F2 – Chapter 3 – Cost accounting techniques

Cost accounting techniques

Key Points to Highlight in Chapter 3

Accounting for Materials

• Involves tracking material acquisition and usage within an organization.
• Helps in monitoring inventory levels, controlling costs, and ensuring efficient resource utilization.

Accounting for Labor

• Focuses on providing information for internal decision-making processes.
• Includes tracking labor costs, analyzing productivity, and optimizing workforce utilization.

Overheads

• Refer to indirect production costs incurred during the manufacturing process.
• Include expenses such as rent, utilities, depreciation, and maintenance of production facilities.

Absorption Costing

• Considers all production costs, both variable and fixed, when valuing inventory.
• Allocates both direct and indirect manufacturing costs to units of production.

Job Costing

• Assigns costs directly to individual units or batches of products.
• Suitable for industries where products or services are customized or produced in small batches.

Process Costing

• Used in industries with continuous, mass production of homogeneous products.
• Calculates average costs per unit over a specific production period.

Joint Products

• Refer to products produced in the same process up to a split-off point.
• Share common production costs up to the split-off point and may require further processing.

Standard Costing

• Involves comparing actual costs to predetermined standards or benchmarks.
• Provides a systematic framework for cost control, performance evaluation, and continuous improvement.

Activity-Based Costing (ABC)

• Assigns indirect costs to products based on activities that consume resources.
• Provides more accurate cost information for decision-making purposes.

Variable Costing

• Allocates only variable manufacturing costs to products.
• Focuses on separating variable costs from fixed costs for internal decision-making.

Historical Costing

• Not an alternative costing principle but a traditional costing method.
• Involves valuing inventory and recording costs based on actual historical costs incurred.

Machine Depreciation

• Example of a fixed overhead cost in manufacturing.
• Incurred to maintain production capacity and remains constant regardless of production levels.

Cost per Equivalent Unit

• Calculated in process costing for each production department or process.
• Combines costs incurred to date with the equivalent units of production.

Predetermined Cost Benchmarks

• Set in standard costing for various cost components.
• Represent expected costs to produce one unit of output under normal operating conditions.

Custom-Made Products

• Best suited for job costing, where costs are assigned directly to specific jobs or projects.
• Allows for accurate cost estimation and pricing of customized products or services.

Continuous Production Industries

• Process costing is commonly used in industries with continuous, mass production of homogeneous products.
• Calculates average costs per unit over large production volumes.

Internal Decision-Making

• Variable costing is primarily used for internal decision-making rather than external reporting.
• Focuses on separating variable costs from fixed costs for better decision-making.

Overhead Allocation

• Activity-based costing is particularly useful for identifying and allocating overhead costs based on resource consumption.
• Traces costs to specific activities or resources for more accurate allocation.

Fixed Overhead Costs

• Examples include machine depreciation in manufacturing.
• Remain constant regardless of the level of production activity.

Continuous Flow Production

• Process costing is suitable for industries with continuous flow production processes.
• Calculates average costs per unit over successive production stages.

Topic 1. Accounting for material, labor and overheads

This comprehensive exploration delves into the intricacies of accounting for material, labor, and overheads, equipping you with the knowledge and skills to effectively manage and analyze these key cost components.

A. Mastering Material Management:

i. Ordering, Receiving, and Issuing Systems:

• Ordering: Implement purchase orders specifying quantity, quality, delivery time, and price.
• Receiving: Conduct physical counts and verify against purchase orders and invoices.
• Issuing: Use requisitions and issue notes to ensure authorized use and track inventory levels.

ii. Control Procedures:

• Physical inventory counts: Regular counts compare physical stock to accounting records, identifying discrepancies.
• Periodic reconciliations: Reconcile inventory records with purchase orders, receipts, and issues.
• Perpetual inventory systems: Continuously update inventory records after each transaction.
• Access controls and segregation of duties: Limit access to materials and separate purchasing, receiving, and storage functions.

iii. Interpreting Material Inventory Accounts:

