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There are broadly three elements of cost - (1) material, (2) labour and (3) expenses.: The substance from which the product is made is known as material. It may be in a raw stateraw material, e.g., timber for furniture and leather for shoe, etc. It may j also be in manufactured state-components, e.g., battery for car, speaker for radio, etc, Materials can be direct and indirect. Direct Material: All materials which become an integral part of the finished j product, the cost of which are directly and completely assigned to the specific physical units and charged to the prime cost, are known as direct material. The following are some of the materials that fall under this category: (a) Materials which are specifically purchased; acquired or produced for a particular job, order or process. (b) Primary packing material (e.g. carton, wrapping, cardboard, etc.) (c) Materials passing from one process to another as inputs. In order to calculate the cost of material, expenses such as import duties, dock charges, transport cost of materials are added to the invoice price. Material considered direct at one time may be indirect on other occasion. Nail used in manufacturing wooden box is treated as direct material, but treated as indirect material when used to repair the factory building. Indirect Material: All materials, which cannot be conveniently assigned to specific physical units, are termed as 'indirect material'. Such commodities do not form part of the finished products. Consumable stores, lubrication oil, stationery and spare parts for the machinery are termed as indirect materials. Labour Human efforts used for conversion of materials into finished products or doing various jobs in the business are known as labour. Payment made towards the labour is called labour cost. It can also be direct and indirect. Direct Labour: Direct labour is all labour expended and directly involved in altering the condition, composition or construction of the product. The wages paid to skilled and unskilled workers for manual work or mechanical work for operating machinery, which can be specifically allocated to a particular unit of production, is known as direct wages or direct labour cost. Hence, 'direct wage' may be defined as the measure of direct labour in terms of money. It is specifically and conveniently traceable to the specific products Wages paid to the goldsmith for making gold ornament is an example of direct labour. Indirect Labour: Labour employed to perform work incidental to production of goods or those engaged for office work, selling and distribution activities are known as 'indirect labour'. The wages paid to such workers are known as 'indirect wages' or indirect labour cost.
Example: Salary paid to the driver of the delivery van used for distribution of the product. Expenses All expenditures other than material and labour incurred for manufacturing a product or rendering service are termed as 'expenses'. Expenses may be direct or indirect. Direct Expenses: Expenses which are specifically incurred and can be directly and wholly allocated to a particular product, job or service are termed as 'direct expenses'. Examples of such expense are: hire charges of special machinery hired for the fob, carriage inward, royalty, cost of special and specific drawings, etc. These are also known as 'chargeable expenses'. Indirect Expenses: All expenses excluding indirect material and indirect labour, which cannot be directly and wholly attributed to a particular product, job or service, are termed as 'indirect expenses'. Some examples of such expenses are: repairs to machinery, insurance, lighting and rent of the buildings.
Elements of Costs – Examples and Chart
FEATURES OF PROCESS COSTING:
Process costing can be defined as costing method which ascertains the cost of a product at the stage of manufacturing. In simple words under process costing the product of one process becomes the input of next process. Here is the list of the features of process costing – 1. Production under process costing is done through continuous flow of products which are identical or homogeneous. 2. Costs are computed periodically and also average cost can be easily computed under this method of costing. 3. Under this cost data is available process as well as departments thus enabling a better control over costs by the management. 4. In process costing sometimes by-products may emerge which have to be further processed in order to make them marketable and hence accordingly accounting adjustment needs to be made for such by- products. 