COST ACCUMULATION

OBJECTIVE
By the end of this lesson you should be able to describe the cost accumulation process for materials, labor
and overheads and solve computational problems

CONTENT
Cost accumulation
 Define cost accumulation
 Elements of cost: material, labor and overheads
 Determination of costs in manufacturing, services and retail industries
Material costs
 Ascertainment of material costs/classification.
 Material cost records
 Material purchasing procedures
 Receipts, issue and storage of materials
 Methods of valuing material issues.
 Stores control procedures.
 Ledger entries for material costs. (Introduction to cost book keeping)

Labour costs
 Classification labor costs
 Methods of labor remuneration
 Labor control procedures
 Maintenance of labor records
 Wages department
 Ledger entries for labor costs

Overhead costs
 Definition
 Types/Classification
  Purposes of overhead cost analysis
 Allocation and apportionment of overhead costs
 Absorption of production overhead costs
 Absorption of non-production overhead costs by cost units
 Over or under absorption
 Ledger entries for overhead costs

INSTRUCTIONS
Read the assigned study pack text
Reinforcement Questions 3.
3. MATERIAL COSTS
Materials refer to the tangible inputs into the process of producing useful output. They could be direct
materials or indirect materials (overheads) e.g. to produce tea, tealeaves is the material (input).
3.1 Material cost classification
Material costs may be classified as:
a) Direct Material Cost: Refers to costs of materials that may readily be identified with output
units. The cost of timber used in the manufacture of a chair is an example of a direct material.
b) Indirect Material cost: refers to items of raw materials for which it would be difficult and or
inefficient to attempt to charge directly to specific cost units. For example the glue used to bind
the joints in the assembly of a chair
Other examples of indirect materials include:
- Materials used by service departments e.g. spare parts used by maintenance department in
repairing and servicing plant and machinery
- Materials used by non production functions e.g. stationary used in accounting department

Material cost control

Materials form a significant cost of output units and therefore should be controlled. Material Control is
more than simply recording the accounting transactions relating to material cost. Control should be
implemented to ensure that material is available
a) In appropriate quantities
b) In appropriate quality
c) In appropriate location
d) At an appropriate time
e) At the most economic cost

Control may be exercised at a number of points in the business cycle as follows

a) When the choice is made as to the type and quality of material to be used
b) Where the purchase order is being placed with the chosen supplier
c) On receipt of the material from supplier, check the appropriateness of quality and quantity of
materials received.
d) Where the material is held in store before use: It must be safe from theft and damage
e) Where the material is issued from the store: It must be issued to the correct department
f) Where the material is being used for intended purposes e.g. the material must be utilized to
produce the desired output.

The material control system must attempt to ensure that the company does not incur costs in excess of an
agreed efficient level of expenditure. Lack of adequate control routines will result in the incidence of
costs in excess of an acceptable level, reduced profitability of production and increased operational costs.
Inventory Control and Management
The objectives of inventory management are
 To ensure adequate stocks to allow for continuous operations/production, and
 To minimize the cost of having inventory.

Inventory management is important since in most organizations it represents the largest single investment.
The major types of inventory are:
 Raw materials
 Work in progress
 Finished goods

To achieve the above objectives of material cost costing , the manger has to make decisions regarding the
following:
a) What commodities to stock?
 Use Material Requirement Planning
From the Master Production Schedule, the manager has determined the products to be produced.
A Bill of Materials can then be prepared. This lists in descending order the components required
to make the final product. The information required includes part name or description, part
number, next higher level assembly, required quality per end item, quantity per end item and
quantity required for the next higher level assembly.

Stores Ledger Account is also used to obtain information on what is currently available. The
file shows balance on hand as well as past data on how much is usually ordered, lead-time, and
safety stock.
From the above the manager can determine what need to be purchased.
b) How much to stock?
 Use The Economic Order Quantity Model
This is a simple model that helps the manager to determine the optimum quantity of stock to
order so as to keep total costs at a minimum. The main costs of inventory are:
 Holding or carrying costs
 Ordering or set up costs
 Shortage costs
To determine the economic order quantity the following formula may be used:

EOQ = √2 ChDCO

Where D is the annual demand (knits)

Co is the cost of making one order
Ch is the holding cost per unit per annum

 Use Pareto Analysis

Items are classified into three classes as follows:
Class A: These are high cost, fast moving and high usage items. They are few accounting for
only 20 percent of the total number of items yet account for 80 percent of the total
inventory budget.
Class B: These are medium moving goods. They account for 15 percent of the total number of
the budget
Class C: These are slow moving low value items. They are very many accounting for 65 percent
of the total number of items and only 5 percent of the total inventory budget.
c) When to stock?
This will be influence by the inventory system in place as follows:
 Periodic order system.
The firm receives a new order of the amount specified by the order quantity at equal intervals of
time. The firm determines the maximum and minimum inventory, the safety stock and the
reorder level.
 Continuous Review System
The firm places orders at regular intervals but the order quantity varies according to how much a
firm requires to bring the level to some predetermined size or value.
 Just In Time Inventory System
This is a concept developed by the Japanese and advocates zero inventory and stockless production.
In addition, it calls for 100 per cent quality. Some of the major features of JIT include:
a) Frequent and reliable deliveries to avoid inventory build up. Companies are also setting
delivery dates with penalties for not meeting them.
b) Closer location to suppliers and customers
c) Improved communication between companies and suppliers through the use of computerized
purchasing systems that allows for online ordering.
d) Single sourcing and building long-term relations with a few trusted suppliers.

e) Increased supplier involvement in the design aspects of a product to ensure that they meet the
company’s quality requirements.
 f) Maintenance of strict quality control by all parties.
Material Handling
The objective is to ensure that goods are delivered to the right places at the right time and in aright
manner to avoid delays, congestation and unnecessary handling. A big percentage of production costs is
taken up by material handling activities. A good material handling system should minimize these costs.

The manger needs to determine the type of equipment to be used to handle the material. The type of
equipment that is most frequently used includes:
 Cranes
 Lifts
 Trucks
 Conveyors
 Towing
The factors that influence the type of equipment used includes:
 Type of materials being moved
 Volume
 Rate or frequency of movement
 Route of movement speed required
 Method of storage employed
 Safety or hazards involved.

