Chapter 4: INTRODUCTION TO COST ACCOUNTING · Chapter 4: INTRODUCTION TO COST ACCOUNTING ... 4. Cost behaviour is how a cost changes in relation to the level of production activity.
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Test your knowledge 1. A direct cost is able to be traced to a product or service with a high degree of accuracy. Directly traceable means that the cost can be physically and easily (i.e. economically and conveniently) traced to the finished product. Direct materials and direct labour are the two most common direct costs for a business. Examples are:
• Raw materials used in making gold ring
• Wages of a mechanic in a car repair business
• Parts and supplies used in a panel beating business
• Cost of bottles used in making wine
• Cost of paint used in making a motor cycle
Indirect costs are not so easily traced to a product or service. These are items that are not actually incorporated in the product or are too insignificant to make it worth tracing the cost to the finished product. Examples are:
• Salary of the factory manager
• Local government rates and taxes
• Paint used in making a Dolls House
• Glue used in making furniture
• Oil and lubricants used in maintaining factory machinery
• Insurance of the business premises
2. Some costs may be direct in the making of one cost object and be indirect in the making of another cost object. Therefore the distinction between direct and indirect costs is important as it allows the determination of a cost object to be more accurate.
3. The factor that affects the classification of an item as a direct or indirect cost is whether it is traceable to the finished product. To be traceable means that the cost can be physically and easily (i.e. economically and conveniently) traced to the finished product.
4. Cost behaviour is how a cost changes in relation to the level of production activity. This is important as the distinction between fixed, variable and mixed costs is important to the accurate determination of the cost of a product or service. With a fixed cost the unit activity cost will change as the level of units produced increases or decreases, while with a variable cost the unit cost does not change. Fixed costs in total are constant as the level of activity increases whereas with a variable cost the total cost does increase as the level of activity increases. This cost behaviour affects the unit cost of a product or service.
5. Fixed costs are those that do not change in total when the level of activity changes. For example, the rent of a factory building will be the same in total no matter how many units are produced. Examples are:
• Depreciation of factory machinery • Office supervisor’s salary • Rent of a shop • Delivery vehicle insurance
A variable cost is one that changes in total as the level of activity changes. For example, the cost of raw materials in total will increase as the level of units produced increases. Examples are:
• Wages for casual staff to make glassware
• Raw materials used in the manufacture of a computer
• Cost of goods sold
• Commission paid to salespeople
Mixed or semi‐variable costs are those costs which contain both fixed and variable elements. For example, a telephone bill will contain the line rental cost, which is a fixed cost, and the cost of phone calls made, which is a variable cost. Examples are:
• Telephone bill
• Maintenance costs
• Electricity
• Water rates
6. Direct materials are those raw materials that are directly traceable to the product being made.
Raw materials are what go into the making of a product. For example, in the making of a men’s suit the raw materials would be such items as the fabric, the lining, buttons and thread. Other examples are in making a bottle of wine the bottle would be a direct material, in making a lounge chair the wood in the chair structure would be a direct material, for a T‐shirt product the cotton material would be a direct material and for shoes the direct material would be leather.
The direct labour cost is the amount paid such as wages, salaries, long‐service leave, sick leave, and payroll tax paid to the employees that is traceable to the finished product. Examples are machine operators in a factory making security screens, panel beaters fixing vehicles and bakers making bread products
Manufacturing overhead represents costs that are not direct materials or direct labour, but which are still part of the manufacturing process. Examples are:
• Indirect materials
• Indirect labour
• Electricity, water and gas used in the production of a product
• Depreciation
• Insurance
• Maintenance of the factory buildings
• Repairs to equipment used in the manufacturing process
7. Costs of operating a business that are not incurred in the manufacturing process are called non‐manufacturing costs. These can be categorised as selling or marketing costs, distribution or transport costs, administration costs and financial costs. Examples are:
• Direct materials used in the making of a surfboard
• Direct labour used in making a diamond ring
• Overheads assigned to the manufacture of a ball gown
8. A product cost includes all those costs that are attributable to a product and are those costs to do with merchandise acquired or manufactured or a service provided. It is recorded as an expense in the period in which the product is sold and this will be recorded as the cost of goods. The product is an asset because it has future economic benefit to the business.
