National minimum wage rates set by the government. National average wage rates for comparable jobs. Wage rates paid by other organisations in the same geographical area. Grants and incentive schemes that may be available to encourage job creation. Local employment conditions if the area has high unemployment then the wage rates set tend to be lower than those in areas with low unemployment. The availability of suitably skilled workers. Local living costs wages in big cities tend to be higher than in smaller towns because the general cost of living in cities is higher. The prevailing economic climate, including the impact of changes in interest rates and exchange rates which affect business confidence. Once pay rates have been set, employees will usually expect regular pay reviews and increases. These pay increases need to be anticipated and included in forecast figures for costing products and setting budgets. 62

71 Basic Costing Pay increases are normally affected by: The rise in the cost of living measured by the Retail Price Index (RPI). Local and national employment conditions. Whether the organisation is profitable and can afford to make a pay increase. Employers need to strike a balance between keeping their employees motivated and controlling costs to ensure that profits are maximised or losses minimised. Direct labour costs Direct labour costs are the wages paid to employees whose work can be directly attributable to a unit of production or the performance of a service. The labour costs that are incurred by an organisation and included in product or service costing are the gross costs of employment. Gross wages are the amounts earned before any deductions are made for income tax and national insurance. Before the gross wages cost can be calculated, the organisation needs to have a system of recording the hours and type of work undertaken by its employees. There are different ways of collecting this type of data: Clock cards Clock cards are documents which record the times that an employee starts and finishes work. This is often recorded electro-mechanically by a special clock at the entrance to the factory or production area. The difference between the two recorded times is the number of hours that have been worked. This is then used to calculate the gross pay of the employee. Time sheets A time sheet collects the time worked each day by an employee and is usually filled in by the employee and authorised by a supervisor. Time sheets can be completed daily, weekly or monthly and may collect 63

72 Home Learning College information not only on the hours worked, but also the jobs actually carried out. The example below shows how a time sheet can record the activities undertaken so that they can be allocated to specific jobs and also the split between direct and indirect labour hours. This is needed so that the costs can be classified correctly in the cost accounting records. Example Time sheet B K GALLERIES TIMESHEET EMPLOYEE: Joanna King WEEK ENDED: 11 August 2007 WORKS NO: 7 DESCRIPTION JOB NO MON TUE WED THU FRI SAT TOTAL HRS DIRECT HOURS: Packing Dispatch printing P Retail Dispatch R Packing Dispatch printing P Retail Dispatch R Retail Dispatch R Packing Dispatch printing P Packing Dispatch printing P Packing Dispatch printing P Retail Dispatch R Packing Dispatch printing P INDIRECT HOURS Admin Other TOTALS Direct Labour Hours Indirect Labour Hours

73 Basic Costing Job card or job sheet This is similar to the previous two items except that it is kept with a particular job. Employees who work on the job fill in their own time and then when the job is finished the total cost of labour on that job can be calculated. Swipe cards These are the electronic equivalent of clock cards. Employees are each given a card, which is also an identity card, and they swipe it through a card reader to enter the building to work and to get out for breaks. These cards can also be used to record time spent on jobs and other activities. The employee swipes it every time they change jobs and each job has a bar code which is read at the same time. Signing in book This method is less popular in today s electronic world. When an employee arrives in the building they sign a book and enter the time. When they leave they also enter the time. Calculating gross pay The Basic Costing unit requires students to be able to calculate gross pay using three different methods: Time rate (basic rate plus overtime) Piecework rate Bonuses Time rate Time rate is where an employee is paid based on the number of hours they have worked multiplied by an hourly rate. The hourly rate is specified in the employee s contract of employment and represents the minimum they will be paid per hour worked. This is also known as the basic rate. 65

74 Home Learning College Example Basic rate Wallgrove Ltd employs a number of people on its production line. The time sheet summary for last week identified the following information in respect of hours worked. Employee Basic hourly rate Hours worked Mon Tue Wed Thu Fri J. Empson L. Heighton M. Matthews Required Calculate the basic pay for each employee for last week. Solution The simplest way to do the calculations is to add up the total hours worked by each employee in the week and then multiply the number of hours by the employee s hourly rate: J. Empson = 32 hours x 8.50 = gross pay L. Heighton = 35 hours x = gross pay M. Matthews = 34 hours x = gross pay Most organisations expect their direct employees to work a minimum number of hours. Any hours worked in excess of these hours is known as overtime hours and may be paid at an overtime rate. Each organisation will decide the hourly rate for any extra hours an employee works above 66

75 Basic Costing their contracted hours. The rate could simply be the same as for regular hours or it could include a premium. Overtime premium is the additional pay, above the basic rate, which is paid to employees who work overtime hours. The overtime premium rate is usually expressed as a multiple of the basic rate. For example: Time and a quarter: Time and a half: Double time: This is basic rate plus an extra ¼ of the basic rate or 1¼ times basic rate. This is basic rate plus an extra ½ of the basic rate or 1½ times basic rate. This is basic rate plus a premium equal to basic rate or 2 times basic rate. Example Overtime rate Wallgrove Ltd pays its employees in the packaging department to work for seven hours a day and five days a week (Monday to Friday). The basic rate of pay is 12 per hour. Any hours worked in excess of this are paid in the following way: Monday to Friday: Hours in excess of seven hours are paid at time and a quarter. Saturday: Hours worked on a Saturday are paid at time and a half. Sunday: Hours worked on a Sunday are paid at double time. Last week one of the employees in the packing department worked the following number of hours: Day Mon Tue Wed Thu Fri Sat Sun Hours Required Calculate the total pay for the employee for last week. 67