Storage and Issue of Material

A number of factors are relevant in control of materials during storage and issue of materials. They are:
a) Stores location and layout
b) Stock level and its control.
c) Stock control records and issue procedures
d) Stock taking procedures
e) Valuation of inventories (issues and closing stock)

Stores location and layout

The layout of stores should ensure
a) Ease of access for movement of material in and out of stores
b) The issue of perishable materials on a first in first out basis
c) The segregation of toxic and dangerous materials in a separate location
d) Security of materials by restriction of access to authorized personnel only
The location of stores should ensure
a) Nearness to point of use to minimize expenditure on handling costs
b) Specialist stores e.g. spare parts for machinery should be located close to the point of use.

Stock Level and its control

Management must make decisions about the control of stock levels with a view to minimizing the cost of
the company while achieving more efficiency in the availability of material to fulfill planned usage
requirements. Consideration should be given to the following control levels:
a) Minimum stock level
b) Maximum stock level
c) Re-order level
d) Re order quantity (Note the re-order quantity is not necessary the EOQ)

a) Minimum stock level

This is the level below which stock should not fall. It is essentially a base (buffer) stock level. If stock
falls below this point, there is a danger of stockout.
Minimum stock level = Reorder level – (Normal consumption x normal reorder period)
b) Maximum stock level
This is the upper limit above which stock should not be allowed to rise. Each material to be kept in
store must have a maximum level and stock should not be allowed to go beyond this level
Maximum stock level = Re-order level +re-order Quantity - (Minimum consumption x minimum re-
order period)
c) Re-order level
Is a point that lies between minimum and maximum stock levels at which purchase orders must be
placed to ensure that goods ordered are received before the minimum stock level is reached? It is the
level of stocks at which replenishment must be made to avoid a stock-out.
Re-order level = maximum consumption X maximum re-order period
d) Re-Order quantity
This is the quantity of stock ordered once the re-order point is reached. The quantity is such as to
minimize stock costs taking into consideration the cost of holding stocks and making an order. This is
also regarded as the Economic Order Quantity (EOQ). It is computed as follows:
Where D is the annual demand (knits)
Co is the cost of making one order
Ch is the holding cost per unit per annum

EOQ = √ Ch
2 DCO

Economic Order Quality (EOQ)

Define the EOQ model and the three methods of computing EOQ.
- Assumptions of the model.

Illustration

The following information was extracted from the books of Danex Holdings regarding its stocks:
i. Reorder quantity 1,800
ii. Reorder period 4 weeks
iii. Maximum consumption 450 units/week
iv. Normal consumption 300 units/week
v. Minimum consumption 150 units/week
Vi Maximum reorder period 5 weeks
Vii Minimum reorder period 3 weeks

Required
Determine the following stock levels for Danex Holdings:
i. Re-order level
ii. Maximum stock level
iii. Minimum stock level
Solution
i) Re-order level = Maximum consumption X maximum reorder period
= 450 units X 5 weeks = 2,250 units
ii) Maximum stock level = reorder level + reorder quantity-
(Minimum consumption X minimum reorder period)
= 2250 + 1800 – (150 X3) = 4050 – 450 = 3600 units
iii) Minimum stock level = Reorder level – (Normal consumption X
normal reorder period)
= 2,250 – (300 X 4) = 2250 – 1200 = 1050 units

Economic Order Quantity (EOQ):

It constitutes the quantity purchased of either stocks or raw materials that is considered most optimum.
This is the quantity that minimizes both holding costs and ordering costs, As the quantity of purchase
increases there is a reduction in ordering costs, but an increase in holding costs as illustrated in the graph
below:

Total cost
Ordering costs Total cost

Holding Costs Holding costs

Ordering costs

0 Qx Quantity of Inventory

Qx represents the EOQ where the aggregate stock cost is lowest

 Total cost = Total ordering costs + Total holding costs
Total ordering costs = cost per order X no of orders in a period
Total holding cost = average stock quantity X holding cost per unit

The EOQ can also be delivered mathematically as explained below:

Mathematical Derivation of EOQ
Let cost per order be represented by C o. This is the cost incurred every time one order is placed.
Let the economic quantity purchase every time be represented by Q
Let holding cost per unit be represented by Ch
Let total demand be represented by D
The total holding cost = ½ QCh
D D
Q Q
The total Ordering cost = CO: Note that gives you the number of order in the period
Then total cost = ½ Qch + D/Q C O (or simply the total holding up cost plus the total
ordering costs)

EOQ is at the point where holding cost is equal to ordering costs

i.e. ½ Ch = D/Q CO

∴ ½ Q2Ch = D CO Q 2= √ 2DO
h
Q2Ch = 2D CO

Q2 =
2DCo
Ch
Therefore Q
√ 2DCo
Ch
Therefore EOQ=
√ 2DCo
Ch

The EOQ model assumes:

 Annual demand is known
 Hold costs are constant and known
 Ordering costs are known and constant
 The same quantity is ordered every time an order is made since demand as assumed not to
fluctuate significantly.
Example
ABC Ltd has an aggregate demand of 1.2 Million units. Each time they place an order there is an ordering
cost of shs 1,000, holding cost is shs 100 per unit. Determine:
i. EOQ
ii. No. of order to be made based EOQ
iii. Total cost of stocks based on the EOQ
 Solution

EOQ = √
2DCo 2 X 1200 000X1000
= =4899 units
Ch 100

i) No of order = 1200000 = 244.9 ≈ 245 Orders

4899
ii) Total cost = DCo + ½ QCh = 1200000(1000) + ½ (4899)100 = 489,900
Q 4899

3.4 Valuation of inventory (Issues and closing stocks)

Valuation of inventory aims at attaching a monetary value in the stores or issued for production.
This is useful in producing. State costing the output and pricing production, as well as decision
making.
Methods used in valuing inventory:
a) First In First Out
b) Last In Last Out
c) Weighted Average method
3.41 First in First out (FIFO)
This method is based on the assumption that stock purchased first is issued first. Prices of stock
purchased first are used to determine the cost or value of inventory issued. Closing stocks are carried at
the latest costs.
Advantages
1. It is a realistic system: oldest items are usually issued first out.
2. Unrealized profits or losses do not arise
3. It is easy to calculate if prices of materials don’t fluctuate
4. Closing stocks values reflect the latest costs thus tend to reflect the current market values.
5. It is acceptable to many tax authorities and is also consistent with accounting practices e.g. IAS/IFRS.
Disadvantages
1. It involves tedious calculations if the price of materials fluctuate from time to time
2. Product costs, based on the oldest material prices, lag behind current conditions especially in
inflationary markets.
3. Comparison of one job with another may be difficult if materials are issued at different prices.