5. There is always some work in progress under proves costing both at the beginning and at the end of the accounting period because it is a continuous process. Features of Process Costing The following features distinguish process costing from other costing methods: a) The continuous nature of production in many processes means that there will usually be closing work in progress which must be valued. In process costing it is not possible to build up a cost record of the cost incurred on individual units of output because production in progress is an indistinguishable homogeneous mass. b) The output of one process becomes the input of the next,unless it is the final process, culminating in the finish product. c) Losses often occur during the process due to spoilage, wastage, evaporation and so on. d) Output from production may be a single product, but depending on the industry there may also be by-products and joint products. Process accounts are used to accumulate the cost incurred during a process. The following four step approach is used to complete the process accounts, minimizing the chances of error: i. Determine output and losses ii. Calculate cost per unit of output, losses and work in progress iii. Calculate total cost of output, losses and work in progress iv. Complete accounts Example:
The input to a process is 2,000 units at a cost of $ 9,000. Normal loss is 10%. No opening and closing stocks. Complete the process accounts if output is 1660 units Solution: Before solving the example, the following points should be noted. a. Normal loss is given no share of cost. Therefore, the cost of output will be based on 90% of units completed i.e. 2,000 @ 90% = 1,800 b. Abnormal loss will be given a cost. Abnormal loss = Total loss – Normal loss Step 1: Now, to complete the process account the first step is to determine output and losses Total Input = 2,000 Output = 1,660 Normal Loss = 200 Abnormal Loss = 140 Step 2: Calculate cost per unit of output and losses Total Cost Incurred / Expected Output = 9,000 / 1,800 = $5 per unit Step 3: Calculate total cost of output and losses Output = $8,300 Normal Loss = Nil Abnormal Loss = $700 Step 4: Process accounts Particular Units Amount ($) Particular Units Amount ($) Cost Incurred 2,000 9,000 Normal Loss 200 0 Abnormal Loss 140 700 Output 1,660 8,300 2,000 9,000 2,000 9,000
STAGES IN ABC SYSTEM:
Activity based costing is essentially a change in accent. People carry out activities and activities consume resources. Therefore, by controlling activities the manager is ensuring that costs are controlled at their source. A wise manager will not concentrate on how to calculate product costs but will concentrate more on why the costs were there in the first place. When designing an activity based costing system this should be used as a departure point. In order to design an activity based costing system it is important to remember that the objectives should be met at the minimum cost and complexity. To be successful, the final activity based costing system should provide the right kind of information at the right level of detail. In addition to this the design of the system should be as simple as possible without being too simple, since it may report inaccurate costs if it is too simple. The answer is to strike a balance between simplicity and complexity. In addition to this, performance measures should be identified at process level and for key activities. They should be used to monitor and evaluate activities or processes and must be used to promote consistent improvement. This should be done without unnecessarily complicating the design of the system. It is true that managers too often focus on precision and ignore how accurate the data used are. This can lead to the erroneous assumption by a manager that information is more exact than it really is. The seven assumptions underlying the design of an activity based costing system are that: 1. 2. 3. 4. 5. 6. 7. Activities in a business consume resources Producing products or servicing customers utilize activities The Business model is focussed on consumption rather than spending Consuming company resources can have numerous causes A wide variety of activities can be identified and measured in any company Cost pools should be homogeneous Costs in each pool are variable (strictly proportional to activity).
There are a number of different approached possible when introducing an activity based costing system, the following steps are generally accepted to be present in most system implementation processes: STEP 1: STEP 2: Identified all the major activities. Established the major resource pools.
STEP 3: Collected cost driver information, assigned costs to each activity, and calculated cost per outcome. STEP 4: Analysed processes with costs, outcomes, and benchmarks.
Identified additional improvement opportunities.
