CHAPTER 10

Cost Accounting
Progression

 Grade 10: Understanding basic cost concepts

 Grade 11: Calculation of manufacturing costs and preparation

of ledger accounts of a manufacturing enterprise

 Grade 12: Preparation, presentation, analysis, interpretation

and reporting on cost information for manufacturing enterprises

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Introduction
 Trading enterprises are businesses that :
 buy “finished” products at a certain price,
 add a mark up, and then
 sell the products at a higher price without changing the products in any way.

 The cost of the products, in the books of the trading enterprise, is simply the price
paid for the products.

 In a manufacturing enterprise, the manufacturer :

 purchases raw materials, and then
 transforms the raw materials , through a manufacturing process, into finished
products.
 A mark up is then added and the finished products are sold.

 The cost of the products, in the books of the manufacturer, is determined by

adding all the costs incurred in manufacturing the products .

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Types of manufacturing costs
Manufacturing costs are the costs that are incurred by a manufacturer when
converting raw materials into finished products.

Manufacturing costs may be broadly

divided into three types:

 material costs

 labour costs

 manufacturing overheads

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Material costs
 Material costs consist of the costs of all the raw materials used in the manufacture of a product.

 Material costs are further subdivided into direct material costs and indirect material costs.

Direct material costs

 Cost of raw materials used directly in the manufacture of a product.

 These raw materials can be identified as components of the final product.

Example: The costs of the fabric, zips and buttons used to make a dress are direct
material costs.

Indirect material costs

 Cost of the raw materials, which are either not directly identifiable in the
finished product, or are a relatively insignificant part of the finished product.

 Indirect material costs form part of the manufacturing overheads .

Example: The oil used to lubricate the sewing machine (not directly identifiable in the
finished product) and the thread used to stitch the dress (relatively insignificant part of the
finished product), are indirect material costs.

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Labour costs
 Labour costs consist of the costs of the labour involved in the manufacturing of a product.
 Labour costs are subdivided into direct labour costs and indirect labour costs.

Direct labour costs

 Salaries and wages paid to employees who are directly involved in the manufacture of
a product.
 The work done by these employees can be directly identified in the production process.
 Direct labour is often referred to as “touch labour” because these workers generally
touch the product that is being manufactured.

Example: In the manufacture of a dress, the wages paid to the sewing machine operators who
stitch the dress is a direct labour cost.

Indirect labour costs

 Salaries and wages paid to employees who are not directly involved in the manufacture
of a product.
 These employees are often involved with a range of different products and the work done
by these employees cannot be directly identified in the manufacture of a specific product.
 Indirect labour costs form part of the manufacturing overheads.

Example: The salary paid to a dress designer is an indirect labour cost.

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Manufacturing overheads

 Manufacturing overheads are all the costs of the manufacturing process that
are not directly identifiable with a specific product.

 In other words, manufacturing overheads include all the costs of production,

excluding the direct material and direct labour costs .

 Manufacturing overheads include costs such as :

 indirect materials

 indirect labour

 water and electricity

 factory rental

 depreciation on machinery

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Classification of manufacturing costs
 Since indirect material costs and indirect labour costs form part of manufacturing overheads,
manufacturing costs are generally classified under the following three headings :

 Direct material costs

 Direct labour costs

 Manufacturing overheads

 Apart from the manufacturing costs, a manufacturing business should

provide for the following other costs :

 Sales and distribution cost:

this is the cost incurred to market and sell the product.

 Finance cost:
this is primarily the interest on borrowed capital.

 Administrative cost:
this is the cost incurred to run the business.

 The sales and distribution cost, finance cost and administrative cost are period costs and
thus do not form part of the cost price of the manufactured product .
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Manufacturing cost calculations
Prime cost
 The prime cost is the total direct costs involved in the manufacturing process.
 The prime cost comprises of the direct material costs, the direct labour costs and any other
direct costs.

Prime cost = Direct material costs + Direct labour costs + Other direct costs

Total manufacturing cost

 The total manufacturing cost (also known as the cost of production) is calculated by adding
all the costs involved in the manufacturing process .
 This is equal to the sum of the prime cost and the manufacturing overheads.

Total manufacturing cost = Prime cost + Manufacturing overheads

Unit cost
 The unit cost of a product is calculated by dividing the total manufacturing cost by the total
number of units produced.