3.42 Last in first out (LIFO)

Is based on the assumption that the stock purchased last is issued first. Stock valuation should therefore
be based on the prices ruling on the acquisition of the last stocks.
 Advantages
1. Product costs tend to be based on current market prices and is therefore realistic.
2. A charge to production is as closely related to current price levels as possible
Disadvantages
1. Stocks are valued at the oldest prices.
2. It involves tedious calculations if the price of materials fluctuate from time to time.
3. Comparison of one job with another may be unfair and difficult
3.43 Weighted average method
i. This method is a perpetual weighted average system where the issue price is recalculated after each
receipt of stocks taking into account both quantities and money vale of the stocks received.
In this case stock used or unused is based on the average price per unit where the average price per
unit is calculated as follows:
= Total value of stocks = Average Price Per Unit
No. of units of stock

= (Money value of old stocks + Money Value of New Stocks)

(Quantity of old stocks + Quantity of New Stocks)

Illustration
Assume the following purchases were made in ABC Ltd
Date of purchase Units purchased Price/unit
1st January 500 100
2nd January 600 200
3rd January 800 400
Units used on 4th January are 900. Determine the value/cost of units used by using FIFO, LIFO and
weighted average.

Required:
Determine the cost of units used and the value of the closing stocks using FIFO, LIFO and Weighted
Average.
Solution
1. FIFO
Cost of units used
Date Units Unit price Total cost
Jan 1 500 100 50,000
Jan 2 400 200 80,000
900 Cost of units used 130,000

Closing stock is valued as

Jan 2 200 units x 200 shillings =
40,000
Jan 3 800 units x 400 shillings = 320,00
0
1,000 360,00
0

2. LIFO
Cost of units used
Date Units Unit price Total cost
Jan 3 800 400 320,000
Jan 2 100 200 20,000
900 Cost of units used 340,000

Closing stock is valued as

Date Units Unit price Total cost
Jan 2 500 200 100,000
Jan 1 500 100 50,000
1,000 Value of closing stocks 150,000

3. Weighted average
Date Units Unit price Total Cost of Issues

0–0 900 257.8 232,105.20

Closing Stock Valuation = (Goods Available – Goods Issued) x Unit Price =

 500(100)+ 600 (200 )+ 800 ( 400) 490,000
= = 257 . 8
1, 900 1,900
Unit Price =

Other methods include

 Standard cost
 Replacement cost
 Next in first out
4. LABOUR COSTS
4.1 DEFINITION
Labour costs refers to all the costs incurred in compensating the human resources employed to
provide a useful service in the production process. This compensation usually comes in the form of:
 Basic salary
 Wages
 Overtime pay
 Bonus
 Allowances

4.2 CLASSIFICATION OF LABOUR COSTS

It can be classified into
a) Direct or indirect cost
b) Fixed or variable cost
c) Controllable and non controllable cost

a) Direct labour cost may be defined as the cost of remuneration for employees efforts and skills
applied directly to a product or saleable service and which can be identified separately in product
costs.
Indirect labour cost may be defined as labour costs, which are not charged directly to a product.
The analysis of labour costs into direct or indirect cost depends upon the circumstances under
review
Examples include-
The wage paid to a worker who assembles components for a product is a direct cost while that
paid to a worker who is moving components for a range of products from one part of the factory
to another is an indirect cost.
b) Fixed cost in relation to labour is where by an employee is paid a fixed weekly wage irrespective
of the output produced cost varies directly with level of activity, for example where wages are
paid at a rater per unit.
c) Variable Labour Cost varies directly with level of activity, for example where wages are paid
per unit.
d) Controllable labour cost is a cost, which can be influenced by the actions of a person in whom
authority for such control is vested. The control of labour costs will be influenced by the method
of remuneration and the degree of management control, which is exercised.
Uncontrollable labour costs cannot be influenced by an officer in the organization, for example,
wage rise agitated by the trade union is an uncontrollable labour cost.
4.3 Time Keeping
 A labour cost control routine should ensure that payments are paid only to employees who have
spent time at the work place and that payments are at agreed rates of pay including overtime
premium and shift premium payments where relevant.
Where an employee is paid a fixed sum for an agreed length of working week, it may be decided by a
check by the supervisor that the employee is at work is all that is necessary.
Where the employee is being paid at the rate per hour for the time spent at work together with premium
rates for overtime work, it is likely that a detailed record of time spent on the premises is required. This is
done by having the employee to register his arrival and departure times.

4.3.1 Time analysis

This is usually achieved by having the employee complete a daily or weekly timesheet or by having job
cards or piecework tickets. Where time sheets are issued, the employee records the time analysis stating
how much time was spent on each job and recording idle time. This sheet will then be authorized by the
supervisor. Job cards move with a job as it passes from one employee to another. There may be time
clocks at each work center where the time spent on the job is recorded. Where this routine is used,
employees may also be required to clock idle time on an idle time card, which will be analyzed to
determine the cause of idle time. Where payments are made in return for out put units, piecework tickets
may be completed which are signed by the supervisor certifying the number of units claimed. The
analysis of employee time will facilitate:
a) Correct charge of direct labour cost to each job
b) Correct charge of indirect labour cost to cost centers
c) Control of labour costs by job and cost center
d) Calculation of employee bonus
e) Measurement of efficiency

4.4 Methods of Labour Remuneration

Labour remuneration methods can be broadly classified into two:
i. Time rate (on the basis of the time spent in the factory)
ii. Piece Rate (On the basis of work done)
Most of the remuneration methods are a combination of or modification of these 2 systems
4.4.1Time Rate System
May be a flat time rate or a high day rate.
Under flat time rate, each worker is paid for the time spent without considering the volume of production
during that period
This may be paid daily, hourly or monthly basis as follows:
Total Pay = Hours worked X rater per hour
Under the high day rate system the workers time rate is fixed at a higher level than the usual rate of
payment if the output exceeds the expected (usually set) level. The objective of this system is to provide
an incentive to the workers while retaining the simplicity of the system. It is most appropriate for easily
measurable output to which groups of workers contribute e.g. car assembly lines.
4.4.2 Piece Rate System
An employee is paid a fixed amount for each unit produced irrespective of time taken; the wages payable
are calculated as follows:
Wages = Number of units produced X Rate per unit
In this case, there is a flat rate per unit. However, a company may modify this and apply the Taylor’s
differential price rate system where three piece rates are set for each job: the low, normal higher piece
rate. The low piece rate is applicable where a worker is not able to achieve the standard (normal) output
and the highest piece rate is for those above standard. If it does not guarantee minimum wages on time
basis, this may lead to high wage differential in the company and consequently demotivation. For this
reason, the differential price rate system as well as many variations of the piece rate system contain a
minimum (guaranteed) pay.
Premium Bonus Schemes
Illustration 1
Under a premium bonus scheme, workers received a guaranteed basic hourly minimum rate of pay plus a
bonus of 50% of the time saved. No payment is paid beyond the time allowed but the bonus which is paid
at the basic hourly rate is applicable to the accepted output only. No penalty is imposed on rejected
output. The following details are available for the month of January 2003