• Debit: Represents purchases and opening balance.
• Credit: Represents issues and closing balance.
• Balance: Reflects the value of materials on hand.

iv. Inventory Costs:

• Ordering costs: Costs associated with placing orders (e.g., setup costs, ordering costs).
• Holding costs: Costs of keeping inventory (e.g., storage, obsolescence, insurance).
• Buffer inventory: Additional safety stock to mitigate uncertainty in demand or supply.

v. Optimal Reorder Quantity (EOQ):

Minimize total inventory costs by balancing ordering and holding costs: EOQ = √(2DS/H), where D is annual demand, S is the setup cost, and H is the holding cost per unit.

vi. EOQ with Discounts:

Discounts for larger orders may influence EOQ. Use adjusted costs considering the discount impact.

vii. Continuous Replenishment:

Order smaller quantities more frequently to reduce holding costs. Calculate order quantity based on average daily usage and lead time.

viii. Reorder Levels with Constant Demand:

Reorder level = Lead time demand + Safety stock. Ensure sufficient inventory to cover lead time needs and fluctuations.

ix. Inventory Valuation Methods:

LIFO (Last-in, First-out): Assumes recently purchased items are issued first, reflecting current costs.

• FIFO (First-in, First-out): Assumes older items are issued first, reflecting historical costs.
• Average cost: Assumes a weighted average cost for issued items.

x. Just In Time (JIT):

Reduce inventory by receiving materials only when needed for production, minimizing holding costs and improving quality.

B. Demystifying Labor Accounting:

i. Direct vs. Indirect Labor Costs:

• Direct: Can be directly traced to specific cost units (e.g., production workers).
• Indirect: Cannot be directly traced to specific cost units (e.g., supervisors, HR personnel).

ii. Labor Tracking Systems:

Time sheets: Capture employees’ time worked on specific tasks or projects.

• Clock-in/clock-out systems: Electronically track working hours.
• Production reports: Document completed work units for piecework systems.

iii. Journal and Ledger Entries:

• Debit direct labor expenses for actual or accrued amounts.
• Credit accrued wages payable or wages payable accounts.
• Allocate indirect labor costs using an appropriate overhead absorption rate.

iv. Remuneration Methods:

Time-based: Wages based on hours worked (e.g., hourly pay).

• Piecework: Wages based on units produced (incentive to increase output).
• Individual and group incentive schemes: Bonuses based on meeting or exceeding individual or group performance targets.

v. Labor Turnover Analysis:

Calculate turnover rate = (number of leavers / average number of employees) x 100%.

• Analyze reasons for turnover (e.g., compensation, working conditions).

vi. Labor Efficiency and Capacity:

• Labor efficiency: Output per unit of labor input (e.g., units produced per labor hour).
• Capacity: Maximum output achievable with available resources.
• Production volume ratio: Actual output compared to capacity.

vii. Interpreting Labor Account:

• Debit side shows total labor costs incurred.
• Credit side shows wages paid and accrued wages payable.
• Balance represents unpaid wages for work already performed.

C. Unveiling the Overhead Labyrinth:

i. Direct vs. Indirect Expenses:

• Direct: Directly attributable to specific cost units (e.g., raw materials used in production).

• Indirect (Overheads): Cannot be directly traced to specific cost units and require allocation methods (e.g., rent, utilities, depreciation).

ii. Production Overhead Absorption Rates:

• Spread overheads to cost units using an appropriate base (e.g., direct labor hours, machine hours, production units).
• Predetermined overhead rate = Estimated total overheads / Chosen allocation base.

iii. Allocating and Apportioning Overheads:

• Production cost centers: Departments directly involved in production (e.g., machining, assembly).
• Service cost centers: Departments providing support to production (e.g., maintenance, administration).
• Allocate service cost centre costs to production cost centers using:
  • Direct method: Allocate directly traceable costs.
  • Step method: Allocate costs sequentially, considering service provided to other cost centers.
  • Reciprocal method: Iterate to account for reciprocal service provision between service cost centers.

iv. Selecting Appropriate Bases:

