Chapter Two

Cost Determination: The Costing of Resource Inputs

Materials
 Accounting for stock (inventory) movements
 Determination of optimum purchase quantities
 Identification of accounting for stock losses
Introduction:
Every product, we see and use, is made from a basic raw material or a combination of two or
more raw materials. For example, a gunny bag is made from jute fibre, a car tyre is made
from rubber, steel wire is made from steel, a dining table is made from wood and steel and so
on. The jute fibre, rubber, steel and wood are raw materials. For manufacturing organisations,
raw materials cost is a major part of the total cost of the product. For example, raw material
cost is 70% of the total cost of a bag of cement. The investment in inventory of materials
represents one of the largest current asset items of the organisation.
In recent years, much emphasis has been given to minimise the cost of materials and to
optimise the physical flow of materials into the business and within the business. To keep
materials cost at a minimum, safeguarding and accounting for materials is extremely
important. In manufacturing organisation materials exist in various forms: raw materials in
warehouse, materials waiting for processing; raw materials being processed; again, finished
goods at the warehouse, in transit, at selling depot / counters, and so on. Therefore, proper
planning and control of materials are two very important tasks of the management
Management needs to establish procedures to ensure that:
[A] the correct quantities of materials are ordered at the right price and the right time;
[B] the correct materials are Received;
[C] adequate arrangements exist to store materials until they are required;
[D] materials are issued from stores only with proper authorisation, and records are
maintained of materials issued or returned;
[E] a consistent and realistic system is operated to charge production or the appropriate
department with the cost of materials used and to give a satisfactory valuation of
materials in store.
Meaning Of Certain Associated Terms
 Materials: They refer to the tangible, physical inputs used in production of a product. It
consists of raw materials, components, spare parts, consumable stores, packing material,
etc.
 Direct Material: It refers to the material which forms part of the finished product.
Examples of Direct Material are:
 Cotton used in manufacture of  Timber used in manufacture of
textiles papers
 Wood used in manufacture of  Glass used in making spectacles
pencil  Clay used in making bricks
 Steel used in manufacture of pens  Fruits used in making juices,

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 Indirect Material: It refers to material used in the process of production but does not form part of
the finished product. Examples of indirect materials are:
 Stationery used in office
 Items used in maintenance of machinery like cotton waste, etc.
 Materials used in service departments like transportation, canteen, power generation, etc.
 Material Cost: It refers to the cost of materials used in the manufacturing of a product. In relation
to material, the following are the costs involved:
 Procurement Cost It refers to the cost of purchasing or manufacturing the raw materials
required for production of the finished product.
 Holding cost or Carrying Cost It refers to the cost of storing the material till they are
issued for production.
 Ordering Cost It refers to the cost of placing an order for purchase of materials.
 Set-up Cost It refers to the cost of setting up the facility for producing the materials, in case
the materials are made, instead of purchasing them.
 Shortage Cost It refers to the fines, penalties, loss of demand, loss of goodwill, etc.
associated with shortage of material. In case, a business enterprise is not able to meet the
customers’ demand within the assured time due to shortage of raw material, the fines and
penalties to be paid, loss of potential demand, etc. suffered by the enterprise are considered
as shortage costs.
Materials: Procedures and Documentation
The need for procedures and documentation of materials when an entity purchases materials from a
supplier, the purchasing process should be properly documented. There are several reasons for this.
Any purchase of materials from a supplier should be properly authorised and approved at the
appropriate management level. Documentation of the purchasing process provides evidence that
approval has been obtained. The receipt of materials from a supplier should also be documented, to
make sure that the goods that were ordered have actually been delivered. There should be an invoice
from the supplier for the goods that have been delivered. (In rare cases when goods are bought for cash,
there should be a receipt from the supplier.) The amount payable for the materials provides
documentary evidence about their cost. When materials are received from a supplier, they might be
held in a store or warehouse until needed. When they are issued from the store, there should be a
documentary record of who has taken the materials and how many were taken. This is needed to
provide a record of the cost of materials used by different departments or cost centres.
Documentation of materials is therefore needed:
 to ensure that the procedures for ordering, receiving and paying for materials has been
conducted properly, and there is no error or fraud
 to provide a record of materials purchases for the financial accounts
 to provide a record of materials costs for the cost and management accounts.
The procedures and documents
The detailed procedures for purchasing materials and the documents used might differ according to the
size and nature of the business. However, the basic requirements should be the same for all types of
business where material purchases are made.
Purchasing procedures and documents
In a large company with a purchasing department (a buying department) and a stores department, the
procedures for purchasing materials might be as follows.
 The stores department identifies the need to re-order an item of raw materials for inventory. It
produces a request to the purchasing department to buy a quantity of the materials. This request is

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 called a purchase requisition. It should be properly authorised by a manager with the authority to
approve any such requisition.
 A buyer in the purchasing department selects a supplier and provides the supplier with a purchase
order, stating the identity of the item to be purchased, the quantity required and possibly also the
price that the supplier has agreed.
 Purchase of Materials Generally, there is a purchasing department whose function is to
order/ purchase materials and supplies for production. The purchase manager is responsible
for ensuring that the items ordered: (a) Meet the quality standards, (b) Are acquired at the
lowest price and (c) Are delivered on a timely basis. A typical purchase procedure involves
three steps: (1) Purchase requisition, (2) Purchase order, and (3) Receipt of materials
 When the supplier delivers the goods, the goods are accompanied by a delivery note from the
supplier. The delivery note is a statement of the identity and quantity of the items delivered, and it
provides confirmation that the items have been delivered. One copy is kept with the stores
department, and another copy is retained by the supplier (the driver of the delivery vehicle), as
evidence of the delivery.
 The stores department prepares a goods received note, recording the details of the materials
received. This should include the inventory identity code for the item, as well as the quantity
received.
 Copies of the delivery note and goods received note are sent to the accounts department, where they
are matched with a copy of the purchase order.
 A purchase invoice is received from the supplier, asking for payment. The accounts department
checks the invoice details with the details on the purchase order and goods received note, to
confirm that the correct items have been delivered in the correct quantities.
 The purchase invoice is used to record the purchase in the accounting records.
 In the cost accounting system, there should be inventory records to record the quantities and costs
of materials received. Data for recording costs of purchases for each item of inventory is obtained
from the goods received note (quantity and inventory code) and purchase invoice (cost).
The purchase processes:

Inventory records
An entity should keep an up-to-date record of the materials that it is holding in inventory.
 In the stores department, the materials should be kept secure, and there should be systems,
processes and controls to prevent loss, theft or damage. The stores department should keep a record
of the quantity of each item of material currently held in inventory. For each item of material, there

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 might therefore be an inventory record card, or ‘bin card’. This card is used to keep an up-to-date
record of the number of units of the material currently in the stores department, with records of
each receipt and issue of the inventory item. This process of continuous record-keeping is known as
perpetual inventory. The inventory record should be updated every time materials are delivered
into store from a supplier, and every time that materials are issued to an operating department.
Instead of having a ‘physical’ card for each stores item, there may be a
computerised record containing similar information.
 In the cost accounting department, another separate record of inventory might be kept, with an
inventory ledger record for each item of material. The inventory ledger record is a record of the
quantity of the materials currently held in inventory, the quantities received into store from
suppliers and the quantities issued to operational departments. In addition, the inventory ledger
record also records the cost of the materials currently held in inventory, the cost of new materials
purchased and the cost of the materials issued to each operating department (cost centre).
 In a computerised inventory control system, the stores department and the cost accounting
department should use the same computerised records for inventory.
Issues and returns of materials
A cost accounting system also needs to record the quantities and cost of items of materials that are
issued to the user departments and the quantities and cost of any items that are subsequently returned to
store unused
Purchase Requisition
The decision for purchase of materials is taken by the purchase department after receiving requisition
for such purchase from any authorised department. Requests for purchases are made by the authorised
department to the purchase department on a prescribed form known as Purchase Requisition. A
Purchase Requisition form includes three basic information which helps to the purchase officer to carry
on the function of purchasing efficiently.
The information’s are:
a) What materials are to be purchased (purchase of right quality).
b) When they are to be purchased (right time).
c) How much is to be purchased (right quantity).
Although a purchase requisition is usually pre-printed according to the specifications of a particular
company, most forms include the requisition (serially numbered); name of the department/ individual
making the request; quantity of the items requested; identifying the catalogue number; description of
the item; unit price; total price; shipping, handling, insurance and related costs; total cost of entire
requisition; order date; required delivery date, and authorised signature.

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The Purchase Requisition is prepared in triplicate-two copies are sent to the purchase department where
one copy 1s retained as evidence of authorisation and the other copy is returned to the indentor (the one
who made a request) after quoting therein the details of the order placed which indicates the action
taken by the purchase department. The third copy is retained by the Store for office record and for
future reference.

OBJECTIVES OF INVENTORY CONTROL

Scientific control of materials should serve the following purposes:
 To provide continuous flow of required materials, parts and components for efficient and
uninterrupted flow of production.
 To minimise investment in inventories keeping in view operating requirements.
 To provide for efficient store of materials so that inventories are protected from loss by fire and
theft and handling time and cost are kept at a minimum.
 To keep surplus and obsolete items to minimum.
It might seem obvious that inventory control is efficient as long as material level is going down.
Materials should increase or decrease in amount and time as related to sales requirements and
production schedules. Responsibility for control of materials is that of the top management, though
decisions in this regard might well be based upon the combined judgment of the production manager,
controller, the sales manager and the purchasing manager. This is desired in view of the financial
considerations involved in the problem and also because of need for coordinating the different kinds of
materials and conflicting viewpoints of different departments. For example, sales manager, purchasing
executive and production manager usually favour, though for different reasons, the policy of carrying
larger amount of stock whereas the financial manager will prefer to keep investment in material at the

5
lowest possible level. However, in a large number of organisations material control is generally made
the specific responsibility of purchasing department.
Techniques of Inventory Control
A number of techniques and mathematical models are employed in the process of inventory control.
Inventory control is exercised over raw materials and work-in-progress. The main aim of inventory
control is to maintain optimum level of inventory. For this, an organization has to determine:
1) The quantity that they should be ordered and
2) The time when they should be ordered.
The first aspect—the quantity—how much to order is associated with the determination of economic
order quantity.
The second one—the time—when they should be ordered is associated with the determination of re
order level
Determination of Optimum Purchase Quantities
Minimising materials costs
Organisations that purchase and consume large quantities of materials should try to minimise the total
costs. Total materials costs, for any item of materials, consist of:
 The cost of materials purchased (the purchase price)
 The costs of making purchase orders to buy the material (ordering costs)
 The costs of holding inventory (this is often a cost of interest on the investment in inventory).
In most cases, the most significant cost is the purchase cost of the materials. However, ordering costs
and holding costs might also be substantial.
Economic Order Quantity (EOQ)
This method makes an attempt to resolve the issue: How much to order at a time? EOQ refers to the
quantity of order which gives maximum economy in acquiring materials. It puts much thrust on
standard ordering quantity. In order to understand EOQ, the costs associated with it have to be analysed
first. They are (I) carrying costs, (II) ordering costs and (III) costs of stock-out (shortage)
Carrying costs: These are “costs of holding” the inventory. These are the costs of keeping items in
stock. These costs include store-keeping cost, interest on capital blocked in inventory, insurance
premium, handling costs, stores staff, maintenance of equipment costs, cost of warehousing, cost of
perpetual inventory and continuous stock taking, deterioration, obsolescence etc.
Ordering costs: These are the costs of placing an order and receiving the supplies. These costs include
expenses involved in purchasing, rising of stores requisition, follow-up, transportation, receipt in store,
sorting inspection, storage etc.
Stock-out costs (shortage/inadequate inventory): These costs incur due to the shortage of inventories
for meeting the needs of production and consumer demand. These costs include uneconomic
production schedules, push-up cost of production, crash and expedite purchases at high costs, customer
loss, erosion of goodwill etc. These costs are not easy to measure as many of the costs are intangible.
These two costs, ordering costs and stock-out costs, are called “cost of acquiring”. The optimum
ordering quantity—the quantity for which the cost of holding plus the cost of acquiring is the minimum
—is referred to as “economic ordering quantity”.
The economic ordering quantity is computed by using the formula:

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 EOQ=
√ 2U ×P
S
Where:
E.O.Q = Economic ordering quantity
U = Units purchased (or) used in a year
P = Cost of placing an order
S = Annual cost of storage of one unit
Assumptions of EOQ:
 There is a constant demand for the materials throughout the year. For example, if annual
demand is 4,000 units of the item each year, the item is consumed at a constant rate throughout
the year.
 There will be an immediate supply of new materials (Q units) as soon as existing as quantities
in store run down to 0. The minimum quantity held in store is therefore 0 units and this always
occurs just before a new purchase order quantity is received. The maximum quantity is Q units.
The average amount of inventory held is therefore Q/2 and total holding costs each year are
(Q/2) × CH.
 The number of orders each year is D/Q. Total ordering costs each year are therefore (D/Q) ×
CO
The economic order quantity (EOQ) is the order size that will minimise the total of these costs during a
period (normally one year), given the assumptions stated above.
For the purpose of the EOQ formula, the costs that should be used in the formula are only those costs
that are incurred as a direct consequence of ordering inventory or holding inventory. Costs that would
be incurred anyway – such as the salary costs of the buyer or the costs of renting warehouse space –
should not be used in the formula because they are not relevant costs for deciding the EOQ size
Example:
A company uses 14,450 units of Material X each year, which costs $2 for each unit. The cost of placing
an order is br 125 for each order. The cost of holding inventory each year is 10% of the purchase cost.
What is the order quantity for Material X that will minimise annual costs?
Given:
P= br 125
S = 0.1 * 2 = 0.2
U= 14,450

EOQ=
√ 2∗14,450× 125
0.2
=√ 18,062,500 4=4250 Units

Bill of Materials
This document is prepared by the design or engineering or production planning and control department.
This document contains the quantity required by such departments. Following are the purpose
underlying the preparation of bill of materials:
[A] It serves as a basis for the computation of direct material cost when quotations are submitted.
[B] It serves the purpose of intimation to purchase department to purchase materials.
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 [C] It serves as a guideline to production department.
[D] It facilitates accounting of materials consumed as needed data can be passed on to relevant jobs
or processes.
[E] It functions as a controlling technique.
Four copies of bill of materials are prepared. One copy each is sent to the production, stores and cost
accounting
departments, and one copy is retained by the planning or engineering department

When to Order (Reorder Level)

The EOQ determines how much to buy at a particular time. But the question “when to buy” is equally
important for business firms. This question is easy to answer only if we know the lead time-the time
interval between placing an order and receiving delivery-and know the EOQ, and are certain of
the consumption pattern during lead time. The order point or re-order level is a point or quantity level
at which if materials in stores reach, the order for supply of materials must be placed. This point
automatically initiates a new order. The order point is calculated from three factors:
1) The expected usage.
2) The time interval between initiating an order and its receipt, referred to as the lead time.
3) The minimum inventory or safety stock.
Some business firms fix re-order level taking into account maximum usage and maximum lead time so
that the stock will not reach the zero level.
The formula for computing re-orders level is:
ℜ−order≤vel=Safety stock +( Average usage X Averagereorder period∨lead time)
In terms of maximum usage and maximum lead time, the formula for re-order level is as follows:
ℜ−order level=Maximum ℜ−order period X Maximum usage
It is advisable to use the first formula given above to calculate re-order level. However, when adequate
information is not given about the factors of this formula, the second formula can be used if
information is available about the factors of this formula.

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For example, if daily usage is 400 units of material which have a lead time of 20 days and the safety
(minimum) stock is 500 units, the order point will be calculated as follows:
Daily consumption X lead time = 400 X 20 = 8,000 units
Add safety stock = 500 units
Order point units = 8,500 units

The order point is determined after considering the worst possible expected conditions. This only
ensures that the minimum stock will always remain in the inventory and will not be used at least in the
short run. However, situations may arise where there will be stock-out and thus, the order point may
not be an absolutely accurate forecasting
Reorder level without safety stock
Example
The David IT Store sells 500 laptops on an average in a week. The maximum demand in a week is 523
laptops. If, the lead time is 4.5 week then the reorder level would be:
Reorder level = Maximum weekly usage × Lead time in weeks
= 523 units × 4.5 weeks
= 2,354 units
It means that every time the number of laptops decreases to 2,354, the David IT Store must place a new
order.
Determination of Safety or Minimum Stock Level
It is advisable to carry a reserve or safety stock to prevent stock-out. The safety stock should be used
only in abnormal circumstances, and the working stock in ideal or normal conditions. Therefore, for
normal working conditions, the stock should not be allowed to fall below the safety limit, kept only for
emergencies. If the usage pattern is known with certainty, and the lead time is also known accurately,
then no safety stock would be needed. However, if either usage or lead time is subject to variation then
it is necessary for a business firm to maintain safety stock levels equal to the difference between the
expected usage over lead time and the maximum usage over lead time that the firm feels is necessary
for cost minimisation. The safety stock level can be computed by using the following formula:
Safety∨minimum stock level=Ordering Level−¿