Worker A B C
Time allowed per unit (hrs) ¼ 1/6 ½
Units produced 474 684 175
Units rejected 54 84 25
Time taken (hrs) 78 72 80
Basic Pay per hour (Kshs) 6 6 3

Required
From the above information calculate for each employee
a) Bonus hours and amount of bonus paid
b) Gross wages earned
c) Labour cost for each good unit sold

Solution
4.3.1 Worker A
Total time saved = Expected time – Time taken
= ¼ (474 – 54) – 78 = 1/4/ X 420 – 78
= 105 – 78 = 27 hours
 Accepted time saved = 50/100 x 27 = 13.5 hrs
Therefore bonus hours = 13.5 hours
Bonus pay = 13.5 x 6 = Shs 81

Worker B
= 1/8 (684 – 84) = Shs 100
Time saved = 100 – 72 = 28 hours
Bonus hours = 28/100 X 50 = 14 hours
Bonus pay = 14 x 6 = Shs 84

Worker C
= ½ (175 – 25) = 150/2 = 75 hours
Time saved = 75 – 80 = - 5
Bonus hours =0

4.3.1 Gross Wages = Regular wage by Bonus

A B C
Time allowed per unit ¼ 1/6 ½
Regular pay 78 x 6 72 x 6 75 x 3
= 468 = 432 = 225
Bonus pay
81 84 0
549 516 225
4.4.3 Good units
A B C
474 – 54 684 – 84 175 – 25
Good units = 420 = 600 = 150
Labour cost per unit of output 549 516 225
420 600 150
= 1.30 =0.86 =1.5

Illustration 2
Based on the data below you are required to calculate the remuneration of each employee as determined
by each of the following methods
i. Hourly rate
ii. Basic piece rate
iii. Individual bonus scheme where the employee receives the bonus in proportion of the time
saved to time allowed

Name of employee Salmon Roala Pike

Units produced 270 200 220
Time allowed in minutes per unit 10 15 12
Time taken (hours) 40 38 36
Rate per hour (Kshs) 125 105 120
Rater per unit (Kshs) 20 25 24

Solution
Salmon Roala Pike
i. Hourly rate 40 x 125 38 x 105 16 x 120
= 5000 = 3990 = 4320

ii. Piece rate Salmon Roala Pike

Gross wage 270 x 20 200 x 25 220 x 24
Therefore regular wage = 5,400 = 5,000 = 5,280
 iii. Bonus scheme Salmon Roala Pike
Time saved
Time allowed (270x100)/60 (200x15)/60 (220 x12)/60
= 45 hours = 50 hours = 44 hours
Time taken 40 hours 37 hours 36 hours
5 hours 12 hours 8 hours

Bonus time = Time taken x total time saved

Time allowed

Salmon Roala Pike

40 38 36
x5 x 12 x8
45 50 44
= 4.4 = 9.12 = 6.55
► Bonus Pay 4.4x125 = 550 9.12x105 = 958 6.55x120= 786
► Total pay
= Gross pay + Bonus 5,000 + 550 3990 +958 4320 + 786
Using hourly rate = 5550 = 5958 = 6066

4.4.4 Group Bonus Plan

There are certain jobs or operations which require to be done collectively by a group of workers, for
example, continuous production work flows in a sequence or in assembly work of computers, radio,
televisions e.t.c A team of workers is engaged in various operations and as such it becomes necessary to
introduce bonus schemes for collective efficiency of the group as a whole and the intention is to create a
collective interest in the work. In this case, the bonus is shared among the members. The proportionate
share may depend on a number of factors, for example, the level of employee in management structure,
the department in which the employee falls, his current salary e.t.c.
 Benefits associated with group bonus schemes include
i. It encourages cooperation and teamwork among workers
ii. It reduces absenteeism since an absent worker is found to reduce the group earnings
and the group may dislike him
iii. The approach reduces supervision time and cost, thus it is administratively much
simpler.
iv. It greatly reduces the number of rates to be negotiated.
v. It may encourage flexible working arrangements within the group.

But it suffers the following setbacks

(i) It may not provide a strong incentive to the individual workers, as it is group based.
(ii) Less hardworking group members are similarly rewarded as the very hardworking
ones: this may cause demotivation in the group.
(iii) It is hard to determine each group members’ fair, have of the bonus.

4.4.5 Co-ownership incentive scheme (Profit Sharing Schemes)

The organization allows for ownership whereby the employees are allowed to own a percentage
of the shares in the firm and therefore, have in the company’s profits. This converts employees
from mere salary seekers to individuals who are part of the organization. They will be directly
affected by the decisions taken in the firm in form of changes in earnings per share and dividends
per share. The company may offer financial assistance in form of security, guarantees or loan if
possible

4.5 THE WAGES DEPARTMENT

It is responsible for the preparation of the payroll and the payment of wages. The routine will
require:
a) Analysis of clock cards and check of overtime authorization
b) Calculation of bonus
c) Compilation of gross earning
d) Calculations of deductions
e) Preparation of pay details for each employee showing net wages
f) Arranging for payment of wages to employees

4.5.1 Calculation of deductions

A range of deductions are made from gross earnings when calculating the net payment due to the
employee such deductions may be statutory, obligatory or voluntary in nature
- Statutory deductions are pay as you earn (PAYE) tax, pensions, and employees, national
insurance contributions. The employer calculates the amount due to be deducted using
 the relevant rates in force and then arranges to make a total payment in respect of all
employees to the revenue authority.
- Obligatory deductions are most likely to comprise payments to an approved pension
fund. e.g. National Social Security Fund (NSSF). Once again it is likely that the
employer will make a contribution in addition to the employee
- Voluntary deductions include items such as trade union subscription, charity deductions
and contributions to saving schemes.