To introduce an activity based costing system, it is essential to combine it with practical business operations. The elected function should be profitability management which will provide an ideal pilot area for learning about activity based costing whilst, at the same time, furthering company understanding about the relationship between product turnover and customer dividends. Different authors suggest different methods to be followed in designing an activity based costing system. From the various proposed methods it is recommended that the following design steps are followed: Process Value Analysis The first step involved in the design of an activity based costing system should be to do a process value analysis. A process value analysis is a systematic method of identifying activities involved in the processes of the organisation. When doing this the first stage is to identify the primary activities in the organisation. Here it is important to match the detail of the activities to the purpose of the final costing model. In order to achieve simplicity, the aggregation of related activities to balance conflicting objectives, can be effectively used. Activities that are too small and insignificant should be combined to reduce system confusion. A clear and consistent description of activities makes it easy to isolate similar activities or processes. The isolation and clear documentation of the value adding activities are essential for the next step in the process. Creating Activity Centers Once the process value analysis is complete the next step is to create activity centres. An activity centre can be defined as a cluster of related activities. The purpose of activity centres is that they give structure to activity information in the system and facilitate reports about related activities. In activity based costing systems the primary element is activities. The next step is the assignment of cost of various activities to activity cost pools and then to assign these costs to products. It is unnecessary and costly to consider every single activity as an independent activity centre. It is better to integrate several associated activities into one cost centre, to decrease the amount of detail and record keeping cost involved. A two-phased cost-driver approach is recommended to assist with the pooling of costs into activity centres before subsequent allocation to products. The result of activity combining is to better the correctness of product costs, the actual improvement lay in the capability, first, to query the presence of activities and associated
costs and, second, to begin measuring activity achievement. An activity based costing system assign costs to products or customers in two stages. In stage one, costs are assigned to activities, and, in stage two, costs are assigned from activities to products or customers with the use of cost drivers. This should be kept in mind when creating activity centres during the design of the system. Whilst every effort should be made to calculate activity based costing for all products, the real emphasis should be placed in ensuring the accuracy of activity based costing attributed to product families at which level the decision making process was most critical. The greatest accuracy in costing is achieved by recognising four levels of activities, with several of these levels then subdivided into specific activity centres. This approach is given substance when one views this as four general levels of activities 1. Unit-level activities A unit level activity is an activity performed on units of products. Activity drivers for this type of activity can be direct labour hours or machine hours. 2. Batch-level activities Batch activities are performed on batches of products rather than individual product units. Activity drivers for this type of activity can be number of movements or number of runs. 3. Product-level activities Product activities benefit all units of a particular product. Activity drivers for this type of activity can be number of machine set-ups to produce a batch of products or engineering change notices. 4. Facility-level activities Facility activities sustain the general processes in a facility. Facility level costs include items normally described as general overheads. This may include financing and other management cost not attributable to any of the previous levels of activities. In order to achieve the greatest benefit from the introduction of an activity based costing system it is imperative to isolate the various levels of activities in accordance with the four activity levels described above. Defining Resource Drivers
The next step in the design process of an activity based costing system is defining the resource drivers. They in turn define the resource consumption of activities. The factors that have to be considered when defining a resource driver, includes the ease of collecting relevant resource driver data and the level to which the resource driver really measures the consumption by the product. The adoption of the activity based approach to cost collection, revealed that there were logical separations in the manufacturing and distribution processes for which costs were easy to pool. More significant is that completed products are directed through different subprocesses, depending on type and complexity of the manufacturing process. This results in two major advantages. The first is that the assignment of costs from activity pools to products can be done in a far more concentrated and differentiated way. The second is that the activities themselves can be measured and targeted for improvement. It is therefore important to note that cost should be traced wherever possible and only allocated in the final stages. Determining Attributes In the first generation systems, activities were distinguished initially, and costs were allocated to corresponding activities. Product costs were evolved from this. In the second-generation system, processes were distinguished and activities linked to the processes. When implementing an activity based costing process more efficiently a company should define processes before it attempts to associate related activities to the defined process. Processes should not be forced or defined to fit activities; activities should fit processes. It is for this reason important to attach labels that enhance the meaning of the activity based information to the data in the system. Some sensitive attributes should be left to the user to create. Selecting Activity Drivers An activity driver is the factor that measures the activity consumption of a cost object. A cost object is generally defined as the reason for carrying out the activity. Activity based costing requires that attention be given to a different product costing approach. The primary contribution of the activity based costing system is the recognition that cost drivers may encompass more than one facet of an organisation. Utilizing an activity based costing approach correctly revealed that low-volume products having significant transaction costs were unprofitable. The successful selection of activity drives will result in dividing the costs into value-added and non-value-added components, with cost drivers separated into volume-related and transaction-related categories. This will result in approaching cost drivers as a way to manage and control expenses.