76 Home Learning College Solution This employee is required to work 35 hours a week during Monday to Friday (7 hours x 5 days). Excess hours on these days are paid at time and a quarter. The total hours worked between Monday and Friday were: = 41 hours Therefore 6 hours (41 hours less 35 hours) are to be paid at premium rate. Six hours were worked on Saturday, which are to be paid at time and a half, and three hours were worked on Sunday, which are to be paid at double time. The total gross pay can now be calculated: Basic rate: Time and a quarter: Time and a half: Double time: Total gross pay The rate for time and a quarter can be calculated in two ways: 1. The hourly rate can be divided by 4 (into quarters) and then this can be added to the basic hourly rate = 3 (premium) + 12 = The hourly rate can be multiplied by 1.25 because 0.25 is a quarter of x 1.25 =

77 Basic Costing The rate for time and a half can be calculated in two ways: 1. The hourly rate can be divided by 2 (into half) and then this can be added to the basic hourly rate = 6 (premium) + 12 = The hourly rate can be multiplied by 1.5 because 0.5 is a half of x 1.5 = The rate for double time is simply the hourly rate multiplied by 2. (The premium rate per hour is the same as the basic rate per hour.) (premium) = Some organisations require that the overtime premiums are split out from the basic rate. This is because the premium may be accounted for as an indirect cost rather than a direct cost. 69

78 Home Learning College Example Direct and indirect labour rate split Using the previous example for Wallgrove Ltd, the total pay for the employee in the packaging department could show the overtime premium paid. The employee worked a total of 50 hours during the week. Therefore pay can be calculated as: Basic rate: Basic Premium Total Time and a quarter Time and a half: Double time: The same information could be provided by completing a weekly time sheet. 70

79 Basic Costing Example Calculating gross pay using a time sheet Using the previous example for Wallgrove Ltd, the total pay for the employee in the packaging department could be entered onto a time sheet. Hours worked Basic pay Overtime premium Total pay No. Monday Tuesday Wednesday Thursday Friday Saturday Sunday Total An organisation will select whichever recording method best suits its own purposes and needs. Piecework rate Piecework is where an employee is paid based on the level of output. This could be based on each task performed or each unit produced. There are different types of piecework schemes. Simple piecework schemes simply pay the employees based on the number of items produced, irrespective of how many this is. Some schemes may guarantee employees a minimum wage so that even if the organisation does not have enough work for its employees, they will still receive a minimum rate of pay each week. 71

80 Home Learning College Differential piecework schemes pay a higher rate per unit when a certain level of output is achieved by the employee within a particular time frame. Example Simple piecework A company pays its employees based on a piecework rate of 0.65 for each completed unit of output. Last week two employees produced the following: F. Smith 600 units T. Combes 425 units Required Calculate the gross pay for each employee for last week. Solution The gross pay is calculated as the number of units multiplied by the piecework rate per unit. F. Smith 600 units x 0.65 = T. Combes 425 units x 0.65 = In schemes where the employee is guaranteed a minimum wage then the piecework rates need to be compared to the guaranteed amount. In all cases the payment providing the highest gross wage is selected. Example Piecework with a guarantee (1) A company pays its employees 3.00 for every unit produced. It also guarantees a minimum payment of for each 7-hour day. Last week one employee produced the following output and worked 7 hours each day: 72

81 Basic Costing Day Mon Tue Wed Thu Fri Units Required Calculate the gross pay for the employee for last week. Solution The pay for each day must be calculated based on the units produced and then compared to the daily rate of The gross pay will be based on the higher of the two amounts. Day Units Piecework rate Gross pay after guarantee Monday Tuesday Wednesday Thursday Friday Total So the employee will be paid for the week. It is also possible for piecework with a guarantee to be calculated based on a weekly or monthly minimum wage. Example Piecework with a guarantee (2) Using the example above assume that the company guarantees a minimum weekly wage of

82 Home Learning College In this case the employee would be paid because this is higher than If the employee had produced 10 units a day for each of the 5 days then the total earned would be (10 units x 5 days x 3). Under these circumstances the employee would be paid because this is higher than the piecework rate earned. The objective of differential piecework is to encourage higher productivity amongst employees. Example Differential piecework A company uses a differential piecework pay scheme as follows: Output per week Rate per unit Up to 100 units to 200 units 2.75 Over 200 units 3.00 Required Calculate the gross pay for an employee who produced 111 units last week. Solution There are two ways of calculating the gross pay and the method used will depend on the terms of the employee s contract. Method 1 The first 100 units are paid at 2.50 each and the remaining units are paid at 2.75 each. (100 x 2.50) + (11 x 2.75) =

83 Basic Costing Method 2 As the total output falls within the range of units then all 111 units are paid at x 2.75 = Assessment tasks will probably focus on simple piecework schemes but students should also be familiar with the other types of schemes. Bonuses Bonuses are paid when a company or department has done well and output is better than expected. Bonuses are paid in addition to the normal pay an employee receives. Where there is a formal structure to bonus calculations, it is often based upon time saved in doing a job. It assumes that saving time is beneficial to the organisation and pays some of the value of that time to the employee. Under bonus schemes an employee is paid on a combination of time worked and output achieved. Example Bonus payments (1) A company sets a standard rate of production of 10 units per hour. Employees are paid a basic wage of 8 per hour plus a bonus of 2 for every unit in excess of the standard 10 units per hour. Required Calculate the gross pay for an employee who worked 35 hours during a week and produced 400 units. Solution The standard production expected from 35 hours worked is 350 units (35 hours x 10 units) and this employee produced 400 units. This is an extra 50 units. 75