5.0 Accounting for Labour costs

We will have an overview of accounting for labour costs.
a) Gross Earnings
This is shown as item, A which appears as a credit in the wages account and as a debit in the
wages analysis control. The gross earnings are analyzed to show the various deductions leaving
net pay and also direct and indirect wages are charged to a range of account codes
b) PAYE tax
Is show as item C which is credited to a PAYE tax account before being paid to the Kenya
revenue Authority by the employer. Item X shows the payments from the bank account (credit)
and the clearing of the PAYE tax account (Debit)
c)National Hospital Insurance Fund (NHIF) Deductions
The employee’s national insurance deduction is credited to a national insurance account (Item
D). In addition the employer makes a national insurance contribution for each employee. This is
shown as item F, which is debited to an expense account and credited to the national insurance
account. The total insurance (D+F) is then paid to the national Inland Revenue. Item Y shows
the entries, which clear the national insurance account (Debit) and record bank payment
(Credit). The employer’s national insurance is a business overhead expense.
d) Other deductions
Includes such items as pension contributions and trade union subscriptions. The initial
deductions from employees are credited in deductions account (Item E) before payment is made
to the appropriate fund.
e)Net pay
This is shown as item B which is the balancing figure in the wages account (debit) and when
payment is made, it is shown in the bank account (credit)
f) Direct Wages
Item T shows the credit to wages analysis control and the debit to job/product accounts.
Individual accounts would be kept for each job or product in addition to overall control
account.
g) Indirect Wages
It is a simple analysis transaction which is debited to overhead expense account or departmental
accounts
Figure 4.0 Accounting for Labour cost
Gross Earnings and deductions
(wages department)

(a) The financial Accounting Approach

Wages Account

Net pay B Gross earning A

Paye
C

NI D D

Other deductions E

PAYE Tax Account

Bank X Wages Account

C

National Insurance Account

Bank Y Employees NI D

Employees NI F
 Other deductions Account
Bank Z
E
Wages Account

Employees NI Expense Account

NI Account F

(b) The Cost Accounting Approach:

Wages Analysis (costing department)

Wages Analysis Control Account

Gross Earning A Direct wages J
Indirect wages K

Job production Account

Direct wages J

Overhead Expense Department Account

Indirect wages K

Cash/Bank Account
Net payment B
PAYE X
NI Y
Other deduction Z
 5.0 OVERHEAD COSTS
5.1 Introduction
Overhead costs may be defined as the total cost of indirect materials, indirect labour and indirect
expenses. They may occur or be charged to:
a) Production cost centers i.e. making, finishing and packing departments.
b) Service costs centers for example maintenance and power generation
c) Other non production cost centers for example administration, selling and distribution
In this section, we will look at how these overhead costs are changed to production and non-
production departments so as to determine the total cost incurred by every department in the
organization.

5.2 Overhead cost classification and analysis

Overhead costs may be analyzed into
a) That which may be directly identifiable with a single cost center, for example, wages paid to
indirect workers who work solely in one cost center such as making department.
b) That which is incurred as a single figure and is then shared amongst cost centers which make
use of it, for example, the rates payable to the local authority
c) The total cost of a service department, for example, maintenance department will have
various costs charged to it for material, labor and other expenses.

cost analysis
There are a number of situations in which the analysis of overhead costs will assist in the
satisfactory evaluation of the relevant cost data. These include:

a) The control of overhead expenditures

There must be a link between overhead cost and the manager responsible for its control. This is
best achieved by having the planned level of overhead costs for each cost center compared to the
actual cost incurred in order that any differences may be investigated and corrective measures
taken.
 b) Charging of overheads to cost units
As products pass from one cost center to another in the production cycle, direct costs for material
and labour are charged to them. In addition, each product or job should share a part of indirect
costs of the business. This may be done by assessing the benefits extracted from each cost center
through which the product or job passes and then choosing a suitable absorption basis
c) Valuation of work in progress
At any point in time, there may be partly completed goods in the production cycle. Such work in
progress must be valued at the end of an accounting period in order that profit be calculated and a
balance sheet arrived at. This may be achieved by the absorption of production overheads in each
cost center.
d) Valuation of abnormal losses
This is a similar procedure to that for work in progress. Such losses also need to be charged to
the departments that incur them for efficiency analysis purposes.
e) Profit measurement
The valuation of work in progress and finished goods stock will affect the profit reported. The
basis on which production overhead has been absorbed by cost units will therefore have a direct
influence on the level of profit reported during the period.
f) Decision making
It is vital that relevant costs are used in any decision making situation. Production overhead costs
may be allocated to a department (cost center) or apportioned to it using some arbitrary
apportionment basis. In addition overhead cost may be a fixed or variable behaviour pattern as
activity changes. The total costs associated with cost centre and the organization as a whole
affect the kind of decisions made by the management. But such relevant costs need to be
incremental (making a difference) and future costs (not sunk costs) that are controllable (not
uncontrollable) by management.

Absorption Costing
The process described in this lesson by which total overheads are absorbed into production naturally
enough is known as absorption costing. The absorption of total overheads into product costs has
implications for performance measurement, cost control and stock valuation and students should be aware
that the process described is subject to criticism by some managers and accountants.
The criticism arises from the fact that overheads contain items, known as fixed costs – which do not
change when the activity level changes and which would still have to be paid if there was no activity, e.g.
rates – and items, known as variable costs, which vary more or less directly with activity, e.g. power
consumption. To overcome some of the difficulties, an alternative method of costing has been developed,
known as marginal costing, which, although using the process of absorption, excludes fixed costs from
the absorption process.
COST ELEMENTS
Stage 1 Wa Sala Ma Ex

Two way
Coding by cost department of type of
Coding
expenditure and location of
Stage 2

Cost Analysis
Allocation
Apportionment Service

Ov e.
Stage 3

Service Cost Centres

Stage 4

Production
Ov Ov Ov Ov Ov
Cost Centres
Stage 5 ● ● ● ● ●

● ● ● ● ●

Overhead Absorption ● ● ● ● ●

State 6 ● ● ● ● ●

COST UNITS
Figure 9.1
Stage 1. Cost Elements
The raw data relating to Labour, Materials, Expenses are gathered from Invoices, Payroll,
Goods Issued Notes and Requisitions.
Stage 2. Coding
All the raw cost data needs to be classified and then coded in respect of the type of expense
and location. This process is fundamental to all costing and management accounting
procedures.
Stage 3. Cost Analysis
Where discrete items of cost can be allotted to cost centers this is termed allocation. Where
the cost has to be spread or shared over several cost centers this is known as apportionment.
Stage 4. Service Cost Centres
These are cost centers which provide a service to production cost centers. Examples are
Maintenance, Sores and Boiler House. Their costs are built up by the usual process of
allocation and primary apportionment and then their total costs are apportioned (secondary
apportionment) over the production cost centers, thus forming part of production overheads
which are absorbed into the cost units produced. The problems of service cost centers are
dealt with in more detail below.
Stage 5. Production Cost Centres
These are the cost centers involved directly in the production process. Typical examples are,
the Assembly shop, Drilling machines, Centre lathes, Spray Shop.
Stage 6 Overhead Absorption
The overheads of each production cost centre are absorbed into the costs of the units
produced, usually in proportion to the time involved, i.e. by the Labour Hour or Machine
Hour Rate.

