Chapter Two: Cost Determination 1

The Costing of Resource Inputs

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 fiber, 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 fiber, rubber, steel and wood are raw materials. For manufacturing organizations,
raw materials cost is a major part of the total cost of the product.
 2

Management needs to establish procedures to ensure that:

 The correct quantities of materials are ordered at the right price and the right time;
 The correct materials are delivered;
 Adequate arrangements exist to store materials until they are required;
 Materials are issued from stores only with proper authorization, and records are
maintained of materials issued or returned;
 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.
 Cont… 3

Meaning of certain associated term.

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.
 Cont… 4

Examples of Direct Material are:

 Cotton used in manufacture of textiles
 Wood used in manufacture of pencil
 Steel used in manufacture of pens
 Timber used in manufacture of papers
 Glass used in making spectacles
 Clay used in making bricks
 Fruits used in making juices,
Indirect Material: It refers to material used in the process of production but
does not form part of the finished product.
 Cont… 5

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:
 Cont……… 6

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.
 Materials: Procedures and Documentation 7
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 s e v e r a l reasons for this.

 Any purchase of materials from a supplier should be properly authorized and approved at the

appropriate management level.

 Documentation of the purchasing process provides evidence that approval has been obtained.

 There should be an invoice from the supplier for the goods that have been delivered.

 The amount payable for the materials provides documentary evidence about their cost.
 Cont… 8
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 9

 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.

1. 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.
 Cont… 10

 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 called a purchase requisition.
 It should be properly authorized by a manager with the authority to approve any such
requisition.
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:
 Meet the quality standards
 Are acquired at the lowest price and
 Are delivered on a timely basis.
 Cont… 11
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
 The stores department prepares a goods received note, recording the details of the
materials
 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.
12
 2. Inventory records 13

 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.
 Cont… 14
 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 center).
 Cont… 15

Purchase Requisition
 Requests for purchases are made by the authorized
department to the purchase department on a prescribed form
known as purchase requisition.
 A Purchase Requisition supplies have basic information
which help the purchase officer to carry on the function of
purchasing efficiently.
 Cont… 16

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).
Cont… 17
 Cont… 18

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 minimize 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.
 Techniques of Inventory Control 19

 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 : associated with the determination
of economic order quantity.

2) The time when they should be ordered: associated with the determination of
re order level
 Cont…… 20
Determination of Optimum Purchase Quantities
1. Minimizing material costs
 Organization‘s that purchase and consume large quantities of materials should try to
minimize 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).
 21
2. Economic Order Quantity
 It 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 analyzed first.
 They are (I) carrying costs, (II) ordering costs and (III) costs of stock-out Carrying
costs:
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.
 Cont… 22

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.

.
 CONT…… 23

 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:

E.O.Q=√(2D X S)/( H)
 Cont… 24

Where:

E.O.Q = Economic ordering quantity D = Units purchased (or) used in a year

H= 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

 There will be an immediate supply of new materials (Q units) as soon as

existing as quantities in store run down to 0.
 Cont… 25

 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

Example: A company sells 5,000 units of a product annually, with a cost of

$20 per unit. The ordering cost is $50 per order, and the holding cost is $4 per
unit per year. What is the EOQ?
 Cont… 26
Given:

S =$ 50 H = $4 D = 5000 unit

𝐄𝐎𝐐 = √ 𝟐 ∗ 5000 × 50/4 = 791 𝐔𝐧𝐢𝐭𝐬

 Therefore, the company should order 791 units at a time to minimize the
total cost of inventory management.
 Cont… 27

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:
 Cont… 28

 It serves as a basis for the computation of direct material cost when quotations are
submitted.

 It serves the purpose of intimation to purchase department to purchase materials.

 It serves as a guideline to production department.

 It facilitates accounting of materials consumed as needed data can be passed on to

relevant jobs or processes.

 It functions as a controlling technique.

 Cont… 29
 Four copies of bill of materials are prepared.
 One copy each is sent to the production, stores and cost accounting departments, and
one copy are retained by the planning or engineering department.
Cont… 30
 2. When to Order (Reorder Level) 31

 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.

 It is calculated from three factors:

 Cont… 32
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:
𝐑𝐞 − 𝐨𝐫𝐝𝐞𝐫 𝐥𝐞𝐯𝐞𝐥 = 𝐒𝐚𝐟𝐞𝐭𝐲 𝐬𝐭𝐨𝐜𝐤 + (𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐮𝐬𝐚𝐠𝐞 𝐗 𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐫𝐞𝐨𝐫𝐝𝐞𝐫 𝐩𝐞𝐫𝐢𝐨
𝐝 𝐨𝐫 𝐥𝐞𝐚𝐝 𝐭𝐢𝐦𝐞)
In terms of maximum usage and maximum lead time, the formula for re-order level is
as follows:
𝐑𝐞 − 𝐨𝐫𝐝𝐞𝐫 𝐥𝐞𝐯𝐞𝐥 = 𝐌𝐚𝐱𝐢𝐦𝐮𝐦 𝐫𝐞 − 𝐨𝐫𝐝𝐞𝐫 𝐩𝐞𝐫𝐢𝐨𝐝 𝐗 𝐌𝐚𝐱𝐢𝐦𝐮𝐦 𝐮𝐬𝐚𝐠𝐞
 Cont… 33

