Chapter Two

Cost Determination: The Costing of Resource Inputs

2.1Materials
 Accounting for stock (inventory) movements
Commonly Used Classifications of Manufacturing Costs
Three terms commonly used when describing manufacturing costs are direct material costs,
direct manufacturing labor costs, and indirect manufacturing costs. These terms build on the
direct versus indirect cost distinction we had described in chapter one.
1. Direct material costs are the acquisition costs of all materials that eventually become part
of the cost object (work in process and then finished goods) and can be traced to the cost
object in an economically feasible way. Acquisition costs of direct materials include freight-
in (inward delivery) charges, sales taxes, and custom duties.
2. Direct manufacturing labor costs include the compensation of all manufacturing labor
that can be traced to the cost object (work in process and then finished goods) in an
economically feasible way. Examples include wages and fringe benefits paid to machine
operators and assembly-line workers who convert direct materials purchased to finished
goods.
3. Indirect manufacturing costs are all manufacturing costs that are related to the cost
object (work in process and then finished goods) but cannot be traced to that cost object in an
economically feasible way. Examples include supplies, indirect materials such as lubricants,
indirect manufacturing labor such as plant maintenance and cleaning labor, plant rent, plant
insurance, property taxes on the plant, plant depreciation, and the compensation of plant
managers. This cost category is also referred to as manufacturing overhead costs or factory
overhead costs. We use indirect manufacturing costs and manufacturing overhead costs
interchangeably.
The Flow of Inventoriable Costs and Period Costs: Manufacturing-Sector Example- We
illustrates the flow of inventoriable costs and period costs through the balance sheet and
income statement of a manufacturing company, for which the distinction between
inventoriable costs and period costs is most detailed.
The figure below highlights the differences in the flow of inventoriable and period costs for a
manufacturing-sector company. Inventorable costs go through the balance sheet accounts of
work-in-process inventory and finished goods inventory before entering cost of goods sold in
the income statement. Period costs are expensed directly in the income statement.
Step 1: Cost of direct materials used in 2011.
The cost of direct materials used is based on the values indicated in the figure is calculated as
follows:
Beginning inventory of direct materials, January 1, 2011 $11,000
+ Purchases of direct materials in 2011 73,000
– Ending inventory of direct materials, December 31, 2011 8,000
= Direct materials used in 2011 $76,000

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Figure: Flow of Revenue and Costs for a Manufacturing-Sector Company

The income statement and schedule of cost of goods manufactured of a manufacturing

company (ABC Co.) is presented below.

ABC Company
Income statement
For the year ended Dec. 31, 2011

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 ABC Company
COST OF GOODS MANUFACTURED
For the year ended Dec. 31, 2009

Step 2: Total manufacturing costs incurred in 2011. Total manufacturing costs refers to all
direct manufacturing costs and manufacturing overhead costs incurred during 2011 for all
goods worked on during the year.
i. Direct materials used in 2011…………………… $ 76,000
ii. Direct manufacturing labor in 2011……………….. 9,000
iii. Manufacturing overhead costs in 2011……………. 20,000
Total manufacturing costs incurred in 2011…. $105,000
Note: these costs increase work-in-process inventory.
Step 3: Cost of goods manufactured in 2011. Cost of goods manufactured refers to the cost
of goods brought to completion, whether they were started before or during the current
accounting period.
Beginning work-in-process inventory, January 1, 2011………...…….. $ 6,000
+ Total manufacturing costs incurred in 2011……………………….…105,000
= Total manufacturing costs to account for……………………...…….. 111,000
– Ending work-in-process inventory, December 31, 2011…………..…….7, 000
= Cost of goods manufactured in 2011……………………………… $104,000

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Step 4: Cost of goods sold in 2011. The cost of goods sold is the cost of finished goods
inventory sold to customers during the current accounting period. This cost of goods sold is
an expense that is matched against revenues. The cost of goods sold is computed as follows:
Beginning inventory of finished goods, January 1, 2011………………….. $ 22,000
+ Cost of goods manufactured in 2011 ……………………………………... 104,000
– Ending inventory of finished goods, December 31, 2011……….…………..18,000
= Cost of goods sold in 2011…………………………………………………. $108,000
We are now in a position to prepare income statement for 2011.
Gross margin = Revenues - Cost of goods sold = $210,000 - $108,000 = $102,000. Operating
income equals total revenues from operations minus cost of goods sold and operating (period)
costs (excluding interest expense and income taxes) or equivalently, gross margin minus
period costs. See the above statements for detail.