Example
In a manufacturing operation, a particular material is used as follows:
Maximum consumption = 9,000 units per week
Minimum consumption = 3,000 units per week
Normal consumption = 6,000 units
Time required for delivery = 4 to 6 weeks
Time required for emergent supplies: 1 week
Required
9
Calculate the minimum stock level.
Reorder Level = Maximum Consumption per week x Maximum time required to obtain
suppliers
= 9,000 units x 6 weeks
= 54,000 units
As the next step, we can calculate minimum stock level as follows:

• Minimum Stock Level = 54,000 units – (6,000 units x 5 weeks)

=54,000–30,000=24,000units

• Note: The average time required to obtain suppliers was calculated in the
following way:
AT= (Minimum period + Maximum Period) / 2
= 4 weeks + 6 weeks / 2
= 5 weeks
Example 2
• Suppose we have the following information:
- Normal consumption = 300 units per week
- Normal delivery time = 7 weeks
- Reorder level = 2,400 units
• Calculate the minimum stock level.

Minimum Stock Level= 2,400–(300x7)

= 300 units
Maximum Stock Level

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The maximum level ensures that the stocks will not exceed this limit although there may be low
demand for materials or quick delivery from the suppliers. Maximum stock level can be computed as
follows:
Maximum Stock Level=ℜorderig Level+ EOQ−¿
Example
• ZEE is a product manufactured from three raw materials: M, N, and Q. Each unit of ZEE
requires 10 kg, 8 kg, and 6 kg of M, N, and Q respectively.
• The reorder levels of M and N are 15,000 kg and 10,000 kg, respectively.
• The minimum reorder level of Q is 25,000 kg.
• The weekly production of ZEE varies from 300 to 500 units, while the weekly average
production is 400 units.
Required: Calculate the following:
1. Maximum stock level of N
The following additional data are given

Solution
Maximum Stock Level of N
= Reorder level + Reorder quantity – (Minimum consumption per week x Minimum time required to
obtain supplies)
= 10,000 kg + 15,000 kg – (300 units x 8 kg x 4 weeks)
= 25,000 kg – 9,600 kg
= 15,400 kg
Some factors to be considered in deciding the maximum stock level are as follows:
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  Holding or carrying cost of inventory
 Availability of storage facility
 Seasonal nature of some products such as agricultural products
 Availability of fund
 Future price trends of raw materials or components
 Government policies or restrictions
 Properties of some raw materials such as explosive, chemical, inflammable
 Availability of raw materials in the international market.
Danger level
Generally, the danger level of stock is indicated below the safety or minimum stock level. Sometimes
depending on the practices of the firm and circumstances prevailing, the danger level is determined
between reorder level and minimum level. In the second case (danger level being between reorder level
and minimum level), the firm can only take steps to ensure that materials ordered will arrive in time.
Average stock level
Average stock level is computed in the following manner:
Minimum+ Maximum Stock
Average Stock Level=
2
Or
Minimum+ Reorder Quantity
Average Stock Level=
2
The following example further illustrates the different stock levels.

Maximum usage (units) 650 per day

Minimum usage (units) 300 per day
Normal usage (units) 500 per day
Economic order quantity (units) 75000
Re-order period-lead time 25 to 30 days
Minimum level (units) 5000
(10 days at normal usage)

The different stock levels will be as follows:

Re-order level =normal usage X normal lead time + minimum level
= (500 X 30) + 5,000 = 20,000 Units
Maximum level = Re-order level + EOQ - Minimum quantity used in re-order period
= 20,000 + 75000 – (300*25) = 87,500 Units
Minimum+ Maximum Stock 5,000+87,500
Average Stock Level= = =46,250 Units
2 2
Accounting For Stock (Inventory) Movements
In a system of cost accounting, a separate record is kept for each inventory item. This record – an
inventory account – is used to maintain a record of all movements in the materials, in terms of both
quantities and cost.
The main contents of an inventory record are shown in the previous example. An inventory record in
the cost accounts provides a continual record of the following:

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 Purchases/deliveries from suppliers: quantity and cost
Raw materials xx
Cash/Account payable xx
 Returns to suppliers: quantity and cost
Cash/Account payable xx
Raw Material xx
 Issues of the item to user departments: quantity, cost and department identity
Work in Process xx
MOH xx
Raw Material xx
 Returns from user departments to the stores: quantity, cost and department identity
 The balance held in inventory (quantity and cost or value).
 Sales of Inventory and recording costs of goods sold
Cash (Accounts Receivable) xx
Sales xx
Costs of Goods Sold xx
Finished Goods Inventory xx
The inventory records are combined into a total record for all inventory, which is used for reporting
purposes such as the preparation of a costing statement or an income statement of the profit or loss
made in a period. The system for recording inventory and materials costs might also be a part of a
bigger cost accounting system.
A cost accounting system is a system for recording all costs and in large organisations it is maintained
in the form of a double entry accounting system of cost records in a ‘cost ledger’.