• Choose a base that causally related overheads to cost units (e.g., machine hours for depreciation of machinery).
• Consider practicalities and consistency for accurate cost allocation.

v. Journal and Ledger Entries:

• Debit production overhead accounts for incurred overheads.
• Credit overhead expense accounts for allocated overheads.
• Debit cost unit accounts for allocated overhead costs.

vi. Under and Over Absorption of Overheads:

• Under Absorption: Actual overheads exceed applied overheads. Indicates potentially inefficient resource utilization.
• Over Absorption: Applied overheads exceed actual overheads. May indicate inaccurate estimates or unused resources.

Remember:

• Effective cost accounting requires accurate data collection, appropriate cost allocation methods, and regular analysis of material, labor, and overhead costs.
• Understanding these components is crucial for informed decision-making on pricing, production planning, and cost control.
• Continuously evaluate and refine your cost accounting practices to maintain efficiency and profitability in a dynamic business environment.

This in-depth exploration equips you with the foundational knowledge and key concepts to navigate the complexities of material, labor, and overhead accounting. Remember, the journey continues with further exploration of advanced cost accounting techniques like activity-based costing, variance analysis, and cost management strategies, empowering you to gain even deeper insights and optimize your organization’s financial performance.

Topic 2. Absorption and marginal costing

In the dynamic world of cost accounting, understanding cost behavior is crucial for informed decision-making. This exploration delves into the concepts of absorption and marginal costing, highlighting their impact on inventory valuation, profit determination, and their relative advantages and disadvantages.

A. Contribution:

Contribution: The difference between selling price per unit and the variable cost per unit. It represents the amount available to cover fixed costs and contribute to profit.

Formula: Contribution = Selling price per unit – Variable cost per unit

Importance:

• Helps assess product profitability and identify contribution margin at different sales volumes.
• Provides essential information for decision-making on pricing, product mix, and resource allocation.

Illustration: A product selling for $10 has a variable cost of $6. The contribution per unit is $4 ($10 – $6). If fixed costs are $20,000, the break-even point (where contribution meets fixed costs) is 5,000 units ($20,000 / $4).

B. Contrasting Costing Approaches: Inventory Valuation and Profit

Absorption Costing:

• Considers both fixed and variable production costs as product costs, reflected in inventory valuation.
• Profit determination:

Profit = Revenue – Total cost of goods sold (COGS) – Operating expenses

• COGS includes fixed and variable production costs absorbed based on an overhead absorption rate.

Marginal Costing:

• Treats only variable production costs as product costs, excluding fixed costs from inventory valuation.
• Profit determination:

Profit contribution = (Contribution per unit x Number of units sold) – Fixed costs.

Illustrative Comparison:

Company A produces 10,000 units with a selling price of $10, variable cost of $6, and fixed costs of $15,000.

C. Calculating Profit under Different Costing Systems:

Absorption costing profit represents profit after recovering all production costs, while marginal costing profit reflects the contribution available to cover fixed costs after covering variable costs.

D. Reconciling Profits: Bridging the Gap:

The difference between profits calculated under absorption and marginal costing arises due to the treatment of fixed production costs. The formula to reconcile them is:

Absorption profit – Marginal profit = Fixed production costs under absorbed/over absorbed

E. Weighing the Options: Advantages and Disadvantages

Absorption Costing:

Advantages:

• Provides full costing information for inventory valuation, complying with accounting standards.
• Useful for external reporting and long-term planning.

Disadvantages:

• Complex and time-consuming, especially with varying activity levels.
• Fixed cost allocation can be arbitrary, impacting profit figures.

Marginal Costing:

Advantages:

• Simpler and easier to understand, focusing on short-term decision-making.
• Provides clearer insights into product profitability and contribution to fixed costs.

Disadvantages:

• Not suitable for external reporting due to incomplete inventory valuation.
• Potential misuse for pricing decisions if fixed costs are ignored.