Prime Costs and Conversion Costs

Two terms used to describe cost classifications in manufacturing costing systems are prime
costs and conversion costs. Prime costs are all direct manufacturing costs. For Cellular
Products,
Prime costs = Direct material costs + Direct manufacturing labor costs
=$76,000 + $9,000 = $85,000
Conversion costs are all manufacturing costs other than direct material costs. Conversion
costs represent all manufacturing costs incurred to convert direct materials into finished
goods.
Conversion costs = Direct manufacturing labor costs + Manufacturing overhead costs
= $9,000 + $20,000 = $29,000

 Determination of Optimum Purchase Quantities

The major function of a cost control1 system is to keep expenditures within the limits of a
preconceived plan. The control system should also encourage cost reductions by eliminating
waste and operational inefficiencies.

Material Control
The two basic aspects of materials control are (1) the physical control or safeguarding of
materials and (2) control over the investment in materials. Physical control protects materials
from misuse or misappropriation. Controlling the investment in materials maintains
appropriate quantities of materials in inventory.

1
Controlling is a process of comparing the actual performance with the set standards (budget) of the
company to ensure that activities are performed according to the plans and if not then taking corrective action.

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 1. Physical Control of Materials- every business requires a system of internal control
that includes procedures for the safeguarding of assets of all types. Because raw
materials usually represent a significant portion of a manufacturer’s current assets and
often comprise more than 50% of a product’s manufacturing cost, a business must
control its materials from the time they are ordered until the time they are shipped to
customers in the form of finished goods. In general, to effectively control materials, a
business must maintain:
i. Limited access
ii. Segregation of duties, and
iii. Accuracy in recording.
i. Limited Access. Only authorized personnel should have access to materials
storage areas. Finished goods should be safeguarded in limited-access storage
areas and not released for shipment in the absence of appropriate documentation
and authorization.
ii. Segregation of Duties. A basic principle of internal control is the segregation of
employee duties to minimize opportunities for misappropriation of assets. With
respect to materials control, the following functions should be segregated:
purchasing, receiving, storage, use, and recording.
iii. Accuracy in Recording. An effective materials control system requires the
accurate recording of the purchase and issuance of materials. Inventory records
should document the inventory quantities on hand, and cost records should
provide the data needed to assign a cost to inventories for the preparation of
financial statements.
2. Controlling the Investment in Materials- Maintaining an appropriate level of raw
materials inventory is one of the most important objectives of materials control. An
inventory of sufficient size and variety for efficient operations must be maintained,
but the size should not be excessive in relation to scheduled production needs.
The planning and control of the materials investment requires that all of these factors
be carefully studied to determine
i. When orders should be placed? and
ii. How many units should be ordered?
Order Point- A minimum level of inventory should be determined for each type of raw
material, and inventory records should indicate how much of each type is on hand. A
subsidiary materials ledger, in which a separate account is maintained for each material, is
needed. The point at which an item should be ordered, called the order point, occurs when the
predetermined minimum level of inventory on hand is reached. Calculating the order point is
based on the following data:
1. Usage—the anticipated rate at which the material will be used.

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 2. Lead time—the estimated time interval between the placement of an order and the
receipt of the material.
3. Safety stock—the estimated minimum level of inventory needed to protect against
stockouts (running out of stock). Stockouts may occur due to inaccurate estimates of
usage or lead time or various other unforeseen events, such as the receipt of damaged
or inferior materials from a supplier or a work stoppage at a supplier’s plant.
Assume that a company’s expected daily usage of an item of material is 100 lb, the
anticipated lead time is five days, and the desired safety stock is 1,000 lb. The
following calculation shows that the order point is reached when the inventory on
hand reaches 1,500 lb:
100 lb (daily usage) * 5 days (lead time). . . . . . . . . . . . . . . . . . . 500 lb
Safety stock required ................................................................ 1,000 lb
Order point . . ............................................................................1,500 lb
If estimates of usage and lead time are accurate, the level of inventory when the new order is
received would be equal to the safety stock of 1,000 lb. If, however, the new order is
delivered three days late, the company would need to issue 300 lb of material from its safety
stock to maintain the production level during the delay.
Economic Order Quantity (EOQ) - The order point establishes the time when an order
should be placed, but it does not indicate the most economical number of units to be ordered.
To determine the quantity to be ordered, the cost of placing an order (order costs) and the cost
of carrying inventory in stock (carrying costs) must be considered.
Order costs and carrying costs move in opposite directions—annual order costs decrease
when the order size increases, while annual carrying costs increase when the order size
increases. The optimal quantity to order at one time, called the economic order quantity, is
the order size that minimizes the total order and carrying costs over a period of time, such as
one year.