84 Home Learning College Basic rate: 35 hours x 8 per hour Bonus: (400 units 350 units) x Total pay Bonuses can be stated in terms of an extra amount of money per unit or hour or as a percentage of basic rate. Example Bonus payments (2) A company sets a standard rate of production of 10 units per hour. Employees are paid a basic wage of 8 per hour plus a bonus of 15% of basic rate for every unit produced in excess of the standard. Required Calculate the gross pay for an employee who worked 35 hours during a week and produced 400 units. Solution The bonus payment is based on 1.20 per unit (15% x 8) Basic rate: 35 hours x 8 per hour Bonus: (400 units 350 units) x Total pay

85 Basic Costing The above methods of calculating gross pay are usually associated with direct labour costs. This is because employees working on production are traditionally paid on an hourly or output basis, or a combination of the two. Most other employees, such as sales staff, office staff and supervisors, are paid on a weekly or monthly basis. This group of staff comprise the indirect labour costs. However, it is not unusual for these staff to also be eligible for a bonus payment. Sales staff may receive commission payments, office staff may receive a bonus based on the organisation s profitability and supervisors may share in production bonuses. Comparing gross pay methods Each of the methods explained have their own advantages and disadvantages. Time rate Advantages Disadvantages Easy to calculate and to understand It is not related to output so an employee receives a regular wage Flexible enough to be used for all direct labour employees Quality of output is not affected by the need to meet targets Makes budgeting easier and more accurate There is no way of differentiating between good employees and poor employees Employees are not offered any incentives to work harder or increase output Workers may deliberately work more slowly to ensure that overtime rates need to be paid to meet required output levels May be more need for supervision of direct workers Organisation does not have to set piecework rates or standard levels of output 77

86 Home Learning College Piecework rate Advantages Disadvantages Employees can earn as much as they wish Harder working employees are rewarded by higher wages Production output is higher due to harder working employees A fixed labour cost per unit makes budgeting easier and more accurate Payments are only made when output is achieved Recording of actual output is open to abuse so strong control systems need to be implemented The quality of output can deteriorate as employees work faster to earn higher wages May require more quality control employees If employees rush to complete work, they may overlook basic safety rules and accidents could occur Not suitable for all direct labour employees Wages may be reduced through no fault of the employees (for example a machine breaks down) Not as easy to plan cash flow as payments are based on activity 78

87 Basic Costing Bonuses Advantages Disadvantages Employees are encouraged to work efficiently Workers can earn more if they are efficient Bonus systems can be applied to departments or to the whole workforce Employees earn a guaranteed wage before any bonus payments Bonuses may not be paid due to no fault of the employees (for example a machine breaks down) Pay calculations may be more complicated Quality can deteriorate when employees are striving to meet output levels to receive a bonus Group bonuses may be unfair if some employees work harder than others May require improvements in controlling the recording of activity 79

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89 Basic Costing LESSON 7 Manufacturing Accounts On completing this lesson you should be able to: Prepare a manufacturing account to demonstrate the flow of inventory through various stages of manufacture 81

90 Home Learning College Introduction If information is to be useful for monitoring and controlling costs and making decisions then it needs to be presented in a format that can be understood by management. The construction of a total cost statement was seen earlier in this unit but this statement does not show the impact of any changes in levels of inventory i.e. raw materials, work in progress and finished goods. This lesson is concerned with the construction of manufacturing accounts and the presentation of summary information to show the total production cost for a period. Manufacturing accounts A manufacturer will have a range of different costs, including direct and indirect materials, labour and overheads. In addition, at any one point in time, they are likely to have products in various stages of production. These inventory levels need to be accounted for in the calculation of manufacturing costs for a period so that when compared to the revenue earned from sales, the cost relates only to those goods sold and not to the goods produced. Before considering the manufacturing account in detail it is useful to see how it fits into the income statement. The income statement identifies how much profit an organisation has made during a specific period by deducting costs incurred from revenue earned. The manufacturing account is used to identify the cost of production by totalling up the direct and indirect production costs. This figure is then transferred into the income statement where it is deducted from sales revenue to arrive at the gross profit. Gross profit is calculated as sales revenue less the direct cost of making those sales; thus it is the difference between the selling price and the cost of producing the items sold. Non-production overheads are then deducted from the gross profit to arrive at the net profit. This is the profit made by an organisation after all of the costs have been deducted. The manufacturing account forms an essential part of the income statement but it is not required for any statutory legislation. It is simply an internal statement that helps to inform management because it shows a detailed breakdown of the costs of production. 82

91 Basic Costing The link between the manufacturing account and the income statement is shown below: Direct materials plus equals plus equals less equals Direct labour PRIME COST Production overheads Production cost (Factory overheads) Sales revenue Production cost Gross profit Manufacturing Account less equals Non-production overheads Selling and distribution Administration Finance Net profit Statement of Profit or Loss Although the above diagram demonstrates the link between the management accounting statement (manufacturing account) and the financial accounting statement (income statement), it does not illustrate the impact of changing levels of inventory. The manufacturing account identifies costs at different stages of production. These costs will be affected by the level of opening inventory at the beginning of a period and the level of closing inventory at the end of a period. The amount of raw materials actually used in production can be calculated by the following formula: 83

92 Home Learning College Raw materials inventory at the beginning of the period plus less equals Raw materials bought during the period Raw materials inventory at the end of the period Raw materials used in production To put this in simple terms, the amount of material used must be equal to the amount of material in hand at the beginning, plus material purchased, less the amount of material left at the end of the period. Once the amount of material used has been calculated, the prime cost can be calculated by adding the costs of direct labour. Prime cost is the total of all of the direct costs of production, i.e. direct materials and direct labour. The total production cost also includes the indirect costs, known as production or factory overheads. These are added to the prime cost to arrive at the factory cost. The final adjustment in the manufacturing account is for work in progress. By adjusting for the opening and closing levels of work in progress the production cost of goods manufactured can be calculated. As with the adjustment for raw materials inventory, work in progress is adjusted for as follows: Work in progress at the beginning of the period plus less equals Factory cost Work in progress at the end of the period Factory cost of goods manufactured The manufacturing account is now complete. 84