Remember:

• The choice of costing method depends on the specific needs and objectives of the organization.
• Both absorption and marginal costing offer valuable insights, but it’s crucial to understand their underlying assumptions and limitations.
• Consider using both methods for a comprehensive understanding of cost behavior and informed decision-making.

This exploration equips you with the foundational knowledge and tools to navigate the contrasting realms of absorption and marginal costing. Remember, the journey continues with further exploration of advanced costing techniques like activity-based costing, variance analysis, and cost-volume-profit analysis, empowering you to make informed decisions and optimize your organization’s financial performance in an ever-evolving business landscape.

Topic 3. Cost accounting methods

Navigating the complex world of cost accounting requires understanding diverse methods to accurately track and analyze costs. This exploration delves into the characteristics, applications, and practical applications of job, batch, process, and service costing, empowering you to choose the right method for your specific needs.

A. Unveiling Job and Batch Costing:

(i) Characteristics:

• Job costing: Tracks costs for unique, identifiable projects or jobs.
• Batch costing: Tracks costs for groups of similar units produced together as a batch.

(ii) Applications:

• Job costing: Construction projects, custom printing, engineering services.
• Batch costing: Pharmaceutical production, chemical processing, bakery products.

(iii) Cost Records and Accounts:

• Job costing: Maintain dedicated job cost sheets to track all direct and indirect costs for each job.
• Batch costing: Use batch cost sheets to accumulate costs for each batch, allocated to individual units based on a chosen basis (e.g., number of units, total cost).

(iv) Establishing Costs:

• Job costing: Sum up all direct and allocated indirect costs on the job cost sheet to determine the total job cost.
• Batch costing: Divide the total batch cost by the number of units in the batch to calculate the unit cost.

Illustration: A construction company tracks costs for a building project using job costing. They record direct costs like materials and labor specific to the project. Indirect costs like overheads are allocated based on labor hours. The total job cost sheet reflects the project’s profitability.

B. Understanding Process Costing:

(i) Characteristics:

• Tracks costs for continuous production of identical or similar units through defined processes.
• Costs are accumulated in process cost centers representing specific production stages.

(ii) Applications:

• Chemical processing, oil refining, food production, paper production.

(iii) Normal vs. Abnormal Losses:

• Normal losses: Expected and unavoidable losses inherent in the production process (e.g., evaporation, spoilage).
• Abnormal losses: Unforeseen or excessive losses exceeding normal expectations (e.g., equipment malfunction, negligence).

(iv) By-products and Joint Products:

• By-products: Secondary products with lower commercial value than the main product.
• Joint products: Two or more valuable products resulting from a common production process.

(v) Valuing By-products and Joint Products:

• By-products: Valued at net realizable value (NRV) or notional value, reducing the cost of the main product.
• Joint products: Valued using methods like the sales value at the split-off point, constant or proportional costing, or market value adjustments.

(vi) Evaluating Further Processing:

• Analyze the additional costs and potential revenue from further processing by-products or joint products.
• Compare the benefits of further processing to selling them at the split-off point to determine optimal decisions.

Illustration: A chemical plant produces both chlorine and caustic soda as joint products. Their values at the split-off point are used to allocate joint production costs, and then further processing of chlorine is evaluated based on the additional cost-benefit analysis.

C. Demystifying Service/Operation Costing:

(i) Service Organizations:

• Provide intangible services rather than tangible products (e.g., hospitals, law firms, airlines).

(ii) Applications:

• Any service-oriented organization aiming to track and analyze service costs for pricing, resource allocation, and performance evaluation.

(iii) Unit Cost Measures:

• Direct cost per unit: Cost directly attributable to a specific service unit (e.g., patient-day in a hospital).
• Cost per activity: Cost of a specific activity involved in service delivery (e.g., cost per surgery).
• Time-driven costing: Cost based on the time taken to deliver a service.

(iv) Service Cost Analysis:

• Identify cost drivers and key activities influencing service costs.
• Allocate indirect costs to service units using appropriate bases (e.g., number of customers, service time).
• Analyze cost variances and identify areas for improvement and cost reduction.