Total manufacturing cost

Unit cost of a product =
Number of units produced

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Example: Manufacturing cost calculations
Information: Required:
In March 2017, Pants-up Manufacturers produced 2 000 leather Use the information given alongside to calculate the:
belts.
1) direct material cost
The following is a list of the costs they incurred during the month:
Leather used for the belts R30 000 2) direct labour cost
3) prime cost
Buckles used for the belts R5 000
4) manufacturing overheads
Wages paid to the leather cutters R9 000
5) total manufacturing cost
Wages paid to the sewing machine R16 000
operators 6) unit cost of a leather belt
7) selling price of the leather belt if Pants-up
Rent paid for hiring of sewing machines R12 000
Manufacturers
Salary paid to the factory supervisor R8 000 use a profit mark-up of 60% on cost.
Other general overheads R20 000

SOLUTION

1) Direct material cost = Leather cost + Buckles cost Total manufacturing cost
6) Unit cost of a belt =
= R30 000 + R5 000 = R35 000 Number of units produced
2) Direct labour cost = Wages (cutters) + Wages (sewing machine R100 000
operators) = = R50
2 000
= R9 000 + R16 000 = R25 000
3) Prime costs = Direct material cost + Direct labour cost
7) Selling price of a belt = Cost price + Profit mark-up
= R35 000 + R25 000 = R60 000
= R50 + (R50 × 60%) = R80
4) Manufacturing overheads = Rent (sewing machines) + Salary + General
= R12 000 + R8 000 + R20 000 = R40 000 _________________________________________
5) Total manufacturing cost = Prime cost + Manufacturing overheads
= R60 000 + R40 000 = R100 000
Classification of manufacturing costs
according to behaviour
 In addition to classifying manufacturing costs into direct material costs, direct
labour costs and manufacturing overheads, manufacturing costs are often
also classified according to their cost behaviour.

 The term “cost behaviour” refers to the behaviour of a

specific manufacturing cost in relation to changes in
production levels (number of units produced).

 Manufacturing costs are classified into the following

four groups according to their cost behaviour:

 Fixed costs

 Variable costs

 Semi-variable costs

 Semi-fixed costs (step costs)

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Fixed and variable costs
Fixed costs

 Fixed costs do not vary according to changing levels of production .

Fixed cost behaviour
 Even if production is stopped, these costs will still be incurred.

 Fixed costs are constant at all levels of production. Cost

Fixed cost

Example: The rent paid for a factory is a fixed cost. The amount paid for
rent remains constant irrespective of the number of units that are produced.
Number of units
Even if no units are produced the same amount of rent must still be paid.

Variable costs

 Variable costs vary according to the number of units produced .

Variable cost behaviour
 If production stops, these costs will no longer be incurred.

 Variable costs are directly proportional to the level of production. Cost Variable cost

Example: Direct material costs and direct labour costs display variable cost
behaviour. A manufacturer who produces leather belts pays R10 for a belt
buckle. If 50 belts are produced, then the cost for belt buckles will be R500
Number of units
(R10 × 50). If no belts are produced, then the cost for buckles will be zero.

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Semi-variable and Semi-fixed costs
Semi-variable costs

 Semi-variable costs have both a fixed and variable component .

Semi-variable cost behaviour
 The fixed component is the minimum cost that will be incurred even
if no units are produced.
Semi-variable cost
Cost
 The variable component increases as production levels increase .

 If production stops, only the fixed component of the cost is incurred.

Example: The electricity cost for a factory is a semi-variable cost. There is a fixed Number of units
monthly charge that must be paid even if no electricity has been used – the fixed
component. The electricity cost will then increase as production increases, since
the machinery will use more electricity – the variable component..

Semi-fixed (step) costs Semi-fixed cost behaviour

 Semi-fixed costs are costs that are fixed up to a certain level of
production. Semi-fixed cost
Cost

 If production exceeds this level then these costs increase in steps.

Example: A machine can produce a maximum of 1 000 units per day. If more than
1 000 units have to be produced in a day, then a second machine is required. Number of units

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General classification and classification
according to behaviour
 It is important that the classification of manufacturing costs according to behaviour
is not confused with the general classification (direct material costs, direct labour
costs and manufacturing overheads).

 The same cost may be categorised using both classifications.

 For example:

 A raw material used to make a product is a direct material

cost as well as a variable cost.

 Factory rental is a manufacturing overhead as well as a

fixed cost.

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Manufacturing cost calculations using
fixed and variable costs
For the purpose of this section we will ignore semi-variable cost and semi-fixed cost
behaviour, and categorise manufacturing costs as either fixed or variable .

Total manufacturing cost

 The total manufacturing cost of a product may be calculated by adding the fixed
and variable costs involved in the manufacturing process .

Total manufacturing cost = Fixed costs + Variable costs

Unit cost

 As mentioned before, the unit cost of a product is calculated by dividing the total
manufacturing cost by the total number of units produced .