93 Basic Costing Example Manufacturing account format Opening inventory of raw materials 3,200) Add: Purchases of raw materials 62,400) 65,600) Less: Closing inventory of raw materials (3,500) Cost of direct materials used 62,100) Direct labour 40,265) Prime cost (Direct cost) 102,365) Manufacturing overheads 40,950) Manufacturing cost 143,315) Add: Opening work in progress 5,600) Less: Closing work in progress (6,640) Cost of goods manufactured* 142,275) Note: Manufacturing overheads may also be referred to as production overheads or factory overheads. These are the indirect costs of production and could either be listed individually or in total. Some organisations may use slightly different terms. For example, the factory cost of goods manufactured may be referred to as the production cost of goods completed. Students should be prepared to use the terms production, manufacturing or factory overheads and cost of goods completed interchangeably in the assessment for Basic Costing. Once the manufacturing cost of production has been calculated it is then used in the income statement as part of the cost of sales calculation. 85

94 Home Learning College The cost of sales is calculated as: Inventory of finished goods at the beginning of the period plus less equals Factory cost of goods manufactured Inventory of finished goods at the end of the period Cost of sales This calculation identifies the actual cost of producing the goods that have been sold. It starts with the cost of the finished products held at the beginning of the period, adds the cost of products manufactured during the period and then deducts the cost of all those products that have not yet been sold at the end of the period. The example below demonstrates how the factory cost of goods manufactured calculated in the manufacturing account feeds through to the statement of profit or loss. Example Statement of Profit or Loss format Sales 234,292 Less cost of goods sold Opening inventory of finished 14,500) goods Cost of goods manufactured* 142,275) 156,775) Less inventory of finished goods (16,200) Cost of sales 140,575 Gross profit 93,717 Less non-production overheads Selling and distribution costs 8,400) Administrative costs 26,750) Finance costs 1,923) 37,073 Net profit 56,644 86

95 Basic Costing Assessment tasks may require students to create a manufacturing account from a list of balances or reorder costs to produce the correct format for a manufacturing account. If an assessment task provides information on inventory of finished goods but no other statement of profit or loss items, then these costs are adjusted for on the bottom of the manufacturing account to arrive at cost of sales. Detailed example Manufacturing account The following costs have been extracted from the records of a manufacturing organisation at 31 December. Direct labour 45,820 Manufacturing overheads 58,688 Opening work in progress 2,528 Closing inventory of raw materials 5,568 Opening inventory of finished goods 11,664 Opening inventory of raw materials 4,864 Purchases of raw materials 55,290 Closing work in progress 2,080 Closing inventory of finished goods 12,224 87

96 Home Learning College Required Prepare a manufacturing account for the year ended 31 December. Solution The different costs can simply be slotted into the manufacturing account format. Manufacturing account at 31 December Opening inventory of raw materials 4,864) Add: Purchases of raw materials 55,290) 60,154) Less: Closing inventory of raw materials (5,568) Cost of direct materials used 54,586) Direct labour 45,820) Prime cost (Direct cost) 100,406) Manufacturing overheads 58,688) Factory cost 159,094) Add: Opening work in progress 2,528) Less: Closing work in progress (2,080) Cost of goods manufactured 159,542) Add: Opening inventory of finished goods 11,664) Less: Closing inventory of finished goods (12,224) Cost of sales 158,982) 88

97 Basic Costing LESSON 8 Budgeting On completing this lesson you should be able to: Identify sources of income and expenditure information for historic, current and forecast periods Compare actual and expected results and identify differences 89

98 Home Learning College Introduction This lesson in concerned with budgeting and calculating differences arising between budgeted costs and actual costs. It is important that any variations from budget are reported to the appropriate manager so that they can be investigated. Significant variances may indicate problems with controlling costs or problems with recording cost data. However, some differences may occur due to more efficient working practices or lower costs and an organisation needs to identify such reasons and use them to reduce costs in the future. Budgets Management accountants have three key roles in an organisation: 1. Decision-making 2. Planning 3. Control Budgets play an important role in the planning and control of activities and therefore budget preparation needs to be as accurate as possible and take into account all of the known factors relating to the organisation s activities. A budget is a formalised plan for the future activities of the organisation and can be expressed in monetary terms or in numbers of items depending on the type of budget being prepared. Budgets are normally short term and therefore prepared on a monthly basis for the next twelve months. However, each organisation will set its own budget period to coincide with its individual requirements. Budgets use standard costs or budgeted costs for forecast periods to assist management in making decisions regarding production scheduling and resource allocation. The purpose of budgets The purpose of a budget can be summarised as the provision of a tool by which managers can plan their operations and then control those operations by comparing actual results with budgeted (expected) results. 90