Illustration: A hospital uses service costing to determine the cost per patient-day. They track direct costs like medication and indirect costs like nursing staff salaries. Analysis helps identify cost-saving opportunities and optimize resource allocation based on patient needs.

Remember:

• Choosing the appropriate cost accounting method depends on the nature of your business and production processes.
• Each method offers valuable insights, so understanding their characteristics and applicability is crucial for effective cost management.
• Continuously analyze and refine your cost accounting practices to maintain efficiency and profitability in today’s dynamic business environment.

Remember, continuous learning and practice are key to mastering the complexities of cost accounting. By leveraging the knowledge gained from this exploration and actively seeking further resources, you can become an invaluable asset to your organization, contributing to its financial success and informed decision-making.

Topic 4. Alternative cost accounting principles

While traditional costing techniques like absorption and marginal costing offer valuable insights, the dynamic business environment demands more sophisticated approaches. This exploration delves into three alternative cost management techniques – Activity-Based Costing (ABC), Target Costing, and Life-Cycle Costing – highlighting their unique contributions and how they differ from traditional methods.

A. Activity-Based Costing (ABC):

Beyond averages: Unlike traditional methods that allocate overheads based on broad measures like direct labor hours or machine hours, ABC focuses on activities that drive costs. It identifies, measures, and assigns costs to these activities, then links them to specific cost objects (products, services, customers) based on their actual consumption.

Benefits:

• More accurate product costing, identifying hidden costs in complex processes.
• Improved decision-making for pricing, product mix, and process improvement.
• Enhanced understanding of cost drivers and their impact on profitability.

Key Differences:

• Traditional: Averages costs across product units, potentially masking inefficiencies.
• ABC: Focuses on activity-level costs, providing more granular insights.

Illustration: A furniture manufacturer uses ABC to identify that setup costs for customized orders drive a significant portion of their costs. This empowers them to adjust pricing and focus on streamlining setup processes for improved profitability.

B. Target Costing:

Cost as a strategic tool: This technique sets a target cost for a product before production begins, aligning it with the desired selling price and profit margin. The process then works back from the target cost to identify cost reduction opportunities and ensure product profitability.

Benefits:

• Encourages proactive cost management throughout the product lifecycle.
• Improves communication and collaboration across departments.
• Aligns product costs with market demands and profitability goals.

Key Differences:

• Traditional: Focuses on historical costs and cost allocation, with limited influence on future costs.
• Target Costing: Sets future cost goals and actively manages costs to achieve them.

Illustration: A car manufacturer sets a target cost for a new electric car based on market research and desired profit margin. This drives design decisions, material selection, and production processes to achieve the target cost and ensure market competitiveness.

C. Life-Cycle Costing (LCC):

Beyond immediate costs: This technique considers all costs associated with a product or asset throughout its entire lifecycle, from acquisition and operation to disposal or recycling. It provides a holistic view of financial implications and aids in informed decision-making.

Benefits:

• Identifies long-term cost implications beyond initial purchase or production.
• Supports informed decisions on investments, maintenance strategies, and disposal options.
• Encourages sustainable practices by considering environmental and social costs.

Key Differences:

• Traditional: Focuses on short-term production or acquisition costs, neglecting long-term implications.
• LCC: Considers all costs across the entire lifecycle, providing a broader perspective.

Illustration: A company evaluating whether to purchase a new machine considers not only its initial cost but also its energy consumption, maintenance requirements, and disposal costs throughout its expected lifespan, providing a more complete picture of its financial impact.

Remember:

• Each alternative cost management technique offers unique advantages and is best suited for specific situations.
• Understanding their differences and when to utilize them empowers informed decision-making and cost optimization.
• Continuously evaluate and refine your cost management practices to adapt to evolving business needs and remain competitive.

This exploration equips you with the foundational knowledge of alternative cost management techniques. Remember, the journey continues with further exploration of advanced topics like cost behavior analysis, variance analysis, and cost-volume-profit analysis, empowering you to leverage these tools to navigate the dynamic landscapes of cost management and ensure your organization’s financial success.