Quantitative models or formulas have been developed for calculating the economic order
quantity. One formula that can be used is the following:
/K
WHERE, where
EOQ = economic order quantity
C =cost of placing an order
N =number of units required annually
K = annual carrying cost per unit of inventory

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To illustrate this formula, assume that the following data have been determined by analyzing
the factors relevant to materials inventory for Pacific Paint Company:
Number of gallons of material required annually . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
Cost of placing an order . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 10.00
Annual carrying cost per gallon of inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0.80
Using the EOQ formula, 500 gallons should be ordered at one time:
/ Annual carrying
cost per unit of inventory

The EOQ can also be determined by constructing a table using a range of order sizes. A
tabular presentation of the data from the previous example, assuming no safety stock,
follows:

In this table, the amounts in each column are determined as follows:

1. Number of gallons per order (given)
2. 10,000 annual gallons / order size in column (1); 10, 000 is given here
3. Number of orders*$10 per order
4. Order size / 2 = average inventory on hand during the year
5. Average inventory * $0.80 per gal. = Carrying cost for one year
6. Total order cost in column (3) þ total carrying cost in column (5)

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Assume in the preceding example that the company desires a safety stock of 400 gallons to
protect against stockouts. The average number of gallons in inventory then would be
calculated as follows:
Average number of gallons in inventory = (1/2 *EOQ) + safety stock
= (1/2 *500) + 400
=650 gal.
The total carrying cost then would be:
Carrying cost = Average number of inventory * Carrying cost per unit
$0:80*650gal=$520
Note that the order cost of $200, which doesn’t change in this example because the number of
orders is the same as before, is significantly less than the carrying cost of $520 when safety
stock is present.
2.2. Labor
Labor costs are divided into two categories: direct labor and indirect labor. Direct labor, also
known as touch labor, represents costs traced directly to an individual job. Direct labor costs
include the wages of machinists, assemblers, and other workers who physically convert raw
materials to finished goods—thus the term touch.
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 laborer.
Indirect labor costs are charged to Factory Overhead.

Labour can be said to be one of the factors of production. It is the effort of people used in
production. Labour is however defined as the physical and mental efforts of man used in
production. It is also said that labour is the mental and physical human effort geared toward
the production of goods and service. In providing labour for the production of goods and
services, man is paid wages as a reward which on the other hand is referred to as
remuneration of workers.
Wages as a reward to labour is a great incentive to workers to increase productivity.
Where an organization pays the workers poorly, they will be demoralized and may tend to
lower their productivity. Therefore, management should see it as its responsibility to
introduce a wage remuneration system that can promote the morale of workers to ensure
increased productivity.
METHOD OF REMUNERATION OF WORKERS
The following methods are in use for the remuneration of workers:
i. Fixed salary
ii. Time rate or day rate
iii. Piece rate or piece work
iv. Differential piece work
1. Fixed salary per month. This applies to permanent employees who are salaried a
fixed amount per month. Common in our Country.
2. TIME RATE
This is a method of calculating wages based on the hours of works put at work by each
worker. Workers paid according to the effective hours worked. Formula for this is Hours
worked X Rate Hour. Example: John 20 hours per week. The rate of pay is Br.150 per hour,
calculate his weekly pay.
Wage = Hours worked X Rate Hour
= 20*Br. 150=Br. 3, 000

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 3. PIECE RATE
This is method of remunerating workers based on the number of work or piece of work done.
This method does not consider the time spent on the work. There are different types of piece
rates.
TYPE OF PIECE RATE
i. Straight piece rate
ii. Piece rate with Guarantee
iii. Differential piece rate
a) STRAIGHT PIECE RATE
In this method, the worker is paid a specified sum of money per unit of production. In some
cases, a standard time for the production of each unit of work is set, and the worker is paid a
sum per standard hour worked. Example John produced 50 chairs a week. The rate of pay is
Br. 25 per chair, calculate his weekly pay.
Solution
Units of production ……….50 chairs
Rate of pay……………....Br. 25 per chair
Weekly Wage/pay………………Br.1250
b) PIECE RATE WITH GUARANTEED PAY RATE
This is a method used to compensate the worker in the case where his production falls as a
result of no fault of his. This method guarantees the worker a day's pay at the stated rate at
any time earning under the piece rate falls short of what it should have been under tine rate.
This method prevents uncertainty in the income of workers.
c) DIFFERENTIAL PIECE RATE
Taylor’s Differential Piece-Rate System was introduced by F.W. Taylor, who believed that
the workers should be paid on the basis of their degree of efficiencies. Under this method,
with the help of Time and Motion Study, the standard time for the completion of a job is
fixed on the basis of which the performance of the workers is evaluated.