Total manufacturing cost

Unit cost of a product =
Number of units produced

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Example: Manufacturing cost calculations using fixed and variable costs
 As the level of production increases:
 the variable costs will increase proportionally,
 while the fixed costs remain constant.

 From this it follows that the unit cost of a product decreases as the number of units produced increases.

 This is illustrated in the following table:

Number of Total
Variable costs Fixed costs Unit cost
units produced manufacturing cost

100 R1 000 R5 000 R6 000 R60

500 R5 000 R5 000 R10 000 R20

1 000 R10 000 R5 000 R15 000 R15

 From this table we see that the variable cost per unit is constant:

R1 000 R5 000 R10 000

Variable cost per unit = = = = R10
100 500 1 000

 While the fixed cost per unit decreases as the level of production increases:

R5 000 R5 000 R5 000

Fixed cost per unit = = R50 ; = R10 ; = R5
100 500 1 000
Break-even analysis
 Break-even analysis is used to determine the number of units of a product that
needs
to be produced and sold in order for:

the income generated from the sales to equal the costs of manufacturing.

 At this point, the business:

 will neither make a profit,
 nor suffer a loss.

 The business is said to “break even” at this point.

 This point is therefore known as the break-even point.

Income from sales Manufacturing costs

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Example: Break-even point
The following information about the manufacture and sale of a product:
 Selling price R50 per unit
 Fixed costs R120
 Variable cost R20 per unit

We can use the information given above to draw up the following table:

No. of Income from Fixed Variable Total manufacturing Profit

units sales cost cost cost (Loss)

1 R50 R120 R20 R140 (R90)

2 R100 R120 R40 R160 (R60)

3 R150 R120 R60 R180 (R30)

4 R200 R120 R80 R200 0

5 R250 R120 R100 R220 R30

6 R300 R120 R120 R240 R60

From the table we can see that the break-even point occurs when 4 units are produced and sold.
At this point:
 the income from sales = R50 × 4 = R200, and
 the manufacturing cost = R120 + (R20 × 4) = R200

If less than 4 units are produced (and sold) then the business will suffer a loss.
While the business will make a profit when production (and sales) is more than 4 units.
Calculation of the break-even point
The following steps are used to calculate the break-even point :

Step 1: Split the costs involved into fixed costs and variable cost per unit.

Step 2: Calculate the difference between the selling price per unit and the variable costs per unit.

Note: This amount is called the contribution, since it is the amount that is “contributed”
towards covering the fixed costs from each unit that is sold.

Step 3: Divide the fixed costs by the contribution to get the break-even point.

These steps may be set out as follows (using the information from the previous example):

Step 1: Fixed costs = R120

Variable cost per unit = R20

Step 2: Contribution = Selling price per unit – Variable cost per unit
= R50 – R20 = R30

Fixed cost R120

Step 3: Break-even = = 4 units
= R30
point Contribution
Manufacturing accounts in the General Ledger

 We have learnt that during a manufacturing process, costs are incurred for :

 Materials

 Labour

 Overheads

 These manufacturing costs are recorded in the General Ledger as follows :

 Materials purchased are recorded in the Raw Material Stock account.

 Labour costs are recorded in individual expense accounts such as:

Wages account Salaries account

 Overheads costs are recorded in individual expense accounts such as:

Rent account Electricity account Depreciation account

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Materials
The following flow chart shows the route that material takes in the production process and in the accounting records.

Route of material In the General Ledger Account classification

Raw materials stock is purchased and placed in the  Raw Materials Stock account is debited Raw Materials Stock account is
warehouse.  Bank or Creditors Control account is credited an asset account.

Factory requests raw materials for production, which  Raw Materials Stock account is credited Raw Materials Issued account
are then transferred from warehouse to factory.  Raw Materials Issued account is debited is a nominal account.

 Raw Materials Issued account is credited Direct Materials Cost account is

Raw materials are processed during the  Direct Materials Cost account is debited a cost account.
manufacturing process.  Direct Materials Cost account is then credited The Work-In-Progress account
 Work-In-Progress account is debited is an asset account.

The final product is transferred from the factory to a  Work-In-Progress account is credited Finished Goods account is an
warehouse for finished products (to be sold).  Finished Goods account is debited asset account.

Indirect Material account is a

Indirect material transferred from the warehouse to  Indirect Material account is credited nominal account.
be used during the manufacturing process.  Manufacturing Overheads account is debited Manufacturing Overheads
account is a cost account.
Labour
 Salaries and wages are paid to different employees for different reasons.
 Not all salaries and wages relate directly to the production process .
 Certain forms of labour relate to indirect manufacturing cost – treated as manufacturing overheads.
 Some salaries are an operating expenditure and are recovered from the gross profit.