99 Basic Costing The difference between the actual and the budgeted results is known as a budget variance. This can be expanded further into distinct benefits associated with budgeting: 1. Planning It is important when organisations set objectives that these objectives are achievable. One way of assessing achievability is to prepare formal budgets which will determine what resources are required at each stage. Management can then ensure that these resources will be available at the required time through careful planning to enable the organisation s objectives to be met. Any potential problems with meeting the resource need should be highlighted early enough in the process to determine the achievability of future plans. 2. Communication and co-ordination A formal budget acts as a communication tool. It sets down the various stages of the planned activities so that each department is aware of what is expected of them. It also allows co-ordination between departments. For example, the production department will schedule production to meet estimated sales demand for the products as determined by the sales budget. Without this interlinking of the two departments the organisation could find itself with too many units of a product with low demand and run out of those products for which there is a greater demand. 3. Authorisation The budget sets out the authorised plans of an organisation and therefore it can be used to provide authorisation for departments to follow a set course of action or spend a delegated amount of money. 4. Monitoring and control An important aspect of management accounting is the control of activities. A budget allows the measurement of performance and the control of activities by setting a benchmark from which actual activities can be measured and thus controlled. Where deviations from budget occur they can be easily identified and corrective action taken. 91

100 Home Learning College 5. Motivation Budgets can be used as a management tool for motivating managers and employees to achieve the organisation s objectives. However, the extent to which this is successful depends primarily on how the budgets are set. Budgets can also be used to set targets. Rewards can then be given where the targets are met or exceeded. Variances As part of the monitoring and control activities, the actual costs incurred will be compared with the budgeted costs to identify any differences between the two figures. These differences are known as variances. A variance is the difference between the actual costs of an organisation and the budgeted costs. It is important to understand that variances are also calculated for sales and revenue as well as for costs, however only variances in costs are assessable in this unit. Management accounting units at Levels 3 and 4 include variances for costs and revenues. Variances are expressed in monetary terms and denoted as either adverse or favourable. Where the actual cost is lower than the budgeted cost, the variance will be favourable (F). Where the actual cost is higher than the budgeted cost, the variance will be adverse (A). It is not sufficient merely to calculate a variance. For it to have any usefulness it must be denoted as either favourable or adverse. Example Calculating variances A cost report has been prepared for a company showing the budgeted and actual cost for the last month. Required Calculate the variances and identify whether they are adverse or favourable. 92

101 Basic Costing Budget Actual Materials 20,500 19,750 Labour 36,700 37,800 Expenses 14,200 13,250 Variance Adverse/ Favourable Total 71,400 70,800 Solution The variance is calculated simply as the difference between the budgeted figure and the actual figure. In this example the figures being compared are all costs and so if the actual cost is lower than the budgeted cost then the variance is favourable. But if the actual cost is higher than the budgeted cost then the variance is adverse. Budget Actual Variance Adverse/ Favourable Materials 20,500 19, ) Favourable Labour 36,700 37,800 (1,100) Adverse Expenses 14,200 13, ) Favourable Total 71,400 70, ) Favourable It is conventional to show adverse variances as minus figures. This can be with brackets or with minus signs. Be very careful to read the instructions for tasks in the CBT, especially with respect to the need to enter minus signs. Brackets should not be entered unless specifically instructed. 93

102 Home Learning College Cost variances One way to identify easily whether a cost variance is adverse or favourable is to always deduct the actual cost from the budgeted cost: budgeted cost less actual cost If the resulting answer is positive then the variance is favourable, but if the resulting answer is negative then the variance is adverse. Budget cost greater than actual = favourable variance Actual cost greater than budget = adverse variance When all of the variances are added together they should equal the difference between the total budgeted costs and the total actual costs. Costs can be compared for a range of different types of cost but the process is exactly the same: find the difference between the budgeted and actual costs and then identify whether the variance is favourable or adverse. Revenue variances One way to identify easily whether a revenue variance is adverse or favourable is to always deduct the budgeted revenue from the actual revenue: actual revenue less budgeted revenue If the resulting answer is positive then the variance is favourable, but if the resulting answer is negative then the variance is adverse. Actual revenue greater than budget = favourable variance Budget revenue greater than actual = adverse variance 94

103 Basic Costing Significant variances If calculating variances is going to be useful for control purposes then they need to be reported to management. However, managers will only want to be informed of significant variances because these are the ones that will have the greatest impact on the performance results of the organisation. Each organisation will decide on what constitutes a significant variance. A variance is not significant merely by its size but also by its size in relation to the budgeted cost. Example Significant variances For one organisation a variance of 40,000 on materials, whether adverse or favourable, may be considered to be significant. However, if the budgeted material cost was 800,000 then the variance would only be 5% ( 40, ,000 x 100) of budget and may not be considered to be significant. Assessment tasks will identify the size of the variance that is considered to be significant for that particular task. Organisations could have a policy that specifies variances to be significant in one of two ways: 1. Monetary value, for example, all variances over 5,000, or 2. As a percentage of budget The most common way is as a percentage but students should be prepared to deal with either method. Example Identifying significant variances (1) The following variances have been identified for an organisation for the last quarter. The organisation considers any variance in excess of 5,000 to be significant. 95

104 Home Learning College Required Identify which of the variances are significant. Budget Variance Materials 150,000 6,000 A Adverse/ Favourable Significant/ Not significant Labour 178,000 9,800 F Expenses 45,000 3,000 F Solution This organisation uses a monetary amount to determine significance and therefore only variances of 5,000 or more will be significant. Budget Variance Adverse/ Favourable Significant/ Not significant Materials 150,000 6,000 A Significant Labour 178,000 9,800 F Significant Expenses 45,000 3,000 F Not significant To identify whether a variance is significant based on the percentage method, it is necessary to first calculate the variance as a percentage of the budgeted figure. The variance is always calculated as a percentage of the budgeted cost and NOT the actual cost. The formula for calculating the variance as a percentage of budgeted is: Variance in s x 100 Budgeted cost in s 96