Accounting for Labour Costs (Direct and Indirect Labour Costs)

Factory payroll costs are divided into two categories: direct labor and indirect labor. Represents payroll
costs traced directly to an individual job. Direct labor, also known as touch labor, labor costs include
the wages of machinists, assemblers, and other workers who physically convert raw materials to
finished goods—thus the term touch. For example, a painter on the production line at the Toyota plant
in Georgetown, Kentucky is a direct labourer. The cost of direct labor is debited to Work in Process.
Indirect labor consists of labor costs incurred for a variety of jobs related to the production process
but not readily traceable to the individual jobs worked on during the period. Indirect labor costs include
the salaries and wages of the factory superintendent, supervisors, janitors, clerks, and factory
accountants who support all jobs worked on during the period. For example, the plant manager of the
Toyota manufacturing facility is an indirect labourer. Indirect labor costs are charged to Factory
Overhead.

You may also think of the distinction between direct labor and indirect labor relative to service firms.
For example, auditors with a public accounting firm would be considered direct labor relative to the
individual jobs that they worked on, whereas the salary of the managing partner would be indirect
labor that should be allocated to all of the clients audited in determining the total cost of servicing
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clients. Other examples of indirect labor in an accounting firm would include the human resource’s
function, the technical support staff, and the secretarial function.
The accounting system of a manufacturer must include the following procedures for recording payroll
costs:
1. Recording the hours worked or quantity of output by employees in total and by job, process, or
department.
2. Analysing the hours worked by employees to determine how labor time is to be charged.
3. Charging payroll costs to jobs, processes, departments, and factory overhead accounts.
4. Preparing the payroll, which involves computing and recording employee gross earnings,
withholdings and deductions, and net earnings.
Wage Plans

Employees’ wages are based on plans that have been established by management, approved by the
unions, if present, and that comply with the regulations of governmental agencies. A
manufacturer may use many variations of wage plans. This chapter covers the wage plans most
frequently encountered, including hourly rate, piece-rate, and modified wage plans.

Hourly Rate Plan (Time-based systems)

An hourly rate plan establishes a definite rate per hour for each employee. An employee’s wages are
computed by multiplying the number of hours worked in the payroll period by the established
rate per hour. The hourly rate plan is widely used and is simple to apply. Critics argue that it
provides no incentive for the employee to maintain or achieve a high level of productivity. An employee is
paid for merely ‘‘being on the job’’ for an established period of time. The plan gives no extra
recognition or reward for doing more than the minimum required of the position. Proponents of
the plan argue that because productivity is not an important factor of such a plan, employees
will not be tempted to sacrifice the quality of the product by speeding up production to earn a
higher wage. Productivity is measured as the amount of output per hour of work.

To illustrate the hourly rate plan, assume that an employee earns $15 per hour and works 40
hours per week. The employee’s gross earnings would be $600 (40 $15 per hour).

Piece-Rate Plan
A company that gives a high priority to the quantity produced by each worker should
consider using an incentive wage plan, such as a piece-rate plan, that bases earnings on the
employee’s quantity of production. To illustrate, assume that a machine operator will earn $0.30 for
each part (or ‘‘piece’’) finished. If the operator finishes 2,200 parts in a week, he or she will

14
earn $660 ($0.30 2,200 parts). The plan provides an incentive for employees to produce a
high level of output, thereby maximizing their earnings and also increasing the company’s revenue.
However, a serious shortcoming of such plans is that they may encourage employees to sacrifice
quality in order to maximize their earnings, unless the plan is based on only the production
of good units. Also, piece rates are not appropriate if machines, rather than people, control
production speed

Modified Wage Plans

Modified wage plans combine some features of the hourly rate and piece rate plans. An
example of a modified wage plan would be to set a base hourly wage that the company will
pay if an employee does not attain an established quota of production. If the established quota
is exceeded, an additional payment per piece would be added to the wage base. This type of
plan rewards high-performing employees and directs management’s attention to employees
unable to meet the established quotas.
Controlling Labor Cost
The timekeeping and payroll departments have the responsibility of maintaining labor
records. The timekeeping and payroll functions may be established as separate departments or
organized as subdivisions of a single department. Increasingly, automated timekeeping
technology has replaced ‘‘timekeeping’’ as a separate department. For example, many companies issue
magnetic cards to direct laborers who use them to ‘‘log on’’ and ‘‘log off’’ to specific job assignments. They
slide the card through a magnetic card reader connected to a remote computer terminal, much as
you would do to pay for your groceries at the supermarket. The computer sends this labor
time information to the accounting department for preparation of the payroll and distribution
of labor costs to the appropriate jobs.
The payroll department, or payroll function within the accounting department, uses the labor
time records, whether manually or electronically generated, to compute each employee’s gross earnings, the
amount of withholdings and deductions, and the net earnings to be paid to the employee. The
payroll function includes completing and maintaining the payroll records, the employees’ earnings records,
and the payroll summaries.
Payroll Function
The payroll function’s primary responsibility is to compute the employees’ wages and salaries. It involves
combining the daily wages, determining the total earnings, and computing deductions and
withholdings for each employee. Payroll is often a function within a single accounting
department, as opposed to being a separate department.

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Accounting for Labor Costs and Employers’ Payroll Taxes
For all regular hourly employees, the hours worked should be recorded on a labor time
record. The payroll department enters pay rates and gross earnings and forwards the reports to
accounting. Cost accountants examine the labor time records and charge the labor costs to the
appropriate jobs or department and to factory overhead. This analysis of labor costs is
recorded on a labor cost summary that summarizes the direct labor and indirect labor charges
to a department for the period.
Salaried employees, such as department supervisors, are often not required to prepare labor
time records. Payroll sends a list of salaried employees to accounting showing the names of
employees, the nature of work performed, and the salaries. The accounting department
records the earnings on the labor cost summary and in factory overhead ledger accounts,
because the salaried factory employees are supervisors and other factory managers who do
not physically convert the raw materials to finished goods, and therefore their salaries are
indirect labor
The labor cost summary becomes the source for making a general journal entry, shown
below, to distribute payroll to the appropriate accounts.