Service Cost Centres

Because no production cost units pass through the service cost centers, it is necessary to apportion the
service department costs, to the production cost centers so that all production costs (including those for
the servicing departments) are absorbed into production. Typical basis for secondary apportionment, i.e.
the apportionment of service costs to production departments are given below:
 Service Department Possible basis of Apportionment to
Production Cost Centres

Maintenance Maintenance Labour Hours

Maintenance Wages
Plant value

Stores Number of Requisitions

Weight of Materials issued

Inspection Number of production employees per cost centre

Number of Inspection Tickets
Number of Jobs
Notes
The basis
Production Control No of Production Employees per cost centre chosen
No of jobs should be
one that is
judged to
Power General Generation Metered Usage be the
most
Notional Capacity equitable
Technical Estimate way of
sharing
the
Personnel Department No of Employees per Department service
department ‘s costs over the departments which use the service. This may mean that a particular and
unique basis of apportionment may have to be derived. It must reflect the use made of the services
provided.
Wherever possible, service department costs should be charged directly, i.e. allocated. An example
of this would be maintenance wages and materials. When a maintenance job is done for a department, the
wages and materials used would be charged directly to the department concerned. In this way only
unallocated service department costs need to be apportioned.

tionment of Overhead Costs

Allocation of overheads is the term used where the overhead cost item can be charged to a specific
cost center without the need for any estimation procedure. For example,
a) The salary of the sales manager will be allocated to the selling overhead cost center,
b) The salary of the engineer in charge of power generation will be charged to power generating
cost center.
 Apportionment of overheads occurs where the total value of an overhead item is shared between two
or more cost centers that use the overheads. It is important that an apportionment basis which reflects
the benefit extracted by a cost center is used. For example, the rates payable to the local authority
may be apportioned on the basis of area of occupancy of each cost center
Re-apportionment of overheads occurs when service department costs are charged to user
departments. For example, the maintenance department overhead costs are summarized and then
charged to the user department, which will probably include other service or non-production
departments.
Service departments do not participate directly in the manufacturing process but play a supportive
indirect role. Products do not pass through the support departments. It is for this reason that service
department costs have to be reapportioned to the production cost centers or departments.
The re-apportionment of service department costs may be implemented in a number of ways.
The Two extremes are
a) Where costs of each service department are only charged to production centers administration;
selling and distribution centers are not charged with the cost of the service departments are they
are they not production centres. This is referred to as the Direct Method
Where the reciprocal nature of service costs is fully recognized; that is service departments serve
each other. This approach may be implemented using two methods.
i. The repeated distribution method
ii. Using an algebraic approach
b) A compromise method (elimination method) may be used where by the costs of each service cost
centers are re-apportioned in turn. The costs of the first service center will be reapportioned to all user
centers including other service centers. The first service center however, is then eliminated from any
further reapportionment. The cost of the second service center including any costs already reapportioned
from the first service center are then reapportioned to all user centers other than the first service center.
The process is continued until all service centers are eliminated
Illustration 1
The following information is available in respect of overhead costs by Getwell Ltd
Making Finishing Packin Mainte Power Admin. Selling Distri
g
nance bution

Shs Shs Shs Shs Shs Shs Shs Shs

Allocated Overheads
Indirect materials 1500 1000 2400 4800 3300 1000 1200 1600
Indirect labour 10000 1200 900 14000 4400 2000 800 5600
Other expenses 15000 8000 3000 1500 12400 24000 6600 4000
Depreciation 8000 800 1200 2000 4800 1500 2300 1800
Unallocated overheads
Rates 18000
 Net vending machine cost 2300
Heat and light 4000
Other statistics
Occupancy sq. m 600 400 500 50 100 200 50 100
Number of employees 20 40 50 20 10 60 15 5
Power estimate (Kwh) 15000 2500 2500 2000 1500 500 1000
Maintenance (hours) 2000 200 400 1000 250 400 750

Required
Calculate the final distribution of overheads to cost centers including the reapportionment of maintenance
and power generation service costs to user cost centers where
a) The reciprocal nature of maintenance and power generation center is ignored.
b) The elimination method is used whereby the costs of each service center are apportioned in turn
between users but once they have been apportioned they are eliminated from any subsequent
apportionment
c) The repeated distribution method is used taking into account the reciprocal nature of the
service costs
d) An algebraic approach is used as an alternative to the repeated distribution method

Solution
a) The Direct Method Ignoring reciprocal service charges
Overhead cost allocation and apportionment statement
Basis of Making Finish Packing Maint Power Admin. Selling Distribu Total
Allocation ing tion

Shs Shs Shs Shs Shs Shs Shs Shs. Shs.

Overhead
item Direct 1500 1000 2400 4800 3300 1000 1200 1600 16800
Indirect
materials
Indirect Direct 10000 1200 900 14000 4400 2000 800 5600 38900
labour
Other Direct 15000 8000 3000 1500 12400 24000 6600 4000 74500
expenses
Depreciat Direct 8000 800 1200 2000 4800 1500 2300 1800 22400
ion
Rates Direct 5400 3600 4500 450 900 1800 450 900 18000
Vending Emploee 200 400 500 200 100 600 150 150 2300
machine
Heat and Area 1200 800 1000 100 200 400 100 200 4000
light
Subtotal 41300 15800 13500 23050 26100 31300 11600 14250 17690
0

Service reapportionment
Maintenance 11525 1152 2305 (23050) 1441 2305 4302
Power 17622 2837 2837 (26100) 1702 567 1135
Total Costs 69847 19789 18642 0 0 34443 14472 19707 176900

b) Using elimination method:

This procedure is exactly the same as for the above method except for the reapportionment of the
maintenance and power generation costs. The illustration is therefore commenced on the subtotal
point where the initial allocation and apportionment has been implemented

The final apportionment will appear as follows

Overhead item Makin Finishing Packin Maint Power Admin. Selling Distribt Total
g g .
Shs Shs Shs Shs Shs
Shs Shs
Subtotal 41300 15800 13500 23050 26100 31300 11600 14250 176900
Service
reapportionment
Maintenance
9220 922 1844 (23050 4610 1152 1844 3458
)
Power 20028 3338 3338 (30710 2003 668 1335
)
Total 70548 20060 18682 0 0 34455 14112 19043 176900
 c) Recognizing fully the reciprocal nature of service costs (repeated distribution method)
This method differs from the elimination method in that it continues to reapportion a share of a
service cost center to other service centers instead of eliminating a center once its costs have been
reapportioned in the first instance. The cycle is repeated until the numbers become so small that no
further reapportionments are required
The repeated distribution summary will appear as follows:
Overhead item Makin Finishing Packin Maint. Power Admin Sellin Distrit Total
g g . g .