Costs that are not product costs are period costs. Period costs are an expense and therefore shown in the business income statement in the period in which they are incurred. A period cost is a cost that relates to the current accounting period and which does not have a future economic benefit to the business. Period costs are not carried forward with the product until the time of sale. Examples are:
• Advertising • Wages paid to sales personnel
• Office rent • Office contents insurance
9. Cost accounting is the measuring, analysing, recording and reporting on the cost of a product or service. Cost accounting is useful to both financial and managerial accounting for such purposes as:
• determining profitability – management can determine if it is worth producing or selling the product or service.
• the setting of selling prices – often set with reference to the cost of the product or service • control of costs – comparing actual product costs with planned costs and, if necessary, taking corrective action so that the predetermined targets are met in the future
• planning – using past product costs to estimate future product costs
• inventory valuation – calculating the value of products that are complete (finished goods) and products that are partially complete (work in progress) at the end of each accounting period for inclusion in the financial statements
10. Absorption costing is the method whereby all fixed manufacturing costs and variable manufacturing costs are included in the product cost.
11. Job order costing is the process of recording all the costs of a distinct product or service. A job order costing system is used when a business creates a single unit or multiple units of a distinct product, makes a product to a customer order or provides a service to meet specific customer requirements. Each job has its own special characteristics and may be, for example, a single product, a batch of the same product or a service provided to an individual client.
12. A predetermined overhead rate allocates the indirect costs of production to the actual quantity of the product or service produced.
The predetermined overhead rate is calculated as = budgeted manufacturing overhead cost budgeted allocation base
13. A normal costing system determines the cost of a product or service with job order costing using actual direct materials, actual direct labour and a predetermined overhead rate. These figures are applied to the actual quantity related to a job. The predetermined overhead rate allocates the indirect costs of production to the actual quantity of the product or service produced.
14. Standard costing is a system of product costing where the cost of a product is based on standard costs for direct materials, direct labour and manufacturing overheads. A standard cost is a predetermined cost and based on some preconceived benchmark of what is considered appropriate to the making of a product. Therefore, the direct materials, direct labour and manufacturing overhead are not actual costs but rather estimates based on a standard cost.
15. Variance analysis is the comparison of the actual results compared to the standard amount or value called the flexible budget. The flexible budget is the standard quantity or hours allowed for output multiplied by the standard price or rate
16. The markup is the amount (either in dollars or percentage) added to the unit cost price of a product or service to determine its selling price. Therefore the selling price = cost + (markup percentage × cost)
17. As there are too many possible answers to this question, students should check their answers with their teacher.
Wages of vehicle factory assembly workers Manufacturing cost Direct cost Variable cost Product cost
Salaries of marketing staff Non‐manufacturing cost N/A Fixed cost Period costDepreciation of office equipment in a law practice Non‐manufacturing cost N/A Fixed cost Period cost
Surfboard factory supervisor’s salary Manufacturing cost Indirect cost Fixed cost Product costGlue used in the production of chairs Manufacturing cost Indirect cost Variable cost Product costLinen cloth used in the upholstery of a chair Manufacturing cost Direct cost Variable cost Product costStationery used in the administration office of an architect Non‐manufacturing cost N/A Fixed cost Period cost
Salary of the business accountant for a chain of jewellery stores Non‐manufacturing cost N/A Fixed cost Period cost
Wages of factory store personnel Manufacturing cost Indirect cost Fixed cost Product costDepreciation of factory machinery Manufacturing cost Indirect cost Fixed cost Product costElectricity used in a factory brewing beer Manufacturing cost Indirect cost Variable cost Product costInsurance of business delivery vehicles Non‐manufacturing cost N/A Fixed cost Period costVarnish paint used in making furniture Manufacturing cost Indirect cost Variable cost Product costDye used in making t‐shirts Manufacturing cost Indirect cost Variable cost Product cost
4.2 Item Manufacturing or Non‐
