Cost CH-2
Cost CH-2
Cost CH-2
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.
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Materials:
Direct Material: It refers to the material which forms part of the finished
product.
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When an entity purchases materials from a supplier, the purchasing process should be properly
Any purchase of materials from a supplier should be properly authorized and approved at the
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.
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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
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.
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.
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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.
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2. Inventory records 13
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.
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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
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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.
Ordering costs:
These are the costs of placing an order and receiving the supplies.
These costs incur due to the shortage of inventories for meeting the needs of
production and consumer demand.
.
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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‖.
E.O.Q=√(2D X S)/( H)
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Where:
Assumptions of EOQ:
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
S =$ 50 H = $4 D = 5000 unit
Therefore, the company should order 791 units at a time to minimize the
total cost of inventory management.
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Bill of Materials
It serves as a basis for the computation of direct material cost when quotations are
submitted.
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
However, when adequate information is not given about the factors of this
formula, the second formula can be used if information is available about
the factors of this formula.
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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)
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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.
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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.
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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:
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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.
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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.
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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.
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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.
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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
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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.
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