Work in Process (Direct Material) xx

MOH (Indirect Material) xx
Salaries and Wages Payable xx

The entry is then posted to the control accounts, Work in Process and Factory Overhead, in
the general ledger. The labor time records have been used to record the labor costs in both the
subsidiary job cost ledger and factory overhead ledger, as well as in the labor cost summary.
Therefore, the debit to the work in process control account must equal the total direct labor
cost charged to the individual jobs, and the debit to the factory overhead control account must
equal the total indirect labor costs recorded in the factory overhead ledger
Labour Efficiency Ratio (productivity ratio)
Non-financial information might be provided to management about labour performance.
Performance measurements include the labour efficiency ratio or productivity ratio:

When output is produced in exactly the time expected, the efficiency ratio is 100%. When
output is produced more quickly than expected, the efficiency ratio is above 100%.
Example: During July, a factory produced 3,600 units of a product. The expected production
time is 3 direct labour hours for each unit. The actual number of direct labour hours worked
in the month was 10,000 hours.

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Labour turnover rate
Labour turnover occurs when employees leave their job and have to be replaced. The labour
turnover rate is a measure of the rate at which employees are leaving and have to be replaced

Costs and causes of labour turnover

The main cause of labor turnover is when employees leave one company to go and
work for another.
Labour turnover can be very costly for an employer, and result in higher costs.
When employees leave, their experience is lost. New employees taking their place
are less experienced, and will be less efficient until they learn how to do the job. A high
labour turnover, by reducing efficiency, increases costs.
New employees might make many more mistakes, and so there will be additional
costs of correcting faulty work.
New employees might have to be trained, and there will be additional training costs.
A very high labour turnover rate could have an adverse effect on the morale and
efficiency of the employees who remain in their jobs.

Accounting for Manufacturing (Factory) Overhead

All costs incurred in the factory that are not chargeable directly to the finished product are
called factory overhead These operating costs of the factory cannot be traced specifically to
a unit of production. A variety of other terms have been used to describe this type of cost,
such as indirect expenses, indirect manufacturing costs, or factory burden. These costs are also referred
to simply as ‘‘overhead’’ or ‘‘burden.
One method of determining whether a factory expenditure is an overhead item is to compare
it to the classification standards established for direct materials and direct labor costs. If the
expenditure cannot be charged to either of these two categories, it is classified as factory
overhead. Thus, all indirect factory expenditures are factory overhead items. Factory
overhead includes (1) indirect materials consumed in the factory, such as glue and nails in the
production of wooden furniture and oil used for maintaining factory equipment; (2) indirect
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factory labor, such as wages of janitors, forklift operators, and supervisors and overtime
premiums paid to all factory workers; and (3) all other indirect manufacturing expenses, such
as insurance, property taxes, and depreciation on the factory building and equipment.
Accounting for factory overhead involves the following procedures:
1) Identifying cost behaviour patterns.
2) Budgeting factory overhead costs.
3) Accumulating actual overhead costs.
4) Applying factory overhead estimates to production (to be widely discussed on chapter 3).
5) Calculating and analysing differences between actual and applied factory overhead (to
be widely discussed on chapter 3)
Identifying Cost Behaviour Patterns
Direct materials and direct labor are classified as variable costs. Variable costs are costs that
vary in direct proportion to volume changes. In contrast are those costs that remain the same,
in total, when production levels increase or decrease. These unchanging costs are referred to
as fixed costs. Semi- variable costs, also called mixed costs, have characteristics of both
variable and fixed costs.
Factory overhead expenses include costs that may be classified as variable, fixed, or mixed.
Therefore, factory overhead creates a difficult problem for most companies because they
must predict costs that will be incurred at various levels of production. The factory overhead
costs, such as supplies, that behave in the same pattern as direct materials costs and direct
labor costs are considered variable costs and are readily forecasted because they move up or
down proportionately with production volume changes. The factory overhead charges
deemed fixed costs, such as the plant manager’s salary, remain unchanged when production
varies; therefore, they are also quite predictable. The factory overhead costs that are semi-
variable, such as the cost of utilities, have to be first broken into their variable and fixed
components before they can be predicted at different volume levels. In many companies,
semi-variable costs constitute a substantial portion of the factory overhead charges, and the
method used to forecast these costs must be carefully selected
Fig: cost behaviour pattern

Budgeting Factory Overhead Costs

Budgets are management’s operating plans expressed in quantitative terms, such as units of production
and related costs. After factory overhead costs have been classified as either fixed or variable,
budgets can be prepared for expected levels of production. The segregation of fixed and
variable cost components permits the company to prepare a flexible budget. A flexible
budget is a budget that shows estimated costs at different production volumes.

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Assume that management desires to budget factory overhead costs at three levels of
production— 10,000, 20,000, and 40,000 units. The variable factory overhead cost is $5 per
unit, and fixed overhead costs total $50,000.
The budgeted costs at these volumes are as follows:

As the volume of production increases, the factory overhead cost per unit decreases because
the total fixed cost, $50,000, is spread over a larger number of units. For example, the fixed
cost per unit will add
$5 to the per unit cost ($50,000/10,000 units) at the 10,000-unit level but only $1.25
($50,000/40,000 units) when 40,000 units are produced. The variable cost remains constant at
$5 per unit for the entire range of production. Budgeting is a valuable management tool for
planning and controlling costs. A flexible budget aids management in establishing realistic
production goals and in comparing actual costs with budgeted costs.
Definition of absorption costing
Absorption costing is based on the idea that the cost of a product or a service should be its
direct costs (direct materials, direct labour and sometimes direct expenses) plus, a share of
overhead costs.
Absorption costing is therefore a system of costing in which a share of overhead costs is added to
direct costs, to obtain a full cost. This might be:
 a full production cost, or
 a full cost of sale.
An absorption costing system might be used to decide the full production cost of the
product, so that only a share of production overheads is added to product costs.
Administration overheads and selling and distribution overheads are simply charged as an
expense to the period in which they occur