manufacturing cost Direct or
Indirect cost Fixed or Variable cost
Or Mixed cost Product or Period cost
Paper used in the making of a textbook Manufacturing cost Direct cost Variable cost Product costDepreciation of factory machinery Manufacturing cost Indirect cost Fixed cost Product costSales commission paid to sales staff Non‐manufacturing cost N/A Variable cost Period costWages paid to factory assembly workers Manufacturing cost Direct cost Variable cost Product costWages paid to workers making pizzas in a fast food shop Manufacturing cost Direct cost Variable cost Product cost
Leather used in making shoes Manufacturing cost Direct cost Variable cost Product costSalary paid to business director of chain of music stores Non‐manufacturing cost N/A Fixed cost Period cost
Wages paid to delivery drivers in a transport company Non‐manufacturing cost N/A Variable cost Period cost
Wages paid to pizza delivery drivers in a fast food business Non‐manufacturing cost N/A Variable cost Period cost
Plumbing materials used in a plumbing business Non‐manufacturing cost N/A Variable cost Period cost
Electricity used in repairing a vehicle in a panel beating workshop Non‐manufacturing cost N/A Variable cost Period cost
Oil used by a mechanic in servicing and repairing vehicles Non‐manufacturing cost N/A Variable cost Period cost
Steel used to make pergolas Manufacturing cost Direct cost Variable cost Product cost
Standard hours allowed for output X standard rate625 direct labour hours (5 000 deserts X 7 ½ minutes per desert) X $87.27 per direct labour hour = $54 543.75
Spending variance is $10 000 U Production volume variance is $9 000 U
c) and d) Direct labour rate and efficiency variances Actual results Flexible budget
Actual hours of inputs X actual rate 800 hours (3 200 frames X 15 minutes per frame) X $24.00 per hour wage rate = $19 200
Actual hours of inputs X standard rate 800 hours (3 200 frames X 15 minutes per frame) X $22.00 per hour = $17 600
Standard hours allowed for output X standard rate 853.33 hours (3 200 frames X 16 minutes per frame) X $22.00 per hour = $18 773.26
Rate variance is $165 U Efficiency variance is $1 173.26 F
g) and h) Fixed overhead spending and production volume variances Actual results Budgeted Flexible budget Allocated fixed overhead applied
Actual hours of inputs X actual rate $14 080 (1 600 machine hours X $8.80 per machine hour)
Budgeted amount regardless of output $13 496 (1 400 machine hours X $9.64 per machine hour)
Budgeted amount regardless of output $13 496 (1 600 machine hours X $8.44 per machine hour)
Standard hours allowed for output X standard rate $14 395.70 (1 493.33 machine hours (3 200 frames X 28 minutes per frame) machine hours X $9.64 per machine hour)
Spending variance is $584 U Production volume variance is $899.70 F
e) and f) Variable overhead spending and efficiency variances Actual results Flexible budget
Actual hours of inputs X actual rate $13 280 (1 600 machine hours (3 200 X 30 minutes) $8.30 per machine hour)
Actual hours of inputs X standard rate $13 712 (1 600 machine hours (3 200 X 30 minutes) X $8.57 per machine hour
Standard hours allowed for output X standard rate $12 797.84 (1 493.33 hours (3 200 frames X 28 minutes) machine hours X $8.57 per machine hour)
Spending variance is $432 F Efficiency variance is $914.16 U
4.22 Direct materials price and quantity variances
Actual results Flexible budget Actual quantity of inputs X actual price 7 200 square metres X $210 per sq metre = $1 512 000
Actual quantity of inputs X standard price 7 200 square metres X $200 per sq metre = $1 440 000
Standard quantity allowed for output X standard price 6 900 square metres (3 sq metres X 2 300 rugs) X $200 per sq metre = $1 380 000
Price variance is $72 000 U Quantity variance is $60 000 U
Direct labour rate and efficiency variances Actual results Flexible budget
Actual hours of inputs X actual rate 4 400 hours X $22.00 per hour wage rate = $96 800
Actual hours of inputs X standard rate 4 400 hours X $21.00 per hour = $92 400
Standard hours allowed for output X standard rate 4 600 hours (2 300 rugs x 2 hour per rug) X $21.00 per hour = $96 600
Rate variance is $4 400 U Efficiency variance is $4 200 F
$46 000/51 000 machine hours = $0.91 per machine hour
4.23 a) Predetermined overhead per machine hour
$430 000/4 570 = $94.09 per machine hour
b) Cost of new outback tent
Direct materials ($463 000/500) $ 926 per tent
Direct labour ($23 560/500) $ 47 per tent
Overheads ($94.09 X 160 hours = $15 054.40/500) $ 30 per tent
Total cost of one tent $1 003
c) Price to be charged of one new tent
$1 003 + ($1 003 X 35%)
$1 003 + 351
= $1 354
Therefore the price to charge of one new camping tent is $1 354
d) The factors that would be considered would be: o The selling price that the customer is willing to pay
o The selling price that is competitive in the marketplace
o The desired rate of return on investment, that is, what profit margin does the business wish to make. o The business’s costs, as all costs must be covered.