When selecting an activity driver, care should be taken as not all cost drivers are volume related and sometimes the drivers associated with transactions have a greater cost than the cost drivers associated with volume. Activity drivers merge the requirements that cost objects places on activities. The importance of selecting activity drivers accurately cannot be over emphasised. This will impact on the accuracy of the costing of cost objects. Conclusion The design of an Activity Based Costing system is a complicated and complex process that needs the cooperation of many different functional heads in an organization. To simply match the level of the activity driver with the activity does not always ensure that the desired level of accuracy is achieved. A part of the answer may be found in involving the correctly motivated individuals at the correct time with a strong mandate and then to let the team establish the correlation between the performance of the activity and the activity driver.
ADVANTAGES AND DISADVANTAGES OF MARGINAL COSTING:
Advantages of Marginal Costing:
Ø Cost Control: Practical cost control is greatly facilitated. By avoiding arbitrary allocation of fixed overhead, efforts can be concentrated on maintaining a uniform and consistent marginal cost useful to the various levels of management. Ø Simplicity: Marginal Costing is simple to understand and operate; it can be combined with other forms of costing, such as, budgetary costing, standard costing without much difficulty. Ø Elimination of varying charge per unit: In marginal Costing fixed overheads are not charged to the cost of production due to this the effect of varying charges per unit is avoided. Ø Short-Term Profit Planning: It helps in short-term profit planning by break-even charts and profit graphs. Comparative profitability can be easily assessed and brought to the notice of the management for decision-making. Ø Prevents Illogical Carry forwards: It prevents the illogical carry-forwards in stockvaluation of some proportion of current years fixed overhead.
Ø Accurate Overhead Recovery Rate: It eliminates large balances left in overhead control accounts, which indicate the difficulty of ascertaining an accurate overhead recovery rate. Ø Maximum return to the business: The effects of alternative sales or production policies can be more readily appreciated and assessed, and decisions taken will yield the maximum return to the business.
Disadvantages of Marginal Costing:
Ø Misleading Results: It is very difficult to segregate all costs into fixed and variable costs very clearly, since all costs are variable in the long run. Hence such segregation sometimes may give misleading results. Ø Distorted Picture of Profits: The closing stock consists of variable cost only and ignores fixed costs. This gives Distorted Picture of Profits. Ø Avoids Semi-Variable Costs: Semi-Variable costs are not considered in the analysis. Ø Problem of Recovery of Overheads: There is problem of under or over-recovery of overheads, since variable costs are apportioned on estimated basis and not on the actuals. Ø Ignorance of Time Factor: Since the time factor is completely ignored; comparison of performance between two periods on the basis of contribution alone will give the misleading results.
STEPS IN PREPARING A MASTER BUDGET:
A business master budget is an estimate of your business' financial position in the future. It's a written plan projecting income, as well as expenses, in multiple categories. Planning your financial affairs helps you to be successful in the future. Budgeting can also help you see potential problems that may occur. Master budgets are made up of three main components: revenues; costs; and profit. Each of these is broken down into smaller parts, to give a more detailed view of the financial projections of the business. Instructions
Set an operating profit goal. Stephen Covey, in "The Seven Habits of Highly Successful People", advises that you should "begin with the end in mind." If you know where you want to end up in terms of net operating profit per year, you'll be able to work backwards from that number and calculate your projected expenses as well, arriving at the amount of sales you'll need to deliver these objectives.
Determine what your operating expenses will be. If you've been in business for awhile, you can predict based on your past expenses. If you have a new business, many of these figures will be estimates. With careful calculation, these estimates should be close to your actual expenses. The estimating process forces you to take a close look at what you expect for expenses, and this is important for accurate planning. Fill in amounts for each line item, and total them.
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Compute your gross profit total. Add the net profit that you want to earn, to the expenses that you forecast, and you'll have a figure that represents the total gross profit of the business. This is the amount of money, in gross profit, that you'll need to earn to deliver on your net profit goals.
Forecast your sales revenue. To do this correctly, you need to know the gross profit percentage that you expect to earn on sales. If you've been in business, an average of the last couple of years should provide a good starting point for reference. If you're just starting out, you'll need to do some research on what typical gross profit margins are for your business. Multiply your projected gross profit amount by the percentage of gross profit margin that your business earns, to calculate the sales revenue required to deliver that gross profit amount.