105 Basic Costing Example Identifying significant variances (2) The following variances have been identified for an organisation for the last quarter. The organisation considers any variance in excess of 5% of budget to be significant. Required Identify which of the variances are significant. Budget Variance Materials 150,000 6,000 A Labour 178,000 9,800 F Expenses 45,000 3,000 F A or F Variance % Significant/ Not significant Solution The first step is to calculate each variance as a percentage of budget. Materials: 6, ,000 x 100 = 4% Labour: 9, ,000 x 100 = 5.5% Expenses: 3,000 45,000 x 100 = 6.67% These can be entered into the table and those over 5% marked as significant. 97

106 Home Learning College Budget Variance A or F Variance % Significant/ Not significant Materials 150,000 6,000 A 4% Not significant Labour 178,000 9,800 F 5.5% Significant Expenses 45,000 3,000 F 6.67% Significant Compared to the previous example the materials variance is no longer significant but the expenses variance is. Calculating the variance as a percentage of the budgeted cost enables those variances which vary in the greatest proportion to the budgeted figure to be identified, reported to management and then investigated. This is necessary so that actions can be implemented to reduce adverse variances and try and repeat the success of favourable variances. Some students assume that only adverse variances are significant and need to be investigated. This is not true. All significant variances, whether adverse or favourable need to be identified and reported. Reporting variances Significant variances need to be reported to the appropriate manager so that they can be investigated and suitable action taken. When deciding who is the most appropriate manager to report to the following factors need to be considered: The type of cost variance. The structure of the organisation in terms of departments and managers. The responsibility and accountability of the manager. 98

107 Basic Costing In a small organisation there may only be one manager who is in charge of all departments, for example, sales, production and administration. In larger organisations there will be a number of different managers who are responsible for different areas of the organisation s activities. A typical organisation structure for a large manufacturing organisation is shown below. Production Director Sales Director Finance Director Administrative Director Production Manager Purchasing Manager Sales Manager Marketing Manager Chief Accountant HR Manager Admin Manager Production Supervisor Sales Staff Accountant Admin Staff Production Employees Assistant Accountants Different cost variances will need to be reported to different managers. Sometimes there will be more than one possibility within the reporting structure, or there may be other managers that are not included on the above organisational chart, for example, the stores manager. The table below summarises different types of costs and the manager or managers that should be informed of the variance. 99

108 Home Learning College Type of cost variance Manager to inform Direct material cost Purchasing Manager Production Manager Direct labour cost Production Manager Human Resources (HR) Manager Production expenses Production Manager Purchasing Manager Selling and distribution costs Sales Manager Marketing Manager Finance costs Administrative expenses Indirect labour costs Chief Accountant Administration Manager Depends on the role of the employees but could be: HR Manager Administration Manager Stores Manager Sales Manager Marketing Manager 100

109 Basic Costing LESSON 9 Spreadsheets On completing this lesson you should be able to: Enter income and expenditure data into a spreadsheet Explain how spreadsheets can be used to present information on income and expenditure Enter budgeted and actual data on income and expenditure into a spreadsheet to provide a comparison of the results and identify differences Use basic spreadsheet functions and formulae Format a spreadsheet 101

110 Home Learning College Introduction This final lesson is concerned with the role, features and application of spreadsheets in cost and management accounting. Many students use spreadsheet software such as Microsoft Excel as part of their daily work role and therefore may feel that they only need to skim over the contents of this lesson. However, there are four tasks on the assessment relating to spreadsheets and variance calculations and so this lesson should be studied as carefully as the other lessons. The primary role of spreadsheets is to enable users to record, manipulate, analyse and present large amounts of data. Format of spreadsheets Before computers became an essential part of data processing, cost and management accounts would prepare summaries, calculations and reports on large pieces of paper ruled with rows and columns. Spreadsheets are an electronic form of these manual workings enabling users to work more quickly and perform recalculations following the change of a single figure instantaneously. A spreadsheet is basically a grid of columns and rows that can be used to display numerical information and perform simple and complex calculations quickly and accurately. Although there are different types of spreadsheet programs, the illustrations in this text book use Microsoft Excel. The columns are lettered and the rows are numbered. The point at which a column and row meet is called a cell. The illustration on the next page shows that the active cell is called A1. The active cell is always shown with a thick black border. The name of the workbook appears at the top of the screen. When the workbook is saved, the workbook name will then change to display the saved file name. Below this are 8 tabs which allow the user to change and control the Excel workbook. At the bottom of the workbook there are three tabs called Sheet 1, Sheet 2 and Sheet 3. In the illustration Sheet 1 is activated as the tab is white, rather than grey. The buttons to the left of the tabs can be used to navigate through the different sheets of an Excel workbook. More sheets can be added to the workbook by selecting the Insert Worksheet button. 102

111 Basic Costing The three types of data that can be entered into a cell are text, numbers and formulae/functions (used to perform calculations). Quick Access Toolbar 8 Tabs Name of workbook Buttons used to Minimize, restore and close the workbook Active cell (A1) Formula Bar where data and text can be entered and edited. Column I Row number 12 Worksheet tabs Button to add a new worksheet Program Window Zoom controls Features of spreadsheets There are a number of features of spreadsheet systems that enhance their usefulness for accounting personnel. Performing arithmetical calculations This is one of the key functions of spreadsheet systems. Cells can be programmed to perform simple mathematical calculations, such as addition, subtraction, division and multiplication, which also recalculate anytime a piece of data is amended. This 103

112 Home Learning College function resembles that of a calculator but saves the operator time providing that the functions input are correct. Formulae There are a number of different formulae that can be used within the software. While the operator can create any formulae from scratch, there are a number of inbuilt functions that simplify the process: SUM function adds up rows and columns COUNT function counts how many numbers there are in a specified range MAX function returns the largest number in a specified range MIN function returns the smallest number in a specified range AVERAGE function finds the average value in a cell range IF function tests data in a worksheet for a true or false condition AND function tests whether logical arguments are true or false Cells in one worksheet can also be linked with cells in other worksheets and the dependent cell will automatically update when there is a change made to the source cell. Sorting data Data within a worksheet can be sorted into various formats, for example, in ascending or descending order alphabetically or numerically. 104