30 000 X 30% = 9 000 hours X $35 per hour $315 000
Overheads
Installation Department –
30 000 X 30% = 9 000 hours X $7 per hour $ 63 000
Total cost of one $568 000
Cost of one Basic Installation Package:
Production 2 500 X 40% = 1 000 air conditioners
Therefore $568 000/1 000 = $568 each
c) Quote for Holly Spears
One A67 Basic Air Conditioner $3 467
One Basic Installation Package $ 568
Other parts for installation $ 250
Extra direct labour time 2 hours $35 per hour = $ 70
Total cost $4 355
Plus mark up $4 355 X 25% $1 089
Total cost to make and install $5 444
Essay The following is a skeleton outline only showing some key points.
Cost accounting is important to the accurate measuring, analysing, recording and reporting on the cost of a product or service so as to determine the selling price of an item and its profitability. Cost accounting information is therefore used to make informed decisions and to maximise profits. The business can see how profit is linked closely with costs and the level of business activity.
Costing can be used to improve the efficiency and effectiveness of business operations through identifying value‐added and non‐value‐added costs. The latter can then be eliminated to make the business more profitable.
Specifically cost accounting is important and useful as follows:
• control of costs – comparing actual product costs with planned costs and, if necessary, taking corrective action so that the predetermined targets are met in the future
• planning – using past product costs to estimate future product costs
• inventory valuation – calculating the value of products that are complete (finished goods) and products that are partially complete (work in progress) at the end of each accounting period for inclusion in the financial statements
• the setting of selling prices – often set with reference to the cost of the product or service • determining profitability – management can determine if it is worth producing or selling the product or service.
In explaining how it is useful students should give examples for each of the above relating to manufacturing, service and retail businesses.
Job order costing is the process of recording all the costs of a distinct product or service. A job order costing system is used when a business creates a single unit or multiple units of a distinct product, makes a product to a customer order or provides a service to meet specific customer requirements.
Each job has its own special characteristics and may be, for example, a single product, a batch of the same product or a service provided to an individual client. In each case the job uses its own specific resources. A batch may be a variety of wine, a type of shirt made for a particular market or a small quantity of invitations printed for an expo. The business may manufacture a number of different unique products in small or large quantities or provide a number of different services to meet client requests. The product being manufactured or service provided is unique and different to the other products being made by the business.
Job order costing is used in both manufacturing and service industries but is rarely used in merchandising firms as the cost of the product is already known.
Many firms are not purely manufacturing, merchandising or service firms, but a bit of each, as they may make and/or sell a product and also provide a service to the customer. For example, a firm may manufacture, sell and install swimming pools or a café may make sandwiches, sell pre‐purchased cakes and provide customers with an agreeable venue to eat them in. Job order costing is used in such service industries as accounting firms, legal firms and repair shops.
Job order costing records all the costs for each finished job whereby all costs are traced and allocated to the job and the quantity noted. It is possible then to calculate the average cost per unit of the item being made or service provided.
A job order costing system is used when a business creates a single unit or multiple units of a distinct product, makes a product to a customer order or provides a service to meet specific customer requirements.