Adjust your budget as necessary. If the total sales figure that you've arrived at seems too high for what you expect in sales revenue, you'll need to adjust and review your budget. Reduce expense categories to make the sales figure attainable. Increasing the gross profit margin even by a couple of tenths of a percent can have a big effect on your budget. Adjust this budget as necessary
throughout the year to reflect increases or decreases in categories, and to keep your planning realistic.
Create a budget for each department in your business. Expand the single budget from one department into separate budgets that all fit together into one master budget. This will also help you to see how the different departments of your business operate together.
Sales budget: The sales budget shows the expected sales in units at their expected selling prices. A business firm will prepare the sales budget for a given period of time based on the forecasted sales level, production capacity, and long and short term goals. The sales budget must be done first in the process of preparing the master budget because it must identify the expected sales level before it plans for any other activities.
A production budget is a plan for obtaining the needed resourced to carry out the manufacturing operations to meet the expected number of sales and maintain the desired inventory ending. The number of units produced is directly dependent on the sales level, units of finished goods ending and beginning inventory.
Direct Material Budget: The directed material budget will show the direct materials your business needs for production and the budgeted cost.
Direct Labor Budget: The production budget is needed to prepare a direct labor budget as well as the direct materials budget. It enables the personnel department to plan for new hires and repositioning employees. A good labor budget will help businesses avoid emergency hiring and will also help prevent labor shortages.
Factory Overhead Budget: Your factory overhead budget will include all the production costs except for the direct materials and direct labor budgets. Manufacturing costs will include costs that vary in direct proportion with the manufactured units as well as how the business carries out its operations.
Ending Inventory Budget
Selling and administrative expenses budget: The selling and administrative expenses budget is a plan for all non-manufacturing expenses. This particular budget gives you a guideline for selling and administrative activities during your budget period.
Budgeted income Statement: The last part of operational part of your master budget is the budgeted income statement. It estimates the expected operating income from budgeted operations. It also gives management a vision of the likely operating result upon completing the budgeted operation. Once this part is complete it will become the benchmark against which the budget is evaluated.
The second part of your master budget will include your financial budget. The financial budget consists of two individual budgets: Cash Budget: Your cash budget will show the effects of all the budgeted activities on cash. By preparing a cash budget your business management will be able to ensure that they have sufficient cash on hand to carry out activities. It will also allow them enough time to plan for any additional financing they might need during the budget period, and plan for investments of excess cash. A cash budget should include all items that affect the business cash flow and should also include three major sections; cash available, cash disbursements, and financing. Budgeted Balance Sheet: The last step in preparing a master budget is the budget balance sheet. This is the sheet that will show the expected financial position at the end of the fiscal year or budget period. Understanding how to prepare a master budget is the most important thing a business can do in order to maximize its profits and get a good handle on their budget period.
TYPES OF OVERHEAD VARIANCES: In cost accounting, variance is very important to evaluate the performance of company for increasing its efficiency. In variance analysis, we compare actual and standard cost and revenue to know whether it is favorable or unfavorable. Favorable variance ( F ) shows that standard cost is less than actual cost or standard revenue is more than actual revenue. But unfavorable or adverse ( U or A ) variance shows that actual cost is more than standard cost or actual revenue is less than standard revenue. Types of variance are the steps to deep study of variance. We classify variance with following ways.
1st Type of Variance: Direct Material Variance Direct material variance shows the difference between the actual cost of material of actual units and standard cost of material of standard units. It is also the total of material price variance, material quantity variance. If there is favourable material quantity variance and unfavourable material price variance or vise-versa, direct material cost may be either favourable or unfavourable because it is total of material price and material quantity variance.
2nd Type of Variance: Labor Variance Labor variance shows the variance of labor cost. It is the difference between standard cost of labor for actual production and the actual cost of labor for actual production.