113 Basic Costing Formatting data The appearance of data within a spreadsheet can be displayed using different fonts and colours to match the needs of the operator or the organisation s house style. Rows and columns can be inserted and deleted as required. Copy and paste Charts and graphs Search and replace Security This feature is common in word processing packages as well as spreadsheet packages and allows data to be copied from one location and pasted into one or more additional locations. This includes text, numbers and formulae. Spreadsheet software also includes a facility to convert a range of data into a graph or a chart. This function allows a large amount of data to be searched very quickly and global changes made in a single action. For example, currency symbols can be changed throughout a workbook from, say to $. Any cell within a workbook can be locked to prevent a third party making changes. This is particularly useful where spreadsheets are distributed between departments and the original integrity needs to be maintained. The workbook can also be password protected to prevent unauthorised access. Saving The save function enables different versions of the spreadsheet to be saved or a single spreadsheet to be saved in multiple locations. An automatic backup can also be set which minimises the possibility of lost data should there be a power failure. 105

114 Home Learning College Printing The print function is highly flexible and allows the operator to select which cells they wish to print and the page layout can be adjusted to suit the nature of the data (portrait and landscape, scaling and no scaling) Gridlines can also be removed if this would enhance the appearance of the data. Underlying formulae, though not usually visible, can be printed if required (see the illustration below). Use of spreadsheets in cost accounting There are many ways that spreadsheets can be used by cost accountants in their daily work routine. They are particularly useful for planning and budgeting, making complex calculations and summarising or consolidating large amounts of data. Planning Planning involves forecasting data as well as assessing the impact of potential changes in operations. Forecasts and budgets are two areas where spreadsheets can help managers plan activity and forecast costs, revenues and profits or losses. The impact of a change in any one of the 106

115 Basic Costing variables can be assessed quickly and easily (sensitivity analysis) and results can be summarised and distributed to all relevant parties. Budget control Budget control can be simplified by using spreadsheets firstly to prepare the original budget and then to monitor actual performance against budget. Variances can be identified using the mathematical functions of spreadsheets. This enables managers to take responsibility for monitoring and controlling their departments and also to see the impact that poor results from their department might have on other departments within the organisation. Budgets can also be updated and rolled forward incorporating actual results. An organisation may prepare a number of different budgets which can be linked and incorporated into a budgeted statement of profit or loss and a budgeted statement of financial position. Performing calculations There are some calculations that are simplified through the use of a spreadsheet, especially those that may need repetition and updating. For example, calculating interest on borrowing or on investments can be performed with a high degree of accuracy providing that the original formula is correct and is capable of being replicated. Summarising data Spreadsheets enable large amounts of data to be consolidated or summarised into smaller key data that can be used by management in their planning, decision making and control activities. Advantages and disadvantages of spreadsheets There are a number of advantages and disadvantages with spreadsheet software which students should be aware of. Advantages Spreadsheet software is easy to understand and use. Basic and complex mathematical calculations can be performed quickly and accurately. The impact of changes can be performed quickly enhancing managers ability to analyse different courses of action (what-if scenarios). 107

116 Home Learning College Data can be assimilated, analysed, sorted and shared in a convenient manner Disadvantages Incorrect formulae can result in inaccurate and misleading data. Formulae are not displayed in the worksheet cells so recipients may not easily be able to follow the logic of the calculations. Spreadsheets may look impressive but could contain critical errors which result in poor management decisions. Large amounts of data may lead to complicated looking worksheets which make quick assimilation and understanding of the critical facts difficult. Entering data into a spreadsheet Spreadsheets usually contain a combination of data in the form of text and numbers as well as calculations using formulae. Text and numbers are entered into a cell by clicking on the required cell and typing either words or numbers. The example below shows the heading Income/Expenditure in cell A1. The heading spans cells A1 and B1. The column width can be adjusted by placing the cursor on the right edge of cell A until an arrow appears and then dragging the cell to the required width. 108

117 Basic Costing Assuming that the spreadsheet being created relates to budget and variances then the following can be entered into the spreadsheet: A2 A3 A4 A5 Income Material Labour Overheads B1 Budget C1 Actual D1 Variance E1 Adverse or Favourable (A or F) The cells will be widened where neccesary and the spreadsheet will appear as follows: Cell E1 is really wide and so it might be preferable to decrease the width of the cell but increase its height so that the header is on two lines. This can be done by right clicking on the cell, selecting Format cells and ticking wrap text under the alignment tab. 109

118 Home Learning College Alternatively the cell can be highlighted and the wrap text icon selected. The cell width can then be adjusted as required. The headings can be formatted as bold and centred by highlighting cells A1 to E1 and selecting the Bold icon and then the centred icon as shown below: Numbers can be entered into any cell by clicking on the required cell and then typing in the number using the computer keyboard. 110

119 Basic Costing The budget figures for the period are to be entered into the spreadsheet: Income 70,000 Material 18,000 Labour 14,500 Overheads 21,000 The number cells can also be formatted to include comma separators and no decimal places. This ia accessed by highlighting the cells, right clicking, selecting Format cells, Number, nil decimal places and Use 1000 separator, as illustrated below. The actual figures for the budget period were: Income 68,000 Material 18,300 Labour 14,250 Overheads 20,000 These can be entered into the spreadsheet in column C. 111