Maintenance hrs (%) 40 4 8 20 5 8 15

Power kwh (%) 60 10 10 8 6 2 4
Subtotal Kshs 41300 15800 13500 20050 26100 31300 11600 14250 17690
Service reapportionment
1st distrib. Maintenance 9220 922 1844 (23050) 4610 1152 1844 3458
1st distribution power 18426 3071 3071 2457 (30710) 1843 614 1228
2 distrib.maintenance
nd
983 98 197 (2457) 491 123 196 396
2 distribution power
nd
295 49 49 39 (491) 123 196 396
3rd distrib. Maintenance 15 2 3 (39) 8 2 3 6
3 distrib. Power
rd
5 1 1 (8) 1
Total distrib maintenance 10218 1022 2044 5109 1277 2043 3833
Total distribution power 18726 3121 3121 2496 1873 624 1248
Total overhead charge to 70244 19943 ? 0 0 34450 14267 19331 17690
user department

d) Algebraic approach
This method requires that the reciprocal nature of the service costs is expressed in a set of
simultaneous equations which are solved by matrix algebra
Let x = Total cost of the maintenance cost center
Let y = Total cost of the power generating cost center
Then x = 23050 + 0.20Y
Y = 26100 + 0.20x

The equation shows that

Maintenance cost = initial allocated and apportioned costs of Shs.23050 plus 8% of the total cost of the
power generating center
Power generating cost = initial allocated and apportioned costs of Shs. 26100 plus 20% of the total cost of
maintenance center

In a matrix equation it is
1 -0.08 24050
-0.2 1 26100

Simplifying the matrix gives

1 0 25546
0 1 31209

Hence x = Total maintenance cost center cost is Kshs 25,546

y= Total power generating cost center cost is Kshs 31,209

The percentage distribution of the service in the repeated distribution calculation summary shown above
are then applied to the total cost figures x and y
For example for the making cost center
Maintenance cost to making cost center = Kshs 25546 x 40% = Shs. 10,218
Power to cost to making cost center = Kshs 31209 x 60% = Shs. 18,726

Note
You can also use the simultaneous equation solving method to arrive at exactly the same answers above
(Shs.25,546 and shs.31,209). Probably, this is more popular than the matrix.

5.2.4 Absorption of production overhead costs

What is overhead absorption?
Absorption of overheads refers to the sharing out of overhead costs to the various cost centers that
used the overheads. It is used when the overheads cannot be allocated or attributed to a specified
cost centre.
The aim is to establish the overhead cost per unit of output having allocated and or apportioned
overhead costs. The next stage should be to absorb them into the cost of production.
What are the bases of overhead absorption and what factors are considered in their selection?
The first stage in absorption is to establish the absorption rate
What is an overhead absorption rate and what types are there?
 NB: Overheads incurred are normally absorbed on the basis of estimated or budgeted figures. The
following basis may be applied leading to the following types of rates.

i. Percentage of direct material cost = overhead cost x 100

Direct material cost

ii. Percentage of direct labour cost = overhead cost x 100

Direct labour cost
iii. Direct prime cost = overhead cost x 100
Prime cost
iv. Labour hours = overhead cost
Labour hours

V . Units of output = overhead cost

Units of output

Illustration 2
The budgeted production overheads and other budgeted data of calculata Ltd are as follows:

Budget
Overhead cost for the period = Kshs 36,000 Production department
Direct material cost Kshs 32000
Direct labour cost Kshs 40000
Machine hours Kshs 10000
Direct hours of labour Kshs 18000
Units of output Kshs 10000

Required
Determine the absorption rate of the overheads
Solution
Total overhead costs to be absorbed = Kshs 36000
Absorption rate Calculation
a) Direct material cost 36000 x 100 = 112.50%
32000
b) Direct labour 36000 x 100 = 90%
40000
c) Machine hours shs 36000 = Shs 3.6/machine hour
10000 hrs
d) Labour direct hours shs 36000 = Shs 2/direct hour
18000 hrs

e) Units of output 36000 = Shs 3.6/unit

10000 units
f) Prime cost = Direct labour + direct material cost
= 32000 + 40000
= Shs 72000

∴ Overhead absorption rate based on prime cost = 36000 x 100 = 50%

72000
The overhead cost will vary according to the absorption base. Assume that in the company an individual
production has a material cost of Shs 80, labour cost of shs 85, requires 36 labour hours and 23 machine
hours to complete. Determine
i. Overhead per individual production on the above different bases
ii. Individual production cost
Solution
a) Production overhead per each absorption rate
Direct Material cost 112.5 x 80 = Shs 90
100
Direct labour cost 90 x 80 = Shs 72
100

Prime cost 50 x (80+ 85)= Shs 82.50

100
Machine hours 23 x 36 = Shs 82.80

Labour hours 36 x 2 = Shs 72

b) Production cost per each absorption base = Prime cost + Overhead cost
Prime cost + Overhead cost = Product cost
Direct material cost 165 + 90.00 = 225.00
Direct labour cost 165 + 72.00 = 237.00
Prime cost 165 + 82.50 = 247.50
Machine hours 165 + 82.80 = 247.80
Labour hours 165 + 72.00 = 237.00

Illustration 3
The following is the budget of Superb Engineering Works for the year 2002
Factory overheads Kshs 62,000
Direct labour cost Kshs 98,000
Direct labour hours 155,000
Machine hours 50,000
Actual labour hours were 40,000
Actual machine hours were 30,000
Actual direct labour costs were Kshs 50,000
Actual direct material costs were Kshs 45,000