The Purpose of Absorption Costing

There are several reasons why absorption costing is sometimes used, and production
overhead costs are added to direct costs to calculate the full production cost of products (or
services).
 There is a view that inventory should include a fair share of production overhead cost. This
view is applied in financial accounting and financial reporting. It can therefore be argued
that inventory should be valued in a similar way in the cost accounting system. (However,
inventory valuations may differ between the cost accounts and the financial accounts.)
 There is also a view that in order to assess the profitability of products or services, it is
appropriate to charge products and services with a fair share of overhead costs. Unless
products contribute sufficiently to covering indirect costs, its ‘profitability’ might be too
low, and the business as a whole might not be profitable.
Criticisms of absorption costing
There are criticisms of absorption costing. The main criticisms are as follows:
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  Absorption costing does not provide reliable information about profitability. Methods
of charging overhead costs to products, as we shall see, are not ‘scientific’, and rely on
fairly arbitrary assumptions.
 There are better methods of measuring profitability, such as marginal costing. There
are also better ways of providing cost information to help managers make decisions
(relevant costs).
When absorption costing was first used in manufacturing, well over 100 years ago, total
overhead costs were fairly small compared with direct costs. Manufacturing was labour-
intensive, and direct labour costs were a significant proportion of total costs. Adding a share
of overheads to product costs, usually in proportion to the cost of direct labour or direct
labour time, was therefore a reasonable method of dealing with overhead costs.

In a modern manufacturing environment, however, direct labour is a fairly small proportion

of total costs. Most work in production now consists of the ‘support’ activities of indirect
labour employees, and the cost of this labour is an overhead cost. Overhead costs are high
compared to direct labour costs. As a consequence, it is often argued that a costing system
should use a different approach to overhead costing, and try to present overhead costs in a
way that is more useful to management for information purposes. One such technique,
activity-based costing which will be elaborated I chapter six.
Allocation, Apportionment and Absorption (Recovery)
There are three main stages in absorption costing for charging overhead costs to the cost of
production and cost units:
Allocation. Overheads are allocated to cost centres. If a cost centre is responsible for
the entire cost of an item of expenditure, the entire cost is charged directly to the cost
centre.
Apportionment. Many overhead costs are costs that cannot be allocated directly to one
cost centre, because they are shared by two or more cost centres. These costs are apportioned
between the cost centres. ‘Apportionment’ means sharing on a fair basis.
Absorption (also called overhead ‘recovery’). When overheads have been allocated and
apportioned to production cost centres, they are charged to the cost of products
manufactured in the cost centre. The method of charging overheads to cost units is to
establish a charging rate (an absorption rate or recovery rate) and to apply this rate to all
items of production.

Overhead Cost Allocation

Many items of indirect cost cannot be charged directly to a cost unit (a unit of product or

20
service), but they can be charged directly to a cost centre (for example, a department or
work group). Items of expense that can be identified with a specific cost centre should be
charged in full as a cost to the cost centre. The process of charging costs directly to cost
centres is called cost allocation. In absorption costing for a manufacturing company,
overhead costs may be allocated to:
 production departments or production centres: these are cost centres that are directly
engaged in manufacturing the products
 service departments or service centres: these are cost centres that provide support to
the production departments, but are not directly engaged in production, such as
engineering, repairs and maintenance, the production stores and materials handling
department (raw materials inventory), production
planning and control, and so on
 administration departments
 selling departments and distribution departments

Financial Statement for Manufacturing Organization

Financial statement of a manufacturing company is more complex as compared to financial
statement of merchandising and service giving companies. Particularly, the balance sheet and
income statement of a manufacturing enterprise are somewhat different from their
merchandising and service counterpart. All costs mentioned above should be properly
accounted for and reported in the financial statement for a manufacturing firm.
Manufacturing organizations perform selling and administrative functions similar to
merchandising firms. However, instead of purchasing goods that are ready for resale, a
manufacturing firm buys raw materials, labor, and other components needed to perform the
manufacturing function of converting the raw materials into finished products. This
difference is shown in the cost-of-goods-sold statements. In addition, the balance sheet at the
end of the period will show ending inventories for raw materials, work-in-process, and
finished goods. My objective here is to explain the computation of cost of goods
manufactured and to illustrate the development of external financial statements for a
manufacturing organization.
1. Balance Sheet of a Manufacturing and Merchandising Firm

The Balance sheet of a manufacturing firm differs from the balance sheet of a merchandising
firm principally by the type of inventories reported. A manufacturing firm carries three types
of inventory. Namely, Raw material inventory, work-in-process inventory and finished
Goods inventory.
I. Materials inventory (sometimes called raw materials inventory). This inventory
consists of the costs of the direct and indirect materials that have not entered the
manufacturing process.
Examples for Deluxe Furniture: Wood (timber), nails, glue, varnish, etc.
II. Work in process inventory. This inventory consists of the direct materials, direct
labor, and factory overhead costs for products that have entered the manufacturing
process, but are not yet completed (in process).
Example for Deluxe Furniture: Unfinished (partially assembled) Office Table.
III. Finished goods inventory. This inventory consists of completed (or finished)
products that have not been sold.
Example for Deluxe Furniture: Unsold office Table.
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Exhibit 2.2 illustrates the reporting of inventory on the balance sheet for a merchandising and
a manufacturing business. Bambies Super Market a whole seller of several cosmetics and
shampoos, confectionaries and packed juices., reports one type of inventory (i.e.
merchandising inventory) Deluxe Furniture, a manufacturer of innovative wooden made
office and room furniture , reports Finished Goods, Work in Process, and Materials