Taylor’s differential piece-rate system posits that the worker who exceeds the standard output
within the stipulated time must be paid a high rate for high production. On the other hand, the
worker is paid a low rate if he fails to reach the level of output within the standard time.
Thus, there are two piece-rates, one who reach the standard output or exceeds it, is paid 120
percent of the piece rate. While the one who fails to reach the standard level of output, is
paid 80 percent of the piece-rate. The minimum wages of the worker are not guaranteed.
This system can be further understood through the example given below:

Standard Output = 200 units; Rate per unit = Br. 10

Case (1): Output = 220 units; Earnings = 220 x (120/200) x 0.1 = Br.1, 320

Case (2): Output = 180 units; Earnings = 180 x (80/200) x 0.1 = Br.720

It is clear from the above example that the worker is paid a higher rate (Br.1, 320) for high
production (220 units) and low rate (Br. 720) for low production (180 units). Thus, Taylor’s
differential piece rate system works on the principle that the inefficient worker must be paid
at a low piece-rate for low production such that he is left with no other option but to leave the
organization.

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2.3. Overheads
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.
Apportionment of overhead - Apportionment of overhead is distribution of overheads to more
than one cost centre on some equitable basis. When the indirect costs are common to different
cost centres, these are to be apportioned to the cost centres on an equitable basis. For
example, the expenditure on general repair and maintenance pertaining to a department can
be allocated to that department but has to be apportioned to various machines (Cost Centres)
in the department. If the department is involved in the production of a single product, the
whole repair & maintenance of the department may be allocated to the product. Absorption of
overheads - Absorption of overheads is charging of overheads from cost centres to products
or services.
To include factory overhead as part of the total cost, the amount of factory overhead incurred
by each production department must be determined. In a factory, the manufacturing process
consists of a series of operations performed in departments or cost centers. Companies
distinguish operating departments (and operating divisions) from support departments.

 An operating department, also called a production department, directly adds value

to a product or service.
 A support department, also called a service department, provides the services that
assist other internal departments (operating departments and other support
departments) in the company. Examples of support departments are information
systems and plant maintenance.
Allocating Costs from One Department to another Department
Consider Castleford Engineering, which operates at practical capacity to manufacture engines
used in electric-power generating plants. Castleford has two support departments and two
operating departments in its manufacturing facility:

The two support departments at Castleford provide reciprocal support to each other as well as
support to the two operating departments. Costs are accumulated in each department for
planning and control purposes.
We now examine three methods of allocating the costs of reciprocal support departments:
direct, step-down, and reciprocal. To simplify the explanation and to focus on concepts, we
use the single-rate method to allocate the costs of each support department using budgeted
rates and budgeted hours used by the other departments.
1. Direct Method
The direct method allocates each support department’s costs to operating departments only.
The direct method does not allocate support-department costs to other support departments.
Data for Allocating Support-Department Costs at Castleford Engineering for 2012is given
below:

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Illustration: The direct method using the above data

2. Step-Down Method
Some organizations use the step-down method, also called the sequential allocation
method, which allocates support-department costs to other support departments and to
operating departments in a sequential manner that partially recognizes the mutual services
provided among all support departments. We assume that support-departments provide
services to operating departments; plant maintenance department provides service to
information system department, but information system department delver services only
operating departments.

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 3. Reciprocal Method
The reciprocal method allocates support-department costs to operating departments by fully
recognizing the mutual services provided among all support departments. The reciprocal
method fully incorporates interdepartmental relationships into the support-department cost
allocations. One way to understand the reciprocal method is as an extension of the step-down
method. This approach is illustrated below.

IAS 2 inventories
Fundamental principle of IAS 2 states that inventories are required to be stated at the lower of
cost and net realisable value (NRV). Measurement of inventories: Cost should include all:
 Costs of purchase (including taxes, transport, and handling) net of trade discounts
received
 Costs of conversion (including fixed and variable manufacturing overheads) and
 Other costs incurred in bringing the inventories to their present location and condition
(e.g. The costs of designing products for specific customers)

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