3rd Type of Variance: Overhead Variance Overhead Variance shows the variance of all indirect cost. It is the difference between standard cost of overhead for actual output and actual cost of overhead for actual output. 4th Type of Variance: Sales Variance Sales variance is that type of variance which shows the difference between actual sales and standard sales. But in unfavourable sales variance, our standard sale is less than actual sale. Sales variance is good way to calculate the responsibility of sales department.
Overhead variances arise due to differences between the actual overheads and the absorbed overheads. Thus, if we have to calculate an overhead variance, we have to know the amount of the actual overheads and that of the absorbed overheads. The actual overheads can be known only at the end of the accounting period when the expense accounts are finalized. The absorbed overheads are the overheads charged to each unit of production on the basis of pre-determined overhead rate. This pre-determined rate is also known as standard overhead recovery rate, standard overhead absorption rate or standard burden rate. To calculate the standard overhead recovery rate, we have to first make an estimate of the likely overhead expenses or each department for the next year. The estimate of the overheads is to be divided into fixed and variable elements. An estimate of the level of normal capacity utilization is then made either in terms of production or machine hours or direct labor hours. The estimated overheads are divided by the estimated capacity level to calculate the predetermined overhead absorption rate as shown below: Standard Fixed Overhead Rate = Budgeted Fixed Overheads/Normal Volume Standard Variable Overhead Rate = budgeted Variable Overhead/Normal Volume Overhead Variances can be classified in the following two major categories: 1. Variable overhead variances
2. Fixed overhead variances Variable Overhead Variances These variance arise due to the difference between the standard overhead variance overhead for the actual output and the actual variable overhead. If the standard variable overhead exceeds the actual variable overhead, the variance is favorable and vice-versa. Mathematically it may be expressed as follows Variable Overhead Variance = Standard * (Actual Variable Overhead – Variable Overhead) Variable overheads are usually measured in relation to output if the details of the input quantities on which these variable overheads have been incurred are not readily available. In such circumstances, only the variable overhead variance is calculated. Fixed Overhead Variances Fixed overhead variances maybe broadly classified into a) Expenditure variance : It represents the difference between the fixed overheads as per budget and the actual fixed overheads incurred b) Volume Variance: this variance represents the unabsorbed portion of the fixed costs because of the underutilization of capacity. In case a firm exceeds capacity, this variance is favorable in nature.
A standard, as the term is usually used in management accounting, is a budgeted amount for a single unit of output. A standard cost for one unit of output is the budgeted production cost for that unit. Standard costs are calculated using engineering estimates of standard quantities of inputs, and budgeted prices of those inputs. For example, for an apparel manufacturer, standard quantities of inputs are required yards of fabric per jean and required hours of sewing operator labor per jean. Budgeted prices for those inputs are the budgeted cost per yard of fabric and the budgeted labor wage rate.
Standard quantities of inputs can be established based on ideal performance, or on expected performance, but are usually based on efficient and attainable performance. Research in psychology has determined that most people will exert the greatest effort when goals are somewhat difficult to attain, but not extremely difficult. If goals are easily attained, managers and employees might not work as hard as they would if goals are challenging. But also, if goals appear out of reach, managers and employees might resign themselves to falling short of the goal, and might not work as hard as they otherwise would. For this reason, standards are often established based on efficient and attainable performance.
Hence, a standard is a type of budgeted number; one characterized by a certain amount of rigor in its determination, and by its ability to motivate managers and employees to work towards the company’s objectives for production efficiency and cost control.
There is an important distinction between standard costs and a standard costing system. Standard costs are a component in a standard costing system. However, even companies that do not use standard costing systems can utilize standards for budgeting, planning, and variance analysis.
Historical costing :
Actual cost adjustment is delayed until after the completion of the operation and there is no indication of efficient or inefficient performance. The time-lag in reporting costs delays the introduction of corrective action The necessary investigation is time-consuming Compared to: Standard Costing:
Standard costing is a system which introduces cost control and cost reduction Standard costs are carefully prepared estimates of the cost of operations, carried out under specified working condition. Management is motivate and employees are given an incentive. A yardstick is provided to measure performance Only variances are investigated by use of the principle of exceptions. Corrective action can be taken at an early stage.
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