The total salaries and wages paid is debited in the Salaries and Wages account in the General Ledger

Direct labour Indirect labour Operating expense Operating expense

Wages paid to factory
workers directly involved in
manufacturing are periodically
transferred from the Salaries
and Wages account to the
Direct Labour Costs
account.
This is a cost account.
From there it is carried
over to the
Work-In-Progress
account.
Salaries paid to workers not
directly involved in
manufacturing but still
working at the factory (e.g.
factory security) are
periodically transferred from
the Salaries and Wages
account to the
Manufacturing Overheads
account.
This is a
cost account.
Salaries and wages paid to
people responsible for the
administration and
management of the business
(e.g. the secretary) are closed
off and transferred to the
Administration Cost account
at the end of the financial
year.
This is regarded
as a
period cost.
Salaries and wages paid to
people responsible for the
sale, distribution and
marketing of the product (e.g.
sales representatives) are
closed off and transferred to
the Sales and Distribution
account at the end of
the financial year.
This is regarded
as a period cost.
Overheads
 When manufacturing overheads are incurred, various different expense accounts are debited
(e.g. Water and Electricity account, Insurance account, Maintenance account).
 The part of these expenses allocated for manufacturing is then periodically transferred to the
Manufacturing Overheads account.
 In turn, the manufacturing overheads are allocated and transferred from the Manufacturing
Overheads account to the Work-In- Progress account.

The following flow chart shows how water and electricity is allocated and recorded in the General Ledger:

Water and electricity paid is debited in the Water and Electricity account in the General Ledger

Water and electricity for factory Water and electricity for office

Manufacturing Overheads account Administration Cost account

Work-In- Progress account Profit and Loss account

 Allocation of manufacturing costs
The flow and allocation of manufacturing costs may be summarised as follows :

Allocation of manufacturing costs

Overheads
Materials Labour
(e.g. Rent, maintenance, insurance, depreciation, etc.)

Indirect materials Indirect labour

Manufacturing Overheads

Direct materials Direct labour

Work-In- Progress

Finished Goods

 Completed products are physically moved from production into storage .

 This movement is recorded in the General Ledger by transferring the costs allocated to those products from
the Work-In-Progress account to the Finished Goods account, as shown above.
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Recording cost of sales in a manufacturing enterprise
 We have seen that when a trading enterprise sells goods :
 the Bank or Debtors Control account is debited with the selling price, and
 the Sales account credited with the selling price.

Bank or Debtors Control Sales

5 000 5 000

 In addition:
 the Cost of Sales account is debited with the cost price of the goods, and
 the Trading Stock account credited with the cost price of the goods.

Cost of Sales Trading Stock

3 000 3 000

 In a manufacturing enterprise, a similar procedure is followed, except here the Finished

Goods account is credited with the cost price (instead of the Trading Stock account).
Cost of Sales Finished Goods

3 000 3 000

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Closing transfers in manufacturing accounts
As with any other type of business, the nominal accounts of a manufacturing business must be closed off
at the end of the financial period. The following flow chart illustrates the route of the closing transfers.

Nominal accounts Cost accounts Balance Sheet accounts Final accounts

Expenses for administration Administrative

(e.g. telephone, salary of secretary) costs
Profit and Loss
account
Expenses for sales and distribution Sales and
(e.g. commission, fuel for delivery vehicles) distribution costs

Direct material
Raw material issued
cost

Wages paid to factory staff

Direct labour Work-in-progress

Gross profit
(directly involved with manufacturing)

Sundry expenses for manufacturing Manufacturing

(e.g. water and electricity of the factory) overheads

Finished goods sold

Cost of sales Finished goods

Sales Trading account

Summary of manufacturing ledger accounts

Balance Sheet accounts

Raw Materials Stock

Starting balance of raw material Direct raw material issued to Raw Materials Issued account

Acquisition of raw material

Work-In-Progress
Starting balance of uncompleted work Total cost of finished products to Finished Product Stock account

Direct material placed in factory

Direct labour in the manufacturing process

Overheads allotted to manufacturing

Finished Product Stock

Opening balance of finished products on hand Cost of finished products sold to Cost of Sales account

Cost of finished products transferred from factory

Consumables on Hand
Indirect material on hand at beginning of year Indirect material on hand at beginning of year

Indirect material on hand at end of year

Summary of manufacturing ledger accounts (continued)

Nominal accounts

Sales
Closing transfer to Trading account Cash and credit sales for the year

Cost of Sales
Cost price of finished products sold Closing transfer to Trading account

Raw Material Issued

Raw materials issued from Raw Materials Stock account Raw material used in manufacturing to Direct Material Cost account