Required
a) Determine the overhead application rate on the basis of
i. Direct labour hours
ii. Direct labour cost
iii. Machine hours, and
iv. Overhead costs
v. Production cost
Solution
i. Direct labour hours method
62,000
= Shs .0 . 4/labour hour
Overhead application rate (OAR) = 15,500
ii. Direct labour cost method
62,000
x 100= 63 .27%
98,000
OAR =

iii. Machine hour method

62,000
x 100 = Shs. 1 .24/machine hour
OAR = 50,000

b) Overhead costs using

i. Direct labour hours = 0.4 x 40000 = Shs 16000
ii. Direct labour cost = 63.27% x 50000 = Shs 31630
iii. Machine hours = 30,000 x 1.24 = Shs 37200
 c) Production cost using each of the methods
Prime cost Overheads Total cost ∴Cost/unit
i. Direct labour hours 95,000 16,000 111,000 111.00
ii. Direct labour cost 95,000 31,630 126,630 126.63
iii. Machine hours 95,000 37,200 132,200 132.20

5.2.5 Over and under absorption of production overhead costs

This may be analysed under
a) Activity
Level of the business or cost center. Expenditure on some items of production overhead costs
will vary directly with activity whereas others will be fixed irrespective of the changes in activity
level. For example in a machine orientated cost center, power cost will vary in proportion to
machine hours whereas salary of the cost center manager will be fixed.
b) Level of expenditure on production overhead
Expenditure level may change from the budgeted level because of a change in the price of an
overhead item or a change in the usage of the overhead item
c) Activity level and the absorption of production overhead cost
In the table below the variable overhead absorbed per machine hour is constant (Shs.3)
irrespective of the activity level. The fixed overhead cost per machine hour depends on the
activity level used as the base. If 100 machine hours are used, Shs.5 per machine hour must be
charged in order to absorb the fixed overhead cost of Shs.500. if 300 machine hours are used,
Shs.1.67 per machine hour is a sufficient charge in order to absorb the total fixed overhead cost.
 Figure 5.0 Machining cost center
Activity Total fixed Total Total Average Overhead Cost
level variable overhead per
Overhead Machine Hour
cost
Machine costs Overhead
hrs costs

Shs. Shs. Shs. Shs. Shs. Shs. Shs.

100 500 300 800 5.00 3.00 8.00
150 500 450 950 3.33 3.00 6.33
200 500 600 1100 2.50 3.00 5.50
250 500 750 1250 2.00 3.00 5.00
300 500 900 1400 1.67 3.00 4.67

Production overheads will be absorbed by jobs or products at the pre-determined rater per machine hour.
If the actual number of machine hours used differs from the number used in the calculation of the
overhead absorption rate, an over or under absorption will occur.
Note that this problem does not occur with variable overheads since the incidence of the cost (such as
power cost) varies with changes in activity.

Illustration 4
Using data from figure 5.0 assume that the production overhead absorption rate was calculated where an
activity of 200 machine hours was estimated. Prepare a summary showing any over or under absorption
of overhead cost where the actual machine hours charged to jobs turns out to be
a) 150 hours
b) 250 hours
Solution
Absorption rate is Shs. 5.50 per machine hour. This may be analysed into fixed rate Shs.2.50 per machine
hour and variable rate; Shs. 3 per machine hour.

a) Where actual activity is 150 hours

Fixed Variable Total

Shs. Shs. Shs.
Overhead incurred 500 450 950
Variable overhead absorbed (450)
(150 x 3)
Fixed overhead absorbed (375)
(150 x 2.50)
Total Overhead absorbed (825)
(150 x 5.50) ____ ____ ___
Under absorption of overhead 125 NIL 125

b) Where actual activity is 250 hours

Fixed Shs. Variable Shs. Total Shs.
Overhead incurred 500 750 1250
Variable overhead absorbed (750)
(250 x 3)
Fixed overhead absorbed (625)
(250 x 2.50)
Total Overhead absorbed (1375)
(250 x 5.50) ___ ___ ___
Under absorption of overhead 125 NIL 125

c) Expenditure level and the absorption of production overhead cost

A charge in expenditure on an overhead cost item may occur because of a charge in the price per unit
and/or because of change in the number of units of the overhead commodity which are required
Expenditure changes can affect the absorption of both fixed and variable overheads
Illustration 5
AB Ltd has a machine cost center for which the following information is available
a) Budget
i. Budgeted (expected) activity 3000 machine hours
ii. Variable production overhead cost per machine hour Shs. 2
iii. Fixed production overhead cost (total) Shs. 9000
b) Actual
i. Activity level 3000 machine hours
ii. Variable production overhead cost incurred Shs. 6400
iii. Fixed production overhead cost incurred Shs. 8800

Required
1. Calculate the over and under absorption of variable overhead and fixed overhead cost
2. Comment on possible causes of over or under absorption figures

Solution
Variable overhead cost
Actual cost incurred Shs.6400
- Overhead absorbed 3000 hrs x Shs. 2 Shs.6000
Shs. 400

Under absorption may have occurred through a combination of

a) Increased price per unit of variable cost e.g. a rise in price or electricity
b) An increase in the number of units of overhead cost item, e.g. machine efficiency has fallen through
lack of maintenance

Fixed overhead cost:

Actual cost incurred Shs. 8800
- Overhead absorbed 3000 hrs x Shs. 3 Shs. 9000
Over absorption of overhead cost Shs. 200

The fixed overhead absorption rate 9000/3000 machine hours = Shs. 3 per machine hour.
The actual activity level of 3000 machine hours is the same as that budgeted. The over absorption of fixed
overhead is therefore due to expenditure factors. It may have occurred because of the combination of
a) A lower price of a fixed item e.g. salary may be lower than budgeted
b) A reduced usage of what was classified as a fixed cost item e.g. the quantity of oil used to
lubricate the machines.
5.2.6 Absorption of non production overheads in production cost
Product costs may be compiled for a range of purposes including
a) Stock valuation
b) Product pricing
c) Decision making
For stock valuation purposes International Accounting Standard No. 2 define cost being that expenditure
which has been incurred in the normal course of business in bringing the product or service to its present
location and condition. This expenditure should include in addition to the cost of purchase such costs of
conversion as are appropriate to that location and condition.
Costs of conversion include production overheads and other overheads attributable in the particular
circumstances of the business in bringing the product or service to its present location and condition
For product pricing purposes, administration, selling and distribution overheads may be absorbed in a
number of ways including
a) As a percentage of selling price
b) As a percentage of full cost of production
c) As a percentage of conversion costs
d) As a rate per unit sold
For decision making purposes it is also relevant to know which part of administration selling and
distribution overhead costs are directly attributable to a particular product and which are avoidable if that
product is discontinued.