120 Home Learning College Using formulae There are a number of formulae that can be used in spreadsheet software. The ones that students will be expected to understand and use for basic costing are total, addition, subtraction, multiplication and division. When entering a formula to perform mathematical calculations it is important to remember not to insert any spaces in the formula. The following symbols are used in the formulae: + add - subtract * multiply / divide = total The spreadsheet used above is going to be expanded to incorporate the total of the expenses and the profit for both the budgeted figures and the actual figures. The total of the expenses will be entered on Row 6 using a formula. There are two ways to arrive at a total; the cells can be added together or the SUM function can be used. The budgeted expenses will be calculated using the first method. The cells to be added together are B3, B4 and B5. This can be entered in cell B6 as: =(B3+B4+B5) The coloured lines around the cells show which cells are included in the formula. 112

121 Basic Costing When enter is pressed the answer 53,500 will show in cell B6. The second method is to use the autosum function on the spreadsheet. This is found on the toolbar in the editing section. With the cursor at cell C6 the autosum button can be selected and the software will select the cells that it thinks require totalling. In this case the software has selected cells C2, C3, C4 and C5. This is not what is required because it includes the figure for income. This can be amended by using the cursor to select just cells C3, C4 and C5. 113

122 Home Learning College When enter is pressed the total 52,550 will appear. The sum formula can also be entered manually as =SUM(C3:C5) with the colon specifying all cells between C3 and C5. It may be useful for management to know the amount of budgeted profit as well as the actual profit so this can be entered onto the spreadsheet on Row 7. The budgeted profit can be calculated by deducting the total expenses from the profit. Therefore the formula to be entered is: =(B2-B6) The actual profit is calculated using: =(C2-C6) The variance is calculated as the difference between the budgeted figure and the actual figure. It is possible to calculate the variance so that an adverse variance shows as a negative figure. However, it is uncertain how the AAT will expect students to show the variances. It is important that the task requirement is read carefully to determine whether or not adverse variances should be shown as negative figures. 114

123 Basic Costing Assuming that the AAT wish the variances to be shown in the variance column without brackets then the smaller figure needs to be deducted from the larger figure to determine the variance amount. Hence the following formulae will be inserted into the spreadsheet: Cell D2 Cell D3 Cell D4 Cell D5 Cell D6 Cell D7 =(B2-C2) =(C3-B3) =(B4-C4) =(B5-C5) =(B6-C6) =(B7-C7) The spreadsheet will then be as shown below: The spreadsheet can be completed by entering A or F in column E to denote whether the variances are adverse or favourable. Remember that if actual revenue is lower than budget then the variance will be adverse and if actual expenses are higher than budget then the variance will be favourable. The content of column E should be centred. If management requires adverse variances to be shown as negative figures then the formulae to be entered would be: Cell D2 Cell D3 Cell D4 =(C2-B2) =(B3-C3) =(B4-C4) 115

124 Home Learning College Cell D5 Cell D6 Cell D7 =(B5-C5) =(B6-C6) =(C7-B7) The spreadsheet would then appear as follows: If negative variances are required then it is important to ensure that the budgeted figure is deducted from the actual figures for revenue and profit and that the actual figure is deducted from the budgeted figures for expenses. The spreadsheet can be used to show the variance as a percentage of the budgeted figure. This may be needed to determine whether a variance is significant or not significant. Percentages can be calculated using basic mathematical functions of division and multiplication, thus: Variance Budget x 100 Column F is to be used to calculate the variance as a percentage of budget for income, material, labour and overheads. Therefore the formulae to be used is: Cell F2 Cell F3 Cell F4 Cell F5 =(D2/B2*100) =(D3/B3*100) =(D4/B4*100) =(D5/B5*100) The spreadsheet will be as follows: 116

125 Basic Costing The variance percentages can be displayed to 2 decimal places by highlighting cells F2 to F5, right clicking, selecting format cells, number tab, number category and 2 decimal places. Percentages can also be calculated using the percentage function of the spreadsheet. The first step is to format cells F2 to F5 by right clicking, selecting format cells, number tab, percentage category and 2 decimal places. The following formula are then entered and the percentage will automatically be calculated and displayed to 2 decimal places: Cell F2 Cell F3 Cell F4 Cell F5 =(D2/B2) =(D3/B3) =(D4/B4) =(D5/B5) Assuming that the company considers any variance above 2.5% as significant then an additional column can be inserted to show whether the variance is significant (S) or not significant (NS). The spreadsheet would be as follows: 117

126 Home Learning College Reordering and averaging data Spreadsheets allow users to manipulate data quickly and easily. There are two functions that students should be able to perfom for this unit: reordering data and calculating an average. Reordering data is done using the sorting function on the spreadsheet. The data to be sorted should be highlighted and the sort filter selected, then custom sort. A second window will open which allows the user to select the parameters for sorting the data. The drop down menus allow the user to select which column is to be used to sort the data, the criteria for sorting and the order of the data. In this case the column to be used to sort the data is the variance column based on values and the data is to be sorted from the largest to the smallest (or in descending order). 118

127 Basic Costing If the data is required in ascending order or the smallest to the largest based on the % variance then the criteria can be changed as follows: The results will be: The average function calculates the average of a specified set of data The average function is found under autosum on the tool bar. Assume that the company wants to know the average budgeted expenses and the average actual expenses. The average budgeted expenses will be entered in cell B9. The cell should be highlighted and the average function selected. The software automatically selects all of the cells above. 119

128 Home Learning College As the required range is C3 to C5 then these cells should be highlighted. When enter is selected the average will be calculated. The same result could have been achieved by entering the formula =(B3+B4+B5)/3 however the AAT assessment is likely to require use of or identification of the average function. The average actual overhead cost can be calculated using the average function. 120

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