 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.
Cont… 34
 Cont……. 35

 This only ensures that the minimum stock will always remain in the inventory and will
not be used at least in the short run.
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.
The safety stock level can be computed by using the following formula:
𝐒𝐚𝐟𝐞𝐭𝐲 𝐨𝐫 𝐦𝐢𝐧𝐢𝐦𝐮𝐦 𝐬𝐭𝐨𝐜𝐤 𝐥𝐞𝐯𝐞𝐥
= 𝐎𝐫𝐝𝐞𝐫𝐢𝐠 𝐋𝐞𝐯𝐞𝐥 − (𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐫𝐚𝐭𝐞 𝐨𝐟 𝐜𝐨𝐬𝐮𝐦𝐩𝐭𝐢𝐨 𝐗 𝐑𝐞 − 𝐨𝐫𝐝𝐞𝐫 𝐩𝐞𝐫𝐢𝐨d)
 Cont….. 36
Maximum Stock Level
 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 𝐋𝐞𝐯𝐞 = 𝑹𝒆𝐨𝐫𝐝𝐞𝐫𝐢𝐠 𝐋𝐞𝐯𝐞𝐥 + 𝐄𝐎𝐐 − (𝐌𝐢𝐧𝐢𝐦𝐮𝐦 𝐜𝐨𝐧𝐬𝐮𝐦𝐩𝐭𝐢𝐨𝐧 𝐗 𝐌𝐢𝐧𝐢𝐦𝐮𝐦
𝐑𝐞 − 𝐨𝐫𝐝𝐞𝐫 𝐩𝐞𝐫𝐢𝐨)
Some factors to be considered in deciding the maximum stock level are as follows:
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.
 Cont….. 37

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.
Cont…… 38
Cont…… 39
Cont….. 40
 Accounting For Stock (Inventory) Movements 41

 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:
Cont…… 42
Cont……. 43
 Cont…… 44

 A cost accounting system is a system for recording all costs and in large
organizations it is maintained in the form of a double entry accounting system of cost
records in a ‗cost ledger‘.
3. Accounting for Labor Costs (Direct and Indirect Labor 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 laborer.
 The cost of direct labor is debited to Work in Process.
 Cont….. 45

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.
 Cont…… 46

The accounting system of a manufacturer must include the following procedures for
recording payroll costs:
 Recording the hours worked or quantity of output by employees in total and by job,
process, or department.
 Analyzing the hours worked by employees to determine how labor time is to be charged.
 Charging payroll costs to jobs, processes, departments, and factory overhead accounts.
 Preparing the payroll, which involves computing and recording employee gross earnings,
withholdings and deductions, and net earnings.
 Cont…… 47

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 including hourly rate, piece-rate, and modified wage plans.
1. Hourly Rate Plan (Time-based systems)
 It 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.
 The plan gives no extra recognition or reward for doing more than the minimum required of the
position.
 Cont….. 48

 Productivity is measured as the amount of output per hour of work.

 Cont……. 49
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.
 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
Modified wage plans
 It 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.
 50
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.
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.
 Accounting for Labor Costs and Employers’ Payroll Taxes 51
 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
Cont…… 52
Labor Efficiency Ratio (productivity ratio) 53
Cont…. 54
Cont……. 55
Cont…. 56
 Cont….. 57

Costs and causes of labor turnover

 The main cause of labor turnover is when employees leave one company
to go and work for another.
 Labor 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 labor 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 labor 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 58
 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
 factory overhead includes
 indirect materials consumed in the factory, such as glue and nails in the production of
wooden furniture and oil used for maintaining factory equipment;
 indirect factory labor, such as wages of janitors, forklift operators, and supervisors and
overtime premiums paid to all factory workers; and
 all other indirect manufacturing expenses, such as insurance, property taxes, and
depreciation on the factory building and equipment
 Cont…. 59

Accounting for factory overhead involves the following procedures:

 Identifying cost behavior patterns.
 Budgeting factory overhead costs.
 Accumulating actual overhead costs.
 Applying factory overhead estimates to production
 Calculating and analyzing differences between actual and applied factory overhead
Identifying Cost Behavior 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.
 Cont….. 60
Factory overhead expenses include costs that may be classified as variable, fixed, or
mixed.
 Cont…….. 61

Definition of absorption costing

Absorption costing is 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.
 Cont……. 62
The Purpose of Absorption Costing
 There is a view that inventory should include a fair share of production overhead cost.
 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.
Criticisms of absorption costing
 Absorption costing does not provide reliable information about profitability.
 There are better methods of measuring profitability, such as marginal costing.
 Cont……. 63

 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 centers. If a cost center is responsible for the entire cost of an
item of expenditure, the entire cost is charged directly to the cost center.
Apportionment
 Many overhead costs are costs that cannot be allocated directly to one cost center, because they
are shared by two or more cost centers.
 These costs are apportioned between the cost centers.
 ‗Apportionment‘ means sharing on a fair basis.
Absorption (also called overhead ‗recovery‘)
 When overheads have been allocated and apportioned to production cost centers, they are charged
to the cost of products manufactured in the cost center.
 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.
Cont……… 64
65