inventories.
2. Income statement of a Manufacturing Firm

The income statements for merchandising and manufacturing businesses differ primarily in
the reporting of the cost of merchandise (goods) available for sale and sold during the period.
These differences are shown below.
Merchandising Business Manufacturing Business
Sales $ Sales $ xxx
xxx
Beg. Mercha. goods $xxx Beginning finished inventory xxx
inventory
Plus Net purchase xxx Plus cost of goods xxx
manufactured
Merchandise available for xxx Cost of finished goods xxx
sale available for sale
Less ending merchandising xxx Less ending finished goods xxx
inventory inventory
Cost of Merchandise sold xx Cost of goods sold xxx
x
Gross profit xx Gross profit xxx
x

A merchandising business purchases merchandise ready for resale to customers. The total
cost of the merchandise available for sale during the period is determined by adding the
beginning merchandise inventory to the net purchases. The cost of merchandise sold is
determined by subtracting the ending merchandise inventory from the cost of merchandise
available for sale.

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A manufacturer makes the products it sells, using direct materials, direct labor, and factory
overhead. The total cost of making products that are available for sale during the period is
called the cost of goods manufactured. The cost of finished goods available for sale is
determined by adding the beginning finished goods inventory to the cost of goods
manufactured during the period. The cost of goods sold is determined by subtracting the
ending finished goods inventory from the cost of finished goods available for sale. Cost of
goods manufactured is required to determine the cost of goods sold, and thus to prepare the
income statement. The cost of goods manufactured is often determined by preparing a
statement of cost of goods manufactured. In general, the following four steps are required
to prepare income statement of a manufacturing firm.

Step 1: The Schedule of Direct Material Used In Production

The cost of direct material used is equivalent to the beginning inventory of direct material
plus purchase made during that period less the direct material left at the end of the period.
Schedule 1: Cost of Direct Material Used
Beginning materials inventory xxx
Add: purchase in the period xxx
Direct material available for use xxx
Less: ending direct material inventory xxx
Cost of goods sold xxx

Step 2: The Schedule of Cost of Goods Manufactured

Cost of goods manufactured refers to the cost of goods brought to completion whether they
were started before or during the accounting period. To determine the cost of goods
manufactured, three factors are necessary; cost of direct material used, cost of direct labor
and manufacturing overhead. In addition, work in process at the beginning and at the end
should be incorporated in the calculation. The following is the schedule used to calculate the
cost of goods manufactured.
Schedule 2: Cost of Goods Manufactured
Work in process at the beginning xxx
Add: cost of direct material used Xxx
Direct labor cost Xxx
Manufacturing overhead cost Xxx
Cost incurred in current period xxx
Total cost incurred to date xxx
Less : work in process ending xxx
Cost of goods manufacturing xxx

Step 3: The Schedule of costs of Goods Sold

The cost of goods sold represents the cost of goods that are sold during a given period. In
computing the costs of goods sold amount, cost of finished goods at the beginning, cost of
goods manufactured in the period and cost of finished goods at the end will be taken in to
account. The following is the schedule used to compute cost of goods sold.
Schedule 3: Cost of Goods Sold
Finished goods beginning Xxx
Add: cost of goods Manufactured Xxx
Cost of goods available for sale Xxx
Less: finished goods ending Xxx
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 Cost of goods sold Xxx

Step 4 Income statement

All of the above schedules are inputs one to the other. The ultimate goal of making all the
schedules is to prepare the income statement. The income statement contains three main
elements. These are sales, cost of goods sold and operational expense. The cost of goods sold
is deducted from sales to arrive at gross profit. From gross profit, operational expense is
deducted to arrive at operating income. The following is the schedule used to calculate
operating income.

Schedule 4: Income statement

Revenues Xxx
Cost of goods sold Xxx
Gross profit Xxx
Operating expense Xxx
Operating income Xxx
Chapter End Exercises
A fire destroyed XYZ manufacturing company completely on January 29, 2011. Fortunately,
certain accounting records were kept in another building. It revealed the following for the
period from January 1, 2011 to January 29, 2011.
Direct material used Br 160,000
WIP January 1 34,000
Direct material January 1,2011 16,000
Finished Goods Inventory January1,2004 36,000
MOH cost 40% of conversion cost
Revenue 500,000

Direct labor cost 180,000

Prime cost 294,000
Gross profit based on sales 20%
Cost of Goods available for sale 450,000

Required:

a) Direct material destroyed

b) Cost of goods manufactured
c) Finished goods destroyed
d) WIP destroyed
[Q5] Melat recently took over as the controller of Johnson brothers Manufacturing. Last
month, the previous controller left the company with little notice and left the accounting
records in disarray. Melat needs the ending inventory balances to report first quarter
numbers. For the previous month (March 2011) Melat was able to piece together the
following information:
Direct materials purchased $ 240,000
Work-in-process inventory, 3/1/2011 70,000
Direct materials inventory, 3/1/2011 25,000
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 Finished goods inventory, 3/1/2011 320,000
Conversion Costs 660,000
Total manufacturing costs added during the period 840,000
Cost of goods manufactured 4 times direct materials
used Gross margin as a percentage of revenues
20% Revenues
1,037,500

Calculate the cost of:

1. Finished goods inventory, 3/31/2011
2. Work-in-process inventory, 3/31/2011
3. Direct materials inventory, 3/31/2011

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