Each job has its own special characteristics and may be, for example, a single product, a batch of the same product or a service provided to an individual client. In each case the job uses its own specific resources. A batch may be a variety of wine, a type of shirt made for a particular market or a small quantity of invitations printed for an expo. The business may manufacture a number of different unique products in small or large quantities or provide a number of different services to meet client requests. The product being manufactured or service provided is unique and different to the other products being made by the business.
Job order costing is used in both manufacturing and service industries but is rarely used in merchandising firms as the cost of the product is already known. Job order costing is used in such service industries as accounting firms, legal firms and repair shops.
Job order costing records all the costs for each finished job whereby all costs are traced and allocated to the job and the quantity noted. It is possible then to calculate the average cost per unit of the item being made or service provided.
Actual costing calculates the cost of a product or service using the actual direct materials, actual direct labour and actual overheads costs. All costs are applied to the actual quantity. In the case of the actual overhead costs, an actual overhead rate is applied at the end of each accounting period to the product or service to determine the total unit cost.
Normal costing determines the cost of a product or service with job order costing using actual direct materials, actual direct labour and a predetermined overhead rate. These figures are applied to the actual quantity related to a job. The predetermined overhead rate allocates the indirect costs of production to the actual quantity of the product or service produced.
Absorption costing is the method whereby all fixed manufacturing costs and variable manufacturing costs are included in the product cost.
Standard costing is a system of product costing where the cost of a product is based on standard costs for direct materials, direct labour and manufacturing overheads. A standard cost is a predetermined cost and based on some preconceived benchmark of what is considered appropriate to the making of a product.
A direct cost is able to be traced to a product or service with a high degree of accuracy. Directly traceable means that the cost can be physically and easily (i.e. economically and conveniently) traced to the finished product. Direct materials and direct labour are the two most common direct costs for a business. Indirect costs are not so easily traced to a product or service. These are items that are not actually incorporated in the product or are too insignificant to make it worth tracing the cost to the finished product
Fixed costs are those that do not change in total when the level of activity changes. For example, the rent of a factory building will be the same in total no matter how many units are produced. A variable cost is one that changes in total as the level of activity changes. For example, the cost of raw materials in total will increase as the level of units produced increases
A product cost includes all those costs that are attributable to a product and are those costs to do with merchandise acquired or manufactured or a service provided. It is recorded as an expense in the period in which the product is sold and this will be recorded as the cost of goods. The product is an asset because it has future economic benefit to the business. Costs that are not product costs are period costs. Period costs are an expense and therefore shown in the business income statement in the period in which they are incurred. A period cost is a cost that relates to the current accounting period and which does not have a future economic benefit to the business. Period costs are not carried forward with the product until the time of sale.
Ethics case study The General Manager may have chosen direct labour hours for the allocation of overheads instead of the machine hours recommended by the Financial Controller so as to ensure that more or less cost is charged to the contract. The selection of the inappropriate cost allocation base could see more or less cost charged to the contract than would otherwise be the case if machine hours had been chosen.
The first ethical issue relates to the over‐charging or under‐charging of cost to the Sarich contract. The question here is why? Is it to make extra profit out of the Sarich contract or is under‐charge them so as to ensure further business in the future. The other question related to this is ethical issue is: what is the relationship of the General Manager to the Sarich contract? Is there a conflict of interest?
A further ethical issue relates to the perceived technical competence of the financial controller. This decision of the General Manager could reflect poorly, although not correctly so, on the Financial Controller. If a problem was to occur in the future with the Sarich business and this contract, and the Board of Directors was to investigate all aspects of the contract, it could perhaps incorrectly attribute some of the problem to financial controller for not selecting the appropriate allocation base. This business may have under‐charged or over‐charge Sarich and may blame this on the Financial Controller.
The Financial Controller has a number of possible options. He/she could contact the Board of Directors of Digital Electronics Ltd and explain his/her concerns to them. He/she could write a memo to the General Manager outlining his/her concerns and in this way place it on the records. He/she could contact the Sarich business, although this may be seen by Digital as breaking confidentiality. A further possible course of action is for the Financial Controller to resign.