Indirect Material
Indirect material on hand at beginning of year Indirect material on hand at end of year

Indirect material purchased Closing transfer to Manufacturing Overheads account

Wages and Salaries

Wages and salaries paid during the year Wages of factory workers to Direct Labour Cost account

Salaries of office workers to Administration Cost account

Salaries of sales personnel to Sales and Distribution Cost account

Summary of manufacturing ledger accounts (continued)

Cost accounts

Direct Material Cost

Raw material issued Raw material used to Work-In- Progress account

Direct Labour Cost

Wages and employer benefits of factory workers Transferred to Work-In-Progress account

Manufacturing Overheads

Indirect material used in manufacturing Total manufacturing overheads transferred to Work-In-Progress account

Sundry expenses allotted to factory and manufacturing process

Administration Costs

Sundry administration expenses Account is closed off and transferred to Profit and Loss account

Sales and Distribution Costs

Sundry sales and distribution expenses Account is closed off and transferred to Profit and Loss account
Summary of manufacturing ledger accounts (continued)

Final accounts

Trading account
Cost of sales Sales

Profit and Loss account

Administration cost Trading account (gross profit)

Sales and distribution cost

Capital account / Appropriation account

Note: The Profit and Loss account is closed off to the Capital or Appropriation account, depending on the type of business.
 If the manufacturing enterprise is a sole proprietor, the net profit will be closed off to the Capital account.
 If the business is a partnership, Close Corporation or company, the net profit will be transferred to the Appropriation account.

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Ethics
Unethical practices relating to manufacturing include the following:

• operating or using sweatshops, which are small factories where employees

Unethical labour are made to work very hard, in poor conditions, for very low wages
practices • using child labour
• non-compliance with health and safety regulations in factories

• non-compliance with environmental regulations

Practices that • obliteration or depletion of scarce resources
have a destructive
• spillages and leaks of hazardous material
impact on the
environment • illegal disposal of waste
• various other forms of pollution

• producing goods without conducting adequate safety testing

Manufacturing of • producing unsafe goods
potentially harmful
products • manufacturing addictive products, e.g. tobacco (cigarettes)
• manufacturing weapons

• using animals in product testing

Cruelty to animals
• intensive farming

Other unethical • offering bribes to secure contracts or tenders

practices • manufacturing for and trading with governments that abuse human rights
Risks associated with the manufacturing environment
RISK!
Production risks
 Risks associated with the efficiency of the production process and the quality of the products
manufactured.
 E.g. Delays, stoppages or bottlenecks in the production line, shortages of raw materials,
contaminations within the production process, faulty machinery, production of too many defective
products, excess waste etc.

Safety risks
 Risks associated with the safety and well being of the employees working in the manufacturing
process, as well as the protection of the factory, machinery and products in the production line.
 E.g. Employees being injured or becoming ill due to a lack of health and safety precautions, damage
caused to the factory, machinery and products due to a preventable disaster (e.g. a fire), etc.

Fraud, theft and error risks

 These inherent business risks are compounded due to the complex nature of the manufacturing
environment.
 E.g. Pilfering of raw materials, theft of finished products, fraud schemes involving fake orders or
fictitious suppliers, production errors, costing mistakes and unnecessary wastage.

Environmental risks
 Risks associated with the harmful impacts that the manufacturing process could have on the
environment.
 E.g. Various forms of pollution and depletion of scarce resources.
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Internal control and internal auditing
Internal control
 It is essential that manufacturers establish strict internal control processes and procedures to
address the risks associated with manufacturing.

 Internal control policies, processes and procedures may differ from one manufacturer to
another depending on the complexity, size and nature of the production process .

 Most manufacturers should adhere to the following fundamental internal control procedures :

Click here to view some fundamental internal control procedures of a manufacturing enterprise

Internal auditing
 Establishing and implementing internal controls is the first line of defence against risk .

 However, it is essential that an internal audit is performed to assess the effectiveness of

these internal controls and to evaluate the risk management of the manufacturing enterprise.

 An internal audit of a manufacturing enterprise may typically involve the following :

Click here to view internal audit procedures relating to a manufacturing enterprise

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Solutions to activities

 Activity 10.1  Activity 10.11

 Activity 10.2  Activity 10.12

 Activity 10.3  Activity 10.13

 Activity 10.4  Activity 10.14

 Activity 10.5  Activity 10.15

 Activity 10.6  Activity 10.16

 Activity 10.7  Activity 10.17

 Activity 10.8  Case study 10.1

 Activity 10.9  Case study 10.2

 Activity 10.10  Informal assessment 10.1

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